SELECTED ENFORCEMENT CASES: MARKET PROFESSIONALS AND OTHER SIGNIFICANT CASES

This is the fifth in a series of articles examining future trends in securities enforcement.

The regulation of market professionals is a key area of responsibility for the Commission. Actions brought in this area are a critical part of the Enforcement Division’s responsibilities. Last year, the Division brought a number of important cases in this area focused on investor protection and the integrity of the markets.

In the Matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Admin. Proc. File No. 3-13407 (March 11, 2009) and In the Matter of Commonwealth Equity Services, LLP, Adm. Proc. File No. 3-13631 (Sept. 29, 2009) focus on the integrity of customer information. Merrill Lynch, the so-called “squawk box” case, discussed here, is a settled proceeding based on the failure of the brokerage firm to adequately protect the confidentiality of customer order flow information. Specifically, the Order for Proceedings claims that the firm did not have adequate procedures to prevent day traders from overhearing and using material non-public information regarding unexecuted institutional orders being transmitted through the firm’s squawk box. This failure permitted those who overheard the information to trade ahead of the customer orders and, in many instances, profit from the price movement following the execution of customer orders. The case was resolved with the institution by Merrill of a series of procedures designed to ensure the integrity of customer information in the future, the payment of a $7 million penalty and the entry of a cease and desist order.

Commonwealth Equity focused on the integrity of customer account information. There, the Order for Proceedings alleges that the company failed to require that its representatives maintain antivirus software on its computers. As a result, an intruder was able to obtain login credentials and access to customer accounts to make unauthorized purchases. This action was settled with the entry of a cease and desist order and the payment of a $100,000 penalty.

A third case, In the Matter of INTECH Investment Management, LLC, Adm. Proc. File No. 3-13463 (Filed May 7, 2009) concerned investor voting rights. This settled action against the firm and its former chief operating officer centers on Advisers Act Rule 2006(4)-6, which requires registered investment advisers to adopt proxy voting policies and describe them to clients. The Order alleges that the procedures adopted by the firm were inadequate because they lacked provisions to deal with conflicts and they were not adequately discussed with clients. The matter was resolved with a cease and desist order and the agreement of the firm to pay a $300,000 penalty and its former COO to pay a $50,000 penalty.

Other cases against regulated entities are based on claims regarding the adequacy of disclosure about fees. In the Matter of New York Life Investment Management, LLC, Adm. Proc. File No. 3-013487 (Filed May 27, 2009) focused on the fees charged by investment advisers. A settled action against the investment adviser to the Equity Index Fund, a series of The MainStay Funds, alleges a violation of Section 206(2) of the Advisers Act based on the fact that, during the process for renewing three investment advisory contracts between Respondent and the Equity Index Fund, the board of trustees received information showing that the management fees charged were among the highest of the Fund’s peer group. Although the Adviser urged the board to consider a guarantee feature in evaluating the fees, no information was furnished so it could be evaluated. At the same time prospectuses, annual reports and registration statements claimed that there was “no charge” to the Fund or its shareholders for the guarantee. This representation was false. The action was settled with the entry of a cease and desist order, the payment of disgorgement of about $3.9 million and a penalty of $800,000. See also Jones v. Harris Associates LP. S.Ct. No. 08-586 (issue regarding the standard which investors must meet under Section 36(b) of Investment Company Act to challenge adviser fees; the case is pending decision as discussed here).

In the matter of Ameriprise Financial Services, Inc., Adm. Proc. File No. 3-13544 (July 10, 2009) also focused on fees. In this settled proceeding, the Order claimed that, over a four-year period, Ameriprise received undisclosed cash payments from certain REITS to sell shares in the funds. The payments were mislabeled as invoices to make it appear that they were legitimate reimbursements for service. In fact, they were not. The proceeding was settled with the entry of a cease and desist order and the payment of disgorgement in the amount of $8.65 million and a penalty equal to the amount of the disgorgement. See also In the Matter of Value Line, Inc., Adm. Proc. File No. 3-13675 (Filed Nov. 4, 2009) (settled action against a registered investment adviser based on inflated fees); In the Matter of J.P. Morgan Securities, Inc., Adm. Proc. File No. 3-13673 (Filed Nov. 4, 2009) (settled action based on a pay to play scheme); SEC v. Brantley Capital Management, LLC, Case No. 1:09-CV-01906 (N.D. Ohio Filed Aug. 13, 2009) (settled case against investment adviser, firm and individuals for incorrectly valuing assets).

Other cases which may suggest trends for 2010 and beyond focused on conduct in the marketplace and specifically short selling, an area in which the Commission has recently issued new regulations. These include the first actions based on naked short selling: In the Matter of Hazan Capital Management, LLC, Adm. File No. 3-1570 (Filed Aug. 5, 2009) and In the Matter of TJM Proprietary Trading, LLC, Adm. File No. 3-13569 (Aug. 5, 2009), both discussed here. Others include violations of, respectively, based on Regulation SHO and Regulation M: In the Matter of Rhino Trading, LLC, Adm. Proc. File No. 3-013677 (Filed Nov. 4, 2009)(Reg. SHO), discussed here, In the Matter of First New York Securities, LLC, Adm. Proc. File No. 3-13656 (Filed Oct. 20, 2009) (Reg. M), discussed here and In the Matter of Perceptive Advisors LLC, Adm. Proc. File No. 3-13657 (Filed Oct. 20, 2009) (Reg. M), discussed here.

Two other cases brought last year which center on deceptive market conduct may also indicate trends for the future. In the Matter of ICAP Securities USA LLC, Adm. Proc. File No. 3-13726 (Dec. 18, 2009) is a settled action brought against the subsidiary of the world’s largest inter-dealer broker, ICAP, Inc., discussed here. The action, brought against the firm and several registered representatives, alleged manipulative market conduct based on the use of fictitious flash trades, misrepresentations regarding certain workup protocols and other misrepresentation regarding whether the firm engaged in proprietary trading in certain markets. The case was settled with the entry of a cease and desist order, the payment of $1 million in disgorgement and a $24 million fine.

In the Matter of Perry Corp., Admin. Proc. File No. 3-13561 (Filed July 21, 2009) is an action against a broker which failed to file a Schedule 13D disclosing its nearly 10% stake in Mylan Laboratories, Inc. because it was trying to implement a strategy known as “merger arbitrage.” The stake the firm held in Mylan was put together through a series of swap transactions which were designed to fully hedge its position. The position gave the firm voting rights to about 10% of Mylan’s shares. The case as settled with the entry of a cease and desist order and the payment of a $150,000 civil penalty.

Three other cases brought by the Commission last year may also be a harbinger of things to come in the new decade. One concerns the Sarbanes Oxley clawback section, another, Reg. FD and a third, penalties. SEC v. Jenkins, Case No. CV 09-1510 (D. Ariz. Filed July 23, 2009) is the Commission’s first clawback case under SOX Section 304, discussed here, which seeks the repayment of an executive bonus where the SEC admits that the defendant had not engaged in any wrongful conduct.

Jenkins is a civil injunctive action brought against Maynard Jenkins, the former CEO of CSK Auto Corporation. During a period when the company and other executives engaged in financial fraud which resulted in two restatements, Mr. Jenkins was paid about $2 million in incentive compensation. The complaint seeks the repayment of the incentive compensation on what is essentially a strict liability theory. Mr. Jenkins was not named in the Commission’s enforcement action based on the fraud. SEC v. Fraser, Case No. 2:09-cv-00442 (D. Ariz. Filed March 6, 2009). Briefing has been completed on a motion to dismiss, but no ruling has been entered.

A second case involves Regulation FD, In the Matter of Christopher A. Black, Adm. Proc. File No. 3-13625 (Sept. 24, 2009) and SEC v. Black, Case No. 09-cv-0128 (S.D. Ind. Sept. 24, 2009). These settled actions are based on claims that the former senior vice president and CFO of American Commercial Lines, Inc. furnished a revised earnings forecast to several analysts prior to its issuance by the company. To resolve the action Mr. Black consented to the entry of a cease and desist order and the payment of a $25,000 penalty.

In an usual statement the Commission articulated its reasons for not bringing an action against the company. Those included the fact that: 1) the company cultivated an environment of compliance; 2) Mr. Black acted alone and outside the control systems of the company in distributing the information from home; 3) once the illegal conduct was discovered, the company promptly disclosed the matter to the public and the SEC; 4) the company self-reported and took remedial steps to prevent a reoccurrence. See also Litig. Rel. 21222 (Sept. 24, 2009).

Finally, the resolution of In the Matter of Ernst & Young LLP, File No. 3-13726 (Filed Dec. 17, 2009) may signal a new approach to settlement. The underlying action is based on audit failures regarding fitness giant Bally. The company had, prior to its bankruptcy, engaged in an number of improper accounting practices according to the Commission. The Order in this case charges Ernst & Young, the firm’s outside auditors, and several of its professionals, with improperly issuing unqualified audit opinions during the period 2001 – 2003. To resolve the matter, the audit firm agreed to the entry of a cease and desist order and proposed a series of undertakings it would institute. One of those undertakings was the payment of $8.5 million to the treasury “in the nature of a penalty.” The language makes it clear that it is intend to be similar to a civil penalty of the type which the SEC can impose on regulated entities in administrative proceedings or others in civil injunctive actions.

Next: The concluding segment to the series

Seminar sponsored by the ABA Criminal Justice Section: January 13, 2010, Enforcement Trends in Securities & Commodities Actions 2010, in person in Washington, D.C. at 600 14th St. N.W. 9th Floor and webcast nationally. http://www.abanet.org/cle/programs/t10ets1.html

Speakers: Adam Safwat, Deputy Chief, Fraud Section, Department of Justice; Steve Obie, Director, Division of Enforcement, CFTC; Laura Josephs, Assistant Director, SEC Division of Enforcement and Cheryl Evans, Special Counsel U.S. Chamber Initiatives For Legal Reform.

THIS WEEK IN SECURITIES LITIGATION (January 8, 2010)

To begin the new year and decade, the SEC won an important ruling in its Bank of America case, concluded settlements in two insider trading cases and wrapped up the “Enron Barge” case. At the same time, the Galleon insider trading case continued to move forward with another guilty plea. The Commission and DOJ also continued their focus on the FCPA, concluding another case.

The litigation with Bank of America

SEC v. Bank of America, Case No. 09 Civ. 6829 (S.D.N.Y. Filed Aug. 3, 2009) is the Commission’s action alleging proxy fraud by the bank during its solicitation regarding the acquisition of Merrill Lynch. Specifically, the complaint claims that a key schedule attached to the acquisition agreement showing that billions of dollars in bonuses had been approved for Merrill executives had been omitted while the materials furnished to shareholders suggested that bonuses would not be paid. Although the parities tried to settle this action, Judge Rakoff rejected it in a scathing order as discussed here.

Bank of America has contended since the rejection of the settlement that it did not defraud shareholders. This claim is based on the bank’s contention that information about the bonuses was widely available to shareholders from many sources. As the case moves toward trial, the bank has indicated it will offer testimony from several experts based in part on those sources. The SEC moved to exclude all evidence regarding reports about the bonuses that are outside the proxy materials.

In a January 4, 2010 ruling, Judge Rakoff granted the SEC’s motion. The court’s order is predicated on the fact that at the beginning and end of the Proxy Statement, shareholders were told to only rely on the information contained in the materials they were furnished. In reaching its conclusion the court stated that: “[I]n effect, the Bank is arguing that, even though it expressly warned its shareholders to disregard the media, it can now defend itself by asserting that a reasonable shareholder would have disregarded these warnings and, by consulting the media, perceived that the Bank’s alleged lies were immaterial. Even a zealous advocate might perceive that such an argument hints at hypocrisy.”

SEC enforcement actions

Aiding and abetting: SEC v. Bayly, Civil Action No. H-0300946 (S.D. Tex. March 17, 2003) is an action against former Merrill Lynch investment banking head Daniel Bayly. The complaint is based on the infamous “Enron barge” deal in which Enron allegedly sold an interest in certain Nigerian barges to Merrill in late 1999. The deal permitted Enron to book $28 million in revenue and $12 million in pre-tax income. In fact, the deal was a sham (see also U.S. v. Brown discussed here).

To resolve the case, Mr. Bayly consented to the entry of a permanent injunction prohibiting future violations of the antifraud, aiding and abetting and books and records and internal control provisions of the federal securities laws. He also agreed to the entry of an officer/director bar for five years and to pay $300,001 in disgorgement and civil penalties.

Insider trading: SEC v. Saleh, Case No. 3:09-CV-01778 (N.D. Tex. Filed Sept. 23, 2009) is an insider trading case centered on the plan of Dell Inc. to acquire Perot Systems, discussed here. According to the SEC, defendant Reza Saleh, an employee of Perot Systems, purchased call options in Perot shortly before the announcement based on inside information. On January 5, Mr. Saleh agreed to settle the action with the SEC, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 14(e) and the pertinent rules thereunder. Mr. Saleh also agreed to the entry of an order baring him from associating with an investment adviser in a related administrative proceeding. Under the terms of the settlement, the SEC will request that the court enter an order to distribute the frozen trading profits and determine an appropriate penalty. See Litig. Rel. 21361 (Jan. 6, 2010).

Insider trading: SEC v. Guttenberg, Case No. 07 CV 1774 (S.D.N.Y. March 1, 2007) was the blockbuster insider trading case of 2007. It was brought against a number of market professionals as discussed here. There were also parallel criminal actions. On January 5, the Commission settled with the last remaining defendant in its complaint. That defendant, Ken Okada, consented to the entry of a permanent injunction prohibiting future violations of Section 10(b). In addition, he agreed to disgorge trading profits of $327,191, payment of which was waived except as to $45,000 based on financial condition. See Litig. Rel. 21359 (Jan. 5, 2010). In a related administrative proceeding, Mr. Okada consented to the entry of an order barring him from associating from any broker, dealer or investment adviser. All of the parallel criminal cases have been resolved with pleas or convictions.

CFTC

Investment fraud: CFTC v. Capital Funding Consultants, LLC, Case No. 2:09-cv-7409 (E.D. La. 2009) is an action against Matthew Pizzolato, William Guidry and Capital funding. The complaint alleges that Mr. Pizzolato solicited about $19 million and obtained over $3.1 million primarily from elderly investors based on claims that the funds would be invested safely. In fact, the money was put in high risk commodity futures and other instruments. Portions were misappropriated. The CFTC obtained a temporary freeze order followed by a preliminary injunction. Mr. Pizzolato was also named as a defendant in a criminal case based on the same conduct. U.S. v. Pizzolato, No. 2:09-cr-00378 (E.D. La. 2009).

FCPA

SEC v. UTStarcom, Inc., Case No. CV-09-6094 (N.D. Cal. Filed Dec. 31, 2009) alleges that UTStarcom, a telecommunications company based in California, paid about $7 million for 225 foreign trips by employees of a Chinese state owned company. While the trips, made between 2002 and 2007, were alleged to be for training, the SEC claims that in fact there were largely entertainment. The complaint also alleges that there were expenditures for executive training programs in the U.S and field trips to nearby tourist destinations. In addition, the company provided $10,000 in French wine and $13,000 in other entertainment expenditures to employees of a government owned telecommunications customer in Thailand. In Mongolia, $1.5 million was paid to an agent for a so-called “license fee” when in fact the actual fee was only $50,000 and the balance was used to make improper payments to a government official.

The action was settled with the consent of the company to the entry of a permanent injunction prohibiting future violations of the anti-bribery, books and records and internal control provisions of the FCPA. The company also agreed to pay a $1.5 million penalty. See Litig. Rel. 21357 (Dec. 31, 2009).

To resolve the parallel criminal investigation, UTStarcom entered into an agreement with the Department of Justice under which it will pay a fine of $1.5 million. This payment is in addition to the one made as part of the settlement with the SEC.

Criminal

U.S. v. Kumar, ( S.D.N.Y) is one of the “Galleon” insider trading cases, discussed here. Mr. Kumar is a former director of McKinsey & Company who is alleged to have tipped Raj Rajaratnam about the acquisition of ATI Technologies by Advanced Micro Devices. On Thursday Mr. Kumar pleaded guilty to one count of securities fraud and one count of conspiracy to committee securities fraud. During his plea Mr. Kumar stated that he was paid by Mr. Rajaratnam for inside information. Mr. Kumar will now cooperate with the government. To date, seven people have pleaded guilty as part of the Galleon investigation.

Circuit courts

SEC v. ING USA, Case No. 09-35250 (9th Cir. Dec. 29, 2009) is an appeal brought by creditors involved in the Commission’s enforcement action, SEC v. Sunwest Management, Inc., Case No. CV 06056 (D. Ore. Filed March 2, 2009). That case was brought against the operator of retirement facilities in 34 states. The complaint, discussed here, alleges that investors were defrauded in a securities offering. As the market crisis deepened and the company began to unravel, it was operated like a Ponzi scheme, according to the SEC. An asset freeze was obtained and a preliminary injunction entered.

The circuit court reversed the entry of the preliminary injunction. Since the district court failed to make any findings beyond stating that “good cause” was shown at the time the preliminary injunction was entered, the circuit court held that the order failed to comply with Federal Civil Rule 52 requiring that appropriate finds be made.

Private actions

A new report by Cornerstone Research concludes that the number securities fraud class actions filed last year fell by about 24% compared to the year before. Specifically. the number of suits filed dropped from 223 in 2008 to 169 in 2009. The annual average is 197, according to Cornerstone. The drop is attributed to the decline in the number of credit market suits tied to the subprime mortgage losses. The report is consistent with the one issued earlier by NERA, discussed here.

Seminar sponsored by the ABA Criminal Justice Section: January 13, 2010, Enforcement Trends in Securities & Commodities Actions 2010, in person in Washington, D.C. at 600 14th St. N.W. 9th Floor and webcast nationally. http://www.abanet.org/cle/programs/t10ets1.html

Speakers: Adam Safwat, Deputy Chief, Fraud Section, Department of Justice; Steve Obie, Director, Division of Enforcement, CFTC; Laura Josephs, Assistant Director, SEC Division of Enforcement and Cheryl Evans, Special Counsel U.S. Chamber Initiatives For Legal Reform.

Series on Trends in Securities Litigation: This series will be concluded next week.