This is the sixth in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

While increasing corporate fines is a hallmark of the aggressive posture of FCPA enforcement officials, another key focus is on individuals despite the recent set back for the DOJ in the Africa Sting case. That case was based on the largest FCPA sting operation ever conducted. It involved a proposed transaction in which companies were solicited to bid on procuring uniforms for an overseas government. To obtain the contract bribes had to be paid. At the center of the proposed deal was an FBI sting operation. Overall 21 individuals were named in 19 cases. Three individuals pleaded guilty prior to the commencement of what was planned as a series of trial involving groups of defendants. The case collapsed when the first two that proceeded to trial ended with hung juries and acquittals and amid adverse court rulings on key legal issues for the DOJ. Eventually all the cases were dismissed and the DOJ requested that the guilty pleas vacated. U.S. v. Goncalves, No. 09-cr-335 (D.D.C.)

Despite the set back, the prosecution of individuals continues to be a center piece of the New Era. Key to these efforts is the increasing demand for longer prison sentences although that demand has been met with mixed results. For example:

· U.S. v. Green, No. 2:08-cr-00059 (C.D. Cal. Filed Jan. 16, 2008). The defendants were convicted on nineteen counts which included conspiracy, FCPA and money laundering charges. The government sought sentences of ten years in prison despite the advanced age of the defendants. The court imposed a sentence of six months.

· U.S. v. Jumet, No. 09-cr-00397 (E.D. Va. Nov. 13, 2009). The defendant was convicted on one count of conspiracy to violate the FCPA and one count of making a false statement. The guideline range was 87-108 months in prison. The Government requested 87 months, which the Court ordered.

· U.S. v. Warwick, No. 3:09-cr-444 (E.D. Va. Dec. 15, 2009). The defendant was convicted of one count of conspiracy to violate the FCPA. The pre-sentence report contained a sentencing range of 37-46 months. The Government requested 40 months. The Court ordered 37 months.

· U.S. v. Steph, No. 07-cr-307 (S.D. Tex. Jul. 19, 2007). The defendant pleaded guilty to one count of conspiracy to violate the FCPA. The sentence was 15 months in prison.

· U.S. v. Nyugen, No. 2:08-cr-00522 (E.D. Pa. Sept. 4, 2008). The defendant was convicted of one count of conspiracy and one count of FCPA charges. The Government sought 37-46 months in prison. The Court ordered 24 months of probation.

· U.S. v. Esquenazi, No. 09-cr-21010 (S.D. Fla. Filed Dec. 4, 2009). Defendants Joel Esquenazi and Carlos Rodriguiz were sentenced to, respectively, 15 years and 7 years in Haitian Telco related cases.

In the end corporations and their executives are at risk when doing business internationally. Enforcement authorities continue to be aggressive and while many companies have adopted compliance procedures the increasing ability of enforcers to conduct industry sweeps continues to result in FCPA liability. Those efforts are aided by a growing legion of whistleblowers from inside and outside the company, a development which will be discussed later in this series.

Next: The continued criminalization of securities enforcement

This is the fifth in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

FCPA enforcement

Aggressive enforcement of anti-corruption laws by the DOJ and the SEC is another area in which individuals and their business organizations are at risk. Enforcement officials have declared that this is a “new era” of FCPA enforcement. Few would doubt that they are correct. More FCPA enforcement cases have been brought in the last few years than in the history of the statute. More is being paid in settlement by corporations than at any time in the history of the FCPA. More individuals are being prosecuted and sent to prison and there are more FCPA trials than at any time since the enactment of the law in 1977. While enforcement of anti-corruption laws around the globe is on the increase as indicated in a a recent report by the OECD Working Group on Bribery, there is no doubt that the U.S. is far and away the leader in bringing corruption actions.

The key trends and characteristics of the New Era are:

• Ever increasing amounts paid by business organizations to settle;

• Ever increasing amounts paid by companies to cooperate with enforcement officials in an effort to mitigate their potential liability;

• Expansive interpretations of the statutes by enforcement officials;

• An increasing use of industry sweeps; and

• An emphasis on individuals coupled with demands for prison terms.

One of the hallmarks of corporate FCPA settlements is the spiraling cost of settlement. That cost begins with what is paid to the enforcers. The current top ten largest settlements as compiled by the FCPA blog are:

• Siemens in 2009 paid $800 million in 2008

• KBR in 2009 paid $579 million

• BAE in 2010 paid $400 million

• Snamprogetti Netherlands B.V. in 2010 paid $365 million

• Technip S.A. in 2010 paid $338 million

• JGC Construction in 2011 paid $218.8 million

• Daimler AG in 2010 paid $185 million

• Alcatel-Lucent in 2010 paid $137 million

• Magyar Telekom/Deutsche Telekom: $95 million in 2011 and

• Panalpina in 2010 paid $81.8 million

It is noteworthy that eight of the largest amounts paid were from settlements in 2010 and after with 6 cases added in 2010 and 2 in 2011. These cases are frequently, but not always, based on pervasive patterns of misconduct. Siemens and Daimler for example, involved that type of conduct based on multiple violations over a period of time – essentially corporate cultures which utilized bribes as a business tool, according to prosecutors. The cases involving KBR, Tehnicup,Snamprogetti and JGC centered on the years long and highly profitable TSKJ consortium, formed to secure contracts and ultimately the payer of millions of dollars in bribes.

In contrast, the latest addition to this rogues gallery of FCPA cases is Magyar Telekom/Deutsche Telekom. There the action is not based on a pervasive, years long pattern of misconduct or an international conspiracy running for years. Rather, the action is based on just two transactions. Indeed, an analysis of the underlying conduct raises significant question concerning just how the case moved up to the number nine slot on the list and ahead of Panalpina which engaged in multiple violations around the globe for years. Despite the fact that settlements are based on the sentencing guidelines on the criminal side and the SEC’s disgorgement policies on the civil side, it appears that the cost of settlement is increasing.

An often unseen cost of these cases is what is spent on cooperation credit. Each of the amounts paid by the companies in the top ten, with the exception of BAE, was reduced by “cooperation credit,” that is, credit from enforcement officials for cooperating with their investigative efforts. Enforcement officials urge business organizations to self-report and cooperate, promising meaningful credit, although in the top ten only Magyar Telekom/Deutsche self-reported. Cooperation is typically defined in terms of self-reporting, furnishing enforcement officials the pertinent facts and instituting the necessary remedial steps to prevent a reoccurrence of the wrongful conduct. An examination of the settlement papers in the top ten clearly demonstrates that meaningful credit is given by the DOJ, although the SEC settlements evidence little impact from the often extensive efforts of the company.

Regardless of whether settlement costs are increasing, it is beyond dispute that those costs are only the beginning. The hidden cost in all of this is that of cooperation. In their quest to earn credit many companies are going far beyond the basics. Siemens, Panpelina and others, for example, have developed evidence of wrong doing by others, becoming a kind of corporate whistleblower which is part of a trend that will be discussed later in this series. Others, such as Siemens, created a significant compliance function while Alcatel-Lucent fundamentally altered its business model.

The cost of these undertakings can be significant. Siemens, for example, spend $850 million in its efforts to cooperate over two years and another $150 million on compliance. Diamler reportedly spent $500 million in its efforts to win cooperation credit. Currently, Avon Products Inc. has reportedly spent over $160 million in its efforts to cooperate with enforcement officials conducting an FCPA inquiry and has yet to settle the underlying actions. The increasing cost of settlement, coupled with the expense of cooperation, can make the decision by a corporate board to self-report and cooperate most difficult. It may be for this reason that the President of TRACE International, a non-profit focused on anti-corruption, recently noted that most corporations do not self-report after learning of a potential difficulty.

Another characteristic of the new era of FCPA enforcement is an expansive interpretation of the statutes. On the question of jurisdiction, for example, enforcement officials have frequently adopted a reading of the provisions which some commentators argue unduly expands the reach of the statutes. The case involving JGC Corporation is a good example.

There the defendant is a Japanese company with no operations in the United States. It was a member of the TSKJ discussed above. The jurisdictional contacts, according to the court papers, appear to be two e-mails from the company to Houston and two bank transfers from one foreign bank to another through New York.

Initially, the company raised jurisdictional issues. Later the company cooperated, according to the DOJ. The case was resolved when the JGC entered into a deferred prosecution agreement. Subsequently, the court in U.S. v. Patel, Case No. 1:09-CR-335 (D.D.C.) one of the prosecutions arising out of the now collapsed Africa Sting actions discussed later in this series, rejected a DOJ claim that similar contacts were sufficient to support a claim of jurisdiction.

Enforcement officials have also taken an expansive view of what constitutes a bribe. Under U.S. law small facilitation payments for routine items are not bribes. Yet the vitality of this exception despite specific statutory authorization is anything but clear in view of recent FCPA cases. The point well illustrated by the SEC’s settlement in In the Matter of Diago plc., Adm. Proc. File No. 3-14410 (July 27,2011). That action charges FCPA books and records violations based on small payments to government-owned liquor store operators for product placement, label registration, lobbying fees and promotion. Another payment was to a Korean Customs Service official as a reward for assistance in negotiating a tax refund. Rewards are not bribes, but gratuities under domestic U.S. law. Gratuities are not violations of the FCPA. In this case the payments were not charged as bribes but for not being properly recorded, an FCPA books and records violation.

Even if the payments are properly booked, however, there may be liability. In SEC v. Noble Corporation, No. 4:10-cv-4336 (S.D. Tex. filed Nov. 4, 2010); SEC Litg. Rel. No. 21728 (Nov. 4, 2010) the payments were actually recorded in a facilitating payments account. The SEC said they were not facilitation payments so the books and records were false.

Under the expansive views of the New Era, even payments made under compulsion can be viewed as bribes. This point is illustrated by the SEC’s settlement in In the Matter of NATCO Group, Inc., Adm. Proc. File No. 3-13742 (Jan 11, 2010); SEC v. NATCO Group. Inc., No. 4:10-cv-00098 (S.D.Tex. Jan. 11, 2010). There the company employed local workers and expatriates in Kazakhstan. Local immigration authorities claimed the expatriates did not have the proper documentation and threatened to impose fines and to either jail or deport the workers if the company did not pay the fines. Management paid the fines based on the belief that the workers would otherwise be jailed. The local subsidiary made payments to facilitate the proper visas using bogus invoices totaling $80,000 to obtain the money from the bank. The company reimbursed the invoices. NATCO settled the case based on FCPA books and records charges.

Next: FCPA enforcement (cont.)

This is the fourth in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Employees, the company and insider trading

The enforcement of insider trading laws is a key SEC enforcement priority. Acting in conjunction with the U.S. Attorney’s Office in New York City, the Commission has brought a series of high profile insider trading actions. Many of those cases have focused on hedge funds and professional traders. As enforcement officials seek to protect the integrity of the markets however, increasingly employees of public companies are coming in their sights. This can result in liability for the employee and entangle the company in a law enforcement investigation, something which can be costly and time consuming.

The SEC has been very aggressive in utilizing its new tools. While criminal prosecutors tend to garner the headlines from outsized investigations and cases such as the Galleon and Expert Network series of cases, it is the Commission which is pushing the edge — some might say redefining – of what constitutes insider trading.

Bolstered by new enforcement techniques, the SEC’s approach to insider trading is increasingly aggressive. A series of insider trading cases have centered on events that employees viewed at work prior to trading. One group involves those which seem to focus on the mosaic theory. Traditionally, analysis and other market participants have investigated with an eye to gathering bits and pieces of information they fit together and utilize as the predicate for their predictions, hunches and outright guesses as to the direction of the market, a company or a particular security. This activity adds to the efficiency of the markets and improves price discovery. While the line between what constitutes permissible investigation and projection and acquiring actual inside information has always been difficult to draw with precision, the Commission seems to be redrawing it in a way which at least suggests that employees who gather virtually any information at work and then trade are at risk.

Typical of the cases in this group is SEC v. Steffes, Case No. 1:10-cv-06266 (N.D. Ill. Filed Sept. 30, 2010). There the defendants are all family members or friends. The case centers on acquisition of Florida East Coast Railway, LLC by Fortress Investment Group, announced on May 8, 2007. The transaction traces to December 4, 2006 when Morgan Stanley & Co. was engaged to sell the company. After inquiry by possible acquirers the company was in fact sold. Shortly prior to the sale each defendant traded in the securities of the company reaping total trading profits of $1.6 million.

The critical question in the case is whether the defendants actually possessed material non-public information at the time of the trades. The complaint specifies the bits of information from which the Commission concluded that a particular defendant possessed inside information at the time of the trades. For defendant Gary Griffiths, a vice president of the railroad who was not a member of the deal group, the complaint claims he had inside information because:

• In early March the CFO asked him to prepare a comprehensive list of equipment owned by the company;

• He became aware that there were an unusual number of yard tours by outside executives, that is, individuals were viewing properties owned by the railroad;

• “He believed” these tours were provided to investment bankers;

• Employees asked him if the company was being sold and they would lose their jobs; and

• He also arranged and monitored a rail trip for Fortress executives in a special rail car reserved for visitors.

Defendant Cliff Steffes, a trainman at the company, had inside information according to the SEC because:

• He observed that there was an unusual number of yard tours for people in business attire;

• Many employees became aware of them;

• Shortly before the tours began a number of employees expressed concern about the company being sold and the possible loss of jobs of their job; and

• Fortress executives toured where he worked.

It is clear that those outside the company would not be privy to the fact that yard tours were being taken by executives in suits. Equally clear is the fact that speculation by employees about the meaning of the tours or the impact of a take-over on their job is just that – speculation and conjecture. Whether or not this type of information actually constitutes inside information is the subject of the on-going litigation. To date only defendant Robert J. Steffes has settled with the Commission, consenting an injunction and paying disgorgement and a penalty equal to the trading profits of $104,981. The other defendants are litigating the case. See also, SEC v. Carroll, Case No. 3:11-cv-00165 (W.D.Ky. Filed March 10, 2011)(employees learn bits of information that results in trading); see also SEC v. Ni, Case No. CV 11 0708 (N.D. Ca. Filed Fed. 16, 2011)(action against brother who overheard bits of a conversation by corporate executive sister).

While cases such as Steffes focused on what individuals observed at work, others suggest that even complying with company procedures may not be adequate to avoid liability. Many public companies have some type of insider trading policies and procedures. Typically the company institutes black out periods around earning releases and other significant events which preclude certain executives from trading. When the black out periods are not in effect those executives are generally permitted to trade although the policies may require pre-clearance with a designated individual.

In a recent action however, an executive informed the general counsel’s office of her intent to trade prior to the institution of a black out period but, nonetheless, was named as a defendant in a Commission enforcement action. SEC v. Knight, Civ. 2:11-cv-00973 (D. Ariz. Filed May 18, 2011).

The defendants in Knight are Mary Beth Knight, a senior vice president of Choice Hotels and her friend, Rebecca Norton. Ms. Knight learned at a senior management meeting that the company expected to miss expectations as to its quarterly earnings. At lunch following the meeting Ms. Knight told executives she planned to sell shares of the company. The next day she e-mailed the associate general counsel about her plan to sell company stock and asked about black out days. She received a response stating that the black out ran from June 30 to July 26. A copy of the insider trading policy was attached to the e-mail from the associate general counsel.

The next weekend Ms. Knight told her friend Rebecca the information she learned at the management meeting. She knew that her friend was a shareholder of the company.

Subsequently, on June 27 Ms. Knight sent a follow-up e-mail to the associate general counsel stating: “exercising 12,000 shares today. I also mentioned to [my boss] last week I would be doing so.” The complaint does not indicate that she received a response.

Prior to the black out period both Ms. Knight and her friend sold company shares. The day after the earnings announcement the share price dropped nearly 25%.

Both defendants settled, consenting to the entry of permanent injunctions. Ms. Knight agreed to pay disgorgement. That obligation was deemed satisfied by the fact that Ms. Knight had previously given the amount of the disgorgement to the company. No explanation is provided for that action. Ms. Knight also agreed to pay the disgorgement for her friend and pay a penalty. Ms. Norton agreed to pay a civil penalty.

Collectively there can be little doubt that Steffes, Carroll and Knight are aggressive enforcement. The SEC views these cases as straight forward insider trading actions. Others view them as pushing the edge of what constitutes insider trading. Which ever view is correct, the common thread is that employees observed or learned something while on the job, engaged in transactions in company stock, followed company procedures and were named in an enforcement action charging insider trading. While it might be argued that the cases tend to push toward the discredited “parity of information” theory of insider trading, perhaps the more important question is how to avoid becoming entangled in the cases in the first place. In view of these trends companies would do well to reconsider their policies and procedures and alert employees in programs about those procedures to avoid becoming entangled in a investigation.

Next: FCPA enforcement

This is the third in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Directors and officers (cont)

While enforcement officials are focusing on the duties and obligations of directors in cases such as Krantz, they are also concentrating on ways to expand their reach. Negligent fraud, as in the Dell case, is one way. Another is through the use of Exchange Act Section 20(a), control person liability. This provision, which permits liability to be imposed on certain executives for failing to properly oversee operations, has been sporadically used over the years. Now, however, enforcement officials are using the provision to broaden the reach of SEC enforcement while avoiding the complexities of proving primary or aiding and abetting liability.

The cases brought the against executives of Nature’s Sunshine Products, Inc are illustrative of this new trend. There the first FCPA case imposing Section 20(a) liability was brought against company CEO, Douglas Faggioli and CFO, Craig D. Huff. SEC v. Nature’s Sunshine Products, Inc., Case No. 09CV672 (D. Utah Filed Jul. 31, 2009). The claims are based on payments made in 2000 and 2001 by the Brazilian subsidiary of the company to local regulators to circumvent new import restrictions. The company was charged with FCPA violations. The two officers were charged under Section 20(a) as “control persons.”

To resolve the case, the three defendants consented to the entry of permanent injunctions prohibiting future violations of the antifraud and books and records and internal control provisions of the federal securities laws. The company agreed to pay a civil penalty of $600,000. Messrs Faggioli and Huff each agreed to pay a civil penalty of $25,000. See also SEC v. SinoTechEnergy Ltd., Civil Action No. 2:12-cv-00960 (W.D. LA. Filed April 23, 2012)(Chairman and controlling shareholder alleged to have control person liability); SEC v. Harbert Management Corp., Civil Action No. 12 Civ. 5092 (S.D.N.Y. Filed June 27, 2012)(Funds charged with control person liability for failing to prevent controlled entities from engaging in manipulation).

Finally, the Commission is using a strict liability approach in clawback actions to recoup certain incentive based compensation of CEOs and CFOs. The cases here are being brought despite the fact the executive was not involved in any wrong doing.

Sarbanes-Oxley or SOX Section 304 and Dodd-Frank Section 954 each provide for the clawback of certain executive incentive based compensation when there is a restatement. Section 304 requires the repayment of certain CEO and CFO incentive-based compensation and stock trading profits when the company must restate its financial statements because of misconduct. The Section does not specify that the misconduct be that of the CEO or CFO.

Dodd-Frank Section 954, now Exchange Act Section 10D, is similar. It expands the class of those at risk using the undefined term “executive officers.” It also expands the time period from the one year in SOX to three while dropping the requirement that wrongful conduct cause the restatement. The remedy is more limited however, apparently being restricted to disgorgement. The requirement will be implemented through exchange listing standards under a yet to be written Commission rule.

The SEC has adopted a strict liability approach in SOX 304 cases. See, e.g., SEC v. Jenkins, Case No. CV 09-01510 (D. Ariz. Filed July 22, 2009); SEC v. O’Del, Civil Action No 1:10-CV-00909 (D.D.C. Filed June 2, 2010). Indeed, the complaints typically state that the defendant was not involved in the underlying wrongful conduct which may be the subject of a separate SEC and/or DOJ action. While the wisdom of the SEC’s view might be debatable, its position has been upheld by the Second Circuit. Cohen v. Viray, Case No. 3860-cv (2nd Cir. Sept. 30, 2010).

Collectively, these cases represent not just an aggressive approach to executive liability but one which is expanding and in some instances easing the SEC’s burden of proof. To be sure, cases such as Kravitz are based extreme sets of facts. Yet when viewed in the context of the expanding reach of SEC enforcement in this area there should be little doubt that in the future directors and officers need to be particularly cognizant of their monitoring obligations as good corporate stewards.

Next:Employees, the company and insider trading

This is the second in a series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Directors and officers

Traditionally, the duties and obligations of corporate directors and officers are a function of state corporate law defined in decisions such as In re Caremark International, Inc. Derivative Litigation, 698 A. 2d 959 (Del. Ch. 1996). SEC enforcement officials are, however, giving increasing scrutiny to their role and duties in select circumstances. At the same time the Commission is expanding its reach while easing its proof standards in these actions.

The oversight duties of directors have being scrutinized in cases such as SEC v. Krantz, Civil Action No. 0:11-cv-60432 (S.D. Fla. Filed Feb. 28, 2011). There the Commission named as defendants the outside directors of DHB Industries, at one time the largest manufacturer of bullet proof vests. The complaint is based on a massive financial fraud orchestrated by the former CEO, CFO and others. See, e.g., SEC v. DBH Industries, Inc., Civil Action No. 0:11-cv-60431 (S.D. Fla.). Former CEO David Brooks and CFO Sandra Hatfield were both charged and convicted criminally in connection with the looting of the company. U.S. v. Schleged, Case No. 2:06-cr-00550 (E.D.N.Y).

Each defendant in the Commission’s action is an outside, independent director. Yet the Commission’s complaint makes the unusual allegation that none of the defendant directors is in fact independent. Each is alleged to lack the impartiality to serve as independent board or audit committee members. This allegation is based on the fact that each was a longtime friend or neighbor of the former CEO or had personal relationships with him. As a result, according to the complaint, the directors willfully ignored a series of red flags about the conduct of the former CEO as he looted the company. The complaint alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)B) and 14(a). This case is in litigation.

Another case focused on the duties of directors is SEC v. Kohavi, Case No. 08-43-48 (N.D. Cal. Sep. 17, 2008). It is an option backdating case against three outside directors. While the complaint does not claim that the directors lacked independence as in Krantz, it allege claim that the directors failed in their duties, essentially deferring to management. From 1997 through 2002 the directors approved 21 separate backdated option grants at the behest of management, according to the complaint. In approving the options the directors are alleged to have ignored a series of “red flags” which should have alerted them to the wrongful conduct they were approving. Each defendant settled, consenting to a fraud injunction and paying a civil penalty of $100,000. See also SEC v. Mercury Interactive, LLC, Case No. 07-2822 (N.D. Cal. May 31, 2007).

The SEC is also broadening the theories it is utilizing while in some instances easing its burned of proof in complex cases. One theory being increasingly utilized is negligent fraud based on Securities Act Sections 17(a)(2) and (3). This approach was a staple of SEC enforcement prior the Supreme Court’s decisions in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1978) and Aaron v. SEC, 446 U.S. 680 (1980). Following those decisions the theory has been used in a limited number of cases as the enforcement program shifted focus to scienter based cases.

Recently, however, the Commission has returned to negligent fraud theories which effectively broadens it reach while easing its burden of proof. For example, SEC v Dell Inc., Civil Action No. 1:10-cv-01245 (D.D.C. Filed July 22, 2010) is a financial fraud case based on negligent fraud theories. The defendants include Chairman and CEO Michael Dell and former CEO Kevin Rollins.

The case centers on claims of false statements regarding the key source of revenue and growth for the company. For years Dell had picture perfect financial results, but largely from what investors were not told. A major source of revenue for a period of years was payments by Intel Inc. to Dell not to use the chips manufactured by a competitor. As those payments increased over time Dell’s revenues and profits rose. The company credited its management systems and efficiencies for those increases. Dell did not disclose the payments. When the payments decreased and eventually terminated the revenues of the computer giant tumbled along with this stock price.

The complaint was based on a negligent rather than a scienter based fraud theory. Since proving complex accounting cases and the requisite scienter of each individual can be difficult, crafting the complaint in this manner has the effect of easing proof requirements for the Commission while enabling the agency to write a complaint alleging fraud.

Charging negligence can also induce settlement, as here, by side stepping the difficulty many defendants may have to resolving a case in the face of claims that they intentionally defrauded the shareholders and the public. Here Messrs. Dell and Rollins settled by consented to an entry based in negligence since it is tied to Securities Act Sections 17(a)(2) & (3) but which still gives the Commission a fraud injunction. See also SEC v. Citigroup Global Markets, Inc., Civil Action No. 1:11-cv-07387 (S.D.N.Y.)(market crisis action charging negligent fraud in which court refused to enter the injunction in the settlement, a question which is on appeal).

Next:Directors and officers (cont.)

This is the first of an eight part series discussing new trends in SEC enforcement which impact corporate directors and officers and steps that can be taken to avoid future liability.

Introduction

Enforcement officials and regulators are charting new, aggressive paths. New approaches, strategies and tactics are being used to cast an ever widening net.

• A focus on corporate governance means increasing liability for directors and officers.

• Fairness in the markets and eliminating insider trading means increased liability for employees on the job and entanglement in law enforcement investigations for business organization.

• Leveling the playing field for business means increasing FCPA liability.

• Cooperation with law enforcement can mitigate liability but at skyrocketing costs.

• Greater efficiencies for government by pooling its assets and using parallel proceedings also fuels a trend toward criminalization and can result in overreaching.

• Everywhere there are whistleblowers.

Navigating these currents requires a knowledge of current enforcement trends, a vision of where the trends go in the future and preparation now to cope with the events of tomorrow.

This series will analyze these issues by focusing on five key points:

1) An increasing focus on directors and officers.

2) Potential liability of employees.

3) Key trends in FCPA and anti-corruption cases regarding individuals.

4) The increasing criminalization of the securities laws.

5) Increasing numbers of whistleblowers.

The conclusion discusses future trends and avoiding liability.

Next: Directors and officers

This is the fifth and concluding segment of a series examining issues arising in SEC Enforcement Actions relating to issuers from the PRC whose shares are traded in the U.S.

Insider trading compliance

Insider trading has long been a priority for the Commission. Since the reorganization of the enforcement division and the creation of its market abuse specialty unit which focuses in part on these cases, the SEC has been very aggressive in brining insider trading actions.

A number of recent SEC insider trading cases have involved residents of the PRC. Once example is SEC v. All Know Holdings Ltd., Case No. 11 cv 8605 (N.D. Ill. Filed Dec. 5, 2011), a case which centers on the acquisition of Global Education and Technology Group Ltd. by Pearson plc.

Global is a Cayman Islands corporation headquartered in Beijing, China. It provides English language services in China. Global’s American Depository Shares or ADSs are traded on NASDAQ. Pearson is a British corporation headquartered in London whose shares are traded in New York and London. On November 21, 2011 Pearson announced the acquisition of Global at a premium of 105% over the previous day share closing price. Global’s share price spiked 97% from $5.37 to $10.60.

Named as defendants are All Know Holdings Ltd, a British Virgin Islands Company, Lili Wang, Sha Chen, the president of All Know, and ZhiYao. Each of the defendants made large purchases of Global ADSs in the days shortly prior to the deal announcement. None of the purchasers had a history of trading in these shares, although Ms. Wang had bought shares in Global’s IPO. In some instances the traders do not appear to have the financial means to conduct the trading.

Ms. Wang is the only defendant which the complaint connects to the transaction other than through trading. She has an undefined relationship with Xiaodong (Veronica) Zhang, the co-founder and Chairman of the Board of Global. On information and belief the complaint claims Ms. Zhang financed the trading of Ms. Wang.

The complaint does not allege a source of information for the other trading groups. It also does not allege a connection between the four groups. The Commission’s complaint alleges violations of Exchange Act Section 10(b). At the time the complaint was filed the SEC obtained an emergency freeze order over $2.7 million is trading profits. The case is in litigation.

Another insider trading action involving PRC residents is SEC v. Yang, Case No. 12-cv-02473 (N.D. Ill. Filed April 4, 2012). The complaint names as defendants Siming Yang, a New York City resident who, until recently, worked for a New York City investment adviser; Prestige Trade Investment Ltd., a company created in January 2012 by defendant Yang; Caiyin Fan, a PRC citizen; Shui Chong (Eric) Chang, a resident of Hong Kong formerly employed at Deutsche Bank Securities, New York City; Biao Cang, a PRC citizen resident in Hong Kong; Jia Wu, a PRC citizen; and Ming Ni, a PRC citizen resident in Hong Kong.

The action centers on the March 27, 2012 announcement by Xianfu Zhu, Chairman and CEO of Zhongpin Inc., that he had submitted a non-binding proposal to take the company private by purchasing all the outstanding shares at $13.50 per share, a 46% premium.

The SEC’s complaint focuses largely on the trading of each defendant shortly prior to the deal announcement: Defendants Yang and Fan purchased 2,571 call options and 58,000 shares and had unrealized profits of $733,000; Prestige purchased over 3 million shares of stock and had unrealized profits of $7.6 million; Defendant Chang purchased 4,035 call options and 32,500 shares of stock yielding unrealized profits of $828,188 after the deal announcement; Defendant Cang bought 306 call options which yielded realized profits of $39,745; Defendant Wu bought 257 call options which yielded realized profits of $34,288; and Defendant Ni purchased 4,300 shares of stock and 169 call options which yielded realized profits of $57,108.

A key allegation in the complaint is coordinated activity. Defendants Yang and Chang are alleged to have used a computer with the same IP address to access brokerage accounts. Defendants Cang, Wu and Ni are alleged to have accessed their brokerage accounts using networks with the same IP address and hardware with identical Media Access Control addresses.

The complaint alleges violations of Exchange Act Section 10(b). The Commission obtained a temporary freeze order. The case is in litigation.

Another insider trading case centered on the acquisition of Canada based Nexen, Inc. by China based CNOOC Limited, announced on Monday July 23, 2012. Within days of that announcement the SEC brought an insider trading action against Well Advantage Limited and unknown traders related to two accounts. The agency won a freeze order over millions of dollars in profits made from trading in the shares of Nexen which appreciated 52% on the deal announcement. The case is based largely on the timing and size of the trades which the complaint calls “suspicious.” SEC v. Well Advantage Limited (S.D.N.Y. filed July 27, 2012).

The deal was highly publicized since it involves the acquisition of Canadian owned oil assets by a Chinese oil company. Nexen is a global energy company domiciled in Canada with its headquarters in Calgary. Its shares were listed on the Toronto and New York Stock Exchanges. CNOOC is China’s largest producer of crude oil and natural gas. The company is based in Hong Kong and its shares are listed on the Stock Exchange of Hong Kong Limited.

The only named defendant is Well Advantage, a British Virgin Island company based in Hong Kong. It is indirectly owned by Zhang Zhi Rong, a Hong Kong business man who controls a number of companies including China Rongsheng Heavy Industries, a company which public sources say has a close business relation to CNOOC. Two accounts are also identified in the complaint. One is at Phillips Securities PTE Ltd., a Singapore-based brokerage firm. The other is Citibank NA, A/C HK 4.

Two trading days before the deal announcement, Well Advantage purchased 831,033 shares of Nexen at a cost of about $14.3 million. The purchases were made through accounts at UBS Securities LLC and Citigroup Global Markets Inc. On “information and belief” the purchases were made while the trader or traders were in possession of inside information because: 1) The buys were made just two trading days prior to the announcement; 2) Well Advantage had not traded in Nexen shares since at least January 2012; 3) The Citigroup account had been dormant for six months; and 4) Well Advantage is headquartered in Hong Kong, the same location as CNOOC’s main office and its beneficial owner, Zhang Zhi Rong, is a controlling shareholder of Rongsheng, a company that has a close business relation to CNOOC, according to public reports.

On the Thursday following the Monday deal announcement, a sell order was placed to liquidate the Nexen position in the account. At the time the account had an unrealized gain of $7.2 million.

In the Phillips omnibus account, beginning July 12, 2012 and continuing through July 20, 2012, 597,990 Nexen shares were purchased for about $10 million. At the time of the transactions the trader or traders were, based on information and belief, in possession of material non-public or inside information because of: 1) The timing of the transactions; 2) The size of the transactions; 3) The lack of prior history of significant trading in the shares, although there had been some transactions; and 4) The profitability of the trades which yielded about $15.1 million. The position in the account was largely liquidated on Tuesday, July 24, 2012.

The Citibank account purchased 78,220 shares of Nexen on Tuesday, July 17, 2012 at a cost of about $1.31 million shares. The trader or traders who directed the transactions were in possession of inside information at the time, based on information and belief, because of: 1) The timing of the transactions; 2) The size of the transactions; 3) The profitability of the transactions which yielded profits of about $721,000; and 4) The lack of prior trading history in Nexen shares. The position in the Citibank account was liquidated immediately after the deal announcement. The case is in litigation.

Conclusion

Although the number of securities class actions is declining, the Commission and the PCAOB continue to struggle with issues, their executives and auditors based in the PRC. To date neither the SEC nor the PCAOB have been able to obtain the degree of cooperation and transparency required for trading in the U. S. capital markets. The promise of SOX and the PCAOB that the Board would have access to the work papers of firms registered with it has yet to be fulfilled despite repeated efforts by U.S. officials. While the recent filing by the SEC in the Deloitte Touche Tohmatsu subpoena enforcement action suggests that progress is being made, if past history is a guide it will be a long road.

Other cases involving Chinese issuers and their executives only serve to highlight the difficulties and lack of transparency regarding these companies while raising issues about accountability. Financial fraud, manipulation and insider trading are issues in all markets. They can be particularly difficult to police in a forum which is known its shroud of secrecy and impenetrability.

Nevertheless, it is clear that Chinese companies and their executives want access to international capital markets and business channels, including those in the U.S. As this drive continues these companies and their executives will find it necessary adopt the much greater degree of transparency and accountability required by the U.S. and international markets.

This is the fourth segment of a five part series examining issues arising in SEC Enforcement Actions relating to issuers from the PRC whose shares are traded in the U.S.

Foreign corrupt practices act

A series of cases have been brought alleging violations of the bribery and books and records and internal controls provisions of the Foreign Corrupt Practices Act that involve PRC state owned entities and their employees and U.S. companies and their officials. FCPA enforcement is of course a priority of for the Department of Justice (“DOJ”) and the SEC. Each has specialized units dedicated to investigating and prosecuting corruption cases and the DOJ has declared this to be a “new era” of FCPA enforcement.

For public companies the cases have two aspects. One is the bribery provisions which generally prohibit making payments to any foreign official to obtain or retain business. Typically this includes employees of state owned enterprises, at least according to the DOJ and the SEC. The other is the books and records and internal control provisions. Generally, public companies are required to keep there books in reasonable detail. When payments to foreign officials are not properly recorded in the books and records of the enterprise it violates these provisions.

One recent example of the cases being brought by the DOJ and the SEC in this area are the cases involving former Morgan Stanley employee Garth Peterson. U.S. v. Peterson, (E.D.N.Y.) and SEC v. Peterson (E.D.N.Y. Filed April 25, 2012). Mr. Peterson, a U.S. citizen, is the former head of Morgan Stanley’s Shanghai office. The violations alleged in the court papers stem from Mr. Peterson’s dealings with the former Chairman of Yongye Enterprise (Group) Co., a Chinese state owned entity involved in real estate.

Mr. Peterson began working for Morgan Stanley in 2002 and became the head of the Shanghai office of the firm’s wholly-owned global real estate business in 2006. His primary responsibility was to evaluate, negotiate, acquire, manage and sell real estate investments. From 2004 through 2008 Morgan Stanley partnered with Yongye on a number of significant Chinese real estate investments. At the same time Mr. Peterson and the Chairman expanded their dealings in real estate, secretly acquiring property from Morgan Stanley and investing in other endeavors. Mr. Peterson did not disclose these dealings to his firm as required.

In one transaction, according to the court papers, Mr. Peterson encouraged his firm to sell an interest in Shanghai real estate to Yongye. Mr. Peterson falsely represented that the purchaser, a shell company, was owned by the Chinese company. In fact it was owned by Mr. Peterson, the Chairman and a Canadian lawyer. In effect, Mr. Peterson negotiated for both sides. He secured Morgan Stanley’s approval for the sale at a discounted price. As a result of the deal the shell company had an immediate profit of about $2.5 million.

Subsequently, in 2006 Morgan Stanley was negotiating at least five separate Chinese real estate investments involving Yongye. Mr. Petevson invited the Chinese official to invest along with Morgan Stanley and its funds to reward him for what he had done for the firm and further incentivize him. During the negotiations he set up an arrangement for Morgan Stanley to sell the Chinese official a 3% interest in each deal he brought to the firm for the cost of 2%. This gave the official a discount of 1% which Mr. Peterson called a “finders fee.” Mr. Peterson also promised the official an added return. When Mr. Peterson disclosed this arrangement to his supervisors he was warned of the FCPA bribery implications and told to drop the arrangement. Nevertheless, he paid the official.

Mr. Peterson resolved the charges by pleading guilty in April 2012 in the criminal case to one count of conspiracy to evade the company’s internal accounting control. He also settled with the SEC, whose complaint alleged violations of the bribery and books and records and internal control provisions. Mr. Peterson agreed to the entry of an injunction based on the provisions cited in the complaint and to pay disgorgement of $250,000. In addition, he will relinquish his interest in Shanghai real estate valued at about $3.4 million and consented to be permanently barred from the securities industry.

Another FCPA case involving a PRC based subsidiary of a U.S. company is the action involving Biomet Inc., a global medical device company headquartered in Warsaw, Indiana whose shares are listed on NASDAQ. The company, along with its subsidiaries, made more than $1.5 million in payments in violation of the FCPA from 2000 to 2008 to publicly-employed health care providers in Argentina, Brazil and China.

Biomet China made illegal payments through a distributor in China who provided publicly-employed doctors with money and travel in exchange for purchases with the knowledge of Biomet employees. The payments were falsely recorded in the books and records of the company.

The company resolved charges with the DOJ by entering into a deferred prosecution agreement. Under the agreement the company will pay a criminal fine of $17.28 million, implement rigorous internal controls, cooperate with the Department and retain a compliance monitor for 18 months. The DOJ acknowledged the extensive cooperation of the company which consisted of “wide-reaching self-investigation . . .remedial efforts and compliance improvements.” As a result the company received a reduced penalty. U.S. v. Biomet, Inc., Case No. 1:12-cr-00080 (D.D.C. Filed March 26, 2012).

Biomet also settled with the SEC, consenting to the entry of a permanent injunction without admitting or denying the allegations in the complaint, which prohibits future violations of Exchange Act Sections 30A, 13(b)(2)(A) and 13(b)(2)(B). The company also agreed to pay disgorgement of $4,432,998 along with prejudgment interest and retain an independent compliance consultant for 18 months to review its FCPA compliance program. SEC v. Biomet, Inc., Civil Action No. 1:12-cv-00454 (D.D.C. Filed March 26, 2012).

Next: Insider trading and the conclusion

This is the third segment of a five part series examining issues arising in SEC Enforcement Actions relating to issuers from the PRC whose shares are traded in the U.S.

Corporate governance

A number of PRC based issuers have been named as defendants in SEC enforcement actions. These cases involve a range of issues including financial fraud, manipulation and misuse of assets.

Misrepresentations and financial fraud are the central allegations in SEC v. SinoTechEnergy Ltd., Civil Action No. 2:12-cv-00960 (W.D. Louisiana Filed April 23, 2012). The defendants are the company, a Cayman Island corporation based in the PRC, its chairman and controlling shareholder, Qingzeng Liu, its CEO, Guoqiang Xin, and the former CFO, Boxun Zhang.

The complaint alleges that the defendants mislead investors about the use of the $120 million raised in its IPO. Company filings claimed that it purchased key equipment carried on the balance sheet at $94 million. In fact it made only limited purchases worth less than $17 million. A separate count charges the Chairman with misappropriating over $40 million from the company. The complaint alleges violations of Securities Act Sections 17(a)(2) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) and seeks to impose liability under Section 20(a) as to the individuals. The case is in litigation.

SEC v. Li, Civil Action No. CV-11-1712 (D. Ariz. Filed Aug. 30, 2011) is another action based on financial fraud allegations. The defendants are James Li, Thomas Chow, Wayne Pratt, Christopher Liu and Roger Kao. Mr. Li is a director, president and COO of Syntax-Brillian Corporation, a developer and distributor of H-D LCD TVs. Mr. Chow is a director and chief procurement officer of Syntax-Brillian while Mr. Pratt is the CFO. Messrs. Liu and Kao are executives with Taiwan Kolin, Co. Ltd.

The complaint centers on a financial fraud orchestrated by defendants Li and Chow. According to the SEC, from at least mid-2006 through early 2008 defendants Li and Chow executed a complex scheme to record revenue from the sale of TV sets in China when in fact the sales never occurred. As the scheme progressed, a circular cash flow was developed involving Syntax’s primary manufacturer, Taiwan Kolin and defendants Christopher Liu and Roger Kao. Syntax CFO Wayne Pratt ignored red flags of improper revenue recognition and participated in preparing backdated documentation that were later provided to the outside auditors to support the fictitious sales, according to the Commission’s allegations. The complaint alleges violations of Securities act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5).

Each defendant settled with the Commission with the exception of Mr. Chow. Mr. Li consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 13(b)(5) and from aiding and abetting violations of the other sections cited in the complaint. He also consented to the entry of an officer and director bar. The court will determine disgorgement and a civil penalty.

Mr. Kao consented to the entry of an injunction based on Exchange Act Sections 10(b), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). He also agreed to pay a civil penalty of $100,000. Mr. Liu consented to an injunction based on Securities Act Section 17(a) and Exchange Act Section 10(b) and 13(a) and to an order imposing an officer and director bar. Mr. Pratt consented to the entry of an injunction based on Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 3(b)(5). He also agreed to pay disgorgement in the amount of $88,000 along with prejudgment interest and a civil penalty of $90,000 and to a five year officer and director bar. In a related administrative proceeding he agreed to the entry of an order suspending him from appearing or practicing before the Commission as an accountant for a period of five years.

SEC v. AutoChina International Ltd., Case No. 1:12-CV-01643 (D. Mass. Filed April 11, 2012) is an action centered on manipulation claims. The complaint names as defendants the China based company, eight individuals and two entities. The individual defendants include Hui Kai Yan, a member of the board of directors.

In order to facilitate obtaining financing using company stock as collateral, the defendants and others are alleged to have engaged in a scheme to increase its trading volume to enhance the appearance of liquidity. Using numerous accounts, many of which were opened on the same day, the defendants and their cohorts engaged in manipulative trading such as wash sales and matched orders. The trading created the appearance of activity, increasing volume from about 18,000 shares per day in the summer of 2010 to over 139,000 shares per day in the late fall of that year. In February 2011 an entity controlled by AutoChina’s Chairman and his spouse obtained about $120 million in financing. The only asset of the entity was AutoChina stock. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 9(a) and 10(b). The case is in litigation.

The complaint in SEC v. Ming Zhao, Case No. 12 CV 1316 (S.D.N.Y. Filed Feb. 22, 2012) is based on allegations concerning the misuse of company assets. The action is against the former Chairman and CEO of the company as well as its current CEO. It focuses on Puda Coal, Inc., a Delaware corporation with a principal office in Taiyucan, Shanxi Province, PRC. Shares were traded on the NYSE from September 2009 through August 2011. Its primary asset was Shaux Coal, a coal mining company that was an indirect subsidiary 90% owned by Puda.

On September 28, 2009, Puda announced that Shanxi Coal was one of the entities selected by the Shanxi provincial government to become a coal mining consolidator. This was an extremely lucrative opportunity for the company. Earlier in September, however, Puda’s CEO, defendant Ming Zhao, transferred all of the company’s interest in Shanxi Coal to himself. Subsequently, a series of steps were taken which culminated with U.S. investors buying shares in a shell company.

First, in July 2010 Mr. Zhao transferred 49% of the coal company to CITIC Trust Co., a Chinese private equity fund. That fund was controlled by CITI Group, the largest state-owned investment firm in the PRC. Mr. Zhao also arranged to have Shanxi Coal pledge 51% of its assets to CITI Trust as collateral for a loan of about $370 million. Second, during the summer of 2010 CITI Trust sold shares to the Chinese public in a trust which held a 49% interest in Shanxi Coal. Third, in 2010 Puda conducted two public offerings in the United States of shares to raise capital for the operations of Shanxi coal, its supposed sole source of revenue. Those shares were sold to U.S. investors. As a result Chinese investors received shares in a trust which owned part of the coal company. U.S. investors received shares in a company which was a shell.

After the Commission’s investigation began, defendant Liping Zhu forged a letter supposedly from CITIC Trust which falsely disclaimed any interest in Shanxi Coal. The letter was produced to the SEC staff by U.S. counsel. After it was disclosed in a filing with the Commission, the letter was exposed as a fraud. Mr. Zhu then admitted the forgery and resigned. Mr. Zhao became CEO. The share price of Puda dropped from $17 to a few cents. The Commission’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 12(b)(2)(B), 13(b)-5 and 14(a). The action is pending.

Next: The FCPA

This is the second segment of a five part series examining issues arising in SEC Enforcement Actions relating to issuers from the PRC whose shares are traded in the U.S.

Failure to file periodic reports

One group of cases brought by the SEC involving PRC issuers centers on allegaions that they failed to file the required periodic reports with the Commission. Companies who have registered their securities for trading with the SEC are required to file periodic reports with the SEC under Section 12 of the Exchange Act. Those include annual and quarterly reports. Failure to file those reports can result in the revocation of the company’s registration statement under Exchange Act Section 12(j). In that instance the company’s shares can no longer be traded on a U.S. exchange.

The SEC has revoked the registration statements of over a dozen Chinese issuers. At least 27 other revocation cases pending. In the Matter of Longtop Financial Technologies Ltd., Adm. Proc. File No. 3-14622 (Nov. 10, 2011) is an example of an action brought under Exchange Act Section 12(j) to revoke the registration statement of the company. Longtop is a Cayman Island company based in Shanghai whose ADRs have been traded in New York since its IPO in October 2007. On May 17, 2011 the Exchange halted trading and subsequently delisted the shares of the company. Longtop failed to file its annual report with the Commission for the fiscal year ended March 31, 2011. It also failed to provide investors with annual reports for 2008 – 2010. On December 14, 2011 a order was entered revoking the registration statement of the issuer by default.

Another China based company which went public through a reverse merger and had its registration statement revoked under Exchange Act Section 12(j) also spawned five other Commission enforcement actions. China Yingxia International, Inc. was a Florida corporation headquartered in Harbin, China. The company entered the U.S. capital markets through a reverse merger in May 2006. Its shares were quoted on OTC Link which was formerly the “pink sheets.”

From 2006 through 2009 the company purported to be in the health food business. On February 2, 2012 the Commission instituted an administrative proceeding against the company alleging violations of Section 12(j) since it had failed to file any periodic reports since late 2008. In an order dated March 7, 2012 each class of China Yingxia’s registered securities was revoked. In the Matter of China Yingxia International, Inc., Adm. Proc. File No. 34-66304 (February 2, 2012).

Related actions

One of the actions related to China Yingxia named as defendants Peter Siris, and his companies, Guerrilla Capital Management, LLC and Hua Mei 21^st Century, LLC. Mr. Siris and his entities served as advisers to China Yingxia as well as several other China based entities. SEC v. Siris, Civil Action No. 12-cv-5810 (S.D.N.Y. Filed July 30, 2012).

Mr. Siris is the author of several books on investing and manages two New York based funds which invest in U.S. listed Chinese companies. Guerrilla Capital is a management company and Hua Century is a sub-advisor to it. Mr. Siris invested $1.5 million in China Yingxia through the funds he manages. He was one of three consultants to the firm and, along with Hua Mei, helped raise money for it. In the reverse merger through which the company went public Hua Mei received both cash and shares in return for performing due diligence. Portions of the shares came directly or indirectly through a person controlled by the issuer, in a transaction structured to evade the registration provisions of the securities laws, according to the court documents. The shares were sold yielding $24,600 in illicit proceeds. The next year Mr. Siris acted as an unregistered broker in raising over $2 million for an $8.7 million PIPE transaction conducted by China Yingxia. In connection with that deal he was paid $107,500 in transaction based compensation.

As a consultant for the firm Mr. Siris reviewed filings made with the SEC, press releases and was involved in hiring decision. In February 2009, after learning of difficulties at the company from its CEO, including the fact that she had engaged in illegal fundraising in China and that the company had shut down, he sold a substantial number of company shares prior to the public disclose of these events. The next month, after reviewing a draft press release disclosing the matters he increased his selling activity. Overall Mr. Siris sold 1,143,600 shares of China Yingxia yielding profits of $172,000 while in possession of material non-public information. After a press release was issued on March 6, 2009 the share price plummeted and the directors and CFO resigned, effectively ending the operations of the company.

The complaint also alleges that Mr. Siris made misrepresentation to investors in his funds concerning China Yingxia and traded on inside information regarding ten other Chinese issuers. He is also alleged to have directed short sales on the shares of two other Chinese issuers in violation of restrictions prohibiting such sales prior to his funds’ participation in firm commitment public offerings for the companies. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b), 15(a) and Advisers Act Sections 206(4). Each defendant settled, consenting to the entry of permanent injunctions based on the sections cited in the complaint. In addition, the three defendants have agreed to pay disgorgement in the amount of $592,942.39 along with prejudgment interest. Mr. Siris will also pay a civil penalty of $464,011.93.

A related action was brought against Ren Hu, Alan Sheinwald and Alliance Advisors, LLC. SEC v. Sheinwald, Civil Action No. 12-CV-5810 (S.D.N.Y. Filed July 30, 2012). Mr. Hu became the CFO of China Yingxia in 2008 despite having expressed skepticism about the company. He was also the CFO of several other Chinese reverse merger company. He signed certifications required by the Sarbanes-Oxley Act of 2002 regarding the controls of the company. Mr. Hu claimed to have participated in the design of the disclosure and internal controls of China Yingxia when in fact it had virtually none. Mr. Sheinwald and his investor relations firm, Alliance Advisors, acted as unregistered securities brokers for China Yingxia in 20 07. The complaint alleges violations of Exchange Act Sections 10(b), 13(b)(2)(B) and 15(a). The case is in litigation.

See also In the Matter of Peter Dong Zhou, Adm. Proc. File No. 3-14964 (July 30, 2012)(settled administrative proceeding against a registered representative who helped China Yingxia engage in the unregistered distribution and sale of restricted securities, assisted with the retention of its CFO and insider traded when he learned the company was collapsing; the action settled with a consent to a cease and desist order based on violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b), the imposition of a bar from the securities business and from participating in a penny stock offering with a right to reapply after three years and an agreement to pay disgorgement of $20,900, prejudgment interest and a penalty of $50,000); In the Matter of Stephen Mazuchowski, Adm. Proc. File No. 3-14965 (July 30, 2012)(settled proceeding based on allegations that the Respondent acted as an unregistered broker for China Yingxia; the action settled with a consent to a cease and desist order based on Exchange Act Section 15(a), a bar from the securities business and from participating in a penny stock offering with a right to reapply after two years and an agreement to pay disgorgement of $126,800, prejudgment interest and a penalty of $25,000); In the Matter of James Fuld, Jr., Adm. Proc. File No. 3-14966 (July 30, 2012)(settled proceeding based on the alleged sale of securities of China Yingxia; based on the Respondent’s cooperation the case was resolved with the payment of disgorgement of $178,594.85 along with prejudgment interest).

Issues with auditors

The accessibility of work papers prepared by PRC based auditors registered with the PCAOB for Chinese issuers whose shares are traded in the U.S. markets is a critical issue. The Sarbanes Oxley Act of 2002 or SOX requires the independent audit firm for any issuer who has a class of securities registered with the SEC be registered with the Board. SOX Section 106(b) provides that any audit firm that registers with the PCAOB consents to produce its work papers on request by the SEC or the Board.

Despite the mandate of SOX, U.S. regulatory officials have not been able to access the accounting work papers related to PRC based issuers whose shares are traded in the U.S. capital markets. This is the critical issue on which the Commission’s action captioned In the Matter of Deloitte Touche Tohmatsu Certified Public Accountants Ltd., Adm. Proc. File No. 3-14872 (May 9, 2012) is based.

That proceeding names as a Respondent PRC based Deloitte Touche Tohmatsu Certified Public Accountants or D&T Shanghai. The action is based on Rule 102(e)(1)(iii) of the SEC’s Rules of Practice which permits the Commission to revoke the right to appear and practice before it as an accountant if that professional engages in a willful violations of the federal securities laws.

The Order for Proceedings or OIP alleges violations of SOX Section 106(b). According to the Order, since April 2010 the SEC staff has made extensive efforts to obtain the work papers related to “Client A.” The firm has declined, through its international parent, to produce the requested work papers based on its understanding that PRC law precludes production. The Order alleges that the failure to produce the requested work papers constitutes a violation of SOX Section 106(b). A hearing will be convened.

The same audit firm became the subject of a second Commission action which relates to Longtop Financial Technologies, Ltd. SEC v. Deloitte Touche Tohmatsu CPA, Ltd., File No. 1:11-MC-00512 (D.D.C. Filed Sept. 8, 2011). This is a subpoena enforcement action. The court papers allege that the audit firm is registered with the PCAOB and served as the outside auditors for Longtop. In a letter dated May 23, 2011 the firm resigned from the engagement after discovering numerous improprieties during a year end audit.

Subsequently, the SEC issued an investigative subpoena for documents to the audit firm. To date no documents have been produced. Initially, the Commission moved forward with the action, requesting that the court order the documents produced. In a July 18, 2012 filing however, the SEC asked that the Court stay the proceeding for six months. The request was made because of “ongoing negotiations with a foreign regulator that could impact the appropriate resolution of this case. If the Court grants this stay, the SEC would file a status report with the Court no later than January 18, 2013 to advise the Court of the general status of these negotiations and, if appropriate, to request that the briefing schedule be reset.”

The PCAOB has also engaged in discussions with their counterparts in the PRC. To date those discussions have not resulted in any agreement to give U.S. regulators access to audit work papers as required by SOX.

Next: Corporate governance