There were news reports this week that Ponzi king Bernard Madoff’s brother, Peter, has agreed to plead guilty to criminal charges that will land him in jail for ten years. At the same time the NY AG settled a case against a the operator of Madoff feeder funds, making a significant recovery for investors.
The Commission and the Manhattan U.S. Attorney’s Office continued to focus on insider trading, bringing another action from the expert network investigation. The SEC also brought a series of cases involving well known investment adviser Philip Falcone centered on market manipulation and misappropriation charges. In addition, the Commission brought and action centered on commercial bribery and an investment fund fraud action.
Dodd-Frank rules: The SEC adopted new procedures for reviewing clearing submissions. The rules specify how clearing agencies will furnish information to the agency and are important to determining if security-based swaps are required to be cleared (here).
Speech: Susan Nash, Associate Director, Division of Investment Management addressed the IRI 2012 Government, Legal & Regulatory Conference (Washington, D.C. June 26, 2012). Topics addressed include product development, exchange offers, contingent deferred annuities, target date funds, prospectus complexity and variable annuity disclosure reform (here).
SEC Enforcement: Filings and settlements
Statistics: This week the SEC filed 9 civil injunctive actions and 1 administrative proceeding (excluding tag-along and 12(j) actions).
Commercial bribery: SEC v. Falconstor Software, Inc., Case No. CV 12-3200 (E.D.N.Y. Filed June 27, 2012) is an action against Falconstor which specializes in electronic data protection and storage technology. Over a three year period beginning in 2007 the now deceased CEO of the company directed the payment of a series of bribes to employees of JPMorgan Chase Bank, National Association, a subsidiary of the bank. The bribes totaled $430,000 and included stock options, restricted stock, lavish entertainment and gift cards.The payments were improperly booked. In return the company obtained three contracts for the licensing of FalconStaor’s storage software and related services valued at $12.2 million or about 7% of the firm’s revenue in 2008 and 2009. The complaint alleges violations of Securities Act Sections 5 and 17(a)(2) and (3) and Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B). In a parallel criminal action, U.S. v. Falconstor Software, Inc., 1:12-mj-00615 (E.D.N.Y. Filed June 27, 2012), a conspiracy charge was resolved with a deferred prosecution agreement under which the company agreed to pay a $5.8 million criminal fine and institute certain remedial procedures to prevent a future reoccurrence.
Hedge funds:The SEC filed four cases involving well known hedge fund manager Philip Falcone and entities related to him:
- Manipulation: SEC v. Falcone, Civil Action No. 12 CIV 5027 (S.D.N.Y. Filed June 27, 2012) is one of a series of actions centered on fund manager Philip Falcone. The complaint names him as a defendant along with two controlled entities, Harbinger Capital Partners Offshore Manager, LLC and Harbinger Capital Partners Special Situations GP, LLC. Mr. Falcone is the co-founder of the Harbinger Master Fund and Harbinger Special Situations Fund. The complaint centers on a 2006 short squeeze involving trading in a series of distressed high-yield bonds issued by MAAX Holdings, Inc. In April, May and June 2006 the defendants purchased 108 million MAXX’s junior discount bonds for Harbinger Capital Partners Master Fund I. This represented 63% of the issue. Subsequently, there were rumors that a Wall Street Firm providing prime brokerage to the Master Fund was shorting the bonds and encouraging others to take the same position. Mr. Falcone, according to the complaint, crafted a scheme to punish the Wall Street Firm by manipulating the market using a short squeeze after acquiring more than all of the outstanding bonds. The Commission’s complaint, which is in litigation, alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b).
- Misappropriation: SEC v. Harbinger Capital Partners LLC, Civil Action No. 12 CIV 5028 (S.D.N.Y. Filed June 27, 2012) is a second action involving Mr. Falcone who is a defendant along with Harbinger Capital Partners LLC, and Philip Jensen, the one time COO of Harbinger. The complaint alleges two schemes. In the first, Mr. Falcone and Harbinger, aided by Mr. Jenson, misappropriated $113.2 million from a Harbinger fund. The money was used to pay Mr. Mr. Falcone’s taxes. To create the appearance of legality the Defendants sought advise from a law firm. It was not furnished all of the facts. Shareholder approval was not obtained. In the second, Harbinger Fund and Mr. Falcone granted select large investors favorable redemption and liquidity terms in return for their vote to approve more stringent redemption restrictions on investors. This scheme was concealed from the board. The Commission’s complaint, which is in litigation, alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 206(4).
- Control person liability: SEC v. Harbert Management Corporation, Civil Action No. 12 CIV 5029 (S.D.N.Y. Filed June 27, 2012) is another suit related to Mr. Falcone. Here the complaint is against Harbert Management Corporation, HMC-New York, Inc., and HMC Investors, LLC. Harbert Management is an investment management company that created Master Fund and Special Situations Fund and hired Mr. Falcone to manage its investments. HMC Investors was a managing member of the Master Fund. HMC-New York, Inc. is a managing member of the general partner for the Special Situations Fund. Essentially, the complaint claims that the defendants had the ability to halt the short squeeze executed by Mr. Falcone. The complaint alleges control person liability under Exchange Act Section 20(a). The defendants settled this action, agreeing to pay a civil penalty in the amount of $1 million. The Harbert defendants also consented to the entry of a judgment enjoining them from violations of Exchange Act Section 10(b).
- Reg M: In the Matter of Harbinger Capital Partners, LLC, File No. 3-14928 (Filed June 27, 2012) is a settled proceeding against Harbinger Capital Partners LLC. It centers on the purchase of shares in three public offerings in April and June 2009 after having sold the shares short during the restricted period. This violates Rule 105 of Regulation M which establishes a restricted period prior to an offering during which the shares cannot be shorted. Harbinger made profits of $857,950 on the transactions. To resolve the action the Respondent consented to the entry of a cease and desist order based on Rule 105 of Regulation M and a censure. The firm also agreed to disgorge its trading profits, pay prejudgment interest and a civil penalty of $428,975 in addition to adopting certain procedures.
Advisor fees: SEC v. AMMB Consulting Sendirian Berhad, Case No. 1:12-cv-01052 (D.D.C. Filed June 26, 2012) is an action against the company which is a Malaysian investment adviser that is a unit of one of Malaysia’s largest banking groups. AMC served as a sub-adviser to the Malaysia Fund, Inc. From 1996 to 2007 the adviser was paid fees for which it rendered virtually no services. Nevertheless, each year it submitted a report to the Malaysia Fund’s board of directors falsely claiming that it provided specific advice. In addition, AMC failed to adopt and implement adequate policies, procedures and controls over its advisory business, contrary to certifications provided to the fund’s directors in 2006 and 2007. The complaint alleges violations of Sections 15(c) and 36(b) of the Investment Company Act and Sections 206(2) and (4) under the Advisers Act. The firm settled the action, consenting to the entry of a permanent injunction based on the sections cited in the complaint. It also agreed to pay disgorgement of $1.3 million and a $250,000 penalty.
Insider trading: SEC v. Nguyen, Civil Action No. 12-CV-5009 (S.D.N.Y. Filed June 26, 2012) and U.S. v. Nguyen (S.D.N.Y.) are actions against Tai Nguyen, founder of Insight Research, a consulting firm that analyzed publicly traded technology companies for hedge fund managers. Mr. Nguyen is charged with having traded on inside information on at least seven occasions between 2006 and 2009 that was provided by a relative who worked at Abaxis, Inc. about upcoming earnings announcements. As a result he reaped approximately $145,000. He also tipped Sonar Capital, an investment adviser based in Boston that advised several hedge funds. That firm reaped profits and avoiding losses totaling over $5.4 million. Finally, Mr. Nguyen is also alleged to have tipped Bari Capital on at least two occasions. The founder of Bari Capital is Samir Barai who pleaded guilty in the expert network cases and was named as a defendant in the parallel SEC enforcement action. Bari Capital had trading profits of over $1.7 million. The SEC’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). In the parallel criminal case Mr. Nguyen pleaded guilty to one count of conspiracy to commit securities fraud and wire fraud in connection with an insider trading scheme. As part of the plea he agreed to forfeit the proceeds of the offense.
Investment fund fraud: SEC v. National Note of Utah, LC, Case No. 2:12-cv-00591 (D. Utah Filed May 25, 2012) is an action against Wayne Palmer and his controlled entity National Note of Utah LC. Beginning in 2004 National Note raised over $100 million from 600 investors. Mr. Palmer lured investors with claims that his company purchased and sold collateralized loans that would generate outsized returns of 15% to 20% annually. In fact National Note was insolvent. Investor repayments were made from funds put in by subsequent investors. Those payments stopped in October 2011. The SEC’s complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b) and 15(a). The Commission obtained a freeze order. The case is in litigation.
Stock lending scheme: SEC v. Bello, Civil Action No. 2:12-cv-03794 (D.N.J. Filed June 25, 2012) is an action against Ayunda Equity Funding, LLC, AmeriFund Capital Holdings, LLC and their owner Manuel Bello. The complaint claims that the two companies induced certain affiliates of issuers to transfer ownership of millions of shares of publicly traded stock as collateral for loans based on a false promise to return identical shares. The borrowers were not told that the shares were actually sold. In 35 instances the shares were unregistered. Defendants reaped over $3.2 million in unlawful gains. The complaint alleges violations of Exchange Act Section 10(b) and Securities Act Section 5. The defendants agreed to resolve the matter and to pay $3.2 million in disgorgement along with prejudgment interest, a $500,000 penalty and to be barred from the securities industry.
Investment fund fraud: SEC v. Small Business Capital Corp., Case No. CV 12-03237 (N.D. Cal. Filed June 21, 2012) is an action against the company, Investors Prime Fund, LLC and SBC Portfolio Fund LLC, all of which are controlled by defendant Mark Feathers. The defendants raised about $42 million from over 400 investors from 2009 through March 2012. Investors were told that the funds would invest their money in mortgage loan portfolios that would pay a return of at least 7.5%. In fact over $6 million was transferred to SB Capital and used for operating expenses and payments to Mr. Feathers. In the first quarter of 2012 Mr. Feathers and SB Capital also caused SPF to sell eight mortgage loans to IPF at a substantial premium and then had SPF use that premium to pay over $570,000 to SB Capital. Ponzi like payments were also made to investors. The Commission’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a). The court recently entered a temporary restraining and freeze order. The case is in litigation.
Court of Appeals
Rapoport v. SEC, No. 11-11082 (D.C. Cir. June 19, 2012) is an action in which the Circuit Court reversed the SEC’s refusal to vacate a default judgment for failing to comply with its own rules. The Order for Proceedings in the underlying action was issued in December 2008 against OOO-CentreInvest Securities or CI-Moscow, a Moscow based broker dealer which specialized in the sale of second tier Russian equities, its New York affiliate, CentreInvest, Inc. or CI-New York, and several of the employees of each company, including Dan Rapoport. The OIP alleges violations of Exchange Act Section 15(a) since CI-Moscow never registered as a foreign broker dealer with the SEC but sold securities in the U.S. From 2003 through November 2007 CI-Moscow and Mr. Rapoport solicited institutional investors in the U.S. to purchase and sell thinly-traded stocks of Russian companies, according to the OIP. In December 2008 the Enforcement Division served the OIP on CI-New York and on attorneys for other U.S. Respondents. Counsel for Mr. Rapoport was also served although he only appeared in the proceeding to contest a motion requesting that service be made on his client by serving him. Mr. Rapoport did not respond to the OIP. A default was entered which the ALJ later refused to vacate on a motion by Mr. Rapoport. The Commission affirmed that ruling. A cease and desist order was entered and a second tier civil penalty imposed.
The D.C. Circuit reversed and remanded the proceeding. First, the Commission did not follow Rule 155(b) which governs such motions. That rule has a three prong test but the Commission declined to consider the third prong which concerns the defenses to the proceeding. The Commission found it unnecessary to consider that point after concluding that the motion had not been filed within a reasonable time and that adequate reasons for failing to defend were not offered. While the Circuit Court did not state that the SEC was precluded from interpreting Rule 155(b) in this manner, it held that the agency must provide a consistent interpretation of its rules or, when it deviates, explain. Second, the Commission “has failed to provide any intelligible standard to assess what constitutes a ‘reasonable” amount of time for filing a motion to set aside a default under Rule 155(b).” While it concluded that the time within which the motion was filed was not reasonable, the Commission failed to state when the reasonable period begins and what constitutes such a period. Finally, the Court held that the civil penalty had not been calculated in accord with the statute since it was not based on each violation attributed to Mr. Rapoport.
Speech: Thomas M. Selman, Executive Vice President, Regulatory Policy, addressed the IRI Government, Legal and Regulatory Conference, Washington, D.C. (June 25, 2012). His remarks focused on dynamic regulation and the need for predictability (here).
Investment fund fraud: In April 2009 the NY AG filed suit against Ezra Merkin and his controlled funds, Ariel Fund Ltd, Gabriel Capital L.P, Asset Fund Ltd. and Ascot Partners L.P. Mr. Merkin raised over $4 billion from individuals and charities by portraying himself as a skilled money manager for over two decades. In reality he simply turned the money over to Bernard Madoff’s giant Ponzi scheme while concealing this fact from investors with false statements. The NY AG’s suit was brought under the Martin Act, Section 352 of the General Business Law and Section 63 of the Executive Law. This week a settlement was announced under which $410 million will be recovered. Investors will be repaid based on the size of their loss and whether they knew about the involvement of Madoff. Those that did not will receive a larger settlement. All investors are expected to receive additional payments. The state will recoup $5 million in litigation costs under the terms of the agreement.
Self-dealing: The Securities and Futures Commission filed an action against James Li Nga Kuk and Li Wo Hing, the former Chairman and CEO of China Asean Resources Ltd. The complaint, which seeks court orders against the defendants, contains three allegations: 1) That in late December 2004 the two defendants had company checks issued for $10.7 million supposedly to pay U.S. suppliers when in fact the funds were diverted to Mr. Hing; 2) Earlier in December 2004 the defendants announced the sale of a subsidiary for $5 million, claiming that the buyer was independent when in fact Mr. Hing funded the transactions; and 3) In February 2003 Mr. Li had the company issue a press release stating there had been no change in the distribution right of its group when earlier a U.S. supplier had terminated a distribution agreement. The case is pending.
Short sales: Allan Tsang Kwok Leung pleaded guilty to one count of illegal short selling in the shares of Bao Yuan Holdings Limited. He was fined $20,000 and directed to pay the investigation costs of the SFC. The charge was based on selling shares which they expected to receive in rights issues before the allocation of shares had been finalized and the shares were allocated. This constitutes naked short selling which is prohibited.