by T. GormanPosted on Posted in SECActions

The SEC and the NY AG have been successful in settling a series of market crisis cases centered on the collapse of the auction rate securities market in March 2008. In litigation both regulators have experienced more difficulty however. Earlier this year the court ruled against the SEC and in favor of Morgan Keegan & Co. in an ARS case, granting the firm’s motion for summary judgment (here). There the court concluded despite false claims that the securities were “liquid” and “the same as cash” the risks of a market collapse had been adequately disclosed in a series of firm marketing materials to preclude liability. SEC v. Morgan Keegan & Co., Civil Action No. 1:09-cv-1965 (N.D. Ga. Opinion and Order dated June 28, 2011).

The New York AG’s Martin Act complaint against Charles Schwab & Co., Inc. alleging false representations in connection with the sale of ARS suffered the same fate as the SEC’s case – it was dismissed. The People of the State of New York v. Charles Schwab & Co., Index No. 453388/2009 (N.Y. Sup. Ct.). The action against Schwabis similar but not identical to the one brought against Moran Keegan. In its complaint the AG alleged that the broker sold action rate securities to its customers based on false representations that the securities were liquid, similar to money market funds and essentially the same as cash. The complaint cited passages from audio tapes of Schwab representatives making the sale pitch using these and similar descriptions to customers.

The complaint also alleged that the sales force was inadequately trained regarding the risks of ARS. The sales staff was not told that in fact the liquidity of the market depended on the supporting bids of the sponsoring underwriter the AG claimed. This allegation was backed by statements obtained from firm sales personnel.

Finally, investors were not told what Schwab learned in the fall of 2007. It was during that period that the firm saw the market begin to experience difficulties.

The court dismissed the complaint, concluding that it failed to allege the statements were false. Under the Martin Act the AG is required to demonstrate only that the challenged act or practice was misleading in a material way. The court however concluded that the statements made to investors at the time were not false. At the time the representations were made the market had been in operation for 20 years. Thus the representations were not false.

In motion papers the AG re-characterized his claim as a failure to explain the risks of future illiquidity. While the court noted that the paragraphs of the complaint cited by the AG referenced a failure to adequately warn the customers, it concluded that “this is not a failure to disclose case.” Rather, the focus is on the representations at the time they were made. At the time they were made the representations were made they were not false. Accordingly, the case was dismissed.

Program: The ABA National Institute On Securities Fraud is being held on November 3-4, 2011 in New Orleans. This is one of the premier securities law programs each year. For more information please click here.

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by T. GormanPosted on Posted in SECActions

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. SEC v. Whittemore, No. 10-5321 (D.C. Cir. Oct. 28, 2011).

The underlying enforcement action was brought against Peter Cahill and another group identified as the Whittemore defendants. The complaint centered on an alleged pump and dump scheme involving a thinly traded penny stock quoted in the Pink Sheets. Mr. Cahill and other defendants consented to the entry of permanent injunctions but reserved the resolution of questions regarding disgorgement to the court. The district court entered an order which concluded that Mr. Cahill was liable for disgorgement in an amount based on valuing the stock from the scheme at zero, effectively finding that the entire sale price was the proper measure of the remedy. The court also concluded that Mr. Cahill could be held responsible for the entire amount of the disgorgement despite his claim that he had transferred a portion of the proceeds to others and that he is jointly and severally liable with the other defendants.

The Circuit Court affirmed. First, the Court concluded that using a zero basis for the value of the stock was appropriate. Separating legal from the illegal profits exactly may at times be virtually impossible the court held. Thus the SEC is only required to make a reasonable approximation of profits causally connected to the violation. Here the agency argued that the stock should have a zero basis while the Appellant claimed that the proper value is $0.32 per share. The value offered by Mr. Cahill however was from one market quote in an otherwise illiquid market. In fact the evidence demonstrates that the stock was rarely quoted. In addition, there is no evidence that Mr. Cahill could have sold the block of stock he obtained in the scheme. Under these circumstances it was appropriate for the SEC to use a zero basis to meet its initial burden. At that point the burden shifted to Mr. Cahill to demonstrate the value of the shares prior to the fraud. Since he failed to offer any evidence on this point, the district court’s calculation was appropriate.

Second, the district court correctly concluded that Mr. Cahill was liable for the entire amount of the disgorgement. A disgorgement order, the court held, pertains to “’a sum equal to the amount wrongfully obtained, rather than a requirement to replevy a specific asset’ and ‘establishes a personal liability, which the defendant must satisfy regardless [of] whether he retains the selfsame proceeds of his wrongdoing,’” quoting SEC v. Banner Fund International, 211 F. 3d 602 (D.C. Cir. 2000). Thus a person who controls the distribution of funds such as Mr. Cahill is responsible for those he retains and those he distributes.

Finally, the Court found it appropriate under the circumstances here to hold Mr. Cahill jointly and severally liable with the other defendants. Mr. Cahill argued that to impose such liability the court had to find that two or more individuals or entities collaborate and have a close relationship in engaging in the illegal conduct. While these tests are appropriate the Court noted, they should be stated in the disjunctive. Accordingly, once the Commission established the 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.

Program: The ABA National Institute On Securities Fraud is being held on November 3-4, 2011 in New Orleans. This is one of the premier securities law programs each year. For more information please click here.

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