by T. GormanPosted on Posted in SECActions

Budgets were a key topic this week. The President proposed one which would increase the SEC’s funding. The agency also proposed a budget for FY 2013 which would increase the size of the Enforcement Division by adding 191 positions.

In Court the SEC had two split decisions. In one action centered on market timing claims, the SEC prevailed after trial on a late trading charge but the court rejected its assertion that market timing violated the antifraud provisions. In another case in which the agency is seeking to compel SIPIC to act regarding certain victims of the Stanford Ponzi scheme, the court partially sustained its and ordered additional briefing on procedural questions.

Finally, the Commission brought another Galleon related insider trading case in conjunction with the Manhattan U.S. Attorney’s Office. It also settled one of its longest running market crisis actions on the eve of trial.

The Commission

Budget: The Commission’s proposed FY 2013 budget requests funding for a total of 1,545 positions for the Division of Enforcement. This would represent an increase of 191 positions above FY 2012 levels. During FY 2011 the Division, which is the Commission’s largest, filed 735 enforcement actions. That is more than in any other single year in the Commission’s history. The division also obtained more than $2.8 billion in penalties and disgorgement ordered in FY 2011.

SEC v. Securities Investor Protection Corporation, Case No. 11-mc-678 (D.D.C.) is an application by the SEC to compel SIPIC to file an application for protection for the customers of Stanford Group Company or SGC. The case is predicated on the collapse in 2009 of a group of companies controlled by Robert Allen Stanford which are reputed to have sold more than $7 billion of certificates of deposit through registered broker dealer SGC which is now defunct. A receiver has been appointed to oversee the assets of SGC which had about 32,000 active accounts for which that company served as the introducing broker. SIPIC declined to file an application with the Court for a protective decree for the SGC customers, concluding that they were not covered because Stanford Group Company did not perform a custody function for the customers. The Court agreed with the SEC that it was appropriate to proceed in a summary fashion by filing a petition rather than a civil complaint. It rejected the Commission’s claim that its preliminary determination regarding SGC is not subject to judicial review. The Court directed the parties to brief the question of what portions of the Federal Civil Rules might apply to future proceedings.

SEC Enforcement: Court decisions

Market timing/late trading: SEC v. Pentagon Capital Management Plc., Case No. 1:08-cv-03324 (S.D.N.Y. Filed April 3, 2008) is an action against Pentagon Capital Management Plc and its Chief Executive Officer, Lewis Chester. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b) centered on market timing and late trading claims. The evidence at trail demonstrated that from 1999 to 2003 Pentagon market timed using multiple accounts at brokers while restricting its trades to relatively small amounts to avoid detection by mutual funds. Despite these precautions, Pentagon was kicked out of a number of funds, a result it expected for a certain percentage of its trades. Pentagon and Mr. Chester also engaged in late trading through TW&Co. beginning in February 2001 and continuing through early September 2003. The Court rejected the market timing claim, concluding that it is not illegal in and of itself and, while funds had policies banning the practice there was to much uncertainty to tie those to a fraud charge since many had side deals and the SEC failed to establish the policies of those involved here. Late trading however is prohibited under SEC Regulation 22c-1, and well known industry practice. Here the defendants’ submission of late-trade orders “constituted a fraudulent device and an implied misrepresentation in violation of Rule 10b-5 because it suggested that final orders were received before the funds’ 4:00 pm. pricing time . . .” Based on the late trading claim the Court entered an injunction prohibiting future violations of the antifraud provisions and requiring that the defendants pay disgorgement of $38,416,500 plus prejudgment interest and a civil penalty equal to the amount of the disgorgement.

SEC Enforcement: Filings and settlements

Investment fund fraud: SEC v. Eschbach, No. SA CV 12 0244 (C.D. Cal. Filed Feb. 15, 2012) is an action against Brenda Eschabch. The complaint alleges that she misappropriated client funds for her personal use beginning while employed by a large investment adviser and later after she established Aventine Investment Services, Inc., a defunct California corporation. Overall she is alleged to have misappropriated over $3 million in investment advisory client funds from 2003 through 2009. In a related criminal case she pleaded guilty to one count of mail fraud and one count of money laundering. She is awaiting sentencing. U.S. v. Eschbach, 8:10-cr-00017 (C.D. Cal.). To resolve the Commission’s case without denying the allegations in the complaint she consented to the entry of a final injunction prohibiting future violations of Securities Act Section 17(a), Exchange Act Sections 10(b) and 15(a) and Advisers Act Sections 206(1) and 206(2). She also agreed to the entry of an order requiring the payment of disgorgement of $2,561,873 payment of which will be satisfied on a dollar for dollar basis by the payment of restitution in the criminal case.

Misappropriation: In the Matter of Robert Pinkas, Adm. Proc. File No. 3-14759 (Feb. 15, 2012) is an action against Mr. Pinkas, who was an investment adviser to several funds. He is also a defendant in SEC v. Brantley Capital management LLC., a case based on the claimed overvaluation of assets and misrepresentations. In September 2010 Mr. Pinkas agreed to settle the case, consenting to the entry of a permanent injunction and agreeing to pay disgorgement of $632,729 along with prejudgment interest and a civil penalty of $325,000. He was also barred from serving as an officer or director for five years and barred from associating with any investment adviser with a right to reapply after one year. In this case he is alleged to have misappropriated $173,000 from a fund client to pay his defense costs in Brantley Capital and an additional $632,000 to cover the disgorgement in that case. The Order also alleges he has also violated the bar in the other case by continuing to associate with a investment adviser. The case is proceeding to hearing.

Unregistered offering: SEC v. Venulum Ltd., Civil Action No. 3:12-cv-00477 (N.D. Tex. Feb. 15, 2012) is an action against Venulum, a British Virgin Island Company, and Venulum Inc., a Canadian entity, along with their owner and chairman, Giles Cadman. The complaint alleges that the defendants engaged in an unregistered offering of promissory notes in fine wines beginning in 2002. Investors were solicited to invest in interests in fine wine that would be managed by Venulum. Beginning in 2010 Venulum solicited 94 of its wine investors to purchase high interest promissory notes. The defendants settled the action by consenting to the entry of a permanent injunction prohibiting future violations of Sections 5(a) and 5(c) of the Securities Act.

Insider trading: SEC v. Whitman, Case No. 12-cv-01055 (S.D.N.Y. Filed Feb. 10, 2012); U.S. v. Whitman, 12-cr-00125 (S.D.N.Y.) are actions against Douglas Whitman and, in the SEC’s complaint, his fund, Whitman Capital LLC. The SEC’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The criminal complaint charges two counts of conspiracy to commit securities fraud and two counts of securities fraud. Both cases allege insider trading in the securities of Polycom, Inc. and Google Inc. based on tips from Roomey Kahn, Mr. Whitman’s neighbor. Ms. Kahn obtained the information regarding Polycom from an insider and, about Google, from an outside consultant of the company. Whitman Capital obtained illegal trading profits of more than $360,000. on the Polycom shares and over $620,000 from trading in Google securities. The criminal complaint also alleges that Mr. Whitman traded in the securities of Marvel Technology Group, Ltd. based on inside information. Both cases are pending.

Market crisis: SEC v. Cioffi, Case No. 08-2457 (E.D.N.Y. Filed June 19, 2008) is one of the Commission’s earliest market crisis cases. It named as defendants former Bear Stearns fund managers Ralph Cioffi and Matthew Tannin. It was brought in tandem with U.S. v Cioffi, 08-CR-001415 (E.D.N.Y.) which was tried to a jury and ended with an acquittal in November 2009. The actions center on the collapse in July 2007 of two Bear Stearns hedge funds once valued at about $20 billion which were tied to the subprime real estate market. The SEC’s complaint alleges an intentional fraud in which the defendants misrepresented the true condition of the two funds to investors as the market crisis began to unfold to induce investors to not withdraw their funds. As the funds were collapsing the defendants continued to misrepresent their true financial condition, according to the SEC. Investors were also not told that Mr. Cioffi began moving about one third of his $6 million investment out to another fund. Investors lost about $1.8 billion when the funds collapsed. The Commission’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Under the terms of the proposed settlements, Mr. Coffi agreed to disgorge $700,000 and pay a $100,000 civil penalty. He will also be barred from the securities business for three years. Mr. Tannin will pay disgorgement of $200,000 and a $50,000 civil penalty. He will be barred from the securities business for two years.

Criminal cases

Investment fund fraud: U.S. v. Stein (S.D.N.Y.) is an action in which defendant Eric Stein pleaded guilty to one count of mail fraud and one count of wire fraud in connection with the operation of an investment fraud in connection with Return-A-Pet LLC. From June 2007 through January 2010 the defendant is alleged to have sold sham Return-A-Pet “distributorships” for fees that ranged from $5,000 to $50,000. The company purportedly facilitated the return of lost pets to their owners. He lured investors with false representations and reportedly took in at least $500,000. Sentencing is scheduled for June 13, 2012.

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by T. GormanPosted on Posted in SECActions

The Commission obtained a partial victory in a late trading and market timing case against Pentagon Capital Management Plc and its Chief Executive Officer, Lewis Chester. SEC v. Pentagon Capital Management Plc., Case No. 1:08-cv-03324 (S.D.N.Y. Filed April 3, 2008). The SEC prevailed after trial on its late trading claim, securing an order enjoining the defendants from future violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and requiring that they pay disgorgement of $38,416,500 plus prejudgment interest and a civil penalty equal to the amount of the disgorgement. The Commission lost on its market timing claim. An analysis of the Court’s rationale on the late trading claim however suggests that the decision may not be sustained on appeal.

The decision

Pentagon Capital is an investment adviser based in London, England. It has furnished investment advisory services to Pentagon Fund, a British Virgin Island entity, and related entities since at least 1999. Mr. Chester, a resident of London, England, has served as CEO since 1999 and as one of two portfolio managers. The Commission’s complaint against the investment adviser and its CEO alleges violations of the antifraud provisions based on claims of market timing and late trading. Those claims centers on trading in the shares of mutual funds from 1999 through September 2003 on the New York Stock Exchange.

Following a seventeen day bench trial the Court rejected the Commission’s market timing claim. Market timing refers generally to buying and selling mutual fund shares in a fashion which takes advantage of short-term pricing inefficiencies. Many mutual funds during this period had policies which restricted short term in and out, market timing transactions. At the same time a number of funds made side deals with certain traders which permitted those policies to be circumvented.

Here the defendants utilized multiple accounts at brokers and restricted their trades to relatively small amounts to avoid detection by mutual funds. This “under the radar” approach was designed to elude detection by funds which policed their policies. Despite these precautions, the Pentagon was kicked out of a number of funds, a result it expected for a certain percentage of its trades.

From 1999 to 2003 Pentagon placed a total of 44,488 mutual fund transactions through thirteen U.S. broker-dealers. The transactions had a value of over $14 billion and were held ffor an average of three days. Approximately 22,448 transactions were purchases totaling about $7.1 billion while 22,038 were sales or redemptions totaling almost $7.2 billion.

Pentagon and Mr. Chester also engaged in late trading through TW&Co. beginning in February 2001 the Court concluded. Mutual funds accept orders up to 4:00 p.m. EST when the New York Stock Exchange closes. Late trading is an extreme form of market timing. By trading after the close of the trading day for the NAV calculated traders can profitably utilize certain informational advantages to profit.

To trade after hours the Pentagon initially sent its orders to the firm prior to 4:00 p.m. EST but was later permitted to cancel them. Initially the firm processed late trades up to about 5:15 or 5:30. Later that deadline was extended to 6:30 p.m. EST. Pentagon and Mr. Chester were aware of the 4 p.m. closing of the New York Stock Exchange and its significance to the mutual funds and the calculation of NAV.

Between February 1, 2001 and September 3, 2003 the Fund placed about 10,052 purchases of open-ended U.S. mutual funds through TW&Co. for a principle investment of about $3.1 billion. The average hold period for these transactions was two days. The Fund made about $38.4 million in profits from trades executed through TW&Co.

In its conclusion of law the Court rejected the SEC’s market timing claims. Market timing alone “is neither illegal nor necessarily fraudulent,” the Court concluded. The SEC has not prohibited the practice. Nevertheless, many mutual funds prohibit market timing. In essence the Commission is enforcing the corporate regulations enacted by various mutual funds by bringing a market timing claim.

Critical to such a claim is the element of deception which is at the core of a Section 17(a) and 10(b) claim. While market timing itself is not illegal, the execution of certain practices in connection with it may be deceptive. In this regard courts have concluded that practices such as breaking down trades, cloning accounts and using multiple accounts and brokers with the intent to deceive a fund into accepting trades may constitute fraud.

In this case the defendants engaged in the kind of practices some courts have found to be deceptive. However, during the time period of this case there was uncertainty regarding market timing. There were no definitions or prohibitions from the responsible agency on the issue. While various mutual funds had policies prohibiting the practice, enforcement was inconsistent. In this case the SEC has not presented evidence to the contrary. Yet “to establish securities fraud in connection with market timing, the SEC must forge a link between a given market timed transaction and a given prospectus or standard utilized by the market timing police of a specific fund.” Here “the lack of clarity by either the funds’ prospectuses or their enforcement policies undermines the SEC’s case . . . “

In contrast, the Court concluded that the defendants engaged in fraudulent late trading. Under SEC Regulation 22c-1, and well known industry practice, mutual funds orders must be placed by the close of the markets at 4 p.m. in order to receive the NAV for that day. Every court which has considered the question has concluded that the practice constitutes a violation of the anti-fraud provision of the securities laws the Court found.

Here the defendants’ submission of late-trade orders “constituted a fraudulent device and an implied misrepresentation in violation of Rule 10b-5 because it suggested that final orders were received before the funds’ 4:00 pm. pricing time . . .” according to the Court. The defendants knew that late trading gave them an impermissible advantage over other investors. In reaching this conclusion the Court relied in part on the fact that the defendants knew of the 4:00 p.m. cut-off and that they were aware of the practice by TW&Co. of falsely stamping timesheets as if their orders were placed prior to the deadline. This is deliberately misleading and false for which defendants are primarily liable the Court concluded.

The Court rejected the argument of Pentagon and Mr. Chester that they could not be primary violators under the Supreme Court’s decision in Janus Capital Group, Inc. v. First Derivative Traders., 131 S.Ct. 2296 (2011). That decision was a private damage action which is not applicable to an SEC enforcement action, according to the Court. This conclusion is bolstered by the fact that Janus is based on subsection (b) of the Rule while this action is predicated on scheme liability under subsections (a) and (c). In view of this conclusion the Court found it unnecessary to address the question of aiding and abetting.

Analysis

While the Court authored a lengthy 126 page set of findings of fact and conclusions of law it seems doubtful that its late trading determination will withstand scrutiny if the defendants chose to appeal. The findings as to market timing issues are clear and well grounded. During the time period of this case funds frequently adopted market timing policies and then engaged in side deals which permitted certain traders to time their trades. Utilizing those policies as the predicate for securities fraud given the inconsistencies in their application would be inappropriate. This is particularly true in view of the lack of proof offered by the SEC regarding the practices of the specific funds involved in this case.

At the same time the Court’s conclusion that Janus does not apply in an SEC enforcement action simply ignores the directive of the Supreme Court. Janus is predicated squarely on the language of the Section and Rule. That language applies with equal force in every action based on the statute and the rule. Indeed, the position of the Court here was argued by the SEC staff in a recent administrative proceeding and rejected. In the Matter of John P. Flannery, Adm. Proc. File No. 3-14081 (Initial Decision Dated Oct. 28, 2011).

Likewise, the Court’s conclusion that this case is based on scheme liability rather than a misrepresentation appears to be little more than an attempted end run on Janus. If accepted it would eviscerate the Supreme Court’s holding as the court concluded in rejecting this contention in SEC v. Kelly, Case No. 08-CV 4612 (S.D.N.Y.), a case not cited by the Court here. But see Hawaii Ironworkers Annuity Trust Fund v. Cole, Case No. 3:10CV371 (N.D. Ohio)(holding the opposite). In any event, the Court’s attempt to rely on scheme liability is belied by its own finding that the fraudulent late trading was based on an implied misrepresentation that the orders were timely when the brokers presented them to the funds. In view of the Court’s disregard of Janus and its failure to address the question of aiding and abetting, it seems clear that the Second Circuit will have little choice but to reverse the decision.

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