THE SEC MUST FOCUS ON THE MERITS NOT PENALTIES

Last week was busy for SEC Enforcement Director Robert Khuzami. On Tuesday, he spoke to the AICPA, reviewing the recent achievements of the enforcement program. Wednesday he testified on Capital Hill, detailing for lawmakers positive developments about enforcement. On Friday he was back on Capital Hill defending the Commission’s settlement with Bank of America, discussed here. Little new information about the program or the Bank of America settlement emerged beyond some statistics about matters such as the number of formal orders issued discussed here.

A critical assumption to all of these proceedings is that SEC enforcement actions are firmly grounded in the merits. Commission cases are, after all, law enforcement actions designed to enforce the law. In all the discussion about the health of SEC enforcement however, this assumption is never discussed. Perhaps now it is time.

The SEC has always insisted its enforcement actions are firmly grounded in the facts, reflecting the merits. So did plaintiffs in congressional hearings about class actions. Those hearings lead to the PSLRA in 1995. Congress found the merits mattered little. Corporate defendants were paying large sums to buy peace.

In Commission enforcement actions the increasing reliance on corporate penalties in this decade challenges this assumption the assumption that the merits matter. Bank of America is a case in point. The bank has steadfastly maintained that it did nothing wrong. It paid the penalty as a business decision to avoid a confrontation with a regulator. No wiggle room in its position. No suggestion that perhaps the Commission had a point. The bank has made it clear in briefs that it gave little weight to the SEC’s previously issued Section 21(a) report which gave warning that the practice used in crafting the challenged proxies and omitting the key schedule with the bonus information was wrong. Nevertheless, the bank agreed to pay the penalty. Plain and simple, the bank paid the SEC to go away.

The Commission for its part has maintained that the shareholders were told a lie. The bank and its lawyers knew the practice it followed was improper, according to the SEC. The SEC also knew the position of the bank at the time of settlement. Yet, it tried to take the money and go away. Its rationale, according to its brief, is that the corporate penalty would inform shareholders and the marketplace about the management of the bank. Armed with that information appropriate action could be taken by shareholders in the next proxy cycle. The market place would also be cautioned not to take actions like those of the bank because of the big and costly penalty the SEC theorized.

The Commission’s rationales are dubious at best and belied by the facts. The bank made it clear the fine was paid to make the SEC go away. Stated differently, the penalty was paid to end the matter irrespective of the merits. Replay the 1995 congressional hearings. Any corporation involved in an SEC investigation, like a plaintiff facing a securities class action, confronts the potential for a costly, time-consuming and difficult process. Like the class action, the investigation can take months if not years. As in the class action, millions of pages of paper and now electronic documents may have to be produced at an enormous cost. Executives must spend time prepping for and in testimony as well as managing the inquiry. Once the matter becomes public there will be a wave of adverse publicity followed, typically by a drop in the stock price. Under these circumstances, litigating is not a real choice because it just extends a costly and difficult process. As with class actions prior to 1995, there is only one choice for most companies: try to obtain a settlement that makes business sense. Forget the merits.

Settlements structure around a standard injunction and a corporate penalty such as Bank of America make it possible and in fact facilitate a replication of the settlement model in the class actions: “buy peace.” Settlement is a business decision, not a reflection of the merits. Bank of America made this clear.

Viewed in this context, it is not difficult to understand how Wall Street’s once highly respected watch dog fell into disrepute. The heavy reliance on penalties gives corporate America the opportunity to extricate itself from any difficulty with the once feared watchdog by simply paying a fine.

To be sure scandals such as Madoff and others have contributed heavily to eroding the Commission’s reputation as an effective regulator. When however, its enforcement actions become like the nuisance suits Congress was told about in 1995, the program no doubt garners the same respect in the corporate suite as the frivolous class actions which propelled congress to pass the PSLRA.

Keying settlements to the merits in contrast rather than the payment of penalties will ground enforcement actions in the merits and help rebuild respect for the program. This means that that the SEC must return to its remedial roots, crafting settlements using its traditional remedies not just to halt a violation, but to ensure against repetition in the future. New compliance procedures, the installation of monitors and other similar remedies long effectively used by the Commission should again be employed to settle cases.

The return to using remedial procedures to resolve cases rather than fines will have a two-fold impact. First, the procedures are grounded in the conduct since they are designed to make sure that it is not repeated. Second, through these kinds of settlements, the Commission effectively stays involved with the company long after the ink on the consent decree has dried, monitoring and bringing the new ethics to the marketplace Congress intended when it wrote the securities statutes long ago. Thus, not only does the Commission not go away, but regardless of what executives claim about the situation, the company will under this kind of settlement be precluded from repeating the conduct. When the SEC crafted these kinds of settlements, the enforcement program was respected as one of the most effective in government. If the SEC is going to once again become an effective regulator and the watch dog of Wall Street, it must return to a focus on the merits.

THIS WEEK IN SECURITIES LITIGATION (December 11, 2009)

NERA released statistics on the SEC enforcement program this week showing that the number of cases settled by enforcement declined for the second straight year. Those results contrasted with the presentation made to the AICAP by the Enforcement Director. Those remarks detailed a series of statistics depicting significant increases over the prior year. They do not include settlements.

The Supreme Court heard argument in three cases significant to securities litigation. One concerns the constitutionality of the PCAOB, while the other key on the scope of honest services fraud which is frequently charged in criminal securities cases. SEC enforcement brought a new insider trading case based on the on-going investigations into trading by hedge funds, as well as cases stemming from the market crisis, financial fraud and Ponzi schemes. The U.S. Attorney’s Office in New York obtained another guilty plea from an attorney in its on-going insider trading cases while the co-founder of Broadcom had his plea vacated after testifying in a criminal options backdating after being immunized by the court.

Market reform

Settlements: According to NERA, the number of cases settled by the SEC last year declined by about 8%. This is the second straight year in which the number of settling cases has declined. The dollar value of those settlements rose, according to the report. In making that calculation however, the report adds together disgorgement, prejudgment interest and civil penalties. The value number was also significantly impacted by settlements in two large FCPA cases, Siemens, discussed here, and Halliburton, discussed here. Both of those settlements keyed to the resolution of criminal charges.

Robert Khuzami, Director of the Division of Enforcement, focused on other statistics in remarks before the AICPA National Conference on Current SEC and PCAOB Developments on December 8, 2009. The director stated that the SEC obtained:

• Orders for disgorgement of over $2 billion, up 170% from the prior year;

• Orders to pay penalties of $345 million, up 35% from the prior year;

• Obtained 71 emergency TROs, up 82%;

• Obtained 82 asset freeze orders, up 78%; and

• Issued 496 formal orders, an increase of over 100%. (The impact of the new procedure, discussed here, on this number cannot be determined).

H.R. 4191 was introduced this week by Peter DeFazio, Chairman of the House Subcommittee on Highways and Transit. It was joined by 22 other representatives. The legislation, titled Let Wall Street Pay for the Restoration of Main Street Act, provides for a small additional tax on stock futures, swap, CDS and options transactions. The funds will be used to pay rebuild main street. It will not impact tax favored retirement accounts, mutual funds education savings accounts, health saving accounts and the first $100,000 of transactions annually that are not already exempt. Senator Harkin intends to introduce a similar bill in the Senate next week. The proposed legislation reportedly has the support of over 200 economists and business leaders such as John Bogle, founder of Vanguard. It could raise as much as $150 billion per year.

SEC enforcement actions

Fraudulent investor program: SEC v. Investools, Inc., Civil Action No. 1:09-CV-02343 (D.D.C. Filed Dec. 10, 2009) is a settled action against Investools, Inc., Michael Drew and Eben Miller. The complaint claims that the defendants falsely told investors that they were experts in securities trading to draw them into taking instructional courses and purchasing other products from the firm. Both individual defendants told potential investors that in their recent trading they were very successful when in fact both suffered huge losses. The action was settled with each defendant consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b). The company agreed to pay a $3 million civil penalty while Messrs. Drew and Miller agreed, respectively, to pay penalties of $380,000 and $130,000. See also Litig. Rel 21331 (Dec. 10, 2009).

Market crisis case: SEC v. Brookstreet Securities Corp., Case No. SACV 09-01431 (C.D. Cal. Filed Dec. 8, 2009) is an action against a broker dealer and its former CEO Stanley Brooks based on the sale of risky mortgage backed securities through what was called a “CMO Program.” The sales were made to retail customers looking conservative investments as discussed here. Over a three year period, according to the complaint, the firm and a number of its representatives who are the subject of a separate SEC enforcement action discussed here, used a series of misrepresentations to sell these risky investments to investors for whom they were inappropriate.

In early 2007 when CMO prices dropped precipitously, the firm liquidated all of the accounts in its CMO Program to avoid net capital violations. Since the liquidation included accounts that were fully paid, a number of investors suffered significant losses. Many customers lost their savings, their homes and their ability to retire. By June 2007 the firm failed to meet its net capital requirements. Brookstreet ceased operations. The SEC’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 20(s). The case is in litigation.

Ponzi scheme: SEC v. Rockford Funding Group, LLC, Case No. 1:09-cv-10047 (S.D.N.Y. Filed Dec. 8, 2009) is a suit against a company which the SEC claims raised at least $11 million from over 200 investors in 41 states and Canada since March 2009. Potential investors were told their funds would be safely invested in structured settlements. Those claims were solicited over the telephone and through a website. In fact the company did not have any structured settlement assets and most of the money was sent to offshore banks. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b). The SEC obtained an asset freeze. The case is in litigation. See also Litig. Rel 21329 (Dec. 9, 2009).

Market crisis case: SEC v. Morrice, Case No SAC09-01426 (C.D. Cal. Filed Dec. 7, 2009) is an action against three former New Century executives, CEO and co-founder Brad Morrice, CFO Patti Dodge and Controller David Kenneally. New Century, prior to filing for bankruptcy, was the third largest subprime lender as discussed here. The complaint is based on a disclosure fraud as well as claims of improper accounting.

The disclosure fraud centers on what was not told to the public about the deteriorating condition of the loan portfolio, despite the fact that executives got weekly reports titled “Storm Warning,” which detailed the impact of the crisis on the company.

The accounting fraud centered on alleged manipulations related to the reserves. As a result of a series of improper actions, financial results were overstated for the second quarter of 2006 by 165%. For the third quarter pre-tax earnings were reported as $90 rather than $18 million. These actions artificially inflated the share price, injuring shareholders. In the second half of 2006, the company raised $142.5 million by selling stock to new investors. When the company announced on February 7, 2007 that it would restate its financial results for the first three quarters of 2006 the share price fell nearly 40% from just over $30 to about $19. By early April the company filed for bankruptcy. The Commission’s complaint, which alleges violations of the antifraud and reporting provisions as well as a claim for failure to reimburse under SOX Section 304, is in litigation. See also Litig. Rel. 21327 (Dec. 7, 2009).

Offering fraud: SEC v. Striker Petroleum, LLC, Civil Action No. 3:09-CV-2304 (N.D. Tex. Filed Dec. 3, 2009) is an action against Striker Petroleum, LLC, a Dallas based oil and gas company and its principals Mark Roberts and Christopher Pippin. The complaint claims that over a two year period beginning September 2006 the defendants raised about $57 million from 540 investors by selling debentures collateralized through oil and gas properties. The offering materials for those sales were, according to the SEC, false and misleading as to the earnings, assets, use of proceeds and the existence of an independent trustee. The SEC obtained a consent order to an injunction precluding future violations of the antifraud provisions and appointing a receiver. See also Litig. Rel. 21325 (Dec. 4, 2009).

Offering fraud: SEC v. Nova Gen Corp., Case No. 09 CV 2711 (S.D. Cal. Filed Dec. 3, 2009) names as defendants Nova Gen Company and its current CEO Margaret Grey and sales agent Paul Fraley. The complaint alleges a fraud in connection with the sale of shares in the company. Specifically, the complaint claims defendants fraudulently claimed that they had an operating plant that converted coal into bio-diesel fuel that had virtually no emissions. The offering materials also contained false financial statements for the company according to the complaint. Violations of the registration and antifraud provisions are alleged. The case is in litigation. See also Litig. Rel. 21322 (Dec. 4, 2009).

SEC v. Provident Royalties, LLC, Case No. 3-09 CV 1238 (N.D. Tex. Filed Dec. 3, 2009) names as defendants the company and Joseph Blimline, Paul Melbye, Brendan Coughlin and Henry Harrison. The complaint alleges an offering fraud and Ponzi scheme. According to the complaint, Provident, controlled by the individual defendants, advanced about $93 million of investor funds to Mr. Blimline and entities he controlled. The funds were supposed to be for the purchase of oil and gas properties. In presentations to investors and brokers Mr. Blimline did not disclose his receipt of the funds or involvement with the management of Provident. The complaint alleges violations of the antifraud provisions. An order freezing the assets and appointing a receiver has been entered. See also Litig. Rel. 21321 (Dec. 4, 2009).

Criminal cases

U.S. v. Santarlas, (S.D.N.Y.) is an insider trading case against Brien Santarlas, formerly an attorney at Ropes & Gray LLP. Mr. Santarlas pleaded guilty to an information which charges him with conspiring with others to misappropriate inside information on from his law firm. The information related to pending mergers and acquisitions regarding 3Com and Axcan Pharma, Inc. The two count information charged conspiracy to commit securities fraud and securities fraud. This case is related to the earlier insider trading case brought against Arthur Cutillo discussed here. The SEC brought a parallel civil action, SEC v. Santarlas, Case No. 09-CV-10100 (S.D.N.Y. Filed Dec. 10, 2009). See also Litig. Rel. 21332 (Dec. 10, 2009).

U.S. v. Ruehle, discussed here, is the criminal option backdating case brought against the former Broadcom Corp. CFO. Last week, the court granted a defense motion to immunize company co-founder Henry Samueli. Subsequently, Mr. Samueli requested that his guilty plea be vacated based on claims of prosecutorial misconduct. Mr. Samueli had pleaded guilty to one count of making a false statement in connection with the SEC’s investigation of option backdating at Broadcom, discussed here. This week, after listening to Mr. Samueli’s testimony at trial, the court vacated the guilty plea noting that he had not in fact made a false statement. During his testimony Mr. Samueli said that he had no knowledge of backdating practices. He also said that Mr. Ruehle did not have any role in setting option prices.

U.S. v. Petters, Case No. 0:08-cr-00364 (D. Minn.) is a Ponzi scheme case against Thomas Petters, founder of Petters Group Worldwide LLC. This week, Mr. Petters was convicted of twenty counts of fraud, conspiracy and money laundering based on his operation of the scheme. Mr. Petters had solicited investors and raised about $3.6 billion by claiming the money would be used to purchase consumer electronics which would be resold to big box retailers. Instead the money was used to fund his life style. The sentencing date has not been set.

Private actions

In Re: Bristol-Meyers Squibb Co. Sec. Litig., Case No. 1:07-cv-05867 (S.D.N.Y. Filed June 20, 2007), discussed here, is a securities class action which claimed the company made false disclosures regarding the settlement of patent litigation with a generic drug maker regarding a key product. The complaint claimed the drug maker had negotiated significant side agreements in the litigation settlement which were not disclosed. This week the court approved a $125 million settlement of the suit.

Circuit courts

In re Short Sales Antitrust Litig., Docket No. 08-0420-cv (2nd Cir. Decided Dec. 3, 2008) is a putative class action brought by Electronic Trading Group, LLC on behalf of short sellers against a Bank of America Securities, LLC and other prime brokers. It alleged price fixing regarding the fees charged in connection with obtaining certain securities to cover a short sale. The Second Circuit, following the Supreme Court’s decision in Credit Suisse Securities (USA), LLC v. Billing, 551 U.S. 264 (2007) held that the suit was preempted as discussed here.

Supreme Court

Black v. U.S., Docket No. 08-876; Weyharuch v. U.S., Docket No. 08-1196. Tuesday the Supreme Court heard argument on these cases. The parties attempted to give definition to honest services fraud under 18 U.S.C. § 1346, a charge frequently brought in criminal securities cases. Throughout the arguments, each side attempted to provide an appropriate definition which would delimit the scope of the virtually open-ended statute. Most members of the court, as discussed here, seemed more interested in determining if the statute was unconstitutional, a issue not fully briefed in the case. The Skilling case, discussed here, which will be argued later this year, also concerns this statute and does specifically raise the question of whether the statute is unconstitutional.

Free Enterprise Fund v. Public Company Accounting Oversight Board, Case No. 08-861 is a challenge to the constitutionality of the PCAOB. The case, which was heard this week by the court, and is discussed here, raises questions as to whether the creation of the board under the supervision of the SEC violates the appointment power and separation of powers principles.