Part IX: SEC Enforcement Trends And Priorities, 2009 — Key Legal Issues

Last year, there were important circuit court decisions regarding the scope of aiding and abetting liability in SEC enforcement actions and parallel SEC and DOJ investigations. Each decision is likely to have a significant impact on SEC enforcement in the future.

Following the Supreme Court’s decision in Central Bank of Denver v. First Interstate, 511 U.S. 164 (1994), Congress, in the Private Securities Litigation Reform Act of 1995, restored aiding and abetting liability in SEC enforcement actions. Congress did not extend aiding and abetting liability to private securities actions.

In SEC v. Papa, Case No. 08-1172 (1st Cir. Feb. 6, 2009), the court gave definition to the scope of liability for aiding and abetting in an SEC enforcement action. The complaint named six former employees of Putnam Fiduciary Trust Company. According to the SEC, the six executives engaged in a scheme to defraud Putnam client Cardinal Health, Inc. The misconduct centered on the cover-up of a one-day delay in investing certain assets of Cardinal in a defined benefit plan in 2001. The delay caused Cardinal to miss out on about $4 million of market gains. Following the error, the defendants chose not to inform Cardinal. Rather, they took steps to conceal the error by improperly shifting about $3 million of the costs to the shareholders of other Putnam mutual funds through backdated accounting entries and various accounting mechanisms. Cardinal bore about $1 million in losses.

The district court, on a motion to dismiss, concluded that three of the defendants were primarily violators, having directly participated in the scheme. Three others, however, only attended meetings about the cover-up and one year later executed what are effectively internal audit confirmations stating that all accounts were accurately stated. The district court concluded that this conduct was not sufficient to constitute aiding and abetting liability. Accordingly, the case was dismissed as to these three defendants.

On the SEC’s appeal, the court affirmed. The test of aiding and abetting liability is whether each defendant rendered substantial assistance in furtherance of the wrong committed. First, the execution of the audit letters did not render substantial assistance because the fraudulent scheme was already complete. Second, the SEC’s claim that the three defendants breached their fiduciary duty in executing the audit confirmations, because if they had been answered truthfully, the fraud would have been revealed which would have turned the scheme into a continuing and never ending one. The court rejected this notion of aiding and abetting.

Another key court ruling involved parallel proceedings. Frequently, SEC investigations are conducted at the same time as those by the Department of Justice and other regulators and self-regulatory organizations. Parallel proceedings offer certain efficiencies for both the government and a potential defendant. Their use has repeatedly been upheld by the courts. They do, however, present certain pitfalls.

U.S. v. Stringer, 521 F.3d 499 (9th Cir. 2008) is a key decision involving parallel SEC and DOJ investigations. The district court dismissed a criminal indictment based on misconduct by the U.S. Attorney’s Office and the SEC. The court concluded that the USAO and the SEC violated the constitutional rights of defendants by merging their investigation and concealing the criminal inquiry behind the SEC civil investigations which was used to collect evidence for the USAO. U.S. v. Stringer, 408 F. Supp. 2d. 1083 (D. Or. 2006).

The Ninth Circuit reversed. The court concluded that the government fully disclosed the possibility that information received in the course of the civil investigation could be used for criminal proceedings by furnishing witnesses SEC Standard Form 1662. The decision is predicated on the court’s determination that the SEC did not make any affirmative misrepresentations. Reliance on Form 1662 was argued by the SEC in an amicus brief. The decision in Stringer, as well as the ruling in Papa, are likely to have a significant impact on SEC enforcement actions in the future.

Insider Trading – A Key Focus Around The Globe

Insider trading has long been a key focus of SEC enforcement. It has also become an important priority for market regulators around the world. Earlier this year, the FSA in the UK brought its first criminal insider trading case as discussed here. Now, the European Commission has launched a review of its insider trading directive and the Monetary Authority of Singapore (MAS) has brought its first civil suit based on allegations of insider trading.

The European Commission, in commencing a review of its directive on insider trading, has called for evidence which will “contribute to the intended review of the Market Abuse Directive by the Commission. In this review the Commission services will look, on the one hand, at the possibilities of simplification and burden reduction and, on the other hand, at ensuring greater effectiveness of the MAD in order to respond adequately to any deficiencies or risks” from the current financial crisis.

The review, initiated on April 22, 2009, is seeking evidence on issues which include the definition of inside information, prohibitions of insider dealing, new tools for helping detect suspicious transactions and the reporting of suspicious transactions.

Earlier this month, MAS filed suit against Kevin Lew Chee Fai, former general manager of enterprise risk management at WBI Corporation. Previously, MAS had imposed fines in inside trading cases where the defendant admitted the action.

The action against Mr. Lew is its first litigated insider trading case. In the case, Mr. Lew is alleged to have sold a total of 90,000 shares of WBL at $4.98 per share on July 4, 2007. The suit claims that Mr. Lew avoided a loss of $27,000.

Mr. Lew is alleged to have obtained price sensitive or inside information two days before his July 4 trade at a group management council meeting he attended. There, the internal forecasts regarding the financial results of the company for the third quarter of its fiscal 2007 for the period ended June 30, 2007 were discussed. In those forecasts, the group was projecting a quarterly net loss and impairment costs on its Thai subsidiary, Wearnes Precision Thailand Ltd. At the conclusion of the meeting, the secretary of WBI informed Mr. Lew that the information was price sensitive.

One month after the meeting, WBL announced a third quarter net loss of $27.3 million. The results were adversely affected by impairment of $26.6 million on assets related to its precision manufacturing business in Thailand.

In defense of his actions, Mr. Lew claims that the information obtained at the July 2 meeting was not price sensitive and thus its use did not violate SFA 218(2a). That section prohibits a person in possession of confidential price-sensitive information concerning a corporation to which he is connected from trading in the securities of that company. Here, Mr. Lew claims that the information from the meeting was very preliminary. The case is pending in court.

Insider Trading Seminar

On April 29, 2009 at noon, the ABA will sponsor a live program in Washington, D.C., which will also be webcast nationally on insider trading. The program features speakers from the SEC, DOJ, FINRA, NYSE Regulation and the private sector who will discuss current enforcement efforts in the area as well as practical compliance steps.