by T. GormanPosted on Posted in SECActions

Exchange Act Section 16(b) is typically applied as a “blunt instrument,” according to the courts. Crafted as the only provision to specifically address insider trading at the time the Exchange Act was written in 1934, the Section precludes what are called “short swing” profits. Those are trading profits from transactions in company securities by directors, officers and 10% shareholders where there is a purchase and sale within six months. Transactions which fall within the literal reach of the Section are barred. The profits are forfeit to the corporation in a suit brought for its benefit in its name.

The Second Circuit recently affirmed this “blunt instrument” interpretation of Section 16(b), finding for the shareholder who initiated the suit. Yet in that case the transaction was initiated by the company and was beneficial to it. Huppe v. WPCS International, Inc., No. 08-4463 (2nd Cir. Decided Jan. 20, 2012).

Huppe centers on transactions in the shares in WPCS International, Inc. by two investment funds. The first part of the transaction took place from December 2005 through the end of January 2006. During that period the funds sold WPCS securities in a series of open market transactions at prices between $9.183 and $12.62 per share.

The second part of the transaction took place in April 2006. Following the restatement of its financial statements in March 2006, the share price of WPCS securities dropped. This ended the plans of the company to raise money for a strategic acquisition through a secondary offering. Accordingly, the company approached the funds about a PIPE offering. In April 2006 the funds, in conjunction with other affiliated investment vehicles, purchased 876,951 shares of WPCS at $7.00 per share. That price represented a discount of approximately 7% from the market price. The transaction was approved by the WPCS board of directors which used the capital infusion from the PIPE to make the acquisition. The share price for WPCS began to improve.

WPCS shareholder Maureen Huppe brought a derivative action in the name of the company against the funds. It alleged a violation of Exchange Act Section 16(b) since the funds first sold WPCS shares within six months of the purchases. On cross motions for summary judgment, the district court ruled in favor of the plaintiff, concluding that Section 16(b) had been violated.

The Second Circuit affirmed. Section 16(b) was “designed to prevent these [directors, officers and 10% shareholders] from engaging in speculative transactions on the basis of information not available to others” the court noted, citing the legislative history. Here there can be no doubt that the transactions fall within the literal prohibitions of the Section.

The funds however argued that the transactions here should be exempt from the prohibitions of the Section because they were the product of direct negotiations with the company and were approved by the board. Thus even if the funds had access to inside information, the board which approved the deal had the same information. Accordingly, the funds could not have obtained any informational advantage, the difficulty the Section was designed to address.

The Court rejected the contention of the funds. In limited circumstances the Court will scrutinize what it called “borderline” or “unorthodox” transactions in a pragmatic manner to determine whether they might serve as a vehicle for the type of transactions congress sought to prevent the Court noted. The predicate for the implementation of this approach however is an involuntary transaction by an insider having no access to inside information. Thus“we have been clear that Section 16(b) should be applied without further inquiry if there is at least the possibility of speculative abuse of inside information.” (internal quotes eliminated).

In this case the PIPE deal was not a “borderline” transaction the Second Circuit noted. In it the funds gave WPCS “a wholly volitional capital infusion and had access to inside information.” The sales and purchases not only fall within Section 16(b) but also present the kind of potential congress sought to bar when drafting the Section. Accordingly, the judgment of the district court was affirmed. In the end WPCS thus benefited twice – once from the capital infusion and a second time from the trading profits forfeit to it through the suit. It seems questionable at best that Congress intended the original insider trading provision to create such a windfall for the company and its shareholders.

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by T. GormanPosted on Posted in SECActions

Insider trading, implementing Dodd-Frank, asset valuations and old scandals dominated the securities enforcement litigation this week. The U.S. Attorney’s Office in Manhattan and the SEC brought more high profile insider trading cases focused on the hedge fund industry. These cases however look more like the traditional insider trading actions built on bits and pieces of evidence – aided by three defendants who pleaded guilty – in contrast to the Galleon and expert network cases which center largely on wire tap evidence.

Congress continued to debate the so-called Volker Rule. Two House subcommittees heard testimony from SEC Chairman Mary Schapiro on the proposed rule to implement the provision. While Ms. Schapario’s testimony highlighted the proposal, many commentators consider it so long and complex as to be unworkable.

Finally, SEC enforcement brought another market crisis case and two actions focused on asset valuation. The market crisis case named as a defendant the holding company for the largest bank in Florida. Like other market crisis cases, it centers on claims that the true condition of certain loan assets was not disclosed. It charges intentional fraud. The two asset valuation cases focus on the manner in which funds valued assets and the resulting impact on NAV.

The Commission

Volker Rule: SEC Chairman Mary Schapiro testified before the House Subcommittee on Capital Markets and Government Sponsored Enterprises Subcommittee and Financial Institution and Consumer Credit Subcommittee on “Examining the Impact of the Volker Rule on Market, Businesses, Investors and Job Creation.” The testimony largely reviews the proposed rule and the section of the Act it implements (here).

Conflicts/settlements: Former SEC staff member Spencer Barasch, once the head of Enforcement for the SEC’s Forth Worth office, entered into a civil settlement of ethics and conflict of interest charges with the Department of Justice. The matter stems from his supervisory role regarding Stanford matters while on the staff and his subsequent representation of Mr. Stanford’s company, Stanford Financial Group. Mr. Barasch agreed to pay a $50,000 fine to settle with the DOJ. The Department and Mr. Barasch dispute the factual predicate for the claimed conflicts. The Commission rejected a proposed settlement which called for Mr. Barasch to be barred from practicing before the Commission for six months with an automatic right to re-enter.

The Dell insider trading cases

U.S. v. Newman, 12 mag 0124 (S.D.N.Y. filed Jan. 18, 2012); SEC v. Adondakis, Civil Action No. 12-CV-0409(S.D.N.Y. Filed Jan. 18, 2012). These cases center on trading in the securities of Dell, Inc. and NAVIDA on inside information. Named as defendants in the criminal case are: Todd Newman, a portfolio manager at Diamondback Capital Management, LLC, an investment manager; Anthony Chiasson, a founding partner at Level Global Investors, L.P., an unregistered investment adviser; Jon Horvath, a technology research analyst at an unidentified hedge fund; and Danny Kuo, a vice president and fund manager at an unidentified investment adviser. The Commission’s complaint names each of these individuals as defendants along with: Spyridon Adondakis, an analyst at Level Global; Sandeep Goyal, an analyst at an unidentified investment adviser and formerly a manager of corporate planning at Dell; Todd Newman, a portfolio manager at Diamondback; Jesse Tortora, an analyst at Diamondback; Diamondback Capital; and Level Global. Messrs. Tortora, Adondakis and Goyal were not named in the criminal complaint because each previously pleaded guilty to criminal charges.

The charges center on alleged insider trading in the securities of the two companies in 2008 and 2009. As to Dell, the charges focus on inside information furnished by an unidentified company employee to his friend, Sandeep or Sandy Goyal, regarding future earnings releases in 2008. Mr. Goyal learned that the company would miss market expectations. He passed the information on to Mr. Tortora who conveyed it in an e-mail to his superior, Mr. Newman, and then to Messrs. Adondakis, Horvath and Kuo. Diamondback, Level Global and the unidentified fund which employed Mr. Horvath, sold Dell shares short. They made profits, respectively, of $2.8 million, $50 million and $1 million. In a second part of the scheme Mr. Kuo is alleged to have obtained inside information regarding the revenues, gross profit margins and other financial metrics of NVIDIA prior to the release of the information in 2009. He used this information for the benefit of his employer, an unidentified investment adviser, according to the court papers. Mr. Kuo also passed the information about NVIDIA on to Mr. Adondakis who in turn furnished it to his superior Mr. Chiasson who traded on it for Level Global hedge funds. He also furnished the information to Mr. Tortora who transmitted it to his superior, Mr. Newman, who used it to trade on behalf of Diamondback hedge funds. As a result Level Global’s hedge funds obtained profits or avoided losses of at least $15.6 million. Diamondback’s hedge funds reaped profits of at least $75,000 while the unidentified investment adviser obtained profits and avoided losses of at least $90,000.

The criminal complaint contains two counts of conspiracy to commit securities fraud and four counts of securities fraud. The Commission’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Both are pending. The investigation which resulted in these cases is on-going.

SEC Enforcement: Filings and settlements

Market crisis/failure to disclose: SEC v. BankAtlantic Corp., Case No. 0:12-CV60082 (S.D. Fla. Filed Jan 18, 2012) is an action against the firm which is the holding company to one of Florida’s largest banks, and its CEO and Chairman, Alan Levan. The complaint alleges that as the market crisis unfolded, the defendants failed to disclose, and made false statements regarding, the bank’s commercial residential portfolio and its deteriorating condition. The defendants knew of that condition because a number of the loans were kept current by granting extensions. Specifically, Mr. Levan knew about the deteriorating condition of the portfolio from participating on the bank’s Major Loan Committee which approved the extensions and related principal increases. Despite this knowledge, the disclosure documents for the first two quarters of 2007 continued only generic warnings about what might occur in the future if Florida’s real estate downturn continued. They also failed to disclose the downward trend already occurring in its own portfolio. The MD&A should have disclosed these matters. Mr. Levan signed the filings. The complaint alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). The case is in litigation.

Investment fund fraud: SEC v. Morriss, Case No. 4;12-cv-00080 (E.D.Mo. Filed Jan. 17, 2012) is an action against Burton Morriss and his funds. The Commission claims that between 2003 and 2011 the defendants raised about $88 million from at least 97 investors. The funds were supposed to be invested in their investment funds which would purchase interests in early to mid-stage companies in the financial services and technology sectors. In fact, Mr. Morriss diverted portions of the money to his personal use. The complaint alleges violations of Securities Act Sections 17(a)(1), (2) and (3) and Exchange Act Section 10(b). The Commission obtained emergency relief, including an asset freeze. The case is in litigation.

Improper valuation: In the matter of UBS Global Asset Management (Americas) Inc., Adm. File No. 3-14699 (Jan. 17, 2012) is an action against the firm, a registered investment adviser. According to the Order, in June 2008 UBS Global purchased about 54 fixed income securities from various brokers for its funds. The securities were not listed or sold on any exchange and there was no active market for them. In initially valuing all but six of the securities, UBS Global used data obtained from various dealers. This resulted in valuations that far exceeded the purchase price. In contrast, the firm’s written procedures required that they follow a different valuation method and that the securities initially be valued at the purchase price. As a result, the NAVs for the funds were overstated between one cent to 10 cents per share for several days in June 2008. By failing to comply with its own written procedures the funds violated Rule 22c-1 of the Investment Company Act and UBS Global aided and abetted that violation. To resolve the proceeding the firm consented to the entry of a cease and desist order based on the Rule, a censure and agreed to pay a civil penalty of $300,000.

Valuation/breach of duty: In the Matter of Lisa B. Premo, Adm. Proc. File No. 3-14697 (Jan. 17, 2012) is an action which names as a Respondent Ms. Premo, an investment adviser to the Evergreen Ultra Short Opportunities Fund. From March 2008 through early June 2008 the NAV of the Fund was materially overstated, according to the Order. This resulted from the fact that in late March 2008 the Respondent learned that a CDO owned by the fund experienced an event of default. Ms. Premo failed to report this matter to the valuation committee or the board. Later when the committee became aware of this fact it reduced the value assigned to the CDO from $6.98 million to $0 resulting in a $0.10 per share drop in the NAV of the fund. Within a week of the time the valuation was corrected, the fund was liquidated. The Order alleges that Respondent breached her fiduciary duty. It alleges violations of Sections 206(1) and (2) of the Advisers Act. The Order directs that a public hearing be held for the purpose of taking evidence on the questions set forth in it.

Insider trading: SEC v. Bazshushtari, Civil Action No. CV 12-00354 (C.D. Ca. Filed Jan. 13, 2012) is an action against Farzin Bazshushtari, the Director of Industrial Distribution for STEC Inc. After learning that the company would have positive first quarter earnings, and during a black out period, he repeatedly purchased company shares. He also purchased options. When the earnings announcement was released he made total profits of $76,675.50. To settle the action Mr. Bazshushtari consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b). He also agreed to disgorge his trading profits and pay a civil penalty equal to those profits.

FCPA

U.S. v. Marubeni Corporation, (S.D.Tx.). The company entered into a two year deferred prosecution agreement with the DOJ and agreed to pay a criminal fine of $54.6 million to settle FCPA charges stemming from its role as an agent of the TSKJ consortium. That joint venture was composed of Technip S.A., Snamprogetti Netherlands B.V, Kellogg Brown & Root, Inc. and JGC Corporation, all of whom have settled FCPA charges. The purpose of the venture was to secure contracts from Nigeria LNG, Ltd., a company created by the Nigerian government to capture and sell natural gas associated with oil production in that country. The government retained a 49% interest in Nigeria LNG. The joint venture determined that bribes had to be paid to secure business. As part of its efforts, the venture retained two agents, according to the court documents. One was Jeffrey Tesler, a U.K. solicitor. The other was Marubeni, a Japanese trading company headquartered in Tokyo. Mr. Tesler served as a consultant to the venture and paid bribes to high-level Nigerian government officials. Those included top level executive branch officials. Marubeni was retained to pay bribes to lower level government officials. At key points, a number of the co-conspirators, including employees of Marubeni, met with senior executive level government officials to determine with whom they should meet to negotiate bribes in connection with the awarding of contacts, according to the court papers. The joint venture is alleged to have paid about $132 million to a Gibraltar corporation controlled by Mr. Tesler and $51 million to Marubeni during the course of the scheme. The payments were intended to be used at least in part to bribe Nigerian government officials.

FINRA

Citigroup Global Markets, Inc. agreed to pay a fine of $725,000 for failing to disclose certain conflicts of interest in its research reports and in the public appearances of its research analysts from January 2007 through March 2010. FINRA found that the deficiencies were primarily due to technical deficiencies. The firm also failed to have reasonable supervisory procedures in place to ensure that it was making the proper disclosures in the reports.

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