THIS WEEK IN SECURITIES LITIGATION (February 12, 2010)

This week the entire Federal Government, including the home office of the SEC, has been buried in snow, snow and more snow. Nevertheless, there were significant developments in securities litigation, starting with the call by Commissioner Aguilar for a revamping of the 2006 corporate penalty guidelines. While not new, it comes at a significant time as the Commission is retooling enforcement.

The week opened with more disconcerting news for the SEC and Bank of America: The judge raised questions about the proposed settlement papers filed last week at the same time that the NY AG filed a similar suit, but which named two individuals as defendants. The SEC did obtain a preliminary injunction in an investment fund case, while the criminal prosecutors expanded their insider trading case involving the founder of Galleon. The Government also obtained a plea in a case where a computer hacker entered brokerage accounts and used them to manipulate share prices. In addition, DOJ obtained another guilty plea in an FCPA case.

Reform efforts

Commissioner Louis Aguilar, in remarks at SEC Speaks last Friday, called for a revamping of the Commission’s 2006 guidelines on corporate penalties, discussed here. See Remarks of Commissioner Luis Aguilar, SEC Speaks, Washington, D.C., February 5, 2010.

In his remarks, Commissioner Aguilar termed the 2006 guidelines “misguided” and called for them to be revamped. Under the existing guidelines, the use of corporate penalties is largely a function of two factors: 1) whether there is a direct benefit to the corporation as a result of the violation; and 2) if the penalty will recompense or further harm the injured shareholders. Since the purpose of a penalty is to punish and deter, the key question in determining whether one should be imposed is the conduct, not these factors, in the view of Commissioner Aguilar. The Commissioner did not outline specific proposals for revamping the guidelines.

Bank of America

Earlier this week, the court again raised questions regarding the proposed SEC – Bank of America settlement papers filed last week, discussed here. The settlement would cover the two suits the Commission has pending against the Bank arising out of its acquisition of Merrill Lynch. Both complaints focus on alleged omissions from the proxy materials used in connection with the December 2008 shareholder vote which approved the merger of the bank and the broker. The first complaint focuses on omissions regarding bonuses to Merrill employees while the second concerns the failure to update financial information about the broker.

Two critical questions raised by the court when the earlier settlement was rejected concerned the amount of the penalty and the failure to name individuals. The size of the new proposed penalty is addressed in very general terms in a brief filed by the SEC with the settlement papers.

The second question is clearly presented again since neither of the SEC’s complaints name any individuals. At the same time a similar suit file by the NY AG, also discussed here, named as defendants the bank, as well as its former CEO Ken Lewis and CFO Joseph Price. Court papers filed by the Commission and the NYAG which detail the chronology of the deal are substantially similar. There are differences, discussed here, which suggest the reason the SEC did not name individuals as in the NY AG complaint.

One critical difference which emerges clearly from the court papers is the legal standards. The SEC’s prior comments on this point have focused on a lack of evidence of scienter. The NY papers allege scienter and, alternatively, negligence.

A second is the role of the lawyers as to the disclosure of the Merrill financial information. Both sets of papers suggest that the outside attorneys and bank GC at one point decided disclose of the financial information about the huge fourth quarter losses Merrill was suffering would be appropriate. As the shareholder vote on the deal approached, the NY papers state that the bank GC was given incomplete information by an executive ensuring an opinion that the financial data would not be disclosed while outside counsel played a decreasing role after their initial advice was not followed.

A third, difference concerns the failure to include the bonus material. The New York complaint does not record how the decision was made not to disclose the approval of the bonuses. The SEC papers, in contrast, note that an attorney working on the deal thought the bonuses did not have to be disclosed because they were not special transactional bonuses and were consistent with the prior year. Outside counsel did not actually discuss the issue with the bank.

SEC enforcement actions

Investment fund fraud: SEC v. Elkinson, Case No. 10-CA-10015 (D. Mass.), discussed here. Last week, the SEC obtained a preliminary injunction in this case. The complaint, which charged violations of the registration and antifraud provisions, alleges that while working from home, Richard Elkinson was able to raise about $28 million over a period of several years from 130 investors in twelve states. Mr. Elkinson apparently lured investors to purchase promissory notes in a business that was suppose to be brokering contracts on behalf of a Japanese firm. Investors received promissory notes with interest rates ranging from 9% to 13%, signed by Mr. Elkinson. The SEC claimed that Mr. Elkinson had no relationship with a Japanese uniform manufacture, that there were no contracts, that some investors were paid with funds from others and that money was diverted to the personal use of the defendant.

Criminal cases

Theft of high speed trading program: U.S. v. Aleynikov (S.D.N.Y. Filed Feb. 11, 2010) is an action which charges Sergey Aleynikov with one count of theft of trade secrets, one count of transportation of stolen property in foreign commerce and one count of unauthorized computer access. Mr. Aleynikov previously was employed by Goldman Sachs from May 2007 through June 2009 as a computer programmer. In that position, he was responsible for developing computer programs for the firm’s high frequency trading on various commodities and equities markets. The firm considered these programs proprietary and took significant steps to preserve their confidentiality. Prior to resigning from the firm in April 2009 to take a similar position with a start-up attempting to develop such programs, Mr. Aleynikov is alleged to have transferred a substantial portion of Goldman’s proprietary computer code for its high speed trading platform. He is also alleged to have transferred thousands of computer files related to the trading platform.

Insider trading: U.S. v. Rajaratnam, Case No. 09 mg 2306 (S.D.N.Y.), discussed here, is the insider trading case against the founder of the Galleon fund. This week the Government filed a superseding indictment. Since the original indictment the Government has obtained three additional guilty pleas. The new allegations, which are substantially similar to those in the SEC’s recently amended complaint discussed here, focus largely on Mr. Rajaratnam’s alleged involvement with Mr. Kumar, one of the individuals who recently pleaded guilty. The superseding indictment also contains a forfeiture count and increases the illegal sums claimed to have been made by Galleon to $45 million. New Castle is alleged to have made another $4 million in illegal trading profits.

Investment fund fraud: U.S. v. Stein, Case No. 1:09-cv-03125 (E.D.N.Y. Filed April 2, 2009), discussed here, is an action against investment adviser Edward Stein. Mr. Stein pleaded guilty in June to operating a Ponzi scheme from 1998 through April 2009. As a result of the scheme about 100 investors lost $45 million. This week he was sentenced to nine years in prison for securities fraud and wire fraud.

Brokerage hacking: U.S. v. Marimuthu, (D. Neb. Feb. 5, 2010) is a case in which Jaisankar Marimuthu, a resident of India, pleaded guilty to: conspiracy to commit wire fraud; securities fraud; computer fraud and aggravated identity theft and aggravated identity theft. The indictment centers on a conspiracy operated from Thailand and India from February through December 2006. Its purpose was to hack into various brokerage accounts and use them to make large and unauthorized trades to influence the price of thinly traded securities. Previously another member of the conspiracy, Thirugnanam Ramanathan pleaded guilty.

FCPA

U.S. v. Warwick (E.D. Va.) is an action against John Warwick for FCPA violations. Mr. Warwick pleaded guilty this week to a one count indictment charging him with conspiring to make payments in violation of the FCPA. Specifically, the indictment centers on efforts to secure a maritime contract from certain Panamanian government officials for Ports Engineering Consultants Corporation. According to the indictment, Mr. Warwick conspired with Charles Jumet who previously pleaded guilty as discussed here. As part of the plea, Mr. Warwick admitted that from 1997 through July 2003 he and others made corrupt payments of more than $200,000 to the former administrator and deputy administrator of the Panama Maritime Authority and to a former high ranking elected official of the Panama government. Mr. Warwick will forfeit $331,000 which is the proceeds of the crime. Sentencing is set for May 14, 2010.

SEC v. BANK OF AMERICA: HOW THE DISCLOSURE DECISIONS WERE MADE

The latest SEC – Bank of America proposed settlement is pending before the court. The settlement would cover the two suits the Commission has pending against the Bank arising out of its acquisition of Merrill Lynch. The first suit alleged that shareholders were not told the truth in the proxy materials they were furnished for use on December 5, 2008 when the deal was approved by shareholders. Those materials misled shareholders, according to the SEC, about billions of dollars worth of bonuses which had been approved for Merrill employees. That suit, rejected in a scathing opinion by the court as discussed here, resulted in discovery that led to the second complaint.

There, the SEC claimed shareholders should have been provided updated financial information on Merrill in view of the billion dollar losses the broker was experiencing in the fourth quarter of 2008. The proposed settlement, discussed here, would resolve both cases. As the SEC filed papers seeking court approval of its settlement, the New York AG filed an action based on essentially the same facts which named two senior bank officers as defendants in addition to the bank as also discussed here.

A critical question raised by the Court in rejecting the initial SEC settlement focused on the reason that no individuals were named as defendants. Although the SEC filed an amended complaint in its first case and then a second complaint, it has steadfastly refused to name any individuals. The New York AG however named former bank CEO Ken Lewis and CFO Joseph Prices as defendants. Differentiating the actions based on the court papers is difficult at best. The Commission’s proposed settlement is supported by an unusual “Statement of Facts” which the bank acknowledges has a basis in the discovery record. It provides an overview of the BAC – ML deal. The New York complaint also contains a significant amount of detail, recording the history of the transaction.

While many of the events recorded by the SEC and the New York complaint are identical, and at times one set of papers fills gaps in the other, certain differences persist. First, the SEC maintains that it lacks evidence of scienter. In contrast, the New York complaint repeatedly notes that an individual “knew or was reckless or negligent in not knowing . . .” of a particular fact or event. Clearly there is a difference in standards.

Second, in some senses there is a difference of approach. Both the SEC Statement of Facts and the New York complaint contain a virtual blizzard of numbers regarding Merrill’s fourth quarter performance. All would agree Merrill was deteriorating and suffering billion dollar losses. At the same time, the SEC’s numbers tend to focus on net results, while the New York complaint frequently relies on pre-tax calculations, although it also contains after tax numbers.

Third, the Commission’s Statement of Facts tends to talk about estimates when referring to Merrill’s fourth quarter financial condition, although this is not always the case. The New York complaint stresses that the broker was making actual calculations of its financial position throughout the time period, although it also uses estimates. In some key instances, certain bank officials apparently did not realize the Merrill numbers were actual. This may have impacted their view.

Despite these differences, the basic chronology of the deal which emerges from the two sets of papers details a story of a bank acquiring a brokerage which was under substantial financial stress and incurring multi-billion dollar fourth quarter losses which were not disclosed to shareholder as they voted. Nor were those shareholders told of the commitment to pay billions of dollars of bonuses to the brokerage employees based on a new formula. The essential chronology, drawn form both sets of papers is as follows (the SEC papers are cited by reference to a paragraph while the New York complaint is cited “NY” followed by a paragraph number):

10/08 . A Form S-4 registration statement is filed. It incorporates the Bank of America and Merrill proxy statements. This becomes effective October 30, 2008. The materials state in part that there will be updates for any fundamental chance (7 – 10).

11/3/08. The proxy for the deal with a notice of special meeting for 12/5/08 is filed with the SEC. Incorporated are Merrill’s latest quarterly results which show a net loss for the quarter of $5.1 billion (11 – 12).

11/5. Neil Cotty, the bank’s chief accounting officer, forwards an e-mail to Mr. Price which attaches an estimate of the Merrill October results at $3.8 billion (15). According to the New York complaint, Merrill furnished numbers indicating a loss of $6.113 billion (NY). The difference appears to be pre- and post tax. Both documents agree the e-mail says “Read and weep.”

11/13. The bank’s then general counsel confers with outside counsel. In the discussions, the estimated after tax losses are in the $4 to $5 billion range. Both agree that the proper course is disclosure (NY 79 – 82). Following this, the bank’s GC did additional research on the issue to establish the range of Merrill’s prior losses (NY 85 – 86). This advice was not followed and the outside lawyers would later play a limited role on the issue (NY 92).

Mid-Nov. There were a range of opinions on disclosure, according to the SEC Statement of Facts. Messrs. Thain (CEO of Merrill) and Chai (Merrill CFO) believed that no disclosure was required because Merrill ordinarily did not disclose interim results. Merrill’s outside auditors apparently thought disclosure would be appropriate, although the broker’s in-house attorneys did not (17).

11/20. The bank’s GC met with Mr. Price and had outside counsel on the phone. As a result of this meeting, they concluded that no disclosure was required. The losses discussed in the meeting were only the after tax losses for October (NY 94 – 95). Outside counsel thought the numbers were for the quarter (NY 96).

End Nov. The Bank of America GC, Mr. Price and others consulted with outside counsel in view of a forecast $5 billion quarterly loss. After analyzing Merrill’s loses over prior quarters, the lawyers concluded that no additional disclosure was required. Mr. Price informed Mr. Lewis of this conclusion (18).

12/3. Messrs. Price and Lewis are aware that actual pretax losses at Merrill are about $11.043 billion without adding another $2.3 billion for a goodwill write-off. At the bank, they are estimating that the quarterly loss would be about $16.3 billion pretax or $10.4 billion after tax. Mr. Price met with the bank GC and told him that the losses were increasing, but were about $7 billion. The GC did not change his advice. He was not told that the losses were about $10.4 billion after tax, which is outside the range in which he believed the number had to be if it was not going to be disclosed. He was also not told that the numbers he was furnished were not estimates (NY 122 – 127). The SEC Statement of Facts records essentially the same facts (22 – 24). However, footnote 6 notes that the bank GC recalls the total number he was given was about $7 billion after tax while Mr. Price claimed it was $9 billion. Both numbers included certain “plug” assumptions made by the bank for other unaccounted for items.

12/4. The day before the vote Merrill losses were updated. The Merrill October and November losses were at $7.5 billion after tax. There was no consideration of disclosure (25).

12/5. Early on the morning of the shareholder vote the Merrill pretax losses based on actual numbers were $15.322 billion (136).

The New York complaint does not record how the decision was made not to disclose the approval of the bonuses. The SEC Statement of Facts however notes that an attorney working on the deal thought the bonuses did not have to be disclosed because they were not special transactional bonuses and were consistent with the prior year. Outside counsel did not actually discuss the issue with the bank (40).

Two days later an internal e-mail from Merrill’s then controller forwarded updated results to the bank. It showed a monthly loss of $5.8 billion pre-tax and noted “What a disaster!” (26). By then, the shareholders had approved the deal.