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.

One of Bob Dylan’s most famous songs is “The Times They Are A-Changin’”. One of the SEC’s long standing and recently most talked about rules is the uptick rule, instituted in the 1930s, abolished in 2007 and now coming back, if many have their way. Are the times changing (sorry Bob) or just going round in circles?

On Tuesday, the SEC voted to seek public comment on proposed short sale and circuit breaker rules. Casting the new proposals as a product of the extreme market conditions, the Commission is offering alternate proposals. One approach is a market-wide, permanent approach. The other is a security-specific, temporary approach based on the notion of a circuit breaker.

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 alternative circuit breaker approach is security specific and temporary. The Commission is considering three possible variations here: 1) A circuit breaker halt rule which would ban short selling in a particular security for the day following a severe price decline; 2) A 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 circuit breaker uptick rule that would impose a short sale price test based on the last sale price in a particular security for the remainder of the day following a severe price decline.

These proposals are made against a backdrop of recent Commissions actions and statements which, at best, might be viewed as “mixed signals.” In 2007, the SEC abolished the 1930s era uptick rule, former Rule 10a-1. That rule essentially precluded short selling except following an uptick or higher bid for the security.

As the market crisis evolved in 2008 however, there was concern that short sellers were driving down the share price of financial institution stocks. In July 2008, the price of former Wall Street investment banking giant Bear Stearns’ shares tumbled from about $50 to $10 in one week despite reassurances from the firm and the SEC that it had more than adequate capital.

As Bear Stearns tumbled to its demise, Treasury was concerned with propping up the two giant GSE players in the mortgage backed securities market, Freddie Mac and Fanny Mae. There was also concern about the share price of other financial institutions, particularly those that could borrow from the Fed. Many believed that Bear Stearns and later Lehman Brothers, which slid into bankruptcy after the government refused to assist the firm, collapsed because of bear raids, that is traders who combined short selling with rumors to drove down the share price. The SEC opened investigations which are still in progress.

Those fears prompted the SEC to issue a ban on short selling in the shares of a limited number of securities. That ban was expanded in August 2008 and continued into October 2008 when it ended. During the same period regulators in the UK, Germany, Australia and Japan followed with short sale bans which ran longer than the one imposed by the SEC.

The SEC’s ban resulted in a storm of criticism. Many viewed it an unprecedented intervention into the markets. In a letter to then-Chairman Cox dated September 30, 2008 however, Congressman Markey requested the basis for the Commission’s approval of the repeal of NYSE Rule 80A, the so-called collar rule. That rule restricted certain program trading when there is an up or down movement of 2% from the previous day close.

Days before Congressman Markey’s letter, the SEC Inspector General issued a report which was highly critical of the actions of the Divisions of Trading and Markets and Corporation Finance regarding the collapse of Bear Stearns. Indeed, the report stated that the failure of Corp Fin to conduct a timely review of the investment firm’s most recent 10-K deprived investors of important information which may have helped quell the rumors which swirled about the firm as its share price tumbled.

Following the termination of the SEC’s short sale ban then Chairman Cox called the ban an egregious error undertaken only because of pressure from Treasury and the Fed. Now however, the SEC has come full circle — it is reconsidering rules which could limit the impact of short selling. If adopted, those rules will not become effective for months.