Market reform continued to be a key topic this week with the SEC soliciting comments on a number of provisions under Dodd-Frank even before the opening of the official comment period. SEC enforcement brought an insider trading case based on corporate officers and directors trading through off-shore trusts which is in litigation and filed a settled action against Citibank based on false statements made about its exposure to the sub-prime market. The Commission also filed a settled FCPA case, while a class action was brought against a company and its directors based on violations of the Act.

Market reform

Dodd-Frank: The SEC published a request for comments regarding its study of the obligations of broker-dealers and investment advisers. The Commission is also seeking comments on a number of issues under the Act even before the official comment period begins. The Release lists provisions under Title II (liquidation authority), Title III (transfer of certain powers to the Comptroller), Title IV (regulation of hedge funds), Title VI (improvements to regulation of banks and savings associations holding companies), Title VII (Wall Street Transparency and Accountability), Title VIII (payment, clearing and settlement supervision), Title IX (investor protection and improvements to the regulation of securities) and Title XV (miscellaneous provisions).

Securities class actions: Both NERA Economic Consulting and Stanford Law School Securities Class Action Clearinghouse released reports tracking securities class actions. Both reports noted that for the first half of 2010 the number of cases filed declined. According to the Stanford report, the number of cases filed during that period declined by about 16% compared to the prior year. The number of filings has declined since 2008.

SEC-IG: The inspector general has expanded his probe into the Commission’s action against Goldman Sachs. The IG opened an investigation shortly after the complaint was filed, looking at claimed pre-filing press leaks and allegations that its filing was politically timed. Now, in response to more questions from Capitol Hill – this time claims the settlement was politically timed – the IG has expanded his inquiry as discussed here.

SEC enforcement actions

Insider trading/fraud: SEC v. Wyly, Case No. 10 CV 5760 (S.D.N.Y. Filed July 29, 2010) is an action against Sam Wyly, former Chairman of Michaels, Sterling Software and Scottish Re and former Executive Committee Vice Chairman of Sterling Software; Charles Wyly, former Vice Chairman of the same companies and a former director of Sterling Software; Michael French, their lawyer; and Louis Schaufele, their broker. The complaint centers on an insider trading scheme involving trading in the shares of the companies with which the two Wyly defendants were affiliated. Specifically, it claims that the Wyly defendants maintained an elaborate web of off-shore trusts which they used to hold significant blocks of stock in the companies and which were traded using inside information. Messrs. French and Schaufele are alleged to have facilitated this scheme which traded over $750 million of stock in the four companies with which the Wylys were affiliated. The complaint alleges that all four defendants violated, and that Messrs. French and Schaufelee aided and abetted violations of, Exchange Act Section 10(b). It also alleges that the two Wyly defendants and Mr. French violated Securities Act Sections 13(d), 14(a) and 16(a). The two Wyly defendants are also charged with violations of Securities Act Section 5 and aiding and abetting violations of Exchange Act Sections 13(a) and 14(a). Mr. French is also charged with aiding and abetting violations of Exchange Act Sections 13(d), 14(a) and 16(a). The case is in litigation

False statements: SEC v. Citigroup Inc., Civil Action No. 1:10-CV-01277 (D.D.C. July 29, 2010) is a settled action which alleges violations of Securities Act Section 17(a)(2) and Exchange Act Section 13(a) by the bank. The complaint centers on allegations that beginning in July 2007 and continuing through the fall of that year, the bank misrepresented its exposure to the sub-prime market. Investors were told that Citigroup’s investment bank’s sub-prime exposure was $13 billion. In fact it was about $56 million – the bank failed to tell investors about two groups of sub-prime investments valued at $43 billion. The false disclosures were repeatedly made despite the fact that two senior bank officials named in a related Order for Proceedings, Gary Crittenden, its former CFO, and Arthur Tildesley, Jr., its current head of Global Cross Marketing, were repeatedly given information about the full extent of Citigroup’s sub-prime exposure. To resolve its case, Citibank consented to the entry of a permanent injunction prohibiting future violations of the sections cited in the complaint and agreed to pay disgorgement and a penalty totaling $75,000,0001. See Litig. Rel 21605 (July 29, 2010). To resolve In the Matter of Gary L. Crittenden, Adm. Proc. File No. 3-13985 (Filed July 29, 2010) Messrs. Crittenden and Tildesley consented to the entry of an order directing them to cease and desist from causing any further or future violations of Exchange Act Section 13(a). In addition, Mr. Crittenden undertook to pay $100,000 while Mr. Tildesley undertook to pay $80,000.

Financial fraud: SEC v. Fisher, Case No. 07-cv-4483 (N.D. Ill. Filed Aug. 9, 2007). The complaint alleges a financial fraud which caused the falsification of Nicor’s annual reports for 2000 and 2001 and eight quarterly reports as discussed here. According to the Commission, beginning in 1999 and continuing through 2002, Nicor failed to disclose “rigged reductions in gas inventory levels that enabled it to improperly manipulate its earnings . . .” This scheme increased Nicor’s revenues under a plan administered by the Illinois Commerce Commission. The defendants also understated the expenses of the company during the first quarter of 2001 by improperly bundling a weather-insurance contract with an agreement to supply gas to its insurance provider at below market prices. The losses from that agreement were charged to the customers of the company, contrary to the dictates of the ICC. The complaint also alleges a failure to make disclosures required by GAAP regarding the cash flow impact of certain inventory liquidations. To settle the action, Mr. Fisher consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3) and from aiding and abetting violations of Exchange Act Section 13(a). He also agreed to pay disgorgement and prejudgment interest in the amount of $825,000. The Commission dropped its claim based on Exchange Act Section 10(b), Securities Act Section 17(a)(1) and for a civil penalty. The litigation continues as to the other two defendants.

False statements: In the Matter of Spencer International Advisors, Inc., Adm. Proc. File No. 3-13980 (Filed July 27, 2010) is a proceeding against Spencer International, a registered investment adviser, and its president, Scott Spencer. The Order alleges that in 2006 Mr. Spencer induced 55 clients of Spencer International to purchase $5 million in promissory notes issued by a Florida limited liability company owned by a developer and guaranteed by Mr. Spencer and his wife. The offering materials contained false and misleading information about the developer and failed to disclose personal debt guarantees owed by the developer to other Spencer International clients. The notes defaulted as did the developer. To resolve the action, the Respondents agreed to the entry of an order directing that they cease and desist from current and future violations of Advisers Act Section 206. Mr. Spencer is also barred from associating with any investment adviser with a right to reapply after five years and agreed to pay a civil penalty of $75,000.

False statements: SEC v. Geotec, Inc., Case No. 09-80986 (S.D. Fla.) names as defendant the company, Bradley Ray, Stephen Chanslor, CPA and William Lueck in a complaint filed in 2007. That complaint alleged that the defendants made false statements about the acquisition of millions of tons of coal, improperly reported it as inventory and incorrectly recognized millions of dollars in revenue from the coal. The company also failed to have an independent accountant review its quarterly reports. To resolve the case the defendants consented to the entry of permanent injunctions. As to the company, it is based on Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B); as to Mr. Ray it is based on Exchange Act Sections 10(b) and 13(b)(5) and prohibits him from aiding and abetting violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) while imposing an officer director bar and ordering him to pay a penalty of $75,000; and as to Mr. Chanslor it is based on Exchange Act Sections 10(b) and 13(b)(5) and prohibits him from aiding and abetting violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) while imposing an officer and director bar and a civil penalty of $25,000. Mr. Chanslor also agreed to the entry of an order in a related administrative proceeding which prohibits him from appearing or practicing before the Commission as an accountant with a right to reapply after three years. The Commission’s Release does not indicate the basis for the injunction against defendant Lueck. See Litig. Rel. 21604 (July 28, 2010).

Financial fraud: SEC v. Sunrise Senior Living, Inc., Civil Action No. 1:10-CV-01247 (D.D.C. Filed July 23, 2010). This accounting fraud action was brought against the company and two of its former senior officers, Larry Hulse, former CFO, and Kenneth Abode, former Treasurer. The Commission’s complaint alleges an earnings management scheme that began in the second half of 2003 and continued during 2005. The complaint centers on improper accounting in the corporate bonus accrual account and the health and dental reserve to make earnings forecasts as discussed here.

The company settled by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 13(a) and 13(b)(2)(A) and (B). Mr. Hulse consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a), 12(b)(2)(A) and (B) and 13(b)(5). He also agreed to pay disgorgement of $83,333 and prejudgment interest and a civil penalty of $50,000. In a related administrative proceeding, Mr. Hulse consented to the entry of an order under Rule 102(e) suspending him from appearing or practicing before the Commission as an accountant with a right to reapply after three years. Mr. Abode consented to pay a civil penalty of $25,000. In a related administrative proceeding he consented to the entry of a cease and desist order from causing any violations of Section 13(b)(5) of the Exchange Act and related rules and to the entry of an order denying him the privilege of appearing or practicing before the Commission as an accountant with a right to reapply after one year. The Commission acknowledged the cooperation of the company.

Criminal cases

Investment fund fraud: U.S. v. Greenwood, 09 cr 722 (S.D.N.Y. Filed July 28, 2010) is a case against Paul Greenwood who, along with broker WG Trading Investors, LP, his partner Stephen Walsh and investment adviser Westridge Capital Management, Inc., and other controlled vehicles, is alleged to have raised about $800 to $900 million from investors. The money was to be invested in a stock index arbitrage strategy. Instead, Mr. Greenwood and his partner, Stephen Walsh, diverted the money to his own use. Mr. Greenwood pleaded guilty to a six count indictment which charges conspiracy, securities fraud, commodities fraud, money laundering and two counts of wire fraud. Mr. Greenwood is cooperating with prosecutors. In a related case, SEC v. WG Trading Investors, LP, 09-CV-1750 (S.D.N.Y. Filed July 29, 2010), Mr. Greenwood settled similar charges with the SEC, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206. Disgorgement and the imposition of a civil penalty will be considered later. Mr. Greenwood also settled with the CFTC. CFTC v. Stephen Walsh, 09-CV-1749 (S.D.N.Y. July 29, 2010). In that settlement he consented to the entry of an order which prohibits him from trading commodity futures and options and from soliciting funds for such trading. He also agreed to pay disgorgement and a penalty in amounts to be determined later.

FCPA

SEC v. General Electric Company, Case No. 1:10-CV-01258 (D.D.C. Filed July 27, 2010). The case names as defendants GE, Amersham plc (currently GE Healthcare) and Ionics, Inc (currently GE Ionics). The complaint centers on violations by two GE subsidiaries and two companies which GE acquired after the alleged violations. According to the complaint, discussed here, from 2000 to 2003 the two GE subsidiaries made about $2.04 million in kickback payments in the form of computer equipment, medical supplies and services to the Iraqi Health Ministry as part of the U.N. program. The kickbacks were made through agents in the form of “after sales service fees” on the sale of products to Iraq. Similarly, the two companies which later became GE subsidiaries paid about $1.55 million in cash kickback payments to Iraqi under the U.N. program. The payments were paid as kickbacks through agents in the form of “after sales service fees.” To settle the action, each of the three defendants consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B). GE also agreed to disgorge $18,397,949 in wrongful profits, pay prejudgment interest and a civil penalty of $1 million. The settlement reflects the cooperation of the defendants.

Shareholder suit: York v. Cornwell, No. 651065/2010 (N.Y. St Sup. Ct) is a shareholder suit against the Avon Products Inc., its board and three former directors. The complaint centers on a claimed failure to prevent improper payments in China. In October 2008, the company announced an internal investigation which has continued to expand. It is focused on FCPA compliance. In April, the company suspended four executives as part of that investigation. The litigation is pending.

The SEC settled a 2007 financial fraud action brought against Thomas Fisher, former Chairman, CEO and President of Nicor, Inc., after dropping its primary claims against the executive. SEC v. Fisher, Case No. 07-cv-4483 (N.D. Ill. Filed Aug. 9, 2007). The case continues as to two other executives.

Following the receipt of an anonymous whistleblower fax by public utility advocacy group Citizen’s Utility Board, a memorandum was furnished to Nicor detailing claims of financial fraud from 1999 through 2002. The board of directors of Nicor, a gas utility holding company, appointed a special committee which conducted an investigation that concluded in October 2002. The company immediately issued a press release accepting the findings of the inquiry and in March 2003 restated its financial statements. The Commission filed a settled action alleging financial fraud by the company and its controller a few days later in which both defendants consented to injunctions and agreed to pay substantial financial penalties.

Subsequently, the current action was filed against Mr. Fisher, along with Kathleen Halloran, the former EVP and CFO of the company, and George Behrens, the former VP of Administration and Treasurer of Nicor. The complaint, which repeatedly references actions by “Fisher, Halloran and Behrens,” alleges a financial fraud which caused the falsification of Nicor’s annual reports for 2000 and 2001 and eight quarterly reports from March 2000 through June 2002.

According to the Commission, “Fisher, Halloran, and Behrens” participated in devising a method by which the company could profit by accessing its low-cost last-in, first-out or “LIFO” layers of gas inventory. Beginning in 1999 and continuing through 2002, Nicor failed to disclose “rigged reductions in gas inventory levels that enabled it to improperly manipulate its earnings . . .” This scheme increased Nicor’s revenues under a plan administered by the Illinois Commerce Commission. The three named defendants also understated the expenses of the company during the first quarter of 2001 by improperly bundling a weather-insurance contract with an agreement to supply gas to its insurance provider at below market prices. The losses from that agreement were charged to the customers of the company, contrary to the dictates of the ICC. By overstating revenue and understating expense the company was able to meet earnings targets.

“Fisher, Halloran, and Behrens” also failed to make disclosures required by GAAP, according to the complaint. Specifically, the three failed to disclose the effects of LIFO inventory liquidations on income despite the fact that in at least one instance they amounted to 23% of pre-tax income. The MD&A sections of Nicor’s reports for 2000 and 2001 also failed to discuss the impact of the increases from the liquidation of its LIFO inventory or inform investors that the liquidation of its low cost inventory could not be sustained.

The four count complaint alleges violations by “Fisher, Halloran and Behrens” of Exchange Act Section 10(b) (Count I), Securities Act Section 17(a)(1) (Count II), Securities Act Sections 17(a)(2) and (3) (Count III) and aiding and abetting violations of Exchange Act Section 13(a)(Count IV). The relief requested included statutory injunctions, disgorgement, prejudgment interest and civil penalties.

To settle the action, Mr. Fisher consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3) (Count II) and from aiding and abetting violations of Exchange Act Section 13(a) (Count IV). He also agreed to pay disgorgement and prejudgment interest in the amount of $825,000. The Commission dropped its claim in Count I, based on Exchange Act Section 10(b), and Count II, based on Exchange Act Section 17(a)(1). The demand for a civil penalty was also dropped. As is customary, the SEC’s Litigation Release does not explain the reason for dropping the most significant counts in the complaint or the demand for a penalty. See also Litig. Rel. 21603 (July 28, 2010).

The SEC, the Department of Justice Fraud Section and the United Nations Independent Inquiry Committee continue to investigate matters arising in connection with the U.N. Oil For Food Program. To date, the SEC has brought fifteen enforcement actions in connection with that program.

The SEC’s latest FCPA case based on the Oil For Food Program was brought against General Electric Company and two of its subsidiaries. The case focuses on bribes paid by two wholly owned GE subsidiaries and two entities acquired by the company after the wrongful conduct occurred and charges violations of the books and records and internal control provisions. SEC v. General Electric Company, Case No. 1:10-CV-01258 (D.D.C. Filed July 27, 2010). Last year, GE, a company known for its management and systems, settled a financial fraud case with the Commission. Its latest case emphasizes the need for FCPA controls at the subsidiary level and the need for pre-acquisition due diligence.

The case names as defendants GE, Amersham plc (currently GE Healthcare) and Ionics, Inc (currently GE Ionics). Two wholly owned GE subsidiaries are involved in the transactions in this case. One is third tier subsidiary Marquette-Hellige, based in Germany. This company manufactures and sells medical equipment. Here, it sold fetal monitors, disposable electrodes, and transducers to the Iraqi government. A second is second tier subsidiary OEC-Medical Systems, based in Switzerland. The company manufactures and sells medical equipment.

Two other companies were involved in FCPA violations prior to their acquisition by GE. Defendant Ionics, Inc. is the parent of Ionics Italba S.r.I., an Italian based manufacturer of water purification equipment. It was acquired by GE in February 2005. Defendant Amersham plc, acquired by GE on April 1, 2004, is the parent of Nycomed Imaging A.S. that company manufactures and sells X-Ray and MRI contrast agents.

According to the complaint, from 2000 to 2003 GE subsidiaries Marquette and OEC made about $2.04 million in kickback payments in the form of computer equipment, medical supplies and services to the Iraqi Health Ministry as part of the U.N. program. The kickbacks were made through agents in the form of after sales service fees on the sales of products to Iraq.

Prior to the time GE acquired their parent companies, Ionics Italba and Nycomed Imaging paid about $1.55 million in cash kickback payments to Iraqi as part of the U.N. program. Nycomed authorized and paid the kickbacks through agents in the form of after sales service fees.

The two count complaint alleges violates by each of the three defendants of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B). To settle the action, each of the three defendants consented to the entry of a permanent injunction prohibiting future violations of the Exchange Act Sections cited in the complaint. GE also agreed to disgorge $18,397,949 in wrongful profits, pay prejudgment interest and a civil penalty of $1 million. The settlement reflects the cooperation of the defendants. See also Litig. Rel. 21602 (July 27, 2010).

Cooperation can have a significant impact on the outcome of an enforcement action for the company and its executives. The Seaboard Release in 2001, regarding corporate charging and cooperation principles, for example offers the prospect of no charges or reduced sanctions in exchange for cooperation. Last January, the Commission expanded its efforts to secure cooperation to individuals while also broadening its proposals to business organizations as discussed here.

For the company or individual considering the question of cooperation, the potential impact of cooperation can be difficult to assess. A recent study and a case last week shed some light on the question.

In a forthcoming paper tiled “SEC Enforcement: Does Forthright Disclosure and Cooperation Really Matter?” (available here), Professor Rebecca Files finds “that cooperation increases the likelihood of being sanctioned, perhaps because it improves the SEC’s ability to build a successful case against the firm. However, both cooperation and forthright disclosures are rewarded by the SEC through lower monetary penalties.” The paper is based on an analysis of 1,249 companies which restated their financial statements between 1997 and 2005. The study reports that as a reward for cooperation, the SEC reduces firm penalties on average by $37.4 million when the company initiates its own investigation into the law violation. In addition, penalties are reduced on average by $609,000 for each week earlier that the restatement is announced to the public.

A concrete illustration of cooperation can be seen in the recently filed settled enforcement action against the owner and two executives of Sunrise Living, Inc. SEC v. Sunrise Senior Living, Inc., Civil Action No. 1:10-CV-01247 (D.D.C. Filed July 23, 2010). This accounting fraud action was brought against the company and two of its former senior officers, Larry Hulse, former CFO, and Kenneth Abode, former Treasurer.

The Commission’s complaint alleges an earnings management scheme that began in the second half of 2003 and continued for 2005. It spawned two false annual reports, six incorrect quarterly reports, a false registration statement which incorporated the flawed financial statements and incorrect SOX CFO certifications. The scheme ended with a March 2008 restatement.

The complaint, built on allegations of intentional conduct primarily by Mr. Hulse, centers on improper accounting in the corporate bonus accrual account and the health and dental reserve to make earnings forecasts. For example, guidance for the fourth quarter of 2003 informed investors that earnings would be between $2.63 to $2.65 per share for fiscal year 2003 and between $0.66 and $0.68 per share for the quarter. About two weeks before the fiscal year end internal projections showed that EPS for the fourth quarter would be $0.57. According to the complaint, the day after this projection was made Mr. Hulse, who was aware of it, directed his accounting staff to eliminate the balance in the 2003 bonus accrual account for the company. Yet, before the earnings release for the quarter was issued, senior management, including Mr. Hulse, agreed to pay the bonuses. The company, however, did not have a reserve since it had been released.

In subsequent quarters, similar actions were taken. In each instance, the action was taken to meet guidance. In each instance, the adjustments made to the reserve were improper and, in the end, were restated.

In resolving the case, the Commission gave Sunrise credit for what it termed “its substantial assistance in the investigation.” As is typical, there is no delineation of the steps which constitute that assistance. It does however appear to be reflected in the settlement.

• The company settled by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 13(a) and 13(b)(2)(A) and (B). No penalty was imposed.

• Mr. Hulse consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a), 12(b)(2)(A) and (B) and 13(b)(5). He also agreed to pay disgorgement of $83,333 and prejudgment interest and a civil penalty of $50,000. In a related administrative proceeding, Mr. Hulse consented to the entry of an order under Rule 102(e) suspending him from appearing or practicing before the Commission as an accountant, with a right to reapply after three years.

• Mr. Abode was only named as a defendant in count two, which alleges violations of Exchange Act Section 13(a), and count three, alleging violations of Exchange Act Sections 13(b)(2)(A) and (B) and Section 13(b)(5). According to the Commission’s Litigation Release No. 21600 (July 23, 2010), Mr. Abode consented to pay a civil penalty of $25,000 (his settlement papers are not available at this date). In a related administrative proceeding, he consented to the entry of a cease and desist order from causing any violations of Section 13(b)(5) of the Exchange Act and related rules. He also agreed to the entry of an order denying him the privilege of appearing or practicing before the Commission as an accountant with a right to reapply after one year.

When the SEC filed its enforcement action against Goldman Sachs, it sparked a wave of criticism. Politicians on Capitol Hill argued there were news leaks and the suit was timed to suit the Administration which was seeking to pass what is now Dodd-Frank Act. The SEC’s Inspector General opened an investigation focused on the claims in response to a letter from Republican congressman Darrell E. Issa. Now the IG is expanding his inquiry to include more allegations from Capitol Hill. Now the question is whether the settlement was politically timed. While there is no doubt that Inspector Generals serve a laudable purpose, can there be too much of a good thing?

The SEC’s Office of Inspector General, like those at other agencies, is an independent office. Its purpose is to audit the programs and operations of the Commission to ensure proper operations. According to the Inspector General’s posting on the SEC’s website, the “mission of OIG is to detect fraud, waste and abuse and promote integrity, economy, efficiency and effectiveness in the Commission’s programs and operations.” These are commendable goals which in many ways mirror the SEC’s mission to bring a new ethics to the marketplace.

When the SEC’s Inspector General conducts an inquiry, it is essential that the investigation be focused to achieve the goals of its office. In part, this means that, while seeking to promote the integrity and effectiveness of the SEC, the IG should avoid impeding or otherwise interfering with the Commission’s essential law enforcement functions. It is also means that the IG should not become a political tool of Capitol Hill, something which would inject politics into the SEC’s processes rather that serve as a safeguard against such an occurrence.

The inquiry being conducted by the SEC’s IG raises critical questions about compliance with its mission. The investigation began immediately after the Commission filed what is undoubtedly its most high profile enforcement action in years. As with many high profile cases, it generated controversy. Yet, in response to Capitol Hill, the IG almost immediately stepped into the spotlight, announcing the opening of an investigation into the filing of Goldman.

Investigating an open enforcement action has, at a minimum, the prospect of interfering with a critical SEC function. There can be little doubt that the IG’s inquiry has been a distraction for the Commission staff tasked with litigating a very difficult case against a significant opponent. Equally clear is the fact that the IG inquiry undercut the Commission’s credibility in the marketplace thereby detracting from the merits of the Goldman case. Since the questions being investigated by the IG had nothing to do with the merits of the action, there is no reason the inquiry could not have been conducted later. At a minimum, it should have remained non-public and confidential.

Perhaps more importantly the IG’s inquiry has the potential to undermine the Commission’s processes and of its office. The inquiry is supposed to focus on whether the case against Goldman is tinged with partisan politics. Yet, it was opened and expanded as a direct result of clamor from Capitol Hill and thus risks injecting partisan politics into the process in the name of ensuring against such a prospect. Such needless risk does not promote the integrity of the SEC’s processes and it is inconsistent with the goals of the IG’s office. While there is no doubt that the IG does a commendable job, timing is often crucial and sometimes there can be too much of a good thing. This is one of those times.

The Dodd-Frank bill, now signed into law, contains a number of provisions enhancing SEC Enforcement. SEC Chairman Mary Schapiro estimates that the Commission will be required to hire an additional 800 people to implement the Act. The CFTC, however, is moving quickly to implement its new authority, publishing a list of rule making initiatives regarding derivatives.

SEC enforcement filed a settled action against computer giant Dell Inc, its founders and several officers. The company agreed to pay a large fine, consented to a fraud and books and records injunction and remedial procedures. Mr. Dell and others agreed to a Securities Act Section 17(a)(2)&(3) negligence based injunctions and other relief. Criminal prosecutors continued bringing investment fund fraud cases, while the FSA resolved a father and son insider trading action.

Market reform

SEC enforcement: The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law, has a number of provisions which enhance the authority of SEC Enforcement as discussed here. They include provisions: (1) enhancing the antifraud provisions under Exchange Act Sections 9, 10(1) and 15; (2) on extraterritorial jurisdiction, effectively overruling the Supreme Court’s decision in Morrison and extending the jurisdiction in this area of the government and SEC; (3) extending aiding and abetting authority for the SEC under the Securities Act, the Investment Company Act and the Investment Advisers Act; (4) clarifying the SEC’s authority over formerly associated persons of regulated entities; (5) imposing joint and several liability on control persons in SEC actions; (6) authorizing the nationwide service of subpoenas in SEC district court enforcement actions; (7) authorizing the SEC to impose collateral bars; and (8) expanding the SEC’s authority to impose penalties to all cease and desist proceedings. The Act also imposes certain time limits on investigations and inspections.

CFTC rule making: The CFTC published a list of its rule making relating to over-the-counter derivatives under Dodd-Frank. The list includes: (1) the comprehensive regulation of swaps dealers and major swap participants; (2) clearing; (3) trading; (4) particular products; (5) enforcement; (6) position limits; and (7) other titles.

SEC enforcement action

Financial fraud: SEC v Dell Inc., Civil Action No. 1:10-cv-01245 (D.D.C. Filed July 22, 2010) is a settled action alleging violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 13(a), 12(b)(2)(A) and (B). The defendants are Chairman and CEO Michael Dell, former CEO Kevin Rollins, former CFO James Schneider, former Assistant Controller Leslie Jackson and former regional Vice President of Finance Nicholas Dunning. The complaint alleges that Intel Corporation made exclusivity payments to Dell so that the company would not use CPUs manufactured by its rival Advance Micro Devices, Inc. The payments grew from 10% of operating income in fiscal 2003 to 38% in fiscal 2006 to 76 % in the first quarter of fiscal 2007. When Dell announced in the second quarter of fiscal 2007 that it would begin using ADM CPUs, Intel sharply cut the payments resulting in the equivalent of a 75% decline in Dell’s operating income. The defendants never disclosed that the company was able to meet its earnings targets as a result of the Intel payments. At a second quarter 2007 earnings call, investors were not told that the sharp drop in operating results was caused by Intel’s action. Rather, the drop was attributed to other causes. The company also maintained a cookie jar reserve from the third quarter of fiscal 2003 through the first quarter of fiscal 2005.

To settle the action the company consented to the entry of a permanent injunction prohibiting each of the sections cited in the complaint, agreed to enhance its Disclosure Review Committee and disclosure processes and to retain an independent consultant to make recommendations. The company also agreed to pay a $100 million civil penalty.

Messrs. Dell and Rollins consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) & (3) and aiding and abetting violations of Exchange Act Sections 13(a). Each executive agreed to pay a civil penalty of $4 million. Mr. Schneider consented to the entry of an injunction prohibiting future violations of Securities Act Section 17(a)(2) &(3), Exchange Act Section 13(b)(5) and aiding and abetting violations of 13(a) and 13(b)(2)(A) & (B). He also agreed to pay disgorgement of $83,096 along with prejudgment interest. Messrs. Dunning and Jackson consented to the entry of permanent injunctions prohibiting future violations of Exchange Act Section 13(b)(5) and from aiding and abetting violations of Sections 13(a) and 13(b)(2)(A)&(B). Mr. Dunning also agreed to pay a civil penalty of $50,000. Messrs. Schneider, Dunning and Jackson also consented to the entry of an order under Rule 102(e) suspending each from appearing or practicing as an accountant before the Commission with a right to reapply after five years for Mr. Schneider and three years for Messrs. Dunning and Jackson. See also Litig. Rel. 21599 (July 22, 2010).

Kickbacks: SEC v. Langford, Case No. CV-08-0761 (N.D. Ala. Filed April 30, 2008) is the first enforcement action involving security based swap agreement, discussed here. It centers on a kickback scheme involving Larry Langford, the mayor of Birmingham, Alabama, William Blount, the co-owner and chairman of Blount Parris, a municipal securities broker and Albert LaPierre, a lobbyist and former executive director of the Alabama Democratic Party. Mr. Blount, his brokerage firm, and Mr. LaPierre settled with the Commission, consenting to the entry of permanent injunctions prohibiting future violations of Securities Act Section 17(a), Exchange Act Sections 10(b) and 15B(c)(1) and certain rules of the Municipal Securities Rulemaking Board. The SEC’s claims for disgorgement and civil penalties were dismissed. See also Litig. Rel. 21595 (July 20, 2010). Previously, the defendants in the Commission’s case were indicted on criminal charges based on the same scheme as discussed here. Mr. Blount also consented in a related administrative proceeding to the entry of an order barring him from associating with any broker, dealer or municipal securities dealer. In the Matter of William B. Blount, Adm. Proc. File No. 3-13974 (July 22, 2010).

Criminal cases

Investment fund fraud: U.S. v. Brown (S.D.N.Y. Unsealed July 22, 2010) is a criminal complaint charging securities fraud, wire fraud and money laundering against CPA Laurence Brown. According to the court papers, beginning in 2008 Mr. Brown, a principal in an accounting firm, raised about $2 million from investors who were solicited to purchase shares in Infinity Reserves-Tennessee, Inc. The funds were to be used to upgrade a natural gas pipeline in Tennessee. In fact, the shares were fictitious and most of the money was diverted to the defendant’s personal use. The Commission filed a parallel proceeding against Mr. Brown and his partner Ronald Mangini, SEC v. Brown, Civil Action No. 10-CV-5564 (S.D.N.Y. Filed July 22, 2010). Both cases are in litigation.

FINRA

SunTrust Investment Services, Inc., and two of its brokers, David Bredenburg and another broker, from 2004 through November 2006 engaged in a pattern of unsuitable short term UIT, CEF and mutual fund transactions in the accounts of seventeen customers, most of whom were elderly and/or disabled. In addition, FINRA concluded that the two brokers recommended to ten of those customers unsuitable purchases and sales of securities on margin. The firm settled the action by agreeing to pay $1.44 million. About $900,000 of that amount is a fine while nearly $224,000 constitutes disgorgement. The remaining $540,000 is restitution to the customers. Mr. Bredenburg was permanently barred from the industry in a prior proceeding. The supervisor of the two brokers, Donald Mattran, was suspended for six months from acting in any principal capacity and fined $10,000.

Court of appeals

Fiduciary duties: U.S. v. Lay, No. 08-3893 (6th Cir. July 14, 2010) is, as discussed here, an appeal by an investment adviser from his conviction on violations of the Advisers Act and other charges. Defendant Mark Lay is an investment adviser. His client is Ohio Bureau of Workers’ Compensation. Mr. Lay’s company, Capital Management, Inc. started managing the Bureau’s investment in a long-term bond fund, the Long Fund. Subsequently, in 1998 Mr. Lay started a hedge fund, the Active Duration Fund. The Bureau moved $100 million of its investment from the Long Fund to the Active Duration Fund. The agreement set a non-binding 150% leveraging guidelines which Mr. Lay exceeded. As losses grew at the hedge fund the Bureau transferred additional funds to it but the losses continued and most of the investment was lost. The losses resulted in large part from excessive leverage far beyond the guidelines. The jury was instructed on the elements of Adviser Section 80b-6-(1) or 80b-2(2) or 80b-6(4). The court also instructed the jury that it could find as a matter of fact that Mr. Lay had a fiduciary duty to the Bureau with regards to its investment in the hedge fund. The jury returned verdicts of guilty which the Sixth Circuit affirmed. Mr. Lay did not dispute the fact that he had an investment adviser-client relationship with respect to the Long Fund. He did dispute this claim with regard to the hedge fund, arguing that the fund and not the Bureau was the client. The court rejected this claim.

FSA

Jeremy Burley, the Managing Director of BMS Minerals, a Ugandan company, and his father Jeffery Burley, were fined by the FSA for engaging in market abuse or insider trading in June 2009. According to the FSA Jeremy Burley learned around June 11, 2009 that Tower Resources, a company for which BMS Minerals furnished equipment, was unlikely to find oil in the first well it was drilling and that exploration regarding a second was unlikely to proceed. Before the public announcement of these events Jeremy Burley passed the information to his father and another with instructions to his father to sell his holdings in the company. The father followed the instructions and avoided a loss of over $30,000. The FSA fined Jeremy Burley over $200,000 and his father over $50,000. The fine as to Jeremy Burley reflected his lack of cooperation.

The commentary, speculation and second guessing about the SEC’s settlement in Goldman may be drawing to a close, or at least diminishing. There is no doubt that Goldman is the most significant market crisis case to come from the numerous investigations the Commission has been conducting. Indeed, simply bringing the case was a significant step in view of the bank’s stature on Wall Street and the fact that the claims took the SEC into uncharted and very difficult waters. At the same time, it is beyond dispute that one big case does not create an enforcement program. So what does the SEC Enforcement Division do for an encore?

One might look for clues in the testimony of SEC Chairman Mary Schapiro before the House Financial Services Committee on Tuesday. The remarks were titled “Evaluating Present Reforms and Future Challenges,” available here. The Chairman’s testimony recounts recent efforts of the Enforcement Division, with the promise of a look at future challenges.

The Enforcement program “is a key element to fair and effective markets,” the Chairman told the Committee. She then rehashed the now familiar reforms such as the delegation of authority to issue a formal order of investigation, as well as the initiatives to encourage cooperation. The new Financial Fraud Enforcement Task Force and the structural changes Enforcement Director Khuzami has implemented, creating new specialty units and hiring new personnel were reviewed. All of these reforms were, as usual, tied to themes of speed and efficiency.

The results of these and other efforts, the Chairman noted, are reflected in part by the statistics. In testimony reminiscent of remarks by Mr. Khuzami in a recent speech, discussed here, the Chairman noted that in 2009 the Commission secured orders for disgorgement and civil penalties in amounts that exceeded those for fiscal year 2009 by, respectively, 46% and 101%. The SEC also sought more than twice as many temporary restraining orders while issuing more than twice as many formal orders of investigation.

Cases brought by the Division bolster the statistics, according to the Chairman. Key examples include the action against American Home Mortgage, the cases naming the officers of Countrywide Financial Corp and New Century as defendants, and the actions against Brookstreet Securities and Morgan Keegan. Interestingly, only after citing these cases did the Chairman mention the high profile settlement in Goldman, discussed here. Ms. Schapiro went on to tell the Committee about other significant cases such as ICP Asset Management, the action against the former chairman of Taylor, Bean and the case against State Street Bank.

Overall the Chairman’s remarks recount where the program has been recently. But where is it going? What is happening with all the market crisis investigations Commissioner Walter and others previously mentioned?

While the SEC press release and litigation release for Goldman each contain the identical statement that the settlement does not apply to “any other past, current or future SEC investigations against the firm,” suggesting there may be other investigations, it seems clear the inquiry is over. Goldman’s 8-K states that it “understands that the SEC staff also has completed a review of a number of other Goldman mortgage-related CDO transactions and does not anticipate recommending any claims against Goldman or any of its employees.” Undoubtedly that language was reviewed in the settlement discussions.

So the Goldman investigation is over. Ms. Schapiro’s testimony, despite its title referencing “Future Challenges,” gives no clue about the future direction of any pending enforcement investigations. The question persists: Is Goldman the beginning of a bold new enforcement program that is about to unravel the roots of the market crisis or the end of the significant cases emanating from all the market crisis investigations? What is the encore?

In U.S. v. Lay, No. 08-3893 (6th Cir. July 14, 2010), the court upheld an instruction that permitted the jury to find that a hedge fund adviser had a fiduciary relationship with a client. Defendant Mark Lay began serving as an investment adviser to the Ohio Bureau of Workers’ Compensation when his company, Capital Management, Inc. started to manage the Bureau’s investment in a long-term bond fund, the Long Fund.

Subsequently, in 1998 Mr. Lay started a hedge fund, the Active Duration Fund. The Bureau moved $100 million of its investment from the Long Fund to the Active Duration Fund. The agreement set a non-binding 150% leveraging guidelines which Mr. Lay exceeded. By March 2004, the Active Duration Fund had lost $7 million. In May 2004, the Bureau added $100 million to its hedge fund investment. In September of 2004, the Bureau invested an additional $25 million in the fund. The losses continued.

The Bureau ultimately recovered $9 million of the $225 million that was invested in the hedge fund. Most of the loss involved leveraging over the 150% guidelines. In fact, about one fifth of the trades involved leveraging over 1000% with some trades involving leveraging over 10,000%.

The jury was given an instruction which provided that, to find Mr. Lay guilty of investment adviser fraud, the government had to prove each element contained in either Adviser Section 80b-6-(1) or 80b-2(2) or 80b-6(4). With respect to Section 80-6(1)&(2) the court informed the jury that “it is for you to determine as a matter of fact whether Mark Lay had an investment adviser-client relationship with the [Bureau] with respect to its investment in the . . . Active Duration Fund . . .” With respect to Section 80b-6(4), the jury was told that if it concluded the Bureau was not Mr. Lay’s client with respect to the hedge fund then it should determine as a matter of fact whether he had a fiduciary duty with respect to the hedge fund. The jury returned a verdict of guilty

The Sixth Circuit affirmed, concluding that the jury instructions were correct in the context of this case. Mr. Lay never disputed the fact that he had an investment adviser-client relationship and thus a fiduciary relationship with the Bureau as to its Long Fund investment. Mr. Lay claims however that he did not have such a relationship with the Bureau with respect to the hedge fund based on the decision in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). There, the Court rejected a rule issued by the SEC requiring hedge funds to register based on the number of its clients as discussed here. Previously, the SEC had viewed the fund as the client. In rejecting the rule, the D.C. Circuit concluded that the hedge fund adviser does not tell the individual investor how to spend his or her money. That decision is made when it is put into the fund.

Goldstein did not hold that “no hedge fund adviser could create a client relationship with an investor, but rather held only that the SEC had ‘not justified treating all investors in hedge funds as clients,’” the Sixth Circuit concluded. Indeed, hedge funds have different classes of investors with different rights or privileges with respect to their investments. Accordingly, it was entirely proper for the district court to submit the question to the jury as an issue of fact.

As SEC Enforcement savors its settlement in Goldman and continues to retool into a new and more aggressive program, Congress is giving it new tools. The Dodd-Frank Wall Street Reform and Consumer Protection Act has a number of provisions which enhance the authority of SEC Enforcement. These include:

Enhancement to the anti-fraud provisions: Under the new legislation, Exchange Act Section 9, relating to market manipulation, and Section 10(1), concerning short sales, are being extended to cover all except government securities, rather than just those registered on a national securities exchange. In addition, Section 9(b), regarding options, is being extended to cover non-exchange transactions in options while Section 9(c) will now apply to all brokers and dealers, not just members of a national securities exchange. Section 15(c)(1)(A) will now cover exchange transactions, not just those in the over-the-counter market.

Extraterritorial jurisdiction: The Act precludes the application of the Supreme Court’s recent decision in Morrison, discussed here, to actions brought by the SEC or the United States. Rather, it specifies that the antifraud provisions extend in SEC and government actions to any conduct within the U.S. that constitutes “significant steps in furtherance of the violation,” even where the securities transaction is not in the U.S. and involves only foreign investors. The extension also covers any conduct outside the U.S. that has a foreseeable, substantial effect in the United States. The SEC is required to prepare a study on the impact of applying these extensions to private damage suits.

Aiding and abetting: The Act makes it clear that recklessness is sufficient to prove aiding and abetting. It also gives the SEC explicit authority to bring enforcement actions based on this theory under the Securities Act, the Investment Company Act and the Investment Advisers Act. The Act did not include a provision extending aiding and abetting liability to private civil actions. The GAO, however, is required to study the impact of extending such authority to private damage actions.

Formerly associated persons: The Act makes it clear that the SEC can bring an action against a person formerly associated with a registered entity.

Control person liability, Exchange Act: Under the Act, the SEC may impose joint several liability on control persons.

Service of subpoenas: Parties to SEC enforcement actions in federal district court will be able to serve subpoenas nationwide.

Collateral bars: The SEC will be able to impose collateral bars prohibiting offenders from associating with a range of Commission regulated entities.

Penalties: The SEC will now have authority to seek civil penalties in all of its cease and desist proceedings.

While the SEC’s enforcement authority is being enhanced, the Act also sets deadlines to speed the process. The Commission SEC will now have 180 days after giving a written Wells notice to institute an enforcement action. Likewise, the agency will be required to inform the subject of an examination in writing within 180 days from the date the exam is completed if there are no findings or the staff intends to request corrective action. Both time limits can be extended for complex matters.

The passage of the most sweeping financial reform legislation since the 1930s and the settlement of the SEC’s most high profile enforcement action in years highlighted last week. The Dodd-Frank Wall Street Reform and Consumer Protection Act was sent to the President for signature, which is expected this week. The Act addresses “too big to fail,” derivatives and hedge fund regulation, while establishing new consumer protections.

The resolution of the Goldman Sachs enforcement action was a win for the SEC and a good outcome for the bank, neither of whom could afford to lose in the most high stakes case brought by the Commission in years. For the Commission, it is critical that Goldman Sachs represent the beginning of a new, effective enforcement program and not just one case. For the bank, it is out of the spotlight and back to business and rebuilding its reputation.

Market reform

The Dodd-Frank Wall Street Reform and Consumer Protection Act passed in the Senate and is being sent to the President for signing this week. The bill is being hailed as the most significant regulatory overhaul since the great depression. The 2,000 page piece of legislation is designed to address the roots of the financial crisis. The bill gives the SEC new authority, while requiring the agency to write rules and conduct studies in a variety of areas. Under the bill, the SEC will gain additional authority over derivatives and hedge funds. There are 95 provisions in Dodd-Frank concerning SEC rule making, while seventeen other sections require the preparation of reports, many of which are discussed here.

Implementation of the Act: Anticipating the passage of Dodd-Frank, Chairman Schapiro highlighted some of the areas of focus for the Commission under the Act in remarks last week. These include: 1) Derivatives: Working with the CFTC the Commission will be writing rules that address capital and margin requirements, mandatory clearing, the operation of execution facilities and data repositories and reporting and recordkeeping obligations; 2) Standards of care for broker dealers: The Act calls for a study on this point and gives the SEC authority to promulgate rules that would impose a harmonized fiduciary standard on broker-dealers and investment advisers who provide personalized investment advice to retail or other customers; 3) Hedge funds: The Commission will adopt rules governing record keeping and reporting requirements; 4) Enforcement: There are several key provisions to strengthen the program including the authority to issue subpoenas nationwide in civil actions and clarifying the agency’s aiding and abetting authority; and 5) Corporate disclosure: A number of provisions require that rules be written on corporate disclosure including executive compensation.

SEC enforcement actions

Disclosure: SEC v. Goldman Sachs, Civil Action No. 3229 (S.D.N.Y. Filed April 16, 2010) is the Commission’s landmark enforcement action against the Wall Street icon and one of its employees, Fabrice Tourre. The SEC’s claims, discussed here, are based on conflicts of interest and a failure to disclose critical information about the origins and formation of a synthetic collateralized debt obligation tied to the sub-prime residential real estate market. The CDO was structured at the request of Goldman client Paulson & Co. so it could short the sub-prime market. The marketing materials did not disclose this fact or the influence of Paulson in constructing the CDO. The complaint alleged violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and sought in injunction, disgorgement, prejudgment interest and a penalty. In the settlement, discussed here, the bank agreed to pay a record $550 million, made an unusual admission of having faulty marketing materials, consent to the entry of a fraud injunction based on Securities Act Section 17(a) and agreed to a series of procedures designed to prevent a reoccurrence of the wrongful conduct. The Section 10(b) claim was dropped. It does not end the litigation which will continue as to Fabrice Tourre.

Option backdating: SEC v. Trident Microsystems, Inc., Civil Action No. 1:10-CV-01202 (D.D.C. Filed July 16, 2010) alleges that defendants Trident Microsystems, Inc., a Santa Clara based provider of integrated circuits, and its founder and former CEO Frank Lin, and former Chief Accounting Officer, Peter Jen backdated options from 1993 through 2006. The grants were used to provide compensation to executives and other employees. The SEC claims that Mr. Lin and others he directed used hindsight to select option grant dates so that they would be in-the-money. At times, grants were parked with certain employees and later allocated to newly hired employees. As a result, Trident materially overstated its pre-tax income or understated its pre-tax loses by as much as 113%. The grants caused the company in August 2007 to restate $37 million of compensation expenses. The complaint also alleges that false proxy statements and Form 4s were filed as a result of the scheme.

The company settled by consenting to the entry of an order prohibiting future violations of Securities Act Section 17(a) and Exchange Act Sections (10)(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 14(a). Messrs. Lin and Jen also consented to the entry of a permanent injunction prohibiting future violations of the same sections as the company and, in addition, Exchange Act Section 16(a). In addition, Mr. Lin agreed to disgorge the in-the-money benefits he received from his grants which totaled $817,509, to pay a penalty of $350,000 and to an order barring him for five years from serving as an officer or director of any issuer. In addition to the injunction, Mr. Jen agreed to disgorge the in-the-money component of his options which totaled $359,819, to pay a penalty of $50,000 and to be barred from serving as an officer or director of a public company for five years.

Discovery: In the Matter of Morgan Asset Management, Inc., Admin. Proc. File No. 3-13847 is an action which centers on claimed misconduct by the directors of Morgan Keegan & Company’s Funds as discussed here. Last week, on the motion of the Respondents, the ALJ entered an order essentially walling off the staff litigating the case from those who were conducting a parallel investigation as discussed here. ALJ Kelly found that after this proceeding was instituted the enforcement staff obtained a second formal order which clearly overlapped the administrative proceeding despite the efforts of the staff to make it appear otherwise. To preclude the staff from improperly using investigative subpoenas to supplement the evidence available in the proceeding, an order was entered which precludes the enforcement staff working on the case and using the material from the investigation.

Prohibited contributions: In the Matter of John F. Kendrick, Adm. Proc. File No. 3-13830 (July 14, 2010) is a settled action against John Kendrick, a senior vice president of public finance for New England Southwest Securities. From 2003 through 2008, Mr. Kendrick, according to the Order, contributed $1,625 to Timothy Cahill, the treasurer of the Commonwealth of Massachusetts. The treasurer is responsible for the hiring of brokers for municipal securities business by the state. The contributions here were made through several different sources but exceeded the $250 de minimis amount permitted. Under Rule G-37 each contribution above the $250 level triggered a two year ban on municipal securities business with the issuers. During that period Southwest, with the knowledge of Mr. Kendrick, participated as co-manager for 19 negotiated underwritings by the Issuers totaling approximately $14 billion. To settle this action, Mr. Kendrick consented to the entry of and order directing that he cease and desist from committing or causing any violations and any future violations of Sections 15B(c)(1) of the Exchange Act, MSRB Rule G-37(b) and MSRB Rule G-37(c). He also agreed to pay a $10,000 civil penalty.

Touting: SEC v. InvestSource, Inc., Case No. SACV 10-01041 (C.D. Cal. Filed July 9, 2010) is an action against investor relations firm InvestSource and its principal, Songkram Sahachaiser, alleging violations of Securities Act Sections 17(a) and 17(b) and Exchange Act Section 10(b). The complaint claims that from January 2008, and continuing through early 2009, InvestSource sent a Daily Digest to those listed in its e-mail base which profiled various clients and recommended the stock. Frequently the firm was paid in shares which were sold while the e-mails were being distributed. That fact was not disclosed and a “disclaimer” on its website was false and misleading according to the SEC since it only noted that the firm “may” be compensated when in fact it was always compensated. The disclaimer also falsely stated that shares received for services were immediately sold when in fact they were not. The case is in litigation.

Criminal cases

Insider trading: U.S. v. Plate (S.D.N.Y. July 16, 2010), is another of the Galleon insider trading cases. Here David Plate, a proprietary trader at The Schottenfeld Group LLC, pleaded guilty to one count of conspiracy and one count of securities fraud. Mr. Plate admitted to trading on what he believed to be inside information in the shares of 3Com and Axcan. In fact the information came from Zvi Goffer who had obtained it from Ropes & Gray attorneys Arthur Cutillo and Brian Santarlas through an intermediary. The law firm was providing legal advice to the companies prior to the public announcement of the deals.

Court of appeals

U.S. v. Graf, Case No. 07-50100 (Decided July 7, 2010) resolved an important question regarding the application of the attorney client relationship. There defendant, James Graf, was indicted for his involvement in the fraudulent operation of Employers Mutual LLC, a purported provider of health care benefits to 20,000 plan members. In reality, the company was a fraud and plan members had no benefits or coverage. At trial, the government sought to introduce the testimony of three attorneys who had provided legal advice to the company. Although the trustee for the company waived privilege, Mr. Graf objected claiming that he was a joint holder of any attorney client privilege with the company. The district court rejected the claim and Mr. Graff was convicted on all counts.

The Ninth Circuit affirmed the ruling and adopted the test used by the Third Circuit in In re Bevill, Bresler & Schulman Asset Mgt. Corp., 805 F.2d 120 (3rd. Cir. 1986). This test is also used by other circuits. In that case, the court held that any privilege as to a corporate officer’s role within the company belongs to the corporation. To evaluate whether an individual officer has a personal privilege with corporate counsel the Bevill court employed a five factor test: (1) the person must demonstrate that he or she approached counsel to seek legal advice; (2) the individual must demonstrate that it was made clear to counsel that they were seeking legal advice in their individual capacity; (3) they must demonstrate that the attorney communicated with them in their individual capacity, recognizing that a conflict might arise; (4) the conversations with the attorney must be confidential; and (5) the substance of the conversations with counsel must not have concerned matters about the company or the general affairs of the corporation. Under this test, it is clear Mr. Graff did not have an attorney client relationship with corporate counsel.

FINRA

The Financial Industry Regulatory Authority issued a warning to investors regarding Ponzi schemes called high-yield investment programs which are being marketed through social network media. The promoters of HYIPs are using social media including YouTube, Twitter and Facebook to lure investors and create the illusion of social consensus that the investments are legitimate. The schemes offer yields of 20, 30 and 100%. Some suggest that the investors “ride the Ponzi” by getting in and out before the scheme collapses.

PCAOB

Proposed new confirmation standard: On July 13, 2010 the Board approved for comment a proposed audit standard titled Confirmation. It is intended to strengthen the current requirements regarding confirmation. The proposed standard is based on a concept release issued earlier this year and the comments received.

Work of other auditors: On July 12, 2010 the Board issued Staff Audit Practice Alert No. 6. The alert focuses on requirements for the use of, and reliance on, the work of other auditors when issuing a report. The alert stems from the Board’s observation that a number of registered public accounting firms in the U.S. have been issuing audit reports on financial statements filed by issuers that have most of their operations outside the country.