March 06, 2014
The Supreme Court was the focus of securities litigation this week. Oral argument was presented in the long running Halliburton case where the Petitioners are seeking to rewrite the rules for bringing securities fraud class actions cases by either overruling Basic and its fraud-on-the-market presumption or substantially modifying it. The High Court also handed down its ruling in Lawson, broadly construing the protections afforded whistleblowers under the Sarbanes-Oxley Act and agreed to hear next term a case on the pleading requirements for a Securities Act Section 11 claim.
The SEC continued to prevail in the Circuit Courts. In a ruling by the Tenth Circuit, the Commission’s position that partnership interests could be securities despite their form and a claim that the interests were not securities was sustained by the Court.
The Commission also brought a financial fraud action against five former attorneys, executives and financial professionals from collapsed law giant Dewey & LeBoeuf LLP centered on a fraudulent 2010 $150 million bond offering. A parallel criminal case was filed in the New York Supreme Court against four former Dewey officials. The SEC also prevailed on summary judgment in a case centered on a fraudulent investment scheme while filing an action to halt an on-going pyramid scheme soliciting investors through social media and a proceeding based on Rule 105 short selling violations that yielded the largest amount paid to date to settle such a proceeding.
Remarks: Commissioner Michael S. Piwowar addressed the AIMA Global Policy & Regulatory Forum, New York City (March 6, 2014). He outlined his approach to international regulatory issues (here).
Remarks: Commissioner Daniel M. Gallagher addressed the Institute of International Bankers 25th Annual Washington Conference, Washington, D.C. (March 3, 12014). The Commissioner’s remarks focused on capital requirements and their possible effects in the securities markets (here).
Testimony: Acting Chairman Mark P. Wetjen testified before the House Appropriations Subcommittee on Agriculture, Rural Development, Food and Drug Administration, and Related Agencies (March 6, 2014). The testimony focused on the budget for the fiscal year (here).
Fraud-on-the-market theory:Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317(Argument March 5, 2014). The Court heard argument this week on issues that are critical to securities fraud class actions. The issues under consideration are whether 1) Basic Inc. v. Levinson, 485 U.S. 224 (1988), which adopted the fraud-on-the-market theory in securities class actions, should be overruled or 2) the approach should be modified so that evidence of price impact is permitted at the certification hearing. At argument the parties emphasized the key themes from their briefs while the Justices posed questions that at times sounded more like position statements. Petitioners argued that Basic should be overruled, contending that the fraud-on-the-market presumption is outmoded in view of recent scholarship and that it is out-of-step with the Court’s current jurisprudence on Rule 23. Respondents defended Basic, arguing that its presumption is not economics but a substantive provision of federal securities law and that the decision is also consistent with the approach of the Court in its recent class certification cases. Much of the questioning from the Court focused on what Justice Kennedy called a “midpoint” approach under which event studies would be used at certification regarding price impact. The arguments are summarized here.
Whistleblowers: In Lawson v. FMR LLC, No. 12-3 (Decided March 4, 2014) the Court held that the whistleblower provisions of the Sarbanes-Oxley Act of 2002, Section 1514A apply to employees of entities in a mutual fund cluster who are working for a non-public entity that is affiliated with the public company fund which has no employees. Accordingly, the provision “shelters employees of private contractors and subcontractors, just as it shelters employees of the public company served by the subcontractors and subcontractors.”
Section 11 liability: Omnicare, Inc. v. The Laborers District Council Construction Industry Pension Fund, No. 13-435 (March 3, 2014). The Court agreed to resolve a split in the circuits regarding the pleading requirements for a Securities Act Section 11 claim. Specifically, the Court will determine if to allege such a claim a plaintiff may “plead that a statement of opinion was ‘untrue’ merely by alleging that the opinion itself was objectively wrong, as the Sixth Circuit has concluded, or must the plaintiff also allege that the statement was subjectively false—requiring allegations that the speaker’s actual opinion was different from the one expressed—as the Second, Third, and Ninth Circuits have held?” The case will be heard next term.
SEC Enforcement – Litigated Actions
Investment fund fraud: SEC v. StratoComm Corporation, Civil Action No. 1:11-CV-1188 (N.D. N.Y.) is a previously filed action against the firm, CEO Roger Shearer and IR director Craig Danzig. The complaint alleges that the defendants falsely portrayed the company as a manufacturer and seller of telecommunications systems in underdeveloped countries. Investors were sold over $4 million in stock. In reality the company had no operations or revenue. Much of the money raised was used by Mr. Shearer for his own purposes. The Court granted the Commission’s motion for summary judgment, determining that the company had violated Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). The Court also concluded that Mr. Shearer violated Securities Act Sections 5(a) and 5(c) and aided and abetted violations of Exchange Act Section 10(b) and found him liable as a control person of the company. Finally, the Court concluded that Mr. Danzig also violated the registration provisions along with Securities Act Section 17(a), Exchange Act Section 15(a) and that he aided and abetted the Section 10(b) violations by the company. Remedies will be considered at a later date. See Lit. Rel. No. 1:11-cv-1188 (March 5, 2014).
SEC Enforcement – Filed and Settled Actions
Statistics: This week the Commission filed or announced the filing of 2 civil injunctive, DPAs, NPAs or reports and 1 administrative proceeding (excluding follow-on and Section 12(j) proceedings).
Financial fraud: SEC v. Davis (S.D.N.Y. Filed March 6, 2014) is an action against five executives and finance professionals formerly with the collapsed law firm of Dewey & LeBoeuf LLP. The defendants are: Attorney Steven Davis, chairman of the firm; attorney Stephen DiCarmine, executive director; Joel Sanders, CFO; Frank Canellas, finance director; and Thomas Mullikin who held several accounting positions. The complaint alleges that in connection with a $150 million private bond offering in 2010 the firm and the defendants engaged in financial fraud, furnishing purchasers a PPM with false financial information. In fact, the financial fraud traced back to 2008 when the firm began falsifying its books. Bond purchasers were also furnished with quarterly financial information which was false. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is in litigation. See also People of the State of New York v. Davis (Sup. Ct. N.Y. Filed March 6, 2014)(parallel 106 count indictment against Messrs. Davis, DiCarmine, Sanders and Warren based on the accounting fraud at the law firm).
Short selling: In the Matter of Worldwide Capital, Inc., Adm. Proc. File No. 3-15772 (March 5, 2014) is a proceeding which names as Respondents the firm and Jeffrey Lynn. The Order alleges that from the end of October 2007 through February 2012 the firm sold shares short during the time period prohibited by Rule 105, Regulation M on 60 occasions and then purchased shares of the same firm in the follow-on offering. Respondents had trading profits of $4,212,797. To resolve the proceeding Respondents consented to the entry of a cease and desist order based on Rule 105, Regulation M. They also agreed to disgorge their trading profits along with prejudgment interest and pay a civil monetary penalty of $2,514,571. The total of the three payments – about $7.2 million – is the largest monetary sanction for a Rule 105 short selling violation ever imposed, according to the Commission press release. See Release 2014-43 (March 5, 2014).
Pyramid scheme: SEC v. Fleet Mutual Wealth Ltd,Civil Action No. CV 14-01409 (C.D. Cal. Filed Feb. 25, 2014) is an action against Fleet, a Hong Kong company, and MWF Financial Limited, a Cyprus company. Through the social media, defendants offered interests in a fund that was supposedly engaged in innovative high-frequency trading that yielded guaranteed returns of 2% to 3% per week. About 150 U.S. investors were solicited yielding about $300,000 for the defendants. In fact, virtually everything about the claimed investment program and the companies was false from its claimed Hong Kong headquarters and New York data-center to the list of executives on the website, according to the complaint. That complaint alleges violations of Exchange Act Section 10(b), each subsection of Securities Act Section 17(a) and Securities Act Sections 5(a) and (5)(c). The Commission obtained and Order deactivating the website and freezing the assets. The case is in litigation.
SEC v. Shields, No. 12-1438 (10th Cir. Decided Feb. 24, 2014) is an action in which the Commission won the reversal of an order dismissing its complaint. The defendants are Jeffory Shields, GeoDynamics, Inc.. and several other business entities affiliated with Mr. Shields. They are alleged to have raised over $5 million selling interests in four purported oil and gas exploration and drilling joint ventures to sixty investors in twenty eight states. The interests were marketed through cold calls. Investors were promised annual returns that ranged from 256% to 548%. The investors solicited had little or no experience in the oil and gas business but were told about the unique qualifications of GeoDynamics as an experienced oil and gas driller and operator. Investors who expressed an interest in the program were furnished with documents which represented that they would acquire a partnership interest in a specific project, that they would have the typical rights of a partner and that their money would be in an account segregated from other offerings and dedicated to developing the oil and gas properties. The documents specifically stated that in the view of the defendants the partnership interests were not securities.
The SEC claimed that despite the terms of the contracts, investor funds were in fact comingled. Investors had no access to the books and records and much of the money raised was used by the defendants for their own purposes, according to the Commission. In fact, only a little over $600,000 of the investor funds went to oil and gas development. The complaint alleged fraud.
The District Court granted defendants’ Motion to Dismiss under Federal Rule 12(b)(6), concluding that the limited partnership interests were not securities. In reaching that conclusion the Court relied primarily on the offering documents. The Circuit Court reversed.
Here the critical question is not the form of the instrument but its substance. In determining if an instrument is an investment contract, and thus subject to the federal securities laws, the classic test is whether the scheme “involved an investment of money in a common enterprise with profits to come solely from the efforts of others.” (internal citations omitted). In applying this test the Tenth Circuit has adopted a “strong presumption that an interest in a general partnership is not a security . . . because the partners-the investors-are ordinarily granted significant control over the enterprise.”
In this case, however, the SEC has overcome that presumption.
First, the documents demonstrate that that investors had little control. While the joint venture agreements granted the investors certain rights, in fact investors were still required to rely on GeoDynamics. The turnkey contracts were the key to the success of enterprise and profits “because they were the only way these oil and gas investments could generate money.” Second, the investors were selected because they had little experience in the area. They were thus dependent on the defendants. Finally, the investors received all of their information from the defendants and were encouraged to rely on their touted expertise. Collectively these factors are sufficient to overcome the presumption. Accordingly, the order dismissing the action is reversed and remanded to the District Court for further proceedings
March 05, 2014
Yesterday the Supreme Court heard argument in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317. The case has the potential to rewrite the rules for how securities class actions are brought. This is the concluding segment of a three part series discussing the issues and arguments presented. Parts I and II, published earlier this week, reviewed, respectively, the arguments presented by Petitioners and Respondents. This part outlines the arguments presented, and key questions posed, by the Justices at oral argument.
Oral argument: At oral argument each party emphasized the key themes from their briefs while the Justices posed questions that at times sounded more like position statements. Petitioners argued that Basic should be overruled, contending that the fraud-on-the-market presumption is outmoded in view of recent scholarship and out-of-step with the Court’s current jurisprudence on Rule 23. While Petitioners conceded that generally information is translated into price, they argued that many traders do not specifically rely on the market. Alternatively, Petitioners advocated that at class certification plaintiffs should be required to prove the Basic elements and price impact.
Respondents defended Basic, arguing that under Amgen its presumption is not economics but a substantive provision of federal securities law. The decision is also consistent with the approach of the Court in Wal-Mart and Comcast, Respondents claimed, which contrasts with Respondents’ alternate theory that would require proof of a merits issue at certification.
The Government, arguing in support of Respondents, contended that investors do rely on the markets, contrary to Petitioners’ supposition, and that Basic is consistent with the Court’s recent jurisprudence on class certification. The Government did concede in response to questions from the Court that modifying the Basic approach to permit price information at certification would not have drastic consequences and may benefit plaintiffs.
Throughout the arguments members of the Court questioned the advocates, focusing repeatedly on three key points: 1) The impact of certification and that fact that few cases go to trial; 2) The effect of enacting the PSLRA and SLUSA after the Court’s decision in Basic; and 3) The prospect of requiring evidence of price impact through event studies at certification.
Petitioners: Petitioners focused on their key point: Basic “should be overruled because it was wrong when it was decided and it is even more clearly erroneous today. Basic substituted economic theory for the bedrock common law requirement of actual reliance . . . Basic’s judicially created presumption preserves an unjustified exemption from Rule 23 that benefits only securities plaintiffs . . . [it] has proven unworkable, has been undermined by later developments, and has proven to have harmful consequences for investors and companies alike.”
Justice Kagan sought to clarify Petitioners position asking if they were “saying that Basic is wrong, or are you saying that something has changed since Basic? Because usually that’s what we look for when we decide whether to reverse a case, something that makes the question fundamentally different now than when we decided it. And that’s especially so in a case like this one where Congress has had every opportunity, and has declined every opportunity, to change Basic itself.” Responding, Petitioners claimed that the Court has changed its approach to interpreting a Section 10(b) claim, that it has consistently held that presumptions are inappropriate at certification and that the “economics have changed.”
Subsequently, Petitioners agreed, under questioning from Justice Kagan, that market prices generally respond to new material information but contended that the “binary yes-or-no” approach is a problem. Justice Kagan disputed the characterization of “binary” choice. Justice Alito then turned the discussion to the question of whether in fact the Basic presumption is rebutted. Petitioners claimed that “it is virtually impossible,” a point which would later be termed “wrong” by Respondents.
Justice Ginsburg and Chief Justice Roberts shifted the argument to another issue. First, Justice Ginsburg noted that Petitioners claim is not focused on the ability to rebut the presumption but “when” – that is, at what point in the proceeding can the Basic presumption be rebutted. Petitioners retorted, arguing that “we are not aware of a single instance in which this Court allowed a presumption to be invoked for the very purpose of one stage of litigation, but held that the defendant’s right to rebut must be delayed to a latter state.”
The argument shifted again, this time to a key Petitioner point as Chief Justice Roberts focused on the contention that Basic is built on outdated science: “I understand your friend on the other side to acknowledge that the efficient market theory is not perfect . . . I understand you to acknowledge that it’s accurate to some extent, but that the exceptions . . override the extent to which it is. In other words, you’re each sort of dealing with at the—at the—if not the margins, you know, most of the time it’s sufficient, you say too much of the time it’s not. How am I supposed to review the economic literature and decide . . .” The Court “should get out of the business of reviewing economic literature . . . “ and make reliance an individual question as in Exchange Act Section 18(a), Petitioners responded.
Shifting to a topic which would thread through the remainder of the argument, Justice Kennedy raised what he called a “midpoint” — the use of event studies regarding price impact at certification suggested in an amicus brief — and asked Petitioners to comment on the notion. Petitioners allowed that if Basic remains “then it only makes sense to focus like a laser on the only relevant question, whether the misrepresentation distorted the market price.” The Second Circuit currently follows this practice the Court was told. The cost and difficulty of presenting such evidence would be about the same as for establishing the Basic requirements, Petitioners noted.
Petitioners’ concluded with an exchange involving Justices Breyer and Scalia on the propriety of requiring proof of price distortion at certification. When Justice Breyer questioned this approach, Petitioners argued that it is the same as requiring proof of market efficiency and publicity. Justice Scalia suggested that few cases get to the merits, prompting Justice Breyer to state that “I see that and I understand that. But that still strikes me as a different legal issue . . . I still have my question, why?”
Respondents: Respondents began by “emphasizing, as this Court did in Basic, that the premise of the Basic decision was not economic theory; it was commerce. This Court said the premise was Congress’s premise. And I think that when this Court decided the Amgen case, it said that the fraud on the market presumption was a substantive doctrine of Federal securities law. . . It has been ratified by Congress in the PSLRA and in SLUSA.” Justice Alito disputed this contention, reading Section 203 of the Act which says that “’Nothing in this Act or the amendments made by this Act shall be deemed to create or ratify any implied private right of action . . . ‘” After determining that Amgen did not cite that Section, Justice Scalia noted that a distinction must be drawn between situations when Congress acts “on the assumption that the courts are going to do what they’ve been doing . . . from approving what the courts have been doing.”
Justice Kennedy returned the discussion to his midpoint, inquiring why event studies could not be presented at certification. Respondents, disputing Petitioners’ claim that the burden would be about the same as establishing the Basic requirements, telling the Court “You could . . . “ but it has to be done for each date in the case and “it’s very expensive. It’s a lot of expert testimony. It is why these things, for example, at the summary judgment stage, are very complicated. Now, an event study that demonstrates the efficiency of the market is far simpler.” Justice Kennedy then reverted to the claim that Congress had essentially foreclosed overruling Basic, noting that “if later economic theories show that the market doesn’t react in the way Basic assumed it automatically did, then certainly Congress would not wish to foreclose the Court from considering that new evidence if it was a strong, clear and convincing, et cetera.”
Later Justice Kennedy again probed the underpinnings of Basic, inquiring about Petitioners’ contention that there is a “whole new genre of investors that are quite different from the fellow that’s sitting at home reading the Wall Street Journal [and relying on market price].” Allowing that Petitioners are correct, there are new types of investors, Respondents nevertheless told the Justice and the Court that “those people rely on the integrity of the market. They talk about these high-frequency traders that trade in and out. Well, if they trade in and out during a day, most of them will not be affected . . . Its only when somebody buys when the price is inflated . . .and then sells after the corrected disclosure that there is damage. These people are all buying and selling based on the integrity of the market price.”
This segment of the argument concluded with a reversion to familiar themes: The Basic presumption is rebuttable but most cases do not make it past certification. First Justice Ginsburg reiterated the rebuttable nature of the Basic presumption. Chief Justice Roberts then noted that “You [Respondents] don’t dispute, though that you usually don’t get to the merits stage once the class has been certified, do you?” Respondents replied “That is true . . . but a lot of that is because there are summary judgment motions. Remember, you have – you have three merit stages already, a pleading stage, which under the PSLRA, under this Court’s decision in Dura, is a real obstacle; second, you have summary judgment; and then third, you have the trial. More than half of all securities class actions, summary judgment is granted in whole or in part, 37 percent wholly, another 25 percent in part . . . [and] You could have summary judgment at the class certification stage . . . if you wanted to move price impact or materiality or any issue into an earlier time frame . . .” Justice Scalia then asked about Petitioners’ claim that certification is rarely denied prompting Respondents to state: “Well, I think he’s wrong.”
The Government: The Government attacked two key points presented by Petitioners. “First . . . that investors have adopted new strategies that, in his view, don’t rely on the integrity of the market price. And I think it’s certainly true that investors have devised a wide array of strategies in an effort to beat the market, but it’s hard to imagine one that would render irrelevant evidence that the market price had been distorted by fraud . . . The second thing I wanted to respond to was Petitioners’ assertion that Basic is out of keeping with this Court’s more recent decisions regarding the requirements of Rule 23. And I think that in fact, with – at least with respect to the interaction between the merits and Rule 23, the Court in Basic did precisely what this Court’s decisions in Wal-Mart and Comcast tell courts they out to do . . . “
The Government’s argument concluded with Justice Kennedy returning his midpoint regarding event studies and inquiring about the consequences of such a rule. The Government responded, noting that “I understand the . . . [proposal you are] referring to be the one that basically advocated a shift away from analyzing the general efficiency of the market and focusing only on the effect or lack of effect on the – particular stock. I don’t think the consequences would be nearly so dramatic. In fact if anything, that would be a net gain to plaintiffs, because plaintiffs already have to prove price impact at the end of the day.”
Rebuttal by Petitioners: In a brief rebuttal, Petitioners reiterated two key themes. First, that very few cases survive until summary judgment. Second, under their alternate proposal, a securities law plaintiff should have to prove at certification each of the Basic elements and price impact.
A decision from the Court is expected by the end of the term, June 30, 2014.
March 04, 2014
On Wednesday, March 5, 2014 the Supreme Court will hear argument in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317. The case has the potential to rewrite the rules for how securities class actions are brought. This three part series discusses the issues and arguments presented. Part I, published yesterday, outlines the arguments being presented by Petitioners. Part II, set forth below, outlines the arguments being presented by Respondents. The concluding segment, to be published tomorrow, will outline the arguments presented, and key questions posed, by the Justices at oral argument.
Respondents position keys to the supposition that Basic was correctly decided and the disputes regarding the efficient market theory do not impact the underlying rationale of the decision which is the predicate for the securities laws and SEC regulation. In support of this position Respondents advance six key arguments: 1) Basic is predicated on a common-sense rationale and was correctly decided; 2) criticism of the efficient market hypothesis do not justify overruling Basic; 3) the doctrine of stare decisis applies with special force here because of Congress; 4) overturning Basic would represent the demise of securities class actions and undercut SEC regulation; 5) Halliburton’s Section 18(a) claims are wrong; and 6) Basic is consistent with the Court’s class certification jurisprudence. Respondents also contend that requiring plaintiffs to establish price impact at certification – Petitioners’ alternate argument – is contrary to the Court’s class certification decisions.
First, basic is predicated on common sense principles and was correctly decided, according to Respondents. In deciding Basic, the Court’s decision was consistent with the position of the SEC, nearly every court which had considered the issue and the economic reality of the securities markets. Interposed between the buyer and seller is the market. The economic presumption on which the decision is based “recognizes that, in well-developed markets, material public information is generally reflected in the market price of a security and that investors generally rely in common on the integrity of this market price in making investment decisions.” The presumption is also consistent with the congressional policy embodied in the 1934 Act since “’Congress expressly relied on the premise that securities markets are affected by information, and enacted legislation to facilitate an investor’s reliance on the integrity of those markets . . .’”
The Basic presumption is not based on the mere fact that the stock is publically traded. Rather, plaintiffs must demonstrate that the market for the security is open and well-developed, that misrepresentations were made and in time the truth was revealed. “Establishing these predicates demonstrates that reliance for all class members will rise or fall together, and that common questions will predominate over individual ones.” Contrary to Petitioners’ claims, courts have frequently found that plaintiffs have failed to establish the prerequisites for invoking the presumption.
Citing the Court’s prior decisions in Affiliate Ute [Affiliated Ute Citizens of Utah v. U.S., 406 U.S. 128 (1972)] and Mills [Mills v. Electric Auto-Lite Co., 396 U.S. 375 (1970)], Respondents claim that Basic was correctly decided since it is grounded in the underlying rationale of the securities laws. The disclosure approach adopted in the statutes is built on the theory that there cannot be honest markets without honest publicity. The statutes were enacted “against the backdrop of widespread acceptance of the fraud-on-the-market principle.” In adopting that principle in Basic, the Court utilized the approach of Affiliated Ute which dispensed with the requirement for positive proof of reliance in omission cases. That decision was built on Mills which held that a plaintiff alleging a violation of Exchange Act Section 14(e) need not prove reliance at all since it would not be feasible. There the Court held that the requisite causal connection was supplied by proof of materiality, meaning that the misstatement or omission may have been important to the investor.
Second, Halliburton’s claim that economic disputes over the efficient market theory undercut the foundation of Basic is simply wrong. Whatever the merits of those arguments, Basic is not predicated on establishing perfect efficiency. Rather, the question is whether the market segment where the stock is traded has sufficient efficiency properties such that misinformation is likely to distort the price of the security. Thus several of the articles cited by Halliburton acknowledge that the presumption does not “rise or fall with the . . .” efficient market hypothesis.
Third, in this case the doctrine of stare decisis applies with special force. Halliburton’s claim that Congress has not addressed Basic’s presumption is incorrect. At the time Congress considered the PSLRA, the House of Representatives had before it a bill which would have required actual reliance, effectively doing away with the fraud-on-the-market theory of liability. As the Court noted in Amgen, that bill was supported by testimony. Congress recognized that the bill would undo Basic and did not adopt it. Rather, it enacted a statute which is structured in such a fashion that it is effectively based on the presumption. As the Court stated in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) “’Congress thus ratified the implied right of action [in adopting the PSLRA]’ and’[i]t is appropriate for us to assume that when [the PSLRA] was enacted Congress accepted the Section 10(b) private cause of action as then defined but chose to extend it no further.” (emphasis original).
Fourth, overruling Basic would have an untoward impact on private securities actions and the deterrent role they play as well as undercut SEC regulation. Overruling Basic would preclude certification in the “vast majority of private securities-fraud class actions . . .” This would leave many defrauded investors without recourse. That would be contrary to the repeated statements of the Court noting that private securities litigation is an “essential supplement” to criminal prosecutions and SEC civil enforcement – a position which has also been repeatedly asserted by the SEC. It would also undercut their recognized deterrent impact of the suits on fraud. Adopting the position of Halliburton would also call into question “the very premise of the federal securities laws that ‘[t]he investing public has a legitimate expectation that the prices of actively traded securities reflect publicly available information about the issuer of such securities.’” This would indirectly undercut SEC regulation and policy.
Fifth, Halliburton’s claim that the reliance element of a Section 10(b) claim should be modeled on Exchange Act Section 18(a) misses the mark. Not only does that argument ignore the history of the PSLRA but also the fact that Section 9 of the Exchange Act is the proper comparison. Section 18 does not address price manipulation and is narrowly limited to statements in published documents filed with the SEC. Section 9, however, addresses manipulation as does Section 10. Both Sections address intentional conduct, unlike Section 18 which does not. Importing the Section 18 reliance requirement into Section 10 would destroy the symmetry between Sections 9 and 10.
Sixth, Basic is consistent with the Court’s recent class certification jurisprudence. To secure certification a securities fraud plaintiff utilizing Basic must establish the efficiency of the market, the timing of the class members’ trades and that the defendants’ misstatements were public. Those requirements are consistent with Rule 23 which is the predicate for the Court’s recent decisions in Wal-Mart and Comcast. Indeed, Wal-Mart “approvingly discussed the fraud-on-the-market presumption without suggesting that it was somehow inconsistent with its holding that Rule 23 compliance must be ‘affirmatively demonstrate[d].’’
Finally, Petitioners’ proposed modification of Basic is inconsistent with the Court’s prior decision in this case and Amgen. In Amgen, which built on the Court’s first determination in this case, the Court held that a securities law plaintiff need not establish materiality at the class certification stage because it can be proven through evidence common to the class. There is no risk that a failure of proof would result in individual questions predominating, a key Rule 23 question. The same principles apply to the question of price impact. Proof of that element, which frequently requires discovery, goes to the merits, not the Rule 23 issues.
Amicus briefs:Several amicus briefs were filed in support of Respondents. One was submitted by the United States and the SEC. That brief, premised on the notion that the economic theory of Basic also constitutes the underpinnings of the securities laws, begins by arguing that the fraud-on-the market presumption is an appropriate manner in which to prove reliance in a private securities damage action. Securities are traded in impersonal markets. The fraud-on-market presumption, as a method for proving reliance, is based on two “overarching premises about the operation of developed securities markets. The first is that material, publicly-disseminated information about stock traded on such a market generally influences the stock’s price. . . Second, the decision in Basic reflects the additional premise that investors typically do, and reasonably may, rely on the integrity of the market price . . .” Adopting a presumption premised on those points furthered the policies of Congress in enacting the Exchange Act in 1934 which in part was to “facilitate an investor’s reliance on the integrity of those markets.” At the same time, the Court did not adopt “a particular economic theory” or determine how rapidly information might be absorbed into price. The Court did make it clear that the presumption does not apply in every case and that it may be rebutted.
The government went on to note that Congress has acquiesced in the fraud-on-the-market presumption. In adopting the PSLRA, Congress recognized, as Amgen states, that private securities-fraud actions further important public policy interests such as providing restitution to defrauded investors. In both the PSLRA and SLUSA Congress not only refined the contours of the Section 10(b) private right of action, but expressly rejected efforts to end the use of the fraud-on-the market doctrine.
Academic debate regarding the efficient market theory does not detract from Basic. Economists debate various versions of the theory “in order to determine when investors can take advantage of arbitrage opportunities.” The soundness of the fraud-on-the market theory does not depend on whether or when prices react to information. “Whatever the state of academic debate on that particular question, there is widespread agreement on the basic point that public disclosure of material information generally affects the prices of securities traded on efficient markets.” And, the Basic framework is sufficiently flexible to accommodate criticism of the presumption and permit defendants to present evidence that the markets did not have the specific information.
Finally, it would be inappropriate to permit evidence of price impact at the certification stage. Price impact is “integrally related to the element of loss causation. Unless the alleged misstatements impacted the stock price, the plaintiff will be unable to show that he relied on a distorted price and suffered losses when the truth came to light.” This merits element is thus properly considered at a later stage in the proceeding, not at certification.
A group of Financial Economists also filed an amicus brief in support of Respondents. The group included Professor Eugene Fama of the University of Chicago, widely regarded as the father of the efficient market theory and the winner of the 2013 Nobel Price in Economics for his work on the efficiency of the capital markets. The group acknowledges that, as Petitioners claim, there is controversy about the efficient market theory. Those controversies focus on the various forms of the theory – labeled “weak,” “semi-strong” and “strong.” The debate has played out through a series of empirical studies. “But economists generally do not disagree about whether markets respond to material information. As Professor Shiller – a leading critic of the efficient market theory — recently wrote in explaining the extent of his disagreement with Professor Fama, ‘Of course, prices reflect available information.’” (emphasis original). In this regard “it is important to be clear that economists generally agree that stock prices respond to material information in a predictable direction.” The brief concludes by noting that “[m]ost important, economists generally agree that material information – whether truthful or fraudulent – will generally affect the price of a stock and that the effect will be in a predictable direction.”
Finally, an amicus brief was submitted in support of Respondents by former SEC Chairmen William H. Donaldson and Arthur Levitt, Jr. Congress, in designing the federal securities laws, based the statutes on the supposition that available, material information is reflected in the price of securities, according to the two former Chairmen. The SEC has followed the lead of Congress. The Commission has “long relied on the principle that market prices of actively traded securities generally reflect publicly available information in fashioning regulations. It has actively worked to foster the relationship between prices and information, so that investors may continue to invest with confidence in the integrity of market prices.”
The Commission has also used this approach to simplify and lessen the burden of regulation. For example, in adopting the rules relating to the integrated disclosure system the agency stated that “’integrated disclosure has, since its inception, been premised on the idea that a company’s disclosure in its registration statement can be streamlined to the extent that the market has already taken that information into account.’” (emphasis original). Rejecting that approach would call into question the rationale for many of the SEC’s regulations and would require additional, burdensome regulation. “In short the proposition that market prices of actively traded securities generally reflect publicly available information is a key premise of the system of federal securities regulation . . . This Court’s recognition in Basic that investors too rely on that premise is well-supported and should be reaffirmed.”
Next: Argument before the Court – Part III (conclusion).
March 03, 2014
On Wednesday, March 5, 2014 the Supreme Court will hear argument in Halliburton Co. v. Erica P. John Fund, Inc., No. 13-317. The case has the potential to rewrite the rules for how securities class actions are brought. This three part series will discuss the issues and arguments presented. Part I, set forth below, outlines the arguments presented by Petitioners. Part II, to be published on Wednesday, will outline the arguments being presented by Respondents. The concluding segment, to be published on Thursday, will outline the arguments presented, and key questions posed, by the Justices at oral argument.
Petitioners have presented two critical questions for resolution by the High Court. The first seeks to overrule Basic and its fraud-on-the-market presumption of reliance while the second would substantially modify the class certification process by permitting the introduction of evidence concerning price impact at the certification stage. Petitioners frame the issues this way: 1) “Whether the Court should overrule or substantially modify the holding of Basic Inc. v. Levinson, 485 U.S. 224 (1988), to the extent that it recognizes a presumption of classwide reliance derived from the fraud-on-the market theory. 2) Whether, in a case where the plaintiff invokes the presumption of reliance to seek class certification, the defendant may rebut the presumption and prevent class certification by introducing evidence that the alleged misrepresentations did not distort the market price of the stock.”
Basic is a key predicate for many securities class actions. It permits plaintiffs to establish the element of reliance through the use of a rebuttable presumption, the fraud-on-the-market theory. That theory holds, as the Court explained, “that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business . . . Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements . . .” In adopting the presumption the Court noted that its task was “not to assess the general validity of the theory, but to consider whether it was proper for the courts below to apply a rebuttable presumption of reliance, supported in part by the fraud-on-the-market theory.”
While the Petitioners and their amici in Basic argued that the “fraud-on-the-market theory effectively eliminates the requirement that a plaintiff . . .” prove reliance, the Court rejected the claim. In doing so the Court agreed that reliance is a key element of a claim, but noted that there is “more than one way to demonstrate the causal connection . . .” Not only is the presumption “supported by common sense and probability . . . .[but by] empirical studies . . [that] have tended to confirm Congress’ premise that the market price of shares traded on well-developed market reflects all publicly available information . . .” according to the Court. Finally, presumptions are typically used by courts where, as here “direct proof, for one reason or another, is rendered difficult.” And, presumptions can be rebutted, in this instance under Basic, by any proof that breaks the connection.
The underlying case: This is the second time the High Court has heard this case. In the first the Court reversed a denial of class certification by the District Court which had been affirmed by the Fifth Circuit Court of Appeals. The denial was predicated on then existing Fifth Circuit precedent which required that a securities law plaintiff prove loss causation to prevail on a certification motion. The Court predicated its decision on the Requirements of Federal Rule 23 which governs certification, concluding that the question of loss causation is not relevant to the issue of whether “reliance was capable of resolution on a common, classwide basis.”
The securities fraud complaint in this case was brought against Halliburton and one of its officers. Plaintiffs claimed that the defendants inflated the share price for Halliburton by downplaying the firm’s estimated asbestos liability and overstating revenue in certain business segments and the benefits of a merger. The complaint also claimed that after plaintiffs purchased shares the defendants made corrective disclosures that caused the share price to decline. Certification was sought on behalf of all persons who purchased shares within a specified time period.
Following remand from the Supreme Court the District Court certified the class. In granting the motion the Court rejected a defense contention that price impact must be demonstrated to obtain class certification. The Court of Appeals affirmed, relying on the Supreme Court’s decision in Amgen, Inc. v. Conn. Ret. Plans & Trust Funds, 133 S.Ct. 1184 (2013. There the Court held that in a fraud-on-the-market case the plaintiff need not establish materiality to obtain class certification. That element can be proven through evidence common to the class and thus failure to prove it will not present a situation in which individual questions of law or fact predominate over common ones which is the key Rule 23 question. Following this reasoning the Court of Appeals concluded that price impact is an objective inquiry that relies on evidence common to the class and therefore need not be established at certification.
Arguments: Petitioners have advanced five key arguments is support of either overruling or modifying Basic: 1) The reliance requirement of a Section 10(b) cause of action should have been modeled on Exchange Act Section 18(a), not the fraud-on-the-market theory; 2) Recent scholarship undermines the key premise of the decision; 3) Basic is out of step with the Court’s more recent class action case law; 4) Policy factors support overruling Basic; and 5) Alternatively, plaintiffs should be required to prove price impact to obtain certification. Threaded through these points is the notion that the cause of action is judge made and should therefore be constricted.
First, since the cause of action under Exchange Act Section 10(b) is judge made it should have been modeled on the most analogous express cause of action. That is Exchange Act Section 18(a) since it broadly authorizes damages for misrepresentations by a defendant who did not buy or sell from the plaintiff when the statements were made. That Section requires proof of actual reliance. Indeed, the legislative history demonstrates that Congress discarded an early version of the Section which lacked a reliance requirement. In adopting a presumption in place of actual reliance Basic was in error since “[o]nce Congress required an affirmative showing of actual reliance for causes of action that Congress felt were important enough to create, what could justify permitting a far lesser showing for causes of action that the judiciary crafted? By disregarding the Act’s textual command in favor of a fictional presumption of reliance, Basic exceeded the Court’s proper judicial role.” (emphasis original).
Second, recent scholarship has discredited the predicate of Basic. That decision relied on then recent empirical studies to incorporate into federal law the notionthat when shares are traded on well developed markets they reflect all publicly available information. While this theory was supported at the time, a “new ‘consensus,’ that Basic’s efficient-markets theory ‘simply did not work in practice,’ emerged quickly . . . Shortly after Basic, a leading professor explained that ‘the opposite’ of Basic’s presumption ‘appears to be true’ . . . That is partly because many investors’ ‘strategies’ involve ‘attempt[ing] to locate undervalued stocks in an effort to ‘beat the market,’ meaning that they ‘are in essence betting that the market for securities they are buying is in fact inefficient.’” (emphasis original).
More importantly, according to Petitioners, “overwhelming empirical evidence” suggests that the capital markets are not fundamentally efficient, a point reflected in numerous papers. Even in well-developed markets public information is often not incorporated immediately into market prices. While this does not mean that markets are never efficient, the “binary” view of “yes” they are or “no” they are not is simply an incorrect view which, of necessity, is either under or over inclusive and, in the end lacks meaning. This means, according to Petitioners, that “[t]he bottom line is that ‘[t]he fraud-on-the-market . . . cause of action just doesn’t work. At least that is the consensus view among academics respecting the primary class action vehicle under federal securities laws.’”
Third, Basic is out of step with the Court’s recent decisions regarding class actions. The Court has insisted on actual, not presumed conformance with the requirements of Rule 23. “Basic flouts this principle by presuming common reliance in the face of near-certain falsity.” Indeed, in its recent Wal-Mart decision [Wal-Mart Stores, Inc v. Dukes, 131 S.Ct. 2541 (2011) the “Court required a punitive class to ‘affirmatively demonstrate . . . compliance’ with Rule 23, and thereby ‘prove’ . . . in fact” that the issues were common.” Comcast [Comcast Corp. v. Behrend, 133 S.Ct. 1426 (2013)] reinforced this point. Yet Basic reduces “predominance ‘to a nullity’” with its presumption.
Fourth a series of policy points supports overruling Basic. Those include the fact that securities class actions force settlement without regard to the merits; those actions poorly compensate investors; they do not deter culpable parties; they consume excessive judicial resources; and DOJ and SEC enforcement actions provide superior deterrence and compensation. Collectively these points, when coupled with the text of Section 18(a), scholar ship on markets and the Court’s recent class action jurisprudence, compel the conclusion that Basic is an accidental anachronism of the ‘ancient regime,’ in which the Court created and expanded causes of actions ‘to provide such remedies as are necessary to make effective the congressional purpose.’” [citations omitted]. That “regime” has passed according to Petitioners. Basic should be overruled.
Alternatively, if the presumption is to be retained, it should be modified to require plaintiffs to prove that the alleged misrepresentations impacted price. The predicate of Basic and its presumption is the claim that investors rely on the market price which reflects the misrepresentation. In view of that premise plaintiffs should be required to establish price impact to rely on the presumption.
Amicus briefs: A number of amicus briefs were filed in support of Petitioners. One was filed by Former SEC Commissioners and Officials and Law Professors. The former Commissioners included Paul Atkins, Edward Fleishman, Laura Unger and Joseph Grundfest. The professors included Stephen Bainbridge, Richard Painter and Jonathan Macey. This brief argued that the Court that it “need not wade into the complex and highly technical debate over the efficient markets hypothesis to answer the question here.” Rather, following its traditional approach for crafting elements to an implied cause of action it should look to Exchange Act Section 18(a), the most analogous provision. This is because it is the “only express right of action in existence in 1934 that authorizes damages actions for misrepresentations or omissions that affect secondary, aftermarket trading. It is the only express right that provides a cause of action for damages in favor of open-market purchasers and sellers against those . . . who allegedly made false or misleading statements, but did not transaction with the plaintiffs – the quintessential Section 10(b) class claim today.” In that Section Congress expressly required that reliance be established. Indeed, during the legislative debates a draft bill that did not require reliance was rejected.
The Securities Industry and Financial Markets Association also filed an amicus brief supporting Petitioners. Those organizations argued that Basic should be overruled, eschewing the alternative position advocated by Petitioners. Since Basic was decided a parade of horribles has resulted. Those include the fact that the economic theories on which the decision is based have been “debunked;” the expansion of securities fraud class actions has resulted in large judgments which, in the end, are paid by shareholders; and there is confusion in the courts as to how, if at all, the presumption can be rebutted.
“Defendants, faced with massive potential exposures and the distraction of lengthy and costly litigation, frequently are constrained to submit to in terrorem settlements. Moreover, there is little evidence that providing securities plaintiffs with a virtual free pass to certify a class has had a deterrent effect on misconduct by publicly traded companies, improved the quality of corporate disclosure, or resulted in meaningful recoveries that actually benefit investors in the aggregate, as opposed to their lawyers.” To resolve these issues Basic should be overruled. While the alternative suggested by Petitioners would be preferable to the status quo, “it lacks a sound economic basis,” the two organizations told the Court.
Next: The Respondents – Part II
March 02, 2014
The SEC prevailed in the Tenth Circuit Court of Appeals, securing a reversal of the district court’s order granting a motion to dismiss its complaint. The central issue in the case was if instruments which claimed to be partnership interests and expressly disclaimed being securities were in fact an investment contract under the federal securities laws. SEC v. Shields, No. 12-1438 (10th Cir. Decided Feb. 24, 2014).
The Commission filed an action against Jeffory Shields, GeoDynamics, Inc.. and several other business entities affiliated with Mr. Shields. The defendants are alleged to have raised over $5 million selling interest in four purported oil and gas exploration and drilling joint ventures to sixty investors in twenty eight states. The interests were marketed through cold calls. Investors were promised annual returns that ranged from 256% to 548%. The investors solicited had little or no experience in the oil and gas business but were told about the unique qualifications of GeoDynamics as an experienced oil and gas driller and operator.
Investors who expressed interest in the program received a packet of offering documents. The materials represented that partners would have all the rights and liabilities of a General Partner under Texas law. GeoDynamics would be the managing partner and would have responsibility for the day-to-day operations with broad power to bind the joint ventures, raise and spending funds and interpret the agreements. No investor had any power to bind the joint venture although they did have the right to vote on certain matters, remove the managing partner and terminate the partnership. Investors also had the right to inspect the accounting records and reports. Funds raised for each venture would be maintained in separate accounts and used to pay for drilling and completing wells under the turnkey contracts executed by GeoDynamics, according to the papers.
The SEC claims that despite the terms of the contracts, investor funds were in fact comingled. Investors had no access to the books and records and much of the money raised was used by the defendants for their own purposes. Only a little over $600,000 of the investor funds went to oil and gas development. The complaint alleged fraud.
The District Court granted defendants’ Motion to Dismiss under Federal Rule 12(b)(6), concluding that the limited partnership interests were not securities. In reaching that conclusion the Court relied primarily on the offering documents. The Circuit Court reversed.
Here the critical question is not the form of the instrument but its substance. In determining if an instrument is an investment contract, and thus subject to the federal securities laws, the classic test is whether the scheme “involved an investment of money in a common enterprise with profits to come solely from the efforts of others.” (internal citations omitted). In applying this test the Tenth Circuit has adopted a “strong presumption that an interest in a general partnership is not a security . . . because the partners-the investors-are ordinarily granted significant control over the enterprise.” While the SEC argued that this presumption should be disregard, it has in fact been adopted by other circuits the Court noted, citing decisions from the Third, Fourth, Fifth, Sixth and Eleventh Circuits.
Three factors to be considered when evaluating if the presumption has been overcome that are consistent with the definition of an investment contract: 1) Whether the agreement leaves so little power in the hands of the partner that it in fact distributes power as would a limited partnership; or 2) the partner is so inexperienced and unknowledgeable that he or she is incapable of intelligently exercising the partnership powers; or 3) the partner is so dependent on some unique entrepreneurial or managerial ability of the promoter that he or she cannot replace the manager or otherwise exercise meaningful partnership or venture powers.
An analysis of these factors in this case demonstrates that the SEC has overcome the presumption. The first point concerns the agreements. While the joint venture agreements granted the investors certain rights, in fact investors were still required to rely on GeoDynamics. The turnkey contracts were the key to the success of enterprise and profits “because they were the only way these oil and gas investments could generate money.” This conclusion is consistent with the fact that the interests were marketed to those who had no experience in the oil and gas industry. This point, along with the fact that purchasers relied on the promoters as their sole source of information – both of which also go to the second factor — presents a fact issue as to whether the voting rights given investors were “illusory or a sham.”
Those factors also tie to the third point of consideration – whether the investors are dependent on the unique managerial skills of the promoter. Here the defendants emphasized the “unique expertise of GeoDynamics in the oil and gas industry” to investors in soliciting their funds. This factor, coupled with the first two, demonstrates that while the form of the documents may suggest a partnership, in substance the facts suggest otherwise. Accordingly, the order dismissing the action is reversed and remanded to the District Court for further proceedings.
February 27, 2014
The Supreme Court handed down a significant decision, construing SLUSA in the context of suits by investors defrauded investors in the Stanford Ponzi scheme. The Court concluded that the Act does not bar four state law class actions against two law firms and others.
The SEC prevailed again in the circuit courts, this time convincing the Second Circuit to affirm the decision of the district court on the proper measure of disgorgement. Specifically, the Court adopted the Commission position that a portfolio manager who traded in a managed fund on inside information, but did not trade personally, could be directed to disgorge the profits of the fund.
The Commission settled another action this week in which admissions were required. Swiss giant Credit Suisse admitted to violating the Federal securities laws in connection with soliciting brokerage business and giving investment advice in the U.S. from offices in the firm’s home country without complying with the broker registration requirements. The agency also filed another insider trading action against a market professional, a case against a hedge fund manager for misallocating expenses and an action against a broker for misappropriating client funds.
Remarks: Chair Mary Jo White addressed the SEC Speaks 2014 Conference, Washington, D.C. (Feb. 21, 2014). Her remarks reviewed rule making initiatives, enforcement and corporate finance and the JOBS Act (here).
Remarks: Commissioner Luis Aguilar addressed the SEC Speaks 2014 Conference with remarks tiled Addressing Known Risks To better Protect Investors, Washington, D.C. (Feb. 21, 2014)(here).
Remarks: Commissioner Kara Stein addressed the SEC Speaks Conference, Washington, D.C. (Feb. 21, 2014). Topics discussed included enforcement and individual accountability, executive compensation, money markets and Dodd-Frank (here).
Remarks: Commissioner Daniel Gallagher addressed the SEC Speaks 2014 Conference with remarks titled An Open Letter to the SEC Staff, Washington, D.C. (Sept. 21, 2014)(here).
SLUSA: Chadbourne & Parke LLP v. Troice, No. 12-79 (S.Ct. Decided Feb. 26, 2014) is four state law class actions arising out of the Stanford Ponzi schemes. Investors purchase certificates of deposits issued by the Sanford bank which were supposedly backed by marketable securities. The funds were not invested as advertised but used to repay other investors and support the life-style of Allen Stanford and his cohorts. Mr. Stanford is now in prison, serving a sentence of 110 years and subject to a $6 billion forfeiture order. He is also subject to a $6 billion civil fine from a parallel SEC enforcement action. The plaintiff investors are attempting to recover their losses. The District Court concluded that SLUSA or the “Litigation Act” as it is called by the majority decision here – the Securities Litigation Uniform Standards Act of 1998 – requires dismissal of the actions. The Circuit Court reversed. In a 7-2 decision, the Supreme Court affirmed.
Justice Bryer, writing for the Court, began by noting that the Litigation Act provides that plaintiffs may not maintain a class action involving 50 or more members based on the statutes or common law of any state (with certain exceptions) that alleges misrepresentations or omissions of a material fact “in connection with the purchase or sale of a covered security,” that is, one traded on a national exchange (or issued by an investment company).
Here there were material misrepresentations. The issue for decision, Justice Bryer wrote, is how “broad is that scope” of the phrase in connection with? “Does it extend further than misrepresentations that are material to the purchase or sale of a covered security? In our view, the scope of this language does not extend further.” Stated differently, a “fraudulent misrepresentation or omission is not made ‘in connection with’ such a ‘purchase or sale of a covered security’ unless it is material to a decision by one or more individuals (other than the fraudster) to buy or to sell a ‘covered security.’”
This interpretation of the Litigation Act is supported by five points. First, the focus of the Act is transactions in covered securities, not other instruments. Second, the natural reading of the statute “suggests a connection that matters” to the covered securities and “makes a significant difference to someone’s decision to purchase or to sell a covered security . . .” Third, the prior case law supports this reading of the Act. In this regard “every securities case in which this Court has found a fraud to be ‘in connection with’ a purchase or sale of a security has involved victims who took, who tried to take, who divested themselves of, who tried to divest themselves of, or who maintained an ownership interest in financial instruments that fall within the relevant statutory definition.” (emphasis original). The dissent’s claims that this is a new reading of the requirement are wrong. Fourth, this reading is consistent with the Securities Act and the Exchange Act which “refer to persons engaged in securities transactions that lead to the taking or dissolving of ownership positions.” Finally, to interpret the Act more broadly would interfere with state efforts to provide remedies for victims of ordinary state-law frauds, a result Congress took care to avoid.
Here the Court concluded that “[a]t most, the complaints allege misrepresentations about the Bank’s ownership of covered securities – fraudulent assurances that the Bank owned, would own, or would use the victims’ money to buy for itself shares of covered securities. But the Bank is an entity that made the misrepresentations. The Bank is the fraudster, not the fraudster’s victim . . . And consequently, there is not the necessary ‘connection’ between the materiality of the misstatements and the statutorily required ‘purchases or sale of a covered security.’” Justice Thomas concurred in the result, penning a brief opinion.
Justice Kennedy, joined by Justice Alito, dissented. While everyone agrees that SLUSA does not reach transactions involving only the CDs, here there is more, according to the dissenters. Here the Act “must be given a ‘broad construction,’ because a ‘narrow reading of the statute would undercut the effectiveness’ of Congress’ reforms. . . Today’s decision does not heed that principle. The Court’s narrow reading of the statute will permit a proliferation of state-law class actions, forcing defendants to defend against multiple suits in various state for a.” This will be a serious burden to attorneys, accountants, brokers and investment bankers nationwide.
The Court’s construction of the Act is also inconsistent with prior decisions such as SEC v. Zandford, 536 U.S. 813 (2002)(victims were duped into believing defendant would invest their assets in stock market), Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71 (2006)(suit precluded where covered securities involved but plaintiffs had no cause of action because they lacked standing), and U.S. v. O’Hagan, 521 U.S. 642 (1997)(requiring only that material misrepresentations “’coincide[d] with” third-party securities transactions”)all of which directed that a broad reading of the requirement be given.
Canadian Securities Cases
A new report by NERA Economic Consulting shows that in 2013 there were 10 new securities actions filed in Canada. That is the same number filed in the prior year. While it is below the high of 15 brought in 2011 (NERA statistics go back to 1997), it exceeds the average of just over 8 cases filed per year over the last decade. Trends in Canadian Securities Class Actions: 2013 Update (here).
Nine of the ten actions brought last year were Bill 198 cases. Those are actions tie to secondary market civil liability based on provincial securities act provisions that have come into force since 2005. Nine of the Canadian domiciled companies against whom actions were filed last year were also subject to a U.S. securities class action. At the same time, four Canadian companies were subject to a U.S. securities suit but were not named in a Canadian filing.
SEC Enforcement – Filed and Settled Actions
Statistics: This week the Commission filed or announced the filing of 2 civil injunctive, DPAs, NPAs or reports and 2 administrative proceedings (excluding follow-on and Section 12(j) proceedings).
Investment fund fraud: SEC v. Custis, Civil Action No. 3:12-cv-01696 (D. Oregon) is a previously filed action against attorney Robert Custis. The action alleged that Mr. Curtis made false and misleading statements to investors in funds operated by Yusaf Jawed. Mr. Jawed, who operated a Ponzi scheme through Grifphon Asset Management, LLC and Pacific Northwest Holdings, LLC., was the subject of another Commission enforcement action. This week the Court entered a final judgment against Mr. Custis, enjoining him from future violations of Exchange Act Section 10(b) and Advisers Act Section 206(4). He also consented to the entry of an order in an administrative proceeding prohibiting him from appearing and practicing before the Commission as an attorney. See Lit. Rel. No. 22934 (Feb. 27, 2014).
Expense misallocation: In the Matter of Clean Energy Capital, LLC, Adm. Proc. File No. 3-15766 (Feb. 25, 2014) is a proceeding against the registered investment adviser and its co-founder, CEO and main portfolio manager, Scott Brittenham. From 2008 to the present, according to the Order, the Respondents misallocated over $2 million in expenses from managed funds and then had the adviser secretly loan operating cash to the funds at high rates. The adviser also violated the custody rule and had inadequate compliance procedures. The Order alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2), 206(3) and 206(4). The proceeding will be set for hearing.
Financial fraud: SEC v. China MediaExpress Holdings, Inc., Civil Action No. 1:13-cv-00927 (D.D.C.) is a previously filed action against the company and its Chairman and CEO, Zheng Cheng. It alleged that beginning in October 2009 the defendants engaged in a scheme to mislead and defraud investors by, among other things, overstating the cash balance of the company. This week the Court entered judgments by default against both defendants. A permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b) was entered against each defendant. In addition, Mr. Cheng is precluded from serving as an officer or director of any issuer and was directed to pay disgorgement and prejudgment interest in the amount of $17,718,359.07 along with a civil penalty of $1.5 million. See Lit. Rel. No. 22932 (Feb. 24, 2014).
Misappropriation: SEC v. O’Brien, Civil Action No. 13-CV-169 (S.D. Ohio Filed Feb. 21, 2014) is an action against former registered representative Kevin O’Brien. Beginning in 1998, and continuing through 2008, Mr. O’Brien, according to the court papers, misappropriated sums of money from the brokerage account of a client by writing checks, forwarding them to a P.O. Box, depositing them in a controlled account in the name of the client and then withdrawing the money for personal expenses. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). To resolve the case, Mr. O’Brien consented to the entry of a permanent injunction based on the Sections cited in the complaint. He also agreed to pay disgorgement of $298,917 and prejudgment interest. Payment, and a penalty, were waived based on financial condition. See Lit. Rel. No. 22931 (Feb. 24, 2014).
Financial fraud: SEC v. Sells, Civil Action No. 4:11-cv-04941 (N.D. Cal.) is a previously filed action against Christopher Sells and Timothy Murawski, respectively, the former V.P. of Commercial Operations and V.P. of Sales, for Hansen Medical. In 2008 and 2009 the two men caused the company to book improper sales as part of a scheme to falsify its financial results. To resolve the action each defendant consented to the entry of a permanent injunction based on Securities Act Sections 17(a)(1) and (3) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). In addition, Mr. Sells agreed to pay a civil penalty of $85,000 while Mr. Murawski will pay $35,000. See Lit. Rel. No. 3539 (Feb. 21, 2014).
Broker registration violations: In the Matter of Credit Suisse Group AG, File No. 3-15763 (Feb. 21, 2014). Beginning in 2002, and continuing until about 2008, Credit Suisse provided broker-dealer and investment advisory services to a group of U.S. clients from its offices in Switzerland, according to the Order. During that period the firm had as many as 8,500 client account that held securities and were beneficially owned by U.S. residents. The financial institution solicited some of these clients and furnished them with broker-dealer and advisory services. A number of firm employees serviced U.S. based clients from offices located in Switzerland. To service existing clients, and solicit others, employees traveled periodically to the U.S. During meetings in this country with clients, or potential clients, investment advice was furnished in certain instances. In some meetings securities transaction business was solicited. Credit Suisse recognized that there were risks of violating the federal securities laws as a result of its practices. To mitigate that risk, beginning in 2002 the bank enacted directives and policies which prohibited its representatives from engaging in improper conduct. The efforts were ineffective. In 2008 there was a highly publicized civil and criminal tax investigation of UBS tied to cross-boarder banking, broker-dealer and investment adviser services. Credit Suisse initiated a process to exit from U.S. cross-boarder securities business. By 2010 the bank had either transferred or terminated the vast majority of its relationships with U.S. clients. During the period the institution faced conflicting pressures from various employees regarding the decision to withdraw from the U.S. business and continued to collect fees and manage accounts.
The Order alleges willful violations of Exchange Act Section 15(a) and Advisers Act Section 203(a). To resolve the proceeding Credit Suisse admitted the facts in the Order and that it violated the federal securities laws but not the specific Sections cited in the Order. The firm also agreed to implement a series of procedures focused on ensuring a complete termination of the cross-border business described in the Order. A consultant will be retained to conduct an independent examination and prepare a report which will be made available to the staff. It will assess if the cross-border business described in the Order has fully terminated. The firm also consented to the entry of a censure and a cease and desist order based on the Sections cited in the Order. In addition, Credit Suisse will pay disgorgement of $82,170,990, prejudgment interest and a civil penalty of $50 million.
Insider trading: SEC v. Hixon, Civil Action No. A14CV0158 (W.D. Tx. Filed Feb. 20, 2014) and U.S. v. Hixon, Case No. 1:14-mj-0341 (S.D.N.Y. Filed Feb. 20, 2014) charge investment banker Frank Hixon, a Senior Managing Director at Evercore Group, LLC in 2010 and 2011, with insider trading. The charges center on trading in the shares of two firm clients – Westway Group, Inc. and Titanium Metals Corporation – and his own firm. In September 2011 Westway engaged Evercore as its advisor regarding the sale of two business units to its largest shareholder. Mr. Hixon served as Evercore’s lead on the engagement. As negotiations proceeded in 2011, Mr. Hixon, according to the court papers, traded in the account of Destiny Robinson, the mother of his son. Shares of Westway were purchased for her account. Text messages suggest the transactions, in part, were undertaken in connection with child support. The transactions were traced to Mr. Hixon through IP addresses. At one point during the extended negotiations, 140,000 shares were sold at a profit of about $260,000, according to the papers in the criminal case. The day after the 2012 merger announcement the shares held had an imputed profit of about $64,500, according to the SEC complaint.
Transactions in the shares of Titanium follow a similar pattern. There Mr. Hixon and his firm were retained regarding negotiations the company had undertaken to be acquired by Precisin Castparts. Again IP address track access to Ms. Robinon’s securities account, where Titanium shares were purchased, to Mr. Hixon’s locations. Shares were also purchased for his father’s securities account. Following the transaction announcement, the shares in Ms. Robinson’s account were sold, yielding a profit of $184,000. Those in the account of Mr. Hixon’s father were liquidated at a profit of $71,000. Finally, after learning at a January 14, 2013 firm meeting about the quarterly financial results, and shortly before their announcement, shares of the firm were purchased for Ms. Robinson’s account and that of Mr. Hixon’s father. The shares held by Ms. Robinson’s account were liquidated after the announcement at a profit of $56,000. Those held by the account of Mr. Hixon’s father were liquidated at a profit of $21,000.
Evercore received multiple inquiries from FINRA regarding suspicious trading. Those inquiries asked about trading for Frank P. Hixon, Duluth, Georgia and Destiny W. Robinson, Austin, Texas. Mr. Hixon denied knowing either person. Mr. Hixon also met with the FBI. He informed the agents that he had never traded in, or accessed, the account of Ms. Robinson. The Commission’s complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The criminal complaint contains five counts of securities fraud, two counts of securities fraud in connection with a tender offer and one count of making a false statement. Both cases are pending.
Disgorgement: SEC v. Contorinis, No. 12-1723-cv (2nd Cir. 2014) is an action against Joseph Contorinis, a Managing Director at Jeffries & Company, which centers on a question regarding disgorgement. In January 2006 Mr. Contorinis obtained inside information regarding the then pending acquisition talks for supermarket chain Albertson’s, Inc. from an investment banker working on the deal. He then executed trades in the securities of Albertson’s for the fund he co-managed, Jeffries Paragon Fund. He did not trade for his own account. Paragon Fund realized profits of $7,304,738 and avoided losses of $5,345,700 as a result of the transactions.
Following his conviction on criminal insider trading charges the SEC brought an action against Mr. Contorinis. The court granted summary judgment in favor of the Commission based on the conviction and ordered the payment of disgorgement based on the profits of the fund. On appeal the key question was whether an insider trader who has no trading profits, but placed trades for a fund which was unaware that he possessed inside information, can be directed to disgorge the profits of that fund. The Second Circuit affirmed the disgorgement decision in a 2-1 ruling.
Disgorgement is an equitable remedy the Court began, designed to ensure that wrongdoers do not profit from their illegal conduct. “By forcing wrongdoers to give back the fruits of their illegal conduct, disgorgement also has the effect of deterring subsequent fraud,” according to the Second Circuit (citations omitted). Since disgorgement does not have a punitive function or purpose, the “amount may not exceed the amount obtained through the wrongdoing.”
In this case Defendant Contorinis argued that he should only be required to disgorge what he “personally swallowed,” that is, the money he obtained. The SEC claimed that he should be required to return “not only those profits from the fraud that he has reserved for his own use, but also those that he bestowed on others.” The Court concluded that the SEC is correct based on a series of tipping cases. In those cases the Court held that a “tippee’s gains are attributable to the tipper, regardless whether benefit accrues to the tipper.” This is because a potential “tipper in possession of inside information who seeks to confer a benefit on a friend or to curry favor with someone who can confer reciprocal benefits in the future can do so either by trading on the information himself and passing the profit on to the intended beneficiary, or by passing the information to the beneficiary and thus allowing the tippee to realize the profit himself.” (emphasis original). This rule makes perfect sense the Court found. Thus the district court can in its discretion, but need not, require the payment of disgorgement under the circumstances here. In reaching its conclusion the Court acknowledged that other courts on related issues have reached different results.
Judge Denny Chin dissented, arguing that disgorgement is an “equitable remedy that requires a defendant to give up the amount by which he was unjustly enriched.” (emphasis original). The focus is equitable, not punitive. Requiring a defendant to give up more than he got exceeds the basic theory of the remedy. Furthermore, the tipper and tippee cases are inapposite, according to Judge Chin. In that situation the “tipper and tippee are concerted actors, jointly engaged in fraudulent activity – the tipper breaches a fiduciary duty by disclosing inside information; the tippee trades on that information, knowing of the breach and without disclosing that he knows; and the tipper obtains a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.”
That is not the case here. Mr. Contorinis was not a tipper. The fund was not a tippee engaged in fraudulent conduct. To the contrary, the fund was an innocent party. Accordingly, the tipper-tippee cases are inapplicable. Rather, the basic equitable principles on which disgorgement is based should govern.
Investment fund fraud: U.S. v. Barriger, Case No. 7:11-cr-00416 (S.D.N.Y.) is a previously filed action against the former president and principal shareholder of hedge fund Gafken & Barriger Fund LLC, Lloyd Barriger. Previously, Mr. Barriger pleaded guilty to conspiracy, securities fraud and mail fraud charges in connection with the operation of the fund. The charging papers alleged that from mid-2008 through early 2008 Mr. Barriger raised over $12 million from about 70 investors by deceiving them about the safety of the real estate fund and its performance. This week Mr. Barriger was sentenced to serve five and one half years in prison and ordered to forfeit $12 million. See also SEC v. Barriger, Civil Action No. 7:11-cv-03250 (S.D.N.Y.).
Investment fraud: U.S. v. Mills, Case No. 3:14-mj-70160 (N.D. Cal.) is an action charging Jonathan Mills with wire fraud. Mr. Mills is the founder and former CEO of tech company Motionloft, Inc. Shortly before he was due to be terminated by the board of directors, he solicited investors by falsely representing that the firm was about to be acquired by Cisco, Inc. One investor put up $210,000. The claims were false. The case is pending.
Supervisory failures: Berthel Fisher & Co. and its affiliate, Securities Management & Research, Inc., were fined $750,000 by the regulator in connection with supervisory deficiencies. Specifically, from January 2008 through the end of 2012, Berthel Fisher had inadequate supervisory systems and procedures for the sale of alternative investments such as REITs, managed futures, oil and gas programs, equipment leasing programs and business development companies. Similarly, for three years beginning April 2009, the firm did not have a reasonable basis for certain sales of leveraged and inverse ETFs. Berthel Fisher did not adequately research or review non-traditional EFTs before allowing its registered representatives to recommend them to customers. It also failed to provide adequate training on these instruments.
Insider trading 2.0: Interim agreements were reached with several large New York banks and brokerages to halt the practice of taking analyst surveys. This practice was first challenged under the New York Martin Act last month in an action resolved with BlackRock. Now Merrill Lynch, UBS Securities LLC, Barclays Capital Inc., Citigroup Global Markets Inc., Credit Suisse Securities (USA) LLC, Goldman, Sachs & Co., J.P. Morgan Securities LLC, Morgan Stanley & Co. LLC, Deutsche Bank Securities, Inc., Jefferies LLC, Stifel, Nicolaus & Co., Inc., Stanford C. Bernstein & Co., Keefe Bruyette & Woods, Inc., Thomas Weisel Markets & Co. and Wolf Research have agreed to halt the practice.
European Securities and Markets Authority
Remarks: Executive Director Verena Ross delivered remarks titled Liquidity and new financial market regulation to the European Market Liquidity Conference, London (Feb. 26, 2014). His remarks focused on the implementation of new legislation from the European Parliament and Council and liquidity (here).
Dark pools: The Securities and Futures Commission initiated a two month consultation regarding future regulation of alternative liquidity pools, typically known as dark pools. The SFC is considering a number of points including restricting access to institutional investors, enhancing the level of disclosure by users and maintaining system adequacy.
Annual reports: The Securities and Exchange Surveillance Commission issued its Annual Report 2012/2013. It reviews actions by the agency regarding market surveillance, inspections, investigations, international matters, criminal cases and policy proposals (here).
Misrepresentations: The Financial Conduct Authority banned Arnold Eber, the former CEO of CIB Partners Limited. From 2007 through 2009 SIB was the adviser to SLS Capital S.A., a Luxembourg based special purpose vehicle. During the time period the entity issued bonds underpinning investments sold to UK investors. Mr. Eber learned that without continuous cash injections there was a huge risk that the SLS portfolio would suffer from severe liquidity issues within a year. He also learned that SLS had sold off most of the asset portfolio that underpinned the bonds. Nevertheless, he issued a number of false and misleading documents about the strength of the SLS portfolio and did not disclose the financial problems of the portfolio.
Withheld client profits: The FCA fined Forex Capital Markets Ltd. and FXCM Securities Ltd. £4 million for permitting its U.S. affiliate to withdraw profits worth about £6 million that should have been paid to the UK clients. The firm took orders in one section and then executed the forex transactions in another. Beginning in 2006, and continuing until the end of 2010, the firm kept the profit from favorable market movement between the time the orders were placed and executed but allocated the losses to clients. It also failed to notify UK authorities that U.S. enforcement officials commenced an investigation in 2010 into the practice. Clients with losses were compensated.
February 26, 2014
Earlier this month the Third Circuit resolved an issue regarding causation, intervening causes and disgorgement in an SEC enforcement action. SEC v. Teo (here). Now the Second Circuit has handed down a ruling on the measure of disgorgement in an action against a portfolio manager with inside information who placed trades in a fund that were profitable but did not personally profit from the trading. SEC v. Contorinis, No. 12-1723-cv (2nd Cir. 2014). The 2-1 ruling requires the trader to disgorge the fund’s profits and creates a split in the circuits on the question, according to the Court.
Joseph Contorinis was a Managing Director at Jeffries & Company. In January 2006 Mr. Contorinis obtained inside information regarding the then pending acquisition talks for supermarket chain Albertson’s, Inc. UBS Investment banker Nicos Stephanou, whose firm was involved in the talks, furnished Mr. Contorinis with information on the then pending transaction. Mr. Contorinis executed trades in the securities of Albertson’s while in possession of the information for the fund he co-managed, Jeffries Paragon Fund. He did not trade for his own account. Paragon Fund realized profits of $7,304,738 and avoided losses of $5,345,700 as a result of the transactions.
In February 2009 Mr. Contorinis was indicted on one count of conspiracy to commit securities fraud and nine counts of securities fraud. A jury convicted him on all but two counts of securities fraud. He was sentenced to serve six years in prison and pay $12,650,438 in criminal forfeiture penalties. Following an appeal the Circuit Court reversed the forfeiture penalties, concluding that the governing statutes do not authorize the forfeiture of proceeds that go directly to an innocent third party and are never possessed by the defendant.
The SEC also named Mr. Contorinis as a defendant in an insider trading complaint based on the Albertson’s transactions. The district court granted the Commission’s summary judgment motion, relying on collateral estoppel based on the criminal jury verdict. The District Court then entered a permanent injunction against Mr. Contorinis and directed that he pay disgorgement of $7,260,604 (less any amounts paid in the criminal case), prejudgment interest and a $1 million civil penalty.
The key question before the Circuit Court was whether an insider trader who has no trading profits, but placed trades for a fund which was unaware that he possessed inside information, can be directed to disgorge the profits of that fund. Disgorgement is an equitable remedy the Court began, designed to ensure that wrongdoers do not profit from their illegal conduct. “By forcing wrongdoers to give back the fruits of their illegal conduct, disgorgement also has the effect of deterring subsequent fraud,” according to the Second Circuit (citations omitted). Since disgorgement does not have a punitive function or purpose, the “amount may not exceed the amount obtained through the wrongdoing.”
In this case Defendant Contorinis argued that he should only be required to disgorge what he “personally swallowed,” that is, the money he obtained. The SEC claimed that he should be required to return “not only those profits from the fraud that he has reserved for his own use, but also those that he bestowed on others.”
The Court concluded that the SEC is correct based on a series of tipping cases. In those cases the Court held that a “tippee’s gains are attributable to the tipper, regardless whether benefit accrues to the tipper.” This is because a potential “tipper in possession of inside information who seeks to confer a benefit on a friend or to curry favor with someone who can confer reciprocal benefits in the future can do so either by trading on the information himself and passing the profit on to the intended beneficiary, or by passing the information to the beneficiary and thus allowing the tippee to realize the profit himself.” (emphasis original). This rule makes perfect sense the Court found.
Based on the tipper—tippee cases it “must follow” that a person with inside information such as Mr. Contorinis, who uses it to trade for the and benefit of the fund, is responsible for its profits. This conclusion “prevents insider traders from evading liability by operating through or on behalf of third parties,” the Court stated. Thus the district court can, but need, require the payment of disgorgement under the circumstances here since it is discretionary.
In reaching its conclusion the Court acknowledged that other courts on related issues have reached different results. While no other circuit “has spoken to the precise question . . . [here] Circuits which have considered related issues are mixed regarding the extent to which a party can be ordered to disgorge total gain from an unlawful act, when the party has not personally received the full benefit of the wrongdoing.”
Judge Denny Chin dissented, arguing that disgorgement is an “equitable remedy that requires a defendant to give up the amount by which he was unjustly enriched.” (emphasis original). The focus is equitable, not punitive. Requiring that a defendant give up more than he got goes beyond the basic theory of the remedy.
The tipper and tippee cases are inapposite, according to Judge Chin. In that situation the “tipper and tippee are concerted actors, jointly engaged in fraudulent activity – the tipper breaches a fiduciary duty by disclosing inside information; the tippee trades on that information, knowing of the breach and without disclosing that he knows; and the tipper obtains a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.”
This is not the case here. Mr. Contorinis was not a tipper. The fund was not a tippee engaged in fraudulent conduct. To the contrary, the fund was an innocent party. Accordingly, the tipper-tippee cases are inapplicable. Rather, the basic equitable principles on which disgorgement is based should govern.
February 25, 2014
A report by Cornerstone Research found that the number of securities class actions filed in the U.S. last year ticked up slightly. Yet that number remains below historical averages. In contrast, the number of securities cases filed in Canada last year equaled the prior year and exceeded the average over the last ten year, according to a new report by NERA Economic Consulting. Trends in Canadian Securities Class Actions: 2013 Update (here).
In 2013 there were 10 new securities actions filed in Canada. That is the same number filed in the prior year. While it is below the high of 15 filed in 2011 (NERA statistics go back to 1997), it exceeds the average of about 8 cases filed per year over the last decade.
Nine of the ten actions brought last year were Bill 198 cases. Those are actions tie to secondary market civil liability based on provincial securities act provisions that have come into force since 2005. Nine of the Canadian domiciled companies against whom actions were filed last year were also subject to a U.S. securities class action. At the same time, four Canadian companies were subject to a U.S. securities suit but were not named in a Canadian filing.
Since 1997 over half of the Canadian suits filed focused on the finance, non-energy metals and energy minerals sectors. Specifically, over 24% of the actions centered on finance, over 21% on non-energy minerals and about 8% on energy minerals. In contrast, only 3.6% centered on health technology while 4.5% concerned electronic technology.
In 2013 six Canadian securities cases settled for an aggregate of $52 million. The largest settlement was with SMART Technologies, Inc. for $15.25 million. The second and third largest were with, respectively, Amtec infrastructure Inc. for $12.9 million and Zungui Haixi Corporation for $10.85 million. Those numbers should be viewed in the context of the median settlement amount since 1997 of $12.7 million and the average over the same period of $89.5. The latter number is skewed by two large settlements with Nortel Networks Corp. Overall the number of settlements in 2013 was twice that in 2012 and the most since 2009.
Finally the number of pending securities cases in Canada continues to climb. At the end of 2013 there were 54 pending cases. That compares to 51 in 2012, 46 in 2011, 35 in 2010 and 28 in 2009.
February 24, 2014
Another market professional apparently chose to make a bad day worse. It is bad enough to be caught up and charged with insider trading in a civil SEC enforcement action. It is worse to have those claims and criminal insider trading and false statement charges added. Yet that appears to have been the choice of long time Wall Street investment banker Frank P. Hixon. SEC v. Hixon, Civil Action No. A14CV0158 (W.D. Tx. Filed Feb. 20, 2014); U.S. v. Hixon, Case No. 1:14-mj-0341 (S.D.N.Y. Filed Feb. 20, 2014).
Frank Hixon has been a New York investment banker since at least 2002. From 2010 to January 2014 he served as Senior Managing Director at Evercore Group, LLC, a subsidiary of Evercore Partners. During that period he traded in the shares of two firm clients and those of his firm based on inside information, according to the civil and criminal court papers. Specifically, Mr. Hixon is alleged to have traded in the shares of:
Westway Group, Inc., 2001. In September 2011 that firm engaged Evercore as its advisor regarding the sale of two business units to its largest shareholder. Mr. Hixon served as Evercore’s lead on the engagement. Between October 21, 2011 and December 15, 2011 there were purchases of 229,000 shares of Westway in the account of Destiny Robinson, also known as Nicole Robinson. The account had not previously traded in this security. The IP addresses demonstrate that the trades were placed in the account from locations that tie to Mr. Hixon. Ms. Robinson is the mother of Mr. Hixon’s five year old daughter. Text messages between the two suggest that the transactions relate in part to financial support for their child.
On December 15, 2011 the firm announced that it had received an offer from its largest shareholder to acquire a business unit. Three days later Westway received an offer for the other business unit. That offer was announced on December 20, 2011. The share price increased 47.3% over the prior day’s close.
Westway continued to solicit and consider various merger offers. By the summer of 2012 “people involved in the negotiations knew that a deal for both business units was believed to be likely,” according to the SEC complaint. On October 30, 2012 the firm began tender offer negotiations with a potential buyer. From September 26, 2012 to November 27, 2012 there were purchase of 67,545 Westway shares in Ms. Robinson’s account. Again the IP logs from the brokerage firm indicate the trades were placed from Mr. Hixon’s locations. On December 20, 2012 Westway publicly announced a merger agreement. The share price rose 10% over the prior day’s close.
As the negotiations continued 140,000 shares were sold at a profit of about $260,000, according to the papers in the criminal case. The day after the 2012 merger announcement the shares held had an imputed profit of about $64,500, according to the SEC complaint.
Titanium Metals Corporation, 2012: In late October 2012 Mr. Hixon, then in London, and others from his firm, met with representatives of Titanium. Discussions were held regarding Titanium’s its negotiations to be acquired by Precisin Castparts. The deal was likely to close by year end. That same day a computer with a London IP address accessed Ms. Robinson’s brokerage account and purchased 20,000 shares of Titanium. Additional shares of the firm were purchased by the account of Frank Hixon, Sr., Mr. Hixon’s father who resides outside Atlanta, Georgia. When the transaction was announced on November 9, 2012, the share price for Titanium increased 43.1% over the prior day close. Three days later the shares in Ms. Robinson’s account were sold, yielding a profit of $184,000. An Austin IP address accessed the account. Mr. Hixon’s calendar states that he was in Austin on the date of the transaction. On November 20, 2012 all the shares in the account of Mr. Hixon’s father were liquidated at a profit of $71,000.
Evercore Partners, 2013: At a partner’s meeting on January 14, 2013 the firm announced internally its financial results for the quarter. On January 28 and 29, 2012 shares of the firm were purchased by Ms. Robinson’s account from a computer using an Evercore IP address and other New York related IP addresses. On January 29 shares of the firm were also purchased by the account of Mr. Hixon’s father. When the financial results were announced on January 30, 2013, the share price increased by 5.3% over the prior day’s close. The shares held by Ms. Robinson’s account were liquidated at a profit of $56,000. The shares held by the account of the account of Mr. Hixon’s father were liquidated at a profit of $21,000.
Subsequently, Evercore received multiple inquiries from FINRA regarding suspicious trading. Those included trading for Frank P. Hixon, Duluth, Georgia and Destiny W. Robinson, Austin, Texas. Mr. Hixon denied knowing either. Mr. Hixon also met with the FBI. He informed the agents that he had never traded in, or accessed, the account of Ms. Robinson.
The Commission’s complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The criminal complaint contains five counts of securities fraud, two counts of securities fraud in connection with a tender offer and one count of making a false statement. Both cases are pending.
February 23, 2014
Another example of the Commission’s new and evolving ad hoc admissions policy emerged from the settlement of an administrative proceeding with Credit Suisse Group AG. In the Matter of Credit Suisse Group AG, File No. 3-15763 (Feb. 21, 2014). To resolve the proceed which, centers on violations of the broker-dealer registration provisions, the firm admitted to factual allegations in the Order as well as to violating the “federal securities laws.” The firm did not admit to violating the specific provisions of the statutes cited in the Order.
Beginning in 2002, and continuing until about 2008, Credit Suisse provided broker-dealer and investment advisory services to a group of U.S. clients from its offices in Switzerland, according to the admitted facts. During that period the firm had as many as 8,500 client account that held securities and were beneficially owned by U.S. residents. The financial institution solicited some of these clients and furnished them with broker-dealer and advisory services. During the period Credit Suisse was not a registered broker dealer or investment adviser. The firm, headquartered in Zurich, Switzerland, did however, have a broker dealer subsidiary, Credit Suisse Securities.
During the period a number of firm employees serviced U.S. based clients from offices located in Switzerland. Some employees were in a dedicated section while others worked in various parts of the financial institution.
To service existing clients, and solicit others, employees traveled periodically to the U.S. During meetings in this country with clients, or potential clients, investment advice was furnished in certain instances. In some meetings securities transaction business was solicited. For example, during one trip a bank employee met with 32 U.S. clients who had assets under management totaling about $129 million. That same employee also visited five prospective U.S. clients. One of those prospects opened an account valued at about $744,000. During another trip a bank employee traveled to New York, Washington, D.C. and Florida. Visits were made to 39 clients with assets under management totaling about $111 million. The bank employee also met with two prospective US. clients who eventually opened accounts with a potential value of approximately $2 million. Other, similar trips took place throughout the period.
Credit Suisse recognized that there were risks of violating the federal securities laws by providing broker-dealer and investment adviser services to U.S. clients. To mitigate this risk beginning in 2002 the bank enacted directives and policies which prohibited its representatives from engaging in improper conduct. Training was provided to certain employees. Audits were conducted in some instances. Those policies and procedures were not effectively implemented. The audits proved ineffective. The violations continued.
In 2008 there was a highly publicized civil and criminal tax investigation of UBS tied to cross-boarder banking, broker-dealer and investment adviser services. Credit Suisse initiated a process to exit from U.S. cross-boarder securities business. By 2010 the bank had either transferred or terminated the vast majority of its relationships with U.S. clients. During the period the institution faced conflicting pressures from various employees regarding the decision to withdraw from the U.S. business. In the interim the bank continued to collect fees and manage accounts.
The Order alleges willful violations of Exchange Act Section 15(a) and Advisers Act Section 203(a). To resolve the proceeding Credit Suisse agreed to implement a series of procedures focused on a complete termination of the cross-boarder business described in the Order. A consultant will be retained to conduct an independent examination and prepare a report which will be made available to the staff. It will assess if the cross-boarder business described in the Order has fully terminated. The firm also consented to the entry of a censure and a cease and desist order based on the Sections cited in the Order. In addition, Credit Suisse will pay disgorgement of $82,170,990, prejudgment interest and a civil penalty of $50 million.