SEC ENFORCEMENT TRENDS 2011: Analysis and Conclusions

This is the final installment in a series of articles that has been published periodically analyzing the direction of SEC enforcement.

The Division of Enforcement is critical to the overall mission of the SEC. To bring a new ethics to the market place it is essential that the enforcement program effectively monitor that market and halt malfeasance. Equally critical, the program must deter future violations through its presence, the actions it brings and the remedies obtained in those cases.

When SEC Enforcement began its historic reorganization the program was at a cross-roads. Once it was well respected and considered one of the most effective in government. Scandals and malfeasance tarnished that reputation, leaving many viewing the agency as ineffective or perhaps worse. Some critics suggested it be merged while others thought it should be abolished.

Yet not only has it survived but Congress has fortified the Commission with new weapons, broadening the reach of the antifraud provisions and strengthening its remedies. At the same time new inter-agency task forces have broadened and fortified its reach. All of this should place the newly streamlined program in a good position to achieve its goals. Yet many question whether the agency has moved past the cross-roads.

To be sure, in recent months the enforcement program has compiled impressive statistics. In the most recent fiscal year the SEC opened more investigations, filed more cases and secured more orders for more dollars than in the prior year. Although once criticized for not brining actions against major players, in recent months cases have been initiated against Wall Street titans such as Goldman Sachs, Citigroup and Bank of America. Others were brought against market place giants General Electric, Dell Inc. and Johnson & Johnson.

The SEC has also notched significant settlements in large, headline grabbing cases. Wall Street icon Goldman Sachs made an unheard of admission of error in settling with the Commission while consenting to a fraud injunction and agreeing to pay a record setting civil penalty. The SEC also obtained significant settlements in actions against the key former officers of sub-prime lending giants Countrywide and New Century Financial while bringing its first enforcement action against a state.

There are troubling signs however. The settlements in Bank of America and Citigroup, both major enforcement actions, raise serious questions. In both cases the court initially declined to enter the proposed settlement. In both cases the complaints contain allegations of intentional misconduct which belied by the terms of the proposed settlements, causing the courts to balk at executing the proposed consent decrees. In Bank of America the court went so far as to call the Commission’s investigation a sham. Despite the fact that the judge in each case acknowledged it was not their position to second guess the SEC, neither would sign off on the settlements without revisions to the agreements.

Equally disturbing are the results in the courtroom. While the agency has won cases at trial, it has also lost a significant number, an usual occurrence for a prosecutor. More disturbing however, are comments from the bench noting not just a failure of proof but at times inappropriate tactics such as an argument totally lacking in evidentiary support or the misinterpretation of proof such as misreading an order ticket for the purchase of a security. Every program has a few difficulties. Here there are enough to be called a red flag.

The program is, nevertheless, moving forward, if only in fits and starts while at times still dodging the scandals of the past. An analysis of the Commission’s recent cases in key areas suggests its future course:

• The market crisis cases: The action against Goldman Sachs is not just the most significant market crisis case but the most notable action brought in some time by the Commission. Built on exceedingly complex transactions, the case is at the center of what many believe caused or at least greatly contributed to the market crisis. The Mozilo and Morrice cases against, respectively, executives from Countrywide and New Century were also significant. Unfortunately the difficulties with Citigroup raised significant questions while Bank of America was nothing short of an embarrassment. In view of the depth and breath of the market crisis and the huge amount of resources expended on the ensuing investigations, it would seem that there should be more cases.

• Insider trading: The headlines in this area go to the Manhattan U.S. Attorney. The conviction of Raji Rajaratnam, the aggressive investigation of the expert networks and the wholesale use of blue collar tactics on a scale not seen before in this type of investigation are significant. The Commission however has been equally aggressive but in a manner which many have overlooked by many. In selected cases the SEC is gradually pushing out the edges of insider trading law. Cases such as Cuban and Onubus present issues about the nature of the agreement under which confidential information is obtained and the obligation of its recipient. Others such as Steffes and the recently filed Carollaction (here) raise questions about the viability of the mosaic theory and the use of what can appear to be routine information observed by employees. These trends, together with a renewed emphasis on Reg FD, may eventually rewrite insider trading law into a kind of parity of information standard which was rejected by the courts years ago. In the long run this trend will have a more significant impact on the market than the headline grabbing blue collar tactics. It should also be of concern to compliance officers.

• FCPA: This is an area in which the SEC aggressively took charge years ago. While FCPA enforcement today continues to be a Commission priority, DOJ dominates the scene. This is not to say that the SEC is not playing an important role. The Commission’s approach and settlements however often belie the statements of its officials. In the beginning the focus was on self-reporting and preventing future violations. Initiatives like the 1970s volunteer program encouraged and rewarded self-reporting. The settlements of that era were remedial and focused on future prevention. Today DOJ and the SEC both emphasize these same themes. Yet it is DOJ which frequently highlights the cooperation of a company in an FCPA investigation and points out its benefits in the settlement papers. The SEC, in contrast, frequently says little about the cooperation of the company while imposing settlement terms in cookie-cutter fashion. While there is no doubt that the threat of criminal charges will always be a key focus for any company, the SEC needs to return to its roots and embed in its program the notion of compliance which prevents violations and cooperation which aids in effectively resolving them. The recent announcement that the Commission entered into its first non-cooperation agreement and that the underlying mater in an FCPA case, may signal the beginning of such an effort (here). At the same time, issuers would do well to revisit their compliance procedures, ensure that they are fully integrated with internal controls and extend to agents who are all too frequently at the center of FCPA charges.

• Financial fraud: Many of the recent financial fraud actions have evolved out of the market crisis. Cases like Citigroup, Mazilo and Morrice center on disclosure claims which key to financial fraud. Some cases such as Krantz, the action against the outside directors of bullet proof vest manufacture Point Blank, may suggest a new level of scrutiny for corporate directors. At the same time the settlements in cases like Citigroup and Dell, where the conduct as described in the complaints appears intentional but the resolution is based on lesser charges, suggest an evolving claim of failure to monitor by corporate officials reminiscent of a kind of Caremark duty. In re Caremark Derivative Litigation, 692 A. 2d 959 (Del. Ct. Ch. 1996). At the same time the SEC has made it clear that it will aggressively assert Section 304 of Sarbanes Oxley, demanding repayment from CEOs and CFOs of certain incentive based compensation where there is a restatement tied to wrongful conduct despite the fact that the executives were not involved in any malfeasance. The evolution of a failure to monitor approach should encourage vigilance by corporate officials and perhaps foster cooperation. In contrast the SEC’s administration of Section 304 can only be viewed as counter productive, discouraging incentive compensation, restatements and self-reporting. These conflicting trends should be carefully monitored and assessed by issuers when evaluating incentive based compensation, considering a restatement or faced with a self-reporting decision.

• Regulated entities: The recent key cases in this area, which are largely tied to the market crisis, center on undisclosed conflicts of interest, overreaching and not disclosing the impact of the market crisis on the firm. Others are tied to self-dealing at the expense of the clients.

The trends from these cases clearly indicate a program which is moving forward and should be carefully monitored by issuers and their directors and officers. Equally clear are the red flags of troubles within the enforcement program. Lurking in the background seems to be the never quite gone scandals of the past. Together these trends represent a program in transition. In the end whether it continues to move forward and once again becomes a highly effective and respected regulator and enforcer may well a function of the final results from the on-going market crisis investigations and the ability to move past old scandals.

THIS WEEK IN SECURITIES LITIGATION (May 20, 2011)

This week SEC Enforcement continued to implement its new cooperation initiatives, moving forward from the spectacle of the Stanford testimony last week and the past. The Commission executed its first deferred prosecution agreement. The fact that it resolved an FCPA case, an area in which the agency has stood in DOJ’s shadow in recent years, may suggest a new approach in this key enforcement area. The agency also filed a settled insider trading case, resolved a financial fraud action and brought more investment fund fraud cases.

DOJ obtained guilty pleas in two cases this week. One concluded an insider trading case. The other was the fifth in an FCPA investigation.

Market Reform

Credit rating agencies: Implementing sections of Dodd-Frank, the Commission issued proposed rules regarding credit ratings and the operations of Nationally Recognized Statistical Rating Organizations. The proposals include provisions which would require reports on internal controls, protect against conflicts of interest and require that professional standards be established for credit analysts. They also require disclosure of the methodology used to determine rulings and that would enhance the disclosures about the performance of the ratings (here).

Testimony: SEC Enforcement Director Robert Khuzami and FINRA Chairman & CEO, Rick Ketchum testified before the House Subcommittee on Oversight and Investigations regarding the response of their respective agencies for failing to detect earlier the alleged Stanford Ponzi scheme. Mr. Khuzami’s remarks are here and those of Mr. Ketchum here.

SEC Enforcement – the first deferred prosecution agreement

The SEC and Tenaris S.A resolved and FCPA case with the Commission’s first deferred prosecution agreement.

The agreement: Under its terms the company agreed to pay $5.4 million in disgorgement and prejudgment interest. Tenaris also accepted responsibility for its actions and agreed “not to contest or contradict the factual statements” regarding the underlying conduct detailed in the agreement. As part of the agreement Tenaris will continue to cooperate with the SEC. The company also agreed to: 1) provide the Commission with a written certification of compliance prior to the end of the agreement in 2013; 2) annually review and update its Code of Conduct; 3) require that each director, officer and management level employee certify compliance with the Code of Conduct on an annual basis; and 4) conduct FCPA training and supervision for all officers and managers, finance employees, and others working in areas implicated by its anticorruption and compliance policies and future employees. Tenaris resolved possible charges with DOJ by entering into a non-prosecution agreement. The company also agreed to pay a criminal fine of $3.5 million.

The underlying case: The FCPA violations are based on the following facts: Tenaris is a Luxembourg based international seller of steel pipe products and related services to the oil and gas industry. In 2006 and 2007 Tenaris bid on contracts with OJSC O’ztashqineftgaz (“OAO”) to supply pipeline for the development and production of oil and natural gas in Uzbekistan. OAO was a subsidiary of Uzbekneftegaz, a state owned holding company of Uzbekistan’s oil and gas industry.

To facilitate the bidding process the company retained a local agent who provided the company with confidential information about the bidding process. As a result, it was successful in obtaining contracts during the time period which generated almost $5 million in profits. The agent was paid a commission, portions of which went to state officials as bribes.

Cooperation: Tenaris learned of the bribes in March 2009. The audit committee immediately retained counsel who launched an internal investigation. In a filing with the SEC on June 30, 2009 Tenaris disclosed the customer allegations that lead to the inquiry and the investigation, noting that it had self-reported to DOJ and the SEC. The next month counsel for the company briefed DOJ and SEC officials, promising to conduct a more detailed investigation and report again.

Subsequently, the company conducted a world-wide inquiry of its business operations and controls. It also provided DOJ and the SEC what the latter called “extensive, through, real-time cooperation . . .“ making full voluntary disclosure of the underlying conduct. The company also enhanced its compliance measures. The steps taken include the adoption of a strengthened Code of Conduct, Business Conduct Policy and Agent retention Procedure that addresses anticorruption and compliance with the FCPA.

SEC enforcement – other actions

Insider trading: SEC v. Knight, Civ. 2:11-cv-00973 (D. Ariz. Filed May 18, 2011) is a settled action against Mary Beth Knight, a senior vice president of Choice Hotels, and her long time friend, Rebecca Norton. On June 22, 2006 Ms. Knight attended a meeting for senior executives. During the meeting earnings projections for the quarter were discussed based on materials the executives had been furnished. The projections estimated that the company would fail to meet street expectations by one cent. In an earlier period the market had reacted adversely when the company did not meet street expectations. Subsequently, Ms. Knight told her friend Rebecca who, between June 26 and July 7 sold 3,229 shares of Choice Hotels stock. She also sold shares short. Ms. Knight sold 12,000 shares of company stock on June 27, 2006. When the earnings announcement was released the share price dropped the next day nearly 25%. As a result Ms. Norton avoided losses of $65,747 and made a profit on her short position of $7,690. Ms. Knight avoided losses of $140,400.

Both defendants settled, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). In addition, Ms. Knight agreed to disgorge the loss avoided of $140,400. That obligation was deemed satisfied by the fact that Ms. Knight had previously given this amount to the company. Ms. Knight also agreed to disgorge the losses avoided and profits made by her friend and pay a penalty of $185,111. Ms. Norton agreed to pay a civil penalty in an amount determined by the court.

Investment fund fraud: In the Matter of Armando Ruiz, Adm. Proc. File No. 3-14388 (May 16, 2011) names as Respondents Armando Ruiz and his controlled entity, Maradon Holdings, LLC. From early 2008 through May 2009 while he was a registered representative at Legend Securities, Mr. Ruiz raised about $817, 500 from family members and friends by claiming to sell them interests in Maradon. Investors were told the company was going to be developed into a financial services firm to serve the Hispanic community. In reality no shares were issued and Mr. Ruiz took most if not all of the money for himself. The Order alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The action is pending.

Failure to keep records: In the Matter of Legend Securities, Inc., Adm. Proc. File No. 3-14389 (Filed May 16, 2011) is an action naming as Respondents the firm and Salvatore Caruso, its founder, President and Chief Compliance Officer. According to the Order, in March 2009 the SEC inspection staff requested that Mr. Caruso provide on behalf of the firm various records including those regarding its employees. When Mr. Caruso discovered that he did not have all the required records regarding one employee he e-mailed that person and had them fill out the forms. Those records were then furnished to the inspection staff. The Order alleges violations of Exchange Act Section 17(a) by the firm for failing to keep required records and aiding and abetting that violation by Mr. Caruso. Both Respondents settled, consenting to the entry of cease and desist orders. The firm also agreed to pay a civil penalty of $50,000 while Mr. Caruso will pay $25,000.

Investment fund fraud: SEC v. Barriger, Civil Action No. 11 Civ 3250 (S.D.N.Y. Filed May 13, 2011) is an action against Lloyd Barriger, adviser to the Gaffken & Barriger Fund and Campus Capital Corp. The complaint claims that from January 1998 through March 2008 the G&B fund raised about $20 million and Campus about $12 million. Mr. Barriger is alleged to have defrauded the investors in the G&B fund by failing to disclose its true condition to them while representing it was a safe and liquid investment that paid a premium return of 8%. Although the fund returns were insufficient to pay that premium he credited it in investor accounts and paid it to withdrawing investors. As the market crisis unfolded Mr. Barriger was forced to disclose the true condition of the fund. Prior to those disclosures Mr. Barriger caused Campus to inject $2.5 million into G&B without telling its investors the true financial condition of the G&B fund. The complaint alleges violations of Securities Act Sections 5 and 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and 206 (2). Parallel criminal charges were also filed. Both cases are pending.

Financial fraud/violation of c&d: SEC v. Thor Industries, Inc., Case No. 1:11-cv-00889 (D.D.C. Filed May 12, 2011) is an action against the company and Mark Schwartzhoff. The complaint alleges that Mr. Schwartzhoff, a former v.p of finance of a principle subsidiary of Thor, falsified the books of that sub from 2002 through January 2007 by understating the cost of goods sold to avoid recognizing inventory costs not reflected in the financial accounting system. He did this by making baseless manual journal entries and creating false documents. This materially overstated the pre-tax income of the subsidiary and ultimately resulted in Thor restating its financial statements. The complaint also claims that the fraud was possible because Thor had materially weak internal controls. This violated a 1999 cease and desist order.

The company settled the case, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act sections 13(a), 13(b)(2)(A) and 13(b)(2)(B. It also agreed to pay a $1 million civil penalty for violating the earlier order and to retain an independent consultant to review and evaluate certain internal controls and record keeping policies and procedures. This settlement reflects the cooperation of the company. Mr. Schwartzhoff also settled, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 13(b)(5) and from aiding and abetting violations of the sections cited in the Thor decree. In addition, he agreed to pay disgorgement of $299,805 plus prejudgment interest, to the entry if an officer and director bar and, in a related Rule 102(e) case, to the entry of an order suspending him from appearing or practicing before the Commission as an accountant. In a related criminal case Mr. Schwartzhoff pleaded guilty to one count of wire fraud and was ordered to pay restitution of $1.9 million. His financial obligation under the settlement with the Commission will be deemed satisfied by paying the restitution order in the criminal case.

Criminal cases

Insider trading: U.S. v. Corbin, No. 09-cr-00463 (S.D.N.Y.) is an action against Daniel Corbin which alleged that he and three others engaged in illegal trades using confidential information obtained from the wife of one of the conspirators,, James Devlin. Mrs. Devlin is an executive at public relations firm and had access to confidential corporate information. Previously the three other conspirators pleaded guilty. They are Jamil Boucharb, a former Lehman salesman, Frederick Bowers, Eric Holzer, a tax lawyer at Paul Hastings and Mathew Devlin. This week Mr. Corbin pleaded guilty to one count of securities fraud based on trading on inside information about Veritas DGC Inc. in advance of the announcement that the firm had entered into an agreement to be acquired by Compagnie Generale de Geophysique SA. He made $16,000 in profits on the trade. Mr. Corbin faces six to twelve months in prison under the terms of his agreement. The sentencing date has not been set.

FCPA

U.S. v. Grandos, Case No. 10-2088 (C.D. Fla.) charges former Latin Node Inc. CEO Jorge Grandos with violating the FCPA. Mr. Grandos pleaded guilty to conspiring to violate the anti-bribery provisions of the Act. The case is based on over $500,000 in bribes paid by the company to officials in Honduras. The company is a provider of telecommunications services using internet protocol technology to countries around the world. The company agreed to pay bribes to officials at Empresa Hondurena de Telecommunicaciones or Hondutel, the state owned telecommunications authority in Honduras in connection with a bid for an interconnectedness contract. Portions of the money was laundered through accounts of a company subsidiary in Guatemala to accounts in Honduras controlled by government officials. The company was awarded the contract in December 2005. The date for sentencing has not been set.

Mr. Grandos is the fourth company executive to plead guilty. In April 2009 the company also pleaded guilty. As part of the plea agreement the company will pay a $2 million criminal fine.