SETTLING BANK OF AMERICA: THE SEC HAS THE RIGHT FORMULA

The Wall Street Journal, in a Saturday editorial, claims SEC Chairman Mary Schapiro is some how inconsistent or perhaps disingenuous because of certain corporate governance procedures in the Commission’s proposed settlements with Bank of America. Somehow, the Journal cobbles those together with the Commission’s rule making agenda and a claimed lack of similar procedures at FINRA while Ms. Schapiro was there. Whatever the validity of this far fetched syllogism – and that is far from clear – it is readily apparent that the WSJ has totally missed the mark. Not only does the editorial neglect to discuss the underlying securities law violations and their impact on the shareholders, but perhaps more importantly, it fails to link those issues to the corporate governance which is, after all, the whole point.

The two SEC enforcement actions against Bank of America are about what shareholders were told and what they should have been told when they voted on whether to approve the acquisition of financially troubled Merrill Lynch by the bank. Two points in those cases are beyond dispute: First, the shareholders were not told that the bank and Merrill had agreed executives of the broker could be paid billions of dollars in bonuses. Thus shareholders did not know that in voting for the deal they were also approving huge bonuses for executives who steered the firm historic losses and near collapse. The fact that at the time of the shareholder vote there was wide spread concern and discontent about huge Wall Street bonuses might suggest that shareholder would have wanted to know those facts.

Second, shareholders were not given updated financial information about the brokerage firm’s fourth quarter performance. That information would have told shareholders that Merrill was piling up losses of historic proportions, running into the billions of dollars. Thus, shareholders did not know that in voting for the deal the value of the investment they were approving was plummeting precipitously compared to the financial information in the materials they were furnished. Again, investors may have found this information important when spending their money.

The SEC suits claim that shareholders should have been given the information about the bonuses and the financial condition of Merrill. Judge Rakoff’s inquires have sought to unravel who may have been responsible for these disclosure decisions and the basis for the different conclusions on individual liability reached by the SEC and the New York Attorney General in his suit. Regardless of the outcome of the court’s inquiries, any settlement of the two SEC enforcement actions should address the specific disclosure issues in the case and make sure that the wrongful conduct is not repeated.

For the SEC, charged by Congress with bringing a new ethics to the marketplace, the question should be how to make sure that the shareholders it claims were lied to in the Merrill acquisition get the information they need in the future. The huge fine proposed is supposed to address this question based on the notion that monetary sanctions equal deterrence in the future. This theory is dubious at best. The $30 million penalty in the initial settlement rejected by the court did nothing to halt the bank from insisting that its conduct was absolutely correct, a position which virtually ensured a replication of the claimed wrongful conduct in the future. There is little reason to believe that multiplying the size of the penalty for a huge financial institution like Bank of America will change its stance. The deterrence through big money payments theory, while perhaps appropriate in some cases, is best left to the criminal prosecutors who more typically invoke it.

What can protect shareholders in the future is the installation of procedures which focus on the key problems in the cases. Here, that is what shareholders were told when voting. While there are many ways to fashion appropriate remedial procedures to address this point, those contained in the proposed SEC settlement are keyed to these issues. They include:

• The retention of an independent auditor to review the Bank’s internal disclosure controls;

• New CEO and CFO certifications regarding the annual and merger proxy statement;

• Retention of disclosure counsel who will report to the Audit Committee;

• Adoption of a super-independence standard for all members of the Board’s compensation committee;

• Retaining a consultant to the compensation committee;

• Providing shareholders with a “say on pay;” and

• Implementing incentive compensation principles that will be disclosed on the bank’s web site.

To be sure there no set of procedures designed after the fact which can undo the harm caused. No set of procedures can take the shareholders back in time and tell them about the huge bonuses or the rapidly deteriorating financial condition of Merrill before the December 2008 meeting. At the same time, the procedures in the proposed consent decree do focus on the key issues disclosure and compensation issues in the case to make sure that in the future shareholders are given the proper information when they are required to vote. This is how the securities laws envision bringing a new ethics to the marketplace. Unfortunately the Journal, in an apparent spat of free market anti-regulatory zeal which seems to overlook what happened in these cases and the origins of the current market crisis, missed this critical point. Fortunately for shareholders, Ms. Shapiro and the SEC did not.

THIS WEEK IN SECURITIES LITIGATION (February 19, 2010)

New statistics from NERA show that in the first fiscal quarter of 2010 the number of SEC enforcement settlements increased significantly. This week, the Commission continues to struggle with the settlement of its actions against Bank of America, with more inquiries coming from the court. Enforcement focused on insider trading and option backdating. The SEC prevailed on a summary judgment motion in one insider trading case, but lost on a directed verdict in an options backdating action. In a criminal case arising out of the Stanford Ponzi scheme case the court entered a motion for acquittal on criminal obstruction charges while the jury was deliberating. The parties in another private damage action based on option backdating claims reached a tentative settlement.

SEC statistics

A new report by NERA Economic Consulting notes that the number of SEC enforcement settlements increased for the first fiscal quarter of 2010. In that quarter, there were 205 settlements compared to 181 in the prior quarter and 123 in the same quarter in 2009. The report also notes that the settlement amounts were modest. The average and mean were lower than those for 2009. NERA’s reports regarding settlement amounts are based on the total dollars involved, adding together disgorgement, prejudgment interest and penalties.

SEC v. Bank of America

Since the SEC and Bank of America filed their new proposed settlement of the Commission’s cases, and the NYAG brought a parallel action, the court has been evaluating the proposed settlement as discussed here. Initially, the court asked for certain specific discovery materials which focused largely on the decision making process about whether to disclose the mounting losses at Merrill Lynch and the bonuses. In that request, the court also asked if the parties would approve certain modifications which would potentially give the court more control over the corporate governance provisions in the settlement.

This week the SEC and the bank filed responses. Both agreed with the proposed corporate governance changes requested by the court, although the bank objected to modifying the proposal regarding the compensation specialist.

The SEC and the bank also filed a joint chronology which essentially refutes a suggestion in the papers of the NYAG that the bank’s general counsel was dismissed because of decisions regarding the Merrill deal. Essentially, the new chronology contradicts claims in the NYAG complaint noting that disclosure of the Merrill losses was recommended by a number of persons. The chronology is backed up by an appendix of discovery materials. The NYAG declined a request from the court for certain deposition transcripts which supposedly support its position on the termination of the bank’s general counsel in December 2008. The court has requested additional discovery materials and promised a ruling on the settlement by Monday.

SEC enforcement actions

Insider trading: SEC v. Scoppetuolo, Civil Action No. 1:10-CV-20475 (S.D. Fla. Filed Feb. 16, 2010 named as defendants Steven Scoppetulo, Robert Tocci, Sarang Ahuja, Richard White and Eric Gordon. The complaint centers on two separate groups of traders who traded in the securities of World Fuel Services Corporation while in possession of inside information. Group one involves Messrs. Scoppetuolo, a World Fuel executive, his best friend Mr. Tocci, the former CFO of the company, and their broker Mr. Ahuja. Mr. Scoppetuolo is alleged to have tipped Mr. Tocci regarding upcoming earnings information and then one or both men tipped their broker. Mr. Tocci sold options and shorted the stock prior to the announcement, making profits of about $262,000 and avoided a $34,000 loss. The broker and his customers made about $170,000.

The second group involved Mr. White, the vice president of tax for the company, along with Mr. Gordon and two of his friends. Mr. White tipped Mr. Gordon who in turn tipped his two friends. Defendant Gordon and his friends bought options and made about $659,000. The case is in litigation. See also Litig. Rel. 21415 (Feb. 16, 2010).

Insider trading: SEC v. Horn, Civil Action No. 1:10-CV-00955 (N.D. Ill. Feb. 16, 2010) is an action against Gerald Horn, a medical director for one of the facilities of LCA Visions, Inc., for insider trading in the securities of his company. According to the SEC, from December 2005 through August 2006 the defendant traded while in possession of inside information when he made six separate purchases of LCA options resulting in gains of abut $869,629. In addition, he also was in possession of inside information when he exercised his company stock options and avoided a loss of about $533,603. The inside information came from internal reports about the number of laser eye surgeries done. Those reports permitted the defendant to estimate if the company would meet guidance. Although defendant Horn never traded in options other than for his company, when trading those he never lost. The case is in litigation. See also Litig. Rel. 21414 (Feb. 16, 2010).

Options backdating: SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo. Filed July 12, 2007) is an options backdating case brought against a father and son, Michael F. Shanahan and Michael F. Shanahan, Jr. The father is the former CEO of Engineered Support Systems, Inc. The son was a member of the board’s compensation committee. According to the SEC, both defendants participated in an option backdating scheme from 1997 through 2002. During that time, about $20 million in options were issued to senior executives and employees. Overall the father obtained about $8.9 million from backdated grants while the son made approximately $379,000.

The father settled with the SEC earlier this year. The son went to trial. At the conclusion of the evidence, the court dismissed the jury and directed a verdict in favor of the son. Essentially the court held that on each of its claims the SEC failed to present evidence regarding the appropriate standards. This failure of proof would leave the jury to speculate as to the proper standard and ultimately the outcome as discussed here.

Insider trading: SEC v. Suman, Case No. 07 Civ. 6625 (S.D.N.Y. Filed July 24, 2007) is a pillow talk insider trading case brought against a husband and wife, Shane Bashir Suman and Monie Rahman. The couple maintained separate residences. Mr. Suman worked for a division of Ontario based MDS, Inc. On January 29, 2007 MDS announced a friendly tender offer for Molecular Devices at $35 per share. Following the announcement the share price increased by 45%.

Prior to the deal announcement, Mr. Suman learned information about the acquisition from a variety of sources. During the negotiations he had access to internal e-mails regarding the deal. Just before the deal announcement the couple purchased options for $103,516 and 12,000 equity shares for $287,758.54. Following the announcement, the couple had profits of $1,039,440. At the conclusion of discovery, the court granted summary judgment in favor of the SEC. The ruling is based on the fact that the defendants invoked the Fifth Amendment, the access to information of the husband, and the atypical trading pattern. The court entered an injunction against both defendants and directed disgorgement on a joint and several basis. The penalty was apportioned to reflect the role of each defendant with Mr. Suman being ordered to pay $2 million and his wife a $1 million.

Option backdating: SEC v. Byrd, Case No. C 07-4223 (N.D. Cal. Filed Aug. 17, 2007) is an options backdating case against Michael Byrd, the former CFO and later COO and President of Brocade Communications. The complaint alleges that Mr. Byrd obtained information suggesting that former Chairman Gregory Reyes, who is awaiting re-trial on criminal charges, was improperly backdating stock options and later that he was involved in the process.

Mr. Byrd settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a)(2) & (3) and Exchange Act Sections 13(b)(5) and 16(a) as well as the pertinent rules. Mr. Byrd also agreed to pay a fine of $175,000 and disgorgement and prejudgment interest of $249,843. The Release does not indicate that Mr. Byrd agreed to be barred from practice before the Commission under Rule 102(e). See also Litig. Rel. 21412 (Feb. 12, 2010).

Criminal cases

Document destruction: U.S. v. Perraud, Case No. 09-cr-60129 (S.D. Fla.) is the document shredding case arising out of the Stanford investment fraud action. The case was brought against Thomas Raffanello and Bruce Perraud, respectively, the former head of security and a security specialist. The men were accused of obstructing the SEC’s investigation into the alleged Stanford Ponzi scheme by destroying documents. While the jury was deliberating, the court granted a motion for acquittal made by the defendants.

FCPA

BAE Systems PLC resolved FCPA charges with the UK Serious Fraud office and DOJ. In the U.S., the company will plead guilty to one count of conspiracy to make false statements about having an internal compliance program regarding the FCPA and pay a $400 million fine. The charges stem from undisclosed payments made in connection with defense materials that were leased to the Czech Republic and Hungary and sold to Saudi Arabia. In the U.K., the company will pay a penalty of about $47.26 million and plead guilty to failing to keep reasonably accurate accounting records in connection with the supply of an air traffic control system to Tanzania. The investigation into the actions of the company was at one time halted by the British prime minister.

FINRA

H&R Block Financial Advisors and one of its brokers resolved an inquiry with FINRA for having inadequate supervision of reverse convertible notes. The inquiry determined that one broker sold the structured product, which consists of a high yield short term note of an issuer and effectively a put option linked to the performance of an unrelated or linked asset such as common stock, to a retired couple. The couple had, based on the recommendation of the broker, invested nearly 40% of their total liquid net worth in nine reverse convertible notes or RCNs. This exposed the customers to a risk of loss that was inconsistent with their objectives and which ultimately resulted in a substantial loss. The firm failed to have adequate procedures to supervise the concentration of RCNs. To resole the matter the firm agreed to pay a $200,000 fine and pay restitution to the couple. The broker was suspended for 15 days, fined $10,000 and ordered to disgorge $2,023 in commissions.

New York AG

The New York Attorney General settled an insider trading action former senior UBS executive David Shulman. According to the AG, between August 2006 and August 2008 Mr. Shulman was UBS’ highest ranking executive with day to day responsibility for the ARS program. Between December 11 and 13, 2007 he learned that the program was in distress and that the upcoming auction in student loan ARS could fail. On December 13 Mr. Shulman instructed his broker liquidate his $1.45 million in holdings in these securities. To resolve the Martin Act claims Mr. Shulman agreed to pay $2.75 million as a civil penalty and to be suspended from association with a broker or dealer for a period of 30 months.

Private actions

Options backdating: In re Juniper Sec. Litig., Case No. 06-4327 (N.D. Cal.) is a shareholder suit against the networking equipment manufacturer which was filed in 2006 based on option backdating claims. The complaint alleged that options were backdated over a three year period beginning in 2003. The suit also named several executives as defendants. The company has agreed to pay $169 million to resolve the case. The settlement is subject to court approval. The company previously settled similar claims with the SEC as well as a derivative action.