by T. GormanPosted on Posted in SECActions

The Senate passed financial reform legislation which now must be reconciled with the House bill. SEC Chairman Schapiro and others appeared before Congress this week to testify about the recent market disruption. At the same time the SEC, while joining yet another financial fraud task force, took the unprecedented step of designating the deputy director of the Division of Enforcement as lead litigation counsel in its action against Goldman Sachs. The circuit courts handed down two important decisions, one on double jeopardy and a second on the type of cautionary language necessary to invoke the safe harbor for forward looking statements. In London, the FSA may have become a victim of its own success. The financial regulator is going to be merged with other agencies to form a single white-collar crime agency.

Market reform

Financial fraud task force: On Friday, officials will announce the formation of the Virginia Financial and Securities Fraud Task Force. This group will be composed of the U.S. Attorneys Office for the Eastern District of Virginia, the SEC, CFTC and Virginia state securities regulators. The purpose of the task force is to investigate and prosecute complex financial fraud cases in the nation and in Virginia.

Financial reform: The House Oversight and Government Reform Committee Ranking Member, Darrell Issa, released a report which is highly critical of the SEC. According to the report, the Commission’s securities disclosure processes are technologically backward, reviewing filings manually since it never developed the proper tools. In addition, the Commission has not only failed to properly investigate some of the most significant frauds, it has also failed to govern itself, according to the report. Despite a budget that has nearly tripled over the last decade, current Commissioners claim that they need more money. Overall, the Commission suffers from a “silo problem” the report claims. The Commission’s fragmentation into operational silos has had devastating effect and generates bureaucratic rivalries.

SEC enforcement actions

Financial fraud: SEC v. McCall, Case No. C-03-2603 (N.D. Cal. Filed June 4, 2003) is an action against, among others, Charles McCall, the former CEO and Chairman of HBOC and then Chairman of McKesson HBOC following a merger. The complaint claims that he engaged in a years-long financial fraud scheme with other executives to inflate earnings. To settle with the Commission, Mr. McCall consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(b)(5) and 20(a). He also agreed to be permanently barred from serving as an officer or director of a public company and was directed to pay a total of $1,878,128 in disgorgement and prejudgment interest. Previously, Mr. McCall was convicted of securities fraud and other related charges and sentenced to ten years in prison and ordered to pay a $1 million criminal fine.

Insider trading: SEC v. Galleon Management, LP, Civil Action No. 09-CV-8811 (S.D.N.Y.) is the insider trading case against the founder of Galleon, discussed here. This week the Commission settled with defendant Anil Kumar, a friend of the founder of Galleon, Raj Rajaratnam. Mr. Kumar, a former director of consulting giant McKinsey & Co., was alleged to have provided Mr. Rajaratnam with inside information on which he traded several times. In the settlement, Mr. Kumar agreed to the entry of an order which permanently enjoins him from violating the antifraud provisions of the federal securities laws. He also consented to the entry of an order requiring him to pay disgorgement in the amount of $2.6 million along with prejudgment interest. The court will determine the amount of a penalty at a later date. Mr. Kumar is cooperating with the SEC. Previously, he pleaded guilty in the parallel criminal action, discussed here.

Criminal cases

Investment fund fraud: U.S. v. Green, Case No. 1:09-mj-01880 (S.D.N.Y. Filed Dec. 14 2009) is an action against the former chairman of Mayfair Capital Group, Stephen Green, discussed here. This week Mr. Green was sentenced to 41 months in prison for investment fund fraud. Previously, he pleaded guilty two counts of securities fraud. The information was based on allegations that over a period of four years Mr. Green had raised over $5.75 million from investors based on a series of fraudulent claims. The money was diverted to his personal use.

Circuit courts

Double jeopardy: U.S. v. Rigas, No. 08-3218 (3rd Cir. Decided May 12, 2010) is the second criminal action brought against John Rigas, founder of Adelphia Communications Corporation and his son Timothy, who was a member of the board and CFO as discussed here. The first action centered on claims that the father and son looted the company prior to its collapse. Both were convicted of conspiracy and several substantive counts. Subsequently, both men were indicted in the Middle District of Pennsylvania on one count of conspiracy and six counts of tax evasion. The conspiracy count claimed the two defendants attempted to defraud the United States by evading millions of dollars in taxes on the money and property they took from Adelphia which was at the center of the looting charges in the first case.

The key question in the case focused on whether the second conspiracy claim could be brought under the double jeopardy clause of the Fifth Amendment. The government claimed that Section 371 provides alternative grounds for conspiracy claims while defendants argued that Congress had only created one crime. The Third Circuit concluded that the question was one of statutory construction. In view of the text of Section 371, the court held that, while there are alternative grounds stated in the statute, Congress only created one crime. Accordingly, the case was remanded to the district court for an evidentiary hearing on the double jeopardy claim.

Forward looking statements: Slayton v. American Express Co., Case No. 08-5442-cv (2nd Cir. Decided May 18, 2010) is a securities fraud damage action. The appeal centered on the question of whether cautionary statements made by an issuer were sufficient to bring a forward looking statement within the safe harbor from liability created by the PSLRA as discussed here. The complaint centered on a statement in a quarterly report regarding a rapidly deteriorating portfolio of high-yield debt held by the company. In that report, American Express announced significant losses from the portfolio, but went on to note that future losses were expected to be lower. Several pages later, the quarterly report noted it contained forward looking statements that were subject to various risks and uncertainties and that one factor could be further deterioration in the high yield area.

Plaintiffs argued that the cautionary language was boilerplate. The court agreed. After examining the legislative history of the section, the Second Circuit concluded that Congress expected meaningful and specific cautionary language, not boilerplate. Here, the same warning using the same language appeared in several reports both before and after the challenged statement was made. This led the court to conclude the warning was not meaningful, but boilerplate. While the statement was thus not entitled to the protection of the PSLRA safe harbor, the action was dismissed because plaintiffs failed to adequately plead facts demonstrating knowing falsity, the requisite standard for forward looking statements.

by T. GormanPosted on Posted in SECActions

A critical question in making forward looking statements is whether there is meaningful cautionary language. If there is, then the PSLRA provides a safe harbor from liability. If there is not, the speaker may be liable, but only upon proof of knowing falsity. A critical question then is what constitutes meaningful cautionary language under the PSLRA. In Slayton v. American Express Co., Case No. 08-5442-cv (2nd Cir. Decided May 18, 2010), the Second Circuit rejected defendants’ claim that their forward looking statements came within the safe harbor because the cautionary language was boilerplate. Nevertheless, the Court affirmed the dismissal of the action, concluding that plaintiffs had failed to adequately plead facts demonstrating knowing falsity.

The action is based on a statement made by American Express in its May 2001 10-Q regarding its portfolio of high-yield debts investments in the MD&A section of the filing. There, the company reported a loss of $182 million from those investments. It went on to state that the company expected substantially lower losses for the remainder of 2001. Plaintiffs claim that this statement is false. According to the second amended complaint, at the time of the quarterly filing, the company knew that the $182 million first quarter write down did not reflect the true magnitude of the deterioration of the portfolio. In fact, when the 10-Q was filed, senior management was investigating the question and later reported substantially larger losses totaling over $800 million.

The Form 10-Q also contained cautionary language which appeared several pages after the allegedly false statement. There, the report warned that it “contain[ed] forward-looking statements, which are subject to risks and uncertainties.” It also stated that “[f]actors that could cause actual results to differ materially from these forward-looking statements include . . . potential deterioration in the high-yield sector, which could result in further losses . . .”

First, the court concluded that the statement challenged by plaintiffs was clear a forward looking statement. The PSLRA has several definitions of forward looking statement. One provides that “a statement containing a projection of . . . income . . . or other financial items . . .” is a forward looking statement. Although projections included in financial statements are excluded from the safe harbor, here the statement was in the MD&A section of the 10-Q, not in the financial statements.

Second, the critical question is whether the projection is accompanied by meaningful cautionary language. The PSLRA only provides a safe harbor from liability if the statement is “identified as a forward-looking statement, and is accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward looking statement . . .” 15 U.S.C. § 78u-5(c)(1)(A)(i).

In this case, the Court concluded that the cautionary language was not sufficient. Nothing in the statute requires that the forward looking statement be contained in a separate section. Equally clear is the fact that cautionary language which is misleading in light of historical fact cannot be meaningful within the meaning of the statute. The difficulty in this case, the Court noted, is that the defendants knew of specific risks about the portfolio, but did not warn of them. At the same time however, Congress foreclosed any inquiry into a defendants’ state of mind in applying the safe harbor provision. This creates a difficult tension in applying the statute.

The Court resolved this problem by focusing on a provision in the Conference Report to the PSLRA which warns that the cautionary language may not be boilerplate. Rather, the warnings should be extensive and specific.

Here, the warning was boilerplate. The same cautionary language appeared in several other filings both before and after the one at issue here. The consistency of the language demonstrates it was not tailored to the specific situation. Clearly such language is not meaningful as required by the PSLRA. Accordingly, defendants could not rely on the safe harbor.

Nevertheless, plaintiffs’ complaint failed because it did not adequately plead facts demonstrating knowing falsity. In this case, the totality of the circumstances demonstrates that while there is an inference of scienter, the contrary inference is at least as strong. In addition, the fact that there was no motive to falsify the facts supports the conclusion that the complaint fails to adequately plead actual knowledge. Accordingly, the decision of the district court dismissing the complaint was affirmed.