This Week In Securities Litigation (April 3, 2009)

This week, PWC published a study detailing trends in securities litigation. The SEC: settled with three more defendants in the “Merrill Lynch/Business Week”/insider trading case; filed a settled options backdating case; and brought another Ponzi scheme action.

In private securities cases, a class action based on option backdating claims was dismissed in part, while a settlement in a derivative suit received preliminary court approval. UBS obtained the dismissal of a case based on ARS claims in view of its settlement of similar claims with the SEC. And, world regulators continued to focus on insider trading with the UK’s Financial Services Authority winning its first criminal conviction in an insider trading case.

Securities litigation trends

PWC’s “2008 Securities Litigation Study” details statistics and discusses recent trends in securities litigation. According to the report, the number of securities class actions filed last year increased by 20% from 163 in 2007 to 210 in 2008. Just less than half of those cases focused on banks, brokers, financial service companies and insurance companies.

Pension funds continue to be a driving force in private securities class actions, bringing 100 cases in 2008 compared to 68 the prior year. Pension funds accounted for 85% of the settlements made by institutional investors. According to PWC, 36 class actions were filed against foreign companies in 2008. This number represents an all time high.

While the total value the settlements in securities class actions declined last year compared to the prior year, if the 2007 $3.6 billion Tyco settlement is excluded, the total settlement value for 2008 increased over the prior year by about 9% to $3.6 billion from $3.3 billion.

A recent web cast hosted by Ernst & Young and featuring, among others, Gibson Dunn partner John Sturc also discussed trends in securities litigation. The broadcast is available here.

SEC enforcement

Insider trading: The SEC obtained three more settlements in the “Merrill Lynch/Business Week” insider trading case on Friday, an action which involved a serial insider trading ring, discussed here. These settlements were with defendants Nickolaus Shuster, Juan C. Renteria, Jr. and Monika Vujovic, participants on the Business Week side of the scheme. SEC v. Anticevic, 05-Civ. 6991 (S.D.N.Y. Filed Aug. 5, 2005) (there are also parallel criminal actions).

The case centered on a serial insider trading ring run by Eugene Plotkin and David Pajcin. According to the SEC, these two defendants bribed a Merrill Lynch analyst to obtain inside information on pending deals and planted individuals in the printing plant that produced Business Week to secure advance information about securities discussed in the magazine. All of this information was used by defendants Plotkin, Pajcin and others to trade. Defendants Nicklolaus Shuster and Juan Renteria were recruited to work at the printing plant while Monika Vujovic permitted her boyfriend, Eugene Plotkin, to trade through her account.

In the settlements with defendants Shuster, Renteria and Vujovic, each defendant was enjoined by consent from future violations of the federal securities laws. Defendant Vujovic was also ordered to pay disgorgement of $261,364 to be satisfied by payment of all the funds in a brokerage account in her name which has been frozen since 2005. No disgorgement orders were entered against defendants Shuster and Renteria, who had been paid for the Business Week information. Likewise, no civil penalties were imposed on any of the settling defendants.

Option backdating: The SEC settled an option backdating case with Take-Two Interactive Software, Inc., discussed here. SEC v. Take-Two Interactive Software, Inc., Case No. 09 CIV 3113 (S.D.N.Y. Filed April 1, 2009). According to the complaint, between April 1997 and September 2003 the company granted backdated options without complying with its stock option plan and frequently without board or committee approval of the grant dates and exercise prices. As a result, Mr. Brant (who settled earlier) and others obtained millions of dollars worth of illicit compensation by exercising in-the-money options. These actions also caused the periodic reports Take-Two filed with the SEC to be false and misleading.

To settle the action, Take-Two consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions of the Securities Act and the Exchange Act, as well as the books and records and proxy provisions of the Exchange Act. The company also agreed to pay a $3 million civil penalty. At the same time, Take-Two settled with the New York County District Attorney’s Office by agreeing to pay $300,000 to the state and continue its remedial measures.

Financial fraud: In SEC v. Delphi Corporation, Case No. 06-CV-14891 (E.D. Mich. Filed Oct. 30, 2006), the Commission settled with the former director of finance in the information technology department of the company, Judith Kudia. The complaint alleged that Ms. Kudia participated in a fraudulent scheme in which the company filed materially false and misleading financial statements in 2001. In those financial statements, Delphi improperly recorded a $20 million payment from another company made in connection with a new contract with that company. This is one of four schemes detailed in the complaint.

To settle the case, Ms. Kudia consented to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions of the federal securities laws. She also agreed to the entry of an order requiring the payment of a $30,000 civil penalty. In addition, Ms. Kudia consented to the entry of an order in an administrative proceeding suspending her from appearing or practicing before the Commission as an accountant under Rule 102(e) (3) with a right to re-apply after three years.

Ponzi schemes: In SEC v. Stein, Civil Action No. 09-3125 (S.D.N.Y. Filed April 1, 2009), the SEC filed a complaint and obtained a freeze order over another alleged Ponzi scheme. This action was brought against Edward Stein and seven entities he is alleged to have controlled. According to the complaint, the investment fund was set up in 1992 and told investors that it would be a feeder fund for other investment vehicles engaging in arbitrage and hedge trading. Instead, the fund invested in a magazine controlled by Mr. Stein which went bankrupt in 2003. Nevertheless, Mr. Stein continued to solicit investor funds. A second fund controlled by Mr. Stein solicited funds beginning in 2002 allegedly to purchase life insurance policies. Instead investor funds were transferred to another entity controlled by Mr. Stein. The U.S. Attorney’s Office for the Eastern District of New York filed parallel criminal charges.

Other actions

Teamsters Local 617 v. Apollo Group, Inc., Case No. 06-cv-2674 (D. Ariz. Filed Nov. 2, 2006) is a securities class action claiming that six executives of Apollo Group, which operates the University of Phoenix, backdated stock option grants over a five year period from 2001 to 2006. The court granted in part a motion to dismiss. Some claims were dismissed based on statute of limitations grounds. Other Section 10(b) fraud claims were dismissed against some individual defendants. Leave was granted to amend the complaint against the company and selected defendants.

In re Integrated Silicon Solution, Inc. Shareholder Derivative Litig., Case No. C-06-04387 (N.D. Cal. Filed July 18, 2006) is a derivate suit based on option backdating claims. In an order filed March 31, 2009, the court tentatively approved a settlement of the case. The suit claimed that the individual defendants backdated dozens of stock options. Executives either returned or wrote down the intrinsic value of granted stock options worth more than $2.5 million as part of the deal. Initially, the court rejected the settlement because of questions about the involvement of the defendants’ counsel in the option backdating. An internal investigation by outside counsel found otherwise, however.

In In re UBS Auction Rate Sec. Litig., Case No. 08-cv-2967 (S.D.N.Y. Filed March 21, 2008), the court dismissed an investor suit against UBS based on claims that they were misled when they purchased auction rate securities. The court concluded that the investors were made whole under the terms of the settlement between UBS and the SEC which is discussed here.

The Department of Corporations for the State of California announced settlements with Wachovia and Citigroup to repurchase auction rate securities from California investors. Under the terms of the settlement, Wachovia is repurchasing $1.5 billion in ARS. The offers to individual customers will be completed by June 30, 2009. Citigroup has agreed to repurchase $3.2 billion in auction rate securities from California eligible customers. For institutional investors, Citigroup agreed to work with issuers, customers and regulators to attempt to provide liquidity solutions by December 31, 2009. These terms are similar to those in the settlements each institution entered into with the SEC as discussed here (Wachovia) and here (Citigroup).

World regulators

United Kingdom: In the first criminal insider trading case filed by the FSA, the U.K.’s financial regulator, the former general counsel of Motorola, Inc.’s TTP Communications and his father-in-law were found guilty. Christopher McQuoid and James Melbourne were convicted based on charges that they split about 50,000 pounds in proceeds from the sale of TTP stock purchased just before the announcement that the company would be acquired by Motorola in 2006.

Sweden: On March 27 insider trading charges were filed against six individuals. This is reportedly the largest insider trading scandal in Swedish history. The charges are based on trading in 23 deals.

Hong Kong: A former PNP Paribas vice president and his girlfriend became the first people in Hong Kong to be jailed for insider trading. Ma Hon-yeung was sent to prison for 26 months and fined 230,000 Hong Kong dollars ($29,500) while Ivy Lo, his girlfriend, was imprisoned for 12 months and fined 210,000 Hong Kong dollars. The pair traded in the shares of Egana Jewelry & Pearls before it was privatized three years ago.

What Does Cooperation Earn?

What does a company earn for cooperation with the SEC? To be sure, being a good corporate citizen implies that the company should assist the SEC in rooting out and preventing wrong-doing. Cooperation, as defined by the SEC however, typically requires much more than that which might be expected of a good citizen and often comes at a high price for the company. Hence, the on-gong debate about the “culture of waiver” and stripping entities of fundamental rights in the name of cooperation. In return for that price, the SEC holds out the prospect of credit in the charging process. The question is: what does cooperation as defined by the SEC earn the company?

There is no clear cut answer to this question. The SEC offers little in the way of guidance either in its Enforcement Manual, Seaboard Release or the press releases which acknowledge cooperation by a settling defendant. Likewise, examination of cases where cooperation is acknowledged yields little in the way of concrete guidance. Consider for example, a settled option backdating case the SEC filed yesterday and two similar cases brought last year.

Yesterday, the Commission filed a case against Take-Two Interactive Software, Inc., the New York City based developer of interactive entertainment software games for video game consoles and personal computers. SEC v. Take-Two Interactive Software, Inc., Case No. 09 CIV 3113 (S.D.N.Y. Filed April 1, 2009). See also SEC v. Brant, Civil Action No. 1:07 CV 1075 (S.D.N.Y. Filed Feb. 14, 2007) (settled civil injunctive action against the former CEO of the company who agreed to the entry of a fraud injunction, the payment of about $4.1 million in disgorgement and a $1million civil fine).

The allegations in the complaint are similar to those in many option backdating cases. According to the SEC, between April 1997 and September 2003 the company granted backdated options without complying with its stock option plan and frequently without board or committee approval of the grant dates and exercise prices. As a result, Mr. Brant (who settled earlier) and others obtained millions of dollars worth of illicit compensation by exercising in-the-money options.

The periodic reports of Take-Two filed with the SEC were false and misleading as a result of the scheme, according to the complaint. Specifically, the company did not properly record the expenses associated with the backdated options and created the impression in its filings that the grants had been issued in accord with company procedures when in fact they were not. This caused the company to overstate net income by 13.2% in 1999, 807.4% for 2000, 19.9% for 2002, 10.7% for 2003, 5.2% for 2004 and 5.4% for 2005. The company also understated its losses for 2001 by 57.5%. Take-Two restated its financial statements for the years 1997 through 2005.

To settle the action, Take-Two consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions of the Securities Act and the Exchange Act as well as the books and records and proxy provisions of the Exchange Act. The company also agreed to pay a $3 million civil penalty. At the same time, Take-Two settled with the New York County District Attorney’s Office by agreeing to pay $300,000 to the state and continue its remedial measures.

In announcing the settlement, the SEC stated that it “acknowledges the cooperation provided by Take-Two during the course of the investigation. Take-Two currently operates under new management and a new board of directors.” There is no other definition of what constitutes cooperation or how any cooperation credit impacted the settlement.

The results in Take-Two should be compared with those in other similar cases such as Sycamore Networks and UnitedHealth. In Sycamore Networks the SEC alleged a pervasive option backdating scheme that went on for years and was covered-up with falsified documents. At the time of settlement, the SEC acknowledged the cooperation of the company and accepted a resolution under which Sycamore Networks agreed to essentially the same injunction as Take-Two. No civil penalty was imposed, however. SEC v. Sycamore Networks, Inc., Civil Action No. 1:08-CV-11166 (D. Mass. Filed July 9, 2008) discussed here.

In UnitedHealth, the SEC also alleged a significant option backdating scheme. The Commission also acknowledged the cooperation of the company with its investigation at the time of the settlement. In its release, the SEC took the unusual step of stating the steps the company undertook to cooperate: conducting an internal investigation, sharing the results with the staff and removing the officials involved. In view of that cooperation, the SEC agreed to accept in settlement a consent injunction prohibiting future violations of the books and records provisions — no fraud injunction and no penalty. SEC v. UnitedHealth Group, Inc., Case No. 08-CV-6455 (D. Minn. Filed Dec. 22, 2008) discussed here.

The reason for the significantly different settlements in these three cases is not apparent from the statements of the SEC. While the UnitedHealth release did give some specifics about the cooperation of the company which is helpful, it hardly distinguishes that case from the others. Presumably all of the companies conducted internal investigations, since that is virtually standard operating procedure under these circumstances. Presumably all of three companies made the facts from their investigation available to the SEC, since the Enforcement Manual defines cooperation in terms of making the facts available to the staff. And, the SEC releases for all three cases suggest that those involved have been replaced. So what is the difference?

In each instance, the company was accused of unlawful conduct by a government agency in a lengthy and detailed complaint — a stigma which lingers long. In each instance, the company was enjoined. In UnitedHealth however, the injunction was not for fraud, while in both Take-Two and Sycamore Systems the court order was predicated in the first instance on fraud. Only Take-Two had to pay a civil penalty. While this is hardly a scientific sample of SEC cooperation cases, they do raise a fundamental question about the value of SEC type cooperation. The Commission’s vague promise of credit and typically nondescript press releases regarding cooperation only serve to cloud the question.

To add transparency to the process and encourage companies to cooperate not just in the “good citizen” sense, but the SEC sense, the Commission should consider giving further definition to cooperation and cooperation credit in its press releases about settlements.