The Supreme Court begins its term this week with all eyes on new Justice Sonia Sotomayor. Business organizations, together with directors, officers and general counsels should focus on the slate of cases before the High Court which may have a significant impact on the securities industry, the business community and their personal liability. Those cases include:

Merck & Co. v. Reynolds, Case No. 08-905 which raises the question of when the statute of limitations begins in securities fraud damage suits. Specifically, the Court will consider the issue of “inquiry notice” and when shareholders are on notice of a possible claim such that the limitation period begins. This case arises out of securities fraud class actions brought against Merck relating to its sales of Vioxx, a prescription pain drug. The FDA warned the company about minimizing the risks regarding this drug in September 2001. Three years later, the company withdrew Vioxx from the market.

The circuits all agree that the limitation period begins when investors have notice. The question is when do they have notice and what actions, if any, do they have to take in this regard. The Third Circuit held that shareholders do not have a duty to investigate the claim. The court held that the time for the two-year statute of limitations does not begin to run until shareholders have evidence of scienter. The Ninth Circuit agrees with this view. Other circuits take differing views of what is called “inquiry notice” and what investigative efforts, if anything, shareholders must take. The test adopted and whether shareholders must investigate or be aware, for example of information available from different sources, will have a significant impact on the scope of liability in securities class actions.

Jones v. Harris Associates, L.P. , No. 08-586, presents a question regarding the standard investors must meet under Section 36(b) of the Investment Company Act to challenge the fees of an investment advisor. Ultimately at issue in the case is whether the fees of investment advisers can effectively be challenged.

Section 36(b), as discussed here, was added to the Investment Company Act in 1970. Under that section, the investment adviser has a fiduciary duty with respect to compensation for services. The statute provides for a cause of action by a security holder with respect to the fees paid, noting that approval by the board of directors shall be given consideration as the court deems appropriate but that personal misconduct need not be established. The Seventh Circuit adopted what is essentially a disclosure standard, concluding that as long as all the facts are fully disclosed, the shareholders’ action is defeated. The court rejected the widely followed standard under Gartenberg v. Merrill Lynch, 694 F.2d 923 (2nd Cir. 1982) which held that a cause of action could be maintained if the fee is “so disproportionately large” or “excessive” such that it bears no reasonable relationship to the services rendered as also discussed here.

The government’s brief before the Supreme Court adopts the Gartenberg standard. Interestingly, none of the parties opted for the disclosure approach of the Seventh Circuit. The decision has significant implications for the fund industry, as well as all mutual fund investors.

Free Enterprise Fund v. Public Company Accounting Oversight Board, Case No. 08-861 presents the question of whether the PCAOB violates separation of powers principles and the appointment power since it is overseen by the SEC, rather than the President. PCAOB was created in the wake of corporate scandals such as Enron, Worldcom and Global Crossing. PCAOB, supervised by the SEC, was created as part of the Sarbanes Oxley Act. It has broad authority over the auditors of public companies.

Plaintiffs present two constitutional issues in the district court. The first is whether the SOX sections creating the board violate separations of powers principles. The second focus on the appointment clause based on the fact that PCAOB board members are appointed by the SEC, rather than the President. The district court granted summary judgment in favor of the board. The circuit court affirmed as discussed here.

This case has the potential to undo the SOX accounting and auditing reforms. As such, the result may impact not just the auditing profession, but also every public company as well as the users of financial statements of those companies.

Weyhrauch v. U.S., Case No. 08-1196 and U.S. v. Black, Case No. 08-876 raise a question regarding the scope of “honest services” fraud under 18 U.S.C. § 1346. Specifically, the cases present the question of what limiting principles if any define the prohibited conduct under a statute. Alternatively, the statute may be unconstitutionally vague.

Section 1346 was passed in the wake of the Supreme Court’s decision in McNally v. U.S., 483 U.S. 350 (1987), which held that the theory of “honest services” fraud was outside the scope of the mail fraud statute. Since its passage, Section 1346 has been applied to a wide variety of private and public sector conduct, criminalizing actions which many claim are well beyond that which congress intended. For example, in Brown, discussed here, Merrill Lynch executives were charged with honest services fraud in the infamous “Enron barge” deal, when Enron executives booked the transaction in a manner which falsified the financial statements of that company. The convictions were reversed by the circuit court. Many critics of the statute argue that it is so open ended that virtually any breach of duty can become a federal crime.

Weyhrauch raises the question of what limiting principles should be applied in a public sector case. There the Ninth Circuit rejected state law as a source of limiting principles. Black presents the same question in a private sector case against the backdrop of the convictions of Canadian newspaper magnate Conrad Black. The Court’s recent decision in Stoneridge, discussed here, limited the scope of liability for business executives in securities fraud suits. The question in these cases is whether the Court will adopt similar limitations to honest services fraud where the stakes for business executives and public officials are much higher in view of the potential criminal liability.

Finally, a case seeking review by the Court which is of wide interest to sports fans and others is American Needle, Inc. v. National Football League, Case No. 08-661. In that case the question is whether the NFL and the NFL Players Association are “one person” for purposes of Section 1 liability of the Sherman Act. Stated differently, the question concerns the kind of joint ventures which are immune from Sherman Act liability because they are viewed as one entity. Plaintiff is a disappointed bidder who sought to market NFL licensed materials. Currently Reebok is the exclusive licensee of the NFL. The Seventh Circuit held that the NFL and the Players Association are one person for purposes of Section 1. The NFL, NBA and NHL have urged the Court to hear the case. Major League Baseball does not have a stake here since they have had antitrust immunity since a 1922 decision by the Supreme Court.

The staple of SEC enforcement appears to be investment fund fraud cases with five new actions brought this week. The Commission also settled with former executives of General Re and filed a settled administrative proceeding based on a failure to have adequate procedures. Finally, the SEC filed a settled FCPA case along with DOJ.

SEC enforcement actions

Financial fraud: SEC v. Ferguson, Case No. 06 Civ. 0778 (S.D.N.Y.) is an action against five former senior executives of General Re Corporation and AIG. The complaint alleges that the defendants aided and abetted AIG’s financial fraud, discussed here. Essentially the case was based on a sham insurance transaction. Previously the defendants were convicted in a criminal case based on the same conduct. U.S. v. Ferguson, Case No. 3:06-CR-137 (D. Conn.). Defendants Ronald Ferguson, Elizabeth Monrard, Christian Milton, Robert Graham and Christopher Garand each consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions of the Exchange Act. Each defendant also agreed to the entry of an officer director bar. See also Litig. Rel. 21235 (Oct. 1, 2009).

Investment fund fraud: SEC v. Huber, Civil Action No. 09-CV-6068 (N.D. Ill. Filed Sept. 30, 2009) is an action against William Huber and Hubadex, Inc., based on three different investment funds operated by Mr. Huber. According to the SEC, Mr. Huber falsely represented the amount of assets he had under management to inflate his fees, made false statements about the trading by the fund and provided investors with false account balances. The complaint alleges violations of Sections 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Section 206 of the Investment Advisers Act. The case is in litigation. Litig. Rel. 21230 (Sept.30, 2009).

Internal controls: In the Matter of Commonwealth Equity Services, LLP, Adm. Proc. File No. 3-13631 (Sept. 29, 2009). Respondent is a broker dealer. Under Section 30(a) respondent is required to adopt written policies and procedures to protect customer information. The company recommended, but did not require, its representatives to maintain antivirus software on their computers. As a result, customer information was not adequately protected. In November 2008, an intruder obtained the login credentials of a registered representative to access customer accounts. The intruder used the information to make unauthorized purchase in those accounts. To resolve the action, Respondent consented to the entry of a cease and desist order and agreed to pay a civil penalty of $100,000.

Boiler Room: SEC v. 3001 AD, LLC, Case No. 09-Civ-81453 (S.D. Fla. Filed Sept. 29, 2009) and the parallel criminal case charge several individuals with conducting a boiler room operation as discussed here. https://www.secactions.com/?p=1542 The cases center on the fraudulent sale of shares in 3001 AD and its related entities. Essentially, investors were induced to invest in the company with false promises of a forthcoming IPO. From the late 1990s the defendants raised about $20 million by selling interests in the company and its related entities. Those interests, sold for $5,000 each, were treated as interchangeable. The Commission’s complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b) and 15(a). The case is in litigation. See also Litig. Rel. 21227 (Sept. 29, 2009).

Investment fund fraud: SEC v. Harris, Civil Action No. 3:09-cv-01809 (N.D. Tex. Filed Sept. 28, 2009) is an action against George Harris and Giant Operating, LLC. The complaint alleges that the defendants made five offerings in oil and gas securities offerings, raising over $13 million from 150 investors. Defendants then misappropriated at least $2 million from the offering. The complaint alleges violations of Sections 5 and 17(a) of the Securities Act and Sections 10(b) and 15(a) of the Exchange Act. The defendant consented to the entry of a preliminary injunction and the appointment of a receiver. Litig. Rel. 21226 (Sept. 28, 2009).

Investment fund fraud: SEC v. Bluestein, Case No. 2:09-CV-13809 (E.D. Mich. Filed Sept. 28, 2009) is an action against stock broker Frank Bluestein, alleged to have acted as a feeder for Edward May and his Ponzi scheme E-M Management LLC, discussed here. Mr. Bluestein targeted elderly investors, sometimes inducing them to refinance their homes, to secure funds for the scheme. Using investor seminars to lure investors and gain their confidence, Mr. Bluestein assured investors about the safety of his fund and raised about $74 million from more than 800 investors over a five year period. The Commission’s complaint alleges violation of the antifraud and registration provisions of the securities laws. The case is in litigation. Litig. Rel. 21223 (Sept. 28, 2009).

Investment fund fraud: SEC v. K&L International Enterprises, Inc., Case No. 6:09-CV-1638 (M.D. Fla. Filed Sept. 28, 2009) is an action in which the SEC obtained emergency relief against defendants Stephen Carnes, Lawrence Powalisz and their related companies also discussed here. This scheme focuses on dumping unregistered shares on the market using two groups of companies in a series of sham transactions. The shares were quoted in the Pink Sheets or the Over-the-Counter Bulletin Board. Over a two year period the defendants raised about $7 million through this scheme. The complaint alleges violations of Section 5 of the Securities Act. It is in litigation. Litig. Rel. 21224 (Sept. 28, 2009).

FCPA

SEC v. AGCO Corporation, Civil Action No. 1: 09-CV-01865 (D.D.C. Filed Sept. 30, 2009) is a settled FCPA case brought against Duluth, Georgia agricultural equipment manager AGCO discussed here. From approximately 2000 through 2003 the company paid approximately $5.9 million in kickbacks in connection with sales of equipment to Iraq under the United Nations Oil for Food Program. The payments were made using a Jordanian agent and booked as Ministry Accrual in an account created by the marketing staff. To resolve the matter the company consented to the entry of an injunction prohibiting future violations of the antifraud provisions and agreed to pay disgorgement of about $13.9 million in profits plus pre-judgment interest. The company will also pay a $1.6 million penalty under a deferred prosecution agreement entered into with DOJ. The Danish State Prosecutor will also confiscate over $600,000. Litig. Rel. 21229 (Sept. 30, 2009).