ANTITRUST SUIT BASED ON SHORT SELLING PREEMPTED

The Second Circuit concluded that a putative class action brought by Electronic Trading Group, LLC on behalf of short sellers against Bank of America Securities, LLC and other prime brokers was preempted. Specifically, the court held that the securities laws preempted Sherman Act Section 1 liability for claimed price fixing regarding the fees charged for certain securities located to cover short sales. In re Short Sales Antitrust Litig., Docket No. 08-0420-cv (2nd Cir. Decided Dec. 3, 2008).

Plaintiff claimed that defendants arbitrarily designated certain securities as “hard-to-borrow” and then fixed the price for them in violation of the Sherman Act. SEC regulation SHO requires that, before selling short, the party must borrow the securities. The prime broker charges a fee for this service. The district court dismissed the complaint based on Credit Suisse Securities (USA), LLC v. Billing, 551 U.S. 264 (2007) in which the Supreme Court found that antitrust liability was precluded by the securities laws in the IPO litigation. .

Under Billings, the preclusion analysis turns on four key points: (1) if the area of conflict is squarely within the “heartland” of securities regulation; (2) whether the SEC has clear and adequate authority to regulate; (3) if there is active and ongoing regulation; and (4) whether there would be a serious conflict between antitrust and securities regulation. Here, an analysis of each prong dictated preclusion.

First, the “heartland” prong of the test requires the court to determine if the practices challenged are squarely within the area that is regulated. In this case, the question is thus whether short selling is within the heartland of the securities business. Here, the district court concluded that it is, a point the plaintiff admitted.

The second prong of the test focuses on the existence of regulatory authority. Under Section 10(a) of the Exchange Act, the SEC is given broad regulatory authority. That authority, the court concluded, extends not just to the prevention of fraud, but also permits the SEC to regulate the role of the prime brokers in short selling and the borrowing fees charged. In addition, Section 6 of the Exchange Act permits a national securities exchange to impose a schedule or fix rates of commissions, allowances, discounts or other fees to be charged by its members. This Section, at a minimum, gives the SEC the indirect authority to regulate rates. It is thus clear that the SEC has adequate regulatory authority in this area.

Equally clear is the fact that there is on-going regulation in this area – the third factor. In 2004, the SEC adopted Regulation SHO which imposes a “locate” requirement on brokers involved in short selling before the trade can be accepted. This regulation constitutes an exercise by the SEC of its authority over prime brokers in the area of short selling. Indeed, the complaint here implicitly confirms active regulation, the court found.

Finally, it is also apparent that there is a conflict between the two regulator regimes. The question here is whether allowing antitrust liability in this case would inhibit otherwise permissible market behavior. In this regard, plaintiffs claimed that there should be little difficulty in distinguishing between collusive fee-fixing agreements and routine communications regarding stock availability under Regulation SHO.

The Second Circuit rejected plaintiff’s claim, concluding that there are both actual and potential conflicts with the securities regime. Antitrust liability would inhibit the conduct that the SEC permits and which assists the efficient functioning of the market. “It is a lot to expect” of a broker, the court stated, “’to distinguish what is forbidden from what is allowed,’ so that the broker collects just so much information as required to satisfy the locate requirement and for the efficient functioning of the short selling market – but not an iota more – or suffer treble damages,” quoting Billings.

Likewise, a potential conflict exists since the SEC may act on its authority to regulate the borrowing fees set by prime brokers. This potential conflict, coupled with the actual one, considered in conjunction with the other three Billings factors makes is clear that antitrust liability is precluded and that the district court correctly dismissed the action.

THIS WEEK IN SECURITIES LITIGATION (December 4, 2009)

Market reform was a key topic on Capital Hill this week, as the House Financial Services Committee reported out and sent to the floor a major piece of market form legislation. During the week, House committees also heard additional testimony on the necessity for comprehensive regulation of the derivatives markets. The SEC Inspector General filed his semi-annual report, listing nine open investigations regarding the Division of Enforcement.

SEC Enforcement is reportedly conducting an insider trading investigation into the hedge fund industry. It is unclear if the inquiry is an off shoot of the on-going Galleon investigation discussed here. https://www.secactions.com/?p=1660 Cases brought by the division this week continued to focus on fraudulent investment funds.

In the seemingly never-ending criminal cases spinning out of Broadcom’s option backdating woes, the court in the criminal case of former CFO Ruehle took the unusual step of immunizing a witness at the request of the defense. At the same time, prosecutors announced that they will retry former Broadcom CEO Reyes.

Market reform

Financial reform: The House Financial Services Committee will send H.R. 4173 to the floor next week. The bill includes nine major pieces of legislation approved by the committee to address the financial crisis. It includes: consumer protections, creating the new Consumer Financial Protection Agency; a new Financial Stability Council, an inter agency oversight council focused on the “too big to fail” issue; provisions addressing executive compensation by giving shareholders a “say on pay;” creating investor protection by enhancing the SEC’s authority to regulate the markets; providing for the regulation of derivatives by requiring standardized swap transactions to be cleared and traded on an exchange or electronic platform; provisions regarding mortgage reform and anti-predatory lending; providing for the reform of credit rating agencies; regulation of hedge funds; and requiring the office of insurance to monitor the insurance industry.

H.R. 2873 passed the House this week. The bill proposes to amend the securities laws to give the SEC nationwide service of process in court actions initiated by the agency.

Derivatives: CFTC Chairman Gary Gensler testified this week before the House Committee on Energy and Commerce. In part, his testimony focused on what the Chairman called “much-needed regulatory reform of the OTC derivatives marketplace.” According to Mr. Gensler, the value of derivates traded in the U.S. is nearly 20 times the size of the nation’s economy. This means that on average for a $50 tank of gas would have about $1,000 in derivatives behind it. The Chairman focused on two key points, improving transparency and lowering risk. To add transparency, Mr. Gensler advocated moving all standardized OTC derivative transactions onto regulated exchanges and requiring reporting for all others in addition to data reporting for all transactions and stringent record keeping requirements. To lower risk, Mr. Gensler told the Committee that standard transactions should be required to clear through “robustly” regulated central counterparties. If there are exemptions, they should be narrow and limited. He also advocated adequate capital and margin requirements and stringent business conduct standards.

Former CFTC Chairperson Brooklsey Born also testified about the risks of OTC derivatives. Ms. Born cautioned the Joint Economic Committee, as she has others over the years, about the risks of leaving what she called the “dark market” unregulated. In her testimony Ms. Born made three key points. First, there should be no statutory exceptions from the rule that all standardized and standardizable contracts should be traded on an exchange rather than over the counter. Second, only truly customized contracts should be permitted to be traded off an exchange. For those contracts however, at least one party should be required to certify that the contract is a hedge. This eliminates speculative customized contracts. Finally, any continuing over the counter market must be subjected to a robust federal regulatory regime.

SEC Inspector General: The SEC OIG issued its semiannual report to Congress. After reviewing previously announced and complete inquiries for the period April 1, 2009 through September 30, 2009, the report identifies nine pending investigations regarding the Enforcement Division. These include inquiries into: 1) the circumstances surrounding an enforcement action regarding a prominent financial institution and if there were conflicts of interest; 2) a claim that former SEC attorney took confidential investigative materials when he left and provided them to a company for which he went to work as a lobbyist and whether a settlement with the company was adequate in view of the available evidence of fraud; 3) whether Enforcement failed to properly investigate a corporation where there were substantial shareholder losses; 4) a claim of improper conduct by Enforcement attorneys during an investigation; 5) whether an SEC attorney continued with an investigation despite a conflict; 6) whether Enforcement attorneys in a regional office repeatedly and in violation of policy disclosed non-public information about investigations; 7) an investor complaint about a failure to investigate market manipulation; 8) whether Enforcement attorneys had access to evidence demonstrating insider trading prior to closing an investigation; and 9) whether Enforcement opened and investigation into a public company in retaliation for its complaints about naked short selling.

SEC enforcement actions

Financial fraud: SEC v. Canopy Financial, Inc., Case No. 09 cv 7429 (N.D. Ill.) is a financial fraud case brought against a private company and its co-founder as discussed here. https://www.secactions.com/?p=1738 In July and August 2009 the defendants raised $75 million in a private placement from hedge funds and other investors using a false audit opinion and other fraudulent materials. A portion of those proceeds were misappropriated. The SEC obtained an asset freeze. The case is in litigation.

Transfer agents: SEC v. Lund, Case No. 2:09-CV-1050 (D. Utah Nov. 30, 2009) named as defendants Whitney Lund, Sr. and Standard Transfer & Trust. The complaint alleges that the defendants abused their role as a gatekeeper by distributing restricted shares of Mosaic Nutraceuticals Corp. without the proper legends. This was done so Mr. Lund could profit from shares in the company he owned or controlled. The distribution yielded $700,000 in illicit profits. As part of the scheme, Mr. Lund falsified transfer agent records and obtained a false legal opinion to make the distribution appear legitimate. Mr. Lund also gave false testimony during the SEC’s investigation, according to the complaint. The complaint alleges, among other things, violations of the antifraud and registration provisions of the securities laws. The case is in litigation. See also Litig. Rel. 21317 (Dec. 1, 2009).

Investment fund fraud: SEC v. HomePals, LLC, Case No. 09-CV-81524 (S.D. Fla. Filed Oct. 16, 2009). This action against Abner Alabre and others alleged that the defendant ran a Ponzi scheme which targeted Haitian-Americans in South Florida. The complaint claims that about $14.3 million had been raised from investors beginning in April 2008 and continuing through the end of that year by selling unsecured notes which guaranteed a 100% return every 90 days. This week, Mr. Alabre consented to the entry of a permanent injunction prohibiting future violations of the registration provisions of the Securities Act and the antifraud provisions of that Act as well as the Exchange Act. The amount of disgorgement and any penalty will be determined by the court. See also Litig. Rel. 21316 (Dec. 1, 2009).

Financial fraud: SEC v. Fradella, Case No. 3:09-cv-02269 (N.D. Tex. Nov. 30, 2009) names as defendants Home Solutions of America, Inc. and several of its executives. The complaint alleges that between 2005 and 2006 following Hurricane Katrina the company issued false press releases and made false filings with the Commission boasting multimillion dollar contracts and robust financial results. The stock price soared but later fell. The CEO and others engaged in two other schemes to inflate the results of the company. In one expenses were improperly deferred. In the other more than $9 million of fake revenue based on undisclosed related party transactions was booked. The company was delisted from the NASDAQ National Market in January 2008. The Commission also brought an action for failure to file periodic reports. The complaint alleges violations of the registration, antifraud and books and records provisions of the securities laws. The case is in litigation. See also Litig. Rel. 21314 (Nov. 30, 2009).

Criminal cases

U.S. v. Ruehle, discussed here, is the criminal case against the former Broadcom Corp. CFO arising out of the option backdating practices at the company. This week Judge Cormac Carney took the rare step of granting judicial immunity to a witness. Specifically, company co-founder Henry Samueli will be immunized by the court and compelled to testify in response to a defense motion.

U.S. v. Reyes, discussed here, is the criminal case against the former Brocade CEO whose conviction was reversed by the Ninth Circuit. The government announced that they will retry Mr. Reyes.

U.S. v. Rothstein, Case No. 0:09-cr-60331 (S.D. Fla. Filed Dec. 1, 2009) charges Fort Lauderdale attorney Scott Rothstein, with operating a billion dollar Ponzi scheme. Specifically, the information claims that, from 2005 through November 2009, Mr. Rothstein engaged in a pattern of racketeering activity through his law firm which is alleged to be a criminal enterprise. The firm was used by Mr. Rothstein and other alleged co-conspirators to fraudulently induce investors to loan money to non-existent borrowers based on promissory notes and requests for short term bridge loans for business financing and to invest funds based upon anticipated pay-outs from claimed confidential civil settlements. As part of the scheme, the defendant and his law firm allegedly filed a law suit on behalf of plaintiffs, settled it in favor of the defendants under terms which obligated the plaintiffs to pay $500,000 and then created a false court order and judgment showing that plaintiffs won $23 million. The clients were told that the defendants had transferred the funds off shore and to recover them they had to post bonds. This sham transaction generated $53 million.

U.S. v. Lawton, Case No. 0:09-cr-00319 (D. Minn. Filed Oct. 30, 2009) defendant John Lawton, the operator of hedge fund Crossroad’s Paramount Partners pleaded guilty to mail fraud and making a false statement. Mr. Lawton acknowledged overstating the assets of the fund to conceal losses and creating false monthly statements showing a positive performance for investors.

Private actions

Trend of cases: Recent reports detail the fact that the number of private securities damage suits filed to date had declined. If the trend continues this year may be the lowest for filings in years. A report by Sheri Qualters at Law.com paints a potentially different picture. The report suggests that in fact plaintiffs are being named in securities fraud suits months and years after the events, in contrast to prior practice where suits were filed much more quickly. Some lawyers interviewed for the November 30, 2009 article reported they were working through a “backlog of targets.”

A perusal through press releases at locations such as the Business Wire reveals a number of announcements from plaintiffs firms detailing investigations of corporate activity. All of this suggests that, while the number of class action filings is at this point down, it may not stay that way in the future.

Plumbers and Pipefitters Local v. Zimmer Holdings, Inc., Case No. 1:08-cv-01041 (S.D. Ind. Filed Aug. 5, 2008) is a securities class action against the company and two of its officers. The complaint claims that the defendants withheld information about production issues at one plant and difficulties with a hip replacement product. The court dismissed the complaint concluding that it failed to adequately plead scienter. Plaintiffs relied on information from a dozen confidential witnesses.

Supreme Court

Morrison v. National Australia Bank Ltd., Case No. 08-1191 is the Second Circuit’s “foreign-cubed” decision discussed here. The Supreme Court agreed to hear the case earlier this week. The case centers on the claimed manipulation of financial data in the U.S. subsidiary of an Australian bank. The bank’s shares are traded in Australia and its ADRs are listed in the U.S. The suit is on behalf of the Australian shareholders. The Second Circuit affirmed the dismissal of the complaint for lack of jurisdiction. The Solicitor General recommended that the Court not hear the case.

Merck & Co. v. Reynolds, Case No. 08-905, was argued this week as discussed here. The case focuses on what triggers the commencement of the two year limitation period of 28 U.S.C. § 1658(b)(1) and whether the concept of inquiry notice applies.