PLEADING SCIENTER IN SEC ENFORCMENT ACTIONS

Pleading standards in SEC enforcement actions are suppose to be uniform under the Federal Rules of Civil Procedure. Two rulings last week, however, highlight the different standards that apply in those actions when pleading the key element of scienter. In one, the SEC was only required to plead scienter generally. In the other, the court applied the same standard, but followed the pre-PSLRA Second Circuit case law by imposing a heightened two-part test, at least portions of which were written into the Reform Act by Congress. While the SEC met each standard, its complaint was dismissed in the first for other pleading violations. SEC v. Medical Capital Holdings, Inc., Case No. CV 00-818 (C.D. Cal. Filed July 20, 2009); SEC v. Reserve Management Company, Inc., Case No. 09 Civ. 4346 (S.D.N.Y. Filed May 5, 2009).

Medical Capital Holdings is an action against the company and its principals, alleging fraud in connection with the sale of notes issued by a special purpose entity controlled by the company. The SEC complaint claims that the defendants defrauded investors by misappropriating about $18.5 million of investor funds and by making misrepresentations in the offering materials.

In ruling on a motion to dismiss, the first amended complaint the court rejected claims that the SEC failed to adequately plead fraud with particularity. To the contrary, the court concluded that the Commission had specifically identified false statements in the offering materials. In reaching this conclusion, the court rejected a defense argument that the SEC should be required to identify specific individuals who were defrauded.

In ruling on the adequacy of the allegations regarding scienter, the court rejected a claim by the defendants that the Private Securities Litigation Reform Act requires the SEC to meet a heightened pleading standard. That statute on its face does not apply to the SEC. Rather, quoting Federal Civil Rule 9(b) regarding the pleading of fraud, the court held that the Commission need only plead “[m]alice, intent, knowledge, and other conditions of a persons mind . . . generally.” The SEC met this standard, but failed to adequately plead with particularity how the materials containing the false statements were used in the offering. Accordingly, the complaint was dismissed with leave to amend.

Reserve Management is the Commission’s enforcement action stemming from the collapse of The Reserve Primary Fund, the first fund to “break the buck,” as discussed here. In ruling on the adequacy of the SEC’s complaint, the court agreed that the PSLRA does not apply by its plain terms, rejecting a defense argument. Accordingly, it is beyond dispute that the more relaxed pleading standard of Federal Civil Rule 9(b) need only be met.

The Second Circuit, however, has long held that a securities law plaintiff alleging fraud must plead facts which give rise to a strong inference of fraudulent intent the court noted, citing Novak v. Kasaks, 216 F.3d 300 (2nd Cir. 2000). While the Second Circuit has yet to decide how, if at all, Tellabs, Inc., v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) may apply, it is clear under Novak that plaintiff must plead facts demonstrating a strong inference by either alleging facts that show the defendants had both motive and opportunity to commit fraud, or by pleading facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness. In Reserve Management, the court found that the SEC had met the pleading standard. Accordingly, the motion to dismiss was denied.

While in the end each court agreed that the PSLRA standard does not apply to SEC enforcement actions and that Civil Rule 9(b) governs, the tests used are significantly different. The pleading “generally” standard of the Rule used in Medical Capital Holdings meant just that – a general allegation is sufficient. In contrast, in Reserve Management the same pleading “generally” standard means a strong inference of scienter as demonstrated by a two part test. Ironically, the Second Circuit uses that same two-part test to evaluate compliance with the heightened scienter pleading requirements of the PSLRA which both courts concluded do not apply here.

THIS WEEK IN SECURITIES LITIGATION (February 26, 2010)

This week, the on-going saga of the SEC’s litigation against Bank of America drew closer to resolution with tentative court approval of a proposed settlement. The Commission voted 3-2 to adopt the alternative uptick rule. SEC enforcement brought another case based on the Madoff fraud, an insider trading action and more investment fund fraud cases. DOJ obtained a guilty plea in another Ponzi scheme and an FCPA case.

Market crisis

The Commission adopted the new alternative uptick rule this week over the strong dissent of Commissioner Paredes as discussed here. In essence, the rule would go into effect when a “circuit breaker” is tripped. That happens if the price of a security declines by 10% or more from the close of the previous day. In that instance, the “alternate uptick rule” goes into effect for the balance of the day and the next. The rule applies generally to all securities traded on a national securities exchange, as well as those in the over-the-counter markets. It also requires traders to establish and maintain certain procedures designed to aid implementation and enforcement of the rule.

SEC v. Bank of America

Judge Jed Rakoff tentatively approved the latest proposed settlement of the Commission’s two cases against the bank, subject only to submission of the final papers modified pursuant to suggestions by the Court. The underlying cases claim that the bank improperly failed to disclose to shareholders voting on the acquisition of Merrill Lynch by the bank billions of dollars in approved bonuses for executives of the broker and unprecedented fourth quarter losses of Merrill which undermined the value of the deal as discussed here.

Although the parties won approval of the new settlement, discussed here, the Court made it clear that approval was given reluctantly. Throughout its opinion, the court repeatedly returned to two points. One concerned the culture of Bank of America, which it described as being based on a presumption of non-disclosure. While the corporate governance provisions of the settlement will help correct this, they apparently did not go far enough for the Court.

The second point focused on the penalty. While the penalty is modest for both cases, according to Judge Rakoff, the critical problem is that it is really inflicted on the shareholders. If it is to have any significant deterring impact, it must be imposed on the individuals responsible. Since neither the fine, nor the remedial measures are directed at the specific individuals involved, the impact is likely to be “very modest” and results in “half-baked justice . . .,” according to the Court. In the end, however, the Court deferred to the parties, noting its limited role in approving settlements. Accordingly, the settlement will be approved when modified papers are submitted which adopt additions proposed by the Court to strengthen the governance provisions.

SEC enforcement actions

Insider trading: SEC v. Foley, Civil Action No. 1:00-cv-00300 (D.D.C. Filed Feb. 25, 2010) is an insider trading case brought against John Foley, Aaron Grassian, Timothy Vernier and Bradley Hale. According to the SEC, Mr. Foley, who worked as an employee benefits specialist at Deloitte, obtained material non-public information regarding three firm clients which was passed to Messrs. Grassian and Vernier. Each traded at a profit. Mr. Grassian later returned the favor by providing material non-public information to Mr. Foley about a take-over. Mr. Grassian learned about the pending deal from Mr. Hale, who was employed at one of the companies. Mr. Hale did not trade. To settle the case, each defendant consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions. Each of the three defendants who traded also agreed to disgorge their profits which collectively exceeded $210,000 and pay prejudgment interest. Mr. Foley did not pay a penalty and Mr. Vernier paid a reduced penalty based on their financial condition. Mr. Grassian agreed to pay a penalty equal to his trading profits. See also Litig. Rel 21425 (Feb. 25, 2010).

In a related administrative proceeding, Tara Eisler, who permitted Mr. Foley to repeatedly use her brokerage account to trade in the securities of firm clients consented to the entry of a cease and desist order that she not engage in future violations of Exchange Act Section 10(b). In the Matter of Tara L. Eisler, Adm. Proc. File No. 3-13792 (Filed Feb. 25, 2010).

Cover-up/fraud: SEC v. Bonventre, Case No. 10 CV 1579 (S.D.N.Y. Filed Feb. 25, 2010) is an action against the former director of operations of Bernard Madoff Investment Securities. The complaint alleges violations of the antifraud provisions of the Securities Act, the Exchange Act and the Advisers Act and aiding and abetting violations of Exchange Act Sections 15(c) and 17(a). Mr. Bonventre, who worked for the Madoff firm for thirty years, is charges with helping conceal the fraud by falsifying the books and records of the broker dealer by not properly accounting for the investor funds. To conceal the fact that the firm was operating at a significant loss, over $750 million in investor funds were used to bolster the finances of the firm. According to the SEC’s complaint, Mr. Bonventre made about $1.9 million as part of the scheme. See also Litig. Rel. 21424 (Feb. 25, 2010). The U.S. Attorney’s Office for the Southern District of New York filed parallel criminal charges, discussed below.

Investment fund frauds: SEC v. Loomis, Case No. 2:10-cv-00458 (E.D. Cal. Filed Feb. 23, 2010) is an action against Lawrence Loomis and his father-in-law John Hagener. According to the SEC, the two men, and their controlled entities, misappropriated about $10 million raised from about 100 investors. The money was raised at “Loomis Wealth Solutions” seminars in 2007 and 2008. Investors were told that their funds would be loaned to home buyers and secured by real estate. A 12% return was supposedly guaranteed by a third party. In fact, the funds were misappropriated. The fraud complaint is in litigation. See also Litig. Rel. 21422 (Feb. 23, 2010).

Investment fund frauds: SEC v Pacific Asian Atlantic Foundation, Case No. CV 10-1214 (C.D. Cal. Filed Feb. 18, 2010) is an action against Samuel M. Natt and his controlled entity Pacific Asian Atlantic Foundation. The foundation is supposedly a non-profit humanitarian organization based in California. Mr. Natt, over a three year period beginning in 2009, created billions of dollars in bonds supposedly issued by the company. The bonds were bolstered by false financials. The scheme was to deposit the bonds with brokers and then use them as the basis for loans. Despite repeated efforts Mr. Natt failed to actually implement the scheme as discussed here. The case was settled when Mr. Natt and his company consented to the entry of permanent injunctions prohibiting future violations of Sections 17(a)(1) &(3) of the Securities Act. Mr. Natt also agreed to pay a penalty of $50,000. See also Litig. Rel. 21417 (Feb. 19, 2010).

Criminal cases

U.S. v. Bonventre, Case No. 10 Mag 385 (S.D.N.Y. Filed Feb. 25, 2010) charges Daniel Bonventre, formerly the director of operations for Bernard Madoff Investment Securities, with conspiracy and securities fraud. According to the criminal complaint, Mr. Bonventre, who was arrested yesterday, helped Mr. Madoff conceal the largest Ponzi scheme in history. The SEC filed a parallel civil case which is discussed above.

U.S. v. Nadel, 1:09-cr-0433 (S.D.N.Y.) is a Ponzi scheme case in which promoter Arthur Nadel pleaded guilty to fifteen fraud counts. According to the indictment, Mr. Nadel ran a classic Ponzi scheme through which he raised over $350 million from about 370 investors over a ten year period beginning in 1999. During the operation of the scheme, Mr. Nadel told potential investors that his fund yielded between 11% and 55% per year when in fact it had negative results. As part of the plea, Mr. Nadel will forfeit $162 million. Sentencing has not been scheduled.

FCPA

U.S. v. Fourcand, 10 cr 20062 (S.D. Fla. Filed Feb. 1, 2010) is an FCPA case based on a one count information alleging money laundering which named Jean Fourcand as a defendant. Mr. Fourcand, who pleaded guilty to the information, is alleged to have been involved in a scheme to bribe an official of the Republic of Haiti’s state owned national telecommunications company. Specifically, Mr. Fourcand admitted he received funds between November 2001 and August 2002 from U.S. telecommunications companies used to make improper payments to the foreign officials. Mr. Fourcand agreed to forfeit $18,500 in connection with the plea.

Alcatel-Lucent SA has, reportedly reached a tentative agreement with the Department of Justice and the SEC to resolve FCPA charges. The charges stem from bribes paid in Costa Rica, Taiwan and Kenya, according to a company filing. Under the agreement, Alcatel-Lucent SA will enter into a deferred prosecution agreement with the Department and pay a fine of $137.4 million, of which $92 million is a criminal fine and $45.4 is a civil penalty paid in connection with the SEC settlement. Three subsidiaries, Alcatel-Lucent France, Alcatel-Lucent Trade and Alcatel Centroamerica will plead guilty to violating the anti-bribery provisions of the FCPA.

State cases

The NY AG continues to resolve actions stemming from the crash of the auction rate securities market. This week the AG settled with Oppenheimer. Under the terms of the agreement, the firm will repurchase ARS from individuals, charities, non-profits and other small investors. It will later attempt to buy back other frozen ARS when resources become available. This settlement reflects the same basic pattern as others in this market.