Part VII: SEC Enforcement Trends, 2009 — Option Backdating

Option backdating cases have been a focus of enforcement in recent years. Essentially, they involve fraudulently backdating stock option grants so that they are in the money and then not recording the related expenses of those options properly in financial statements. In many instances, these cases also involve disclosure violations.

The SEC is reportedly working its way through what was once a large inventory of option backdating cases. Most of these cases have been based on allegations of scienter and fraud. Frequently, the actions include allegations of cover-ups. In some instances, criminal charges have been brought. See, e.g. U.S. v. Reyes, No. 06-cr-0556 (N.D. Cal. Aug. 27, 2007) (former CEO of Brocade Communications convicted on criminal backdating charges); but see U.S. v. Roberts, Case No. 3:07-cr-00100 (N.D. Cal. filed Feb. 27, 2007) (former general counsel of MacAfee acquitted of fraud charges based on option backdating, but jury hung on charges regarding falsification of books and records which judge recommended government drop). In some cases however, the Commission has brought actions based on negligence, using Securities Act Section 17(a)(3). This year, these trends have continued.

Typically, option backdating cases are brought against the company and the specific officers involved based on fraud and books and record charges. Most of these cases settle. SEC v. Sycamore Networks, Inc., Civil Action No. 1:08-CV-11166 (D. Mass. July 9, 2009) typifies many of these actions. Here, an action was brought against Sycamore Networks, an optical networking company, its former CFO, Frances M. Jewels, former Director of Financial Operations Cheryl E. Kalinen and former Director of HR Robin A. Friedman. The complaint alleged that between 2000 and 2005 Sycamore used backdated options to compensate employees without properly accounting for about $250 million in related expenses. Between October 1999 and July 2002 defendants repeatedly backdated option grants, providing themselves and employees with options with prices at which they could purchase shares which were lower than the market price at the time the options actually were granted. To conceal these practices, grant documents were falsified.

The case was resolved with the company consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions of the federal securities laws. Defendants Jewels, Kalinen and Friedman also consented to the entry of permanent injunctions. In addition Ms. Jewels agreed to pay disgorgement of $30,000 plus prejudgment interest and agreed to the entry of an order requiring that the company be reimbursed under SOX Section 304 for the $190,000 in cash bonuses she received. She also agreed to pay a penalty of $230,000 and to the entry of an order barring her from serving as an officer or director of a public company for five years. In a related administrative proceeding, Ms. Jewels agreed to be barred from appearing or practicing before the SEC as an attorney or accountant for five years. Ms. Kalinen agreed to an order requiring her to pay $28,000 in disgorgement plus prejudgment interest and to the payment of a civil penalty of $150,000. Ms. Friedman agreed to pay a civil penalty of $150,000.

SEC v. Karatz, Civil Action No. 08-06012 (C.D. Cal. filed Sep. 15, 2008) is another example of a settled options backdating case. This action was brought against the former chairman and CEO of KB Home, Inc. The complaint alleged that Mr. Karatz engaged in a multi-year scheme to backdate stock options for himself and others at the company. From 1999 through 2005, Mr. Karatz used hindsight to pick advantageous grant dates according to the complaint. This resulted in Mr. Karatz receiving a total of 2,860,000 shares of KB Home stock which yielded $6 million when exercised.

To resolve the case, Mr. Karatz consented to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions of the federal securities laws. In addition, he agreed to the entry of an order requiring him to pay approximately $6.7 million in disgorgement and interest and a civil penalty of $480,000. Under the order, Mr. Karatz is also bared from service as an officer or director of a public company for five years.

In some instances, these cases serve as a reminder of the obligations of directors and officers. SEC v. Kohavi, Case No. 08-43-48 (N.D. Cal. Sep. 17, 2008) should serve as a warning to all officers and directors of the Commission’s views regarding the performance of their obligations.

Kohavi is an option backdating case brought against three outside directors. The complaint claims that from 1997 through 2002, the directors approved 21 separate backdated option grants. A series of “red flags” that were ignored by the directors when they approved these grants are detailed in the complaint. Those red flags, which are the predicate for the directors’ liability, included approving grants which were “as of” date which preceded the time the three directors executed the approval papers. In two instances, the three directors executed approvals that were backdated for employees and, a short time later, again executed a consent for backdated options for the same employees, but with different “as of” dates to take advantage of a share price drop. In essence, the complaint alleges that the directors simply went along with management.

To settle the action, each defendant consented to the entry of a permanent injunction prohibiting future violations of the antifraud, proxy and reporting provisions of the federal securities laws. In addition, each defendant consented to the entry of an order requiring that they pay a civil penalty of $100,000. The action against the company had previously settled. SEC v. Mercury Interactive, LLC, Case No. 07-2822 (N.D. Cal. May 31, 2007).

In some instances, the Commission has encountered difficulties because many of these cases are based on years old conduct. For example, in SEC v. Berry, Civil Action No. C-07-04431 slip op. (N.D. Cal. May 7, 2008), part of the case was dismissed on statute of limitations grounds.

Berry is an option backdating case brought against Lisa Berry, former General Counsel of Juniper Networks, Inc. and KLA-Tencor. The SEC’s complaint claimed that from 1997 to 2002, Ms. Berry routinely used hindsight to identify dates which historically low stock prices, facilitating the backdating of option grants by KLA’s stock option committee. After moving to Juniper, Ms. Berry established a similar backdating process at that company, creating minutes of fictitious stock option committee meetings to document false grant dates. This resulted in materially false disclosure and overstated net income at KLA and Juniper. Violations of the antifraud, proxy and books and records provisions were alleged.

Ms. Berry moved to dismiss based on the statute of limitations and a failure to plead fraud with particularity as required by Federal Civil Rule of Procedure 9(b). The motion was granted in part. A five year statute of limitations applies to any relief that is a penalty, but not to the equitable relief. The court held that the request by the SEC for a penalty is time barred, but permitted repleading to demonstrate equitable tolling.

The court also held that Rule 9(b) applies. Here, the SEC’s complaint against Ms. Berry fails to detail her role in the backdating scheme and thus fails to meet this standard. In this regard the court held “Ms. Berry has carried her burden of demonstrating the SEC has failed to allege with particularity any securities fraud based on misstatements, other than the SEC’s allegations arising from Ms. Berry signing KLA’s two Form S-8.”

In many of the option backdating cases, the issuer cooperates with the SEC in an effort to earn “cooperation credit” in the charging decision. Two examples from the inventory of option backdating cases brought last year illustrate the approach of the Commission in some, but not in all cases.

SEC v. Brooks Automation, Inc., Civil Action No. 08 CA 10834 (D. Mass. May 19, 2008) is a settled option backdating case in which the SEC termed the cooperation of the company “swift, extensive and extraordinary … .” The company was able to settle the action by consenting to the entry of a permanent injunction prohibiting future violations of the reporting provisions, but without a fraud charge.

A second example is SEC v. UnitedHealth Group, Inc., Case No. 08-CV-6455 (D. Minn. filed Dec. 22, 2008). In this settled option backdating case, the SEC also gave the company credit for cooperation. In an unusual statement, the SEC outlined the cooperation of the company. According to the Commission, that cooperation consisted of: 1) conducting an internal investigation; 2) disclosing the findings and conclusions of that inquiry in a Form 8-K; 3) sharing the facts uncovered with the government; and 4) adopting extensive remedial actions.

The company settled the case by consenting to the entry of a permanent injunction base on the books and records provisions. The company was not charged with fraud and a penalty was not imposed.

Finally, while most option backdating cases are based on conduct involving scienter, in some instances the Commission has based its claims on negligence as in SEC v. Tullos, Civil Acton No. SACV 08-242 AG (C.D. Cal. filed March 4, 2008). This option backdating case was brought against Nancy M. Tullos, the former vice president of human resources of Broadcom Corporation.

According to the complaint, Ms. Tullos participated in a scheme from 1998 to 2003 to backdate options at Broadcom. As part of the scheme, grants were backdated to the low closing price for the company’s stock. Ms. Tullos communicated the grant dates within the company, provided spreadsheets of stock option allocations for the backdated grants to the finance and shareholder services departments knowing that they would use the information to prepare Broadcom’s books and records and periodic SEC filings. She also personally profited.

To resolve the case, Ms. Tullos consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a)(3) and Exchange Act Section 13(b)(5). She also agreed to the entry of an order requiring her to pay over $1.3 million in disgorgement and prejudgment interest to be offset by the value of her exercisable stock options which were cancelled and to pay a civil penalty of $100,000.

Next: Auction rate securities

This Week In Securities Litigation (April 10, 2009)

This week, the SEC proposed new rules to restrict short selling and the Division of Investment Management began a review of rules applicable to money market funds in the wake of Treasury Secretary Geithner’s recent congressional testimony calling for stronger regulation in the fund industry. The New York Attorney General filed suit against a Madoff feeder fund, offering a window into the operations of largest Ponzi scheme in history. SEC enforcement obtained two more settlements in the long running Brocade option backdating case and initiated or concluded six investment fraud cases. DOJ filed criminal charges based on an accounting fraud against former executives of an Arizona company, following an earlier SEC enforcement action and brought new FCPA actions as the UK overhauled its version of that statute.

Regulation

Short selling: On Tuesday, the SEC voted to seek public comment on proposed short sale and circuit breaker rules as discussed here. The proposal has two variations. One is a market-wide permanent approach, while the other is a security-specific temporary approach.

The market-wide approach has two variations. One, called the proposed modified uptick rule, is a market wide short sale price test based on the national best bid. The other, a proposed uptick rule, would be a market-wide short sale price test based on the last sale price or tick.

The security-specific, temporary approach has three variations: 1) a circuit breaker halt rule which would ban short selling in a particular security for the day following a severe price decline; 2) one which is a variation of a proposed circuit breaker uptick rule that would impose a short sale price test based on the national best bid in a particular security for the remainder of the day following a severe price decline in that security; or 3) a second variation of the proposed circuit breaker uptick rule which would impose a short sale price test based on the last sale price in a particular security for the remainder of he day following a severe price decline.

The Fund Industry: In a recent address at PLI’s Investment Management Institute Andrew Donohue, the Director of the SEC’s Division of Investment Management, raised two key points regarding future regulation of the fund industry as discussed here. In the first, he described as “worrisome” the increasing use of leverage by some funds and called for voluntary restrains. In the second, he announced an overhaul of regulations regarding money market funds. The second point is consistent with Treasury Secretary Tim Geithner’s recent congressional testimony in which he called for the SEC to develop strong requirements for money market funds to reduce the risk of rapid withdrawals as part of the Administration’s plan for overhauling financial regulation. Testimony of Treasury Secretary Tim Geithner, House Financial Services Committee.

The Madoff scandal

In The People of the State of New York v. Merkin, S.Ct. NY, Filed April 6, 2009, the New York Attorney General brought against J. Ezra Merkin and Gabriel Capital Corporation as discussed here. According to the complaint, Mr. Merkin and his investment funds were “feeder funds” which provided the Madoff scheme with millions of dollars of investor money. Ezra Merkin apparently used his position as a “pillar of the New York philanthropic community” to raise money for his funds which he in turn funneled to Mr. Madoff. This happened despite some instances where investors told Mr. Merkin they did not want their money invested with Mr. Madoff. Although Mr. Merkin represented to investors that he had an investment strategy which he implemented, in fact he did little work other than routine paper shuffling while collecting significant investment management fees.

Overall Mr. Merkin lost approximately $2.4 billion, according to the complaint. During the period Mr. Merkin ignored warnings and other red flags indicating that the Madoff fund might be a fraud while earning more than $470 million in management and incentive fees.

SEC Enforcement

Option backdating: Another chapter in the Brocade Communications option backdating saga, discussed here, closed this week as the court entered final judgments against Antonio Canova, a CPA and former CFO and V.P. of Finance and Stephanie Jensen, former V.P. for Human Resources. The final judgment as to Mr. Canova enjoined him from future violations of Securities Act Section 17(a)(2) & (3) as well as the books and records provisions of the Exchange Act. Mr. Canova also agreed to pay a civil penalty of $120,000 and disgorgement and prejudgment interest of about $249.000. The settlement did not indicate that Mr. Canova agreed to any sanction under Rule 102(e). This is one of the few option backdating settlements involving Section 17(a)(2) &(3). SEC v. Reyes, Case No. 3:06-cv-04435 (N.D. Ca. Filed July 20, 2006).

Ms. Jensen was enjoined from future violations of the antifraud and reporting provision of the Exchange Act. She also agreed to pay disgorgement and prejudgment interest totaling $44,416.

Investment frauds: The Commission also brought or concluded six more actions based on alleged investment frauds or Ponzi schemes. Those actions are:

SEC v. Sun Empire LLC, Case No. 09-399 (C.D. CA. Filed April 3, 2009) which alleges that Dililah Proctor, Shauntel McCoy and their entities raised at least $7 million from investors based on claims that the money would be invested in a high yield fund when in fact must of it was diverted to the personal use of the defendants or to other funds. The SEC obtained a freeze order.

SEC v. Oversea Chinese Fund Ltd. Partnership, Civil Action No. 3-09CV01614-B (N.D. Tex. Filed April 6, 2009). This action claimed defendants Oversea Chinese Fund, a hedge fund based in Toronto, and Wizhen Tang, a self-described Chinese Warren Buffet, orchestrated a fraudulent scheme in which between $50 and $75 million was raised from over 200 investors. Investors were told that the fund was in fact a Ponzi scheme and that it posted false profits, using money from new investors to pay others. Mr. Tang apparently targeted members of the Chinese-American community and solicited U.S. investors to his fund. The SEC obtained a freeze order.

SEC v. Market Street Advisors, Civil Action No. 09-CV-00786 (D.Colo. Filed April 7, 2009). This action was brought against Shawn Merriman and his firm, Market Street Advisors. It alleges that he raised from $17 to $20 million form at least 38 investors. The investment fund was in fact a Ponzi scheme. The Commission has requested emergency relief.

SEC v. Lydia Capital, LLC, Case No. 07-CV-10712 (D. Mass. Filed April 8, 2009). This action, originally filed in April 2007 against Glenn Manterfield and his related entities and discussed here, alleged that defendant defrauded 60 investors out of over $34 million. After obtaining an initial freeze order in this action the Commission also instituted an action in the UK against Mr. Manterfield and obtained a second freeze order over assets in that country. This week the court entered a Final Judgment enjoining Mr. Manterfield from future violations of the antifraud and reporting provisions of the federal securities laws and directing him to pay over $2.3 million in disgorgement plus prejudgment interest. The court also imposed a civil penalty of $130,000.

SEC v. Copeland, Civil Action No. 1:09-cv-0943 (N.D. Ga. April 9, 2009) is an action against an attorney who allegedly ran a Ponzi scheme. The complaint claims that over a period from at least 2004 through January 2009 Mr. Copeland raised about $35 million from over 140 investors by promising returns of 15-18%. The returns were to come from transactions in which the funds were lent in connection with private mortgage lending transactions. In reality, the claims were false — defendant Copeland took much of the investor money for himself, diverting it to his law office bank accounts.

Criminal Cases

DOJ brought criminal charges for conspiracy, securities fraud, mail fraud and making false filings with the SEC against Martin Fraser, the former president and COO, and Don Watson, the former CFO of Arizona based CSK Auto Corp. The thirty-one count indictment alleges that the two defendants engaged in a scheme from 2001 to 2006 to misstate CSK’s income primarily by failing to write of millions of dollars in uncollectible receivables. As a result the company misstated its income for the fiscal years 2002, 2003 and 2004 by approximately $10 million, $24 million and $19 million respectively. The SEC previously filed a related enforcement action discussed here.

FCPA

In U.S. v. Latin Node, Inc., Case No. 1:09-cr-20239 (S.D.Fla. Filed March 23, 2009), Latin Node Inc, a privately held Florida corporation, pled guilty a one count information alleging violations of the FCPA anti-bribery provisions in connection with improper payments in Honduras and Yemen.

According to the court documents, Latin Node provides wholesale telecommunications services around the world. From March 2004 to June 2007, it paid or caused to be paid over $1 million to third parties knowing that some or all of that amount would be passed as bribes to officials of Hondutel, the Honduran state owned telecommunications company. In return Latin Node obtained an interconnection agreement and reduced rates. Each payment was approved by a senior company official.

The company also admitted that from about July 2005 to April 2006, it made 17 payments totaling over $1.1 million either directly to Yemeni officials or third parties in exchange for favorable interconnection rates in that country.

As part of the plea agreement Latin Node agreed to pay a $2 million fine during a three year period. The Department acknowledged that the parent cooperated by immediately disclosing the conduct after its discovery, conducting an internal investigation, sharing the factual results of that inquiry with the government and by terminating senior Latin Node management involved with the violations.

In another case, six former executives of an Orange County California valve company were charged with FCPA violations. The executives are: Stuart Carson, former CEO of the company; Hong Carson, former director of sales for China and Taiwan; Paul Cosgrove, former director of worldwide sales; David Edmonds, former V.P. of worldwide customer service; Flavio Ricotti, former V.P. and head of sales for Europe, Africa and the Middle East; and Han Yong Kim, former president of the company’s Korean office. Each was charged with violations of the FCPA and the Travel Act.

The indictment alleges that from 2003 to 2007 the defendants caused the company to make about 236 corrupt payments in more than 30 countries which yielded about $46.5 million in sales for the company. It also alleges that about $4.9 million in bribes was paid to officials of foreign state owned companies in violation of the FCPA and that about $1.95 in bribes was paid in violation of the Travel Act to officers and employees at sate owned entities.

Previously Mario Covino, former director of worldwide factory sales pled guilty to one count of conspiracy to violate the FCPA as discussed here. Earlier this year Richard Morlok, former finance director of the company, pled guilty to once count of conspiracy to violate the FCPA.

United Kingdom: The UK has published a new draft anti-bribery bill. Under the proposed legislation, it will be a criminal offense to give, promise or offer a bribe and to request, agree to receive, or accept a bribe either at home or abroad. The draft also increases the maximum penalty for bribery from seven to ten year in prison. The legislation contains a negligent failure to prevent briber provision and lifts the Parliamentary Privilege to ensure that evidence from proceedings in Parliament can be considered.