SEC Enforcement Trends – Financial Fraud

While financial fraud cases are a traditional staple of the SEC’s Enforcement Program, issuers, directors, officers and even outside vendors and consultants to public companies should take note of the increasing aggressive posture of the Enforcement division, which at times may be over reaching.  A review of the SEC’s cases in this area last year suggests that the agency is aggressively pursing these cases in an effort to expand the contours of potential liability and that it is imposing increasingly large penalties even those who cooperate with the investigation. 

Penalties for financial fraud continue to be large.  For example:  SEC v. McAfee, Inc., (D.D. Cal. Jan 4, 2006) involved an alleged scheme to overstate revenue from 1998 to 200 by about $622 million according to the complaint.  The case settled with the defendant consenting to the entry of a statutory injunction and an order directing the payment of a $50 million penalty. 

SEC v. Tyco International Ltd., (S.D.N.Y. Apr. 17, 2006)  was based, according to the complaint, on a financial fraud centered on a scheme to overstate results by at least $1 billion.  The case settled with the entry of a consent decree which included a statutory injunction and an order requiring the payment of a $50 million penalty.  

Even in cases where the SEC acknowledged the company’s cooperation the Commission assessed large fines.  For example: 

SEC v. Federal National Mortgage, (D.D.C. May 22, 2006) was based on a complaint that alleged multiple violations of GAAP to smooth earnings over a period of years.  The case settled with the entry by consent of a statutory injunction and an order directing the payment of a $400 million penalty.  The SEC’s release acknowledged the cooperation of the company. 

SEC v. AIG, (S.D.N.Y. Feb. 9. 2006)  involved an alleged financial fraud in which the company overstated its loss reserves by $500 million to improve its balance sheet.  The actions settled with the entry of a consent degree under which the company agreed to the entry of a statutory injunction and the payment of a penalty of $100 million. Again, the SEC’s Release acknowledged the extensive cooperation of the company.  

In addition to imposing large penalties in financial fraud cases, the SEC was also aggressive in its case selection.  Consider the following examples: 

In the Matter of City of San Diego, (Nov. 14, 2006), is a settled administrative proceeding brought against the City of San Diego based on allegations of financial fraud involving bond offerings by the City.  The case alleged that the City failed to disclose difficulties with pension and retiree health care obligations in the bond offering.  The action was resolved with the entry of a cease and desist order by consent and the entry of an order, which required the retention of a consultant to review internal controls. 

SEC v. Todd, et al., Case No. 03CV2230 BEN (WMc) involved a claimed financial fraud to inflate the revenues of Gateway, Inc. by former CEO Jeffrey Weitzen, former CFO John J. Todd, and former controller Robert D. Manza.  Following a trial on the merits Todd and Manza were found liable for securities fraud on March 7, 2007.  The evidence established that both men engaged in a scheme to inflate earnings by approving credit for persons who had previously been rejected as bad credit risks and then booking sales to those individuals.  In this pre-SOX (i.e. a CEO certification was not required) case the evidence demonstrated that CEO Weitzen had not signed the filings involved and that, although Weitzen had knowledge of the accounting issues the SEC claimed were fraudulent, the SEC failed to show Weitzen acted with scienter or as a control person.  The SEC, however, sought to hold him liable as the CEO.  The court granted summary judgment in favor of Mr. Weitzen on May 30, 2006.   Both of these cases suggest the aggressive posture of the Enforcement Program.  While the City of San Diego is not the first case involving a municipal government, such cases are not an ordinary occurrence.  The case involving Mr. Weitzen suggests a very aggressive – perhaps overly aggressive – approach of trying to hold those at the top responsible. 

Finally, the SEC is pursing not only those at the company who engage in financial fraud, but others outside the company who aided and abetted the fraud – even to the point of criminal liability.  Consider for example: 

SEC v. Scientific-Atlanta, (S.D.N.Y. June 22, 2006), which is a settled enforcement action alleging that the defendant company aided and abetted Adelphia in inflating its earnings by $43 million.  The action settled with a consent to the entry of a statutory injunction and an order directing the payment of $20 million in disgorgement. 

SEC v. Ronald Ferguson, (S.D.N.Y. Feb. 2006), where the complaint charged four former senior executives of Gen Re and one senior executive of AIG with aiding and abetting AIG in improperly overstating its loss reserves by almost $500 million.  A parallel criminal case was also filed.  Both cases are pending.  

SEC v. Gary Bell, (D.D.C. Jan. 18, 2007) is an action against 13 additional employees and agents of vendors claimed to have aided and abetted a massive fraud at U.S. Food Service, Inc. by executing false audit confirmations.  Several agreed to settle for consent decrees and penalties, while others are litigating with the SEC. 

Collectively these cases suggest aggressive, and at times overly aggressive, efforts in the financial fraud area with potentially expanding contours of liability and very large penalties even when the company is fully cooperative with the SEC’s investigation.  Pushing the edge of liability, as in the action against Mr. Weitzen and others discussed earlier in this series, suggests an approach that may at times be based more on an overly aggressive posture than sound legal theory and the evidence.  All of this suggests that issuers, their directors and executives should carefully review their compliance programs to avoid becoming entangled in one of these actions. 

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All companies, directors and executives should take note of the warning in a March 8, 2007 speech, Linda Chatman Thomsen, the Director of the SEC’s Division of Enforcement.  In that speech, Ms. Thomsen stated that the SEC is “looking at” trading conducted under Rule 10b5-1 Plans by company executives, and looking at those trades “hard.”  She explained that “[w]e want to make sure that people are not doing here what they were doing with stock options.  If executives are in fact trading on inside information and using a plan for cover, they should expect the “safe harbor” to provide no defense.”

Executives frequently have access to material, non-public information and are prohibited from acting on that information by buying or selling shares.  The SEC enacted Rule 10b5-1 in 2000 to permit an executive who has possession of insider information to buy or sell securities pursuant to a previously adopted written trading plan.  17 C.F.R. § 240.10b5-1.  The SEC created this “safe harbor,” as Ms. Thomsen explained, “to give executives regular opportunities to liquidate their stock holdings – to pay their kid’s college tuition, for example – without risk of inadvertently facing an insider trading inquiry.”

Specifically, Rule 10b5-1 provides an affirmative defense to the charge of insider trading if a plan is adopted before the executive becomes aware of the material non-public information.  The Plan must:  specify the amount of securities to be purchased or sold and the price at which, and the date on which, the securities are to be purchased or sold, or include a written formula or algorithm, or computer program, for determining the amount of securities to be purchased or sold and the price at which, and the date on which, the securities are to be purchased or sold; or not permit the person to exercise or to have any subsequent influence over how, when, or whether to effect purchases or sales. 

The Rule also states that the affirmative defense will not apply if the person who entered into the Plan altered or deviated from the Plan (whether by changing the amount, price, or timing of the purchase or sale), or entered into or altered a corresponding or hedging transaction or position with respect to those securities

In December 2006, Alan D. Jagolinzer, an Assistant Professor at Stanford University’s Graduate School of Business, released a study entitled “Do Insiders Trade Strategically Within The Sec Rule 10b5-1 Safe Harbor?”  Professor Jagolinzer examined over 100,000 trades conducted by over 3,000 executives participating in Rule 10b5-1 Plans and concluded that the trades by those executives outperformed the trades by executives who did not participate in such a plan almost 6%. 

In her March 8, 2007 remarks, Ms. Thomsen cited the Stanford Study and pointed to a Business Week article that discussed the results of the magazine’s examination of information available on another database.  Ms. Thomsen stated that the studies “suggest that the Rule [10b5-1] is being abused.”  This is similar to the onset of the stock option backdating scandal where, in late 2005 and early 2006, the Wall Street Journal noted that academic studies suggested options backdating at a number of companies.  By the end of 2006, over 140 companies were under investigation for alleged backdating of stock options and several companies and their executives were named in high profile civil and criminal actions.  Ms. Thomsen’s comments raise a very real issue – executives who participate in Rule 10b5-1 Plans could be next. 

At least one company may already be facing this issue.  On March 3, 2007, New Century Finance Corporation disclosed in filings that federal prosecutors and securities regulators are investigating, among other things, certain stock sales.  As the New York Times reported, the company’s shares have fallen more than 53 percent since the start of the year.  According to the company, in a very short period in late February and March 2007, it was contacted by the regulatory arm of the New York Stock Exchange, the United States Attorney’s office in Los Angeles and the SEC about trading.  Vikas Bajaj and Julie Creswell, Authorities Investigate Big Lender, N.Y. Times, March 3, 2007 at C1.  While it is unclear what stock sales investigators are looking at, a review of the SEC Form 4’s indicate that between August and November 2006, Founder Edward Gotschall sold over 500,000 shares for more than $12 million under a Rule 10b5-1 Plan adopted on June 15, 2006 and Founder Robert Cole sold 150,000 shares for more than $6 million under two Rule 10b5-1 Plans adopted on September 15 and June 15, 2006 (although neither had sold any shares for the prior six months). 

Ms. Thomsen’s comments suggest that the next enforcement target may be Rule 10b5-1 Plans, meaning that a once safe harbor may no longer be safe.  It would be prudent for companies and their executives to carefully review any Rule 10b5-1 Plans, as well as any trades made under those Plans, particularly those in advance of or after news releases.  

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