Insider trading and financial fraud are the repeated themes of securities enforcement this week. The SEC and DOJ both focused on these traditional enforcement priorities. The Galleon insider trading cases continued to roll up guilty pleas as the primary case moves closer to trial next month. The expert network investigation spawned a guilty plea. Finally the Virginia Financial Fraud Task Force also brought an action on the rocket docket.
Securities class actions also continued to increase according to a new report from Cornerstone Research. New statistics on these cases reflect an increase in filings in 2010 compared to 2009 with a large spike in filings in the second half of the year. Suits based on M&A activities increased significantly as did those involving companies in the medical sector.
Financial fraud: SEC v. McGhan, Civil No. 2:11-CV-74 (D. Nev. Filed Jan 14, 2011); SEC v. Maloney, Civil No. 2:11-CV-75 (D. Nev. Filed Jan. 14, 2011) are two actions centered on an alleged financial fraud at MedCor, Ltd. The first, which is settled, names as defendants Donald McGhan, the founder of the company and former Chairman, and Jimmy McGhan, its former COO. The latter, which is in litigation, names as a defendant Theodore Maloney, the former CEO of the company. The complaint against Mr. Maloney alleges violations of Exchange Act Sections 10(b), 13(b)(5) and 14(a) and aiding and abetting violations of Exchange Act Sections 13(a) and 13(b)(2)(A). Both complaints are based on allegations that the defendants misrepresented the source of funds for the company as being Don McGhan or one of his affiliates when it fact it was transfers from Southwest Exchange Corporation, a private company that held deposits for taxpayers seeking to defer capital gains taxes on like kind exchanges. The illegal transfers from that company are alleged to have been concealed by false documents. By 2006 about $54 million in illegal transfers had been made. In 2007 the company collapsed, owing about $97 million to clients. Subsequently, the company filed for bankruptcy. Don and Jim McGhan each settled, consenting to the entry of permanent injunctions prohibiting future violations of Exchange Act Sections 10(b) and 14(e) and from aiding and abetting MediCor’s violations of Section 13(a). In addition, Don McGhan agreed to an officer and director bar while Jim McGhan consented to the entry of a five year officer and director bar.
Financial fraud/insider trading: SEC v. Radcliffe, Civil Action No. 1:11-cv-00091 (D.D.C. Filed Jan 14, 2011) is an action against Joseph Racliffe and his son Michael who operated a sports memorabilia company called Image Innovations Holdings, Inc. Michael was a director of the company and the COO of its operating subsidiary. His father was a consultant although the SEC claims he actually controlled the company. According to the papers the defendants falsified the revenue of the company in 2004 and 2005 by fabricating substantial portions of its income. During that period Joseph sold shares of the company at inflated prices while in possession of material non-public information. Both defendants settled with the Commission, consenting to the entry of permanent injunctions prohibiting future violations of Exchange Act Section 10(b) and from aiding and abetting violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The injunction as to Joseph Racliffe is also based on Securities Act Section 5 and Exchange Act Section 20(a). In addition, Joseph agreed to pay disgorgement of $955,000, prejudgment interest and a penalty of $175,000. The son agreed to disgorge $10,000 along with prejudgment interest and a civil penalty of $75,000. The total amount of disgorgement in the settlements equals the trading profits.
Investment fraud/manipulation: SEC v. Hancher, Case No. 5:11-cv-04005 (N.D. Iowa Filed Jan 14, 2011) names as defendants Lowell Hancher, his company Commerce Street, Edward Whelan and his company, Grace Holdings, Inc. The complaint alleges three fraudulent schemes: 1) An investment fraud scheme beginning in 2005 and continuing in 2007 in which Mr. Hancher, through his company Commerce Street, raised over $1.8 million from at least 60 investors based on misrepresentations which included a claim that a 50% return would be paid after the company went public. The money was misappropriated. 2) A manipulation scheme in which Mr. Hancher directed defendant Whelan and others to place 18 matched orders for more than 60,000 shares of LMWW Holdings, Inc to prop up its share price. At least two of the orders were placed through an account in the name of Mr. Whelan’ company, Grace Holdings. 3) A third scheme involve the misappropriation of money from Cycle Country Accessories. Here the complaint claims Mr. Hancher, a director and audit committee member, obtained the funds based on a claim that it would be used for a stock repurchase. Instead Messrs. Hancher and Whelan misappropriated the money using false documents. Mr. Hancher also lied to the external auditor according to the SEC.
Each defendant settled with the Commission, consenting to the entry of a permanent injunction. As to Mr. Hancher the injunction was based on Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(5) and 15(a)(1). As to Mr. Whelan it was based on Exchange Act Section 10(b). The injunction against Commerce Street was based on Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a)(1) while for Grace Holdings it was predicated on Section 10(b). Mr. Hancher also agreed to pay disgorgement and prejudgment interest of $2,988,405 and a civil penalty of $130,000 while Mr. Whelan consented to pay disgorgement and prejudgment interest of $17,340 and a civil penalty of $20,000.
Misrepresentations re performance: In the Matter of Michael R. Pelosi, Adm. Proc. File No. 3-14194 (Jan. 14, 2011) is a proceeding against the former portfolio manager at registered investment adviser Halsey Associates, Inc. According to the Order, over a three year period beginning in 2005 Mr. Pelosi repeatedly falsified performance returns to clients in periodic correspondence. He exaggerated account gains and minimized performance losses in violation of Advisers Act Sections 206(1) and 206(2). The matter is in litigation.
Supervision: In the Matter of BNY Mellon Securities LLC, Adm. Proc. File No. 3-14191 (Jan. 14, 2011) is a proceeding against a registered broker dealer. The Order claims that Respondent failed to reasonably supervise the manager on its institutional order desk and traders under his supervision from November 1999 through March 2008. During the period the order desk manager failed to meet his duty of best execution to certain customers. Orders were executed at stale or inferior prices which were frequently outside the National Best Bid and Offer at the time of execution. In some instances the orders were executed in cross trades with a favored handful of accounts held by hedge funds and certain individuals. While Respondent had written supervisory procedures establishing a best execution committee, it failed to set up procedures to follow-up on red flags. Respondent also did not have procedures to determine if the order desk manager was fulfilling his responsibility to conduct a daily best execution review of executions on regional exchanges. Although Respondent maintained statistics which showed if executed orders were outside quote at a greater rate than industry averages, beginning in the third quarter 2003 there were no procedures to follow-up. The procedures for monitoring best execution obligations on regional exchanges were also inadequate. As a result of this conduct Respondent failed to reasonably supervise the order desk manager and his traders with the meaning of Exchange Act Sections 15(b)(4)(E) with a view to preventing and detecting violations of Securities Act Section 17(a). To resolve the matter Respondent agreed to certain undertakings and consented to the entry of a censure. Respondent also agreed to pay disgorgement of $19,297,016 along with prejudgment interest and a civil penalty of $1,000,000. The penalty was limited to that amount based on the cooperation of Respondent. It discovering the violations by beginning an investigation promptly after the Commission charged one of the hedge funds in an unrelated matter, terminating the desk manager and self-reporting.
Best execution: In the Matter of Mark Shaw, Adm. Proc. File No. 3-14192 (Jan. 14, 2011) is a proceeding related to the BNY Mellon action. Respondent Mark Shaw was a registered representative and the institutional desk order manager at Mellon Securities. The Order here, based on essentially the same conduct as in BNY Mellon, alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Mr. Saw resolved the action by consenting to the entry of a cease and desist order based on the Sections cited in the Order and agreeing to be barred from association with any broker. He will also pay disgorgement of $195,300 along with prejudgment interest and a civil penalty of $150,000.
Audit failure: In the Matter of Dohan+Company CPAs, Adm. File No. 3-13997 (Filed Aug. 9, 2010) is a Rule 102(e) proceeding against the audit firm and four of its members. The proceeding arises out of the financial fraud at International Commercial Television, Inc. discussed here. This week the firm and Steven Dohan, the firm founder and managing director, and Nancy Brown, formerly a director of the firm and the engagement partner on the International Commercial Television audits, settled. The firm agreed to the entry of a censure. Mr. Dohan will be denied the privilege of appearing and practicing before the Commission with a right to reapply after three years. Ms. Brown agreed to the entry of a similar order.
Financial fraud: SEC v. NutraCea, Civil Action No. CV 11-0092 (D. Ax. Filed Jan. 13, 2011) is a financial fraud case against the company, three of its former executives and two former accounting personnel discussed here. This week the Commission announced settlements with the company and four individual defendants. The company consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). Mr. Edson agreed to the entry of an injunction based on the same provisions, to the entry of a permanent officer and director bar and to pay a civil penalty of $100,000 while reimbursing the company for $350,000 in bonuses received in 2008. Ms. Alderman consented to the entry of an injunction based on Exchange Act Sections 10(b) and 13(b)(5) and to a five year officer and director bar. Ms. Kline and Mr. Wilkinson consented to the entry of injunctions based on Exchange Act Section 13(b)(5) and prohibiting aiding and abetting violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B) and to the issuance of administrative orders based on Rule 102(e) suspending each from practice before the Commission with a right to reapply after one year. The case is on-going as to defendant Crow.
Insider trading: U.S. v. Chesi (S.D.N.Y.). Danielle Chiesi pleaded guilty in the Galleon insider trading cases to three counts of conspiracy to commit securities fraud. She had been scheduled to stand trial in April 2011. Sentencing is scheduled for May 13, 2011. Ms. Cheisi reportedly is not cooperating with prosecutors. Ms. Chiesi was formerly employed at New Castle Funds, LLC, an equity group once affiliated with Bear Stearns Asset Management, Inc. She was initially charged along with Mark Kurland and Robert Moffat. Both men have pleaded guilty. At the same time charges were brought against Ms. Chiesi, Raj Rajaratnam, the founder of the Galleon hedge fund, was charged in an expansive insider trading case. Mr. Rajaratnam is scheduled to begin trial late next month. The SEC also filed an action against Ms. Chiesi, Mr. Rajaratnam and others. SEC v. Galleon Management, LP, Civil Action No. 09-CV-881 (S.D.N.Y. Oct. 16, 2009).
Fraud: U.S. v. Provident Capital Indemnity, Ltd. (E.D. Va.) is an action against Provident, a Dominican company doing business in Costa Rica, and its president Minor Vargas Calvo and Jose Castillo, the auditor of the company. The indictment contains one count of conspiracy to commit mail and wire fraud, three counts of mail fraud and three counts of wire fraud. The SEC brought a parallel action against the same defendants. SEC v. Provident Capital Indemnity, Ltd., Civil Action No. 3:11-cv-045 (E.D. Va. Jan. 19, 2011). The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The defendants are alleged to have engaged in a scheme to defraud by making misrepresentations about Provident’s reinsurers, financial statements and ratings. The scheme was in connection with the sale of financial guarantee bonds to companies that sold life settlements or securities backed by life settlements to investors. Specifically, from 2004 to the present the company sold over $600 million in bonds to life settlement investment companies in the U.S. and several other countries. Those clients then sold investment offerings backed by Provident’s bonds to investors around the world. The cases are in litigation.
Insider trading: U.S. v. Holley (D. N.J.); SEC v. Holley, Case No. 3:11-cv-00205 (D. N.J. Filed Jan. 13, 2011). The criminal case names as defendants George H. Holley, the co-founder of Home Diagnostics and his friend Phairot Iamnaita. Each defendant is charged with conspiracy to commit securities fraud. The SEC action names as defendants those two individuals along with Steven Dudas, the personal accountant to Mr. Holley. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The cases center on the acquisition of Home Diagnostics, Inc. by Nipro Corporation in a deal announced on February 3, 2010. According to the Commission, Mr. Holley told Messrs. Dudas and Iamnaita that Nipro was about to acquire Home Diagnostics. He then furnished the two men with $121,500 to purchase shares of the company. The two men used a joint brokerage account to acquire shares of the company. When the deal was announced the share price for Home Diagnostics increased by 90% over the closing price the previous day. Messrs. Dudas and Iamnaita liquidated their shares yielding a profit of over $90,000. The charging papers in each case allege that Mr. Holley also tipped others. These cases are in litigation.
Insider trading: U.S. v. Nguyen (S.D.N.Y.) is an action against Bob Nguyen, an employee of an expert networking firm. Mr. Nguyen pleaded guilty to an information charging wire fraud and conspiracy to commit wire fraud and securities fraud. From January 2008 to February 2010 Mr. Nguyen’s job at the firm was to solicit employees of public companies to serve as consultants at the firm and furnish inside information to clients. He also facilitated meetings between firm consultants and clients knowing that inside information would be furnished. The date for sentencing has not been set.
Insider trading: U.S. v. Cutillo (S.D.N.Y.). Former Ropes and Gray associate Arthur Cutillo pleaded guilty to one count of conspiracy and one count of securities fraud. The charges stem from the Galleon investigation. According to the court papers, in 2007 and 2008 Mr. Cutillo and another firm attorney, Brien Santarlas, furnished inside information to a third attorney, Jason Goldfarb. The information concerned the then pending deals involving 3Com Corporation and Axcan Pharma, Inc. Mr. Goldfarb in turn furnished the information to Zvi Goffer, who was known as Octopussy because of his multiple sources of information. The information was exchanged for cash. Mr. Cutillo is scheduled to be sentenced on April 27, 2011. The SEC also has an action pending against Mr. Cutillo, SEC v. Cutillo, Case No. 09-cv-9208 (S.D.N.Y.) as well as the others involved here.
Cornerstone Research released its yearly review of securities class actions. According to the report, 176 actions were filed in 2010 compared to 168 the prior year. This resulted from a significant increase in the number of filings in the second half of the year. The number is still below the average of 195 per year for the period 197 to 2009. In 2010 securities class actions against companies in the Health Care sector spiked. Last year 15.4% of the companies in the sector were named in securities class actions Another significant increase occurred in suit based on M&A activity. Those cases increased by 471% compared to the prior year. In 2010 40 cases were filed compared to 7 the prior year. At the same time 12 cases were filed against Chinese issuers. A GAO report noting deceptive recruiting practices and poor student loan repayment at for profit colleges spawned 10 class actions.