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.

This Week In Securities Litigation (April 17, 2009)

The SEC continued to focus on investment fraud cases this week, filing two more actions based on claimed Ponzi scheme. The Commission also filed a financial fraud case, amended its complaint in a New York state financial corruption case and resolved a long running insider trading case following a significant victory in the court of appeals. The Fifth Circuit affirmed the dismissal of private action based on a failure to plead a strong inference of scienter under the Supreme Court’s Tellabs decision continuing a clear trend in the circuit courts. In private litigation, a tentative settlement was reached in the long running IPO private damage actions, while the shareholders of BG Group brought a derivative suit centered on alleged violations of the FCPA. Finally, Citbank and Wachovia resolved ARS claims with state regulators.

SEC Enforcement

The SEC continued to bring Ponzi scheme cases, adding two more to the total this week:

• SEC v. Maximum Return Investments, Inc. Civil Action No. CV 09-2536 (C.D. Cal. Filed April 13, 2009) alleges a fraudulent investment scheme in which Hispanic-Americans were solicited largely by word of mouth to invest in Maximum Return. Investors, from whom about $23 million was raised, were promised returns of up to 25% within 30 to 45 days. Those investors were assured that their investment was risk free because of a claimed bank guarantee. In fact, the fund was a Ponzi scheme.

• SEC v. Ovid, Case No. 09-1521 (E.D.N.Y. Filed April 14, 2009) is a fraudulent investment scheme case in which the defendants, leaders in their church, are alleged to have raised over $12 million through false representations made to largely elderly members of their church. Defendants claimed that the money would be invested in two funds, promising returns as high as 75%. In fact, the defendants are alleged to have misappropriated large portions of the investor funds. The U.S. Attorney’s Office for the Eastern District of New York filed parallel criminal charges against five of the defendants.

Financial fraud: SEC v. Pitters, Case No. 09-20957 (S.D. Fla. April 13, 2009) is a financial fraud case brought against three principles of a now defunct internet telecommunications provider, VoIP, Inc. The complaint alleges that Terrell Kuykendall, the former general manager of a subsidiary, and Osvaldo Pitters, the former CFO, engaged in a scheme to falsify the revenues of a subsidiary when it became apparent that it would not meet revenue projections. As part of the scheme, fictitious sales were recorded and documents were falsified. Defendant Steven Ivester, the former CEO of the company, is charged with missing numerous red flags about the scheme. The case, which alleges violations of the antifraud and reporting provisions, is in litigation.

Sham fees: SEC v. Morris, Civil Action No. 09 CV 2518 (S.D.N.Y. Filed Mar. 19, 2009) is essentially a New York state political corruption case first filed last month. This week, the SEC amended its complaint. The initial complaint, discussed here, named as defendants Henry Morris, a top political advisor and chief fund raiser for the former NY State Controller and David Loglisci, former Deputy Comptroller and Chief Investment Officer of New York State Common Retirement Fund and certain controlled entities. The complaint claims that, over a period of years, the defendants obtained sham finder or placement agent fees in connection the investment of billions of dollars of New York state retirement funds with private equity firms and hedge fund managers.

The amended complaint adds as defendants Raymond Harding, Barrett Wissman and three entities allegedly used by Mr. Wissman in the scheme – Flandana Holdings Ltd., Tuscany Enterprises LLC and W Investment Strategies LLC. Mr. Wissman is a long time family fried of Mr. Loglisci alleged to have participated in the sham fee scheme. Mr. Harding, a political ally, was inserted into two funds, netting him $800,000 in sham fees.

Mr. Wissman and Flandana Holdings partially settled the action, consenting to the entry of permanent injunctions prohibiting future violations of the antifraud provisions. Issues regarding disgorgement and penalties were deferred. Two other entities involved in the matter, HFV Management and HFV Asset Management, also consented to the entry of permanent injunctions prohibiting future violations of Securities Act Sections 17(a)(2) and (3) and Section 206(2) of the Advisers Act. The two agreed to pay a penalty in the aggregate amount of $150,000. The New York AG has filed related criminal cases in which Mr. Wissman has pled guilty.

Insider trading: SEC v. Talbot, Case No. CV 04-04556 (C.D. Cal. Filed June 24, 2004), a long running insider trading case, settled. Initially, the SEC’s complaint was dismissed by the district court. That complaint alleged that Mr. Talbot, a director of Fidelity National, learned that LendingTree, 10% owned by Fidelity, was about to be acquired and later traded on that information. The information came from a LendingTree official who told another Fidelity official and was ultimately communicated at a Fidelity board meeting.

The district court granted summary judgment in favor of Mr. Talbot ruling that the SEC had failed to establish a breach of duty because it did not demonstrate that there was a continuous chain of fiduciary relationships back from Mr. Talbot to the source of the information. The Ninth Circuit reversed holding that a continuous chain back to the source of the information as the district court concluded is not required.

Mr. Talbot agreed to settle the case by consenting to the entry of a permanent injunction and agreeing to the entry of an order requiring him to disgorge $67,881 along with $26,916 in prejudgment interest for a total of $94,797 and to pay a civil penalty of $135,762 as discussed here.

Circuit courts

Pleading scienter: The Fifth Circuit’s decision in Flaherty & Crumrine Preferred Income Fund Inc. v. TXU Corp., Case No. 08-10414 (5th Cir. Decided April 8, 2009) affirmed the dismissal of a securities fraud complaint based on an application of Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007), originally discussed here.

The complaint in TXU centers on plaintiffs’ claim that defendants misrepresented the dividend policy to induce them to tender their shares. Four months before a tender offer, TXU announced that the company did not anticipate a dividend increase until two years later, although it noted that the board might reconsider. Shortly after plaintiffs tendered their shares and the offer closed, a new dividend policy was announced resulting in a significant share price increase.

The Fifth Circuit concluded that the inferences not supporting scienter outweighed those which supported it. After reviewing each statement claimed to support scienter, the court stated that “it is not clear that Appellees [defendants] ever issued a materially misleading statement.” The court went on to reject an argument that the disclosure stating that the policy “was under review” was not sufficient. Indeed, the fact that the company disclosed that fact during the tender period supports an “inference of non-fraudulent intent [that] weights in favor of the” defendants. Since the inference opposing scienter outweighs the one supporting it, under Tellabs the complaint must be dismissed.

Private actions

IPO litigation: A preliminary settlement was reached in In re Initial Public Offering Sec. Litig., Case No. 21 MC 92 (S.D.N.Y.). These class actions claim that 55 underwriters and more than 300 issuers, and those associated with them, defrauded the investing public. Essentially the cases hinged on allegations that the underwriters required IPO allocants to purchase additional shares in the aftermarket, frequently at escalating prices and to pay kickbacks in the form of inflated commissions. Those schemes were not properly disclosed in prospectuses and other offering documents filed with the SEC according to the cases. The tentative settlement of the 309 cases filed in 2001 calls for the payment of $586 million in settlement.
FCPA: Grynberg v. BG Group P.L.C., Case No. 1:09-cv-10543 (D. Mass. Filed April 8, 2009) is a derivative suit brought by the shareholders of BG Group, a natural gas company. The suit alleges that the company paid bribes to various top officials of the government of Kazakhstan and covered up this fact through a series of misrepresentations. The suit, based on claimed breaches of fiduciary duties by the directors, seeks an injunction, an accounting and the repayment by the individual defendants of their salaries and director fees.

State securities actions

The Office of Financial and Insurance Regulation for the state of Michigan announced a settlement with Citigroup and Wachovia regarding their sales practices in the auction rate securities market. Under the terms of the settlement Citi and Wachovia agreed to offer full buybacks to any eligible customer who purchased ARS from the firms up to $717 from Citi and $159 from Wachovia. Citi also agreed to pay an administrative fine of $1.72 million while Wachovia will pay a fine of $654,000. The settlement resolves a multi-state investigation into the sales practices used in connection with auction rate securities.

Seminar

On April 29, 2009, the ABA will sponsor a webcast on insider trading featuring speakers from the SEC, DOJ, FINRA, NYSE Regulation and the private sector.