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).

They Just Keep Coming: Three New Fraudulent Investment Schemes

The current market crisis and credit crunch continues. New fraudulent investment schemes surface. They seem to go hand in hand.

On Wednesday, three more investment schemes became the basis for criminal and civil securities fraud charges. First, James M. Nicholson, President and general partner of Westgate Capital Management, LLC was arrested, charged with securities fraud and named in a suit by the SEC along with Westgate Capital and Westgate Absolute Return Fund, LP. SEC v. Nicholson, Case No. 09-civ-1748 (S.D.N.Y. Filed Feb. 25, 2009).

Since at least 20004, investors have invested at least $100 million with Westgate Funds.
Investors were lured to the fund by representations that Westgate Capital had from $600 to $900 million under management when in fact it had far less. In brochures, Westgate told prospective investors of extraordinary returns. One of its funds supposedly had positive returns for each month from January 2004 through August 2008. Another claimed to have positive returns for every month from October 1999 through December 2007 (with the sole exception of October 1999). In fact, the funds had suffered large losses.

Investors were also told that the funds were audited by an independent accounting firm at a specified address. In fact, the audit firm was fictitious and had only a “virtual office” at the specified address where Mr. Nicholson had arranged for an answering service to take calls.

When investors sought to redeem their shares beginning in December 2008 in the wake of the Madoff scandal, they were paid with checks totaling about $5 million. All of the checks were returned for insufficient funds. Other investors seeking the payment of about $10 million in total have not been able to redeem their shares. The SEC is seeking a freeze order in its case.

Second, Mark Bloom, the operator of North Hills Management LLC, was arrested on securities fraud charges and named as a defendant in an SEC enforcement action along with North Hills. SEC v. North Hills Management LLC, Civil Action No. 09-1746 (S.D.N.Y. Filed Feb. 25, 2009). Mr. Bloom is alleged to have raised about $30 million from 40 to 50 investors between 2001 and 2007. Investors were told that the money would be placed in a diverse group of hedge funds. In fact, Mr. Bloom misappropriated over $13 million. Over half of the funds were put into a commodities trading pool known as Philadelphia Alternative Asset Fund without telling investors. Mr. Bloom also did not tell investors he had had a “referral agreement” with the pool which paid him about $1.6 million. The pool ended in June 2005 with charges it was fraudulent.

The claimed 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 SEC obtained an emergency asset freeze in its case.

Finally, Paul Greenwood and Stephen Walsh were charged with conspiracy and securities and wire fraud and named as defendants in an SEC enforcement action along with their fund, WG Trading Investors. SEC v. WG Trading Investors, LP, Case No. 09-1750 (S.D.N.Y. Filed Feb. 25, 2009).

Beginning in 1996, and continuing through February 2009, Messrs. Greenwood and Walsh solicited funds from investors, including charitable and university foundations, retirement and pension plans and other institutional investors. During that period, they raised more than $668 million from investors. They solicited the funds using claims that the money would be invested in an “enhanced equity index” strategy which would purchase and sell equity index futures and engage in equity index arbitrage trading.

In fact, Messrs. Greenwood and Walsh misappropriated most of the money according to the USAO and the SEC. The conduct 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 in fact receivables from Messrs. Greenwood and Walsh and investments in entities they controlled. The SEC obtained an emergency asset freeze in its case.