This Week In Securities Litigation (August 22, 2008)

This week the SEC had a significant courtroom win in the jury trial of a financial fraud case, but another serious loss in its PIPE/hedge fund cases. Another settlement was announced in the auction rate securities probe, following the template of earlier settlements. Recent articles discuss causation in securities fraud actions and trading under Rule 10b-5-1 plans.

SEC court wins and losses

The SEC had a win and a loss in court this week. The win came in the form of a jury verdict in a financial fraud case, SEC v. Cucuz, Civil Action No. 2:06-CV-11935 (E.D. Mich. Filed April 25, 2006). In this case, the jury returned a verdict in favor of the Commission against Ranko Cucuz, the former CEO of Hayes, Lemmerz International, Inc., an auto parts maker, and William D. Shovers, the former CFO of the company, on securities fraud charges.

The SEC’s complaint alleged that the company, through former senior officers and employees, engaged in a fraudulent scheme to meet earnings targets and conceal declining operating results in 1999, 2000 and 2001. Once the scheme emerged, defendants Cucuz and Shovers made affirmative misrepresentations to the outside auditors and took steps to conceal information about the scheme from the Audit Committee and the Directors. As a result of the scheme, the company made false filings with the Commission and material misrepresentations in a bond offering made by the company.

The two men were found to have violated Securities Action Section 17(a)(3) and Exchange Act Section 10(b) as well as books and records provisions. The other defendants in this action, including the company, previously settled with the SEC. The SEC also previously resolved related administrative proceedings against other employees. In the Matter of James Jarrett, Release No. 34-53716 (April 25, 2006); In the Matter of Greg Jones, Release No. 34-53717 (April 25, 2006); In the Matter of Allen Buntin, Release No. 34-53718 (April 25, 2006).

The SEC suffered a significant loss in SEC v. Mangan, Civil Action No. 06-CV-531 (W.D.N.C. Filed December 28, 2006) (discussed here) when the court dismissed the insider trading claims against former hedge fund manager John Mangan, Jr. Previously, the court had dismissed the SEC’s Section 5 claim which alleged the sale of unregistered securities.

Mr. Mangan, formerly of Friedman, Billings, Ramsey and a hedge fund manager at Mangan & McColl Partners, was initially charged with violating the registration provisions of the Securities Act and insider trading based on short sales made in connection with PIPE offerings.

The case against Mr. Mangan is one of three cases in litigation where the SEC charged hedge fund managers with violating Section 5 and insider trading based on short selling at or just prior to the announcement of a PIPE offering. In each of the litigated cases, the courts have dismissed the Section 5 claims. Typically, those claims alleged that by intending to cover the short position with the securities from the PIPE which were not registered at the time the short position was opened, but were registered at the time of the cover transaction under the resale registration statement of the PIPE, the trader violated Section 5.

Former hedge fund manager Hilary Shane, formerly of First New York Securities LLC, resolved a case based on similar claims with the U.S. Attorney’s Office for the Southern District of New York. Ms. Shane had been indicted on five counts of insider trading. The case was resolved when Ms. Shane entered into a deferred prosecution agreement under which she agreed to comply with the law for the next six months. U.S. v. Shane, Case No. 1:06-cr-00772 (S.D.N.Y. Filed Sept. 12, 2006). Ms. Shane had previously settled with the NASD and the SEC, agreeing to be barred from associating with any NASD registered firm and to pay $1.45 million. The underlying PIPE was for Compudyne shares, the same securities on which the Mangan case had been based. SEC v. Shane, Civil Action No. 05 CV 4772 (S.D.N.Y. Filed May 18, 2005).

Auction rate securities

New York Attorney General Andrew Cuomo and the NASAA multi-state ARS Task Force announced another settlement in their probe of the collapse of the auction rate securities market discussed here. The settlement with Wachovia Capital Markets followed the same template as those announced earlier. The settlement focused on a buy back of the securities by Wachovia, keyed to returning the funds of smaller investors first.

Previously, settlements were announced with UBS, Citigroup Global Markets, J.P. Morgan and Morgan Stanley. The investigations in that market are continuing. Reportedly, The Regional Bond Dealers Association is urging the SEC and the attorney general of New York and those of other states to demand that primary bond dealers repurchase ARS from any customer who bought them regardless of which firm distributed the securities.

Recent articles

Jill Fisch, Cause for Concern: Causation and Federal Securities Fraud, Univ. of Penn. Law School, Paper 240 (abstract here).

M. Todd Henderson, Alan D. Jagolinzer, and Karl A. Muller Scienter Disclosure, Univ. of Chicago Law School, (abstract here). This paper examines the implications of “scienter disclosure” through an analysis of voluntary disclosures regarding insiders’ Rule 10b5-1 trading plans. In part, the paper concludes that 10b5-1 disclosure is associated with abnormal trading returns. (This point has been the subject of speeches by the Director of the Division of Enforcement, discussed here).

Alan D. Jagolinzer, Sec. Rule 10b501 and Insiders’ Strategic Trading, Stanford Graduate School of Business, (abstract here). This paper notes in part that the Rule appears to enable strategic trading.

Part III: Self-Reporting And Cooperation — Key Issues

The Department of Justice, like the SEC, offers the prospect of credit in the charging process in exchange of self-reporting and cooperation. Like the Commission, DOJ defines the question of cooperation in terms of furnishing all the facts. Unlike the SEC, its policy statements are less clear as to what is required. In practice however, that lack of clarity quickly disappears.

The McNulty memo, in statements which are not dissimilar from those used by its predecessors, discusses cooperation in general terms, noting for example that “[i]n gauging the extent of the corporation’s cooperation, the prosecutor may consider, among other things, whether the corporation made a voluntary and timely disclosure, and the corporations’ willingness to provide relevant evidence and to identify the culprits within the corporation, including senior executives.”

The prospects for credit offered in this portion of the McNulty memo are, however, limited by another portion of the memo which states that “whereas natural persons may be given incremental degrees of credit … for turning themselves in, making statements against their penal interest, and cooperating in the government’s investigation of their own and others’ wrongdoing, the same approach may not be appropriate in all circumstances with respect to corporations.” While the memo goes on to detail procedural and substantive limitations on the circumstances under which prosecutors can seek a waiver of privilege, this passage seems to suggest that cooperation may not yield credit. These statements seem to be tempered, if not contradicted, by recent remarks by the head of DOJ’s criminal division. In those remarks, she stated flatly that cooperation will yield benefits for a corporation.

Whichever statement is correct in practice, the necessity for privilege waivers to maximize cooperation credit is clear. Two surveys, one by a number of business and bar organizations taken before the McNulty memo, and a second and less formal one conducted by the Former Chief Justice of the Delaware Supreme Court after its issuance, confirm the fact that in practice waivers are a necessity.

While the necessity for waivers to gain cooperation credit may be clear, any organization considering the question must carefully assess the impact on the company and its employees. Both the SEC and DOJ focus on privilege waivers as a means to obtain all the facts and, in some instances, those which the government might not otherwise obtain. At the same time, waiver can impede the ability of the organization to secure all the facts, remedy the situation and thus ultimately to obtain cooperation credit. Stated differently, the demands of the SEC and DOJ may in fact impede the ability of the company to fully determine the facts and remedy the situation to ensure compliance with the law in the future – the very goals the SEC and DOJ are to implement.