by T. GormanPosted on Posted in SECActions

This week on capital hill, SEC officials essentially refused to talk about their failed investigative efforts regarding the Madoff Ponzi scheme, citing on-going investigations. Unfortunately for the SEC, analyst Harry Markopolos had no problem talking. He detailed for a house committee how he discovered the fraud in late 1999 and early 2000 from public information in a few hours, and then spent nine years trying, without success, to convince the SEC to look at the facts. Following the hearings, SEC Chairman Mary Schapiro sent a letter to the house committee promising to cooperate with its inquiry and to talk with the members.

In SEC enforcement, the Commission filed an insider trading case involving two securities professionals and a hedge fund manager, while Mark Cuban got support for his motion to dismiss the insider trading claims against him from five law professors. The SEC also successfully concluded a financial fraud case after a six day trial, and settled with Wachovia over its role in the action rate securities markets.

In private securities actions, the court refused to dismiss the options backdating class actions brought against Broadcom, permitting those cases to move forward. The Second Circuit reversed a grant of summary judgment based on the statute of limitations in a securities fraud suit, concluding that plaintiffs were not on “inquiry notice” to start the statute running until they had facts demonstrating scienter.

The SEC And Capital Hill

Senior officials from each division, along with the Acting General Counsel appeared before a House oversight committee this week to talk about the Commission’s investigative efforts regarding the Madoff Ponzi scheme. The staff said little, citing on-going law enforcement investigations. After the hearing SEC Chairman Schapiro sent a letter to the committee pledging to meet with them.

Harry Markopolos, a certified financial analyst and fraud examiner, had no problem talking to the house committee about his role in uncovering the Madoff fraud, his efforts to interest the SEC and the Commission’s failures. Mr. Markopolos detailed a nine year effort to get the SEC to recognize what everyone now knows – that Mr. Madoff is a fraudster. Mr. Markopolos said the fraud was obvious to anyone who looked. But the SEC would not look. The refusal of SEC officials to comment on the matter spared them from trying to explain how they failed to follow the road map Mr. Markopolos furnished to the largest Ponzi scheme in history.

Ms. Shapiro reportedly made her first appointment as Chairman this week, naming Kayla Gillan as a senior advisor. Ms. Gillan is a former member of the PCAOB, the Public Company Accounting Oversight Board and, more recently, the chief administrative officer of RiskMetrics.

SEC enforcement

Insider trading: The SEC filed an insider trading action against seven individuals, including two securities professionals and a hedge fund manager. The complaint, based on trading in advance of two acquisitions and one potential deal is alleged to have netted $11.6 million in illegal profits. SEC v. Stephanou, Case No. 09 CV 325 (S.D.N.Y. Filed Feb. 5, 2009). The U.S. Attorney’s Office filed criminal charges against five of the defendants in the SEC complaint based on essentially the same conduct.

The complaint filed by the SEC named as defendants: Nicos Achilleas Stephanou, a U.K. resident who was Associate Director of Mergers and Acquisitions at UBS Investment Bank; Ramesh Chakrapani, a U.K. resident who was a Managing Director in the Corporate and Mergers and Acquisitions group at Blackstone Advisory Services and a former colleague of Mr. Stephanou; Achilleas Stephanou, a resident of Cyprus and the father of Nicos; George Paparrizos, a resident of California and a former class mate of Nicos Stephanou; Konstantinos Paparrizos, a resident of Greece and the father of George Paparrizos; and Michael Koulouroudis, a resident of New York and a close friend of Nicos Stephanou.

According to the SEC’s complaint, Nicos Stephanou had access to material nonpublic information about the acquisition of Albertson’s Inc. by a group of buyers in January 2006 and the take-over of ElkCorp. by Carlyle Group in December 2006. Mr. Stephanou tipped George Paparrizos, Michael Koulouroudis and Joseph Contorinis about the Albertson’s deal. He also either tipped his father or traded through his account. Each person traded on inside information and profited. Later, Mr. Stephanou tipped George Paparrizos and Michael Koulouroudis about the ELK deal and again either tipped his father or traded through his account. Each person traded in advance of the public announcement of the deal and made a profit.

Ramesh Chakrapani, had access to information that National Health Investors was about to announce it had formed a committee, retained an adviser to consider strategic alternatives and rejected an offer as inadequate in October 2006. Before the announcement, Mr. Chakrapani is alleged to have tipped Nicos Stephanous who in turn tipped Michael Koulouroudis, who traded based on the information. Nicos Stephanous again either tipped his father or traded through his father’s account. The case is in litigation. The SEC filed a related complaint against Mr. Chakrapani earlier which is discussed here. SEC v. Chakrapani, 09 CV 325 (S.D.N.Y. Jan. 13, 2009).

SEC v. Cuban, Case No. 3:08-cv-02050 (N.D. Tex. Filed Nov. 17, 2008). In the SEC’s insider trading case against Mark Cuban, discussed here, five law professors filed an amicus brief in support of Mr. Cuban’s motion to dismiss. The five professors are Alan Bromberg of SMU, Allen Ferrell of Harvard, Jonathan Macey of Yale, Todd Henderson of the University of Chicago and Stephen Bainbridge of UCLA. The professors argue that the confidentiality agreement the SEC claims Mr. Cuban executed prior to obtaining information about the PIPE offerings on which the case is predicated, did not create a duty of confidentiality or a fiduciary duty, the predicate of the SEC’s insider trading claims.

SEC v. Wachovia Securities, LLC, Civil Case No. 09 CV 743 (N.D. Ill. Filed Feb. 5, 2009). The Commission filed a settled enforcement action against Wachovia Securities based on its sales practices in the auction rate securities market. Specifically, the complaint claims that Wachovia misled investors. The investors sought a short term liquid investment. Wachovia sold them ARS, falsely claiming the securities were in safe, highly liquid investments comparable to cash or money market instruments.

Under the terms of the settlement, Wachovia agreed to repurchase all ARS purchased before February 13, 2008 in two phases. The first phase focuses essentially on individual and retail customers while the second involves the remaining purchasers. Wachovia also consented to the entry of a permanent injunction, prohibiting future violations of Section 15(c) of the Exchange Act. At the same time, New York Attorney General Andrew Cuomo announced the conclusion of his action regarding Wachovia based on the same terms.

SEC v. Stanard, Case No. 06 Civ. 7736 (S.D.N.Y. Filed Sept. 27, 2006). Here, the SEC concluded its litigation based on the financial fraud at RenissanceRe Holdings, Ltd. with the entry of judgment last week against James N. Stanard, the former CEO of the company. The court found in favor of the Commission on all claims. The complaint alleged a two part round trip scheme which was essentially a sham transaction that allowed the company to shift income from one accounting period to another to smooth earnings.

After a six day trial, the court determined that Mr. Stanard violated the antifraud provisions of both the Securities Act and the Exchange Act and that he aided and abetted violations of Sections 13(a) and 13(b)(2). The court permanently enjoined Mr. Stanard from future violations of these provisions and imposed a civil penalty of $100,000. An SEC request for an officer director bar however, was rejected as discussed here.

Private actions

In In re Broadcom Corp., Case No. 06-5036 (C.D.CA.), the court denied a motion to dismiss a consolidated class action suit against Broadcom. The suit is based on allegations of option backdating.

In Alaska Electrical Pension Fund v. Pharmacia Corporation, Case Nos. 07-4500 & 07-4564 (2nd Cir. Jan. 30, 2009), the circuit court vacated an order from the district court granting summary judgment for defendants based the statute of limitations in a securities fraud class action. The court, as discussed here, held that the plaintiffs were not on “inquiry notice” about their claim, which is based on alleged fraudulent marketing of a drug, until they had sufficient evidence to show scienter.

Here, plaintiffs claimed that defendants marketed the drug based on studies which were keyed to a favorable portion of a study, but which excluded the unfavorable part of the report. The publication of FDA conclusions based on the entire study and which did not agree with the position of defendants did not put the plaintiffs on inquiry notice because they only demonstrated a disagreement, not fraud. Rather, plaintiffs were not on inquiry notice until a Washington Post article was published which exposed the fraud by defendants.

The question of inquiry notice has caused a split in the circuits. One case raising this question is seeking Supreme Court review. See Trainer Wortham & Co. Inc. v. Heide Betz, No. 07-1489 (S.Ct. Docketed May 29, 2008). This case is discussed here.

by T. GormanPosted on Posted in SECActions

For the SEC, the Madoff scandal must seem like the bad dream that will not go away. The House Financial Services Subcommittee on Capital Markets heard testimony from senior SEC staff officials and Harry Markopolos, a certified financial analyst and fraud examiner.

The Directors of Compliance and Inspections, Trading and Markets and Enforcement, and the Acting General Counsel, appeared before the Congressional Committee. Their testimony was largely confined to reviewing the operations of each of the staff divisions. It also briefly sketched the background to prior investigations relating to Mr. Madoff. That information had previously been furnished by the staff to Congress as noted here. The testimony did little to address the apparent failures of the SEC to discovery Mr. Madoff’s unprecedented Ponzi scheme.

In contrast, Mr. Markopolos did not hesitate to discuss the failures of the agency regarding the Madoff scandal. In his testimony, Mr. Markopolos detailed a nine year quest dating back to early 2000 to convince the agency that Barnard Madoff was committing securities fraud. While Mr. Markopolos noted that he failed to convince the agency that Mr. Madoff was running a Ponzi scheme, it clearly was not for lack of effort on his part.

In his testimony, Mr.Markopolos detailed the methodology he used to determined after four short hours of reviewing public materials in late 1999 and early 2000 that Mr. Madoff was engaged in securities fraud. Mr. Markopolos described in detail the reason the derivatives based strategy Mr. Madoff claimed to be using could not yield the claimed results. In sum he discovered that Mr. Madoff’s returns were not possible. As Mr. Markopolos noted in commenting on a Madoff offering brochure provided to investors at one point: “How can any capital market return over any length of time only go up and never down … How did the SEC’s staff miss this … this is picture said ‘FRAUD’ a thousand times over.”

Mr. Markopolos detailed contact after contact with the SEC over the years. In those contacts, he provided the SEC with lengthy written descriptions of the fraud. He also met with staff members at various times to amplify the written materials he furnished the agency. No action was ever brought.

Throughout this period investors continued to pour millions of dollars into Mr. Madoff’s hands for investment. Why? According to Mr. Markopolos: “Yes, BM [Madoff] was a ‘no-brainer’ investment but only in the sense that you had to have no brains whatsoever to invest into such an unbelievable performance record that bears no resemblance to any other investment managers’ track record throughout recorded human history.”

If the fraud was so obvious the question is how did the SEC miss it? According to Mr. Markopolos, the SEC suffers from “investigative ineptitude and financial illiteracy.” While this is harsh criticism, there is no doubt that the SEC had opportunities starting as early as 1992 to discover the Madoff fraud. The testimony given by the SEC staff demonstrates this point.

The SEC’s opportunities to discovery the Madoff fraud seem to have culminated in 2006 when the staff opened an inquiry apparently based on the information furnished by Mr. Markopolos. That inquiry terminated however, apparently without investigating the Ponzi scheme allegations as discussed here. The SEC staff testimony offered no explanation, citing on-going investigations. Perhaps there is none.

It is ironic that all of this testimony came on a day when the Washington Post reported that the new Chairman of the SEC, Mary Schapiro, plans to rejuvenate SEC enforcement. The article (available here, registration required) goes on to suggest that a new enforcement director may be appointed.

The congressional testimony today as well as other recent failures clearly suggests that the enforcement program needs to be revamped. Changes in the staff may or may not be required. What is clearly required however is a new tone at the top – that is, a change in tone from Ms. Schapiro and her fellow commissioners that clearly makes enforcement the top priority as discussed here. Only then will the enforcement division begin to return to being a highly effective cop on the beat.