Part X: SEC Enforcement Trends, 2009 — Analysis And Conclusion

The SEC is at a cross roads. While it is clear that the market crisis is going to have a significant effect on the Commission, its precise impact is yet to be determined. Key events are still unfolding. The roots of the crisis are just beginning to be explored. Legislative proposals to reshape the regulatory landscape are still be proffered, shaped and debated. A new SEC chairwoman with a new team is just getting underway.

Despite the uncertainty, it appears that the SEC will survive as an independent agency, contrary to some early proposals for regulatory reform. The blueprint offered by Treasury Secretary Geithner, while still being shaped, appears to offer a broad outline for the future. Under that proposal, the SEC will have enhanced funding and authority. More funding will mean a larger enforcement staff which will complement the likely additions to the FBI and the Department of Justice. More authority should include, at a minimum, jurisdiction over hedge funds and a directive to address key concerns such as capital requirements for regulated entities and money market funds. While it seems likely that Congress will also craft legislation to regulate derivatives, credit default swaps and other key unregulated sectors of the economy such as mortgage backed securities, it is unclear if the SEC will be given that authority. At a minimum however, it seems likely that the SEC will have at least some role in these areas. In the end, the Commission’s place as a market regulator should be enhanced.

Reform is also taking place inside the agency. New Chairwoman Mary Schapiro was sworn in on promises to rejuvenate and reform. That process has already begun. Key senior staff positions, such as general counsel, director of enforcement and director of corporation finance have all new appointees. The chairwoman is touting a new tone at the top of enforcement, focused on a streamlined and more efficient program which is still in the process of reinventing itself. The new tone will be aided streamlined internal procedures for obtaining a formal order and resolve cases involving corporate penalties. In addition, a number of key rule making projects are underway focused on issues such as short selling, corporate governance and mutual funds. More are undoubtedly under consideration and will emerge shortly.

As these and other changes unfold, the enforcement division can be expected to work hard to restore its more than tarnished image. With multiple task forces working on over fifty investigations which, in probability are expanding, plus other inquiries in traditional areas, the division should have multiple opportunities to reestablish itself. The inventory of the current market crisis related investigations should spawn a series of financial fraud, insider trading and market manipulation cases involving a wide range of entities and individuals. As those cases move forward and expand, the division can also be expected to continue its emphasis on insider trading cases, as well as FCPA actions.

With a drive to restore lost luster to enforcement’s image, there may be a tendency to be over zealous with increasing penalties — a trend which is clearly evident in FCPA cases. Enhanced coordination with DOJ and an expanded FBI is will likely to increase the trend toward the criminalization of SEC enforcement. This is particularly true since it is far easier to plead an indictment which requires little more than basic statutory language than a civil enforcement complaint which requires not just plausibility, but facts specifying the role of the primary violator and compliance with the particularity requirements of Civil Rule 9(b).

Finally, while a return of Wall Street’s top cop is good for the capital markets issuers, directors, officers, general counsels and others within the jurisdiction of the agency should be prepared. Recent SEC settlements suggest that a key to avoiding or at least mitigating liability is strong compliance procedures. Good internal accounting and disclosure controls, insider trading prohibitions and mechanisms to contain the dissemination of material non-public information can help create a defense to enforcement investigations and actions. Likewise, strong procedures and employee educational policies are essential in the FCPA area to avoid or mitigate liability. Careful internal review and preparation now can bring significant benefits down the road — and may be essential to avoiding future liability as the SEC’s authority and resources are enhanced and its enforcement program rejuvenated.

The Test Of Primary Liability In An SEC Enforcement Action

Earlier this year, the First Circuit Court of Appeals defined the scope of aiding and abetting liability in an SEC enforcement action. In SEC v. Papa, Case No. 08-1172 (1st Cir. Decided Feb. 6, 2009), the court rejected the SEC’s claims that conduct which occurred after the fraud was complete constituted aiding and abetting. The court concluded that the conduct was too remote to constitute substantial assistance to that fraud, as discussed here.

The corollary to the question resolved in Papa focuses on when an individual can be considered to be a primary violator. That question was addressed in a recent ruling in SEC v .Lucent Technologies, Inc., Civ. No. 04-2315 (D.N.J. Filed May 17, 2004). There, the court granted summary judgment in favor of four defendants, rejecting the SEC’s claims of primary liability in a financial fraud case.

In Lucent Technologies, the Commission brought an enforcement action alleging, among other things, financial fraud against the company and several individual defendants. Following settlements by the company and several others, four individuals continued to litigate: Jay Carter, president of Lucent’s AT&T Customer Business Unit; Michelle Hayes-Bullock, a finance manager assigned to the AT&T Customer Business Unit; Alice Dorn, Vice President of Indirect Sales for North America; and Nina Aversano, President of Lucent’s North American Regional sales division. Defendants Aversano, Dorn and Carter had limited responsibilities in preparing Lucent’s financial statements, but were expected to fully disclose all terms of sales contracts to the accounting department. Defendant Hayes-Bullock had direct responsibility for ensuring the accuracy of the financial statements for the AT&T unit to which she was assigned.

The complaint alleges that Lucent’s books and records were inaccurate essentially because they improperly recognized revenue. The primary allegation against each defendant is that they authorized or approved verbal side agreements, credits or other incentives in connection with sales. These deals were made to induce Lucent’s customer to purchase equipment. According to the SEC, these extra-contractual commitments cast substantial doubt on Lucent’s ability to collect payment on these sales and made the recording of revenues improper under GAAP. As a result Lucent materially overstated pre-tax income in its financial statements which were filed with the SEC.

Defendants Aversano and Dorn were, according to the complaint, involved in five such transactions with two of Lucent’s top distributors. Both kept the oral assurances secret from the accounting personnel of the company. In addition, Nina Aversano executed a management representation letter for one quarter which acknowledge responsibility for the fair presentation of the financial statements and falsely stated that there were no oral side agreements.

Defendants Carter and Hayes-Bullock were involved in four such sales involving AT&T Wireless Services. In order to recognize the revenue from the transactions defendant Carter instructed his subordinates to obtain purchase orders for the switches. Invoicing the switches was improper, according to the SEC. Defendant Hayes-Bullock knew about these improprieties, but failed to object despite having a duty to do so, according to the Commission.

Here, the SEC based its fraud claims on Rule 10b-5(b) as well as subsections (a) and (c) of the Rule. Although subsection (b) requires the SEC to prove a material misstatement or omission, the other two subjections are more general, prohibiting “any device, scheme, or artifice to defraud” or the participation “in any act, practice or course of business” which acts as a fraud on investors according to the court.

In determining whether a defendant is a primary violator the court relied on the “bright line” test evolved by the Second Circuit and which it had adopted in an earlier opinion. Under that test (discussed here), to be a primary violator the person must actually make a false or misleading statement communicated to the public. See also SEC v. Lucent Technologies, Inc., 363 F. Supp. 2d 708, 719 (D. N.J. 2005) (adopting bright line test on a motion to dismiss). While the bright line test evolved prior to the Supreme Court’s decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (2008), that decision did not alter or even discuss the bright line test. Indeed, from Central Bank to Stoneridge, “the Supreme Court has consistently narrowed the class of defendants reachable by the implied cause of action under Section 10(b).” In this case, it is clear that the defendants are not primary violators because they did not make any misrepresentation to the public.

The result in this case would not be different the court concluded even if it adopted “a more flexible ‘bright line’ test … .” Under this version of the test, there would be primary liability if the defendant “‘was sufficiently responsible for the statement – in effect, caused the statement to be made – and knew or had reason to know that the statement would be disseminated to investors'” quoting SEC v. KPMG, 412 F. Supp. 2d at 375 (emphasis added). This test keys on how extensively the defendant was involved in creating and issuing the financial statements. Thus if the defendant prepared the statements or had authority over their release, there would be primary liability.

Even under the relaxed standard however, the defendants here would not be primary violators. Rather, the court concluded that “[t]he above facts simply depict a chain of causation leading to the making of a misstatement. It does not show that the defendants were integrally involved in the drafting of that misstatement or that they were ultimately responsible for recognizing revenues at Lucent, the province of the Chief Accountant and the senior officers of Lucent.”