March 11, 2013
The SEC charged the State of Illinois with misleading investors when selling about $2.2 billion in municipal bonds over a four year period beginning in 2005. The proceeding alleges violations of Securities Act Sections 17(a)(2) and (3). In the wake of substantial remedial steps initiated by the State of Illinois beginning in 2009 and its cooperation during the investigation, the proceeding was resolved with a consent to the entry of a cease and desist order based on the Sections cited in the Order. In the matter of State of Illinois, File No. 3-14237 (March 11, 2013).
The action centers on the chronic underfunding of Illinois’ pension plans for state workers. In 2011 the Illinois pension systems were, collectively, underfunded by about $83 billion. System assets covered only about 43% of its liabilities. This deficiency is rooted in years of chronic underfunding. Until 1981 the State funded pensions by paying the benefit obligations as they became due. This approach was abandoned in 1982. Over the next thirteen years contributions remained constant. In the face of rising costs however the system was underfunded by about $20 billion by 1995 when it had assets sufficient to cover only about half of the obligations.
In 1994 the State Assembly passed legislation designed to rectify the situation. Essentially the statutory plan called for achieving a 90% funded ration for each system by 2045. Part of the plan called for the State’s contributions to ramp up over a fifteen year period. This permitted Illinois to shift the burden associated with its pension costs to the future, creating a structural underfunding. From 1996 through 2010 the unfunded liability increased by $57 billion. Significant financial stress resulted.
In its bond offering documents the State disclosed the Illinois statutory funding provisions. The documents did not disclose the fact that the contributions required by the statutory plan significantly underfunded the State’s pension obligations. Likewise, the fact that pension funding was deferred into the future was not disclosed.
Beginning in 2005 the State amended the statutory plan, lowering the contributions or it borrowed to cover the payments. Although the basic facts were disclosed, the State did not inform investors that these actions exacerbated the structural underfunding, according to the Order. This resulted from the fact that the State failed to adopt or implement sufficient controls, policies, or procedures to ensure that material information was collected and disclosed.
In 2009 the State undertook to reform the system. In June of that year a Modernization Task Force was created. New personnel have been retained. Following the resolution of this action the State began implementing a series of remedial measures.
This is the second action brought by the Commission against a state focused on the failure properly disclose pension obligations in municipal bond offerings. The first was brought against the State of New Jersey three years ago. In the Matter of State of New Jersey, Adm. Proc. File No. 3-14009 (Aug. 18, 2010). There, however, the Order alleged that the State created the “illusion” that a statutory plan was being implemented to fund the obligations. In fact the state knew that the funding plan had been abandoned. The Order in that proceeding charged violations of the same Sections cited here.
March 10, 2013
Dallas Maverick’s owner Mark Cuban lost his bid to end the SEC insider trading case against him when the court rejected his summary judgment motion earlier this month. Now the nearly five year old case is heading for trial. It will present the court and jurors with critical questions regarding deception, duty and confidentiality for insider trading cases. SEC v. Cuban, Civil Action No. 3-08-CV-2050 (N.D. TX Filed Nov. 17, 2008). At the same time the hotly contested, high profile action presents critical issues for SEC Enforcement in wake of the Division’s recent court room loses in Reserve Management Co., the first fund to “break the buck”and Stoker, the companion case to the Citigroup market crisis action pending before the Second Circuit.
The Commission’s complaint centers on a PIPE offering made by Mamma.com Inc., a NASDAQ traded company based in Montreal, Quebec. When the company was planning the offering in 2004 Mr. Cuban was its largest known shareholder. The company contacted him and offered the opportunity to participate in the planned offering. Mr. Cuban was advised by the company at that time, according to the SEC, that the information he was about to be furnished was confidential. Mr. Cuban agreed to maintain its confidentiality, according to the complaint. When the company informed him of the planned PIPE offering Mr. Cuban became very upset. The offering would dilute his holdings.
In subsequent conversations with the company Mr. Cuban learned more details about the planned offering. Mr. Cuban expressed his opposition to the offering in each instance while acknowledging an obligation to keep the information confidential. In one conversation, according to the SEC, Mr. Cuban noted that he could not sell his shares until after the public announcement.
Following his last conversation with a company official about the proposed offering, Mr. Cuban called his broker and directed that his 600,000 share stake in the company be sold. Over a two-day period his shares were sold. The sales were completed the day before the announcement of the PIPE.
Following the public announcement of the offering, the share price of the company fell about 9.3%. That price continued to fall over the next week. According to the complaint, Mr. Cuban avoided losses in excess of $750,000 by selling before the announcement. The complaint alleges violations of Section 10(b) and 17(a).
The district court
The court granted Mr. Cuban’s motion to dismiss the complaint. Critical to the motion, which was supported by five amicus briefs from law professors, was the question of deception under the Supreme Court’s decision in U.S. v. O’Hagan, 521 U.S. 642, 651-52 (1997). There the Court held that a person commits securities fraud in violation of Section 10(b) and Rule 10b-5 when he or she misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.
Mr. Cuban argued, and the district court concluded, that the critical deception/agreement element was absent. Under O’Hagan, the district court held “the essence of the misappropriation theory is the trader’s undisclosed use of material, nonpublic information that is the property of the source, in breach of a duty owed to the source to keep the information confidential and not to use it for personal benefit . . . Under the misappropriation theory of insider trading, the deception flows from the undisclosed, duplicitous nature of the breach.” The duty between the parties must be to keep the information confidential and, in addition, not to use it for trading purposes the court held. That duty stems from the relationship between the parties.
Here the SEC’s complaint failed to allege an adequate agreement between the parties the Court found. While the complaint states that Mr. Cuban agreed to keep the information confidential, this is not sufficient. Rather, the parties must agree that the information will be kept confidential and that it will not be used for trading purposes. The allegations of the complaint are not adequate to meet this standard. Nor are they bolstered by Rule 10b-5-2 the Court concluded since that Rule is cannot be broader than its predicate, Section 10(b).
The circuit court
Eschewing an opportunity to amend its complaint, the SEC appealed to the Fifth Circuit and prevailed. SEC v. Cuban, No. 09-10996 (5th Cir. Sept. 21, 2010). The Circuit Court essentially disagreed with the district court’s reading of the complaint. Stressing that all reasonable inferences must at the pleading stage be drawn in favor of the SEC, the Court concluded that the “allegations [in the complaint], taken in their entirety, provide more than a plausible basis to find that the understanding between the CEO and Cuban was that he was not to trade . . .” It is plausible the Court found that “each of the parties understood, if only implicitly” that Mr. Cuban could not trade.
The inferences drawn by the court in favor of the SEC are predicated on what the opinion describes as a “factually sparse record.” If there were more facts, the outcome might be different. For example, the Court noted that “it would require additional facts that have not been put before us for us to conclude that the parties could not plausibly have reached” an agreement that Mr. Cuban could not trade. The parties also dispute Mamma.com’s motive in providing Mr. Cuban information, the Court stated. The effect of resolving this dispute is unclear. Finally, the Court declined to consider the SEC’s argument based on Rule 10b-5-2(b)(1) which provides for a duty of trust and confidence.
The Court rejected Mr. Cuban’s motion for summary judgment finding, in essence, that the SEC had produced sufficient evidence at this stage of the proceeding to proceed to trial. In seeking a ruling which would halt the proceeding Mr. Cuban raised a series of issues, including:
Lack of an agreement: The motion papers argued that the Commission cannot meet its burden to demonstrate that there was a valid offer, acceptance and meeting of the mind between the parties. This was the critical issue raised at the motion to dismiss stage. Here however the Court rejected the claim, relying on the fact that an agreement can be implied from the surrounding facts and circumstances: “What the SEC must establish at trial is that Cuban agreed, at least implicitly, to maintain the confidentiality of Mamma.com’s material, nonpublic information and not to trade on or otherwise use it. And the existence of such an agreement can be implied from the parties’ conduct and the surrounding circumstances.”
Confidentiality: Mr. Cuban also claimed that there was insufficient evidence from which a reasonable jury could find that he agreed to keep the PIPE confidential. In rejecting this argument the Court declined to detail every fact supporting its conclusion. Rather, the Court found it sufficient to give examples of the type of evidence available which might support a verdict in favor of the Commission. Pointing to Mr. Cuban’s statement “I can’t sell” made at the time the CEO of Mamma.com spoke with him on the phone about the PIPE and told him he was disclosing confidential information, the Court concluded that “the jury could at least reasonably infer that Cuban would not have considered himself foreclosed from trading unless he believed he had agreed to treat the information as confidential.” Similarly, this phrase, viewed in the light most favorable to the SEC as it must on a summary judgment motion, supports the proposition that Mr. Cuban agreed “at least implicitly” to refrain from trading.
Disclosure: The Court also rejected Mr. Cuban’s contention that he was permitted to trade because he had disclosed his intention. Under O’Hagan the duty not to disclose is owed to the information source. If Mr. Cuban fully disclosed his intention to trade to the company, then there is no liability for insider trading based on O’Hagan. Again viewing the evidence in the context of summary judgment standards the Court rejected this claim, holding that “a reasonable jury could find from the evidence in the summary judgment record that Cuban merely disclosed that he ‘was going to sell,’ not that he specified that he would sell before Mamma.com announced the PIPE.” (emphasis original). In reaching this conclusion the Court rejected the SEC’s contention that the disclosure must be made in such a fashion as to give the source of the information sufficient time to take action to prevent the trading.
Materiality: Finally, the Court rejected Mr. Cuban’s claim that the information he received about the PIPE was not material. Although Mr. Cuban offered expert testimony and an event study demonstrating that the deal announcement had no discernable impact on the market, there is other evidence which points to the contrary conclusion including an expert report from the SEC as well as factors regarding the offering itself from which the jury could reasonably determine that the information was material.
* * *
The stage is set for what may be the concluding chapter in this long running saga. The case is proceeding to trial. The stakes could not be higher, particularly for the SEC. The Commission is coming off two high profile trial losses. In addition, the agency lost the first round in this case and got a second chance only because the Fifth Circuit read the complaint differently and more favorably to it than did the district court. While Commission prevailed on summary judgment no doubt it is carefully considering the statement that “the court emphasizes the closeness of this call” made in ruling on the critical deception/agreement issue. Now that close call will be turned over to a jury for consideration.
March 07, 2013
In Congress this week, a bipartisan bill was introduced to roll back part of the Dodd-Frank legislation related to swaps. It would expanded the swaps trading permitted by federally insured banks. Two high profile enforcement insider trading actions were also in the news. In one the court rejected a motion for summary judgment by defendant Mark Cuban and directed the case to trial in June. In the second Samuel Wyly requested that the Court dismiss the case based on the Supreme Court’s recent decision in Gabelli which concerns the commencement of the statute of limitation for the imposition of a financial penalty.
The Commission issued an investor alert regarding custody of investor securities. The agency also revisited an issue considered earlier, issuing a release requesting information on the standards that should govern brokers and investment advisers when giving advice.
The SEC filed four enforcement actions this week. One named a lawyer as a defendant for filing false Rule 144 opinions while a second focused on the author of a market report who did not disclose that he was being paid to tout certain stocks. Another action involved misrepresentation by the operator of two hedge funds while the fourth centered on a manipulation in which the defendant paid a confidential informant to participate in his scam which was taped by the FBI.
Proposed rule: The Commission issued for comment Rules to Improve Systems Compliance and Integrity (here). Proposed Regulation SCI is designed to replace the current voluntary compliance program with rules which would require self-regulatory organizations, certain alternative trading systems, plan processors and certain exempt clearing agencies to develop, design, test and maintain systems to ensure their core technology meets certain standards and to provide notifications if there is a disruption or for select other events.
Risk alert: The Commission issued a Risk Alert and Investor Bulletin on Investment Adviser Custody Rule (here). The Alert follows recent inspections which identified deficiencies concerning custody related issues at a significant number of the firms.
Comment: The Commission issued a Notice titled “SEC Seeks Information to assess Standards of Conduct and Other Obligations of Broker-Dealers and Investment Advisers.” The release requests data and other information for the agency to utilize in connection with possible rule making on the standards of conduct and regulatory obligations of investment advisers and broker-dealers (here). Previously, the staff issued a Report on this topic as required by Dodd-Frank.
Remarks: Chairman Gary Gensler addressed the Institute of International Bankers (March 4, 2013). His remarks focused on the recent difficulties in the LIBOR market and the implementation of swaps regulation (here).
Canadian securities enforcement actions
The Canadian Securities Administrators or CSA published their annual report recapping enforcement results for 2012. Last year there were 145 enforcement proceedings commenced. This is an increase over the 126 actions initiated in 2011 but down from the 178 reported in 2010. In 2012 the Report states that 135 cases were concluded, up from 124 in the prior year. At the same time, the number of cases resolved last year is far below that of 2010 when 174 cases were concluded. Over the last three years the amount of fines and administrative penalties imposed has steadily declined, according to the Report. In 2012 about $36.6 million in fines and administrative penalties were imposed while in 2011 it was $52.1 million and $63.9 million in 2010. In contrast, the amount of disgorgement ordered in 2012 increased to about $120.5 million, exceeding the $49.5 ordered in 2011 and the $58.5 million in 2010.
Shareholder suits following M&A deals
Last year the number of shareholder suits challenging M&A deals fell to 602 from the 742 filed in 2011 and the 792 brought in 2010. The percentage of deal announcements followed by a shareholder complaint, however, remained constant. Approximately 93% of deals valued over $100 million were challenged, according to a recent Report issued by Cornerstone Research (here). About the same percentage of deals were challenged in 2001 while 90% and 86% were subject to a shareholder lawsuit in 2010 and 2009, respectively. A slightly larger percentage of deals valued over $500 million were challenged. About 96% of those transactions drew a shareholder complaint. On average suit was filed 14 days after the announcement, although in some instances the complaint was lodged within hours. Most of the cases settled while a substantial number were voluntarily dismissed, following the trend of earlier years. In 2012 81% of these suits resolved with an agreement to make additional disclosures. Again, this is largely consistent with earlier years.
SEC Enforcement: Filings and settlements
Weekly statistics: This week the Commission filed 4 civil injunctive actions and no administrative proceedings (excluding tag-along-actions and 12(j) actions).
Unregistered securities: SEC v. J.C. Reed & Co., Inc., Civil Action No. 3:08-CV-1112 (MD. Tn.) is a previously filed action against J.C. Reed & Co., J.C. Reed Advisory Group and Barron Mathis. The complaint claims that over a three year period beginning in 2005 the defendants facilitated the offer and sale of over $11 million of J. C. Reed’s unregistered securities to over 100 investors. Misrepresentations were made to those investors regarding the value of the stock and the profitability of the company. This week the defendants settled with the Commission. The final judgment against Mr. Mathis enjoined him from future violations of Securities Act Sections 5(a), 5(c) and 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2). He was also directed to pay disgorgement of $11 million and prejudgment interest. The two entities were directed to pay disgorgement of $11 million and prejudgment interest. See also Lit. Rel. No. 22633 (March 7, 2013).
Fraudulent scheme: SEC v. Kegley, Civil Action No. 1:12-CV-1605 (N.D. Ga.) is a previously filed action against Gerald Kegley. Mr. Kegley is alleged to have introduced six individuals to a fraudulent scheme involving the potential use of bank guarantees. He also forwarded misrepresentations to them. The individuals invested about $1.95 million. This week Mr. Kegley settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). He was also ordered to pay disgorgement of $99,940 along with prejudgment interest and a penalty of $209,731.92. See also Lit. Rel. No. 22634 (March 7, 2913).
Investment fund fraud: SEC v. McAdams, Civil Action No. 4:10-CV-00701 (D.S.C.) is a previously filed action against M. Mark McAdams and R. Dane Freeman. The defendants sold interests in Global Holdings, raising about $3.5 million from investors in 2008 based on claims that high returns would be paid. The funds were to be used to buy and sell Standard and Poor’s AAA or AA rated bonds and medium term notes on overseas trading platforms. Most, if not all, investors did not receive the promised rates of returns. This week the court entered final judgments of permanent injunction by consent against each defendant prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The defendants were held jointly and severally liable for the payment of disgorgement of $3.5 million along with prejudgment interest. Each defendant was also directed to pay a civil penalty of $120,000. See also Lit. Rel. No. 22635 (March 7, 2013).
False legal opinions: SEC v. Reiss (S.D.N.Y. Filed March 7, 2013) is an action against California lawyer Brian Reiss who operated the website 144letters.com to promote his services. During 2008 on several occasions he issued Rule 144 opinions to transfer agents to facilitate the removal of the restrictive legends on shares, permitting them to become free trading. In issuing the letters Mr. Reiss did not conduct even a basic inquiry regarding the facts and made misrepresentations, according to the Commission. The complaint alleges violations of Securities Act Sections 5(a), 5(c), 17(a) and Exchange Act Section 10(b). The case is in litigation.
False recommendations: SEC v. McCabe, Civil Action No. 2:13-cv-00161 (D. Utah Filed March 5, 2013) is an action against Colin McCabe alleging violations of Exchange Act Section 10(b). Mr. McCabe is the publisher of three newsletters, the Elite Stock Report, The Stock Profiteer and Resource Stock Adviser. Subscribers were told that the newsletter recommendations were based on extensive research when in fact they were not, according to the complaint. Subscribers were also not told that between January 2008 and February 2010 Mr. McCabe was paid more than $16 million to conduct mass mailing promotions and tout specific stocks to his newsletter subscribers. While Mr. McCabe’s touting frequently caused a short term boost in the price of the stock, the impact did not last, harming investors who followed his advice as the stock declined in value. The case is in litigation. See also Lit. Rel. No. 22632 (March 5, 2013).
Misrepresentations: SEC v. Hansen, Civil Action No. 12 CV 1403 (S.D.N.Y. Filed March 1, 2013) is an action against Randal Hansen, the owner of Defendant RAHFCO Management Group, LLC which is the general partner of the two funds and Vincent Puma, the owner of defendant Hudson Capital Partners Corporation or HCP, a sub-adviser and portfolio manager for the two funds. The complaint alleges that after raising over $23 million from about 100 investors between April 2007 and May 2011 based on a series of misrepresentations, the funds devolved into insolvency, leaving investors with an estimated $10 million in losses. Randal Hansen interacted with the public and potential investors on behalf of the hedge funds, falsely assuring them that their investment was safe and would be used to implement a trading strategy in which the funds invested in options and futures on the S&P Index and equities. Mr. Puma bolstered those misrepresentations by provided a stream of information regarding the funds and their trading performance to Mr. Hansen or RAHFCO Management, the auditors and ultimately to investors which was false. Investors were told that from 2007 to early 2011 the two hedge funds earned over $9 million which would have represented a return of about 25%. In fact the two funds earned about $280,000, a return of less than 2%. During their four years of operation Mr. Hansen and RAHFCO Management received about $1.95 million in what were supposed to be investment profits and management fees. Mr. Puma and HCP received about $1.65 million in investor funds. While some investors received payments from the two hedge funds, many suffered losses. The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Sections 10(b) and 15(a) and Advisers Act Sections 206(1), 206(2) and 206(4). The case is in litigation. See also Lit. Rel. No. 22631 (March 4, 2013).
Stock manipulation: SEC v. Falcon Ridge Development, Inc., Civil Action No. 13-1101 (E.D. Pa. Filed March 1, 2013) is an action against the company, a New Mexico real estate firm, and its president, Fred Montano. Beginning in mid-2008 Mr. Montaro had conversations with an individual he believed could help him implement a scheme to manipulate the share price of Falcon Ridge. In fact the individual was a cooperating witness. As a result of those conversations arrangements were made to execute test trades in October 2008. The test trades were matched orders crafted to create an artificial price and illicit trading profits for Mr. Montario. The trades were arranged by Mr. Montario and executed with the FBI. Mr. Montario received the profits and paid the cooperating witness $1,000 for participating in the scheme. The conversations between Mr. Montario and the cooperating witness were taped. The Commission’s complaint alleges violations of Securities Act Section 17(a)(1) and Exchange Act Section 10(b). The case is in litigation. See also Lit. Rel. No. 22630 (March 1, 2013). The U.S. Attorney’s Office for the Eastern District of Pennsylvania announced the filing of parallel criminal charges.
Investment fund fraud: U.S. v. Harris, Case No. 3:12-cr-00170 (E.D. Va. Verdict March 4, 2013) in an action in which a jury convicted Michael Harris of securities, mail and wire fraud in connection with the solicitation of investments in his company, M.F. Harris Research, Inc. Investors were told beginning in 2005 that the company was developing a treatment for the HIV/AIDS based on a discovery by Mr. Harris that hyperbarie chambers used to treat divers for the bends inhibited the virus. In fact the claims were false. Most of the $880,000 in investor funds was misappropriated by Mr. Harris and used for his personal benefit. The date for sentencing has not been set.
Insider trading: U.S. v. Tang, No. 10-80 (N.D. Cal.) is a insider trading action in which defendant King Chuen Tang previously pleaded guilty to one count of conspiracy and one count of insider trading. Mr. Tang was the CFO of a private equity fund. He learned that Tempur-Pedic International, Inc was planning a pre-announcement of its regularly scheduled earnings announcement and that his employer was planning to purchase $50 million in Temur shares. He shared the information with two friends and the three traded, making $1.9 million in profits. In a separate scheme in April 2007 Mr. Tang received a tip from his brother-in-law who was the CFO of another private equity fund. Mr. Tang and others traded making about $3.7 million. He was sentenced to serve one year and a day in prison followed by three years of supervised release. While on supervised release he will also be required to serve twelve months of home confinement.
Market manipulation: SEC v. Crane, Case No. 1:13-cv-00261 (E.D. Va. Filed Feb 26, 2011) is an action against Robert Crane. The complaint alleges that Mr. Crane manipulated two penny stocks in June 2010 by engaging in several wash sales. The purpose of the transactions was to raise the funds to purchase a home. The scheme was unsuccessful – Mr. Crane did not make any money. He settled the matter with the Commission, consenting to the entry of a permanent injunction based on the Sections cited in the complaint which were Securities Act Section 17(a) and Exchange Act Section 10(b). He also agreed to the entry of a penny stock bar. No penalty was sought based on Mr. Crane’s financial condition. See also Lit. Rel. No. 22636 (March 7, 2013).
Suitability: Jeffrey Rubin operated of Pro Sports Financial, which provided financial and other services to professional athletes. From March 2006 through June 2008 while he was registered as a broker at Lincoln Financial Advisors Corporation and Alterna Capital Corporation he recommend that one of his NFL clients invest $3.5 million in four high-risk securities. The largest investment was $2 million in an Alabama casino project. This was the bulk of the player’s liquid net worth. Mr. Rubin did not inform his employer. The customer lost about $3 million. The recommendations were not suitable according to FINRA.
Approximately 30 other clients of the Sports firm were referred to the casino projcct by Mr. Rubin while he was employed at Alterna and International Assets Advisory, LLC without the firms’ knowledge or approval. They invested a total of $40 million in the project. Mr. Rubin received a 4% ownership stake and $500,000 from the project promoter. The regulator barred him from the securities business.
Supervisory systems: The regulator fined Amriprise Financial Services, Inc. and its affiliate, American Enterprise Investment Services, Inc. $750,000 for failing to have reasonable supervisory systems in place to monitor wire transfer requests regarding customer funds and accounts. Specifically, the firms did not have policies and procedures in place to detect or prevent multiple transmittals of funds to third part accounts. Rather, it relied on a manual review of wire requests without the benefit of exception reports. As a result the firms to miss multiple red flags with regard to wire requests from a customer’s account to a bank account which were forged.
Client funds: The Securities and Futures Commission initiated proceedings against two representatives of China Pacific Securities Limited, a company incorporated in Hong Kong and licensed to deal in securities. Previously, a freeze order had been obtained against the two individuals. The proceeding resulted from an inspection which demonstrated that there was a discrepancy in client securities accounts of about $156 million.
Investment fund fraud: The Australian Securities & Investment Commission banned former Astarra Asset Management Pty Ltd director Eugene Liu from the securities business for his activities in connection with Astarra Strategic Fund, a fund of funds. Mr. Liu was a director and chief investment strategist for Astarra Asset Management which was appointed by Trio Capital Ltd as the investment manager of Astarra Strategic Fund. While in that position he was responsible for incorrect statements in the product disclosure statement, furnished misleading research reports about the fund, failed to inform investors how their funds would be invested and took improper compensation outside of his salary. The ASIC has brought a series of enforcement actions related to Trio Capital. As a result 10 individuals have either been jailed, banned from the securities business, disqualified from managing corporations or agreed to remove themselves from participating in the financial services industry.
Insider trading: The regulator announced that Norman Graham, the former managing director of stockbroking firm Lonsec Limited pleaded guilty to two charges of insider trading. In February 2013 Mr. Graham learned that Clean Seas Tuna had suffered financial losses for the second half of the year. Prior to the public announcement he sold a total of 200,000 shares of Clean Seas Tuna across two client accounts.
March 06, 2013
The Commission brought another fraud action centered on losses suffered by investors in two private hedge funds, the RAHFCO Funds L.P. and the RAHFCO Growth Fund LP. After raising over $23 million from about 100 investors between April 2007 and May 2011 the funds devolved into insolvency, leaving investors with an estimated $10 million in losses. SEC v. Hansen, Civil Action No. 12 CV 1403 (S.D.N.Y. Filed March 1, 2013).
Named as defendants in the action are Randal Hansen, the owner of Defendant RAHFCO Management Group, LLC and the general partner of the two funds; and Vincent Puma, the owner of defendant Hudson Capital Partners Corporation or HCP, a sub-adviser and portfolio manager for the two funds.
Randal Hansen interacted with the public and potential investors on behalf of the hedge funds. Prior to their collapse he made presentations to investors and potential investors, assuring then that an investment in the funds was safe. Investors were told that the hedge funds were pursuing a trading strategy in which they invested in options and futures on the S&P Index and equities. Only a portion of the investor funds were to be at risk and some portions were supposedly put in government securities or held in cash some investors were told. In fact the strategy was not followed and the representations were false, according to the complaint. Rather, investor funds were misused to pay other investors and for the benefit of the defendants.
Mr. Puma was instrumental in the continuation of the hedge funds and the overall scheme of the defendants. During the operation of the two hedge funds he is alleged to have provided a stream of information regarding the funds and their trading performance to Mr. Hansen or RAHFCO Management. He also provided that data to an accounting firm retained by the two hedge funds. That data was incorporated into monthly and quarterly reports furnished to investors. In fact Mr. Hansen’s stream of data was false, according to the complaint. For example, investors were told that from 2007 to early 2011 the two hedge funds earned over $9 million which would have represented a return of about 25%. In fact the two funds earned about $280,000, a return of less than 2%. The fictitious results were, however, incorporated in Forms 1099 and Schedules K-1.
During their four years of operation Mr. Hansen and RAHFCO Management received about $1.95 million in what were supposed to be investment profits and management fees. Mr. Puma and HCP received about $1.65 million in investor funds. While some investors received payments from the two hedge funds, many suffered losses.
The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Sections 10(b) and 15(a) and Advisers Act Sections 206(1), 206(2) and 206(4). The case is in litigation. See also Lit. Rel. No. 22631 (March 4, 2013).
March 05, 2013
The number of M&A deals declined last year. Yet shareholder suits continued to challenge most transactions. The number of suits filed in 2012 declined to 602 from 742 in 2011 and 792 in 2010. The percentage of deal announcements followed by a shareholder complaint, however, remained constant. Approximately 93% of deals valued over $100 million were challenged, according to a recent Report issued by Cornerstone Research (here). About the same percentage of deals were challenged in 2001 while 90% and 86% were subject to a shareholder lawsuit in 2010 and 2009, respectively. A slightly larger percentage of deals valued over $500 million were challenged. About 96% of those transactions drew a shareholder complaint. On average suit was filed 14 days after the announcement, although in some instances the complaint was lodged within hours.
The majority of shareholder suits filed in 2012 for which Cornerstone was able to obtain data (about 58%) were settled for deals over $100 million. The 64% settled last year, slightly more than the prior two years when 58% and 62% settled. About 34% of the cases were voluntarily dismissed in 2012 which is the same percentage as in 2011 and about the same as the 32% in 2010.
In 2012 most suits were resolved with an agreement to make additional disclosures. 81% of the M&A related suits filed last year settled on this basis. Only one 2012 settlement had a monetary component. Those numbers are comparable to the two preceding years. In 2011 86% of the suits settled with additional disclosures while 4 involved a monetary component. In 2010 76% of the cases settled with additional disclosures and 8 had a monetary component.
Two of the largest settlements in recent years for shareholder suits were in 2012. One was the El Paso Corporation/Kinder Morgan Inc. deal which resolve for $110 million. The other was the Delphi Financial Group, Inc. – Tokio Marine Holdings, Inc. transaction which settled for $49 million. Both deals were announced in 2011. The largest settlement from 2003 to 2012, according to the Report, was the August 2010 resolution of the Kinder Morgan managed buyout for $200 million with $24.1 million in attorney fees and expenses. The smallest settlement on the top fifteen list was for the eMachines management buyout in April 2007 for $24 million and $7.2 million in attorney fees and expenses.
Noteworthy is the fact that all but two of the settlements of shareholder suits in the top fifteen involved allegations of significant conflicts of interest such as:
–The target companies’ management negotiated premiums for share classes they held;
–The target companies’ CEOs negotiated side deals with acquirers to purchase some of the targets’ assets;
–Majority shareholders obtained ownership of the remaining shares on what were claimed to be unfair terms;
–The target companies’ financial advisers had conflicts of interest; or
–The deal was a management-led buyout.
Finally, the number of shareholder suits challenging the annual proxies spiked in 2012 to 12, doubling the filings from 2011. In 2010 only 4 such suits were filed. Claims focused on say on pay were typically not successful, according to Cornerstone, while those which involved the dilution of existing shareholders appeared to gain more traction. All of the 2012 cases were filed by one law firm. In early 2013, however, two additional firms have announced investigations on these types of claims.
March 04, 2013
For almost six years Michael Harris solicited investments in M.F. Harris Research, Inc. Eighty investors put up thousands of dollars for what they understood was a possible treatment for HIV/AIDS. The investment was a fraud. Yesterday a jury convicted Mr. Harris of securities, mail and wire fraud on proof that in fact he was running an investment fund fraud. U.S. v. Harris, Case No. 3:12-cr-00170 (E.D. Va. Verdict March 4, 2013.
Harris Research was formed in 2003 supposedly to develop a treatment HIV/AIDS. Mr. Harris claimed to have discovered that hyperbarie chambers used to treat divers for the bends inhibited the HIV/AIDS virus. He claimed Harris Research was pursuing a potential treatment regimen for the virus using the chamber.
Beginning in 2005 Mr. Harris and his company solicited investors to develop the treatment. Those investors were told that:
Patents: Harris Research was obtaining patents in the U.S. and abroad for its treatment;
Human trials: That the company was conducting human trials or assisting with human trials using the treatment;
Continuing research: Harris Research was engaged in continuing research; and
Treatment: The company was developing a treatment.
Many investors were requested to put up only $1 on the promise that the company would increase in value 10 to 20 fold. In some instances investors were told funds were urgently needed because of patent deadlines.
In fact the evidence at trial demonstrated that Mr. Harris’ claims were false. The investment fund was a fraud. Investors were not told the actual financial condition of the company or the use being made of their funds. Most of the $880,000 in investor funds was misappropriated by Mr. Harris and used for his personal benefit.
The date for sentencing has not been set.
March 03, 2013
The Canadian Securities Administrators or CSA published their annual report recapping results for 2012 for securities enforcement actions. The CSA is the council of 10 provincial and three territorial securities regulators in Canada. The mission of the organization “is to facilitate Canada’s securities regulatory system, providing protection to investors from unfair, improper or fraudulent practices and to promote fair, efficient and transparent capital markets, through the development of harmonized securities regulation, policy and practices.” Its annual report reviews the results of Canadian securities regulators, actions brought under the criminal code and by self-regulatory organizations.
Proceedings commenced: In 2012 there were 145 enforcement actions commenced targeting securities violations. This is an increase over the 126 actions initiated in 2011 but down from the 178 reported in 2010. Over the last five years the most actions were brought in 2010 when 172 were filed with 2008 second with 172 2009. The low was 124 in 2009.
The Report divides the actions into various categories such as illegal distributions, misconduct by registrants, insider trading and manipulation. Year to year comparisons are difficult, however, since in 2012 the Report introduced a new “fraud” category which is composed of cases previously grouped in other areas, although apparently most of the cases in this new group were previously included under the label of illegal distributions.
One category which appears to have been unaffected by the new groupings is insider trading. Statistics are provided for the number of cases and the number of persons involved in the case. Here the statistics show a decline in the number of actions brought as well as in the number of persons involved. In 2012 there were 4 actions were brought which involved 19 persons. In contrast in 2011 9 insider trading cases filed involving 31 persons compared to 2010 when 12 were brought also involving 31 persons. This trend contrast with U.S. where insider trading is an enforcement priority which continues to result in increasing numbers of cases.
The trend in naming either individuals or business organizations over the last three years in enforcement actions has remained essentially the same. Last year 242 individuals were named as respondents while 146 corporations were named. In 2011 the split was roughly the same with 231 individuals named as respondents while 121 business organizations named. Similarly, in 2010 301 individuals were named while 183 entities were named as respondents.
Concluded cases: The trend regarding the number of cases concluded last year does not mirror the one for bringing actions. In 2012 the Report states that 135 cases were concluded, up from 124 in the prior year. At the same time, the number of cases resolved last year is far below that of 2010 when 174 cases were concluded. The lowest number of cases resolved in one year over the last five years is 123 in 2008. In 2009 141 were concluded.
In contrast, to the U.S. were most securities enforcement actions are settled, the Report notes that over half of the cases in 2012 were concluded at a contested hearing before a tribunal. Another 25% were resolved through settlement while 20% were resolved through a court proceeding under securities legislation.
The split between the number of individuals and corporations named as respondents has remained essentially constant over the last three years. In 2012 206 individuals and 116 business organizations were respondents in concluded actions. In 2011 there were 237 individuals and 128 corporations as respondents in resolved actions while in 2010 there were 207 individuals and100 corporations.
The statistics for categories of resolved cases were altered in the same manner as those for the filing of actions, that is, by adding a new fraud category. Again, the trend for concluded insider trading cases appears to have been unaffected by the change. Last year 16 insider trading cases were concluded equaling the number in 2011 and down by just one case from 2010.
The trend regarding the imposition of fines and administrative penalties in concluded cases is not consistent with the one for resolving the actions. Over the last three years the amount of fines and administrative penalties imposed has steadily declined in contrast to the trend for concluded actions. In 2012 about $36.6 million in fines and administrative penalties were imposed while in 2011 it was $52.1 million and $63.9 million in 2010.
The decline in the amount of fines and administrative penalties may reflect the fact that the amount of restitution, compensation and disgorgement over the last three years has significantly increased. In 2012 those amounts totaled about $120.5 million, up significantly from the $49.5 million ordered the year before and the $58.5 million in 2010.
Agency cooperation: The Report emphasizes the cooperation of Canadian securities regulators among the provinces and with other regulators such as the U.S. Securities and Exchange Commission. One example cited involved an insider trading case involving the husband and wife team of Shane Suman, who resided in Ontario, and Monie Rahman who lived in the U.S. Mr. Suman worked for a subsidiary of NASD traded Molecular Devices Corporation. He learned the firm would be acquired in a friendly tender and tipped his wife. The couple purchased stock and options through the wife’s E-trade Canada account. Following the deal announcement they had profits of over $1 million. The SEC brought an insider trading action in which it obtained judgments ordering the payment of disgorgement and a civil penalty by the husband of $2 million and $1 million by the wife. SEC v. Suman, Case No. 07 Civ. 6625 (S.D.N.Y. ). The Ontario Securities Commission brought an action even though Molecular Devices is not a reporting issuer in Ontario on the theory that the conduct of the couple “was deemed to be contrary to the underlying policy objectives of the Ontario Securities Act’s insider trading provisions.” The OSC ordered the husband to pay disgorgement and an administrative penalty of $250,000. The couple was also ordered to pay administrative costs of $250,000. Permanent cease trading and director and officer bars were also imposed.
A second action cited involved the Arbour Energy Ponzi scheme. There the Alberta securities Commission obtained and shared information with other Canadian securities authorities and the SEC and Washington State Department of Financial Institutions, Division of Securities. A criminal action was also brought in Alberta.
February 28, 2013
The Supreme Court handed down two significant securities law decisions this week. In the first the High Court, in unanimous opinion, rejected the contention of the SEC that the five year statute of limitations for seeking a penalty can be extended by invoking a discovery rule. In the second, the Court concluded that a securities law class action plaintiff need not establish materiality at the class certification stage to invoke the fraud on the market theory. Rather, materiality is a merits issue.
The SEC filed two new enforcement actions this week. One involved a PRC based issuer formed by a reverse merger charged with falsifying its financial statements by failing to include related party transactions and an off-books account. The second focused on claims that a hedge fund manager amended the structure to give certain shareholders a liquidation preference and then sold additional shares without disclosing this fact.
Finally, the SEC Chairman and three Commissioners addressed the annual SEC Speaks Conference, focusing on market safety and structure, regulatory measures to promote the stability of markets, disclosure policy and regulatory burdens and raising questions about the independence of the agency in view of certain provisions in Dodd-Frank. Chairman Walter was honored at a dinner held in connection with the conference of ASECA, the alumni association of former SEC staff.
Remarks: Chairman Elisse Walter addressed the SEC Speaks Conference (Washington, D.C. Feb. 22, 2013) in remarks titled “Making the Markets Safe for Informed Risk-Taking.” Her remarks focused on minimzing the risks in the market (here).
Remarks: Commissioner Luis Aguilar addressed the SEC Speaks Conference (Washington, D.C. Feb. 22, 2013). His remarks focused on regulatory measures to promote market stability (here).
Remarks: Commissioner Daniel Gallagher addressed the SEC Speaks Conference (Washington, D.C. Feb. 22, 2013). His remarks focused on regulatory action that is impacting the Commission’s independence (here).
Remarks: Commissioner Tory Paredes addressed the SEC Speaks Conference (Washington, D.C. Feb. 22, 2013). His remarks focused on disclosure policy in contrast to the regulatory burdens of Dodd-Frank (here).
Remarks: Chairman Gary Gensler addressed the Global Financial Markets Association (Feb. 28, 2013). His remarks focused on the need to transition from LIBOR in wake of recent actions involving that benchmark rate (here).
Testimony: Chairman Gary Gensler testified before the Senate Committee on Agriculture, Nutrition & Forestry (Feb. 27, 2013). His testimony reviewed the recent swaps market reforms including the impact of those reforms on the markets, the LIBOR enforcement actions and the agency’s budget request and the necessity to fund it (here).
The Supreme Court
Statute of limitation: Gabelli v. SEC, No. 11-1274 (S.Ct. Decided Feb. 27, 2013). The Supreme Court rejected the SEC’s effort to extend the five year statute of limitations for imposing a civil penalty by engrafting a discovery exception onto the statute. Chief Justice Roberts, writing for a unanimous Court, held that under Section 2462 of Title 28, the statute of limitations begins when there is a cause of action. The decision is a straight forward reading of the plain statutory language. The ruling came in a case where the Commission claimed a portfolio manager and the COO made false statements regarding an arrangement made with one hedge fund adviser which permitted it to market time while others were banned from using the practice. Although the complaint was filed in April 2008 following an investigation that began in 2003, the underlying conduct occurred from 1999 to 2002. The complaint alleged violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2). The district court granted in part the defendants’ motion to dismiss based on 28 U.S.C. Section 2462, the five year statute of limitations for penalties in government actions. The Second Circuit reversed, concluding that the claim did not accrue until it was discovered or could reasonably have been discovered.
The Supreme Court reversed. Writing for a unanimous Court Chief Justice Roberts stated that “the ‘standard rule’ is that a claim accrues “when the plaintiff has a complete and present cause of action.” That rule has governed since the 1830s when the predecessor to the current Section was written. It is also consistent with the definition of the word “accrued” in standard legal dictionaries. In addition, this reading of the text ensures a fixed date when exposure under the statute begins. While the “discovery rule” advocated by the SEC traces to the eighteenth century, it has never been applied in a context where the plaintiff has not been defrauded. Indeed, the discovery rule is designed to aid plaintiffs seeking recovery for an injury, not a penalty as here.
Class certification: Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, No. 11-1085 (Decided Feb. 27, 2013) is a case in which the Court held in a 6 to 3 decision that a securities class action plaintiff need not prove materiality at the class certification stage to rely on the fraud-on-the market presumption. This case focuses on the interaction of Rule 23, Federal Rules of Civil Procedure, and the Court’s holding in Basic Inc. v. Levinson, 485 U.S. 224 (1988) which adopted the fraud-on-the-market theory is securities fraud class actions. In the underlying case the Ninth Circuit Court of Appeals affirmed a ruling by the district court, holding that the plaintiffs did not have to establish materiality to prevail on a Rule 23 motion for class certification. Rather, the question of materiality, necessary to the invocation of the Basic presumption, is reserved for the merits. At the certification stage it is sufficient to “take a peek at the merits” by ensuring that materiality is plausibly pleaded.
The Supreme Court affirmed in an opinion was written by Justice Ginsburg and joined by Chief Justice Robert, and Justices Breyer, Alito, Sotomayor and Kegan. To obtain class certification , Justice Ginsburg wrote, plaintiff must meet the requires of 23 which, among other things, requires that the questions of law or fact common to the class members predominate over any questions affecting only individual members. Those requirements are distinct from those needed to establish a claim under Exchange Act Section 10(b), one of which is reliance. That element can be demonstrated by the Basic fraud-on-the market presumption.
Although the Court has directed that the certification process be “rigorous” and noted that it may “entail some overlap with the merits of the plaintiff’s underlying claim,” the Rule does not give courts a “license to engage in free-ranging merits inquiries at the certification stage.” In considering the requirements of the Rule the focus is on common questions. Materiality under Basic is an objective test viewed in the context of a reasonable investor. It can be established through evidence common to the class. If established the claim may proceed for the class, assuming the other elements of a cause of action are also proven. If not, the claim fails for the class. In either case the determination is a common question. As a common question it meets the Rule 23 test. Whether it can be proven is, in contrast, a merits question.
Justice Alito joined the majority but also wrote a separate concurring opinion. There he noted that it may be appropriate to reconsider the Basic presumption in view of recent economic studies on market efficiency which suggest that it is not a binary question. While the issue was raised by Petitioners, the question was not properly before the Court.
Justice Scalia dissented. In his view the “Basic rule of fraud-on-the-market . . . governs not only the question of substantive liability, but also the question of whether certification is proper. All of the elements of that rule, including materiality, must be established if and when it is relied upon to justify certification. The answer to the question before us today is to be found not in Rule 23(b)(3), but in the opinion of Basic.”
Justice Thomas, dissenting, also concluded that the requirements of Basic must be met to certify the class. In this regard, Justice Thomas noted that the majority “depends on the following assumption: Plaintiffs will either (1) establish materiality at the merits stage, in which case the class certification was proper because reliance turned out to be a common question, or (2) fail to establish materiality, in which case the claim would fail on the merits, notwithstanding the fact that the class should not have been certified in the first place because reliance was never a common question. The failure to establish materiality retrospectively confirms that fraud on the market was never established, that questions regarding the element of reliance were not common under Rule 23(b)(3), and, by extension, that certification was never proper.” Accordingly, plaintiffs cannot meet their Rule 23 burden without also meeting the requirements of Basic the Justice reasoned.
SEC Enforcement: Filings and settlements
Weekly statistics: This week the Commission filed 2 civil injunctive actions and no administrative proceedings (excluding tag-along-actions and 12(j) actions).
Financial fraud: SEC v. Keyuan Petrochemicals, Inc., Civil Action No. 13-cv-00263 (D.D.C. Filed Feb. 28, 2013) is an action against the company, a China based issuer formed through a reverse merger, and its CFO, Aichun Li. Keyuan systematically failed to disclose related party transactions involving the company, its CEO, controlling shareholders and entities controlled by or affiliated with those person and other entities controlled by management from May 2010 to January 2011. The transactions involved the sale of products, purchases of raw materials, loan guarantees and short term cash transfers for financing purposes. The company also operated an off-balance sheet cash account that was used to pay for various items including cash bonuses for senior officers, fees to consultants, to reimburse the CEO for business expenses and to pay for gifts to Chinese government officials. As a result, in October 2011 the company restated its financial statements for the second and third quarters of 2010. As the CFO Ms. Li encountered several red flags that should have indicated the related party transactions were not disclosed, according to the Commission. Each defendant settled. The company consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The company also agreed to pay a civil penalty of $1 million. Ms. Li consented to the entry of a permanent injunction based on Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(5). She also agreed to pay a civil penalty of $25,000 and consented to being suspended from appearing or practicing before the Commission as an accountant with a right to reapply after two years. See also Lit. Rel. No. 13-cv-00263 (D.D.C. Filed Feb. 28, 2013).
Market manipulation: SEC v. Dynkowski, Civil Action No. 1:09-361 (D. Del.) is an action filed in 2009 against Pawel Dynkowski, Adam Rosengard and others for manipulating the price of penny stock Xtreme Motorsports of California, Inc. in 2007. Mr. Dynkowski is alleged to have orchestrated the manipulation which centered on using wash sales, matched orders and other manipulative trading. Mr. Rosengard acted as a nominee account holder in the scheme and gave Mr. Dynkowski access to an account used in the sales. Mr. Rosengard settled with the SEC, consenting to the entry of a final judgment which permanently enjoins him from violating Securities Act Section 5, requires the payment of $165,646 in disgorgement along with prejudgment interest and bars him from participating in any offering of a penny stock. No civil penalty was imposed and a part of the disgorgement obligation was waived in view of his financial condition. See also Lit. Rel. No. 22626 (Feb. 27, 2013).
Financial fraud: SEC v. Espuelas, Civil Action No. 06 cv 2435 (S.D.N.Y.) is an action centered on an alleged financial fraud at StarMedia Network, Inc., a now defunct company, in 2000 and the first two quarters of fiscal 2001. The action was brought against Peter Morales, the former controller, and others. Mr. Morales settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations and from aiding and abetting violations of Exchange Act Sections 13(a) and 13(b)(2)(A). In addition, he was ordered to pay a civil penalty of $100,000. See also Lit. Rel. No. 22624 (Feb. 26, 2013).
Fraudulent concealment: SEC v. New Stream Capital, LLC, Case No. 3:13-cv-00264 (D. Conn. Filed Feb. 26, 2013) is an action against a hedge fund manager and its principles for secretly altering the structure of the funds for the benefit of select investors and then raising additional funds without disclosing this to the new investors. The New Stream hedge fund complex raised capital from investors and made loans backed by real estate, life insurance policies, oil and gas interests and commercial assets. Its primary investment vehicle was a Master Fund which began receiving investments in 2003. In 2005 the Bermuda Feeder was created to raise money from investors not subject to the U.S. tax laws. In 2008 the complex was restructured, adding two additional Feeder funds. When Gottex Fund Management Ltd., the largest single investor in the Bermuda Feeder, objected to the loss of its preference rights on liquidation as a result of the new structure, the complex was restructured to give the adviser and select others preferences. Subsequently, New Stream raised nearly $50 million from new investors without telling them about the deal with Gottex and select others. As the financial crisis continued in 2008 the complex collapsed into bankruptcy. The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2) and Section 206(4). Director of marketing and investor relations Tara Bryson, who was charged in counts based on Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Section 206(4), settled with the Commission, consenting to the entry of a permanent injunction based on those Sections. She also agreed to be barred from the securities industry. The other defendants are litigating the case.
Option backdating: SEC v. Mercury Interactive, LLC, Civil Action No. 07-2822 (N.D. Cal. Filed May 31, 2007) is an option backdating case, The Commission alleged that from 1997 through 2005 defendants Amnon Landan, the former Chairman and CEO of the company, Sharlene Abrams, the former CFO, Douglas Smith, also a former CFO and Susan Skaer, the former general counsel, participated in a fraudulent scheme in which they awarded themselves and other employees hundreds of millions of dollars in backdated stock options. The company did not report the $258 million compensation expense from these grants, thus fraudulently overstating its revenue and income.
This week Messrs. Landan and Smith settled with the Commission. Mr. Landan consented to the entry of a permanent injunction prohibiting him from violating and/or aiding and abetting violations of Securities Act Section 17(a) and Exchange Act Section 10(b) as well as the financial reporting, record-keeping, internal controls, false statements to auditors and proxy provisions of the federal securities laws. In addition, he agreed to a five year officer/ director bar, to pay disgorgement of $1,252,822 (the in-the money component of the options), prejudgment interest and a $1 million civil penalty. He will also reimburse the company $5,064,678 for cash bonuses and profits from stock sales under SOX Section 304. Mr. Smith consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3). He also agreed to pay disgorgement of $451,200 (the in the money component of the options), prejudgment interest and a penalty of $100,000. Under SOX Section 304 he will reimburse the company $2,841,687. That amount will be deemed satisfied by his prior payment to the company of $451,200 and his agreement not to exercise certain options. Previously, Ms. Abrams and the company settled. Ms. Skaer is the sole remaining defendant. She recently lost her effort to have the case resolved in her favor on dispositive motions. The court’s ruling on that motion cleared the way for the case to proceed to trial.
Insider trading: U.S. v. Perna (S.D.N.Y.) is an action against financial adviser Damian Perna in which the defendant is charged with conspiracy to commit insider trading. Mr. Perna is alleged to have obtained draft earnings reports for several public companies prior to their public release through a contact at an investor relations firm. In one meeting Mr. Perna sold an advance copy of an earnings report to an undercover FBI agent and was paid $7,000 in cash. The case is pending.
Investment fund fraud: U.S. v. Banuelos (N.D. Cal.) is an action in which Michael Banuelos was charged with twelve counts of wire fraud and one count of money laundering in connection with an investment fund fraud. In the scheme investors participated in fraudulent contracts Mr. Banuelos claimed to have arranged for a musical group to open for a famous band and for recording. The scheme yielded about $2 million, most of which Mr. Banuelos diverted to his personal use. In a separate scheme he raised over $200,000 from investors, falsely claiming that he was a successful money manager. Sentencing is set for May 21, 2013.
Stock manipulation: Defendants Blake Williams and Derek Lopez were sentenced by Judge Ed Kinkeade (N.D. Tx.), to serve, respectively, 32 and 24 months in prison for their roles in a stock manipulation scheme. Mr. Williams was an employee of TBeck Capital Inc., an investment banking firm. Mr. Lopez was a securities broker at the firm. The two men admitted trading in their name and through other accounts in a manner designed to create the illusion of interest in the stock as part of a manipulation. Mr. Williams was paid in cash for his participation while Mr. Lopez received free trading shares and cash payments. Collectively the co-conspirators are alleged to have made over $1 million from the manipulation.
The Board released its report titled “Report on 2007-2010 inspections of Domestic Firms that Audit 100 or Fewer Public Companies.” The Board is required under Sarbanes-Oxley to inspect firms which audit 100 or fewer public companies every three years. Overall the Report concluded that the rate of significant audit performance deficiencies – instances where there are significant performance deficiencies where the audit firm cannot issue an opinion because of a lack of evidentiary matter – continued to decline compared to earlier periods.
The regulator announced that three men have been arrested in connection with an insider trading and market abuse scheme. Six search warrants were executed in the London area in connection with the investigation.
February 27, 2013
The Supreme Court rejected the SEC’s effort to extend the five year statute of limitations for imposing a civil penalty by engrafting a discovery exception onto the statute. Chief Justice Roberts, writing for a unanimous Court, held that under Section 2462 of Title 28, the statute of limitations begins when there is a cause of action. The decision is a straight forward reading of the plain statutory language. Gabelli v. SEC, No. 11-1274 (S.Ct. Decided February 27, 2013).
The case: The Commission’s case centered on alleged false statements by Marc Gambelli, the portfolio manager of Gabelli Global Growth Fund, and Bruce Alpert, the COO of the Fund’s adviser, Gabelli Funds, LLC. From 1999 until 2002 the defendants permitted trader Headstart Advisers, Ltd. to engage in “time zone arbitrage” according to the SEC, a form of market timing. At the same time defendants banned others from utilizing the practice. The arrangement with Headstart was not disclosed to the Fund’s board of directors who were thus deceived. Even after Headstart halted the practice, the defendants continued to mislead the board and investors, according to the SEC.
The Commission filed its complaint in April 2008. The underlying investigation began in the Fall of 2003 following the publicized inquiry of the New York Attorney General into market timing. At one point the SEC sought tolling agreements. The complaint alleged violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2).
The lower court rulings: The district court granted in part a motion to dismiss by the defendants based on Section 2462. That Section provides in pertinent part that “Except as otherwise provided by Act of Congress, an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued . . .” Based on this language the Court concluded that the claim for a civil penalty was time barred.
The Second Circuit reversed. On the Section 2462 statute of limitations issue the Circuit Court held that statute of limitations does not being until the claim is discovered or could have been discovered. Here that was not until September 2003 when the complaint alleges the Commission discovered the claim. The fact that the SEC did not plead facts showing that the defendants concealed the claim is not relevant to the case here. That contention relates to the doctrine of fraudulent concealment which is distinct from the question in this case, according to the Circuit Court. While the discovery rule does not apply to most claims, it does apply to the fraud claim in this action, the Court held.
The Supreme Court: Quoting the text of Section 2462 Chief Justice Roberts stated that “the ‘standard rule’ is that a claim accrues “when the plaintiff has a complete and present cause of action,’ quoting Wallace v. Kato, 549 U.S. 384, 388 (2007). That rule has governed since the 1830s when the predecessor to the current Section was written. It is also consistent with the definition of the word “accrued” in standard legal dictionaries. This reading of the text also ensures a fixed date when exposure under the statute begins. That is “vital to the welfare of society” as the Court has long held. Indeed, even wrongdoers are “entitled to assume that their sins may be forgotten” the Chief Justice noted.
Nevertheless, the SEC argued for a “discovery rule” under which the time period would not commence until the claim is discovered or reasonably could have been discovered. While that theory traces to the eighteenth century, it has never been applied in a context where the plaintiff has not been defrauded. Here the plaintiff is not an injured party who might not know of his or her claim but a government enforcement agency. While a private plaintiff cannot be reasonably expected to spend all of his or her time investigating to determine if a cause of action has accrued, that is not the case with a government enforcement agency. “Rather, a central ‘mission’ of the Commission is to ‘investigat[e] potential violations of the federal securities laws’ . . . Unlike the private party who has no reason to suspect fraud, the SEC’s very purpose is to root it out, and it has many legal tools at hand to aid that pursuit.”
Not only is the government a different kind of plaintiff – this statute applies not just to the SEC but the government in general – it seeks a different kind of relief. The discovery rule aids the plaintiff who seeks recompense for an injury. The SEC in contrast is seeking penalties designed to punish. In this context it has long been held that time limits are important. The discovery rule advocated by the government would undercut this established policy.
Finally, the application of a discovery rule would be particularly difficult here. Determining when the government as opposed to an individual knew or reasonably should have known something could be a daunting task. This is particularly true since agencies often have overlapping responsibilities and an array of privileges which might be asserted to block the necessary discovery. While Congress has in some instances expressly provided for such an inquiry that has typically been when the government is an injured victim seeking a recovery. In sum, the Court has long held that the running of a statute of limitations can only be suspended absent express language in the statute in limited circumstances and with “great caution.” In view of the plain text here, this is not one of those times the Chief Justice wrote.
Implications: The Court’s decision today may speed some Commission investigations and bar the agency from obtaining penalties in others. It could increase the number of cases where the staff seeks a tolling agreement. That, however, would seem to undercut the policy of restricting the use of those agreements and seeking to speed the investigative process which underlies the reorganization of the Enforcement Division initiated in 2009.
At the same time it could have a spill over impact on the Commission’s equitable remedies. Traditionally those are not subject to the statute of limitations. Yet in certain instances where the conduct is old – beyond the reach of Section 2462 for example — courts have held that granting an injunction effectively becomes punitive in which case the request may be time barred. This may be particularly true when a remedy such as an officer/director bar or a bar from the securities business is sought. The Fifth Circuit reached this conclusion last year in a years old option backdating case, SEC v. Bartek, No 11-1-594 (5th Cir. Decided Aug. 7, 2012). There the Court rejected the SEC’s reading of Section 2462 and declined to follow the Second Circuit’s ruling in Gabell. Rather the Court adopted an analysis of Section 2462 which presages that of the Supreme Court. It then held the Commission’s request for a penalty was dime barred. The Court also declined to enter and injunction or an officer/director bar in view of the time elapsed.
Program: The “New” DOJ and SEC FCPA Guidance: Is there Anything New? A webcast at noon on February 28, 2013 presented by Tom Gorman on behalf of Celesq and West Legal Ed (here).
February 26, 2013
A hedge fund manager and its principals were charged with fraud for secretly altering the structure of the funds for the benefit of select investors and then raising additional funds without disclosing this to the new investors. The complex eventually collapsed as the market crisis continued in 2008. The SEC’s complaint names as defendants New Stream Capital, LLC, a registered investment adviser; New Stream Capital (Cayman), Ltd., a Cayman Island exempt company; David Bryson, the owner, manager and founder of New Stream; Bart Gutekunst, a managing partner and founder of New Stream; Richard Pereira the registered adviser’s CFO; and Tara Bryson, director of marketing and investor relations. SEC v. New Stream Capital, LLC, Case No. 3:13-cv-00264 (D. Conn. Filed Feb. 26, 2013).
The New Stream hedge fund complex raised capital from investors and made loans backed by real estate, life insurance policies, oil and gas interests and commercial assets. Its primary investment vehicle was a Master Fund which began receiving investments in 2003. In 2005 the Bermuda Feeder was created to raise money from investors not subject to the U.S. tax laws. That fund typically loaned money to the Master Fund. New Stream paid a high interest rate on the loans which were secured by the assets of the Master Fund. That fund profited on the spread between what was paid to the Bermuda Feeder and to the commercial borrowers from the Master Fund.
The Bermuda Feeder investments grew faster than those of the Master Fund. Accordingly, Mr. Bryson decided to restructure the group so that all investors in the Master Fund would have the same investment profile. Two new feeder funds were created which would invest directly in the Master Fund. One was for U.S. taxpayers, The other, a Caymen Feeder, was for investors not subject to the U.S. tax laws. The plan called for investors in the Master Fund to transfer their shares. The Bermuda feeder would eventually be phased out. As part of the plan the rate for fees charged by the adviser was increased.
There were extensive communications with investors to achieve the restructuring. The largest single investor in the Bermuda fund was registered investment adviser Gottex Fund Management Ltd. Gottex advised several funds which had about $300 million invested in the Bermuda fund representing 67% of its assets. Gottex objected to the restructuring since it altered the liquidation rights, eliminating the preference of the adviser. The adviser threatened to withdraw investments. To prevent this, Messrs. Bryson and Guterkunst implemented a scheme to secretly revise the hedge fund’s capital structure, giving Gottex and other select offshore investors priority in the event of liquidation.
Subsequently, New Stream’s marketing department, lead by Ms. Bryson, raised nearly $50 million from new investors. Those investors were provided with solicitation materials which predated the deal with Gottex and thus did not mention the revised capital structure. New Stream’s operative financial statements were altered by Mr. Pereira to conceal the revisions to the altered operating structure. The new investors were not informed about the Gottex deal.
As the financial crisis continued New Stream faced $545 million in redemption requests. Further redemptions were halted. It ceased raising new investor money. Eventually New Stream and its affiliates filed for Chapter 11 bankruptcy. The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2) and Section 206(4).
Ms. Bryson, who is charged in counts based on Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Section 206(4), settled with the Commission, consenting to the entry of a permanent injunction based on those Sections. She also agreed to be barred from the securities industry. The other defendants are litigating the case.