Part I: SEC Enforcement Trends, 2009: Calls For Reform And Their Background

The future of the SEC and securities regulation is at a cross-road. Calls for reform seem to be made virtually every day. Some are rooted in the current market crisis. Others stem from persistent scandals that have left the SEC in crisis. Confidence in the Commission’s ability to effectively police the securities markets is at a low point. An agency that until recently was hardly recognized on main street U.S.A. is now unfortunately becoming known not for its past successes, but for its failure to protect investors. These events will help shape the future of the SEC and securities regulation.

Examination of the demands for reform begins with a brief statistical look at the enforcement program. Last year, the SEC claims it brought a record number of cases, 671. This is the first increase in recent years.

While SEC officials may point to the increased number of cases as a sign of the enforcement program’s vitality, others question the meaning of the number. Many critics note that the number is bolstered by defaults and similar actions. Others point to recently published NERA statistics which demonstrate that the number of cases settled in 2008 declined to one of the lowest levels in years.

While there seems to be a growing trend toward the criminalization of securities enforcement, a recent study published by Syracuse University based on Department of Justice data suggests otherwise. That study found that the number of securities fraud prosecutions declined significantly in 2008. At the same time the FBI reports that it is overburdened with 530 corporate fraud investigations underway. These cases focus on financial fraud and insider trading.

These statistics seem to raise more questions than they answer. While it can be hazardous to make projections from this modest collection of statistics, they seem to undermine SEC claims of a vibrant enforcement program, but point to a future increase in the number of enforcement actions.

Beyond the statistics, the current market crisis has spawned repeated calls for the reform of securities regulation as well as other financial regulators. Many have criticized the SEC’s performance during the current crisis as lackluster, at best. A report from the SEC’s Inspector General, for instance, is highly critical of the agency’s performance during the demise of Bear Stearns. SEC’s Oversight of Bear Stearns and Related Entities, Report No. 446-A Sept. 25, 2008. That same report also criticized the agency’s now defunct program of voluntary supervision over investment bank holding companies.

When the SEC did react to the market crisis, not only was it criticized, but perhaps worse, the agency second-guessed itself. In August, the SEC initiated a ban on short trading for the shares of certain financial institutions. Regulators around the globe instituted similar bans which lasted far longer than the modest few-week embargo imposed by the SEC. Yet, after the SEC’s ban ended then Chairman Cox claimed it was the biggest mistake of his tenure, undertaken only because of pressure from the Secretary of the Treasury and the Chairman of the Federal Reserve.

Scandals are another force propelling the calls for reform. The Pequot Capital debacle seems to be the scandal that will not die. Initiated by a former SEC staff member turned whistleblower, congressional hearings probed claims of undue influence and favoritism in an insider trading investigation of a hedge fund where the testimony of a prominent witness was not taken for reasons which are far from clear. A Senate report was highly critical of the SEC’s performance. Just as the scandal seemed to be fading from view, reports surfaced that there is now a criminal insider trading investigation underway as well as an SEC inquiry, both focused on the same allegations that were involved in the initial botched inquiry.

If Pequot raised difficulties for the agency, Madoff added the finishing touches. Here the SEC had multiple opportunities to discover at an earlier time what appears to be the Ponzi scheme fraud of the ages. The agency was even given a road map to the fraud — but lost its way. The impact of this failure has only been intensified by the surprising comments of then SEC Chairman Cox who sought to distance himself from the scandal by blaming the staff. (There are reports that a biography of Harry Truman who famously said “the buck stops here” has been sent to Mr. Cox.) Apparently heeding the comments of their leader, the entire senior staff of the agency completed the dismal portrait painted of the agency for the public by effectively taking the Fifth Amendment in response to questions from a congressional oversight committee about the SEC’s failed investigative efforts.

Now there is a growing chorus of calls for reform. Some focus on reforming what is seen as an antiquated market regulatory scheme which, having been born of the great depression in the 1930’s, has simply been passed by time and events. This is the predicate for reforms such as those offered by former Treasury Secretary Henry Paulson. Under his proposal the entire financial services industry would be revamped. The SEC would be merged into the CFTC, a proposal which has received favorable comments from others such as SEC Commissioner Luis Aguilar.

Other calls for reform focus on elements of the current market crisis such as adding oversight authority over credit default swaps, hedge funds and investment bank holding companies. Former SEC Chairman Cox repeatedly requested authority over the CDS market and investment bank holding companies but, ironically, not hedge funds, despite his testimony in 2006 before Congress vowing to regulate the entities. At the same time, pending legislation calls for the Commodity Exchange Act to be amended to extend regulation over credit default swaps and give supervisory authority to the CFTC, while investment bank holding companies would be placed under the jurisdiction of the Federal Reserve. The Financial Regulation Reform Act of 2008, S. 3691 (Introduced Nov. 19, 2008).

Other calls for reform focus on the internal operations of the SEC and its enforcement division. Former Commissioner Paul Atkins, for example, published an article last summer calling for the reform of enforcement practices. Paul S. Atkins and Bradley J. Bondi, Evaluating the Mission: A Critical Review of the History and Evolution of the SEC Enforcement Program, 13 Fordham J. Corp. & Fin. L. 367 (2008). In a recent speech Commissioner Luis Aguilar also called for internal reforms to strengthen the enforcement program. Speech, Commissioner Luis Aguilar: Empowering the Markets Watchdog to Effect Real Results, delivered to North American Securities Administrators Association (Jan. 10, 2009).

While the precise path of reform has yet to be charted, new SEC Chairman Mary Schapiro took office with a vow to reform and rejuvenate the enforcement program and has moved swiftly in that direction. With only a few weeks at the helm, Ms. Schapiro has already brought in a new general counsel and a new enforcement director. She has also reversed the “pilot program” of former Chairman Cox which required the question of corporate penalties to be submitted to the Commission prior to staff settlement negotiations and streamlined the process for obtaining a formal order.

Ms. Schapiro is off to a quick start and deserves time to put her program in place, but she may not get it. Recently she received a letter from Senator Grassley inquiring as to whether the SEC followed-up on information give to the enforcement division last year by a Senate committee. The information implicated Lehman Brothers in insider trading. This could trigger more difficulties for the embattled agency.

Regardless of the response to Senator Grassley however, the calls for reform will continue. Whether Ms. Schapiro can revamp the SEC and obtain new tools from Congress to help effectuate its mission, or a legislative fix will merge the agency out of existence is unclear at this point. What is clear from the case load of the FBI is the need for effective enforcement and the potential for many more securities enforcement actions in the future.

This Week In Securities Litigation (February 27, 2009)

The SEC will receive a substantial budget increase under the President’s proposed budget. The 13% increase will permit the agency to increase staff and improve fraud detection, according to Chairman Schapiro. Senator Grassley, a member of the Senate Finance Committee, wants to know however if the Commission has improved at follow-up. Last spring, the enforcement staff was given a substantial quantity of evidence suggesting possible insider trading at Lehman. Senator Grassley wrote to the SEC Chairman to determine if the Commission followed-up.

Following the revelation of the Madoff scandal, the SEC does seem to have improved at finding Ponzi schemes and other fraudulent investment schemes. Its enforcement portfolio last week was dominated by case after enforcement case against defendants who are alleged to have bilked investors in fraudulent investment funds. Most of the cases were brought in conjunction with the U.S. Attorney’s Office and, at times, the Commodity Futures Trading Commission.

Finally, the conviction of former Quest CEO Joseph Nacchio was reinstated. The Tenth Circuit, sitting en banc, reversed a panel decision which had overturned his conviction.

The SEC

Under the President’s budget proposal, the SEC would receive a 13% increase in funding over the previously fiscal year. SEC Chairman Schapiro issued a statement welcoming the proposed increase for FY 2010, noting that it would permit the agency to increase the staff and use new technology to “purse risk-based approached that would better detect fraud and ensure stronger oversight of the nation’s securities markets.”

Better enforcement will hopefully start with good follow-up. In recent weeks, the SEC has been battered for failing to follow-up on leads regarding Madoff and Pequot Capital as discussed here. Last week Charles E. Grassley, the ranking member of the Senate Finance Committee, sent a letter to SEC Chairman Mary Schapiro asking the agency to explain how it had followed-up on a tip that there may have been insider trading at a unit of Lehman Brothers.

Last spring about 4,000 e-mails and related documents were turned over to the Director of the Division of Enforcement by a former Lehman analyst. According to Senator Grassley, his staff examined the materials and concluded that they raise questions regarding whether there was insider trading at Lehman. Specifically, it appears from the materials that members of Lehman’s Product Management Group routinely received research reports before they were made public. Trading patterns for stocks mentioned in the research reports suggest the possibility of insider trading. The Senator noted that it is unclear whether a formal order of investigation had been issued or if there has been any follow-up on the materials. See Gretchen Morgenson, “Regulator Faces Fresh Scrutiny Over Trading Inquiry at Lehman,” New York Times, Feb. 23, 2009 (available here, registration required).

Fraudulent investment schemes

This seems to have been the week for criminal and civil actions involving fraudulent investment schemes defrauding investors ranging from individuals to pension funds and charities of millions of dollars.

In SEC v. Nicholson, Case No. 09-civ-1748 (S.D.N.Y. Filed Feb. 25, 2009) and the related criminal case, James M. Nicholson, President and general partner of Westgate Capital Management, LLC were charged with securities fraud. In the SEC complaint, Westgate Capital and Westgate Absolute Return Fund, LP were also named as defendants.

The cases alleged that, beginning in 2004, Westgate Funds obtained at least $100 million in investor funds. Investors were lured to the Fund with claims of positive returns month after month and false financial information. Investors were also told that the Funds was audited but the phone number they were given went to a phone at a “virtual office” controlled by the defendants.

The scheme began to unravel when investors sought to redeem their shares beginning in December 2008 in the wake of the Madoff scandal. Some investors received checks which bounced while others were told there were no funds to pay for redemption.

In SEC v. North Hills Management LLC, Civil Action No. 09-1746 (S.D.N.Y. Filed Feb. 25, 2009). Mark Bloom, the operator of North Hills Management LLC, was named as a defendant along with North Hills in a complaint alleging securities fraud. Mr. Bloom was also arrested on criminal securities fraud charges.

Mr. Bloom is alleged to have raised about $30 million from investors, who were told the money would be invested in a diverse group of hedge funds. In fact, Mr. Bloom misappropriated over $13 million and put a significant portion of the funds in a now defunct and fraudulent commodity pool which paid him an undisclosed referral fee.

The fraud surfaced when one of the Fund’s largest investors, a charitable trust that funds children’s schools, began making redemption requests which were not honored. Mr. Bloom claimed he did not have the means to repay the $9.5 million owed to the trust. The CFTC also brought an action against Mr. Bloom and his Fund. CFTC Release 5622-09 (Feb. 25, 2009).

In SEC v. WG Trading Investors, LP, Case No. 09-1750 (S.D.N.Y. Filed Feb. 25, 2009), Paul Greenwood and Stephen Walsh along with WG Trading Investors were named as defendants in a securities fraud suit by the SEC. Both men were arrested on charges of conspiracy, securities and wire fraud.

Over the last twelve years, according to the court papers, Messrs. Greenwood and Walsh raised over $668 million from investors, including charitable and university foundations, retirement and pension plans and other institutional investors. The defendants claimed to have a proprietary trading system. In fact, Messrs. Greenwood and Walsh misappropriated most of the money, according to the USAO and the SEC. The scheme was discovered when the National Futures Association conducted an audit of WG Investors and its related entity. The audit demonstrated that $794 million of the $812 million carried on the books was receivables from Messrs. Greenwood and Walsh and investments in entities they controlled. The CFTC also filed an enforcement action. CFTC Release No. 5621-09 (Feb. 25, 2009).

In SEC v. Billion Coupons, Inc., Civil Action No. CV 09-00068 (D. Haw. Filed Feb. 19, 2009), the Commission brought an action alleging that CEO Marvin R. Cooper was operating a Ponzi scheme known as Billion Coupons, Inc. According to the SEC’s complaint, BCI claimed that by trading in foreign exchange markets investors would receive returns of up to 25% compounded monthly. Mr. Cooper is alleged to have misappropriated at lest $1.4 million in investor funds and lost through Forex trading substantial portions of the sums received from investors. The SEC obtained an asset freeze order. See also CFTC v. Billion Coupons, Inc., Case No. 1:09-cv-00069 (D. Haw. Filed Feb. 18, 2009).

Other SEC actions

In SEC v. Kopsky, Case No. 4:07-cv-00379 (E.D.Mo. Filed Feb. 26, 2007), the Commission settled an insider trading case previously brought against Matthew Kopsky and Ronald Davis. The complaint, filed two years ago, claimed that Mr. Davis, a former President of Business Development for Engineered Support Systems, tipped his friend and former broker Matthew Kopsky in advance of three quarterly earnings releases. Mr. Kopsky then traded in the shares of ESSI. Both defendants were enjoined by consent from future violations of the antifraud provisions. In addition, Mr. Kopsky paid $381,590 in disgorgement and prejudgment interest and a civil penalty of about $276,000. Mr. Davis was ordered to pay a civil penalty of about $107,000. Mr. Kopsky also agreed to a suspension from association with any broker, dealer or investment advisor for a period of twelve months.

In SEC v. Lawton, Civil Case No. 09-368 (D. Minn. Filed Feb. 20, 2009), the Commission brought an action against John Lawton and his fund, Paramount Partners, LP. The SEC’s complaint claims that from 2001 to 2008 investors put about $10.8 million into Paramount. The funds were raised based on representations that Paramount produced annual returns which ranged from 65% to 19%.

Although investors were told in January 2009 that the fund had about $17 million in assets, the four brokers who supposedly held those assets confirmed that Paramount has less than $2 million. The Commission obtained an order freezing the remnants of the funds.

Nacchio appeal

The conviction of former Quest CEO Joseph Nacchio on 19 counts of securities fraud was reinstated this week by the Tenth Circuit Court of Appeals sitting en banc. U. S. v. Nacchio, No. 07-1311 (10th Cir. Decided Feb. 25, 2009) (en banc). In a 5-4 decision, the court concluded that the district court did not abuse its discretion by excluding defense expert witness Professor Daniel Fischel.

In March 2007, a 2-1 panel decision by the Tenth Circuit ruled that the district court had improperly excluded Professor Fischel’s testimony. The exclusion of that testimony was critical to Mr. Nacchio’s defense, according to the panel decision.

Mr. Nacchio was originally named in a 42-count indictment in December 2005. Subsequently he was convicted on 19 counts and sentenced to six years in prison. Mr. Nacchio, who has remained free on bail, pending the resolution of his appeals also has been named as a defendant in an SEC enforcement action. SEC v. Nacchio, Case No. 05-MK-480 (D. Colo. Filed March 15, 2005).