During the last two weeks (last Friday was a holiday), the rejuvenation of SEC Enforcement has continued. Reportedly, the Division is reorganizing, shedding supervisory positions in favor of more front line investigators. The Commission also added derivatives expertise while continuing to bring a number of financial fraud cases. The FCPA continued to be a focus of regulators, with the World Bank resolving matters with Siemens in a record-setting fashion, while DOJ brought indicted a private company and its employees. Finally, in the U.K, the FSA continued its “get tough” approach, announcing a new framework for resolving cases and the imposition of financial penalties.
The SEC
Enforcement reorganization: The SEC Enforcement Division is being reorganized in an effort to revitalize the once highly respected program as discussed here. The current focus reportedly is on streamlining operations and adding efficiency. In a move being billed as the largest reorganization in decades, the Division is eliminating supervisory positions and excess layers of management to add more front line investigators. At the same time, five specialist teams will be formed, focused on particularly difficult areas of the market.
New expertise: The SEC reportedly is hiring University of Texas Professor Henry Hu, an expert on systemic risks created by credit derivatives and other complex instruments. Professor Hu has expressed concern over the so-called “empty creditor” problem. This comes from the fact that hedge funds and banks are increasingly using credit derivatives to hedge in ways that create perverse incentives to tip companies into default. The retention of Professor Hu is consistent with reports that the agency is looking to add specialized expertise in areas such as derivatives.
New investment adviser rules: The SEC’s Inspector General H. David Kotz has made three recommendations for tightening the regulations for investment advisers and hedge funds: 1) independent custodians should be used to maintain investments in separate accounts in a manner similar to that of mutual funds; 2) the advisers and funds should be required to certify that they have conducted proper due diligence regarding their advice; and 3) the PCAOB should be given new authority to audit reports prepared by domestic and foreign accounting firms. The IG also recommends expanding the SEC’s bounty program. The recommendations are in a letter to Congressman Paul Kanjorski, Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. Mr. Kotz responded to a letter from the Congressman dated June 16, 2009 regarding the Madoff case.
FINRA
Sweep: FINRA is reportedly conducting a sweep of firms involved in recent collapses in the municipal bond markets. The reviews are part of a new scrutiny of the $2.7 trillion municipal bond markets which has experienced a rise in defaults during the market crisis. The sweeps are apparently focused on sales and supervisory practices, potential conflicts and disclosure practices and the retail sales of certain types of bonds that were underwritten and guaranteed by Lehman Brothers.
SEC enforcement
Stock manipulation: SEC v. Pointer Worldwide, Ltd, Civil Action No. 09-CV-6162 (S.D.N.Y. Filed July 9, 2009) is an action against a Russian entity and its officer who are alleged to have commandeered the online trading accounts of unwitting investors over a two day period, liquidated their holdings, and then used the proceeds to manipulate other stocks. Essentially, the defendants created the false appearance of trading in selected stocks and, when the share price increased, they dumped their holdings and took the profits. This trading pattern was repeated with four different stock yielding profits of over $33,000. The complaint alleges violations of the antifraud provisions of the securities laws. The case is in litigation. See also Lit. Rel. 21122 (July 9, 2009).
Stock manipulation: SEC v. Sky Capital, Case No. 09-CV-6129 (S.D.N.Y. Filed July 8, 2009) was brought against New York broker Sky Capital and its found and principal. The complaint claims that the defendants raised over $61 million over a four year period beginning in 2002 from U.S. and U.K. investors through fraudulent means. Specifically, the complaint claims that the defendants used boiler room tactics to sell shares in two entities to investors. As a result of a “no-net sales” policy, the share price of each company was artificially inflated. The proceeds from the stock sales were used to finance the lavish life styles of the defendants. The complaint alleges violations of the antifraud provisions of the securities laws. The case is in litigation. See also Lit. Rel. 21120 (July 8, 2009). The U.S. Attorney also filed criminal charges. U.S. v. Mandell, Case No. 1:09-cr-00662 (S.D.N.Y. Filed June 30, 2009).
Financial fraud: SEC v. Wells, Civil Action No. 3:09-CV-01792 (D.S.C. Filed July 8, 2009) was brought against Jerry F. Wells, former Executive Vice President and Chief Financial Officer of UCI Medical Affiliates, Inc. and is discussed here. According to the complaint, over a five year period Mr. Wells embezzled more than $2.9 million for his personal expenses. In large part, Mr. Wells concealed his actions by capitalizing the expenses. This caused the financial statements to, in most years, overstate income, in one year by as much as 11.1%. For each year between 2003 and 2008, Mr. Wells executed false annual and quarterly reports filed with the Commission as well as SOX certifications and management representation letter to the outside auditors.
The scheme was unraveled when the outside auditors, acting under the direction of the audit committee, tested all the expenditures of three company executives after questioning some charitable contributions paid for Mr. Wells. When that testing revealed expenditures paid by the company for Mr. Wells, the auditors requested additional documentation. Mr. Wells failed to respond and was terminated shortly thereafter by the company. The Commission’s complaint alleges violations of the antifraud and reporting provisions of the federal securities laws. The case is in litigation. See also Lit. Rel. 21119 (July 8, 2009).
Financial fraud: In. SEC v. Rand, Civil Action No. 1:09-CV-1780 (N.D. Ga. Filed July 1, 2009), the Commission filed a financial fraud action centered on a years long scheme to manage the earnings of home builder Beazer Homes USA, Inc. Defendant Michael Rand is the former chief accounting officer of the company. See also Lit. Rel. 21114 (July 1, 2009).
Mr. Rand, according to the SEC, engaged in a scheme over a period of about eight years to meet analysts’ expectations. In part, the scheme used cookie jar reserves to smooth earnings while for a period Mr. Rand also improperly booked revenue from transactions while concealing the true nature of the deal from the outside auditors. As a result, the filings made by the company with the SEC from were false and misleading. The case, which is discussed here, https://www.secactions.com/?p=1257 is in litigation. The company previously settled an administrative proceeding based on similar conduct, discussed here. In the Matter of Beazer Homes USA, Inc., Adm. Proc. File No. 3-13234 (Sept. 24, 2008).
Financial fraud: In SEC v. Durgarian, Case No. 05-12618 (D. Mass. Filed Dec. 30, 2005), the Commission settled with Donald McCracken, a former senior managing director and head of fund accounting at Putnam, discussed here. The Commission’s initial complaint in this case named six former employees of Putnam, including Mr. McCracken. It centered on a claimed cover-up of a one-day delay in investing certain Cardinal assets in a defined benefit plan in 2001. As a result of the delay, Cardinal lost about $4 million in market gains. Rather than disclose the error to Cardinal, the defendants took steps to conceal it according to the complaint. Those steps included improperly shifting about $3 million of the costs to the shareholders of other Putnam funds by backdating accounting entries and other mechanism. Cardinal ended up with about $1 million in losses. The complaint charged Mr. McCracken and the other defendants with fraud
To resolve the case, portions of which were unsuccessfully appealed to the First Circuit by the SEC, Mr. McCracken consented to the entry of a permanent injunction prohibiting future violations of Section 17(a)(3) of the Securities Act. He also agreed to the entry of an order requiring the payment of a civil penalty of $35,000 and, in a separate administrative proceeding to be filed, an order barring him from association with any broker or dealer or transfer agent with a right to reapply after one year. See also Lit. Rel. No. 21110 (June 29, 2009). The SEC dropped the Section 17(a) and 10b fraud charges initially brought against Mr. McCracken.
Ponzi schemes: The Commission obtained a favorable summary judgment ruling in one investment scheme case while filing another:
• SEC v. Duncan, Case No. CV 08-01323 (C.D. Cal. Filed Feb. 27, 2008) is an investment scheme case in which the SEC prevailed on a summary judgment motion. The action was brought against James Duncan, Hendrix Montecastro and others. The complaint alleged that defendants sold investment contracts to investors promising “financial freedom” within three years in exchange for control over their finances. In fact, the investment fund operated like a Ponzi scheme. Following the summary judgment hearing, the court entered an injunction prohibiting future violations of the securities laws and orders directing the payment of disgorgement and civil penalties by each defendant. See also Lit. Rel. 21121 (July 9, 2009).
• SEC v. Provident Royalties, LLC, Case No. 3:09-cv-01238 (N.D. Tex. Filed July 1, 2009) is an investment scheme case brought against Paul Melbye, Brendan Coughlin and Henry Harrison and their controlled entity. The complaint alleges that over a three year period fraudulent offerings of securities were made to over 7,700 investors with promises of returns ranging from 18 to 85% for investments in oil and gas real estate and mineral rights. According to the Commission, the investment fund was essentially a Ponzi scheme. The complaint, which alleges violations of the antifraud provisions of the federal securities laws, is in litigation. See also Lit. Rel. 21118 (July 7, 2009).
FCPA
World Bank: Last year, Siemens paid a record shattering $1.6 billion to DOJ the SEC and the Munich prosecutors’ office to resolve FCPA charges as discussed here. This is the current record for amounts paid as part of a resolution of an FCPA case. Recently Siemens set another FCPA record — and it still faces other investigations. As discussed here, the company agreed to pay an additional $100 million to the World Bank in a corruption inquiry. The bank has long tried to root out fraud in projects it agrees to finance. In this instance the inquiry focused on an urban transport project the bank financed in Moscow. To resolve the inquiry Siemens agreed to pay $100 million over 15 years to combat corruption through training and education programs. The company also voluntarily withdrew from World Bank sponsored contracts for the next two years.
Private company: U.S. v. Nguyen, Case No. 2:08-cr-00522 (E.D. Pa. Filed Sept. 4, 2008) is an FCPA case in which privately held Nexus Technologies, Inc., and three of its officers were indicted on FPCA charges. Joseph Lukas, formerly of Nexus Technologies, pled guilty on June 29, 2009, to FCPA violations. Mr. Lukas was responsible for overseeing the negotiation of contracts with suppliers in the U.S. At the time of his plea Mr. Lukas admitted that from 1999 to 2005 he and others agreed to and did pay bribes to Vietnamese government officials to obtain contracts with government agencies. The bribes were recorded as “commissions” in the books and records of the company. Sentencing is scheduled for April 6, 2010.
Private actions
In re Gildan Activewear Inc. Sec. Litig., Case No. 1:08-cv-05048 (S.D.N.Y. Filed June 2, 2008) is a securities class action filed against T-shirt maker Gildan Activewear and its executives. The complaint alleged that the company failed to adequately disclose financial problems at its Dominican Republic production facility in a timely fashion. By the time those difficulties were disclosed, executives sold blocks of stock. The disclosure of the difficulties at the Dominican Republic plant caused the share price to fall 30%. The court granted a motion to dismiss the complaint finding, in part, that scienter had not adequately been pleaded. The court rejected claims that disclosure should have been made earlier about the production facility noting that as long as the statements made reflect the underlying facts they are sufficient.
FSA
The U.K. Financial Services Authority has been stepping up enforcement. As part of that effort, the regulator has published a framework for calculating financial penalties. There are five steps in the framework:
1) Removing any profits made;
2) Setting a figure to reflect the nature, impact and seriousness of the breach;
3) Considering any aggravating and mitigating factors;
4) Achieving the appropriate deterrent effect; and
5) Applying any settlement discount.
Fines for companies and individuals will be linked more closely to income. Those fines will be based on the following factors:
• Up to 20% of the company’s income from the product or business area linked to the breach over the relevant period;
• Up to 40% of an individual’s salary and benefits including bonuses from their job elated to the breach in non-market abuse cases; and
• A minimum starting point of 100,000 pounds for individuals in market abuse cases.
