Part VIII: SEC Enforcement Trends, 2009 — Auction Rate Securities

Last year, auction rate securities were a significant area of focus for enforcement. The auction rate securities market crashed in February 2008. Prior to that date, a number of banks and brokers sold ARS as essentially cash equivalents. When the market crashed, purchasers of the securities were unable to liquidate their holdings. The SEC, the Attorney General of New York and other state attorney generals have actively investigated the sales practices for ARS. Those investigations have resulted in final settlements with UBS, Citigroup Capital Markets and Wachovia. While the settlements tend to be similar, they are not identical.

The SEC’s settlement with Wachovia is typical of the resolutions reached in these cases. SEC v. Wachovia Securities, LLC., Case No. 09 CV 743 (N.D. Ill. filed Feb. 5, 2009). Key terms of that settlement require the defendant to repurchase ARS in two phases. First, Wachovia will purchase the securities from essentially small investors – individuals, not-for-profits, religious organization and others with account values up to $10 million. Second, Wachovia will purchase ARS from all other holders. Wachovia also agreed to lend customers the full par value of their ARS pending the buy back with interest rates set so that customers will not have negative carry on their loans. Eligible customers who incurred consequential damages from the illiquidity of the market can participate in a special FINRA arbitration. See also SEC v. UBS Securities LLC, Civil Action No. 08 Civ 10754 (S.D.N.Y. filed Dec. 11, 2008) (similar terms); SEC v. Citigroup Global Markets, Inc., Civil Action No. 08 Civ 10753 (S.D.N.Y. filed Dec. 11, 2008) (similar, but for large institutional holders Citi is only required to use is best efforts to bring liquidity to the markets).

Agreements in principle have been reached with Bank of America, RBC Capital Markets Corp, and Merrill Lynch. See SEC Press Release, “SEC Finalizes ARS Settlement To Provide $7 billion in liquidity to Wachovia Investors” (Feb. 5, 2009) (collecting materials and links to other ARS settlements). Generally, these agreements have similar terms to the final settlement reached with Citigroup Global Markets listed above. Accordingly, they provide for the repurchase of ARS from smaller investors. For large investors the agreements provide that the settling party will use its best efforts to provide liquidity to the market. While the Commission will undoubtedly continue to finalize settlements in this area in the future, this is not likely to be a major area of focus for enforcement going forward.

Next: The concluding two segments of this series will cover, respectively, key legal issues and an analysis of the trends.

Additional materials: The subject tabs to the left have been updated with a number of new materials regarding SEC enforcement, cooperation, securities damage actions and internal investigations.

Restoring SEC Enforcement: Prosecutorial Discretion And Coordination

The new SEC Chairman has promised to improve and rejuvenate the SEC and its enforcement program. Steps have been taken in that direction as discussed here. More will undoubtedly follow. As Chairman Schapiro and her new and expanding team of senior staff move forward, two key topics which should be considered are prosecutorial discretion and coordination. Both are critical to restoring the SEC and its enforcement program to its former role as the top cop of Wall Street.

Prosecutorial discretion and case selection is a key facet of effective enforcement. The SEC has wide discretion in selecting which matters to investigate and what cases to prosecute. At the same time, even with an expanded budget and perhaps more tools from Congress, the Commission cannot pursue every matter arguably within its jurisdiction. This means that the SEC must exercise discretion and carefully select how to use its resources if it is to be effective.

The SEC’s effectiveness can, in many instances, be enhanced by coordinating with other agencies. By working effectively with DOJ, state AGs and SROs, the SEC can effectively expand its reach. To be sure, the SEC often works effectively with other law enforcement agencies in this country and those abroad. At the same time however, there are instances when it may be more prudent for the Commission to step back and conserve its resources, letting another agency take the lead. This may occur when, for example, the matter centers not so much on a violation of the securities law, but on other statutes. This is particularly true where the action is effectively policed by another law enforcement agency. Three recent cases illustrate this point:

• SEC v. Hozhabri, Civil Action No. 08-CV 1359 (D.D.C. Filed Aug. 6, 2008) is an action where defendant Ali Hozhabri, a former project manager for ABB Network Management, fraudulently submitted $468,714 in cash and check disbursement requests to his employer over a two year period. The SEC’s complaint called this an “embezzlement scheme” and charged only books and records violations. Mr. Hozhabri pled guilty to conspiracy to commit wire fraud. The SEC settled and deferred pursuit of disgorgement in favor of the criminal case.

• SEC v. UBS AG, Case No. 1:09-CV-00316 (D.D.C. Filed Feb. 18, 2009) is a settled civil injunctive action which alleged violations of the Investment Advisers Act and Section 15(a) of the Exchange Act. The case centered on a scheme in which UBS is alleged to have conspired to defraud the U.S. by impeding the IRS. UBS entered into a deferred prosecution agreement with DOJ and agreed to pay $780 million in fines, penalties, interest and restitution.

• SEC v. Morris, Civil Action No. 09 CV 2518 (S.D.N.Y. Filed Mar. 19, 2009) is an action against NY political figures alleged to have extorted brokers and hedge funds for fees in return for investing state pension funds. The New York Attorney General has brought criminal charges and obtained one guilty plea, which prompted the SEC to amend its complaint to add that person as a defendant in its action.

Each of these cases is within the broad jurisdiction of the SEC. Each however, raises questions about prosecutorial discretion, coordinating with other agencies and the use of scarce resources. Hozhabri is, as the complaint admits, an embezzlement scheme. DOJ brought criminal charges, which clearly resolved the matter. In fact, the SEC deferred part of its typical remedies to that action. There seems to have been little reason for the SEC to expend resources here. Prosecutorial discretion might have suggested that the SEC conserve its resources and defer to DOJ.

UBS presents a similar question. As DOJ’s papers state, this a tax scam. While the SEC is correct in claiming violations of the federal securities laws, it questionable at best as to whether the Commission needed to use its resources in what appears to be a duplication of efforts by the Justice Department. To be sure, an argument can be made that the case involved investments and that UBS, as a regulated entity, should be prosecuted. This is not the point, however. Nice legal arguments can frequently be raised to support an exercise of SEC jurisdiction. At a time when the agency is struggling to restore its once excellent reputation as the top cop of Wall Street, needless duplication diverts scarce resources from more critical areas and can, in some instances, appear as mean-spirited piling on.

Morris is a more complicated matter. At its core, this is a state political corruption case which clearly should be prosecuted by New York state and local officials. Those law enforcement officials are, from all appearances, pursuing the matter. Two other points are important, however. First, Morris centers on securities transactions. Second, local prosecutors acknowledged early on that given the scope and complexity of the potential inquiry, they need additional assistance. Enter the New York AG and the SEC. Here, effective partnering with other agencies suggests that the SEC step in and work with the local prosecutors as well as the New York AG to ensure effective enforcement. This contrasts with UBS and Hozhabri, where there was no apparent need for the SEC to step in and investigate.

These cases illustrate part of the complexity of reviving SEC enforcement. It is not enough to bring in new senior staff, add millions to be budget or even obtain new tools from Congress. Effectively restoring enforcement requires considered judgment about the direction of the program, the selection of cases, working with other agencies and the use of resources to effectively police the securities markets.