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Thomas O. Gorman,
Dorsey and Whitney LLP
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    This Week In Securities Litigation (Week ending December 6, 2013)

    The SEC got mixed results in court this week. In the district court the agency lost another case with a jury returning a verdict against the Commission on all counts. The SEC did, however, prevail in the court of appeals in another case. There the court affirmed the determination of the Commission on the amount of a penalty in an administrative proceeding.

    New cases brought by the Commission this week included another market crisis action centered on a financial institution which failed to reclassify impaired loans to avoid taking a loss and an insider trading and Rule 105 action against a long time securities trader. In addition, criminal charges were announced against an SEC employee who falsified the personal securities holding reports he furnished to the agency.

    Finally, the PCAOB re-proposed a rule which, if adopted, will require additional disclosures in the audit report. The proposed rule would require the disclosure of the identity of the engagement partner and other firms participating in the engagement.

    SEC

    Remarks: SEC Chair Mary Jo White addressed the 10th Annual Transatlantic Corporate Governance Dialogue, Washington, D.C. (Dec. 3, 2013). Her remarks included comments on the activist shareholder and the role of shareholders and proxy advisory firms (here).

    Remarks: SEC Commissioner Daniel Gallagher addressed the Transatlantic Corporate Governance Dialogue, Washington, D.C. (Dec. 3, 2013). His remarks were titled The Realities of Stewardship for Institutional Owners, Activist Investors and Proxy Advisors. The Commissioner’s comments focused on the role of proxy advisors (here).

    CFTC

    Remarks: Commissioner Scott D. O’Malia delivered remarks titled Setting Priorities and Fixing Broken Rules Must be Commission’s First Order of Business in 2014 at the 9th Annual FIA Asia Derivatives Conference, Singapore (Dec. 4, 2013). His remarks called for “less regulatory activism” and more statutory accuracy, focusing on the cross boarder rules, SEFs and data and technology (here).

    SEC Enforcement – litigated cases

    False statements: SEC v. Kovzan, Civil Action No. 2:11-cv-02017 (D. Ka. Filed Jan. 12, 2011) is an action in which a Kansas jury returned a verdict against the SEC in a case against NIC, Inc. CFO Stephen Kovzan. The action centered largely on the characterization of a number of expenses company founder, board member and CEO Jeffery Fraser charged to the company. Specifically, the claims against Mr. Kovzan, and in a parallel complaint filed against the company and three of its officers, all of whom settled, alleged that from 2002 through 2005 Mr. Fraser falsely claimed that he worked essentially for free while charging many of his expenses to the company. Those included items such as $4,000 per month to live in a ski lodge in Wyoming and monthly cash payments for rent on a home owned by an entity he controlled, travel costs, and other similar items. These totaled over $1 million, according to the Commission. CFO Kovzan authorized the payments and knew, or was reckless in not knowing, that they circumvented company policy, according to the complaint. The false reporting in Commission filings continued even after a whistleblower complaint and the initiation of the SEC’s investigation. The Commission’s complaint alleged violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), 13(b)(5), 14(a) and Securities Act Section 17(a). After a trial the jury rejected each of the SEC’s claims.

    SEC Enforcement – filed and settled actions

    Weekly statistics: This week the Commission filed, or announced the filing of, 1 civil injunctive district court action, DPA or NPA and 1 administrative proceeding (excluding follow-on actions and 12(j) proceedings).

    Investment fund fraud: SEC v. A.L. Waters Capital, LLC, Civil Action No. 12-cv-10783 (D. Mass.) is a previously filed action against Arnett L. Waters and two entities he controlled, broker-dealer A.L Waters Capital, LLC and investment adviser Moneta Management, LLC. Over a three year period beginning in 2009 the defendants are alleged to have raised about $780,000 from at least 8 investors, including $500,000 from Mr. Water’s church. Investors were promised that the funds would be invested in a portfolio of securities when in fact the money was misappropriated. After pleading guilty to sixteen counts of securities fraud, mail fraud and money laundering, and being sentenced to serve seventeen years in prison and ordered to pay restitution of over $9 million, the defendants settled with the Commission. The Court entered final judgments by consent. The order enjoins each defendant from future violations of Securities Act Sections 17(a) and Exchange Act Section 10(b). It also enjoins Mr. Waters and Moneta Management from future violations of Advisers Act Section 206(4). In addition, the order directs the defendants to pay, jointly and severally, $839,000 in disgorgement which is deemed satisfied by the criminal forfeiture order. See Lit. Rel. No. 22885 (Dec. 5, 2013).

    Conflicts of interest: In the Matter of John Thomas Capital Management Group LLC, Adm. Proc. File No. 3-15255 (Dec. 5, 2013) is a previously filed proceeding which names as Respondents in this settlement Order broker dealer John Thomas Financial, Inc. and its founder and chief executive officer Anastasios “Tommy” Belesis (the original proceeding also names as Respondents John Thomas Capital Management Group LLC and George Jarkesy). The proceeding focuses on the conduct of the manager of two hedge funds, John Thomas Bridge and Opportunity Fund LP I and John Thomas Bridge and Opportunity Fund LP II, and the relationships of the broker dealer and Mr. Belesis to those entities. The broker dealer placed customers in the two funds and provided a number of services. The Order alleges that the adviser and manager placed their interests before those of the funds by paying excessive sums to the broker dealer. Although the funds were represented to be independent of the broker dealer, they sometimes acquiesced in the directives of Mr. Belesis. The funds also paid the broker dealer significant sums for services that had little or no value. To resolve the proceeding the broker dealer and Mr. Belesis consented to the entry of cease and desist orders based on Advisers Act Section 206(2) and censures. In addition, Mr. Belesis was barred from the securities business, and from participating in any penning stock offering, with a right to apply for reentry after 1 year. Mr. Belesis will also pay $311,948 in disgorgement along with prejudgment interest and a penalty of $100,000. The firm will pay a civil penalty of $500,000. The penalties will be placed in a fair fund.

    Improper asset classification: In the Matter of Fifth Third Bancorp, Adm. Proc. File No. 3-15635 (Dec. 4, 2013) is a proceeding which names as Respondents the bank and Daniel Poston, the interim CFO during the time period. The Order centers on the classification of certain non-performing assets during the market crisis. Specifically, GAAP requires that commercial real estate assets carried by a bank and reclassified from “held for investment” to “held for sale” then be revalued and listed at fair value. In 2007 and 2008 as the market crisis unfolded the bank’s non-performing assets increased substantially. In the third quarter of 2008 the only meaningful alternative for the company was to consider selling some non-performing loans which would cause a reclassification and a significant charge, increasing losses. Accordingly, Mr. Poston and others on the Corporate Credit Committee, authorized the head of the bank’s commercial banking division to determine likely sale prices. Subsequently, the bank decided to pursue a sale strategy. In September 2009 the financial institution executed engagement agreements with two loan brokers to market and sell loans with combined balances of $1.5 billion. Despite these actions, the bank did not reclassify the assets – an action which would have increased Fifth Third’s pretax loss in the third quarter of 2008 by 132%. In addition, the bank’s November 7, 2008 management representation letter stated that the firm had no plans or intentions that may affect the classification of loans. Ultimately the impairment was disclosed in January 2009. The Order alleges a violations of Securities Act Sections 17(a)(2) and 17(a)(3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). To resolve the proceeding each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, Mr. Poston is denied the privilege of appearing or practicing before the Commission as an accountant with a right to reapply after one year. The bank also agreed to pay a penalty of $6.5 million. Mr. Poston will pay a penalty of $100,000.

    Insider trading/Rule 105: SEC v. Langston, Civil Action No. 1:13-cv-324360 (S.D. Fla. Filed Dec. 3, 2013) is an action naming as defendants Charles Langston, a long time securities trader, and his two controlled entities, CRL Management, LLC and Guarantee Reinsurance, LTD. In March 2010 AutoChina International Ltd. retained Chardan Capital Markets, LLC and Rodman & Renshaw, LLC, to locate potential investors for a follow-on offering. Mr. Langston opened an account for CRL Management at Chardan the same month. In late March 2013 Chardan contacted a Langston associate about a deal involving AutoChina. After a series of communications on the morning of March 23, 2010 Mr. Langston’s representative was furnished with the offering information, including the price, for AutoChina. Included in the materials were papers specifying that the information was confidential and could not be used to trade. The same day Mr. Langston began selling AutoChina shares short, building a position of 29,000 shares. By the end of the day Mr. Langston had also agreed to purchase 40,000 shares in the offering scheduled for the next day. The next day Mr. Langston purchased 29,000 shares of AutoChina stock for Guarantee Reinsurance’s account at an average price of $35.094, a 17% discount to the prior day closing price. By the end of the day the shares of AutoChina closed down about 15% on news of the offering. Overall Mr. Langston had trading profits of $193, 108.

    In the two years prior to the AutoChina deal, the defendants engaged in manipulative short selling on three occasions, according to the complaint. Rule 105 prohibits any person from selling an equity security short during a pre-offering restrictive period that begins “five business days before the pricing of the offered securities and ending with such pricing.” Defendants engaged in prohibited activity once in 2009 and twice in 2008.

    The complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Rule 105 of Regulation M. Mr. Langston agreed to settle the insider trading charges, consenting to the entry of a permanent injunction based on the Sections cited in the complaint as to that charge. He also agreed to pay disgorgement of $193,108 along with prejudgment interest and a civil penalty equal to the amount of the disgorgement. Finally, the three defendants consented to the entry of permanent injunctions base on Rule 105. Monetary sanctions will be determined by the Court at a later date. See Lit. Rel. No. 22882 (Dec. 3, 2013).

    Kickbacks: SEC v. Gaffney, Civil Action No. 13-cv-61765 (S.D. Fla.) is a previously filed action against Thomas Gaffney alleging a fraudulent scheme centered on the shares of Health Sciences Group, Inc. This week the Court entered a final judgment by consent against Mr. Gaffney, prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The order also bars Mr. Gaffney from serving as an officer or director and imposes a penny stock bar which includes a provision prohibiting the defendant from engaging in activities with a broker, dealer, or issuer for purposes of issuing, trading or inducing, or attempting to induce, the purchase or sale of any penny stock. See Lit. Rel. No. 22883 (Dec. 3, 2013).

    Boiler room: SEC v. Laborio, Civil Action No. 1:12-cv-11489 (D. Mass.) is a previously filed action against, among others, Matthew Lazar. The complaint centers on allegations that Mr. Lazar was employed by a boiler room. The complaint claimed that Mr. Lazar sold shares in a PIPE offering to investors based on false claims that there was a guaranteed return. He raised $585,000 from 10 investors. To resolve the case Mr. Lazar consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a), Exchange Act Section 10(b), and Adviser Act Sections 206(1) and 206(2). The order also bars him for three years from participating in any offering of a penny stock and requires the payment of disgorgement in the amount of $16,820.99 along with prejudgment interest, payment of which, along with any penalty, is waived in view of financial condition. See Lit. Rel. No. 22881 (Dec. 2, 2013).

    Criminal cases

    False statements: U.S. v. Gilchrist (S.D.N.Y.) is a case charging three counts of making false statements against former SEC examiner Steven Hoecker. Compliance examiners at the SEC are not permitted to own securities of companies that are directly regulated by the SEC under rules enacted in August 2010. For examiners who held shares in such entities at the time of the rule change there were provisions for divesting the shares. Mr. Gilchrist held shares in several prohibited companies at the time of the rule change. He did not divest the shares. Rather, he transferred them to a joint account with family members that he still controlled. Subsequently, in three separate filings he represented that his holdings were in compliance when in fact they were not. The case is pending.

    Court of appeals

    Penalties: Collins, v. SEC, No. 12-1241 (D.C. Cir. Decided Nov. 26, 2013). The Court affirmed a Commission decision to impose a penalty of over 100 times the amount of the disgorgement in a failure to supervise case. Matthew Collins was employed at broker-dealer Prime Capital Services where he supervised Eric Brown. Mr. Brown sold variable annuities to senior citizens based on claims of guaranteed returns.

    In August 2003 the Florida Department of Financial Services filed an administrative complaint against Mr. Brown based on his sales. After he defaulted the state suspended his insurance license. Later it was reinstated when he appealed, with the proviso that he not sell variable annuities to seniors. Mr. Brown misrepresented the nature of the proceeding to his supervisor, who made no inquiry. Mr. Brown also concealed the fact that he continued marketing the products during the appeal. Following an SEC administrative proceeding, the Commission affirmed a finding of failure to supervise and treated each of five sales as a separate and distinct act or omission. The SEC thus imposed five penalties aggregating $310,000, rather than the single penalty of $130,000 recommended by the ALJ.

    The Circuit Court affirmed. Mr. Collins focused his appeal primarily on the question of whether the penalty met the public interest factor of the statutory test for penalties. In advancing his argument he made two key concessions. First, Mr. Collins agreed that for a second tier penalty the offense must involve, as here, fraud, deceit, manipulation or deliberate or reckless disregard of a regulatory requirement. Second, he agreed that each transaction could be considered a separate act or omission for calculating the penalty.

    Mr. Collins largely confined his argument to a question of proportionality, contending that the penalty was not commensurate with the approximately $2,915 in disgorgement paid. To support this contention he cited a series of district court cases showing that there is typically a close approximation between the amount of the disgorgement and the penalty imposed, although he conceded in one brief that other factors might be considered.

    The Court conceded that the cases cited did in fact reflect the kind of relationship relied on by Mr. Collins. That, however, is not dispositive. There are other factors. First, the $2,915 paid as disgorgement understates Mr. Collin’s obligation. That sum excused over $2,000 in commissions because of the $25,000 Mr. Collins contributed to a NASD settlement in a customer proceeding. Second, disgorgement “obviously doesn’t fully capture the ‘harm’ side of the proportionality test . . .” Third, the statute suggests that the Commission look “beyond harm to victims or gains enjoyed by perpetrators. It lists harm to other persons.” Thus the relation between the amount of disgorgement and the penalty is “informative . . . but hardly decisive.” Considering these factors, the Court concluded that it could not find an abuse of discretion by the SEC.

    FINRA

    Suitability/supervision: Broker Dealer J.P. Turner & Company LLC paid $707,559 in restitution to 84 customers to resolve charges of sales of unsuitable leveraged and inverse exchange traded funds and excessive mutual fund switches. Leveraged and inverse ETFs reset daily, meaning that they achieve their objective each day and performance can quickly diverge from the underlying index, particularly in volatile markets. Here the firm did not establish and maintain a reasonable supervisory system for this product, relying instead on a system designed for standard ETFs. As a result at least 27 customers lost over $200,000. In addition, the firm engaged in a pattern of unsuitable mutual fund switching. These products are not suitable for short term trading because of the fees. J.P. Turner, however, failed to establish a supervisory system to monitor. As a result more than 2,800 switches that appear on firm reports were not rejected. About 66 customers lost over $500,000 as a result.

    PCAOB

    Proposed rules: The Board is re-proposing for comment amendments to its auditing standards that would require the disclosure in the audit opinion of the name of the engagement partner and the names, locations and extent of participation of other public accounting firms in the engagement.

    Hong Kong

    Recording requirements: The Securities and Futures Commission reprimanded Ms. Tang Wai Chun, an account executive at China Merchants Securities (HK) Co., Limited and fined her $40,000 for failing to comply with order recording requirements under the Code of Conduct. Rather than using the firm phone from late December 2010 through mid January 2011 which recorded customer orders, for one customer she used her cell phone. Ms. Tang was obligated to record the time of receipt of the order and the details by making a call to the central telephone recording system or in writing but did not.

    Repurchase plan: The Securities and Futures Commission and the Hong Kong Monetary Authority announced an agreement with the Royal Bank of Scotland regarding the sale of Lehman Brothers related equity-linked notes to professional investors between July 2007 and May 2008. Previously, the bank announced a repurchase plan for the notes that applied to retail investors. Under the terms of the new arrangement, the bank will also repurchase notes sold to professional investors at 100% of the principal value of each eligible investment. In view of this action no enforcement action will be brought against the bank.

    Japan

    Insider trading: The Securities and Exchange Surveillance Commission recommended to the Prime Minister and the Commissioner of the FSA that an administrative penalty be imposed on Stats Investment Management Co., Ltd. for insider trading. The action is based on the fact that on July 2, 2010 the fund manager was tipped by an employee of a securities company that INPEX Corporation was about to do a secondary offering. The tipper learned about the deal during negotiations on the underwriting agreement by his securities firm. The fund sold 456 shares of INPEX for 218,473,000 yen in violation of the applicable code provisions. The amount of the penalty applicable is 540,000 yen.

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