by T. GormanPosted on Posted in SECActions

The Section 304 of Sarbanes Oxley requires the CEO and CFO to repay certain incentive compensation in the event there is a restatement of the company’s financial statements based on wrongful conduct. Few court decisions have construed the Section.

The Commission, however, has invoked it to demand that a CEO repay incentive compensation while admitting that the executive was not involved in the underlying conduct, essentially imposing strict liability. SEC v. Jenkins, Case No. CV-09-01510 (D. Ariz. Filed July 22, 2009) (here) is an action against the former CEO of CSK Auto Corporation in which the Commission asserted such a claim. Mr. Jenkins has disputed the Commission’s view. The case is in litigation. In contrast, the former chairman of Diabold Inc, Walden O’Dell chose not to contest the SEC’s view. He recently settled a Section 304 claim based on strict liability. SEC v. O’Dell, Civil Action No. 1:10-CV-00909 (D.D.C. Filed June 2, 2010) (here). Sometimes the SEC chooses not to invoke the Section. See, e.g., SEC v. Dell, Inc., Civil Action No. 1:10-cv-01245 (D.D.C. Filed July 22, 2010) (here) (settled financial fraud action against the company and its chairman Michael Dell in which 304 was not invoked).

The SEC’s view and authority under Section 304 has been bolstered by the Second Circuit’s recent decision in Cohen v. Viray, Case No. 08-3860-cv (2nd Cir. Sept. 30, 2010) (In re: DHB Industries, Inc. Derivative Litig. ). There, the court concluded that a company cannot indemnify a former corporate executive from any liability under the Section.

Cohen arises out of efforts to settle consolidate class and derivative actions against DHB Industries, Inc., its former CEO, David Brooks and others. The suits began in the fall of 2005 following a severe drop in the stock price of the body armor manufacturer after publication of the fact that its products were made of an inferior material which rapidly deteriorated. Later, Mr. Brooks and others were indicted on securities fraud and other charges which claim they essentially looted the company. Mr. Brooks was recently convicted (here). Parallel SEC enforcement actions are pending (here).

An initial settlement proposal in the derivative suit was presented to the district court in December 2006. In October 2007, DHB restated its financial statements for 2003, 2004 and the first three quarters of 2005. Mr. Cohen filed objections to the proposed settlement, challenging the fees to be paid.

Following the issuance of the restatement, DOJ petitioned the district court under the Class Action Fairness Act for an extension of time to review the settlement. Subsequently, the government objected. DOJ argued that the proposed settlement limited the government’s remedies in the then-pending criminal cases and undermined the efforts of the SEC to hold individuals liable under SOX Section 304. The government’s objections were based on two provisions of the proposed settlement agreement. In one, DHB released Mr. Brooks and another officer from any liability under Section 304, although an amendment provided that this was not intended to limit the government’s remedies in the criminal cases. In another, the company agreed to indemnify Mr. Brooks and another officer for any liability under Section 304 incurred “in any action brought by a third party . . .” The district court overruled the objections and approved the settlement.

The Second Circuit reversed. The court began by considering the question of whether Section 304 contains a private cause of action. Since the statute does not explicitly provide for such a right, the court presumed that Congress did not intend to create one. That conclusion is fortified by the text of the Section and the structure of the statute, according to the court. The text of Section 304 “imposes a mandatory duty on those subject to it . . .” In this regard, Congress provided that only the SEC can exempt persons from liability under Section 304. The fact that other provisions of SOX contain an express private cause of action and Section 304 does not confirmed the court’s conclusion.

The Second Circuit went on to conclude that the settlement provisions violate Section 304. Only the SEC has authority to enforce Section 304 and to exempt a CEO or CFO from liability. In view of this fact, it is clear that the “Settlement’s release and indemnification provisions attempt an end-run around Section 304 that vitiates the SEC’s role and is inconsistent with the law. If allowed to stand, it would effectively bar the relief the SEC is authorized to seek.” This would “fly in the face” of Congress’ efforts to hold senior corporate officials accountable, the court noted.

Finally, permitting the provisions of the settlement agreement to stand would undermine the important public policy predicate of Section 304. In creating the remedy, Congress sought to ensure the integrity of the financial markets. The provisions here are void, the court concluded.

by T. GormanPosted on Posted in SECActions

The Commission filed an unusual investment fund fraud action in SEC v. Chiaese, Civil Action No. 10-cv-5110 (D.N.J. Filed Oct. 5, 2010). In what is now the new staple of SEC enforcement, the typical case alleges that the individual defendants and their related entities raised funds from a number of individuals. False claims of easy, quick, large and safe profits are made. Account statements are furnished detailing the success of the investment scheme and the judgment of the investor. It turns out much of the money is gone, the statements were false and the promoters are living large. The SEC and sometimes DOJ wind up the operation, salvaging for investors what they can.

The complaint in Chiaese has some of the usual allegations. It differs from most, however, because it is built on a series of stories from individual investors who furnished their money to the defendants. Absent are the usual “get-rich-quick” misrepresentations. In their place were claims that funds would be invested in accord with investor directives. Investors were, however, furnished with the usual statements verifying their increasing wealth.

The defendants in this scam are Carlo G. Chiaese, a registered representative associated with a broker dealer. Defendant Micol Chiaese is Carlo’s wife. C.G.C. Advisors, LLC is an entity controlled by the individual defendants. The complaint chronicles the investment efforts of six clients identified with various abbreviations. For example:

• One investor client is a Union Pension Fund. According to the complaint, in November 2008 the Union Fund became an advisory client of Mr. Chiaese. In accord with its instructions, he agreed to invest the money conservatively in bonds and mutual funds. The Union Fund wired $1,715,241.30 to the CGC Bank Account. Subsequently, account statements were sent to the Union Fund depicting the purchase of bonds and mutual fund shares as instructed.

• A married couple identified as the “Ps” also invested with Mr. Chiaese in 2008. Previously they had put their hard earned cash in mutual funds sold by the broker dealer where Mr. Chiaese worked. The shares were in an IRA account. In a series of transactions over a period of months, the couple invested with Mr. Chiaese. In November 2008, for example, the Ps gave him $50,000 and directed it be put in a CD. In September or October 2009 the couple liquidated their brokerage account based on the advice of Mr. Chiaese and transferred $211,390.96 to him for investment. In early 2010, the couple told Mr. Chiaese to invest about $160,000 in various funds. The money was a severance package Mr. P received on being terminated from his job.

• Client “AD,” began investing with the defendants on the recommendation of Mr. Chiaese’s father-in-law, a friend of AD. In a number of transactions AD invested money with Mr. Chiaese. First AD directed that over $168,000 be put in mutual funds. Later, another $50,000 was to be used to purchase an annuity. The client was given statements verifying his investments.

Overall at least $2.5 million was invested by the six clients with the defendants. While the complaint is different from those in many of these cases, the end is the same. The statements were false, according to the SEC. The money was misappropriated and used by the individual defendants to enhance their life style.

The SEC complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Sections 206(1) and 206(2) of the Investment Advisers Act. The Commission sought emergency relief to freeze the assets. As the complaint makes clear by detailing the lavish life style of the individual defendants, much of the cash is gone. The case is in litigation. See also Litig. Rel 21684 (Oct. 5, 2010).

Program: Fifth Annual Securities Fraud National Institute, October 7-8, 2010 in New Orleans. For further information on this excellent program please click here: http://www.abanet.org/cle/programs/securitiesfraud/