SEC Sanctions Firm For Falsifying Value of Deal

Critical to any exchange transaction is the value given and received. It is axiomatic that the firm must conduct appropriate due diligence to determine the appropriate value and properly account for the transaction. A failure to account for the transaction can result in accounting errors. Ignoring obvious and significant flaws and red flags regarding the transaction strongly suggests not just a valuation error but something more. That clearly seems to be the situation underlying the Commission’s latest corporate valuation case. In the Matter of Agria Corporation, Adm. Proc. File No. 3-18917 (Dec. 10, 2018).

Agria is a Cayman Island firm based in Hong Kong engaged in the agricultural business. Its American Depository Shares were listed on the New York Stock Exchange. The firm had significant business interests in the Peoples Republic of China, New Zealand and Australia. The operations in China – corn seed, sheep breeding and seedlings – were operated by Taiyuan Primalights III Modernized Agriculture Development Co., Ltd., known as P3A, a limited liability firm whose results were consolidated with Agria.

In early 2010 Agria negotiated an agreement with P3A’s president under which the firm would divest ownership of the limited liability firm, ending the sheep breeding operations to focus on the seed business. Under the terms of the transaction Agria transferred 100% ownership interest in P3A to that firm’s president. P3A’s president in turn transferred his ownership of 11.5% of Agria’s outstanding shares and added the land use rights held by the firm.

To assess the fairness of the transaction Agria retained three external advisory firms. First, a Chinese law firm offered an opinion which identified defects relating to the legality of the leases that P3A obtained. Those included the fact that eight of the nine lessors did not hold valid title. Second, a consulting firm advised that the fair value of the assets based on the assumption that the properties could be legally leased without any legal defects in terms of relevant tenancy. Finally, a financial advisory firm assessed the impact of the divestiture on Agria’s fair market value by calculating the fair value of the P3A net assets as Agria instructed. The instructions dictated that the amount be determined by netting the fair value of P3A’s total assets and the calculated value of the land use rights rental prepayments. Based on these reports the board approved the transaction.

During the preparation of Agria’s 2010 financial statements no impairment analysis was conduct. This ignored the fact that the senior management of the firm knew two impairment indicators. If the impairment analysis had been conducted the assets would have been written down significantly. Yet no write down was taken in 2010, 2011 and 2012.

Finally, in 2013 the firm was forced to write down the assets secured in the deal with P3A. The decision was based on the fact that the land leases had no expected future economic viability and were not useful to the firm since it changed its line of business and the legal defects. Both factors were known to senior management of the firm in 2010. GAAP required that the financial statements be restated under these circumstances – a write down as taken by the firm was not sufficient. By overvaluing the assets and ignoring market value of the stock received as priced on the NYSE in favor of assigning a value to the shares based on the assets which approximately doubled the share value, Agria concealed a loss of about $17.45 million. If that loss had been properly recorded it would have tripled the net reported loss in 2010. The delay in properly reporting the transaction had a similar impact in 2011 and 2012. The Order alleges violations of Exchange Act sections 10(b), 13(a), 13(b)(2)A) and 13(b)(2)(B).

To resolve the proceedings the firm agreed to fully cooperate with the staff in any action or related judicial or administrative proceeding or investigation. The firm also consented to the entry of a cease and desist order based on the sections cited in the Order. In addition, Agria agreed to pay a penalty of $3 million. See also In the Matter of Laiguanglin (Alan), Adm. Proc. File No. 3-18918 (Dec. 10, 2018)(Action against the executive chairman of the firm for manipulating the share price of the stock to keep it above the $1.00 price limit below which it could be delisted beginning before the period of the action above and continuing through it; settled with a consent to the entry of a cease and desist order based on Exchange Act section 10(b), an order prohibiting Respondent from acting as an officer or director of a public firm for five years and the payment of a $400,000 penalty).

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Trading In Opaque Markets: End the Prosecutions; Install the Ethics

Individual responsibility and accountability became a critical issue in the wake of the great financial crisis. From Capitol Hill to the cross-streets of small-town America it frequently seemed that the question of the day was “who done it,” name them as a defendant. Prosecutors at the Department of Justice and regulators at agencies like the Securities and Exchange Commission responded with statements like the Yates memorandum, demanding that every individual involved be identified, and a series of prosecutions.

One group of cases focused on trading Residential Mortgaged Back Securities (RMBS) or similar instruments. In that group of prosecutions the DOJ and the regulators have been far from a success. Yet the cases continue. The recent dismissal with prejudice by the DOJ and then months later the SEC of the case which started this series of actions presents significant questions about how that case and others are vetted prior to charges being brought. See, e.g., U.S. v. Litvak, No. 13-CR-00019 (D. Conn. Filed Jan. 25, 2013); SEC v. Litvak, Civil Action No. 3:13-CV-00132 (D. Conn. Filed Jan. 28, 2013); see Lit. Rel. No. 24468 (December 6, 2018)(dismissals).

The cases

Litvak is one of a group of trading cases brought the DOJ and the SEC centered on opaque markets. Jesse Litvak was a trader and managing director at Jefferies & Company. The DOJ and SEC charges centered on the manner in which trading was conducted in the opaque market for RMBS. Specifically, Mr. Litvak was charged with repeatedly making misrepresentations regarding pricing, the source of the securities being sold and other material matters to effectuate a transaction for his firm at a time when revenues were declining.

The victims of the fraud were sophisticated funds and investors. They included DE Shaw, Magnetar, Putnam Investments and the U.S. Government. The indictment included 11 counts of securities fraud, one count of TARP fraud and four counts of making false statements based on transactions that took place over a two year period beginning in 2009. Jefferies made about $2 million on the transactions. Following a 14 day jury trial Mr. Litvak was convicted on all counts submitted to the jury. He was sentenced to serve 24 months in prison followed by 3 years of supervised release and ordered to pay $1.75 million.

The conviction of Mr. Litvak turned out to be just the first chapter. Subsequently, the Second Circuit Court of Appeals reversed his conviction while he was out on bond. First, the the Court held that the counts regarding the Government must be reversed. The complex structure used to make decisions regarding purchases by the Government precluded whatever statements were made by Mr. Litvak from being considered. Second, the district court errored by excluding two experts offered as defense witnesses. Those witnesses would have testified that the markets were complex, opaque and inefficient. Perhaps more importantly, the professional traders that populated the market used complex systems and models to evaluate potential transactions which essentially made any statement by Mr. Litvak not relevant.

Retrial went better and worse for Mr. Litvak. The Government counts were excluded. The expert testimony was admitted. The jury found him not guilty on all counts except one. The district court essentially re-imposed the same sentence but increased the penalty to $2 million. Release pending appeal was denied. Mr. Litvak went to prison.

The Second Circuit again stepped in, reversing the conviction. This time the Circuit Court concluded that the district court errored in admitting testimony by a representative of a counter party that all parties agreed was erroneous. Litvak v. U.S., 889 F. 3d 56 (2nd Cir. 2018).

While Mr. Litvak battled the Government other, similar cases were brought. In September 2015, while Mr. Litvak’s first appeal was pending, the U.S. Attorney’s Office in Connecticut and the SEC essentially cloned the Litvak case into one charging three traders from Nomura Securities. U.S. v. Shapiro, No. 15-CR-00155 (D. Conn. Filed Sept. 3, 2015); SEC v. Shapiro, Civil Action No. 15-CV-07045 (S.D.N.Y. Filed Sept. 8, 2015). The charges were essentially the same, minus the Government counts. Supposedly the firm had illicit profits of about $7 million.

Shortly after the reversal of Mr. Litvak’s first conviction by the Second Circuit, Shapiro went to trial. The defense used the Litvak approach, based largely on testimony from traders. That testimony confirmed the opaque nature of the markets, the sophistication of the profession traders and the complexity of the models used to make investment decisions. Compliance understood the wild west tactics of the markets and made no effort to intervene, according to the testimony.

Following a multi-week trial, and a week of deliberations, the jury returned verdicts of largely not guilty. One defendant was found guilty of conspiracy. The jury was unable to return a verdict on three counts. The case lurched into post-trial proceeds and has not been resolved. See also SEC v. Im, Civil Action No. 1:17-cv-0313 (S.D.N.Y. Filed May 17, 2017)(filed against two Nomura traders prior to the Shapiro verdict, one of whom settled, based on trading in commercial mortgage backed securities or CMBS, a similar market; the case continues in litigation).

Comment

After years of litigation what at first blush must have appeared to be open and shut cases remain largely unresolved. Nobody denies that the traders in these markets make misstatements which in many instances in securities markets like the New York Stock Exchange, NASDAQ and others would be material. The markets in these cases are not anything like those exchanges however. The securities involved in these cases have little to no resemblance to shares of stock like Apple and Exxon.

It seems apparent that Government and regulatory investigators did not carefully assess the markets when making the charging decisions in Litvak, Shapiro and Im. Dropping the Government related charges following Mr. Litvak’s first successful appeal more than supports the point.

Yet it is inexplicable it that it took two trials, two appeals and a stint in prison before the charges were dropped against Mr. Litvak – and that the other cases are still in litigation. To be sure, nobody wants to see the kind of unsavory tactics employed in these markets continue let alone proliferate. The U.S. securities markets have long been viewed as the life blood of the world’s largest economy. Those critical streams of commerce should not be polluted with misstatements and lies regardless of their impact. Every brokerage house, every fund, every CCO and every trader needs to understand that each statement made is their word and their bond representing them personally along with their firm in the nation’s market place.

Whatever it was that sparked these cases – the intense pressure to charge individuals, a dislike for the tactics or something else – it is time these cases were brought to an end. Not every spat of improper or unsavory conduct is the stuff of which enforcement actions are made. There are other, much more effective ways to ensure the proper functioning of the securities markets. The DOJ and SEC need to use them now.

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