by T. GormanPosted on Posted in SECActions

The rapid collapse of MF Global into bankruptcy amid claims that millions of dollars in customer funds is a key focus for the SEC and CFTC as well as SIPIC this week. Speculation over the outcome of the hearings before Judge Rakoff on the SEC’s settlement with Citigroup is also a key topic in securities litigation this week.

The SEC lost a significant market crisis case when the Chief ALJ handed down a decision rejecting the Enforcement Division’s legal theory as well as each of its factual claims. The New York AG also lost in court in a ruling which dismissed a significant suit centered on the collapse of the ARS market. The SEC did however prevail in the court of appeals on the issue of remedies.

The Commission

MF Global, Inc., The SEC and the CFTC issued a joint statement regarding the SIPA liquidation of the firm. It notes that both agencies, in conjunction with other regulators ,have been closely monitoring developments at the firm. When MF Global informed regulators that a transaction that would have resulted in the transfer of customer accounts to another firm had not been completed, the SEC and CFTC determined that a bankruptcy proceeding led by the securities Investor Protection Corporation would be the safest course to protect customer accounts.

Settlements: SEC v. Citigroup Global Markets Inc., Case No. 11 Civ. 7387 (S.D.N.Y. Filed Oct. 19, 2011) is the Commission’s most recent market crisis case. The court directed that the parties appear on November 9, 2011 to answer questions about the proposed settlement including: 1) Why the Court should impose a judgment in a case which “alleges a serious securities fraud” but the defendant neither admits nor denies the wrong doing? 2)What was the total loss? 3) How was the penalty calculated and why is it about one fifth of that assessed in the Goldman Sachs case? 4) How were the factors identified in the SEC’s statement on financial penalties applied here? 5) Since an injunction is part of the settlement, how does the SEC monitor compliance and how many contempt proceedings against large financial entities have been brought arising from consent decrees in the past decade? 6) Why is the penalty to be paid in large part by Citigroup and its shareholders rather than culpable offenders and if those offenders could not be identified why not? 7) What “control weaknesses” lead to the acts alleged in the complaint and how do the proposed remedial undertakings which are part of the settlement ensure it will not happen again? 8) How can a securities fraud of this nature and magnitude be the result of simple negligence? 9) Would a trial rather than a settlement be in the public interest here?

SEC Enforcement: Litigation decisions and rulings

Primary liability: In the Matter of John P. Flannery, Adm. Proc. File No. 3-14081 (Initial Decision Dated Oct. 28, 2011) is a proceeding naming as Respondents John P. Flannery and James D. Hopkins, employees of State Street Bank and Trust Company, a subsidiary of State Street Corporation. Both are involved in the management of funds advised by State Street. The proceeding centered a series of claimed false statements made by the Respondents that supposedly mislead investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street’s management. As a result of those false and misleading statements investors continued to purchase shares in the funds or maintain their positions as the market crisis unfolded and the sub-prime market unraveled. Key to the decision is the question of primary liability. Here Chief ALJ Brenda Murray rejected the Division’s contention that Janus Capital Group, Inc. v. First Derivative Traders, 131 S.Ct. 2296 (2011) is limited to Rule 10b-5(2) in damages cases. Rather, it applies to Section 10(b) and to Securities Act Section 17(a). Based on this ruling the judge rejected each of the claims against the Respondents, concluding either that the men were not responsible for the statement, that it was not false, or both.

SEC Enforcement: Filings and settlements

Evasion of purchase limits: SEC v. Drake Asset Management, LLC, Civil Action No. 11-CV-01905 (D.D.C. Oct. 31, 2011) is an action against the firm, an investment adviser to certain funds, and Oliver Grace, Jr., the owner of Drake Asset. The complaint, which alleges violations of Exchange Act Section 10(b), claims that the defendants evaded certain position limits under the banking regulations and the offering circulars in the acquisition of shares in seven bank mutual-to-stock conversion offerings. Specifically, from 2003 to 2007 Mr. Grace certified and submitted stock order forms without disclosing his associations with affiliated entities also participating in the offerings. The firm, under the direction of Mr. Grace, took similar actions in five offerings. The defendants concealed the relationships among a group of participating accounts they controlled. As a result they obtained greater allocations in the oversubscribed offerings than permitted and deprived others of the share to which they otherwise would have been entitled. This fraudulent conduct yielded the defendants $610,781 in ill-gotten gains. The defendants settled the action by consenting to the entry of permanent injunctions. Drake Asset also agreed to pay a civil penalty of $175,000. Mr. Grace agreed to pay disgorgement and prejudgment interest of $838,285 and a civil penalty of $150,000.

Investment fund fraud: In the Matter of David Story, Adm. Proc. File No. 3-14607 (Oct. 31, 2011) is an action against David Story centered on the fraudulent sale of unregistered securities. Specifically, over a seven month period Mr. Story raised $3,844,000 from at least 35 investors. Investors were falsely told that the funds would be used in a trading program where safety was paramount and that they would receive a return of 5% per month. In fact the funds were used to pay other investors and for the personal expenses of Mr. Story. The action was settled with a consent to the entry of a cease and desist order based on Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b). Mr. Story also agreed to the entry of a bar from the securities business. A civil penalty was not assessed based on the Respondent’s financial condition.

Failure to supervise: In the Matter of Hector Gallardo, Adm. Proc. File No. 3-14139 (Oct. 31, 2011) is a proceeding against Orion Trading, LLC, a registered broker dealer, and Michael Zurita, a part owner and president of the firm as well as its chief compliance officer. The Order alleges that Hector Gallardo, a registered representative at the firm, solicited investments from two Bolivian citizens who began dealing with the Orion through a foreign finder, to invest in his sham investment company. The investors paid Mr. Gallardo about $1.154 million to invest in an entity he falsely told them would pay them returns of 9% to 15% per month regardless of market volatility from investments in public offerings and other investment vehicles. In fact portions of the investor funds were lost in stock and option trading while other portions were misappropriated. Mr. Zurita failed to reasonably supervise Mr. Gallardo and to follow up on key red flags such as an e-mail he reviewed which discussed the fraudulent scheme. The firm and Mr. Zurita also failed to develop and implement reasonable supervisory systems with respect to prohibited transactions. The action was resolved with each Respondent consenting to the entry of a cease and desist order based on Exchange Act Section 15(b)(7) and Rule 15b-1. Mr. Zurita will also be barred from association in a supervisory capacity in the securities business with a right to reapply after three years. The firm agreed to pay a civil penalty of $50,000 while Mr. Zurita will pay $35,000. The firm was also directed to implement certain undertakings including the retention of an individual with appropriate supervisory licenses and qualifications to assume supervisory authority. See also U.S. v. Gallardo (E.D. N.Y.)(Mr. Gallardo was charged with wire fraud).

Financial fraud: SEC v. Leslie, Civil Action No. C 07-3444 (N.D. Cal.) is a long running financial fraud action against five former officers of Veritas Software Corporation. The complaint, which alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(b) and 13(b)(5) and the related rules, claims that the defendants engaged in a scheme to artificially inflate the revenue of the firm from 2000 through 2002 by entering into a fraudulent round trip transaction with America-On- Line. This week defendant Mark Leslie, the former chairman and CEO of the company settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of of Rule 13b2-2(a)(2). He also agreed to pay disgorgement and prejudgment interest of $1,550,000 and a civil penalty of $25,000. The Commission initially charged Mr. Leslie with violations of Securities Act Section 17(a), Exchange Act Sections 10(b) nd 13(b)(5) and with aiding and abetting violations of Sections 13(a) and 13(b)(2)(A).

Court of appeals

Remedies: SEC v. Whittemore, No. 10-5321 (D.C. Cir. Oct. 28, 2011). The D.C. Circuit rejected challenges to a disgorgement order which used a zero basis for stock rather than a market quote for the share price and which imposed joint and several liability for the full amount on a defendant who claimed to have transferred a portion of the funds to others.

The appeal stems from a remedies hearing conducted after defendant Peter Cahill and a group identified as the Whittemore defendants consented to the entry of permanent injunctions in a pump and dump case but reserved the question of remedies for the court. . On the question of disgorgement the Circuit Court concluded it was proper to use a zero basis for the value of the shares rather than a price quote offered by the defendants since the stock was so thinly traded and there was no evidence that it could be sold at the price claimed by the defendants. Holding Mr. Cahill liable for the entire amount of the disgorgement was also appropriate, the court concluded, since he was in charge of the distribution of profits to the wrong doers. Finally, the Court found it appropriate under the circumstances here to hold Mr. Cahill jointly and severally liable with the other defendants. Once the Commission established that there the was a close collaboration between Mr. Cahill and the Whittemore defendants in the scheme, the burned shifted to Appellant to establish that apportionment was appropriate. Since Mr. Cahill wrongfully obtained the proceeds from the sale of the stock and controlled the distribution, if any, it was appropriate for the district court to impose joint and several liability.

New York

Auction rate securities: The People of the State of New York v. Charles Schwab & Co., Index No. 453388/2009 (N.Y. Sup. Ct.) is an action by the New York AG under the Martin Act and other state statues against Charles Schwab & Co., Inc. It alleged that false representations were made in connection with the sale of ARS. The complaint claimed that the firm falsely told investors that the securities were liquid and essentially the same as cash and money market funds and that its salesmen were inadequately schooled in the risks of the ARS market. In fact the ARS market, which crashed in March 2008, began experiencing difficulties in the fall of 2007. It was liquid only as long as the underwriters continued to support it. The court dismissed the complaint, concluding that it failed to allege the statements were false. In view of the 20 year history of the market, the court found that the representations made to investors were not false at the time they were made. The court also rejected an argument by the NY AG which contended that customers were not adequately warned about the risks of the market. This is not a “failure to disclose” case the court held.

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by T. GormanPosted on Posted in SECActions

The narrow focus of Janus Capital Group, Inc. v. First derivative Traders, 131 S.Ct. 2296 (2011) may have a significant impact in private damage actions and SEC enforcement cases. Focusing on the word “make” in the second clause of Rule 10b-5 the court concluded that primary liability only attaches where the person controls the statement which is alleged to be false. The High Court not discuss the other subsections of the Rule. Likewise, Justice Thomas, in his opinion for the Court, did not mention Section 10(b)’s analogue in the Securities Act, Section 17(a).

Now the courts are struggling with the application of Janus. In SEC v. Kelly, 2011 U.S. Dist. LEXIS 108805 (S.D.N.Y. 2011) the court held that the test applies to all of the subsections of Rule 10b-5 as well as Securities Act Section 17(a). In contrast, in SEC v. Daifotis, No. 3:11-c-00137 (N.D. CA. 2011) the court refused to expand Janus beyond the one subsection.

Now Chief Administrative Law Judge Brenda P. Murray has held that Janus applies to SEC actions under Section 10(b) as well as Section 17(a). The ruling was made in the Initial Decision handed down in In the Matter of John P. Flannery, Adm. Proc. File No. 3-14081 (Initial Decision Dated Oct. 28, 2011).

The Order for Proceedings named John P. Flannery and James D. Hopkins as Respondents. Both are employed by State Street Bank and Trust Company, a subsidiary of State Street Corporation. Both are involved in the management of funds advised by State Street.

The proceeding centered a series of claimed false statements made by the Respondents that supposedly mislead investors about the extent of subprime mortgage-backed securities held in certain unregistered funds under State Street’s management. As a result of those false and misleading statements investors continued to purchase shares in the funds or maintain their positions as the market crisis unfolded and the sub-prime market unraveled.

According to the Order, by 2007 the fund was almost entirely invested in or exposed to the subprime market. The Respondents however continued to describe it in various materials and statements as having better sector diversification than a typical money market fund. They failed to inform investors about the extent of its exposure to sub-prime investments. Offering materials for the fund such as quarterly fact sheets, presentations to current and prospective investors, and responses to investor requests for proposal were misleading because they omitted material about the exposure of the fund to the sub-prime market. Mr. Hopkins was responsible for these materials the Order alleges.

A series of shareholder communications were also false and misleading because the failed to inform investors about the fund’s concentration in subprime. Messrs. Hopkins and Flannery played an instrumental role in drafting the misrepresentation in these communications, according to the Order.

As the market crisis evolved State Street’s internal advisory groups decided to redeem or recommend redemption from the fund for their clients. State Street Corporation’s pension plan was one of those clients. Mr. Flannery and the investment committee sold the fund’s most liquid assets and use the cash to redeem shares for what the Order calls “better informed” investors. The fund was left with largely illiquid holdings. The Order alleged violations of Sections 17(a) and 10(b).

In the Initial Decision Judge Murray rejected each of the Division’s claims. Critical to the decisions is the ruling on the application of Janus. The Division argued that the Supreme Court’s decision “applies only for purposes of Rule 10b-5(b) implied private rights of action and does not affect its ‘scheme liability’ and ‘course of conduct’ claims pursuant to Rule 10b-5(a) and (c). . . “ or to its 17(a) claims. After considering Janus, Kelly and Daifotis, Judge Murray held: “ I find the Janus test to be the appropriate standard to apply in evaluating the extent of Respondents’ conduct. Therefore, with respect to allegations involving documentary evidence, the Division must establish that respondents’ had ultimate authority and control over such documents.”

Judge Murray then carefully reviewed each allegation and concluded either that the Respondents were not responsible for the statement within the meaning of Janus, that the statement was not false, or both. For example, the Initial Decision concludes that Mr. Hopkins was not responsible for the Fact Sheets, a kind of very summary document about the fund, furnished to investors. The Initial Decision concludes that those sheets were written by others. Although Mr. Hopkins reviewed them he was not ultimately responsible for their content. Likewise, the Initial Decision rejects the claim that Mr. Hopkins was responsible for a claimed power point presentation shown to potential investors which supposedly was false and misleading. While Mr. Hopkins could make corrections to the presentation, he was not ultimately responsible for it under Janus.

Similarly Judge Murray repeatedly rejected the Division’s claims that statements were false and misleading. Typical of those findings is one regarding a July 26 letter to investors which was an attempt to explain the under performance of the fund. In part the letter stated that management was trying to reduce risk where appropriate while seeking to avoid putting undue pressure on the assets. The Initial Decision concludes that at the time of the letter the management team believed that in the long term housing market fundamentals would prevail. It goes on to conclude that “it is with the benefit of hindsight that the Division believes it was incumbent on Flannery and Hopkins to warn investors of something that the evidence shows they were unaware of at the time – the vulnerability of AA and AAA rated subprime bonds.” Stated differently, fraud by hindsight is not fraud. And, under Janus there is no primary liability for documents used by a person when he does not control their content under Section 10(b) or Section 17(a), according to the ruling.

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