COURT APPROVES SEC SETTLEMENT IN CITGROUP – BUT QUESTIONS REMAIN

Two cases in recent months have peered into the SEC’s normally opaque charging and settlement processes and raised disturbing questions. Bank of America, resolved earlier this year took repeated hearings to secure approval of the SEC’s settlement with the Bank. The case was significant, charging that the bank defrauded its shareholders when soliciting approval for its acquisition of then failing Merrill Lynch. (here). The Commission and the Bank eventually secured court approval of the deal. It came only after repeated hearings and explanation. In the process, the court required that the procedures intended to prevent a reoccurrence be bolstered. The amount of the penalty which the SEC claimed would achieve this result was increased. Judge Rakoff also conducted an extensive review of the evidence about the participation by various individuals in the decision to withhold critical information from the shareholders. Reluctantly, the court finally agreed to sign the consent decree.

More recently, the Commission had the same difficulty obtaining court approval of its proposed settlement with Citigroup. That case is based on claims that the bank made false statements to investors about its exposure to the sub-prime market (here). As in the Bank of America, the SEC and the Bank proposed to settle with the payment of a fine and procedures implemented to prevent a future reoccurrence of the wrongful conduct. This time, however, the SEC named two bank officers as Respondents in related administrative proceedings.

Again, the court had piercing questions about the settlement. Additional briefing was ordered in which the parties discussed the procedures, the amount of the penalty and who was involved in the underlying conduct.

On Friday, Judge Huvelle reluctantly approved the Citigroup settlement. In doing so, the Court essentially deferred to the SEC’s judgment regarding the liability of bank officers for the false statements. Repeated language in the complaint raised questions since it at least suggests that individuals other than the two officers named in the administrative proceedings were involved. Judge Huvelle also made it clear that she did not view the $75 million penalty – or for that matter even a $100 million penalty – as any type of a deterrent to future violations by a company the size of Citi, despite claims to the contrary by the parties. This is, of course, consistent with Bank of America’s position in its case. There, the Bank made it clear it would pay a large fine to make peace with the SEC.

As in Bank of America, the court focused on the procedures being installed to prevent a replication of the wrongful conduct in the future. Before signing off on the deal, Judge Huvelle ordered the SEC to certify that Citigroup actually put in place the procedural remedies cited in the papers.

Bank of America and Citigroup should serve as a wake-up call to the SEC. In each case, the court raised significant questions about the terms of the settlements focusing on the remedies in the consent decrees to prevent a future reoccurrence of the claimed wrongful conduct as well as the exercise of prosecutorial discretion in the charging process. In each case, after reading the SEC’s complaint, the court raised questions about its decision on who to charge. This suggests that either the agency is over-stating the facts in the complaint or it is not properly exercising its charging discretion. The fact that the court ultimately deferred to the SEC’s decision in each instance after a more careful review of the case suggests that the former is true. If so, in the future the Commission should implement procedures to give more scrutiny to the facts inserted in complaints. This will help avoid not only the difficulties encountered with these settlements, but also cases such as the Rorech insider trading action where the proof failed at trial to match the allegations of the complaint (here).

Equally important, however, are the questions raised about the terms of the settlement in each case. As both Judge Rakoff and Judge Huvelle recognized, a key focus of any SEC settlement is the steps taken to prevent a reoccurrence of the wrongful conduct. It is axiomatic that the SEC’s mission is not just to halt conduct which violates the law, but also to bring a new ethics to the marketplace. This begins by ensuring that market participants move forward in a fashion which is fully consistent with the letter, as well as the spirit, of the federal securities laws. Thus, in Bank of America, Judge Rakoff directed the parties to add provisions to the procedural remedies to meet these goals. Judge Huvelle in Citigroup ordered the SEC to certify compliance with the procedures.

Large fines generate great headlines, sound good in congressional testimony and make great statistics, but have little real deterrent value for big corporations who are more than prepared to pay big dollars to end an SEC inquiry and move on. Properly crafted procedural provisions can have a lasting impact that implements the goals of the federal securities laws.

In the end, these cases suggest that the SEC conduct a critical evaluation of its settlement procedures. The SEC has broad charging discretion and a wide range of remedies which can be used to fashion effective remedies. For the Commission to be an effective regulator of the securities markets – the agency is not a prosecutor piling up convictions and big fines – it is essential that the enforcement program be effective at halting wrongful conduct and preventing it from reoccurring. Complaints which overstate the facts and remedies keyed to big dollar penalties will generate headlines, but are not necessarily effective enforcement. Rather, complaints charging violations based on carefully presented facts coupled with remedies that halt violations and make sure that they will not reoccur are the keys to a successful enforcement program and an agency fulfilling its statutory mandate.

THIS WEEK IN SECURITIES LITIGATION (September 24, 2010)

On Capital Hill, hearings were held on the state of SEC Enforcement. A bill passed a Senate Committee to repeal Section 9291 of Dodd-Frank which gives the SEC authority to withhold certain documents from FOIA requests. In addition, legislation passed in the House which generally would require those who violate the FCPA to be debarred.

SEC Enforcement lost one insider trading case at trial, but prevailed in the Fifth Circuit in its action against Mark Cuban. The Division also brought more investment fund fraud actions, while settling with another defendant in the Delphi financial fraud case.

Finally, a former Disney administrative assistant followed in the path of her boyfriend and pleaded guilty in an unusual insider trading case. The former aide, and her boyfriend, had shopped inside information and ultimately tried to sell it to an undercover FBI agent.

Reform

Senate hearings on Enforcement: SEC Enforcement Director Khuzami testified on Capital Hill, highlighting the completion of the reorganization efforts he initiated after becoming Director as discussed here. He went on to recount the recent achievements noting that in fiscal 2010 the Division had filed 634 enforcement actions; obtained disgorgement orders totaling $1.53 billion; secured orders requiring the payment of $968 million in penalties; obtained 45 emergency temporary restraining orders and 56 asset freeze orders; and distributed nearly $2 billion to injured investors from 42 separate Fair Funds.

Mr. Khuzami then reviewed a number of significant cases including the actions against Goldman Sachs & Co., ICP Asset Management LLC, Lee B. Farkas, Citigroup, LACE Financial Corp, Morgan Keegan & Co. and State Street Bank as well as the Moody’s Section 21(a) report.

Rose Romero, Forth Worth Regional Office director, largely reiterated the Director’s comments. She also expressed her regret that the SEC failed to act more quickly to limit the investor losses suffered by Robert Allen Stanford. She then recounted the significant actions the Commission has taken since filing its case against Mr. Stanford to improve operations. Ms. Romero also noted that additional Wells notices have been issued in the Stanford investigation, which is continuing.

Finally, the SEC Inspector general reviewed his report on the investigation into Enforcement’s inquiry of the Stanford matter, discussing his view as to the reasons a case was not brought earlier. His report on that matter has been available since March. The IG also speculated during his testimony as to the reasons for the timing of filing the Goldman case.

Dodd-Frank Section 9291: The Senate Judiciary Committee approved a bill (S. 3717) that would repeal this Section (here) which permits the SEC to withhold certain records from the public. The exemption from the FOIA had long been sought by the Commission and was the subject of Chairman Schapiro’s recent testimony.

FCPA: The House unanimously passed the 2010 Overseas Contractor Reform Act, H.R. 5366. Generally, the bill requires agencies to debar companies and individuals found in violation of the Foreign Corrupt Practices Act and to sever their existing government contracts and grants. Waivers can be obtained after notice to Congress and justifying the decision.

SEC enforcement actions

Insider trading: SEC v. Obus, Case No. 1:06-cv-3150 (S.D.N.Y.) is an insider trading case against Thomas Strickland, an employee of GE Capital Corp., Peter Black, an employee of Wynnefield Capital, Inc and Nelson Obus, a manager at Wynnefield. The three defendants were found not liable by Judge George Daniels after trial. The action centered on the acquisition of SunSource by Allied Capital Corp. in 2001. According to the Commission, Mr. Strickland, a member of the GE Capital team underwriting the deal, tipped his friend Peter Black, who in turn passed the information on to Mr. Obus, who purchased SunSource shares. Mr. Obus made a profit of $1.34 million on the transaction. The court concluded that Mr. Strickland did not violate and duty and that there was no deception. No confidentiality agreement existed to suggest Mr. Strickland was a temporary insider of SunSource and GE Capital did not have any confidentiality policy that was breached

Investment fund fraud: SEC v. McAdams, Civil Action No. 4:10-CV-00701 (D.S.C. Filed March 18, 2010) is an action against M. Mark McAdams and R. Dane Freeman. The complaint, filed earlier this year, claims that the defendants raised about $3.5 million from investors over a nine month period in 2008. Those funds were to be used to locate and secure high return investment opportunities for investors on international trading platforms. Some of the documents executed by investors in conjunction with the investments promised returns after 60 days of 4,900% Most investors did not receive the promised profits or a return of their investment. Portions of the funds were diverted to other uses. Defendant McAdams settled the action, consenting to the entry of a permanent injunction this week which prohibits future violations of the antifraud provisions of the federal securities laws. Mr. McAdams was also ordered to pay disgorgement, prejudgment interest and penalties in amounts to be determined by the Court. See also Litig. Rel. 21661 (Sept. 23, 2010).

Reg. M violation: In the Matter of Carlson Capital, L.P., Adm. Proc. File No. 3-14066 (Sept. 23, 2010) names as a Respondent Carlson Capital, L.P. a registered investment adviser that manages several funds. In four instances in 2008, Respondent bought shares from an underwriter or broker participating in a public offering after having sold short the same security during the restricted period. As a result, Respondent made over $2 million in illegal profits. These transactions violated Rule 105 of Regulation M, which prohibits buying an equity security made available through a public offering from an underwriter or broker or dealer participating in the offering after having sold short the same security during a restricted period (generally defined as five business days before the pricing of the offering). To resolve this matter, Respondent consented to the entry of a cease and desist order from committing or causing any violations and any future violations of Rule 105 of Regulation M. Respondent was also censured and ordered to disgorge $2,256,386 along with prejudgment interest and to pay a civil penalty of $260,000.

Undisclosed conflicts: In the Matter of Sierra Financial Advisors, LLC Adm. Pro. No. 3-14067 (Sept. 23, 2010) is an action which names as Respondents Sierra Financial, a registered investment adviser and its two principals, Michael Earl and Michael Breakey. Over a three-year period beginning in 2004, Respondents used their discretionary authority to invest client funds in two entities owned by the individual Respondents. Those are PPR Trust, a real estate venture and Southwinds, another residential and real estate venture. In making these investments, Respondents failed to disclose their conflicts of interest to the investors and contrary to their representations. The funds were subsequently used for other purposes. Respondents also failed to keep adequate records or have appropriate written policies and procedures which were reasonably designed to prevent violations of the Advisers Act. As a result, Respondents willfully violated the antifraud provisions of the Securities Act, the Exchange Act and the Advisers Act.

Each Respondent submitted a sworn affidavit demonstrating an inability to pay disgorgement or a penalty. To resolve the matter SFA consented to the entry of a cease and desist order from committing or causing any violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers act Sections 204 and 206(1), 206(2), 206(4) and 207. Respondent Earl also consented to the entry of cease and desist orders based on Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 204, 206(1) and 206(2) and the pertinent rules. Respondent Breakey, who served at SFA’s compliance officer, consented to the entry of a cease and desist order based on the same sections as the order against Mr. Earl with the addition of Advisers Act Section 207. SFA also resigned as an investment adviser while the individual Respondents were barred from association with any investment adviser and are prohibited from serving in essentially any capacity with an investment adviser, depositor or principal underwriter.

Investment fund fraud: SEC v. True North Finance Corp., Civil Case No. 10-3995 (D. Minn. Sept. 21, 2010) is an action against attorney Todd Duckson and Michael Bozora and Timothy Redpath. The Capital Solutions Monthly Income Fund began operations in 2004, according to the complaint. In May 2008, the fund’s sole borrower defaulted. The fund foreclosed on the borrower’s real estate projects after which the defendants took over its management. Mr. Duckson managed the fund while Messrs. Bozora and Redpath continued to raise money from investors who were not told of the default and foreclosure. The complaint alleges that the defendants raised over $21 million from investors after the default and at a time when the fund had no meaningful income. True North Finance Corporation, which merged with the Fund in 2009, and its CFO, Owen Williams, were also named as defendants and charged with accounting fraud. According to the complaint, in 2008 and 2009 Mr. Williams caused True North to overstate its revenues by as much as 99%. The case, which charges violations of the antifraud provisions, is in litigation. See also Litig. Rel. 21657 (Sept. 21, 2010).

Investment fund fraud: SEC v. Bujkovsky, Case No. 10-CV1965 (S.D. Cal. Filed Sept. 21, 2010) is an action against California lawyer George Bujkovsky. While representing MAK 1 Enterprises Croup and its principals, Mohit Khanna and Sharanjit Khanna, the defendant defrauded certain MAK 1 investors and aided and abetted the fraud of his clients according to the complaint. MAK 1 is a Ponzi scheme halted by a Commission action in 2009. Despite having notice that MAK 1 was conducting an unregistered and likely fraudulent offering, Attorney Bujkovsky made material misrepresentations to some investors about the operations of the entity. Substantial portions of investor funds were diverted and misappropriated. The Commission’s action is in litigation. See also Litig. Rel. 21659 (Sept. 22, 2010).

Earlier, Mr. Bujkovsky pleaded guilty to charges of obstruction of justice for making false statements to the Commission staff and income tax evasion. Mohit Khanna pleaded guilty to conspiracy and mail and wire fraud and filing a false tax return. Both are scheduled to be sentenced November 15, 2010.

Accounting fraud: SEC v. Delphi Corp., Case No. 06-cv-14891 (E.D. Mich. Filed Oct. 30, 2006), discussed here, is a financial fraud action against Delphi Corporation and certain of its officers. This week defendant John Blahnik, the former Treasurer and Vice President of Treasury, Mergers and Acquisitions of the company, settled with the Commission. Mr. Blahnik consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 13(b)(5) and Securities Act Section 17(a) and from aiding and abetting violations of Sections 13(a) and13(b)(2)(A). Mr. Blahnik also agreed to pay disgorgement and prejudgment interest totaling $50,000 and to pay a civil penalty equal to that amount. He also agreed to be barred from serving as an officer or director of a public company for a period of five years. See also Litig. Rel. 21660 (Sept. 22, 2010).

Investment fund fraud: SEC v. LADP Acquisition, Inc., Civil Action No. CV 106835 (C.D. Cal. Filed Sept. 14, 2010), discussed here, names as defendants William A. Goldstein, Marc E. Bercoon and their related entities. The complaint claims that Messrs. Goldstein and Bercoon perpetrated a “bait-and-switch” scheme on investors, promising to invest their funds in high profile Hollywood films and TV shows. These claims drew about 100 investors who put about $3.2 million into the defendants’ scheme beginning in mid-2009. In actuality, LADP Acquisition had no business operations. Its shares were worthless. In addition, defendants misappropriated over $800,000 of the investor funds and diverted them to their own use according to the complaint. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b). The case is in litigation.

Criminal cases

Insider trading: U.S. v. Hoxie, Case No. 1:10-mj-01113 (S.D.N.Y.) is an insider trading case against former Walt Disney Co. assistant Bonnie Hoxie. Ms. Hoxie and her boyfriend, Yonnie Sebbag, who pleaded guilty on August 23, 2010, had shopped the sale of inside information which they ultimately agreed to sell to undercover FBI agents as discussed here. This week Ms. Hoxie pleaded guilty to one count of conspiracy and one count of wire fraud. The date for sentencing has not been set.

Court of appeals

Insider trading: SEC v. Cuban, No. 09-10996 (5th Cir. Sept. 21, 2010) is an insider trading case against Mark Cuban. The district court dismissed the action, discussed here. The Fifth Circuit reversed. According to the complaint, in the spring of 2004 Mr. Cuban, who owned 6.3% stake or 600,000 shares of Mamma.com., was contacted by the CEO of that company about investing in an upcoming PIPE offering. The CEO did not tell Mr. Cuban about the deal until after there was an agreement that the information would be kept confidential. After becoming upset, Mr. Cuban stated that he did not like PIPE offerings because they are dilutive. He ended the call stating “Well, now I’m screwed. I can’t sell.” Subsequently, Mr. Cuban called the banker conducting the deal in accord with an e-mail he had received from the CEO. In that call, he obtained additional non-public and confidential information. One minute after the phone call ended Mr. Cuban sold his stake, avoiding a $700,000 loss.

The circuit court disagreed with the reading of the complaint adopted by the district court. Stressing that all reasonable inferences must at this stage of the case be drawn in favor of the SEC, the court concluded that the “allegations [in the complaint], taken in their entirety, provide more than a plausible basis to find that the understanding between the CEO and Cuban was that he was not to trade.” The court characterized the complaint as “factually sparse record” in reaching its conclusion that there were sufficient allegations for the case to proceed past the motion to dismiss stage.