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Thomas O. Gorman,
Dorsey and Whitney LLP
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    The New SEC Financial Fraud Task Force

    July 08, 2013

    Last week the SEC announced the formation of a Financial Reporting and Audit Task Force. Its purpose is to detect “fraudulent or improper financial reporting” and “enhance the [Enforcement] Division’s ongoing enforcement efforts related to accounting and disclosure fraud.” At the same time the Commission announced the formation of a similar group focused on microcap fraud and the creation of the Center for Risk and Quantitative Analysis. The new Center for Risk and Quantitative Analysis will work in close coordination with the Division of Economic and Risk Analysis and “serve as both an analytical hub and a source of information about characteristics and patterns indicative of possible fraud or other illegality.”

    While this is clearly a positive step for the Enforcement Division, there is little that is new about the financial fraud task force — except perhaps its apparently “high tech” adjunct, the Center for Risk and Quantitative Analysis. In 1998 then SEC Chairman Arthur Levitt originated a similar effort. In his well known address titled “The Numbers Game,” Chairman Levitt announced an eight part plan to combat abuses in financial reporting because he had “become concerned that the motivation to meet Wall Street earnings expectations my be overriding common sense business practices. Too many corporate managers, auditors, and analysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation. As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the quality of financial reporting. Managing may be giving way to manipulation; Integrity may be losing out to illusion.”

    Chairman Levitt identified five key practices being used to manipulate financial results through what he labeled as “accounting hocus-pocus:”

    Big Bath charges; The use of restructuring charges to clean up the balance sheet;

    Acquisitions/R&D: The classification of portions of the acquisition price as “in-process” research and development so it can be written-off in a one-time charge to avoid a drag on future earnings;

    Cookie jar reserves: The use of unrealistic assumptions to create pools of cash to smooth earnings;

    Materiality: Building in flexibility by creating small errors that are just below the so-called materiality threshold which can then later be utilized; and

    Revenue recognition: Boosting earnings through inappropriate manipulation of the recognition of revenue.

    In the wake of Chairman Levitt’s speech the Commission brought a series of financial statement fraud actions. Two years later, for example, Richard Walker, then the Director of the Enforcement Division stated that for fiscal 1999 the Commission brought about 90 financial statement and reporting actions, a 15% increase over 1998. Those cases “cover a broad spectrum of conduct – from multi-faceted pervasive frauds to more subtle instances of earnings management to situation involving violations of auditor independence rules,” he noted. Richard H. Walker, Director, Division of Enforcement, addressing 27th Annual national AICPA Conference on Current SEC Developments (Dec. 7, 1999). In the years that followed the SEC brought a series of financial fraud actions involving an array of issuers such as Waste Management, WorldCom, Tyco International, Enron, Xerox Corporation and others.

    In recent years, however, the number of these cases has declined. One reason may be the reforms initiated by the Sarbanes-Oxley Act of 2002. Another may be that the focus of SEC enforcement has been on market crisis cases, offering frauds and Ponzi schemes rather than difficult to develop, and time and resource consuming, financial statement fraud cases. Whatever the reason, while the world of financial reporting has become more sophisticated and complex, the root of Chairman Levitt’s concerns has not changed. The “pressure to make the numbers” is still present. This suggests that the Commission’s new task force will have much to do.

    SEC Secures Freeze of $4.6 Million in “Suspicious” Trading Profits

    July 07, 2013

    “Money Never Sleeps” is the subtitle to the last Wall Street film staring Michael Douglas as the legendary stock trader Gordon Gekko. That title might also be applied to the SEC’s insider trading watch dogs. While most were preparing for the Fourth of July holiday on Wednesday, they obtained a temporary freeze order over about $4.6 million in what may be insider trading profits. The SEC’s complaint and request for a freeze order was filed just two days after a dramatic spike in the share price of Onyx Pharmaceutical, Inc. following an announcement of a rejected take-over bid. SEC v. One or More Unknown Traders in the Securities of Onyx Pharmaceuticals, Inc. (S.D.N.Y. Filed July 3, 2013).

    The action centers on the proposed acquisition of Onyx Pharmaceutical by Amgen, Inc. On Sunday, June 30, Onyx, a San Francisco, California based biopharmaceutical company, announced that it had received but rejected a bid to purchase the outstanding shares of the company from Amgen, a California based biotechnology company. The bid was for $120 per share.

    The transaction began on June 13, 2013 when Amgen’s CEO met with his counterpart from Onyx. At the meeting Amgen’s CEO made an unsolicited oral offer to acquire Onyx. The offer was followed by a written proposal the next day. The written proposal was sent to the Onyx board of directors that same day.

    On June 26, 2013, Onyx’s board met and decided to reject the offer. Two days later on Friday, June 28, 2013, that decision was conveyed to Amgen. The same day an article appeared in the Financial Post, a Canadian publication, regarding the offer. Amgen, however, did not issue an announcement about the proposal until Sunday, June 30, 2013. In that announcement the company stated that an unsolicited offer for $120 per share had been received and rejected as inadequate. The announcement also stated that the company had authorized its financial adviser to contact potential acquirers.

    Unknown purchasers began buying call options in Onyx on June 26, the day the Onyx board met to consider the offer. On that day 175 calls were purchased. The next day an additional 544 contracts were purchased. On Friday, June 28, the last trading day before the Sunday announcement, and the same day as the Canadian news article, an additional 320 calls were purchased. On each day the option acquisitions represented significant departures from the historical purchasing patterns for the securities in terms of the numbers of contracts purchased. The acquisitions were made through two omnibus accounts, one at Citigroup Global Markets, Inc. and the other at Barclays Capital, Inc. No other information about the accounts is furnished in the complaint.

    On Monday, July 1, 2013, the first trading day after the announcement of the rejected deal, Onyx shares closed at $131.33, an increase of $44.51 or about 51% over the prior day’s closing price. The options in the two accounts, purchased for about $305,000 were worth about $4.6 million, an increase of almost 14,200% in three trading days. Those profits are now frozen under the court’s order. The case is in litigation.

    Happy 4th of July!

    July 03, 2013

    new years 2013

    SEC Charges Three With Insider Trading

    July 02, 2013

    The SEC filed a partially settled insider trading case against the now husband of a corporate officer, his long time friend and a broker. Collectively the defendants are alleged to have netted over $1 million in trading profits. SEC v. Murrell, Civil Action No. 2:13-cv-12856 (E.D. Mich. July 1, 2013).

    The case centers on the acquisition of Rohm & Haas Co. by The Dow Chemical Company, announced on July 10, 2008. Prior to the acquisition defendant Mack Murrell resided with his now wife Stacey Murrell. She was an administrative assistant to Dow’s CFO. Mr. Murrell had known Defendant David Teekell since high school. Although the two men lived in different parts of the country, they kept in touch and were involved in an investment with others. Mr. Teekell’s long time broker was defendant Charles Adams. Mr. Adams was a registered defendant at Raymond James Financial Services, Inc. which is named as a relief defendant because it obtained trading profits from option positions abandoned by Messrs. Teekell and Adams.

    The compliant is built largely on circumstantial evidence, cobbling together the events of take-over deal with emails, telephone calls and securities transactions. In early June 2008 Rhom began discussions about the possible sale of the company with Dow and two others. Discussions proceeded quickly with Dow and by mid-June due diligence was underway and a possible price per share had been discussed. By the end of the month Stacey Murrell and the CFO for whom she worked execute confidentiality agreements. The two women discussed the proposed transaction at the time they executed the agreements.

    On July 2, 2009 Dow held a special meeting. The Board approved a cash offer for Rohm at a price of up to $78 per shares. The next morning Mr. Murrell emailed David Teekell asking him to call, noting he had lost the phone number. Later that day the two men spoke in what became a series of telephone calls. That same day Mr. Teekell called his broker, Defendant Adams.

    On Sunday July 6 Mr. Murrell left for the Middle East on a business trip. Nevertheless, he continued to communicate with David Teekell. Indeed, over the weekend prior to the trip Messrs. Murrell and Teekell communicated several times by telephone and email.

    The next day, Monday July 7, 2008, Mr. Adams made his first securities purchase, buying 1,000 shares of Rohm stock in Mr. Teekell’s SEP IRA account for $45,000. That same day Mr. Teekell went to the brokerage firm, deposited $200,000 and executed forms for option trading. On Tuesday he began purchasing options. Mr. Adams also purchased options that day.

    Messrs. Teekell and Adams continued purchasing Rohm shares and options up to the day of the announcement. The day before the public announcement Mr. Adams purchased options for IBM and Cicso in Mr. Teekell’s account. He also tried to sell 180 of Mr. Teekell’s Rohm options. The order did not fill. By the end of the day shares of Rohm closed at $44.83. Following the deal announcement those shares closed at $73.62, up 64%. Mr. Teekell had profits of $534,526. Mr. Adams had profits of $64,450. Two customers for whom Mr. Adam traded through discretionary accounts had profits of $42,596. The complaint alleges violations of Exchange Act Section 10(b).

    David Teekell agreed to settle with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b). He also agreed to disgorge his trading profits, pay prejudgment interest and a penalty equal to the amount of the disgorgement. The other defendants did not settle. See also Lit. Rel. No. 22738 (July 1, 2013).

    SEC Files Another Fraud Action Centered on a PRC Based Issuer

    July 01, 2013

    The Commission brought another fraud action against a China based issuer and its chairman. This time the case focuses on the lack of internal control and a series of unauthorized cash transactions that were repaid. SEC v. Fuqi International, Inc., Civil Action No. 1:13-cv-995 (D.D.C. Filed July 1, 2013).

    Fuqi is a PRC based jewelry company whose chairman, president and CEO is defendant Yu Kwai Chong, a Chinese national. The company made a public offering of securities in March 2010. Its shares were traded on the NASDAQ Global Market. Eight months after the stock sale the company announced it would restate the first three quarters of 2009 due to accounting errors. Its earnings had been overstated by 12% to 23%.

    While completing the restatement the outside auditors discovered that between September 2009 and November 2010 Mr. Chong had directed the transfer of about $134 million in over 50 transactions from firm bank accounts to accounts at other banks for three jewelry companies in China. The transfers were booked as “other payables” or “prepaids.” The board of directors was unaware of the transactions.

    Subsequently, outside counsel was retained by the company and an internal investigation was conducted. During the inquiry Mr. Chong explained that he authorized the transactions at the request of a local bank manager despite the fact that he did not know the three companies to which the funds were transferred. The firm was able to furnish the staff with documentation for about 19% of the transactions. Although the funds were returned to the company, not all of the money was returned to the same bank accounts or in the same amounts as the initial transfers.

    The company lacked adequate internal accounting controls, according to the SEC’s complaint. During the period of the transfers, Fuqi’s treasury controls did not require that internal fund transfer applications identify any specific business purpose or be supported by documentation. The company also did not have an effective reconciliation process.

    The transactions were not disclosed by Fuqi until March 2011 when a press release was issued. That occurred after the outside auditors sent the board of directors a six page letter providing notice of a potential fraud and violations of internal controls and accounting irregularities surrounding the transactions. The company has not filed any periodic reports with the Commission since November 2009. The SEC’s complaint alleges violations of Exchange Act Section 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5).

    Fuqi and Mr. Chong settled with the Commission, consenting to the entry of permanent injunctions prohibiting future violations of the federal securities laws. In addition, the company and Mr. Chong were directed to pay civil penalties of, respectively, $1 million and $150,000. Mr. Chong was also barred from serving as an officer and director of a public company for five years. See also Lit. Rel. No. 22739 (July 1, 2013).

    Its Time For SEC Enforcement to go Back to the Future

    June 30, 2013

    Four years ago SEC Enforcement went back to the future, reorganizing the Division to include specialty groups. The idea was to marshal the resources of the Division in view of an increasingly complex market place to more effectively and efficiently conduct investigations. The idea of specialty groups was not, of course, new. In the early days of the Division it had specialty groups. That structure was abolished in the 1980s but brought back in 2009.

    The reorganization was successful. Once completed the agency filed record numbers of enforcement actions each year. While the number of cases filed is not the sole criteria for judging the success of an enforcement program, those statistics suggested that SEC Enforcement had been pulled back from the abyss of Madoff and other scandals and was moving forward in a positive fashion.

    Now that momentum seems to be sputtering. The record numbers of cases are gone. In the first half of 2012, for example, the Commission filed 150 enforcement actions (excluding tag-a-long proceedings, which are really an additional remedy adjunct to another action, and delisting proceedings). During the same period this year the SEC filed a total of 116 enforcement actions. Similarly, in the second quarter of 2012 the Commission initiated 99 enforcement cases compared to just 51 in the most recent quarter. By any measure the number of cases being filed by the agency is dropping significantly.

    At the same time the Division appears to be searching for its focus. This is reflected by the following points:

    Co-Division directors: The Enforcement Division now, for the first time, has co-directors. While innovative, it is at best cumbersome. No matter how well the two men work together, someone has to make the decisions. The “buck,” to paraphrase President Harry Truman, has to stop someplace. That is always with the person making the final decision. Groups, committees and similar decision making bodies are typically a cover for lack of focus. While this innovation puts the new SEC Chair’s right had man at the front of the enforcement operation, giving her hands on control, is nothing but unwieldy on a day-to-day basis and makes the Division appear less than focused.

    Admissions: There is a new policy being implemented under which admissions will be required in select cases, in addition to those obtained in actions where they were previously made in a parallel case. The precise criteria for selecting these cases, and the type of admissions that will be required, have not been specified. If the policy is applied to more than a handful of cases, and meaningful admissions are sought, such as those made in a guilty plea or a criminal deferred prosecution agreement, it has the prospect of bogging down the Division with more and perhaps difficult cases to take to trial. That can and will drain the Division of its already scare resources. It could also mean fewer investigations as the agency is required to be ever more selective about which matters to pursue, undercutting its ability to protect investors and markets. If on the other hand the new policy is only applied in limited cases and the admissions sought are along the lines of the “we made an error” type as in SEC v. Goldman Sachs, the new policy will surely undercut the credibility of the agency since it will be viewed as little more than a publicity stunt.

    Financial fraud: This traditional stable of SEC Enforcement has been neglected in recent years. As reports from Cornerstone Research chronicle, the number of financial fraud cases brought by the SEC in recent years continue to dwindle. Now the Division reportedly is refocusing its efforts in this area. Yet no new specialty group is being created which seems contrary to the theory of the recent reorganization.

    The trial unit: This long standing specialty unit of the Division is now rumored to be on the chopping block, doomed to be disbanded. The unit was created in the 1970s for largely the same reasons which underlie the recent reorganization. At the time of its institution each Associate Director group conducted its own litigation. The Unit was created to focus the litigation resources of the Division in a more effective manner. It is currently the only specialty group to have persevered from the early days of the Division. Dropping this specialty group in favor of a model previously found to be less than effective, while retaining others but refusing to create one to implement the new emphasis on financial fraud actions which can be very complex suggests confusion.

    Collectively these changes paint a portrait of a Division in search of focus. To find its focus the Division need go no further than back to its and roots, that is, back to the future yet again. Its statutory mandate is to act as a regulator, not a prosecutor. It is to protect investors and markets by investigating and halting violations, making sure the wrongful conduct is not repeated in the future. It has a vast array of weapons to do this, from injunctions to equitable remedies, penalties and bar orders. These tools have in the past enabled the SEC to craft effective remedies such as corporate compliance and governance initiatives that prevented a repetition of wrongful conduct in the future. While this work may not garner the headlines of a billion dollar fine or an admission of guilt, its ingenuity and creativity protected investors and the markets, making the agency a most effective watch dog. If SEC Enforcement is going to become that watch dog again it is time to stop tinkering with organization and policy and go back to the future, back to crafting effective remedies that protect investors and the markets.

    This Week In Securities Litigation (Week ending June 28, 2013)

    June 27, 2013

    The CFTC took center stage this week, bringing an aggressive enforcement action against former New Jersey governor and Goldman Sachs partner Jon Corzine and his collapsed firm, MF Global. In a settlement with the firm the agency secured and agreement to obtain as much as $1 billion in restitution and a $100 million fine.

    The Chairman of the CFTC and the Chair of the SEC testified before Congress this week, seeking to justify the significant budget increases requested for their respective agencies in the President’ budget for the next fiscal year. In addition, SEC enforcement brought a fraud action against a medical device manufacturer for misstatements regarding the FDA approval process for a key product, another offering fraud action and a proceeding against a former Stanford Group employee tied to the sale of funds.

    SEC

    Testimony: SEC Chair Mary Jo White testified before the Senate Subcommittee on Financial Services and General Government (June 25, 2013). Her testimony focused on the reasons for requesting a budget of $1.674 million for the next fiscal year (here).

    CFTC

    Testimony: Chairman Gary Gensler testified before the Senate Appropriations Subcommittee on Financial Services and General Government (June 25, 2013). His testimony focused on the rationale for the President’s requested budget of $315 million compared to the current $195 million for the next fiscal year (here).

    Remarks: Commissioner Mark P. Wetjen, addressed the Futures Industry Association and Futures & Options Association International Derivatives Expo (June 25, 2013). His remarks focused on cross-border guidance (here).

    Remarks: Commissioner Bart Chilton addressed the Trading Show Chicago 2013, Chicago, Illinois (June 24, 2013). His remarks focused on the proposed PORTECT Act, high speed trading and proposals about wash blockers (here).

    Remarks: Commissioner Bart Chilton delivered remarks to the Global Grain Chicago Conference, entitled “Future Boy” in Chicago, Ill. (June 21, 2013). His remarks focused on implementing the remaining Dodd-Frank rules (here).

    SEC Enforcement: Filings and settlements

    Weekly statistics: This week the Commission filed 2 civil injunctive action and 1 administrative proceedings (excluding follow-on actions and 12(j) proceedings).

    Misrepresentations: SEC v. Imaging3, Inc., Case No. CV 13-4616 (C.D. Cal. Filed June 25, 2013) is an action against the medical device manufacturer and its founder, Dean Norman Janes. A key product for the company is a Dominion Scanner. Based on proprietary technology, and under development for years, it is supposed to produce 3D medical diagnostic images in real time. To market its Dominion Scanner, Imaging3 needs FDA approval. Although the company applied for approval three times beginning in 2007, it was never obtained. In its last denial letter the FDA cited safety concerns and issues with image quality, among other reasons. Nevertheless, on November 1, 2010 Mr. Janes held a news conference at which he told investors that the company would again apply for clearance by the FDA. He also stated that the prior denials were not based on safety concerns or the quality of the images. The Commission’s complaint alleges violations of Exchange Act Section 10(b). The case is in litigation. See also Lit. Rel. No. 22733 (June 26, 2013).

    Offering fraud: SEC v. Hurd, Civil Action No. 13-cv-04464 (C.D. Cal. June 20, 2013). The case centers on the sale of interests in defendant Your Best Memories International, Inc., beginning in 2010 and continuing through the fall of 2012. Your Best Memories, formed by defendant Robert Hurd, was supposed to raise money for the promotion of memory improvement products created by another entity, Moving Pictures, Inc. Investors were told that most of their investment would go toward those products. In fact it did not. Investors were also falsely told that one of the Moving Pictures products had FDA approval. Over the approximately two years shares of Your Best Memories were sold, about $1.2 million was raised from 50 investors in 18 states. The Commission’s complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b) and 20(a). The case is in litigation. See also Lit. Rel. No. 22732 (June 21, 2013).

    In the Matter of Jason A. D’Amato, Adm. Proc. File No. 3-15004 (June 21, 2013). Mr. D’Amato held various positions with the Stanford Group Companies and Stanford Capital Management, LLC over a period of years. Those included President of that company and senior investment officer. The Order alleges that beginning in 2000 SGC offered a mutual fund allocation program known as Mutual Fund Partners. In 2003 Mr. D’Amato was retained as an assistant analyst to track and calculate the performance of the strategies used and to create pitch-books for the SGC financial advisers to use in presentations. The results presented to investors consistently outperformed the S&P 500. Financial advisers, however, complained that clients could not achieve anything close to those results. The pitch books were deficient in several respects, according to the Order, including: The records to support the claimed results could not be located; certain data in them was labeled in a misleading fashion; and unaudited data was presented next to audited data. Mr. D’Amato also misrepresented his credentials, according to the Order. Mr. D’Amato resolved the proceeding, consenting to the entry of a cease and desist order based on Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 207. He also agreed to be barred from the securities business and from participating in any penny stock offering, with a right to apply for reentry after five years, and to pay a civil penalty of $50,000.

    CFTC Enforcement

    Misuse of customer funds: CFTC v. MF Global Inc. (S.D.N.Y. Filed June 27, 2013) is an action against the futures commission merchant, MF Global Holdings Ltd., Jon S. Corzine, former CFO, and Edith O’Brien, former treasurer. The complaint alleges misuse of customer funds, failing to notify the CFTC of deficiencies in customer accounts and filing false reports with the agency. Mr. Corzine is charged with the firm’s violations as a control person and Ms. O’Brien with aiding and abetting the misuse of customer funds. The complaint centers on claims that customer funds, which are required to be segregated, were misused by the firm as it was collapsing in the fall of 2011. Specifically, during that period MF Global was on the brink of collapse from large proprietary trading positions directed by its CEO. At the time the firm not only had deficient internal systems but it ultimately violated its own procedures in utilizing segregated customer funds to meet its obligations. The firm settled, agreeing to make full restitution which is approximately $1 billion, and to pay a $100 million fine. The complaint requests injunctions, restitution, penalties, and registration and trading bans as to the individual defendants. The individual defendants are litigating the case.

    Criminal cases

    Investment fund fraud: U.S. v. Berkman, No. 13-mg-00732 (S.D.N.Y.) is an action against Craig Berkman, a one-time aspiring political figure. Over a period of about two years beginning in 2010 Mr. Berkman raised an estimated $13.2 million from over 120 investors for three fraudulent investment scheme. Essentially the schemes either promised access to pre-IPO shares of stocks like Facebook or those of select start-ups. The claims were false. In fact Mr. Berkman misappropriated much of the money raised from investors. Mr. Berkman pleaded guilty this week to one count of securities fraud and one count of wire fraud. He is scheduled for sentencing on October 1, 2013. The SEC has a parallel action pending. In the Matter of Craig Berkman, Adm. Proc. File No. 3-13249 (Filed March 19, 2013).

    Investment fund fraud: U.S. v. Mattera, 1:12-cr-00127 (S.D.N.Y.) is an action against Florida businessman John Mattera. This week he was sentenced to serve 11 years in prison. Previously he pleaded guilty to securities and wire fraud charges. From 2010 through 2011 Mr. Matteria served as Chairman of the Advisory Board of Praetoria Global Fund Ltd., a mutual fund. In that capacity he was responsible for the investment decisions. Beginning in the late summer of 2010 Mr. Mattera and others offered investors the opportunity to purchase shares in special purpose entities related to the Praetorian which supposedly owned pre-IPO shares of companies such as Facebook and Groupon. Based on those representations about $11 million was raised. Investors were assured that their funds would be held in escrow until after the IPOs. In fact the representations were false. Most of the investor money was transferred to other entities with which Mr. Mattera was associated. About $4 million was spent by Mr. Mattera for personal items. The SEC has a parallel case pending. SEC v. Mattera, Civil Action No. 11-cv-8323 (S.D.N.Y. Filed Nov. 18, 2011).

    Financial fraud: U.S. v. Skilling (N.D. Tx.) is the long running case against former Enron CEO Jeffrey Skilling. Last week Mr. Skilling was resentenced to 168 months in prison, substantially reducing his sentence. He was also ordered to forfeit $42 million. Following his conviction for one count of conspiracy, 12 counts of securities fraud and one count of insider trading, Mr. Skilling was sentenced to serve 292 months in prison on October 23, 2006. The Fifth Circuit Court of Appeals concluded the sentence had been improperly enhanced and remanded for resentencing. Subsequently, Mr. Skilling and the government entered into the arrangement reflected in the resentencing which effectively reduced the term of imprisonment by about nine years. This resolution brings the long running case to a conclusion and permits the money to be distributed to victims of the fraud.

    FINRA

    Improper markups/downs: State Trust Investments, Inc., and its head trader Jose Luis Turnes, were sanctioned by the regulator for improper markups and markdowns in bond transactions. Specifically, the firm was fined $1,045 million and ordered to pay restitution of $353,000 plus interest to its customers who received unfair prices. Mr. Turnes was suspended for six months and fined $75,000. FINRA concluded that the firm charged excessive markups or markdowns to customers in a total of 563 transactions. Previously, the regulator suspended Jeffrey Cimbal, the firm’s CCO, for five months in a principal capacity for failing to supervise Mr. Turnes and fined him $20,000.

    Court of appeals

    Insider trading: U.S. v. Rajaratnam, Docket No. 11-4416-cr (2nd Cir. Decided: June 24, 2013) is the appeal of Galleon Fund founder Raji Rajaratnam of his conviction on conspiracy and insider trading charges for which he is serving an eleven year prison term. The focus of Mr. Rajaratnam’s appeal was his challenge to the district court’s conclusion that the wire tap evidence was admissible.

    Mr. Rajaratnam moved to suppress the wiretap evidence on which the charges against him were centered, claiming that the government made misstatements and omissions regarding the reliability of informant Roomy Khan and that the evidence regarding the need for a warrant in the application had serious omissions. The district court rejected these claims and admitted the wiretap evidence.

    The Second Circuit affirmed. Under Franks v. Delaware, 438 U.S. 154 (1978)suppression is only warranted if it is demonstrated that the inaccuracies or omission in the affidavit offered when requesting the warrant are the result of the affiant’s deliberate falsehood or reckless disregard for the truth and the alleged falsehoods or omissions were necessary to the probable cause or necessity decision, according to the Court. Here, even assuming that this standard was met with regard to Ms. Kahn’s background which omitted her prior conviction and the two paraphrased statements of conversations with Mr. Rajaratnam were inaccurate, the errors were not material to the district court’s determination and analysis on the probable cause issue. Likewise the omission of evidence about the SEC investigation on the issue of whether a wiretap was needed does not meet the required standard. In fact that the evidence actually supported the application for a warrant because it demonstrated that Mr. Rajaratnam carefully limited his exchanges to phone calls thus necessitating the wiretaps.

    Finally, the Court rejected Mr. Rajaratnam’s claim that the jury instructions were erroneous. Those instructions specified in part that the jury had to find that the material non-public information given to Mr. Rajartanam “was a factor, however small” in his decision to buy or sell the stock. The claim that this permitted the jury to convict him without finding the necessary causal connection between the inside information and the trades executed is incorrect the Court found. Indeed, the jury is only required to find that the defendant purchased or sold the securities while knowingly in possession of material non-pubic information.

    SFO

    Financial fraud: The U.K. Serious Frauds Office secured the conviction of Mark Woodbridge, an executive at Torex Retail plc, a company involved in the rental of software. The charges centered on an alleged financial fraud at the company which is now in administration. A jury returned a verdict of guilty as to Mr. Woodbridge but acquitted a co-defendant. Previously a jury acquitted another defendant but was unable to reach a verdict as to another. Two other defendants have been sentenced to prison in connection with the collapse of the company.

    SFC

    Annual report: The Securities and Futures Commission published its 2012-2013 annual report, themed Regulation for Quality Markets (here).

    ASIC

    Investment fraud: The Australian Securities and Investment Commission announced that Carlo Cini, formerly a director of C Cini & Company Pty Ltd. which is now in liquidation, has been charged with obtaining property by deception, fraudulently inducing persons to invest money, obtaining financial advantage by deception and dishonestly using his position as a director. The charges are based on allegations that Mr. Cini raised over $1 million from investors for property development in 2007 and 2008 and then diverted the funds to other purposes. During that period he also issued valueless checks to investors and abused his position as a corporate director.

    SEC Charges Medical Device Company and its Founder with Fraud

    June 26, 2013

    The Commission charged a medical device company and its founder with making false statements regarding the FDA’s refusal to approval a device which is a key component of its business plan. The action was brought against Imaging3, Inc. and its founder Dean Norman Janes. SEC v. Imaging3, Inc., Case No. CV 13-4616 (C.D. Cal. Filed June 25, 2013).

    Imaging3 was founded in 1993 by Mr. Janes. The Burbank, California based company sells, rents and services remanufactured or refurbished mobile imaging devices. That business is operating at a loss.

    A key product for the future, however, is a Dominion Scanner. Based on proprietary technology, and under development for years, the product is supposed to produce 3D medical diagnostic images in real time. Thus, for example, the Scanner has been crafted to produce a 3D image of a broken bone which, if done, would facilitate diagnosis by a physician.

    To market its Dominion Scanner, Imaging3 needed FDA approval. The company first sought that approval in an application filed in 2007. To secure approval the company had to demonstrate in its application that the device is safe and as effective as what is called a “predicate device,” that is, one on the market that is not subject to approval. The year after the application was filed the FDA denied approval. The agency stated that the device was not substantially equivalent to the predicate devices.

    In September 2009 the company tried again. In a January 2010 letter the FDA again denied clearance. The letter recited essentially the same reason as those given for the earlier denial.

    A third application was submitted in July 2010. Again the FDA denied the application. In an October 2010 letter the agency identified several issues that had to be resolved. Those included concerns about the safety of the device and the quality of the images.

    On November 1, 2010 Mr. Janes held a news conference to update investors on the development of the Scanner. He told investors that the company would again apply for clearance by the FDA. During the conference Mr. Janes also stated that the denials by the FDA were not based on safety concerns or the quality of the images. Rather, the denials were what he called “ridiculous” and “administrative,” not “substantive.” The FDA letter was not released.

    Two months later an investor posted the FDA’s October 2010 denial letter, obtained through an FOIA request, on an online message board. Mr. Janus subsequently provided a link to the letter on his personal Facebook page. The company did not release the letter until February 2013.

    The Commission’s complaint alleges violations of Exchange Act Section 10(b). The case is in litigation. See also Lit. Rel. No. 22733 (June 26, 2013).

    Two Investment Frauds Centered on Pre-IPO Shares of Facebook

    June 25, 2013

    Fraudulent investment funds purporting to give the public an opportunity to acquire pre-IPO shares of potentially hot stocks such as Facebook have been front and center in the District Court in Manhattan in recent days. In one case a former Oregon gubernatorial candidate and securities law recidivist pleaded guilty while in the other a Florida businessman was sentenced to prison. In both cases investors lost millions of dollars.

    The first centered on a scheme orchestrated by Craig Berkman, a one time aspiring political figure. Over a period of about two years beginning in 2010 Mr. Berkman raised an estimated $13.2 million from over 120 investors for three fraudulent investment schemes.

    Ventures Trust LLCs: Investors were told these entities held large quantities of pre-IPO shares of Facebook, Groupon, LinkedIn, and Zynga. In fact they did not. One entity did have a small, indirect interest in pre-IPO shares of Facebook.

    Face-Off Acquisitions, LLC: This entity, investors were told, would use the funds to purchase an existing special purpose vehicle that owned a significant stake in Facebook. The representation was false.

    Assensus Capital Investors, LLC: In this scheme investors were lured to provide funding for what they were told would be an investment in various start-ups, including technology, medical device and energy companies. Investor funds were supposedly secured in part by interests in pre-IPO shares of Facebook. The claims were false.

    In fact Mr. Berkman misappropriated much of the money raised from investors. These was not the first such schemes in which Mr. Berkman has been involved. Previously, the Oregon Division of Finance and Securities issued a cease and desist order against him and imposed a $50,000 for selling securities without a license. Later an Oregon jury found him liable in a private action for breach of fiduciary duty, conversion of investor funds and misrepresentations.

    Now Mr. Berkman has pleaded guilty to one count of securities fraud and one count of wire fraud. He is scheduled for sentencing on October 1, 2013. U.S. v. Berkman, No. 13-mg-00732 (S.D.N.Y.). The SEC has a parallel action pending. In the Matter of Craig Berkman, Adm. Proc. File No. 3-13249 (Filed March 19, 2013).

    In the second case, Florida businessman John Mattera was sentenced to serve 11 years in connection with a fraudulent investment fund scheme tied to pre-IPO shares of stocks like Facebook. He had previously pleaded guilty to securities and wire fraud charges. U.S. v. Mattera, 1:12-cr-00127 (S.D.N.Y.).

    From 2010 through 2011 Mr. Matteria served as Chairman of the Advisory Board of Praetorian Global Fund Ltd., a mutual fund. In that capacity he was responsible for the investment decisions.

    Beginning in the late summer of 2010 Mr. Mattera and others offered investors the opportunity to purchase shares in special purpose entities related to the Praetorian. Those vehicles supposedly owned pre-IPO shares of companies such as Facebook and Groupon. Based on these representations about $11 million was raised. Investors were assured that their funds would be held in escrow until after the IPOs.

    In fact the representation were false. Most of the investor money was transferred to other entities with which Mr. Mattera was associated. About $4 million was spent by Mr. Mattera for personal items. The SEC has a parallel case pending. SEC v. Mattera, Civil Action No. 11-cv-8323 (S.D.N.Y. Filed Nov. 18, 2011).

    Second Circuit Rejects Galleon Founder’s Insider Trading Appeal

    June 24, 2013

    Raja Rajaratnam, the founder of the Galleon Group hedge fund lost his appeal on insider trading charges. U.S. v. Rajaratnam, Docket No. 11-4416-cr (2nd Cir. Decided: June 24, 2013). Mr. Rajaratnam was convicted on five counts of conspiracy to commit securities fraud and nine counts of securities fraud by a jury following a lengthy insider trading trial. He is currently serving an eleven year prison term.

    The focus of Mr. Rajaratnam’s appeal was his challenge to the district court’s conclusion that the wire tap evidence was admissible. His case is one of the first insider trading cases to make extensive use of wiretap evidence. The district court admitted evidence drawn from eight wiretaps which began with one of Mr. Rajaratnam’s cell phone in March 2008. In admitting the evidence the district court considered two critical questions when securing the wiretaps: a) whether there was probable cause to wiretap the cell phone; and b) why the proposed tap was necessary.

    In the initial application to establish probable cause the government presented statements made by Mr. Rajaratnam to Roomy Kahn and summarized conversations between the two which Ms. Kahn had taped, indicating that they had discussed inside information. To demonstrate “necessity” the government told the court that the use of grand jury subpoenas, the collection of documents and taking testimony had failed or appeared reasonably unlikely to succeed if tried. The district judge who considered this evidence issued the wiretap authorization.

    Mr. Rajaratnam moved to suppress the wiretap evidence, claiming that the government made misstatements and omissions regarding the reliability of Roomy Khan and that the evidence regarding “necessity” was materially incomplete. Specifically, he argued that the government told the court in the wiretap application that Ms. Khan had not been charged with any crimes when in fact she had previously pleaded guilty to felony wire fraud while incorrectly stating the period in which she had been cooperating with the FBI. The government also failed to tell the court that Mr. Rajaratnam and Galleon had been the subject of an ongoing SEC investigation, that several Galleon employees had testified in that inquiry and that about four million pages of documents had been produced which were subsequently conveyed to the U.S. Attorney.

    The district court concluded that in fact the search warrant application incorrectly stated Ms. Kahn’s background and the period of time she had been cooperating with the FBI. Two statements attributed to Mr. Rajaratnam were also incorrectly summarized and the evidence on “necessity” contained what the court called a “glaring omission.” Nevertheless, the district court refused to suppress the evidence finding that despite the errors and omissions there was sufficient evidence to establish probable cause and necessity.

    The Second Circuit, while not agreeing with all the findings of the district court, affirmed. The analytical framework for evaluating the wiretap issue has been established by the Supreme Court’s decision in Franks v. Delaware, 438 U.S. 154 (1978) and is well grounded in Second Circuit precedent. Under Franks suppression is only warranted if it is demonstrated that the inaccuracies or omission in the affidavit are the result of the affiant’s deliberate falsehood or reckless disregard for the truth and the alleged falsehoods or omissions were necessary to the probable cause or necessity decision, according to the Court.

    To establish deliberate falsehood or reckless disregard the defendant must do more than demonstrate an omission or error. Rather, “the reviewing court must be presented with credible and probative evidence that the omission of information in the wiretap application was ‘designed to mislead’ or was ‘made in reckless disregard of whether [it] would mislead.’” Here, even assuming that this standard was met with regard to Ms. Kahn’s background and the two paraphrased statements, the errors were not material to the district court’s determination and analysis on the probable cause issue. To the contrary, there were sufficient facts before the judge who issued the search warrant to establish probable cause.

    Equally clear is the fact that the omission of evidence about the SEC investigation does not meet the required standard. In reviewing the district court’s finding de novo, the Court of Appeals rejected the conclusion that this was a glaring error. The representatives of the U.S. Attorney’s Office testified that the point about the SEC investigation simply did not occur to them. And, in any event the evidence actually supported the application for a warrant the appeals court concluded because many of the documents and chronologies compiled by the SEC demonstrated that “Mr. Rajaratnam had been careful to exchange nearly all of his inside information by telephone.” This meant that wiretaps were “particularly appropriate” in this case.

    Finally, the Court rejected Mr. Rajaratnam’s claim that the jury instructions were erroneous. Those instructions specified in part that the jury had to find that the material non-public information given to Mr. Rajartanam “was a factor, however small” in his decision to buy or sell the stock. The claim that this permitted the jury to convict him without finding the necessary causal connection between the inside information and the trades executed is incorrect the Court found. To the contrary, the jury is only required to find that the defendant purchased or sold the securities while knowingly in possession of material non-pubic information. According, the instruction given here was “if anything more favorable” to Mr. Rajaratnam” than the required “knowing possession standard.” Thus, like the claim about the wiretap evidence, the alleged error regarding the jury instructions was rejected by the Court.