Foreign regulators also continued to focus on insider trading. In Canada, the Ontario Securities Commission imposed a substantial fine on a legal secretary who traded on information obtained from her law firm. In a practice which the SEC might consider, the OSC noted in the papers filed that the defendant had acted contrary to the public interest, rather than detailing her insider trading activities because of her extensive cooperation. U.K. regulators also continued to focus on insider trading, while Australian authorities released the results of a study of trading by corporate directors.

Finally, three new articles of interest discuss loss causation, springloaded options and the merits of private securities litigation.

Insider trading

In SEC v. Talbot, Case No. 06-55561 (9th Cir. June 30, 2008) the Court of Appeals reversed the dismissal of an SEC insider trading action as discussed here. The district court had dismissed the SEC’s complaint. That complaint alleged that defendant Talbot, a long time Fidelity National Financial director, purchased shares of LendingTree after learning at a Fidelity board meeting that the company was in negotiations to be acquired. Fidelity had been informed about the negotiations because it then owned 10% of LendingTree. Since the SEC failed to prove a direct, continuous link between the communication of the inside information by LendingTree and Mr. Talbot, the district court concluded there was no breach of duty as required by the misappropriation theory and dismissed the case.

The Ninth Circuit rejected the district court’s conclusion. Rather, the circuit court concluded that Mr. Talbot breached a duty to Fidelity. That breach, the circuit court concluded, was sufficient, although it admitted that other cases had the causal link the district court found lacking. This holding potentially broadens the reach of the misappropriation theory.

Backdating

The SEC filed a partially settled option backdating case on Monday (also discussed here), SEC v. Microtune, Inc., Case No. 3:08cv1105-B (N.D. Tex. June 30, 2008). The case named the company, as well as its former CEO Douglas Bartek and former CFO Nancy Richardson as defendants. The complaint alleged a years-long option backdating scheme tied to the hiring and executive compensation practices of the company covered up by fraudulently documents.

The company settled by consenting to a permanent injunction prohibiting future violations of the antifraud and books and records provisions. The individual defendants are litigating the case.

Other jurisdictions

The Ontario Securities Commission approved a settlement with former legal secretary Betty Leung under which she agreed to pay a financial penalty of $103,000 based on settlement papers which alleged that she had acted contrary to the public interest. The settlement reflected credit given to Ms. Leung for her substantial cooperation with the staff.

The underlying facts of the case established that Ms. Leung had been employed as a secretary at the law firm of Bennett Jones LLP since 1989. From April 2005 to March 2008 she traded small amounts of shares – typically 200 to 800 at a time – in eight companies based on confidential information she learned at the law firm about possible takeover deals. The trades were placed in her accounts as well as those of her husband and parent. The fine was twice her trading profits. The settlement papers did not allege insider trading or the details of the transactions in view of the fact that when contacted she immediately acknowledged her actions and fully cooperated with the staff.

The Financial Services Authority in the U.K imposed a fine of £85,000 on John Shevlin a former IT worker at The Body Shop for what it called market abuse – insider trading. The fine represented more than twice the trading profit from a short position. Mr. Shevlin obtained information that the company would miss its financial targets for the period from confidential internal e-mails. At the time, Mr. Shevlin had significant trading losses in his securities account.

The Australian Securities Exchange released a comprehensive review of disclosure of Directors’ Interest Notices (securities transactions by directors in shares of their company). According to the study, of 4,137 Notices filed over a three month period, 538 or 13% were filed late. During the same period, 795 trades were made during blackout periods, that is, between the close of the entity’s financial period and the release of the results. Approximately 7% of those trades contravened the trading policies of the entities.

Recent articles of interest

Shareholder Class Actions and The Counterfactual, by Dr. Frederick Dunbar and Dr. Arun Sen (NERA Economic Consulting). This article discusses the application of counterfactual analysis, a social science approach to causation, to the standards now required in securities damage cases by the Supreme Court’s decision in Dura (discussed here). According to the authors, this approach has significant implications for estimating damages.

Stock Option “Springloading”: An Examination of Loaded Justifications and New SEC Disclosure Rules, by William Hughes, 33 Journal of Corporation Law 770 (2008). The article discusses the concept of springloaded options. It argues that while this type of option does not fit squarely within traditional insider trading analysis, it rejects the conclusions of SEC Commissioner Atkins that they should be permitted.

The Missing Link Between Insider Trading and Securities Fraud by Professor Richard A. Booth, 30 Corporate Governance 42 (Winter 2007/2008). The author explores the frequently stated notion that private securities litigation is an indispensable tool for defrauded investors to recover their losses and that these suits are critical to the integrity of the domestic capital markets.

Insider trading

In SEC v. Talbot, Case No. 06-55561 (9th Cir. June 30, 2008), the Ninth Circuit Court of Appeals reversed the dismissal of an SEC insider trading action. The district court had dismissed the SEC’s complaint, concluding that the SEC had failed to establish the breach of duty necessary to sustain a claim of insider trading.

Mr. Talbot was a director of Fidelity National Financial, which owned 10% of LendingTree, another public company. According to the complaint, LendingTree was in negotiations to be acquired. The CEO of Lending Tree, Douglas Libda, informed Brent Bickett, a vice president of Fidelity, about the proposed transaction, noting that LendingTree would need the consent of Fidelity. Mr. Libda also requested that the information be kept confidential. In the conversation he did not disclose the identity of the potential acquirer or the price.

Subsequently, Mr. Bickett told William Foley, CEO of Fidelity about the potential transaction. Mr. Foley later discussed it with the board at its regular meeting. The board was not told to keep the information confidential, although one of the directors stated at the conclusion of the meeting that this was inside information. Mr. Talbot later purchased shares of Lending Tree prior to the public announcement of the acquisition. Following the announcement the share price of Lending Tree rose about 41%.

The SEC’s complaint claimed that Mr. Talbot violated Section 10(b) by trading on inside information. The district court granted summary judgment in favor of Mr. Talbot. In its opinion the court held that had the SEC had failed to establish a breach of duty because it failed to establish a continuous chain of fiduciary relationships back from Mr. Talbot to the source of the information. The court read U.S. v. O’Hagan, 512 U.S. 642 (1997), which upheld the misappropriation theory, as requiring such a continuous link.

The Ninth Circuit reversed. In its opinion, the court noted that under the classic theory of insider trading the insider breaches a duty by using company information to trade. That breach of duty is a deception on the shareholders. Under O’Hagan and the misappropriation theory, there was also a breach duty and deception, but not to the shareholders involved in the trading. Rather, the breach of duty and deception was to the source of the inside information. The circuit court rejected the district court’s conclusion that there had to be a continuous chain between the source of the information and the trader. Under this theory, the breach would run to the information source who would be deceived.

Here, Mr. Talbot breached a duty to his company by trading on the information. That breach is sufficient. It is not necessary for the SEC to establish a continuous chain back to the Lending Tree official that initially supplied the information. While that chain is present in many cases, the court did not read O’Hagan as requiring such a chain.

Backdating

The SEC also filed a partially settled option backdating case on Monday, SEC v. Microtune, Inc., Case No. 3:08cv1105-B (N.D. Tex. June 30, 2008). This case named the company, as well as its former CEO Douglas Bartek and former CFO Nancy Richardson as defendants. Essentially, the complaint alleged a years-long option backdating scheme. Grants were backdated for new hires by looking back over a window of time. Other grants were backdated for executives. In some instances when the price fell, the grants were canceled and new backdated grants were made. That scheme was covered up by fraudulently backdating various documents such as offer letters, agreements and similar documents.

The company settled the action by consenting to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions. The two individual defendants are litigating the case.

Dura is clearly having an impact on pleading. Not only does it impose loss causation pleading requirements as discussed below, but it has impacted Rule 8(a) notice pleading standards as Twombly made clear and as discussed in an earlier segment of this series here.

The decision is also beginning to have an impact on class certification. See, e.g., Oscar Private Equity Investments v. Allegronice Telecom, Inc., 487 F.3d 262 (5th Cir. 2007) (vacating class certification order because plaintiffs had not shown loss causation); see also Allen Ferrell and Atanu Saha, The Loss Causation Requirement For A Rule 10b-5 Cause of Action: The Implication of Dura Pharmaceuticals v. Brouder, Discussion paper No. 0812007, Harvard Law School, Abstract available here (discussing open issues following Dura).

As to pleading loss causation, essentially three views have emerged. First, some courts have held that Dura did not establish what is sufficient, but only what is not adequate. See, e.g., In re Initial Publ. Offering Sec. Litig., 2005 WL 1529659 (S.D.N.Y. June 28, 2005); In re The Warnaco Group, Inc Sec. Litig., 388 F. Supp. 2d 37, 317 (S.D.N.Y. 2005); In re Coca-Cola Enterprises, Inc., Sec. Litig., 2007 WL 472943 (N.D. Ga. Feb. 7, 2007); Marsden v. Select Medical Corp., 2007 WL 1725204 (E.D. Pa. June 12, 2007).

Second, other courts have held that there are theories beyond the price inflation theory discussed in Dura. Ray v. Citigroup Global Markets, 482 F.3d 991 (7th Cir. 2007).

Finally, an analysis of post-Dura cases suggests that three theories of loss causation have emerged:

1) Fraud on the market: This is the standard theory used in Dura. It requires proof of an artificial price and a decline in value when the truth is revealed.

2) Materialization of risk: Under this theory, a plaintiff must prove that it was the very facts about which the defendant lied which caused its injuries.

3) Representation that the investment is risk free: This theory requires an explicit representation that the investment is risk free.

Next: Cases applying Dura

Prior to Dura, the circuits had split over the question of loss causation. The Second, Third and Eleventh Circuits required more than price inflation to establish a link between the claimed misrepresentation or omission and injury. See, e.g., Emergent Capital Inv. v. Stonepath Group, 343 F.3d 189 (2nd Cir. 2003).

In contrast, the Eighth and Ninth Circuits held that the fraud on the market theory of Basic v. Levinson, 485 U.S. 224 (1988) (holding that where there is an efficient market there is a presumption of reliance on the integrity of the market), permitted the presumption that when stock prices were inflated, it made sense to conclude that plaintiffs were harmed by paying too much for the shares. See, e.g., Gebhardt v. ConAgra Foods, 335 F.3d 824 (8th Cir. 2003).

Dura rejected the notion that price inflation alone was sufficient to establish a Section 10(b) cause of action for damages. The complaint in Dura claimed that the company made false statements about its drug profits and future FDA approval of a new asthmatic spray device. Subsequently, the company announced that its earnings would be lower than expected, principally due to slow drug sales. The next day, its share price fell almost 50%. Eight months later, the company announced that the FDA would not approve its new asthmatic spray device. The share price fell temporarily, but almost fully recovered within one week. Plaintiffs claimed that their economic loss resulted from paying artificially inflated prices for Dura shares.

The district court dismissed the complaint, concluding that it failed to adequately allege scienter as to the drug profitability claim. As to the spray device claim, the court concluded that plaintiffs failed to adequately allege loss causation. The Ninth Circuit reversed on the causation question, holding that price inflation was sufficient because loss causation is established on the date of purchase.

The Supreme Court reversed, holding that price inflation alone is not sufficient to establish a causal link between the claimed fraud and injury. The Court’s opinion has six key points:

1. The elements of a private cause of action under Section 10(b) are based in part on common law principles and in part on those added by Congress. At common law a causal link was required between the claimed misrepresentation and the alleged injury, that is, loss causation.

2. As a matter of logic, an inflated price alone is not sufficient. While an inflated price might mean there is a loss, this does not necessarily follow.

3. Loss causation is consistent with the goals of the PSLRA of maintaining confidence in the markets but not insuring against loss.

4. The decision of the Ninth Circuit lacks precedent and is not supported by common law tort principles in which the Section 10(b) damage action is rooted.

5. Basic Rule 8(a) notice pleading requirements require that “fair notice” be given to the defendant as to the claim. This should not be that difficult of a burden for plaintiff. (This point in the opinion later became part of the rationale for the Court’s Twombly plausibility pleading requirement discussed earlier in this series here).

6. Absent loss causation, baseless claims could go forward.

On remand, the district court found that the complaint adequately pled loss causation because plaintiff’s “explained how the misrepresentations … caused economic loss.” This conclusion is based on the fact that plaintiffs amended the complaint regarding their medical device claim to allege that the misrepresentations inflated the stock price and that the share price dropped following corrective disclosures made on three different dates.

The precise impact of Dura is somewhat controversial. Most commentators would agree that the decision has had an impact. Some, however, argue that the Court left open more questions than it resolved.

Next: The impact of Dura

In securities damage actions, Brooks Automation reached a tentative settlement in a class action. At the same time a decision by the Second Circuit Court of Appeals raised questions as to the pleading standards for scienter in the circuit.

Finally, as the week drew to a close, the SEC prevailed in a long-pending insider trading case where criminal charges had been dropped against the defendant. Earlier in the week, the SEC filed a settled insider trading case where the vague allegations of the complaint raise questions regarding what inside information was actually available to a defendant.

Privilege waivers

The Attorney Client Protection Act got a vote of support this week from 32 former federal prosecutors this week. In a letter to Senator Patrick Leahy, the former prosecutors argued that the Act should be passed because the “widespread practice” of requiring waivers has undercut the privilege and the constitutional rights of employees involved in corporate investigations. Former Deputy Attorney General Paul McNulty was not among those urging passage of the Act. Mr. McNulty authored a 2006 revision of DOJ’s prosecution and cooperation standards which sought to place limits on the circumstances under which prosecutors could request waivers. The revision had little impact in the view of many commentators.

The Act, previously passed by the House, is pending in the Senate. Essentially, the Attorney Client Protection Act would bar any federal prosecutor or attorney, including those at the SEC, from requesting a waiver of privilege.

What impact, if any the proposed legislation would have, is at best debatable. The Act would still permit business organizations to waive privilege and obtain cooperation credit. While there is no doubt that some business organizations would like the opportunity to consider waiving privilege under certain circumstances, the current situation presents clear difficulties.

In many instances, waivers are not the result of a direct request. Rather, they are the by-product of a pressure-packed charging system. On the one hand, prosecutors have very broad charging discretion guided by vague, almost open-ended standards. On the other, business organizations are offered little real guidance on what constitutes cooperation or what it can expect from such action. What is very clear is the potential harm to the company from being charged and the need to take any steps necessary to avoid it.

In this context, the about-to-be-charged business organization has little choice except to grasp for any desperate step that might help mitigate the potential liability. Those desperate steps frequently include privilege waivers which can undercut the rights of the organization and its ability to obtain legal advice, and which can have adverse consequences in private litigation. That waiver can also damage fundamental rights of employees who may want to cooperate with the company, but not necessarily the government. As long as there is cooperation credit to be had for a waiver born of desperation, whether it is the result of a direct request from prosecutors or it is a so-called voluntary waiver is of little moment: the result is the same. The Act may have some impact on waivers resulting from prosecutorial requests, but not on those compelled by the process.

Securities damage actions

Brooks Automation, Inc. tentatively settled a securities class action based on allegations of option backdating. Under the tentative settlement, $7.75 million will be paid into a settlement fund by the liability insurers for the company.

Previously, the company settled an option backdating case with the SEC. A separate enforcement action filed by the SEC against a company executive is still pending. Both are discussed here.

A decision this week by the Second Circuit raised questions concerning the pleading standards being followed in the circuit in securities damage actions. In Bay Harbour Management LLC v. Carothers, Case No. 07-1124-cv (2nd Cir. June 24, 2008), the court affirmed the dismissal of a securities damage action in part for failing to properly plead scienter under Section 21D(b)(2) of the PSLRA. The Supreme Court crafted a new “equipoise” standard in Tellabs v. Makor Issues & Rights, Ltd., 128 S.Ct. 61 (2007) last year for determining when a “strong inference” of scienter has been pled under the Section. Yet, Bay Harbour failed to cite the High Court’s decision or even mention its test. Rather, the Circuit Court used a test it first created prior to the passage of the PSLRA, raising questions about what pleading standards are being followed in the circuit.

Insider trading

The SEC obtained a jury verdict in its favor in a long pending insider trading case, SEC v. Patton, Civil Action No. 02 cv 2564 (E.D.N.Y. April 30, 2002). Following the verdict, the court entered a final judgment against defendant Constantine Stamoulis, enjoining him from violating Section 10(b) and Rule 10(b)-5 and directing him to disgorge his trading profits and prejudgment interest and to pay a fine equal to three times the amount of his gain.

The SEC’s complaint, filed in April 2002, named fourteen individuals as defendant. It alleged insider trading in the securities of WLR Foods, Inc. prior to a September 27, 2000, announcement that the company was being acquired by Pilgrim’s Pride Corporation. Among those named as defendants were Eric Patton, the former Director of Manufacturing for the Turkey division of the company, his brother Steve Patton, the owner of a Pennsylvania trucking company, Michael Nicolaou, Steve Patton’s former registered representative, Mr. Nicolaou’ friend Dimitrios Kostopoulos, also a former representative, and several others. The other defendants have settled with the SEC, consenting to injunctions prohibiting future violations and orders requiring the payment of disgorgement and penalties.

Criminal insider trading charges were also filed in 2002 against Eric and Steve Patton, Mr. Stamoulis, and several other defendants. Three of the defendants pled guilty to conspiracy and securities fraud charges while another defendant pled guilt to a perjury charge. The criminal charges were dismissed as to three defendants including Mr. Stamoulis.

Finally, the SEC also filed a settled insider trading case this week against a Williams-Sonoma, Inc. employee who held the position of manager for financial planning and analysis. The complaint claimed that defendant Di Vita learned inside information about the downward financial trend of the company at a management meeting and traded while in possession of that information prior to its release.

Although Mr. Di Vita settled the action by consenting to an injunction and agreeing to pay disgorgement, prejudgment interest and a penalty, the SEC’s complaint was, at best vague about what information was available at, and transpired during, the key meeting where the financial information was discussed. The case is discussed in more detail here. SEC v. Di Vita, Civil Action No. 1:08-cv-01060 (D.D.C. June 20, 2008).

In Bay Harbour Management LLC v. Carothers, Case No. 07-1124-cv (2nd Cir. June 24, 2008), the court reviewed the dismissal of a securities fraud complaint for failure to comply with the pleading requirements of Federal Civil Rule 9(b), which requires that fraud be pled with particularity, and the PSLRA. In discussing the adequacy of the complaint with respect to pleading scienter, the circuit court did not cite or discuss the Supreme Court’s decision last year in Tellabs v. Makor Issues & Rights, Ltd., 128 S.Ct. 761 (2007). Rather, the court relied on one of its own pre-Tellabs decision, applying the two-prong test crafted prior to the passage of the PSLRA: “We have held that a securities fraud plaintiff’s scienter allegations must ‘give rise to a strong inference of fraudulent intent,’ and that such a plaintiff may establish the requisite intent either ‘(a) by alleging facts to show that defendants had both motive and opportunity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness,” quoting Learner v. Fleet Bank, N.A., 459 F.3d 273, 290-91 (2d Cir. 2006).

In analyzing the scienter allegations in the Bay Harbour complaint, the circuit court applied its traditional two-prong test of scienter rather than Tellabs. There is no mention of Tellabs or the Supreme Court’s directives to consider: 1) all the allegations in the complaint; 2) assess whether there was a strong, cogent inference of scienter; or 3) determine whether that inference is at least as strong as any competing inference. Indeed, in discussing scienter, the court did not even cite its own decision applying Tellabs which incorporated the teachings of the Supreme Court and the circuit’s traditional two-prong test. See ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87 (2nd Cir. 2007). Rather, the test the court applied is the same one it has used since the passage of the PSLRA. Indeed, it is the same test the court has used since prior to the passage of that Act. Compare Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 (2nd Cir. 1999) with In re Time Warner, Inc., Sec. Litig., 9 F.3d 1049 (2nd Cir. 1993).

Perhaps the Second Circuit concluded that only half of its ATSI Communications analysis was required to affirm the dismissal of what it apparently viewed as a weak complaint. Yet, it would seem that any analysis of this question should start with Tellabs, not omit the Supreme Court’s newly minted test. In fact, Bay Harbour, like some others decisions discussed in the earlier post analyzing circuit court decisions following Tellabs, suggests that at least in some circuits the Supreme Court’s teachings are having little impact.

Some early cases concluded that the “all facts” provision required that the sources be identified. See, e.g., In re Nice Sys. Lid. Sec. Litig., 135 F. Supp. 551 (N.N.J. 2001).

In what became the leading case on the question, the Second Circuit in Novak v. Kasaks, 216 F.3d 3000 (2nd Cir.) cert. denied, 531 U.S. 1012 (2000) concluded that “our reading of the PSLRA rejects any notion that confidential sources must be named as a general matter.” The court reasoned that naming informants could have a chilling effect. The First, Third, Fifth, Seventh, Eighth, Ninth and Tenth Circuits subsequently agreed. See, e.g., In re Cabletron Sys., Inc., 311 F.3d 11 (1st Cir. 2002); Cal Pub. Employees’ Ret. Sys. v. Chubb Corp., 394 F.3d 126 (3d Cir. 204); ABC Arbitrage Plaintiffs Group v. Tchruk, 291 F.3d 336 (5th Cir. 2002). As the Seventh Circuit held: the “bright line rule obligating the plaintiffs to reveal their sources has the potential to deter informants from exposing malfeasance. Such a rule might also invite retaliation.” Makor Issues & Rights, 437 F.3d. 588 (7th Cir. 2005) reversed on other grounds, 127 S.Ct. 2499 (2007).

Under Novak, the key question became what must be pled to permit the court to evaluate the allegations from confidential witnesses. The Second Circuit concluded that the sources must be “described in the complaint with sufficient particularity to support the probability that a person in the position occupied by the source would possess the information alleged.” Novak, 216 F.3d at 314. While the Fifth and Seventh Circuits agreed with this approach, the First developed an alternative approach. In Cabletron Sys., Inc., 311 F.3d 11 (2002) the court held that the test should be an “evaluation … of the level of detail provided by the confidential sources, the cooberative nature of the other facts alleged (including from other sources), the coherence and plausibility of the allegations, the number of sources, the reliability of the sources, and similar indicia.” The Third and Ninth Circuits adopted a similar approach.

The Tenth Circuit crafted a third approach. In Adams v. Kinder-Morgan, Inc., 340 F.3d 1083 (2003), the Circuit Court concluded that “source information is more important for allegations that are difficult to confirm than for claims that ‘many be objectively verifiable’ such as contract terms, financial results and similar information.”

In Tellabs, the Supreme Court did not consider the issue of confidential witnesses. Prior to review by the Supreme Court, the Seventh Circuit considered the question and followed Novak. However, the question was not presented for review by the High Court.

Following Tellabs, the Seventh Circuit initially seemed to reverse its position. In Higginbotham v Baxter International, Inc., the court concluded that “One upshot of the approach that Tellabs announced is that we must discount allegations that the complaint attributes to five ‘confidential witnesses’ … It is hard to see how information from anonymous sources could be deemed ‘compelling’ or how we could take account of plausible opposing inference. Perhaps these confidential sources have axes to grind. Perhaps they are lying. Perhaps they don’t even exist.” 495 F.3d 753, 756-757 (7th Cir. 2007). Interestingly, the decision was based on Section 21D(b)(2) rather than the “all facts” requirement.

Subsequently, however, the Seventh Circuit reverted to its prior position. When the court considered the question in Tellabs on remand, it explained Higginbotham as being devoid of facts about the confidential sources, other than the fact that they were three ex-employees of the company. The court then went on to credit allegations from confidential sources in applying the Tellabs test noting that they “are numerous and consist of persons who from the description of their jobs were in a position to know first hand the facts…” In addition, the material from the confidential informants “is set forth in convincing detail” and in some cases “corroborated by multiple sources.” Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702 (7th Cir. 2008).

Next: Dura and loss causation

This is not the first time Commissioner Atkins has raised the issue of a new Wells Committee or raised some of the points contained in the article. Some of the suggestions have been raised by the Commissioner in speeches discussed here and here. Nevertheless, the article does contain a number of thoughtful suggestions regarding the enforcement program.

According to Commissioner Atkins, a new Wells or advisory committee should be formed with the “mission … to conduct an independent review of the Commission’s enforcement program from multiple, diverse perspectives, and to recommend to the Commission, if warranted, any needed changes.” In the article, Commissioner Atkins then suggests several topics for consideration by the new committee including:

1) The implementation of mechanisms to provide more efficacy, predictability and transparency to the enforcement program. In this regard, the overall management and approach of the enforcement program would be examined in view of its mission and goals.

2) The implementation of an “open jacket” policy, such as that used by criminal prosecutors. Under this policy, which Commissioner Atkins as recommended before, the enforcement staff would disclose to defense counsel the evidence supporting its claims.

3) A review of the closing process. As noted the article, a prior GAO report harshly criticized the Enforcement Division for failing to promptly close investigations.

4) An examination of enforcement practices from a due process stand point and consideration of ways to improve the current Wells process.

5) A review and analysis of the costs and burdens imposed by the investigative process. This would include consideration of the necessary scope of requests for documents and consideration of ways to ease the burdens and costs of electronic data production.

6) An examination of the use, effects, amount and appropriateness of issuer penalties.

7) Consideration of the minority recommendation from the Senate Finance Committee regarding the Pequot Capital Management inquiry suggesting that Enforcement adopt a manual of procedures which would be similar to the U.S. Attorney Manual.

These are thoughtful and serious recommendations which deserve careful consideration. Hopefully, the Commission will act on the suggestion of Commissioner Atkins and convene an appropriate committee to consider these and other issues.

The basic facts to the case appear to be similar to many others filed by the Commission. Defendant Adrian P. Di Vita was employed by Williams-Sonoma, Inc. (“WSM”) as a manager for Financial Planning and Analysis. On August 22, 2006, Mr. Di Vita attended a monthly operating review meeting held for senior management at WSM. The meeting was held to discuss the prior month’s results and the outlook for each division. At the meeting “a member of WSM senior management again discussed Pottery Barn’s [a unit of WSM] difficulties and, among other things, said the expectation was that those difficulties would not reverse in the near future,” according to the complaint. The factual section of the complaint does not provide any other details about the meeting. The summary at the beginning of the complaint however, claims that Mr. Di Vita received information which “enabled him to know, that when WSM issued a scheduled earnings press release … the company would lower its earnings guidance … .” (emphasis added).

Following the meeting, Mr. Di Vita sold 707 of his WSM Stock Fund units (from his pension fund) and purchased 1,000 WSM put options. After WSM issued an earnings release in which it lowered guidance, Mr. Di Vita sold his put options. Overall, Mr. Di Vita avoided trading losses and made gains totally $67,690, according to the complaint.

To settle the action Mr. Di Vita consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions. In addition, he consented to the entry of an order requiring him to pay disgorgement and prejudgment interest of $76,932.80 and a civil penalty of $67,690.

While the case seems to be straight forward, it does raise two questions. First, it is unclear why the SEC’s complaint is so vague about the key meeting attended by Mr. Di Vita. The fact section contains virtually no detail about the meeting. There is no claim, however, in the fact section that the managers were told that earnings guidance would be lowered. While apparently the managers were told something about continuing difficulties at the Pottery Barn unit, there is no indication of whether this represented a new trend or simply a continuation of what had previously been disclosed. Likewise, there is no representation that managers were told about earnings projections for the period or that guidance would be lowered.

The allegations in the “Summary” at the beginning of the complaint make a small addition to the allegations about the meeting. That portion of the complaint suggest that, in fact, managers were not told that guidance would be lowered, but were supplied with enough information from which they could figure it out or which “enabled” defendant to know.

While Mr. Di Vita’s trading clearly suggests that he “figured out” something – and the results show he was correct – this is clearly not an adequate basis on which to being an insider trading case. Guesses, right or wrong, are not inside information. If, in fact, WSM managers were told that guidance was being lowered or if they were provided with other details about the financial performance of the company, the SEC should be able to do better than make the vague allegations set forth here.

Second, there is no explanation for the financial penalty imposed here. The penalty equals only the disgorgement. It does not equal the total of disgorgement and prejudgment interest, as in many cases. Nor does it represent a multiple of the disgorgement and prejudgment interest total as in many cases. Overall, this complaint, like one filed earlier last week (discussed here) raises more questions than it answers.

Finally, the SEC is continuing its war on insider trading. The agency brought an insider trading case against five individuals which, unlike many of its cases, did not settle simultaneous with filing. The Commission also has reportedly opened a number of new insider trading investigations.

Option backdating

The derivative suit against Zoran Corporation, centered on option backdating claims, appears to have settled based in part on personal payments to the company by two senior executives. This is the second time the parties have tried to settle this derivative case. Pfeiffer v. Zoran Corp., Civil Action No. 3:06-cv-05503 (N.D.Ca.).

The first proposed settlement was rejected as inadequate by the court. The first proposed settlement was based on three key elements: 1) certain backdated options were canceled; 2) the company agreed to specific corporate governance chances, some of which had been instituted during the term of the litigation; and 3) plaintiffs’ counsel would receive $1.2 million in fees and expenses.

The revised settlement has been tentatively approved by the district court. Under the new proposal the company would receive $3.4 million, certain options would be canceled or re-priced and lead counsel for the plaintiffs agreed to limit fee requests to no more than $1 million plus actual expenses.

A key provision of the settlement involves out of pocket payments by two senior executives. CEO Levy Gerzberg agreed to pay $296,250 to the company, while CFO Karl Schmeider agreed to pay $98,750. These amounts reflect the value received by each executive from exercising backdated options. Both executives agreed to re-price options with a total value of $256,920 and cancel others valued at $482,310. The other cash amounts paid to the company were from insurance.

Securities fraud

On Thursday, the SEC filed civil fraud charges against two former Bear Stearns hedge funds executives. The action is based on the collapse last summer of two Bear Stearns hedge funds. SEC v. Croffi, Civil Action No. 08-2457 (E.D.N.Y. June 19, 2008).

According to the SEC’s complaint, the two executives, Ralph Croffi and Matthew Tannin, misled fund investors repeatedly about the financial condition of the two hedge funds in an effort to stave off redemptions. Specifically, the complaint alleges that as the financial condition of the funds deteriorated, the defendants misrepresented its financial condition and the level of redemptions. In addition, the defendants misrepresented in periodic reports the level of investment of the funds in sub-prime mortgage backed securities. Those reports represented that exposure to sub-prime loans was only about 6-8% when in fact it was about 60%.

Defendant Croffi also misrepresented his investment activities regarding the funds, claiming he continued to buy shares, when in fact he did not. In addition, by the end of March 2007 Mr. Tannin had redeemed about $2 million worth of shares of the funds.

The Commission thanked the U.S. Attorney’s office and the FBI for assistance. In an unusual step, the Release stated that the matter was investigated by Enforcement’s sub-prime task force which is “aggressively” investigating that market.

The U.S. attorney’s office for the Eastern District of New York has issued arrest warrants for Messrs. Croffi and Tannin based on similar charges in indictments which have not yet been unsealed. The two men were arrested late Thursday.

Insider trading

The SEC filed an insider trading case against five individuals this week. SEC v. Tedder, Civil Action No. 3-08-CV-1013-G (N.D. Tex. June 17, 2008). The complaint is based on trading in advance of a business combination, the acquisition of Aviall, Inc. by The Boeing Company. It names Robert Tedder and Brian Carr, two company employees as defendants. It also names two alleged tippees of Mr. Tedder, his father Joseph, and business associate Philip Gunn, and a claimed tippee of Mr. Gunn, his brother Gregory as defendants.

The Commission’s complaint centers on a claims that defendants Tedder and Carr learned inside information about the merger talks because of an extension of the company trading blackout, an e-mail inadvertently directed to over 160 employees by the CEO which discussed the merger, observations that the general counsel was continually in meetings, a plant tour by Boeing executives and rumors. The SEC alleges that these events constitute material non-public information as discussed in more detail here. The case is in litigation.

Finally, there are reports that the SEC has recently opened a number of new insider trading investigations. These include inquiries into trading around the Microsoft bid for Yahoo. The Commission is also reportedly investigation trading in the securities of Lehman Brothers Holding, H&R Block, Boeing, NYMEX Holdings, Zoltek, Clear Channel Communications, National City Corp., Safeco Corp., Thornbury Mortgage and Nationwide Financial Services.