On Friday July 3, 2009, the markets, courts, SEC and most businesses are closed in celebration of the July 4th holiday. At this half way point in the year the Securities and Exchange Commission is at a cross roads.

On one road there are far reaching market reform proposals authored by the Treasury Department and the Administration which would give the SEC significant new authority. Consistent with these proposals the new SEC Chairman is working hard to seize the moment, proposing significant and potentially far reaching new rules while trying to put the embattled agency on the road to once again being a premier regulator.

On another road is the enforcement program which continues to be rocked by revelations of failure. The story in The Washington Post on July 2, 2009, detailing additional Madoff related failures is just the latest sad tale for the once proud enforcement division. There are reports that the program is being revamped, revitalized and has a new tone at the top which will put the division on the road to restoration. Yet there are few positive results from the dozens of market crisis investigations the division reportedly has been conducting for months. To be fair, revitalizing enforcement is not a short term project. It takes time. The clock is ticking however. It needs to get on the right road.

Whether these two roads will merge in the future and become the yellow brick road that returns the SEC to being top cop of Wall Street and an effective protector of investors and the markets remains to be seen. At this half way point in the year however it is appropriate to set all of this aside, pause and enjoy the holiday weekend.

Happy Holiday To All!

With all the discussion of the market crisis, ponzi schemes, toxic assets and regulatory reform, it is easy to lose sight of the fact that ensuring companies make money the old fashioned way — by earning it — and using proper accounting is a critical mission of SEC enforcement. Thus, managed earnings has long been a key target.

In SEC v. Rand, Civil Action No. 1:09-CV-1780 (N.D. Ga. Filed July 1, 2009) the Commission filed a financial fraud action centered on a years long scheme to manage the earnings of home builder Beazer Homes USA, Inc. The defendant is Michael Rand, the former chief accounting officer of the company. Mr. Rand is litigating the case. See also Lit. Rel. 21114 (July 1, 2009).

Beginning as controller and later as chief accounting officer, Mr. Rand, according to the SEC, engaged in a scheme over a period of about eight years to meet analysts’ expectations essentially through the use of cookie jar reserves. The fraudulent scheme had three key facets. First, the land inventory accounts were manipulated. Under company accounting policies, as subdivisions were built, costs accumulated in the land inventory accounts were allocated to individual home lots which were then offered for sale. When the home was sold the allocated costs in the account were expensed as a cost of sale.

Beginning in 2000 and continuing through 2004, Mr. Rand over allocated land inventory costs in material amounts. For example, in the first quarter of 2004, the amounts were overstated by about $3.9 million. In the second quarter, they were over allocated by about $4.2 million. This caused the company to understate income by a total of $56 million between 2000 and 2005 or by about 5% of reported net income. Beginning in 2006, the over allocations were reversed, thereby overstating income.

In a second facet of the scheme, the “house cost to complete” reserves were utilized in a similar fashion. This reserve was established under company policy for completed homes to cover unexpected minor expenses such as small repairs or final cosmetic touchups. Typically, the reserve was a few thousand dollars per home. Company policy called for the reserve to be zeroed out a few months after the sale with any remaining amounts taken to income.

Beginning in 2000 and continuing through 2005, this reserve was over accrued thereby understating income. Beginning in 2006, Mr. Rand, according to the Commission, reversed these entries and took the amounts reserved into income, thereby overstating revenue. For example, in the first quarter of 2007 the reversal of excess cost to complete reserves added over $1.5 million to earnings for that period.

Fraudulent sale-lease back transactions were the final part of the scheme. Prior to 2006, the company typically retained ownership of most of its model homes. For a few models however Beazer entered into sale-lease back arrangements with third parties. Revenue for these transactions was recognized at the beginning of the lease term.

Near the end of 2005, the company began entering into sale-lease back transactions where it retained the right to a percentage of the appreciation on the ultimate sale of the model home. Retention of the appreciation right, the auditors advised, meant the transaction had to be recorded as a financing, not a sale-leaseback. This would preclude the company from recording the model home sales revenue and profit at the beginning of the lease term. To ensure immediate recognition of the revenue, the company put the appreciation rights provisions in oral side agreement. This avoided scrutiny by the auditors and permitted the revenue to be improperly booked. As a result, 2006 revenues were overstated by $117 million and net income by $14 million.

The fraudulent scheme caused filings of the company to be materially false for years. This included Beazer’s annual and quarterly reports and a 2002 registration statement. The complaint contains counts alleging fraud in violation of Sections 17(a) and 10(b) and aiding and abetting violations of various reporting and internal control provisions as well as lying to the accountants in violation of Rule 13b-2-2.

Last year, Beazer settled similar charges with the Commission. In its settlement the Company consented to the entry of a cease and desist order for future violations of Sections 17(a) and 10(b) and the reporting provisions. The SEC stated that it took into consideration the cooperation and remedial efforts of the company in entering into the settlement. In the Matter of Beazer Homes USA, Inc., Adm. Proc. File No. 3-13234 (Sept. 24, 2008).

The Commission settled with former Putnam employee Donald F. McCracken, concluding its case against six former Putnam Fiduciary Trust Company alleged to have engaged in a scheme to defraud Putnam client Cardinal Health, Inc. SEC v. Durgarian, Case No. 05-12618 (D. Mass. Filed Dec. 30, 2005). Mr. McCracken is the former senior managing director and head of fund accounting at Putnam.

To resolve the case, portions of which were unsuccessfully appealed to the First Circuit by the SEC, Mr. McCracken consented to the entry of a permanent injunction prohibiting future violations of Section 17(a)(3) of the Securities Act. He also agreed to the entry of an order requiring the payment of a civil penalty of $35,000 and, in a separate administrative proceeding to be filed, an order barring him from association with any broker or dealer or transfer agent with a right to reapply after one year. See also Lit. Rel. No. 21110 (June 29, 2009).

The Commission’s initial complaint in this action named six former employees of Putnam, including Mr. McCracken. It centered on a claimed cover-up of a one-day delay in investing certain Cardinal assets in a defined benefit plan in 2001. As a result of the delay, Cardinal lost about $4 million in market gains. Rather than disclose the error to Cardinal, the defendants took steps to conceal it, according to the complaint. Those steps included improperly shifting about $3 million of the costs to the shareholders of other Putnam funds by backdating accounting entries and other mechanism. Cardinal ended up with about $1 million in losses. The complaint charged Mr. McCracken and the other defendants with fraud in violation of Exchange Act Section 10(b) and Rule 10b-5 thereunder and Securities Act Section 17(a) as well as aiding and abetting violations of Section 10(b).

Previously, the district court granted a motion to dismiss as to three of the six defendants. The court refused to dismiss the claims against Mr. McCracken and two other defendants however. See Lit. Rel. No. 20373 (Nov. 27, 2007). The Commission appealed the partial dismissal of its complaint to the First Circuit Court of Appeals. That court rejected the SEC’s claims, as discussed here, concluding that the three defendants had not aided and abetted the fraud since their claimed participation in the scheme occurred after the fraud was complete. See also Lit. Rel. No. 20900 (Feb. 13, 2009). The other two defendants, Karnig Durgarian, Jr. and Ronald Hogan, previously settled with the Commission, consenting to the entry of permanent injunctions prohibiting violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and Rule 10b-5 thereunder. Mr. Durgarian also agreed to pay a civil penalty of $100,000 while Mr. Hogan paid $35,000. See Lit. Rel. No. 20797 (Nov. 3, 2008).

Bernard Madoff’s Ponzi scheme of the ages resulted in a sentence for the ages. Yesterday, after Mr. Madoff faced some of his victims for the first time, the court imposed the statutory maximum 150 year sentence. That sentence far exceeds the 12 years Mr. Madoff sought and even the 50 year recommendation of the federal probation department. It also far exceeds those handed down in other recent white collar cases, such as Jeffery Skilling of Enron and Bernie Ebbers of Worldcom, each of whom is serving 25 years.

The preliminary forfeiture order issued on Friday also dwarfs those in other actions. Under that order, Mr. Madoff will forfeit over $170 billion. His wife will be left with about $2.5 million, which could not be “sufficiently linked” to the fraud, according the U.S. Attorney’s Office. There is no assurance that the SEC or others may not try to attach the assets left with Mrs. Madoff, however.

The jail term and the forfeiture order confirm that Mr. Madoff will never leave prison and will not profit from his crimes beyond the lavish life style he enjoyed until caught. At the same time, the huge jail term and forfeiture order do not resolve the two key questions about the Madoff Ponzi scheme: 1) how did the SEC fail to uncover the massive fraud despite multiple opportunities? (2) who else was involved?

How the SEC failed to uncover the Madoff fraud is virtually impossible to understand. With multiple opportunities beginning as early as 1992, and a virtual road map to Madoff and his scheme as discussed here, the fraud should have been detected and the carnage stopped much earlier. To be sure, no law enforcement agency can halt fraud from the start. And, Ponzi schemes can be difficult to detect, although it is hard to make that argument given the number of these cases brought in recent weeks. In the case of Mr. Madoff however, the size and scope of the scheme coupled with the repeated opportunities and road map should have been more than sufficient.

The answer to this question is more than academic. It is fundamental to reforming and rejuvenating SEC enforcement. Perhaps the answer to this question will be in the forthcoming report of the SEC Inspector General who reportedly has interviewed Mr. Madoff.

Equally important is the question of who else was involved. The answer to this question is important to law enforcement and the victims. Law enforcement needs to unravel this issue not just to bring the appropriate actions, but as part of the self-evaluative process of how the scheme was missed earlier. The victims need to identify the other beneficiaries of the scheme to try and salvage some of their investment. It is clear that the Madoff Trustee will not recover anything close to the amount the investors lost. The number in the DOJ forfeiture order, while headline grabbing, has no relation to the amount of money available for investors who are faced with recovering cents on the dollar.

Mr. Madoff has steadfastly insisted that he acted alone. The size and scope of the fraud belie this claim. The cases brought to date against the auditors by DOJ and the SEC (discussed here) and two feeder funds by the SEC (discussed here) offer some insight into the Madoff scheme. The auditors were apparently paid for producing audit reports while doing virtually no auditing. The feeder funds were paid for soliciting investor cash and turning the money over to Mr. Madoff while doing no real investing or fund management. The formula is straight forward: assist Madoff, do little and get paid very well. It can be easy to turn a blind eye to what is really happening when there is so much money involved.

Just how many others prospered from Mr. Madoff’s fraud under this formula will be the subject of intense investigation in the coming weeks and months. The huge sentence yesterday closed one chapter of the Madoff saga. Key questions which must be answered for the benefit of everyone remain, however.

During the legislative hearings which lead to the passage of the Private Securities Litigation Reform Act of 1995 (”PSLRA”), Congress was repeatedly told that “the merits don’t matter” in private securities litigation. That settlements routinely occurred which were all out of proportion to the merits of the case. That even frivolous cases resulted in huge settlements because of the cost of litigation the potential liability if a case could reach the jury. A law review article cited in the legislative materials reflected this theme. Janet Cooper Alexander, Do The Merits Matter? A Study of Settlements in Securities Class Actions, 43 Stan. L. Rev. 497 (1991).

A recent stock manipulation case lost by the Commission raises this same question about SEC enforcement. The Commission’s case against former Morgan Stanley broker Richard Kwak is detailed in an article by Joe Nocera. “Chasing Small Fry, S.E.C. Let Madoff Get Away,” New York Times at B1 (June 27, 2009) (available here, registration required). According to the article, following a three year investigation, an enforcement action was brought against Mr. Kwak and seven others for stock manipulation. The manipulation supposedly involved the shares of Competitive Technologies, a company which marketed university patents. According to the SEC, the seven broker defendants engaged in coordinated trading to push up the price of the stock. While there were numerous phone calls back and forth among the group, there was no evidence about the conversations or if the calls were even received. Trading records did not substantiate the claims by the SEC of coordinated trading and the defendants ended up with huge losses.

Nevertheless, for the most part this case ended the way most SEC enforcement actions conclude: with settlements. Four of the defendants settled immediately. Three went to trial in 2007, including Mr. Kwak. Mr. Kwak and defendant Stephen Wilson were found not liable on one charge but the jury hung on a second. (A third defendant who did not have counsel lost). In 2008, Mr. Wilson was retried. The SEC lost. In March 2009, Mr. Kwak was retried. The SEC lost. Although Mr. Kwak won, he lost. Now he is out of the securities business, cannot get a job and is in debt from the legal fees.

Mr. Nocera points to this case as an example of the SEC only going after the small fish while not pursuing huge fraudsters such as Bernard Madoff. This is not the first time this question has been raised. To be sure, the point is worth considering.

The prosecution of Mr. Kwak raises a more fundamental question however: Do the merits matter in SEC enforcement? Every year the Commission brings hundreds of enforcement cases. Most settle. Pundits trying to gauge the success of the program look at the number of cases, the number of settlements and the amount of money extracted in those settlements. The meaning of those numbers is debatable at best, however.

In fact, far too often settlements obtained by the SEC are no different than those complained of during the 1995 congressional hearings on the PSLRA. Regulated entities such as brokers, investment companies and investment advisers rarely litigate with the SEC. Public companies almost never litigate with the Commission. Rather, a business judgment is made about the impact of the continuing litigation on the company, the adverse publicity, the potential effect on credit lines and customers, the lost executive time and a host of other business factors. In the end, the company decides that the only prudent business decision is to settle on whatever terms the SEC is offering. Litigating with the Commission simply is not a option.

For individuals it is not much different. Again virtually all of the cases settle. Few individuals can afford to litigate with the Commission absent an indemnification from the company or a D&O policy to pay the legal fees. As Mr. Kwak’s case illustrates, winning without such coverage can be losing. Even where there is coverage for the legal fees, executives are often reluctant to litigate. More typically a business decision is made that it is better for the company and the individual to get the deal done and move on.

To be sure the SEC views its actions as meritorious and based on fact. No doubt many have merit and the settlements do in fact reflect the facts. As Mr. Kwak’s case illustrates however — and it is not an isolated instance — sometimes the Commission’s cases do not reflect the facts. This happens not so much because of a bent to pick on small fish as Mr. Nocera suggests, but perhaps because of the way enforcement operates.

In Enforcement, the facts are typically gathered by the junior staff members who are the least experienced. The evidence is summarized in an Action Memorandum which is reviewed by supervisors, senior staff and ultimately set to the Commission to approve the institution of an action. This means that the actual evidence is frequently only reviewed by the junior most members of the Enforcement Division. As a GAO report issued in March 2009 suggests (discussed here), the Division of Enforcement is top heavy with layers of supervisors. Those supervisors spend their time reviewing memos and attending meetings where they are briefed, not reading evidence. Under this system, it is not to hard to see how a case is brought against someone like Mr. Kwak alleging “coordinated trading” — a buzz phrase in manipulation cases — when in reality the facts only show “coordinated phone calls.”

Once the case is brought, little changes. While the SEC typically files lengthy “speaking complaints” it is not unusual for the agency to gloss the facts regarding key elements with conclusions such as “the defendant transmitted material nonpublic information” or the defendants “engaged in coordinated trading” rather than reciting the actual facts. Stock phrases such as these are substituted for facts — a pleading technique which can conceal the fact that the SEC is inferring that the claimed event happened, but has no hard evidence to support its supposition.

In a private securities action under the PSLRA a plaintiff would not be permitted to use this pleading technique — the court would demand the facts or dismiss the case. While the PSLRA does not apply to the SEC, the agency is supposed to plead fraud with particularity under Rule 9(b). More often than not however courts do not rigorously apply that standard to the SEC, despite the fact that the agency should have the facts from its typically lengthy investigation. All of this encourages settlement for the came reason the private cases settle — years of discovery takes its toll in cost and many other ways.

In revamping and rejuvenating enforcement the new Chairman and her team should begin by making sure that the merits do matter — return to basics, focusing on the evidence. Reorganizing the Division should start by getting staff members out of meetings and down in the trenches, reviewing the actual documents and analyzing the testimony. Equally important is a meaningful dialogue during the Wells process as the case moves toward a prosecutorial decision. In that process, the merits should be carefully considered and evaluated by both sides rather than just rushing forward to settlement.

In the end, the only way to ensure that the resolution of a Commission enforcement action reflects the merits is if the facts are the key focus starting from the Director’s office on down through the Division. The chairman reportedly has a sign on her office door which says “how does it help investors?” Perhaps the Enforcement Director should have one which say “what are the facts?”

The proposals in the Treasury White Paper for market reform gathered momentum this week. SEC Chairman Schapiro and CFTC Chairman Gensler testified on Capitol Hill in favor of the regulatory proposals in the paper regarding OTC derivatives. The SEC also moved forward with rule making proposals discussed in the White Paper for money market funds.

As Mr. Madoff’s sentencing approaches, two actions were brought against those the SEC claims helped feed the Ponzi scheme. At the same time, DOJ brought criminal charges against Mr. Stanford and his confederates, while the SEC amended its complaint to add parties and claims. SEC enforcement also brought insider trading and financial fraud cases, as well as more investment fund actions. DOJ also obtained a guilty plea in an investment fund case while Jones Soda won dismissal of class actions brought against the company and its officers based on allegations of financial fraud.

Market reform

Last week the Treasury Department issued its White Paper regarding market reform as discussed here. The proposals, in part, called for increased regulation over OTC derivatives. That authority would be shared by the SEC and CFTC. This week, SEC Chairman Mary Schapiro and CFTC Chairman Gary Gensler both testified before Congress in support of such legislation.

The Treasury White Paper also called for the SEC to continue its efforts to strengthen the regulation of money market funds. This week the Commission put out for comment proposed rules for those funds. Generally, the proposals focus on increasing liquidity and improving disclosure in the wake of the Reserve Primary Fund case (discussed here). http://www.secactions.com/?p=1076 Consideration is also being given to whether funds should continue to maintain a stable $1 per share NAV. Both Chairman Schapiro and Commissioner Aguilar made statements regarding the proposed rules in an open meeting on June 24, 2009.

Ms. Schapiro also outlined future Commission priorities in a speech before the New York Financial Writers Association this week. Those priorities include: 1) Target date funds — determining how to improve the disclosure regarding the operation of these funds; 2) Municipal securities — improving the quality, quantity and timeliness of information about these investments; 3) Fiduciary duties for professionals who give investment advice — this question, addressed in the Treasury White Paper, is a key concern for the protection of investors; and 4) Dark pools — improving the disclosure regarding the operation of these pools which the Chairman defined as “automated trading systems that do not display quotes in the public quote stream.”

The Madoff case

Two new Madoff related cases were filed this week, SEC v. Cohn, Civil Action No. 09 cv 5680 (S.D.N.Y. Filed June 22, 2009) and SEC v. Chais, Civil Action No. 09 cv 5681 (S.D.N.Y. Filed June 22, 2009). The Cohn case names as defendants New York broker dealer Cohmad Securities, its chairman Maurice Cohn and registered representative Robert Jaffee. The firm is owned in part by Bernard Madoff. For more than two decades the defendants in Cohn facilitated Mr. Madoff’s fraudulent operations by aggressively marketing the Ponzi scheme. The firm’s extensive dealings with Mr. Madoff were concealed from regulators by falsifying the broker dealer’s SEC filings.

During their years of marketing the Madoff Ponzi scheme, defendants ignored numerous red flags suggesting the true nature of the fraudulent operations. At the same time they were paid more than $100 million while their investors lost their money. The case, discussed here, is in litigation.

The Chais defendants also fed the Madoff Ponzi scheme. This suit is against a California investment adviser who has funneled money to the Ponzi operation since the early 1970s. Mr. Chais, according to the SEC, held himself out as an “investing wizard, purporting to execute a complex trading strategy on behalf of hundreds of investors . . .” In fact he lacked any real investment skills. The investor funds he solicited were turned over to Mr. Madoff for use in his fraudulent scheme. Despite clear indications of fraud, Mr. Chais continued to distribute account statements to the investors in his three funds based on the purported returns of the Madoff scam. By November 2008, Mr. Madoff claimed that the investors in the three Chais funds had over $900 million invested, all of which has been wiped out. Mr. Chais and his family however made about a half a billion dollars as also discussed here. The case is in litigation.

Stanford

DOJ filed criminal charges against financier Robert Stanford and his confederates while the SEC amended its complaint, adding new defendants and claims. DOJ’s charges are in two indictments and one criminal information. One indictment named as defendants: Robert Allen Stanford, chairman of Sanford Financial Group (”SFG”); Laura Pendergest-Holt, SFG’s chief investment officer; Gilberto Lopez, the chief accounting officer; Mark Kuhrt, global controller; and Leroy King, the former chief executive officer of the Antigua’s Financial Services Regulatory Commission (”FSRC”). The charges include conspiracy and wire, mail and securities fraud and conspiracy to commit money laundering.

A second separate indictment charges Bruce Perraud, former SFG global security specialist with destruction of records relating to a federal investigation. The information names Mr. Davis, SFG’s CFO, and charges him with conspiracy, mail fraud and conspiracy to obstruct an SEC investigation.

The SEC’s amended complaint adds as defendants Messrs. Kuhrt, Lopez and King. Mr. Stanford, James Davis, Laura Pendergest-Holt and various Stanford controlled entities had been named as defendants in the initial complaint.

According to the court papers Defendants Stanford and Davis, operating a decade long Ponzi scheme under the guise of a bank based in Antigua, raised more than $7 billion from investors to purchase what were suppose to be bank certificates of deposit paying above average returns as well as another $1 billion from a fund program. Profits were supposed to come from the bank’s investment portfolio. In fact, the returns in that portfolio were an illusion — they came from fraudulent, reverse engineered accounting documents. To create those documents, a rate of return was selected and then numbers were backed out to achieve the desired result. Stanford Bank is a Ponzi scheme, according to the SEC. Over a period of years Mr. Stanford has taken over $1 billion of investor funds for his own use, booked as loans but not properly disclosed as related party transactions.

The Commission’s investigation was impeded, according to the charges, by Mr. King, who coordinated the regulatory response from Antigua bank authorities while secretly being on the payroll of Mr. Stanford. As the SEC inquiry developed, the Commission contacted the Antiguan banking authorities. Mr. King, who had assured the local banking authorities for years that the Stanford operation was sound, passed on similar assurances to the SEC.

The SEC’s freeze order over all of the assets of the group remains in effect. The criminal cases and the SEC’s enforcement action are in litigation. See also DOJ Press Release, June 19, 2009; SEC Lit. Release 21092 (June 19, 2009).

SEC enforcement

Insider trading: SEC v. Northern, Civil Action No. 05-CV-10983 (D. Mass.) is a case in which the jury returned a verdict in favor of the SEC. The complaint alleged that defendant Steven Northern, a former Senior Vice President and manager of seven fixed income mutual funds for Massachusetts Financial, traded in U.S. treasury 30 year bonds on inside information. The Commission claimed that defendant Northern was tipped with confidential information from Peter Davis, who obtained the information at a special Treasury Department briefing. Those who attended the briefing agreed not to release the information until 10:00 a.m. The information concerned the Department’s plans to suspend issuance of the 30 year bond. Despite the agreement to embargo, the information Mr. Davis phoned defendant Northern, who traded on the information, yielding $3.1 million in illegal profits. See Lit. Release No. 21099 (June 22, 2009); see also Lit. Releases 18322 (Sept. 4, 2003) (initial action against Mr. Northern and two others), 18453 (Nov. 12, 2003) (co-defendant in original case settles with the commission and pleads guilty in parallel criminal case) and 19223 (May 12, 2005) (case re-filed against Mr. Northern after voluntary dismissal).

Financial fraud: In SEC v. Schroeder, Civil Action No. 4:09-CV-00470 (W.D. Mo.) the former chairman of the board of American Italian Pasta, Horst Schroeder, settled with the Commission. The SEC claimed in its complaint that in 2004 the company booked a $3.4 million receivable that was not collectable. The inflated financials were then incorporated in a Form S-8 registration statement Mr. Schroeder signed. To settle, defendant Schroeder consented to the entry of an injunction prohibiting future violations of Section 17(a)(3) and aiding and abetting violations of Section 13(a) and the related rules. Mr. Schroeder also agreed to pay a $50,000 civil penalty. See also Lit. Release No. 21098 (June 22, 2009).

In a related case, SEC v. Schmidgall, Civil Action No. 4:08-cv-00677 (W.D. Mo.) defendants Warren Schmidgall, former CFO of the company, also agreed to settle. Mr. Schmidgall consented to the entry of a permanent injunction prohibiting future violations of Sections 10(b) and 13(b)(5) of the Exchange Act and aiding and abetting violations of Section 13(a) and related rules. Mr. Schmidgall also agreed to pay disgorgement of $28,500, prejudgment interest and a $100,000 civil penalty. He will also be bared from serving as an officer or director of a public company. See also Lit. Release No. 21097 (June 22, 2009). Mr. Schmidgall had previously pleaded guilty to a one count information. See Lit. Release No. 20715 (Sept. 15, 2008).

Financial fraud: SEC v. Garfinkel, Civil Action No. 99-CV-2851 (E.D. Pa. June 25, 2009) was brought against Steven Garfinkel, the former CFO of DVI, Inc., and Michael O’Hanlon, the former CEO of the company. According to the complaint, over a period of four years the two defendants engaged in a fraudulent scheme to obtain additional funding for, and conceal the true financial condition of, DVI, a firm which made loans to small medical equipment companies. The two defendants manipulated loan paper work, double pledged collateral provided to company lenders and sent them false reports. As a result, the company made false filings with the commission. To settle with the SEC, each defendant agreed to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions and to the entry of an order barring them from serving as an officer or director of a public company. This settlement followed a criminal action in 2006 in which Mr. Garfinkel pleaded guilty to mail fraud and filing false SOX certifications. Mr. Garfinkel was sentenced to 30 months in prison and ordered to pay restitution of $51 million. See also Lit. Release No. 21206 (June 25, 2009).

This week the SEC brought two investment fund fraud actions:

SEC v. Regan & Company, Civil Action No. 09-CIV 5799 (S.D.N.Y. Filed June 24, 2009) is an action against Michael Regan and his firm Regan & Company, discussed here. Over an eight year period, Mr. Regan sold shares in his defunct investment fund, luring more than 70 investors to rely on his claimed stock market expertise. In fact, Mr. Regan has not invested in the stock market for several years. To conceal the fraud investors were furnished with periodic statements documenting their returns at 12%, while redemptions were paid with other investor funds. By the time the fund collapsed, it had only about $101,600 under management.

To resolve the SEC’s case Mr. Regan and his company consented to the entry of permanent injunctions prohibiting future violations of the antifraud provisions. They also agreed to be jointly and severally liable for the payment of approximately $8.7 million in disgorgement and prejudgment interest. Payment is deferred pending the resolution of the criminal case. In a parallel criminal case, Mr. Regan pleaded guilty to a one count information. See also U.S.A.O. (E.D.N.Y) Press Release (June 24, 2009); SEC Lit. Release No 21102 (June 24, 2009).

SEC v. Pacheco, Case No. 09-CV-1355 (S.D. Cal. June 24, 2009) is an action brought against Moises Pacheco and his controlled entities. According to the complaint, Mr. Pacheco claimed to operate five hedge funds which generated returns ranging from 2.5% to 4% per month as also discussed here. Mr. Pacheco raised about $14.7 million from over 200 investors, many of whom were family and friends. Prior to the collapse of the funds, investor returns were paid using other investor money. The SEC’s complaint alleges violations of the antifraud and registration provisions of the securities laws. The case is in litigation. See also Lit. Release No. 21101 (June 24, 2009).

Criminal cases

U.S. v. Stein, Case No. 1:09-cv-03125 (E.D.N.Y. Filed April 1, 2009) is a case in which investment advisor Edward Stein pled guilty on June 22, 2009 to a five count information. In that information he was charged with operating a Ponzi scheme and defrauding clients out of $30 million. From 1998 through 2009, Mr. Stein operated several funds and partnerships for which he solicited investors. Rather than invest their funds, he took portions of the money for himself while using some of the investor cash to pay other investors. To conceal the fraud, Mr. Stein furnished investors with false quarterly statements. Sentencing has not been scheduled.

Private actions

In re Jones Soda Company Sec. Litig., Case No. 07-cv-1366 (W.D. Wash. Filed Sept. 3, 2007) was dismissed for failure to plead a strong inference of scienter as required by the PLSRA and the Supreme Court’s decision in Tellabs, discussed here. In evaluating the question of scienter, the court noted that “there is little consistency within the Circuit Courts regarding the state of mind that is required in private securities litigation and what type of evidence satisfies the PSLRA’s ’strong inference” requirements . . . the Ninth Circuit . . . [requires] at a minimum, ‘deliberate recklessness” that reflects some strong degree of knowing misconduct . . . plaintiffs may no longer rely on evidence which suggests that the corporation and/or its officers had [only] a motive and opportunity . . .” to defraud. The complaint was based on claimed false statements about agreements with retailers, the allocation of resources and business prospects. Derivative suits based on similar facts are still pending. In re Jones Soda Co. Derivative Litigation, Lead Case No. 07-31254-4 (S.Ct. King Co. Wash); In re Jones Soda Co. Derivative Litig., Case No. 07-1782 (W.D. Wash).

Circuit Courts

A key question in pleading loss causation under the Supreme Court’s decision in Dura Pharmaceuticals v. Broudo, 544 S.Ct. 336 (2005) (discussed here) is how much truth must emerge. In Alaska Electrical Pension Fund v. Flowerserve Corporation, Case No. 07-11303 c/w 08-10071 (5th Cir. Filed June 19, 2009) (discussed here), a per curiam opinion joined by retired Supreme Court Justice O’Connor, the court held that to establish Dura loss causation at least some of the truth must emerge. The action was based on three claimed false earnings statements from 2001. The share price for the company plummeted in July and again in September 2002 when the company announced it would miss guidance, but the fraud was not revealed until a 2004 restatement. The court rejected defendant’s notion that Dura requires each fact to emerge and the plaintiff’s theory that emergence of the financial condition of the company established the causal link. Rather, at least some of the fraud must be revealed, a question the district court could assess on remand.

Ponzi schemes. Enforcement officials typically claim that these schemes are difficult to detect. In the wake of Ponzi scheme king Bernard Madoff, and one who may be vying for the top spot in fraudulent investment scheme world, Robert Allen Stanford, things have changed. Now, the SEC and the Department of Justice appear to be finding a fraudulent investment operation at every turn. Wednesday, for example, the SEC filed two more Ponzi scheme cases, and DOJ one.

SEC v. Regan & Company, Civil Action No. 09-CIV 5799 (S.D.N.Y. Filed June 24, 2009) is an action brought against Michael Regan and his firm Regan & Company. A one count information alleging securities fraud was filed in the Eastern District of New York, naming Mr. Regan as a defendant.

According to the court papers, over an eight year period, Mr. Regan sold shares in his defunct investment fund — River Stream — to more than 70 investors. Mr. Regan falsely told investors their money would be safe, invested in the stock market under the supervision of his expertise in an $18 million fund. In fact Mr. Regan has not invested in the stock market for several years. To conceal the fraud, investors were furnished with periodic statements documenting their returns at 12%. Over a period of years, Mr. Regan paid more than $9 million in redemptions to investors using new investor funds. Part of the funds were used to support Mr. Regan’s extravagant life style. By the time the fund collapsed it had only about $101,600 under management.

In the criminal case, Mr. Regan pled guilty to the one count information. In the SEC’s case, Mr. Regan and his company consented to the entry of permanent injunctions prohibiting future violations of the antifraud provisions. They also agreed to be jointly and severally liable for the payment of approximately $8.7 million in disgorgement and prejudgment interest. Payment is deferred pending the resolution of the criminal case. See also U.S.A.O. (E.D.N.Y). Press Release (June 24, 2009); SEC Lit. Release No 21102 (June 24, 2009).

SEC v. Pacheco, Case No. 09-CV-1355 (S.D. Cal. June 24, 2009) is an action brought against Moises Pacheco and his controlled entities. According to the complaint, Mr. Pacheco claimed to operate five hedge funds which generated returns ranging from 2.5% to 4% per month until January 2008, when he reduced the rate of return to 1.25% per month because of the market crisis. Mr. Pacheco raised about $14.7 million from over 200 investors. Many of those investors were his family members and friends. In fact, Mr. Pacheo’s hedge funds generated only about $367,000 in trading profits despite claims that he used a proprietary option trading methodology. Prior to the collapse of the funds investor returns were paid using other investor money.

The SEC’s complaint alleges violations of the antifraud and registration provisions of the securities laws. The case is in litigation. See also Lit. Release No. 21101 (June 24, 2009).

These cases represent what has become a continuous stream of investment fund fraud cases. Clearly, these once-difficult-to-detect cases are no longer so hard to find. The reason is unclear. It may be that the market crisis has caused these fraudulent funds to surface. It may also be a sign that the enforcement division is moving past some of its recent difficulties and returning to its former watch dog self.

A key question in pleading loss causation under the Supreme Court’s decision in Dura Pharmaceuticals v. Broudo, 544 S.Ct. 336 (2005) (discussed here) is how much truth must emerge. The Fifth Circuit held that at least part of the truth must emerge in Alaska Electrical Pension Fund v. Flowerserve Corporation, Case No. 07-11303 c/w 08-10071 (5th Cir. Filed June 19, 2009), a per curiam opinion joined by retired Supreme Court Justice O’Connor. The decision is consistent those of other circuits. See, e.g., In re Williams Sec. Litig. — WCG Subclass, 558 F.3d 1130 (10th Cir. 2009).

This action against Flowerserve, a manufacture of pumps and related equipment, focuses on three claimed misstatements: 1) a February 6, 2001 release claiming $13.2 million in earnings for FY 2000 when in fact they were $5.4 million, a fact revealed in a 2004 restatement; 2) an April 24, 2001 announcement of positive first quarter 2001 earnings that overstated those earnings; and 3) an October 22, 2001 release which contained overly optimistic FY 2002 earnings guidance. The statements followed acquisitions in 2000 and 2002 undertaken to bolster sagging earnings.

In 2002, the share price of the company declined dramatically twice. Once in July 2002 by over 37% when guidance was lowered. A second time in September by over 38% when the announcement that guidance would be lowered was repeated. Expert testimony established that a significant portion of each decline related to company specific rather than general market factors. It was not until February 2004 however, that Flowerserve announced it would restate 2000-2003 earnings by $11 million. There was no significant impact on the share price at the time of the announcement, however.

To establish Dura loss causation, plaintiff must prove a causal connection between a misstatement and a subsequent decline in the stock price according to the court. Plaintiff is also required to establish that “after the purchase and before the loss there was a disclosure of negative ‘truthful’ information . . . ” that is related to the earlier false statement.

Here, the district court applied the wrong standard. It required, as defendants argued, that plaintiff show a fact-for-fact disclosure of information that fully corrected prior misstatements. The only statements here that meet this requirement are the 2004 restatements which had no share price impact. This standard, the Circuit Court concluded, is wrong because it does away with the fraud on the market theory of reliance. In addition, “if a fact-for-fact disclosure were required to establish loss causation, a defendant could defeat liability by refusing to admit the falsity of its prior statements . . . And if a ‘complete’ corrective disclosure were required, defendants could ‘immunize themselves with a protracted series of partial disclosures’” quoting Freeland v. Iridium World Commc’ns, Ltd., 233 F.R.D. 40, 47 (D.D.C. 2006).

The court also rejected the plaintiff’s theory of loss causation. That theory posited that loss causation may result when the true financial condition of a company becomes known regardless of whether the disclosure of that financial condition corrects past misstatements. Under this theory, if the difference between the market’s erroneous perception of the financial condition of the company and the true financial condition is a consequence of the fraud, a loss that results from the revelation of the true condition is sufficient. This theory is flawed, the court held, because undisclosed information cannot drive down the market price of the stock.

While the market may never learn the relevant truth about Flowerserve’s claimed fraudulent statements, it clearly understood there was some problem when guidance was dropped in 2002 according to the court. But a loss caused by a general impression that something is wrong is not sufficient. If “Alaska cannot prove . . . that the market learned more than that Flowerserve’s earnings guidance was lower and so its business seemed less valuable, it cannot establish that its loss was caused by Flowerserve’s misstatements pertaining to past financials.” Rather, to establish loss causation, the “disclosed information must reflect part of the ‘relevant truth’ — the truth obscured by the fraudulent statements.” The case was remanded to the district court for reconsideration based on these principles.

Since the Madoff Ponzi scheme scandal emerged, key questions have been “how” and “who.” How did he bilk so many people for so long? Who else knew and helped him? Mr. Madoff, whose sentencing is scheduled for Monday, June 29, 2009, has said little about how it was done except to insist he acted alone. It’s fair to say that everyone wants to know how, and few believe Mr. Madoff about the who.

To date, the authorities have said little. Some insights came from the suit by the New York AG against Ezra Merkin and his feeder fund Gabriel Capital, discussed here. Other insights come from the actions by the SEC and DOJ against the auditors, SEC v. Friehling, Civil Action No. 09 cv 2467 (S.D.N.Y. Filed Mar. 18, 2009) and U.S. v. Friehling, Case No. 09-mj-00729 (S.D.N.Y. Filed Mar. 18, 2009), both of which are discussed here. Still, little is known about what has been called the Ponzi scheme of the ages.

More pieces are emerging however, with two new suits by the SEC, SEC v. Cohn, Civil Action No. 09 cv 5680 (S.D.N.Y. Filed June 22, 2009) and SEC v. Chais, Civil Action No. 09 cv 5681 (S.D.N.Y. Filed June 22, 2009). The Cohn case names as defendants New York broker dealer Cohmad Securities, its chairman Maurice Cohn and registered representative Robert Jaffee. The firm, located in the same building as Madoff’s securities operation, is owned by Maurice Cohn, Marcia Cohn, Bernard Madoff, Madoff’s brother, Maurice Cohn’s brother, Robert Jaffee and another Cohmad employee.

For more than two decades the defendants in Cohn facilitated Mr. Madoff’s fraudulent operations by aggressively marketing the Ponzi scheme. According to the complaint, defendants projected a “false aura of exclusivity and privilege that came to be associated with the opportunity to invest with the great Madoff. Madoff’s secret marketing operations were housed within the office of Bernard L Madoff Investment Securities Corporation LLC (”BMIS”) under the façade of a separately registered broker-dealer, defendant Cohmad.” The marketing targeted affluent, but financially unsophisticated investors, according to the SEC. The firm’s extensive dealings with Madoff were concealed from regulators by falsifying its filings with the SEC — acts which furthered Mr. Madoff’s efforts to evade detection. In fact, Mr. Madoff directed defendants to maintain secrecy about their arrangements.

During their years of marketing the Ponzi scheme king, the Cohmad defendants ignored numerous red flags suggesting the true nature of the fraudulent operation they were selling unsuspecting victims. Those included the fact that BMIS employees were generating false confirmation and statements that reflected backdated trades in Mr. Jaffe’s own personal accounts at the Madoff firm.

The Cohmad defendant faired far better than the investors they lured into the scheme. Their marketing efforts yielded them more than $100 million paid through Cohmad. Maurice Cohn and Robert Jaffee were paid, in addition, millions of dollars directly from Madoff’s brokerage firm.

The complaint alleges violations which include Section 17(a) and 10(b) of the Securities Act and the Exchange Act as well as Section 206 of he Advisers Act. The case is in litigation. See also Lit. Release No. 21095 (June 22, 2009).

The Chais defendants also fed the Madoff money abyss. The suit is against a California investment adviser who has funneled money to the Ponzi operation since the early 1970s. Mr. Chais, according to the SEC, held himself out as an “investing wizard, purporting to execute a complex trading strategy on behalf of hundreds of investors . . .” Mr. Chais claimed to operate three investment funds, Lambeth Company, the Brighton Company and the Popham Company.

Contrary to the representations he made to his investors, Mr. Chais lacked any real investment skills. The money he raised from investors was, unknown to them, simply turned over to Mr. Madoff for use in his fraudulent scheme. Despite clear indications of fraud, Mr. Chais continued to distribute account statements to the investors in his three funds based on the purported returns of the Madoff scam. By November 2008, Mr. Madoff claimed that the investors in the three funds had over $900 million invested, all of which has been wiped out.

Mr. Chais and his family however profited from the Madoff relationship. Through an array of accounts Mr. Chais and his family received about a half a billion dollars over a thirteen year period according to the SEC.

The complaint in Chais, alleges violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Section 206 of the Advisers Act. The case is in litigation. See also Lit. Release No. 21096 (June 22, 2009).

Two more Madoff complaints. More defendants who were paid handsomely to ignore the repeated warnings that those whose money they gave to Mr. Madoff were being defrauded. Slowly the “how” and the “who” is emerging. There undoubtedly will be more.

Based on what sound more like a page out of Hollywood script than court actions, the Department of Justice and the SEC detailed fraud charges against financier Robert Allen Stanford and his confederates on Friday. The newly unsealed criminal charges and amended SEC complaint chronicle a years-long scam built on misleading investors, concocted financial statements, phony loans to cover the theft of investor funds, years of bribing an Antiguan official and efforts to thwart the SEC through the use of a foreign regulator even as the scheme began to unravel and ooze to the surface.

DOJ brought charges in two indictments and one criminal information. One indictment named as defendants: Robert Allen Stanford, chairman of Sanford Financial Group (”SFG”); Laura Pendergest-Holt, SFG’s chief investment officer; Gilberto Lopez, the chief accounting officer; Mark Kuhrt, global controller; and Leroy King, the former chief executive officer of the Antigua’s Financial Services Regulatory Commission (”FSRC”). The charges include one count of conspiracy to commit mail, wire and securities fraud; seven counts of wire fraud; ten counts of mail fraud; and one count of conspiracy to commit money laundering. Messrs. Stanford and King, along with Ms. Pendergest-Holt (who was previously indicted as discussed here) were also charged with conspiracy to obstruct an SEC proceeding.

In an information, James Davis, SFG’s CFO, was charged with conspiracy to commit mail, wire and securities fraud, mail fraud and conspiracy to obstruct an SEC investigation. A separate indictment charges Bruce Perraud, former SFG global security specialist with destruction of records relating to a federal investigation.

The SEC’s amended complaint adds as defendants Messrs. Kuhrt, Lopez and King. Mr. Stanford, James Davis, Laura Pendergest-Holt and various Stanford controlled entities had been named as defendants in the initial complaint (discussed here). SEC v. Stanford International Bank, Ltd., Civil Action No. 3:09-cv-0298 (N.D. Tex. Filed Feb. 17, 2009).

The fraudulent scheme had two major components, according to the court papers. In the first Defendants Stanford and Davis, operating a decade long Ponzi scheme under the guise of a bank based in Antigua, convinced investors to pore more than $7 billion into what were supposed to be bank certificates of deposit. Defendants claimed the certificates would pay investors an above average return on their investment. As bank certificates of deposit, the investment was touted as safe, conservative and monitored by banking regulators in Antigua.

A second component of the scheme involved a proprietary mutual fund wrap program. Shares in this program were sold from 2004 through 2009 based on a fraudulent track record of so-called “historical performance.” This scheme garnered over $1 billion from investors for defendants, according to the SEC’s complaint.

Central to the schemes was the bank and the profits claimed from its investment portfolio. The success of this portfolio was chronicled in regulatory filings, financial statements and the public pronouncements of various defendants. The claims however, were based not on successful investing, but reverse engineered fraud according to the court papers. As part of the scheme to make the portfolio appear profitable, a rate of return was selected for each period and then financial statements were crafted by calculating the necessary numbers back from the pre-selected result. This permitted the defendants to present the Stanford group as very successful, when in fact its financial statements were fabrications.

As the market deteriorated Mr. Stanford and his confederates realized they could not continue to report high rates of return. In late 2008, they understood that reporting a loss may require a contribution to regulatory capital. Accordingly, they announced that Mr. Stanford would make a capital contribution to the bank to ensure its soundness in the turbulent times.

In early 2009, as the markets continued to deteriorate, Mr. Stanford and others sought to reassure the markets and stem concern that the group did not experience losses related to Ponzi scheme king Bernard Madoff. Ms. Pendergest-Holt thus gave a speech assuring investors and the public that the Stanford group was financially sound. Investors were told that the group had not suffered Madoff related losses.

In fact, the Stanford bank is a Ponzi scheme, according to the SEC. Over a period of years Mr. Stanford has taken over $1 billion of investor funds for his own used, booked as loans which are not reported in the related party transaction section of filings. The 2008 capital contribution was sham. And, the group did in fact suffer Madoff-related losses through various investment funds.

As the SEC inquiry unfolded, the Commission contacted the Antiguan banking authorities. Mr. King, who had been taking bribes from Robert Stanford for years, coordinated the response to the SEC, assuring the agency that the Stanford bank was financially sound. Indeed, Mr. King had made sure over the years that the Antigua regulator has “looked the other way” as he collected bribes from Mr. Stanford, according to the court papers.

The SEC’s freeze order over all of the assets of the group remains in effect. Its web site contains links for investors to contact regarding their investments. The criminal cases and the SEC’s enforcement action are in litigation. See also DOJ Press Release, June 19, 2009; SEC Lit. Release 21092 (June 19, 2009).