THIS WEEK IN SECURITIES LITIGATION (August 27, 2010)

The Commission adopted its controversial “proxy access” rules this week by what is becoming the standard 3-2 vote. SEC enforcement brought an insider trading case against two residents of Spain just days after the announcement of the take over bid on which it centers and obtained a partial settlement in an international financial fraud case. Option backdating cases continued to move toward resolution with the settlement of two more derivative actions.

Market reform

The Commission adopted its new “proxy access” rules by a 3-2 vote this week. Under the new rules, which take effect 60 days after publication, shareholders who own at least 3% of the total voting power of the company’s securities and have held those shares for at least three years will be eligible to nominate directors and have proposals included in the company proxy materials sent to all shareholders. Shareholders can nominate one director or a number up to 25% of the board, which ever is greater. Nominees must not violate applicable laws and regulations. Shareholders cannot use the rules if the securities are held for purposes of changing control. The rules will apply to all Exchange Act reporting companies but be phased in for small issuers. They do not apply to foreign private issuers.

SEC enforcement actions

Insider trading: SEC v. Garcia, Civil Action No. 10C 5268 (N.D. Ill. Filed Aug. 20, 2010). The case names as defendants Juan Jose Fernandez Garcia, the Head of European Equity Derivatives at Banco Santander, S.A., and Luis Martin Caro Sanchez, both of Madrid, Spain (discussed here). It centers on the unsolicited bid for Potash Corporation of Saskatchewan by BHP Billiton Plc, announced on August 17, 2010. In the bid, BHP offered a 16% premium to market or $130 per share for the stock of Potash. Potash was advised on the bid by Banco Santander, S.A. The day after the bid the share price of Potash rose over 27%.

Shortly before the deal announcement, Mr. Garcia purchased 282 Potash call options for approximately $13,669 through Interactive Brokers. On August 17, 2010, after the take over announcement, Mr. Garcia sold his holdings for a profit of $576,033. Mr. Sanchez purchased 331 call options in Potash in mid-August at a cost of $47,499 through Interactive Brokers. Mr. Sanchez sold his position just after the announcement at a profit of $496,953.33. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is in litigation.

Financial fraud: SEC v. Escala Group, Inc., Case No. 09 CV 2646 (S.D.N.Y. March 23, 2009). The Commission settled with the founder and former chairman of Escala, Gregory Manning (here). Escala is an international company whose business centers on the collectibles market. Through a series of transactions involving collectable stamps with related parties, the Commission claims that Mr. Manning and the other defendant fraudulently boosted the revenues of Escala just prior to a merger. The related party transactions were disclosed as being at arms length. The scheme also included round trip transactions and improperly recorded expenses. Overall revenues were improperly increased by over $80 million. Mr. Manning resolved the case with the Commission by 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 Escala’s violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). He also agreed to pay $669,489 in disgorgement, prejudgment interest and penalties and to the entry of an officer and director bar for ten years.

FINRA

Undisclosed conflict of interest: Zions Direct, Inc. was fined $225,000 by FINRA in connection with its failure to disclose a potential conflict of interest in auctioning certificates of deposit through its website. The potential conflict stems from the fact that Liquid Asset Management, an affiliate, participated in the auctions. From the commencement of the auctions in February 2007 through November 2008 LAM’s participation was not disclosed. Even following disclosure of its participation, the potential conflict was not disclosed. FINRA determined that customers were potentially disadvantaged in the auctions. The regulator also concluded that Zions Direct advertisements in connection with the auctions were misleading.

Private actions

Option backdating: In re Blue Coat Systems, Inc. Derivative Litig., Case No. 5:06-cv-04809 (N.D. Cal.); In re Blue Coat Systems, Inc. Derivative Litig., Case No. 1:05-cv-041436 (Sup. Ct. Cal., Santa Clara). The complaints, filed in 2007, against the directors, former directors and outside auditors Ernst & Young, alleged that the company had backdated and used spring loaded options since 1999. It was based on a report from an internal investigation. To settle the action, the company will adopt certain corporate governance provisions. Insurers and E&Y will pay about $3.9 million and certain former executives will repay about $170,000 in compensation. Plaintiffs counsel will be given $1.775 million worth of Blue Coat stock and $225,000 in cash from E&Y as attorney fees and costs.

FSA

The U.K. Financial Services Authority fined Societe Generale approximately $2.25 million (£ 1.575 million) for filing inaccurate reports on 80% of its trades over a two year period. From November 2007 through February 2010, the bank failed to report 320,000 trades and furnished inaccurate data on 531,000 transactions. Other reports had inaccurate counterparty data. The bank is the sixth institution to be fined in connection with inaccurate reports. Previously, Barclays, Getco, Instinet and Commerzbank were fined for similar irregularities. The difficulty stems from the 2007 adoption of the Markets in Financial Instruments Directive which imposed new reporting requirements on European Union financial institutions.

INSIDER TRADING AND SUSPICIOUS TRADING, NOT THE SAME

Investigating insider trading is difficult. Proving it is even more difficult. Frequently, the trading is “suspicious” because of its timing, magnitude, or for a variety of other reasons. Market watchers such as FINRA use this term to classify trading that merits additional investigation. It is a starting point, not a conclusion and clearly not proof of insider trading. More is needed.

Sometimes suspicious trading becomes the predicate for an enforcement action. This is the case in the Commission’s most recent insider trading case, SEC v. Garcia, Civil Action No. 10C 5268 (N.D. Ill. Filed Aug. 20, 2010). The case was filed just three days after the takeover announcement on which it centers. The defendants are Juan Jose Fernandez Garcia and Luis Martin Caro Sanchez, both of Madrid, Spain. As in many such cases, the SEC sought and obtained emergency relief, freezing the brokerage accounts of the two defendants and securing an order for expedited discovery.

The case centers on the unsolicited bid for Potash Corporation of Saskatchewan, Inc. by BHP Billiton Plc, announced on August 17, 2010. In the bid, BHP offered a 16% premium to market or $130 per share for the stock of Potash. Potash, the world’s largest fertilizer company, was advised on the bid by Banco Santander, S.A. It shares are traded on the New York and Toronto Stock Exchanges and its options are listed on the Chicago Board Options Exchange. BHP is a global natural resources company based in Australia. The day after the bid, the share price of Potash rose over 27%. The bid was ultimately rejected.

On August 12, 13, and 16 Mr. Garcia purchased 282 Potash call options for approximately $13,669 through Interactive Brokers. Virtually all of the contracts were in the “front month” August series and were due to expire on August 21, 2010. Most were out of the money when purchased by Mr. Garcia. On August 17, 2010, after the take over announcement, Mr. Garcia sold his holdings for a profit of $576,033.

From January 1 through August 12, 2010, Mr. Garcia did not trade in any Potash securities at Interactive Brokers and he engaged in what the complaint calls “minimal” options trading. At the time of the purchases, Mr. Garcia was the Head of European Equity Derivatives at Banco Santander, S.A. Mr. Sanchez purchased 331 call options in Potash on August 12 and 13, 2010, at a cost of $47,499. All of the options were due to expire on September 18, 2010, and were out of the money. They were purchased through Interactive Brokers. From January 1 through August 12, 2010, Mr. Sanchez did not own or trade any Potash shares at Interactive. The day after the take over bid was announced Mr. Sanchez sold his position in Potash for a profit of $496,953.33. He has been unsuccessful in attempts to withdraw the funds.

The complaint claims that the trading of Messrs. Garcia and Sanchez is “suspicious.” That allegation leads to the statement that “on information and belief” Messrs. Garcia and Sanchez traded on inside information. Perhaps so.

The complaint may, however, be more noteworthy for what it does not state. It does not claim that Mr. Garcia accessed or learned material non-public information through his work. It does not claim that Mr. Garcia tipped Mr. Sanchez, although it alleges that the trading patterns in Potash options are similar. It does not claim that Mr. Garcia knows or ever communicated with Mr. Sanchez. It does not allege that trading options is atypical for either defendant, other than to note that Mr. Garcia’s trading in this regard earlier in the year was minimal. It does not analyze the historical trading of either defendant beyond what occurred over the last few months in one account.

In some cases where the Commission has quickly filed insider trading charges it has been successful such as SEC v. Wong, Civil Action No. 07 Civ. 3628 (S.D.N.Y.) (here). In other instances, the defendants are demanding that the Commission prove its case such as SEC v. Condroyer, Case No. 1:09-cv-3600 (N.D. Ga.) (here). In still others the Commission has been unable to prove the claim at trial such as SEC v. Rorech, Civil Action No. 09 Civ. 4329 (S.D.N.Y.) (here).

Regardless of the results here, it is clear the proving insider trading based primarily on a set of trades in advance of a corporate event is not only difficult, but perhaps as much luck as anything else. Aggressive and efficient enforcement is important and can facilitate the program. Enforcement based on luck does not. The need for speed – even if one or both of the defendants are attempting to withdraw their trading profits – should not eclipse getting it right. It clearly is not a reason to rely on luck rather than sound investigation and evidence.