This is the sixth in a series of articles that will be published periodically analyzing the direction of SEC enforcement.
Most SEC enforcement investigations end with a settlement. Few corporations are willing to litigate with the Commission. Even fewer regulated entities will undertake the burdens and uncertainties of trial. For many individuals the cost is prohibitive. Nevertheless, prevailing at trial is a key component of the SEC enforcement program. Over the last year a sample of the cases which proceeded to verdict suggests that the Commission has won its share of cases in court. At the same time the agency has suffered some significant losses while others decisions were split.
Wins in court
In SEC v .Jasper, Case No. CV-08-6122 (N.D. Cal.) the Commission prevailed at trial in its action against Carl W. Japer, the former CFO of Maxim Integrated Products, Inc. The case was based on stock option backdating claims. Specifically, the SEC claimed that Mr. Jasper participated in a scheme in which over a five year period beginning in 2000, stock options were backdated. Mr. Jasper was alleged to have selected dates which corresponded to low points for the stock price. Paperwork was prepared which made it appear the options had not been backdated. The company did not take the appropriate accounting charges for the backdated options which caused its financial statements to be incorrect. The complaint alleged violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(1)(A), 13(b)(2)(B), 13(b)(5) and 14(a).
Following an eight day jury trial Mr. Jasper was found liable for violations of the antifraud provisions, for lying to the auditors and aiding and abetting Maxim’s failure to maintain accurate books and records. He prevailed on the alleged proxy rule violations and certain other counts. See also Lit. Rel. 21507 (April 26, 2010).
Two other actions in which the Commission prevailed at trial last year are SEC v. Huff, Civil Action No. 08-06315 (S.D. Fla.) and SEC v. U.S. Pension Trust Corp., Civil Action No. 07-22570 (S.D. Fla. Filed Sept. 28, 2007). In Huff the Commission prevailed in a financial fraud case following a seven day bench trial against defendant W. Anthony Huff. Mr. Huff was alleged to have violated Exchange Act Sections 10(b) and 20(a) along with Securities Act Section 17(a) in connection with a scheme to overstate the financial results of Certified Services, Inc. According to the Commission, Mr. Huff fraudulently obtained over $10 million for himself and his family after recording $47 million in bogus letters of credit on the books of the company between 2002 and 2004. Following the trial the court entered a permanent injunction prohibiting future violations of the sections cited in the complaint, an officer director bar and an order requiring the payment of over $10 million in disgorgement and prejudgment interest and a civil penalty of $600,000.
In U.S. Pension Trust the Commission prevailed after a five day bench trial against defendants U.S. Pension Trust Corp, U.S. College Trust Corp, Iliana Maceiras, Leonard Maceiras Jr. and Nikdo “Verdeja. Each defendant was found liable for violating Exchange Act Sections 10(b) and 15(a) and Securities Act Section 17(a). The court concluded that investors in the funds were mislead about the registration of the investments with the SEC, the Federal Reserve Bank and the Office of the Comptroller of the Currency and not told that commissions ran as high as 85%. The companies also acted as unregistered broker dealers. The court ordered the companies to disgorge $62.5 million of investor contributions that had been fraudulently raised from 1995 through 2008 and to pay a $50 million civil penalty. The individuals were directed to pay disgorgement ranging from $674,567 to $1,093,364 which constituted the salaries they paid themselves. Each individual was also ordered to pay a civil penalty of $200,000. See also Lit. Rel. 21680 (Oct. 4, 2010).
Losses in court
Defense verdicts were returned in three significant insider trading enforcement actions. SEC v. Rorech, Civil Action No. 09 Civ. 4329 (S.D.N.Y.) is perhaps the most high profile trial lost last year. It is the first insider trading case based on swaps.
In Rorech the Commission claimed that defendants Jon-Paul Rorech, a trader in the high yield bond sales group at Deutsche Bank, and Renato Negrin, a portfolio manager for hedge fund Millennium Partners, L.P., engaged in insider trading using securities based swaps regarding a bond offering for VNU N.V, a Dutch media holding company. According to the SEC, Mr. Rorech misappropriated inside information about the bond offering and furnished it to defendant Negin.
Following a trial on the merits the court upheld the SEC’s claim that it had jurisdiction over the security based swaps. In a lengthy, detailed findings however, the court rejected the insider trading charges. The SEC presented a series of suspicious circumstances revolving around cell phone calls between the two defendants. In fact however Mr. Rorech did not have inside information the court concluded at the time of those cell phone calls. Rather, the information he had involved requests from the market that the bond offering be restructured and facts about that question. That information was widely circulated in the market. Mr. Rorech had informed his firm that he had discussed it with others. In fact restructuring in this niche market was common and frequently undertaken to meet market conditions after discussions with various market players. The actual decision to restructure the bond offering was not made until after the cell phone calls relied on by the SEC.
In SEC v. Obus, Case No. 1:06-cv-3150 (S.D.N.Y.) the Commission lost because it failed to prove the key insider trading elements of duty, breach of that duty and deception. In this case the Commission brought an action against Thomas Strickland, an employee of GE Capital Corp, Peter Black, an employee of Wynnefield Capital, Inc. and Nelson Obus, a manager at Wynnefield. The case centered on the acquisition of SunSource by Allied Capital Corp. in 2001. According to the SEC, Mr. Strickland, a member of the GE team underwriting the deal, tipped his friend Peter Black who then tipped Mr. Obus who traded, making a profit of $1.34 million. Judge Daniels rejected the SEC’s claims concluding that Mr. Strickland did not violate any duty. No confidentiality agreement existed to suggest that Mr. Strickland was a temporary insider of SunSource. Likewise, GE Capital did not have any confidentiality policy that was breached. Absent a breach of duty there was no deception.
In SEC v. Zachariah, Case No. 08-60698 (S.D. Fla.) the Court found against the Commission because it failed to prove that the defendant possessed inside information. The Commission’s claims involved alleged tips on two deals. The first concerned the acquisition of IVAX by Teva Pharmaceuticals Ltd. In this instance the SEC claimed that Dr. Zachariah and his brother traded on inside information obtained by the doctor in a telephone call from the chairman of IVAX. That call supposedly occurred after the Chairman met with Teva in New York. The SEC claimed it was made from the Chairman’s private plane, relayed through his Miami office and to the offices of Dr. Zachariah. The court found that the SEC failed to establish who was on the phone at the Doctor’s office. More importantly, the telephone records contradicted the Commission’s claim. They established that the chairman placed another call from the plane while the call was in progress at the Doctor’s office thus making it impossible for the Chairman to have been speaking with the Doctor. The court rejected the Commission’s argument that the phone records were off by three minutes. If true the call from the plane to the office would have been possible, but there was no evidence to support the argument according to the court.
The court also rejected the SEC’s claim that Dr. Zachariah had illegally tipped his brother and a friend about the take over of another company for which he had served as a consultant. The court carefully reviewed each possible source of information including a Commission claim that a key trade occurred just after Dr. Zachariah and a company official had traveled together. None of the evidence supported the Commission’s claim. Indeed, the evidence regarding the trade contradicted the Commission’s claim because it demonstrated that the trade was from a limit order which had been placed before the trip.
Finally, the court concluded that the SEC failed to present sufficient evidence to establish its claims in SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo. Filed July 12, 2007). This is an option backdating case in which the court granted a motion for a directed verdict at the conclusion of the evidence.
In this case Michael F. Shanahan was named as a defendant. He is the son of the former CEO of Engineered Support Systems, Inc. who had previously settled with the SEC and pleaded guilty to criminal charges based on option backdating claims. The defendant in this case had been a director and member of the compensation committee of Engineered Support Systems, Inc. The question before the court was whether Michael Shanahan was liable for fraud and proxy violations and aiding and abetting the false filings of the company.
After eight days of trial the court directed a verdict in favor of the defendant. On the fraud and proxy claims the court concluded that the SEC had failed to offer evidence of the appropriate standards governing the conduct of a director. Similarly, on the aiding and abetting claim the court concluded that the Commission failed to prove that the defendant acted with a wrongful purpose by either demonstrating that he engaged in atypical business behavior or that the transactions lacked a business justification.
In some instances the Commission obtained mixed results. For example in SEC v. Berlacher, Civil Action No. 0-3800 (E.D. Pa. Filed Sept. 13, 2007) the court rejected the key claims of the SEC but did find the defendant had made misstatements. Berlacher is one of a series of cases brought against hedge funds involved in PIPE offerings. In this case the Commission claimed that Robert Berlacher and several investment funds he managed made unlawful trading profits of about $1.7 million over a five year period by investing in PIPE offerings without market risk. This was typically done by shorting the stock prior to the offering but after learning about it and then covering that position with the shares acquired under the resale registration statement. This violates the registration provisions and constituted insider trading according to the Commission.
Following a three day bench trial which centered on four offerings, the court rejected the SEC’s insider trading claims. As to one PIPE offering involving largely the shares of insiders, the court concluded that the information Mr. Berlacher learned about it prior to the offering was immaterial. As to the others, the court found that there was insufficient evidence that a confidentiality agreement was breached because the factual record on this key point was vague. The court did find Mr. Berlacher liable for having made two false statements in executing the stock purchase agreements for the PIPE offerings. In one instance Mr. Berlacher represented he did not have a short position when in fact he did. In the other the defendant stated he had not had any recent transactions in the stock when in fact he held a long position. Prior to trial the court dismissed the SEC’s Section 5 claim which was based on the short position.
The court rejected the SEC’s request for an injunction as unnecessary since Mr. Berlacher was not operating any funds. It also rejected a request for a penalty. An order was entered directing Mr. Berlacher to pay disgorgement on the two claims on a net basis.
Overall the SEC obtained better results following a jury trial in SEC v. Delphi Corporation, Civil Action No. 2:06-cv-14891 (E.D. Mic. Filed Oct. 30, 2006) but still lost on key claims. This action was tried to verdict against Delphi’s former CEO J.T. Battenberg III and the former Chief Accounting Officer, Paul Free. The complaint centered on multiple schemes alleged to have been used to illegally boost revenue. Two schemes were used to conceal a $237 million warranty claim from Delphi’s parent company. Another involved a round trip sham inventory deal in the fourth quarter of 2000. A third concerned the improper recognition of a $20 million payment as revenue rather than a loan in the fourth quarter of 2001. Another scheme was used to conceal about $235 million in factoring or sales of receivables. The complaint alleged violations of the antifraud provisions, lying to the auditors and aiding and abetting books and records violations.
The jury returned a verdict finding Mr. Battenberg not liable on the fraud charges involving the scheme to conceal the liability to Delphi’s parent company. This was the only fraud charge asserted against him. The jury did conclude however that he had lied to the auditors and aided and abetted the books and records violations of the company.
Mr. Free was also found not liable on the fraud charge involving the parent company. The jury found against him and in favor of the Commission on additional fraud and other charges.
Overall an analysis of the record suggests mixed results for the enforcement program at trial. Clearly there were victories. At the same time there were significant losses.
Next: Significant market crisis and other cases.