LESSONS FROM THE PEQUOT INVESTIGATON

Things are not always as they seem. This sage maxim has been cited many times in different contexts. The resolution of Pequot insider trading investigation last week, along with the earlier scandal the initial inquiry generated, is a good illustration of how this principle applies in SEC investigations.

The inquiry began as many do with information from the exchange in 2004 about possible insider trading by Pequot Capital, a large hedge fund run by Arthur J. Samberg. By the Spring of 2005, the SEC staff began examining trading by Pequot in Microsoft securities. In April 2001 Pequot and Mr. Samberg had made a profit of about $14.7 million from a synthetic long position in Microsoft built prior to the first quarter earnings call. At the time the position was established, the market was awash with rumors that the company would miss its estimates when earnings were announced for the first quarter of the year, ended March 31. It turned out the rumors were wrong. Not only did the company meet the estimates, it exceeded them. The share price increased giving the fund and Mr. Samberg a profit.

At the time Pequot and Mr. Samberg built the long position, David Zilkha, a Microsoft employee had accepted a position with the fund, working for Mr. Samberg. He was not reporting for work until late April 2001, after the Microsoft earnings call. According to the court papers, prior to reporting for work Mr. Samberg had solicited information from Mr. Zilkha about his then employer. Mr. Zilkha gathered that information, which in part was reflected in e-mails, and reported to Mr. Samberg prior to the first quarter 2001 earnings call that Microsoft would meet or exceed expectations.

At the SEC, staff attorney Gary Aguirre was working on the Pequot investigation. A subpoena as sent to Mr. Zilkha for documents. The e-mails reflecting the inside information given to Mr. Samberg were not produced. In a December 2005 interview, Mr. Zilkha apparently suggested to the staff that he had not contacted anyone to obtain information about the earnings call and that he had nothing new to report about the company to his new employer.

As the inquiry slowly unfolded, attention turned to John Mack, then the incoming chief executive of Morgan Stanley. He was a friend of Mr. Samberg. Mr. Aguirre sought to issue a subpoena to Mr. Mack. The subpoena, however, was not served at that time.

By 2006 Mr. Aguirre, who was eventually fired after having received a positive performance review the prior year, became a whistle blower. In reports published in the New York Times and later before Congress, Mr. Aguirre claimed that his investigation was thwarted by senior SEC staff officials. Mr. Mack’s testimony was taken by the SEC. Congressional hearings were held. A Senate report on the matter was highly critical of the staff’s handling of the investigation as were many others. Scandal was in the wind, suggesting the staff botched the inquiry perhaps because of high level favoritism from senior SEC enforcement officials to a former high level government lawyer representing Mr. Mack. The Pequot investigation languished and was closed in October 2006. It was widely believed the staff had failed.

In January 2009 the SEC staff received copies of the 2001 e-mails Mr. Zilkha used to obtain information about Microsoft’s first quarter earning for Pequot and Mr. Samberg. Although they were withheld from the document production during the inquiry, Mr. Zilkha’s then ex-wife located them on a computer hard drive and furnished them to the SEC. An employment law complaint Mr. Zilkha prepared in 2007 against Mr. Samberg which recorded the story of the illegal trading also surfaced after having been under seal.

The SEC reopened its Pequot investigation. Mr. Zilkha was asked to testify. He declined, citing his constitutional privileges. An administrative proceeding was eventually brought against him, discussed here. An enforcement action was brought against Pequot and Mr. Samberg claiming insider trading, also discussed here. The now defunct hedge fund and Mr. Samberg settled, agreeing to disgorge their trading profits and pay a civil penalty. Mr. Zilkha is litigating.

Now it seems clear that the SEC’s investigation into Pequot and Mr. Samberg’s trading had merit. Those who criticized the staff’s efforts during the initial inquiry, suggesting some type of favoritism while appearing correct at the time, were clearly wrong. Claims that the Commission had botched the inquiry by not seeking the testimony of John Mack were unfounded. Mr. Mack’s testimony yielded nothing. The key was e-mails which were improperly withheld, something which is difficult at best to detect.

It appears that the SEC has been vindicated. There are however lingering questions. The reasons the initial inquiry conducted proceeded at such a slow pace remain unclear. The reasons for the delay in taking Mr. Mack’s testimony also remain unclear. The reasons the initial inquiry did not focus on more on Mr. Zilkha in view of his employment at Microsoft and subsequent position with Pequot is also unclear.

It is clear that the whiff of scandal which surrounded the closing of the initial inquiry was wrong. While the SEC was fortunate that it was able to resolve the case, that end came more from the good luck that a divorced wife turned over her ex-husband’s papers than from superior investigative work. In the end the tale of the Pequot investigation should serve as a good lesson for those who are quick to criticize. It should also serve as a reminder to those who conduct investigations which can result in accusations of wrong doing that carry significant consequences that care must be taken before making such an assertion – things are not always what they seem.

THIS WEEK IN SECURITIES LITIGATION (May 28, 2010)

This week, the SEC continued moving forward with its reorganization, hiring its first COO. The Commission also brought insider trading actions arising out of the Pequot investigation and an FBI sting operation, as well as cases alleging investment fund fraud. The Commission also settled an old late trading case. The Galleon cases continued to move forward with first defendant to be sentenced being order to serve a prison term. FINRA fined a firm for again failing to properly retain e-mails. In Canada the government took an important step toward creating a national securities regulator.

The SEC

Enforcement stats: A new report from NERA concludes that the SEC settled with 345 defendants in the first half of fiscal 2010 compared to 328 in the second half of fiscal 2009 and 290 in the first half of 2009. This is the second consecutive semi-annual increase in settlements. It is also the third largest number of settlements in any six month period since 2005. Overall settlement values have remained relatively steady.

COO appointed: The SEC announced the appointment of its first Chief Operating Officer, Jeff Heslop. In this new position, he will report directly to the Chairman and be responsible for operations of the SEC’s Office of Information Technology. He will also oversee the finance and accounting functions of the Commission’s Office of Financial Management and its FOIA, Privacy and Records Management.

SEC enforcement actions

Insider trading: SEC v Pequot Capital Management, Inc., Civil Action No. 3:10-cv-00831 (D. Conn. Filed May 27, 2010) is an action against hedge fund Pequot Capital and its Chairman and CEO, Arthur Samberg. The complaint alleges that David Zilkha, then a Microsoft employee who had been offered a position with Pequot, tipped Defendant Samberg regarding Microsoft’s upcoming earnings call. Specifically, at a time when rumors were circulating that Microsoft’s earnings would be below expectations, Mr. Samberg e-mailed David Zilkha, inquiring if the company would meet expectations. After making inquiries and learning from other Microsoft employees that the company’s earnings would exceed expectations, he told Mr. Samberg who traded. After Microsoft released earnings is share price increased and Pequot funds had increased in value by about $14.7 million. The gains by Pequot and Mr. Samberg from their interests in the funds amounted to about $4.1 million. A friend of Mr. Samberg who also traded on his recommendation had gains of about $372,060. The complaint alleges violations of Exchange Act Section 10(b). To settle the case, the defendants consented to the entry of a permanent injunction prohibiting future violations of Section 10(b). They also consented to the entry of an order requiring the disgorgement of $18 million in trading profits and the payment of $10 million in penalties.

Insider trading: In the Matter of David E. Zilkha, Adm. Proc. File No. 3-13913 (Filed May 27, 2010) is a proceeding against David Zilkha based primarily on the facts in the Pequot Capital case discussed above. The Order goes on to claim that Mr. Zilkha concealed his actions during the Commission’s investigation. After the inquiry however, Mr. Zilkha prepared a draft complaint for an employment law claim against Pequot and Mr. Samberg in which he admitted the tipping. Eventually, the claim was settled. It was kept confidential until its disclosure during divorce proceedings. Subsequently, Mr. Zilkha invoked his Fifth Amendment privilege when asked about the trading by Mr. Samberg and Pequot by the SEC staff. The matter is in litigation.

Investment fund fraud: SEC v. Donnelly, Civil Action No. 03:09CV0015 (W.D. Va. Filed March 11, 2009) is an action against John Donnelly and three entities he controlled. The complaint, discussed here, alleges that Mr. Donnelly fraudulently raised about $11 million from about 31 investors, selling interests in three partnerships. Although investors were told their money would be pooled in funds to invest in stock and bond index derivatives and other instruments, in fact the money raised was in part diverted to personal use and in part used to repay other investors. The defendants settled the action this week, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). In addition, the defendants were ordered to disgorge about $3.8 million along with prejudgment interest. Those amounts were deemed satisfied by the payment of a restitution order in a parallel criminal case where Mr. Donnelly pleaded guilty to wire and securities fraud and impeding administration of internal revenue laws. Defendant Donnelly was sentenced to serve ninety months in prison and pay restitution of $5.435 million. U.S. v. Donnelly, Case No. 03:09-CR-00015 (W.D. Va.). The court also ordered the payment of certain funds from three relief defendants, one of whom is Mr. Donnelly’s wife. See also Litig. Rel. 21538 (May 27, 2010).

Market manipulation: SEC v. Williams, Civil Action No. 3:10-cv-1068 (N.D. Tex. Filed May 27, 2010) is an action against registered representative Derek Lopez and several entities that he controls. The complaint alleges that over a two year period beginning in 2006 Mr. Lopez sold unregistered securities that were subsequently manipulated to artificially high prices and volume. Mr. Lopez also acted as an unregistered broker-dealer when he solicited purchases of stock and traded on behalf of investors who bought stock from him. A parallel criminal action has been filed in the Northern District of Texas. See also Litig. Rel. 21539 (May 27, 2010).

Investment adviser fraud: SEC v. Starr, Civil Action No. 10 CIV 4270 (S.D.N.Y. Filed May 27, 2010) is an action against investment adviser Kenneth Starr and his controlled entities. Mr. Starr has served as an investment adviser to high net worth individuals for years, managing client funds and in some instances paying their bills. According to the SEC, Mr. Starr abused his signatory power by misappropriating client funds. About $7.6 million of client money was used by Mr. Starr to purchase a Manhattan apartment for himself. In other instances, he improperly transferred client funds from their accounts for his personal use. His improper actions were facilitated by a failure to comply with the custody rules. The complaint, which seeks emergency relief including an asset freeze and the appointment of a receiver, is in litigation. A parallel criminal action was filed by the U.S. Attorney’s office. U.S. v. Starr (S.D.N.Y. Filed May 27, 2010).

Investment fund fraud: SEC v. GTF Enterprises, Inc., Civil Action No. 10-CV-4258 (S.D.N.Y. Filed May 26, 2010) is an action against Gedrey Thompson, his controlled fund GTF Enterprises, Inc., its account manager Dean Lewis and its assistant treasurer, Sezzie Goodluck. According to the complaint, defendants raised more than $800,000 from at least 20 investors over a five year period beginning in 2004. Investors were told that Mr. Thompson would trade their funds using a risk free “stop loss” trading technique that would return them 4 to 20% per month. In fact, little of the money was invested, there were huge losses, portions of the investor funds were diverted to personal use and GTF was operated as a Ponzi scheme. The complaint alleges violations of Securities Act Sections 5 and 17(a), Exchange Act Section 10(b), Investment Company Act Section 7(a) and Advisers Act Section 206. The case is in litigation. See also Litig. Rel. 21537 (May 27, 2010).

Insider trading: SEC v. Sebbag (S.D.N.Y. Filed May 26, 2010); U.S. v. Hoxie & Sebbag (S.D.N.Y. Filed May 26, 2010). These actions against Bonnie Hoxie, an administrative assistant to a high level executive at The Walt Disney Company, and her boyfriend Yonni Sebbag, stem from an undercover sting operation. In that operation FBI agents posed as traders responding to a letter circulated to a number of hedge funds offering to sell inside information on an upcoming Disney earnings call as discussed here. After corresponding in a series of e-mails, Mr. Sebbag sold the information to the undercover FBI agents to whom he later explained the scheme. Both cases are in litigation.

Investment fund fraud: SEC v. Bass, Civil Action No. 10-CV-00606 (N.D.N.Y. Filed May 24, 2010) is an action against Christopher Bass and his controlled entities. The Commission’s complaint claims that beginning in January 2007 and continuing through June 2009, Mr. Bass defrauded over 400 investors out of about $5.9 million. Investors were told their money would be pooled and invested by European money managers in various enterprises in Europe. Investors were to receive returns of 2.8% to 6%. The complaint alleges that the claims were false and in fact the enterprise was a Ponzi scheme. The complaint, which alleges violations of Exchange Act Section 10(b), is in litigation. See also Litig. Rel. 21533 (May 25, 2010).

Late trading: SEC v. Mancinelli, Case No. 06 cv 7885 (S.D.N.Y.) is an action against Gene Mancinelli, a former broker at Wall Street Access. The complaint alleges that Mr. Mancinelli permitted his hedge fund customers to late trade and market from April through October 2001. To resolve the action Mr. Mancinelli consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b) and from aiding and abetting violations of Section 15(c) of the Exchange Act. He was also directed to pay disgorgement of $158,799 along with prejudgment interest. Based on his financial condition, the Commission did not seek a civil penalty and waived payment of all but $45,000 of the disgorgement. In a separate Administrative Proceeding, Mr. Mancinelli was barred from association with any broker or dealer with a right to reapply after three years. See also Litig. Rel. 21534 (May 26, 2010).

Investment fund fraud: SEC v. Allen, Case No. 1:10-cv-01143 (N.D. Ohio, Filed May 20, 2010) is an action against Edward Allen, David Olson and their company A&O Investments, LLC discussed here. According to the complaint, beginning in September 2005 and continuing through the end of 2008 the defendants raised approximately $14.8 million from at least 100 investors who were solicited to purchase promissory notes issued by A&O. A&O Investments was supposed to purchase, rehabilitate and sell real estate. The notes were supposed to pay a 20% return and be secured by the real estate. These representations were false. A& O was operated as a classic Ponzi scheme with portions of the funds being channeled to Messrs. Allen and Olson. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The Commission has not obtained a temporary freeze order in this case. The action is in litigation.

Criminal cases

Insider trading: U.S. v. Kurland, Case No. 10-cr-69 (S.D.N.Y.). Mark Kurland, a cofounder of New Castle Partners equity hedge fund, is the first of the Galleon defendants to be sentenced. The court sentenced him to serve twenty seven months in prison followed by two years of probation. He will also forfeit $900,000. Previously he pleaded guilty to conspiracy and securities fraud. According to the criminal information, in 2008 and 2009 Mr. Kurland participated in a scheme to trade on inside information pertaining to three companies. The scheme involved trading in the securities of Advanced Micro Devices, Inc., Akamai Technologies, Inc. and Sun Microsystems Inc. Ms. Chiesi obtained the inside information from her sources at Akamai and IBM. Trades were then placed in the shares of ADM, Akamai and Sun by New Castle either by Mr. Kurland or with his approval. Only the Sun trades were profitable.

FINRA

Piper Jaffray & Co. was fined $700,000 for violation related to its failure to retain about 4.3 million e-mails over a six year period beginning in 2002. In November 2002, the firm had been sanctioned based on its e-mail retention policy in a joint action by the SEC, New York Stock Exchange Regulation and NASD. Part of the settlement required the firm to review the system and certify its procedures. The certification was made. Regulators were not told of any difficulties. Those came to light however when FINRA was reviewing a document production that turned out to be incomplete.

Canada

The Canadian government released a draft of a proposed Canadian Securities Act which is a key step towards establishing a Canadian securities regulator. Canada is the only major industrialized country that does not have a national securities regulator. The proposed regime would include: better protection for investors; improved regulatory enforcement; new tools to support the stability of the Canadian financial system; simpler processes for businesses; and more effective international representation.