Last week Morgan Keegan & Co. settled an administrative proceeding centered on the market crisis which claimed that the NAV calculations for certain investment funds made as the markets catapulted downward were false. In contrast, this week the firm prevailed on summary judgment in another market crisis cases with the SEC. This action centered on claims that investors were not given adequate warnings about the risks of auction rate securities as the market unraveled. SEC v. Morgan Keegan & Co., Inc., Civil Action No. 1:09-cv-1965 (N.D. Ga. Opinion and Order dated June 28, 2011).

In Morgan Keegan the Commission brought an action claiming that as the auction rate securities market collapsed the firm continued selling ARS products. Between January 2 and March 19, 2008, the firm sold approximately $647 million of ARS to about 1,145 customers. In making these sales, according to the SEC, the firm misrepresented the risks. The Commission presented testimony from four customers who stated that representatives at the firm told them: ARS are “as good as cash;” ARS are “as good as money;” or the product is “cash equivalents to CDs and money markets;” or they are “just as good as” an investment in a CD insured by the “FDIC;” they are ‘completely liquid except for “a possible 35-day hold;” and ARS presented “zero concerns [and]zero risks;” or they involved “absolutely no risk.”

To bolster its case the SEC pointed to a February 9, 2008 e-mail from the head of Morgan Keegan’s retail ARS desk expressing his concerns about the market. In part it states that ARS auction failures have the “potential to kill consumer confidence and could cause a panic to sell based on fear of losing liquidity. . . [if this happens I fear] a lot of brokers have misrepresented [the] product . . . I know a lot of brokers do not understand the product fully and do not know what a failed auction means. . . “ By the time of this e-mail auctions which rarely failed before 2007, began to fail at increasing rates. By February 12, 2008 there were approximately 100 failures in which Morgan Keegan played some participating role. By that time most ARS underwriters other than Morgan Keegan stopped supporting auction success by placing bids for their own accounts. Subsequently, more auctions failed.

Morgan Keegan had five written disclosures either furnished or made available to investors. First, there was a twenty-four page description of its ARS practices and procedure referred to as the ARS Manual. The Manual tracked the best practices set forth by the Securities Industry Financial Markets Association. It warned customers about the risks including the prospect of auction failure.

Second, the firm issued an annual newsletter to customers in January 2007 and January 2008. It referred investors in ARS to the web site and noted that a written description of the practices and procedures regarding the securities was available. Third, investors received a trade confirmation after each transaction gave the customer ten days to rescind the transaction. Finally, an ARS Brochure reiterated the risks.

On this record the court granted summary judgment in favor of Morgan Keegan. First the SEC claimed that the oral misrepresentations were sufficient to support its claims under Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(c). In making this argument the Commission claimed the firm did not do enough to ensure that customers read the written materials or to adequately distribute them.

The court rejected this argument noting that Morgan Keegan does not have a duty to give each customer a copy of the disclosures and ensure that they are read as contended by the SEC. The firm had available multiple documents with more than adequate warnings. In any event the confirmations notified the customer that the transaction could be rescinded. This “reverse-sale” provision has been found sufficient by the Second Circuit and ensures that unauthorized trading disputes do not devolve into “swearing contests” between the broker and customer, citing Modern Settings, Inc. v. Prudential-Bache, Inc., 936 F. 2d 640 (2nd Cir. 1991).

Second, statements from four investors are insufficient to conclude that the entire firm is liable in an enforcement action. The court concluded that “oral misrepresentations that conflict with written disclosures may, in certain circumstances, form the basis of a Rule 10b-5 action.” This depends on a number of factors including the sophistication of the investor and the nature of the oral representation to determine if reliance on it was justified.

Here however the SEC argues that misrepresentations to four investors by four brokers “is sufficient to create an issue of fact whether all Morgan Keegan brokers made misrepresentations to their ARS customers.” (emphasis original). This proof is simply insufficient the court concluded. The e-mail from the head of the ARS desk is no help here since it expresses only on the fear of the writer. While individual investors may pursue individual remedies, such evidence is insufficient to support an SEC enforcement action against the firm.

Finally, the court agreed with Morgan Keegan that its failure to give investors more strident warnings sooner than it did does not constitute securities fraud. The failure to predict the market is not fraud the court held. Accordingly, summary judgment was granted in favor of Morgan Keegan.

A financial fraud complaint centered on claims that two senior executives of Basin Water, Inc. falsely inflated company revenue beginning before it was publically traded and continuing through the end of 2007 was filed by the SEC. Named as defendants are the founder of the company and its Chairman and CEO, Peter Jensen and the Chief Financial officer Thomas Tekulve. SEC v. Jensen, Civil Action No. CV 11-05316 (C.D. Cal. Filed June 27, 2011).

Basin Water, Inc. designs, manufactures and services groundwater treatment systems. Mr. Jensen founded the company in 1999. It became a public company in May 2006 when its stock was registered for trading with the Commission. In the first quarter of 2006 the two defendants began fraudulently inflating the revenue of the company. Specifically, the two officers caused the company to book revenue contrary to the requirements of GAAP. In this regard the company recorded as revenue:

  • Sales that were contingent on the customer’s acceptance of the treatment system;
  • The resale of a system to the ultimate customer;
  • Sales that did not occur in the quarter;
  • Sales where the company never delivered the treatment system;
  • Sales where collectability was not reasonably assured and for which the company did not receive payment; and
  • Sales to a special purpose entity the defendants created and which involved round trip sham transactions.

As a result Basin’s revenues were overstated by 13% in 2006 and 74% in 2007 according to the complaint.

On August 11, 2008 the company announced it was restating its financial results. The restatement was issued in February 2009.

Prior to the announcement Mr. Jensen sold 1,660,943 shares of company stock realizing profits of $9,173,075. He also donated 290,000 shares of stock for which he took tax deductions of $763,345. These transactions took place while he was in possession of material non-public information about the financial condition of the company.

The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(5) and 20(a). The complaint also alleges that the defendants failed to comply with Section 304(a) of SOX. The case is in litigation.

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