SHIFTING THEORIES OF CRIMINAL LIABILITY SHOULD RAISE RED FLAGS

The line between civil and criminal violations of the securities laws is, at best, difficult to discern. That difficulty is compounded by the increasing criminalization of the federal securities laws. In some instances, this had led to overreaching by prosecutors in an effort to establish the charges filed as discussed here. In others, it has resulted in shifting theories of liability. Each of these should raise a red flag that the charges brought are inappropriate. Unfortunately, the red flags are at times ignored.

U.S. v. Schiff, No. 08-1903 & 08-1990 (3rd Cir. Apr. 7, 2010) is a case where the red flags were ignored, resulting in criticism from the district court of shifting legal theories and ultimately the dismissal of some charges. The Third Circuit affirmed.

Securities fraud charges were brought against the former CFO of Bristol-Myers Squibb, Frederick Schiff, and Richard Lane, another company executive. The fraud charges arose from statements made in an earnings call and corporate filings regarding a sales strategy implemented by the drug manufacturer. Under that strategy, Bristol-Myers paid millions of dollars each quarter to its wholesales as incentives to spur buying of its products in excess of demand projections. Mr. Schiff approved the payment of these sales incentives which were supposed to cover carrying costs and guarantee a return on the investment of the wholesales until the products were sold.

The government claimed that Defendants Schiff and Lane made false and misleading statements in analyst calls and SEC filings to conceal these practices from investors. For example, in analyst calls in April, July, October and December 2001, either Mr. Schiff or Mr. Lane stated that the company was closely watching wholesaler stocking inventories and no unusual items were observed. However, in an April 1, 2002 10-K, the company stated that average wholesaler inventories had increased during 2001 and exceeded levels the company considered desirable. Accordingly, the company stated that is was developing a plan to reduce those levels which will negatively impact its financial results in future periods. In an April 3, 2002 analysts call, the CEO of Bristol announced that Mr. Lane was leaving the company and reiterated the fact that current wholesaler inventory levels significantly exceeded the level considered desirable.

The government charged Messrs. Schiff and Lane with securities fraud based in part on statements he made as well as those of the other executive. In ruling on Mr. Schiff’s motion to dismiss the third superseding indictment in view of a bill of particulars filed by the government, the district court dismissed theories of fraud liability based on omissions. Specifically, the court dismissed a theory of duty based on the alleged falsity of reported sales and earnings in the SEC filings and a second theory called “all of a piece.” Under that theory, raised for the first time one month before trial, the government claimed Mr. Schiff is liable for omissions in the SEC filings stemming from prior misleading statements made on analyst calls. The theory thus sought to link alleged prior statements in the analyst calls to claimed omissions in the SEC filings. The district court rejected this theory and criticized the government for shifting theories, concluding it would permit no further “legal theory morphs.” The government only appealed on the “all of a piece” theory.

The Third Circuit affirmed. First, the court rejected the government’s claim that Mr. Schiff had a fiduciary duty to rectify the alleged misstatements of another executive. A duty to disclose only arises in three circumstances: 1) insider trading; 2) a statutory requirement; and 3) an inaccurate, incomplete or misleading prior disclosure. The court rejected the government’s claim that as a high corporate executive such as Mr. Schiff had a duty to rectify misstatements made by another.

Second, the court rejected the government’s theories of liability based on Mr. Schiff’s statements. Here, the government argued three theories: 1) “all of a piece;” 2) duty to update; and 3) duty to correct. Under the “all of a piece” theory the government claimed that statements made at the analysts calls were tied together with the statements in the SEC filing as essentially one event. The government, however, had stipulated that its theory of liability was based only on omissions, not misrepresentations. Under these circumstances, the court held that that it was “not logical” to conclude that an utterance in an analyst conference call must have other words written into it from a later made SEC filing. Liability under Section 10(b) and Rule 10(b)-5 arises from each statement made. Here, there was an insufficient nexus to tie the statements together.

The court also rejected claims of a duty to update and correct. Both of these were new theories which the court noted the government was trying to insert into the case at the eleventh hour. A duty to update arises only when a statement was reasonable at the time, but later became misleading when viewed in the context of other events. This is not the predicate of the government’s claim here. A duty to correct arises when a historical statement that at the time was true is revealed by subsequent events to be incorrect. Again, this is not the case here. Accordingly, the district court’s order dismissing the charges is affirmed. Clearly in its zeal to prevail, the government missed the red flags here.

THIS WEEK IN SECURITIES LITIGATION (April 9, 2010)

This week the SEC proposed new rules regarding asset backed securities while Chairman Mary Schapiro, in an op-ed article in the Washington Post, called for the Senate financial reform bill to be strengthened. SEC enforcement saw another of its proposed settlements held by Judge Rakoff in the Southern District of New York. The Commission also brought another action against broker for fraudulent calculation of NAV and concluded its long running financial fraud case with against Symbol Technologies.

Market crisis

Legislation: SEC Chairman Mary Shapiro, in an op-ed article in the Washington Post (here, registration required), called for Congress to take three key steps to strengthen the current Senate bill on financial reform: 1) create clearer lines of regulation; 2) have more transparency in the swaps market; and 3) maximize the use of clearinghouses and exchanges in transactions involving swaps where possible.

Uniform fiduciary standard: Commissioner Louis Aguilar, in recent remarks, strongly advocated harmonizing the standards, discussed here. Investment advisers, the Commissioner noted, owe their clients an affirmative duty of the utmost good faith and fair disclosure. They are required to serve their clients with undivided loyalty. This standard has served advisory clients well over the years. This standard, and not a variation of it, should apply to all, according to Commissioner Aguilar.

SEC

Judge Rakoff, in an step reminiscent of the Bank of America case, discussed here, has requested more evidence before accepting a settlement in an insider trading case. The case is against Schottenfeld Group, discussed here, and is related to the Galleon insider trading action as discussed here.

SEC enforcement actions

Offering fraud: SEC v. Kelly, Case No. 1:07-CV-4979 (N.D. Ill. Filed Apr. 8, 2010) is an action against Michael Kelly and twenty-five other defendants. It alleges a massive fraud through the sale of universal leases. The lease investments were structured as timeshares in several hotels. From 1999 through 2005, Defendant Kelly and others, raised at least $428 million through the Universal Lease scheme. Investors were told they would profit from an arrangement under which the leases would generate guaranteed income. The court entered a final judgment against John Tencza and American Elder Group, LLC, his business. The entry enjoined Mr. Tencza and his company from violating there registration and antifraud provisions of the securities laws. The court also order the payment of disgorgement in the amount of about $1.6 million along with interest and a civil penalty of $600,000.

Fraudulent pricing: In the Matter of Morgan Asset Management, Inc., File No. 3-1847 (Apr. 7, 2010). The action named as respondents Morgan Asset, a registered investment adviser, Morgan Keegan, a broker dealer, James Kelso, Jr., a senior portfolio manager for Morgan Asset and Joseph Weller, an employee of Morgan Keegan where he was controller and head of its Fund Accounting Department. The Order alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Section 206 based on false NAV calculations for five funds which prevented a write down of assets backed by sub-prime loans. The Commission has ordered that the matter be set for a hearing. A related proceeding was brought by FINRA.

Financial fraud: SEC v. Symbol Technologies, Inc., Civil Action No 04 CV 2276 (E.D.N.Y.) The Commission concluded this action, settling with the final two executives in this long running financial fraud case. Frank Borghese, former Senior VP of Worldwide Sales and Services and Michael DeGennaro, former VP of finance settled. Mr. Borghese consented to the entry of a permanent injunction prohibiting him from violating the antifraud and reporting provisions of the Exchange Act. He also agreed to pay disgorgement of $450,000. Any penalty was waived based on financial condition. Mr. DeGennaro consented to the entry of an order requiring him to pay a civil penalty of $40,000. He also agreed to the entry of a cease and desist order in a related administrative proceeding.

Registration fraud: SEC v. O’Riordan, 1:10-CV-10550 (D. Mass. Apr. 2, 2010) is an action for registration fraud against Daniel O’Riordan, the president of Paradigm Tactical Products. According to the complaint, the founder of the company sold several million shares of unregistered stock into the market at prices that were inflated by false statements.

Mr. O’Riordan, who was then the president of the company, facilitated the scheme by signing a false Form D which was filed with the SEC in 2005, executing backdated stock certificates and helping prepare a list of purported accredited investors who were in fact nominee shareholders under the control of the founder. The stock price was inflated. After leaving the company Mr. O’Riordan sold unregistered shares of the company. Mr. O’Riordan settled the case, consented to the entry of a permanent injunction prohibiting future violations of the registration and antifraud provisions and agreeing to an officer director bar. A parallel action was filed by the U.S. Attorney’s Office.

Manipulation: SEC v. El-Batrawi, Case No. CV-06-2247 (C.D. Cal. Filed Apr. 13, 2006) is an action, discussed here, which arises out of a scheme by Adnan M. Khashoggi, Ramy Y. El-Batrawi and others based on the manipulate the of the shares of GenesisIntermedia, Inc. (“GENI”) while misappropriating more than $130 million. Most of the money came through a stock loan deal where shares were exchanged for cash. Part of the scheme centered on inflating the share price of GENI.

Each of the defendants settled with the Commission except Ultimate Holdings, which is defunct, and Mr. Khashoggi. Mr. El-Batrawi consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions and an officer/director bar for five years. Mr. Jacobson consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a)(3) and Section 13(a)(5). He also agreed to pay a penalty of $15,000 Richard Evangelista agreed to the entry of a permanent injunction prohibiting future violations of the antifraud provisions. He also agreed to the entry of an order requiring him to pay disgorge of $25,000 and a penalty of $15,000 as well as an order barring him from association with a broker dealer in a parallel administrative proceeding. Mr. Breedon consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions. All financial payments were waived based on financial condition. GENI consented to being delisted in a related administrative proceeding.