SELECTED ENFORCEMENT CASES: PONZI SCHEMES, FINANCIAL FRAUD AND FCPA

This is the fourth of six parts in a series examining future trends in securities enforcement

Ponzi schemes and investment fund fraud cases were at one time thought difficult to detect. Post-Madoff, the schemes seem to have percolated to the surface. Now, the SEC brings these cases which such regularity that they might be viewed as a staple of enforcement.

A few of these schemes are noteworthy because of the epic proportions. The massive fraud of Ponzi scheme king Bernard Madoff (here), currently serving what is essentially a life sentence in prison, and the alleged scheme of Robert Allen Stanford, presently awaiting trial (here) fall in this category.

Fortunately, the overwhelming majority of these cases are not of such magnitude. Most of these cases have common elements. Typically the defendants in these cases include the individuals who are the promoters, an entity which is the fund and perhaps related entities which serve and an investment adviser or provide alternative investment opportunities. Generally, investors are solicited to invest their money in some type of proprietary trading scheme. The claims range from simple representations of uncommon expertise in trading to proprietary systems to various exotic schemes. All offer the prospect of safety and returns which are way to good to be true such as steady returns day in and day out regardless of market conditions (Madoff’s pitch) or more fantastic returns on a weekly, monthly or yearly basis that cannot be achieved elsewhere. The investors, of course, lose while the promoters misappropriate their money.

Typically, the SEC moves quickly after discovering the scheme to file its complaint and obtain an asset freeze. That action is frequently followed by the appointment of a receiver to marshal the assets. Over time, the Commission has become very aggressive in brining these cases. Many are followed by criminal charges. In some instances, the Commission coordinates with the CFTC. See, e.g. SEC v. Rockwell Energy of Texas, Civil Action No. 4:09-cv-080 (S.D. Tex. Filed Dec. 23, 2009) (here); SEC v. Shidaal Express, Inc., Case No. 09 cv 2610 (S.D. Cal. Filed Nov. 19, 2009)(here); SEC v. Nicholson, Case No. 09-cv-1748 (Filed Feb. 25, 2009) (here).

In some matters the Commission may be moving to swiftly, spurred perhaps by the ghost of Madoff. For example in SEC v. Sunwest Management, Inc., Case No. CV 06056 (D. Ore. Filed March 2, 2009) an action was brought against a large operator of retirement facilities. Sunwest had operations 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.

Whether Sunwest was in fact operating like a Ponzi scheme, and the validity of the preliminary injunction, is an open question however. In an appeal prosecuted by a group of secured creditors who contested the injunction, the Ninth Circuit reversed the order because the district court did not make any findings as required by Federal Civil Rule 52 beyond a statement of “good cause shown.” Whether the court can make the necessary findings remains to be seen. SEC v. ING USA, Case No. 09-35250 (9th Cir. Dec. 29, 2009).

In contrast to Ponzi scheme cases, actions based on financial fraud have long been a staple of SEC enforcement. Last year was no exception. Three high profile financial fraud cases are illustrative. One is SEC v. General Motors, Civil Action No. 1:09-CV-00119 (Filed Jan. 22, 2009) (here). The claims in the complaint center on events between 2000 through 2004. In that time period, the SEC claims: 1) the company made material misstatements about its pension discount rate selection and expected return on pension assets; 2) failed to disclose information about its projected cash contributions plans to avoid variable rate premiums and the impact on its liquidity; and 3) improperly accounted for a $97 million transaction involving the sale and repurchase of precious metals inventory. The company also improperly recognized $100 million.

The action, brought only against the company, was settled when the company consented to the entry of a permanent injunction prohibiting future violations of the books, records and internal controls provisions. The Commission did not require the company to adopt any remedial procedures.

Another high profile financial fraud action against a large company is SEC v. General Electric, Civil Action No. 1:09 cv 1235 (D. Conn. Aug. 4, 2009) (here). In this case the complaint focuses on the time period 2002-2003 when the company is alleged to have used improper accounting to boost its revenue and earnings. Two of the errors related to hedge accounting. A third involved the improper recognition of revenue in a deal involving the sham sale of locomotives which rivals the Enron – Merrill Lynch barge deal and a fourth involved improper changes in accounting principles to avoid a significant charge.

The case was settled when the company consented to the entry of a permanent injunction prohibiting future violations of the antifraud and certain books, records and internal control provisions of the securities laws. The company also agreed to pay a civil penalty of $50 million. No individuals were prosecuted. The SEC did not require the company to adopt any remedial measures.

A third high profile case which did involve the prosecution of individuals is SEC v. Greenberg, Civil Action No. 09 Civ. 6939 (S.D.N.Y. Filed Aug. 6, 2009). This action against the former Chairman and CEO of AIG and one other former officer centers on transactions alleged to have occurred over a five year period beginning in 2000. The complaint alleges that the two former officers falsely projected the company as an industry leader with consistently high earnings. In fact, the company faced significant financial challenges, concealed losses, engaged in sham transactions and entered into fraudulent round-trip transactions.

To settle this case Mr. Greenberg and the other defendant consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions. Mr. Greenberg also agreed to pay disgorgement of about $7.5 and a civil penalty in the same amount.

Finally, despite the deliberate pace at which financial fraud cases are investigated and its significant investigative powers, in some instances the SEC has difficulties pleading sufficient facts in its complaint. SEC v. Fraser, Case No. CV 09-00443 (D. Ariz. Filed March 6, 2009) is a financial fraud action brought against former executives of CSK Auto Corporation which is now in bankruptcy (here). The case centers on the time period 2002 to 2004. During that period the defendants are alleged to have overstated revenue, failing to write off allowances obtained from vendors which were worthless. Pre-tax income was overstated by 47% in 2002 and 65% in 2004. The SEC’s initial complaint was dismissed for failing to adequately plead fraud. Its second complaint was dismissed for the same reason. The third complaint is pending.

Another area of emphasis is the Foreign Corrupt Practices Act. Following the blockbuster and record setting settlement with Siemens A.G. (here) last year – which followed record setting settlements from the year before – the SEC continues to focus on this area. Indeed, one of the five new groups being formed as part of the rejuvenation of Enforcement will focus on the FCPA.

While the FCPA is a key area of emphasis for the SEC, in many instances the charge is being led by the Department of Justice. The Department reportedly has well over 100 open FCPA cases under investigation. Many involve public companies and parallel SEC investigations. At the same time the Department has brought a number of actions against private companies. Many focus on individuals.

Once significant SEC action brought last year by the Commission is SEC v. Nature’s Sunshine Products, Inc., Case No. 09 CV 672 (D. Utah Filed July 31, 2009) (here). There, the Commission brought an action against the company and its CEO and CFO. The complaint claims that in 2000 and 2001 the company made improper payments through its Brazilian subsidiary to local regulators in an effort to circumvent certain import restrictions. The case was resolved with each defendant consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, anti-bribery and books and records and internal control provisions. The company agreed to pay a $600,000 civil penalty while each of the individuals paid a $20,000 penalty.

This case, which appears to be typical of many FCPA cases in many respects, has two unusual features. First, it is based in part on the antifraud provisions in addition to the typical FCPA sections. Second, it imposed liability on the officers using the control person provisions of Exchange Act Section 20(a). This may suggest a new trend in this area.

Next: Cases involving regulated entities and other significant actions

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. and webcast nationally. http://www.abanet.org/cle/programs/t10ets1.html

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

SELECTED ENFORCEMENT CASES: MARKET CRISIS AND INSIDER TRADING

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

An examination of selected cases brought by the SEC last year in conjunction with the information about the reorganization of the Division suggests the future direction of enforcement. Key cases brought by the Commission can be classified into several groups including: 1) market crisis cases; 2) insider trading; 3) investment fund and Ponzi scheme cases; 4) financial fraud; 5) FCPA actions; 6) cases involving regulated entities and 7) other significant cases.

Market crisis cases

The on-going market crisis has dominated not only the news, but much of the activity on Capital Hill and apparently at the SEC. Commission officials have repeatedly referenced the dozens of investigation underway which are consuming substantial amounts of staff time.

To date, however, the market crisis investigations have resulted in few significant enforcement actions. A number of cases might be classified in this category. Four prominent cases are emblematic of those brought to date. Two were against the officers of former major lenders in the sub-prime real estate market, SEC v. Mozilo, Case No. CV 09-03994 (C.D. Cal. Filed June 4, 2009) (discussed here) and SEC v. Morrice, Case No. SAC09-01426 (C.D. Cal. Filed Dec. 7, 2009) (discussed here). The former names as defendants former executives of sub-prime lending giant Countrywide Financial, while the latter is against former officers of the third largest lender in that market, New Century Financial Corp.

Mozilo and Morrice are essentially disclosure fraud cases with additional elements. Each is based on allegations that the company failed to fully disclose the state of its sub-prime loan portfolio as the market was deteriorating. Mozilo adds insider trading claims and the manipulation of a 10b-5(1) plan to facilitate wrongful trading. Morrice lacks the insider trading claims of Mozilo, but adds allegations of account manipulation as the market crisis began to unfold.

SEC v. Rorech, Civil Action No. 09-CV 4329 (S.D.N.Y. Filed May 5, 2009) (discussed here) is the Commission’s first insider trading case based on claims involving credit default swaps. While the case centers on CDS, which many blame for much of the market crisis, whether this case is really a “market crisis” case is debatable. In any event, the case which is now in discovery following the recent denial of a motion to dismiss, is significant because it is the first to involve CDS.

Finally, SEC v. Reserve Management Company, Inc., Case No. 09 CV 4346 (S.D.N.Y Filed May 5, 2009) (discussed here) is an action against the principals of the Reserve Primary Fund, the first money market fund to “break the buck.” The complaint, based on alleged violations of the antifraud provisions, claims that the defendants failed to provide material information to Fund investors, the board and rating agencies following the bankruptcy of Lehman Brothers on September 15. At the time Lehman filed for bankruptcy, the Fund held $785 million in Lehman debt securities. Following the bankruptcy filing, the Fund was overwhelmed with redemption requests. In an effort to reassure investors and avoid breaking the buck, the defendants made a series of false and misleading statements.

Each of these cases is in litigation in contrast with most SEC cases which settle at the time of filing. Presumably, the SEC’s market crisis investigations are continuing. In view of the effort and resources being expended on those investigations, it seems reasonable to expect that more cases will be brought. At the same time these four cases do not suggest that there are blockbuster cases in the pipeline.

Insider trading

Insider trading has been a key SEC enforcement priority since at least the 1980s. Last year was no exception. Blockbuster insider trading cases were brought. Many of the cases involved market professionals. A number of the cases illustrate the aggressive posture of the Commission in this area.

Without a doubt the most significant insider trading case brought last year – and perhaps in years – is the one centered on the founder of the Galleon Fund, U.S. Rajaratnam, Case No. 09 mg 2306 (S.D.N.Y. Filed Oct. 16, 2009) and the Commission’s parallel action, SEC v. Galleon Management, LP, Civil Action No. 09-CV-8811 (S.D.N.Y. Oct. 16, 2009 (discussed here). The case centers on allegations that billionaire Raj Rajaratnam, the founder of Galleon Fund, along with other market professionals, has engaged in insider trading over a period of years. The on-going investigations which led to the filing of charges have already spawned a number of guilty pleas. One of the significant features of this case aside from the high profile defendants is the fact that investigators apparently listened on wire taps while the defendants exchanged inside information about a number of companies and subsequently used it to illegally trade. Rajaratnam and Galleon contrast sharply with the more typical insider trading case where the SEC or criminal prosecutors begin their investigation after the trading is over and then probe back in time to try and determine if there was insider trading.

While the Galleon cases are clearly being driven by the U.S. Attorney’s Office, the SEC did in fact bring high profile and aggressive insider trading cases. Two such cases are SEC v. Dorozhko, Case No. 08-0201 cv (2nd Cir. July 22, 2009) and SEC v. Cuban, Civil Action No. 3:09-CV-2050 (N.D. Tex. Decision Filed July 17, 2009). In the former, the Commission prevailed on appeal in an action brought against a computer hacker who misappropriated inside information after breaking into a secure compute and used that data to trade. In arguing that the district court incorrectly dismissed the case, the SEC contended that the key element of deception was supplied by the hacking. Since a computer hacker must electronically deceive the computer being hacked to get in there was deception. The Second Circuit reversed the dismissal with instructions to the district court to evaluate this question.

In Cuban, the SEC’s aggressive posture also yielded a dismissal in the district court. There, the Commission claimed that Mark Cuban traded on inside information after he was told about a pending PIPE offering following his statement that he would keep the information confidential. While the district court rejected defense claims that there had to be a breach of fiduciary duty as a predicate for insider trading, it concluded that there was not a sufficient obligation between Mr. Cuban and the company conducting the PIPE to sustain the charges. Whether the Commission can again turn its aggressive position into victory on appeal remains to be seen (both cases are discussed here).

The aggressive posture of the SEC in this area is also reflected in the case it recently brought against two French nationals residing in Belgium, SEC v. Condroyer, Case No. 1:09-cv-3600 (N.D. Ga. Filed Dec. 22, 2009) (discussed here). There, the Commission brought insider trading claims centered on the take over of a U.S. manufacturer by a French health care products company. The complaint, filed shortly after the deal announcement, is based on little more than the large option positions established by each defendant shortly prior to the deal announcement. This case, along with Cuban, Dorozhko and others clearly illustrates that while the headline grabbing Galleon case may belong to the U.S. Attorney’s Office, the SEC has been and likely will continue to be very aggressive in this area.

Next: Investment fund cases: A new priority.

Seminar: January 13, 2010, Enforcement Trends in Securities & Commodities Actions 2010, in person in Washington, D.C. and webcast. http://www.abanet.org/cle/programs/t10ets1.html

The program, co-chaired by Thomas Gorman and Frank Razzano, features a discussion of enforcement trends by senior officials from the Department of Justice, SEC, CFTC and the National Chamber Litigation Center.