Can SEC Enforcement Be Revitalized? Lessons From Current Scams

SEC enforcement is widely perceived as ineffective. See, e.g., Gretchen Morgenson, “Following Clues the S.E.C. Didn’t,” New York Times, Business at 1 (Feb. 1, 2009) (available here, registration required). Concerns stem from recent high profile failures. The much talked about Madoff scandal is the most visible example. Of equal concern however, should be the responses from the agency to date: Fraud such Ponzi schemes are very difficult to detect; the Commission needs more resources.

Lack of resources is clearly not the reason the Madoff scheme was not uncovered. There the SEC had multiple chances and simply failed to investigation. Beginning in 1992, the SEC had the opportunity to find the fraud. It did not. In 2006 it had another chance as discussed here. It failed. This is not a lack of resources. It is a lack of investigation.

This is not to say that the SEC does not need more resources. Clearly it does. More resources would help the SEC police the markets more effectively. The reality is however, that no matter how many more resources the SEC it given, those will be small compared to the enormous task the Commission has been assigned. As the cop of the securities markets, the amount of resources the SEC can focus on any given matter has always been small compared to those which can be expended by powerful companies it the markets and their large law firms. That has not stopped the SEC from earning a well deserved reputation for excellence in the past. Resources can help it rebuild that reputation in the future – if they are used effectively.

Fraud is difficult to detect. That does not mean it cannot be found. Insider trading, for example, is notoriously difficult to detect. Yet, last year the SEC filed more insider trading cases that the prior year.

Ponzi schemes, like Madoff, are also difficult to detect. That does not mean that the SEC cannot find them. This is particularly true now that everyone is focused on them. A quick review of headlines from the Litigation Releases issued by the agency in January 2009 illustrates the point:

• Release 20842, January 6, 2009: South Florida Investment Adviser Indicted for Multi-Million Dollar Misappropriation and Ponzi Scheme;

• Release 20846, January 7, 2009: Mutual Benefits’ Founding Principals and Others Charged in $1 Billion Investor Fraud and Ponzi Scheme;

• Release No 20947, January 8, 2009: SEC Charges Joseph S. Forte For Conducting $50 million Ponzi Scheme;

• Release No. 20849, January 9, 2009: Temporary Restraining Order Entered in Multi-Million Dollar Offering Fraud and Ponzi Scheme in Western New York;

• Release No. 20850, January 12, 2009: Judgments Entered Against Defendants … in Ponzi Scheme in Colorado;

• Release No. 20953, January 15, 2009: SEC Sees Temporary Restraining Order To Halt Ponzi Scheme; and

• Release No. 20874, January 30, 2009: SEC Obtains Preliminary Injunctive Relief in Case Involving a Ponzi Scheme.

This list does not even include frauds like SEC v. Nadel, Civil Action No. 8:09-CV-00087 (M.D. Fla. Jan. 21, 2009), a claimed fraudulent hedge fund operation or SEC v. Grigg, Civil Action No. 3 09 0087 (M.D. Tenn. Filed Jan. 28, 2009), where the alleged fraudsters were selling investors non-existent shares of a fund that supposedly invested in part in the government’s bail out program, TARP (discussed here) or SEC v.Dreier, Civil Action No. 08 Civ. 10617 (S.D.N.Y. Filed Dec. 8, 2008), where a lawyer sold hedge funds fraudulent securities (discussed here). Clearly these frauds can be uncovered when investigators focus and follow-up on leads as in Dreier, where a potential investor discovered the fraud and reported it.

All of this suggests that uncovering and prosecuting fraud is a function of effective investigation. In part, that requires assistance from investors in the market place as Dreier illustrates. Indeed, investor vigilance is critical. The fraudulent schemes listed above, and others such as Madoff, all hinge on a common element: The promise of returns not usually available from other investments and with little risk.

The scheme conducted by Charles Ponzi in 1920 is typical. Mr. Ponzi promised investors a 50% profit in forty five days. New York Times, July 27, 1920. In hindsight Mr. Ponzi’s promise may seem almost frivolous. A moment of reflection should suggest that the 50% in 45 days Mr. Ponzi promised cannot be done. Yet, that promise differs little from the one made by Mr. Madoff who claimed to make a profit for investors day in and day out year after year regardless of market conditions. Everyone knows that nobody wins all the time, every day, every year as claimed by Mr. Madoff. Yet, investors rushed to give Mr. Ponzi their hard earned cash and flocked to Mr. Madoff.

All this suggests in the end that regulators such as the SEC and investors need to work together. The SEC and other regulators have to encourage investors to provide it with information and then effectively investigate and follow-up on those leads. Investors have to furnish those leads. That begins by realizing that if it the promise is of something others cannot achieve, then it probably cannot be achieved. Stated differently, if it looks to good to be true, then it probably is. If investors report the “to good to be true” opportunities and the SEC effectively investigates, the Bernard Madoff’s of the world will be stopped and prosecuted in a timely fashion before investors are harmed.

This Week In Securities Litigation (January 30, 2009)

This week, the focus was on Capital Hill. New SEC Chairwoman Mary Schapiro was sworn in, vowing to rejuvenate the agency and its enforcement program. The Senate heard testimony from two senior SEC staff members, ostensibly about the agency’s prior investigative efforts regarding the Madoff scandal, but really about little of substance. Legislation was introduced to provide additional funding to law enforcement to fight white collar crime. The bulk of the money would go to the FBI. And, one congressman wrote Ms. Schapiro on her first day on the job to request the restoration of the uptick rule regarding short selling.

In enforcement, the SEC filed what may be a first – a civil fraud complaint alleging that the defendants sold bogus interests in the TARP program. The Commission also concluded a financial fraud case following a jury verdict obtaining less that the findings and remedies it sought, while prevailing in a UK appellate court which sustained an asset freeze the SEC had obtained in the High Court of London. The SEC also settled with two former Enron lawyers.

Halliburton Co. announced what will be the second largest FCPA settlement, if approved by DOJ and the SEC. The case relates to an earlier criminal plea bargain of a former employee based on the acts of its KBR subsidiary in Liberia.

Private actions focused on options backdating cases. Brocade Communications, the company caught up in the first of the option backdating cases, settled class actions brought against the company based on action backdating claims. The directors of Computer Sciences prevailed in the Ninth Circuit, which affirmed the dismissal of an option backdating derivative suit. The case was dismissed for demand futility.

Finally, the PCAOB staff published guidance on the application of Auditing Standard No. 5 to small companies.

The SEC and capital hill

Mary Schapiro was sworn in as the new SEC Chairwoman. Ms. Schapiro has previously served as the CEO of the FINRA, the Chairwoman of the CFTC and as an SEC Commissioner. Ms. Schapiro assumes this position at a crucial time in the history of the agency. The SEC is being harshly criticized in many quarters as the market crisis continues and high profile cases such as the Madoff scandal unfold. Ms. Schapiro has promised to revitalize the agency and its enforcement program.

Staff members Lori Richards, Director, Office of Compliance and Inspections and Examinations, and Linda Thomsen, Director Division of Enforcement, testified before the Senate Committee on Banking, Housing and Urban Affairs. While the testimony follows in the wake of allegations that the SEC failed to uncover the Madoff Ponzi scheme, neither commented directly on that issue. Both cited on-going law enforcement inquiries in declining to comment on the Commission’s past investigative efforts. The suggestion in the testimony that limited resources is a partial explanation for not uncovering the scam seems questionable at best in view of the repeated opportunities over available to the Commission over a period of years.

Senators Schumer and Shelby have introduced legislation to provide additional resources for fighting white collar crime. S. 331, titled the Supplemental Anti-Fraud Enforcement Markets Act (“SAFE”), would provide the FBI with $80 million to hire 500 new agents in its white collar crime division. The SEC would receive up to $20 million to hire 100 new enforcement officials. DOJ would be given $10 million for 50 new assistant U.S. attorneys.

On January 27, 2009, Congressman Gary Ackerman sent a letter to SEC Chairwoman Schapiro asking that the uptick rule regarding short selling be restored. The congressman has also introduced legislation to require that the rule be reinstated. The bill is HR 02 was introduced in the House of Representatives on January 8, 2009.

SEC enforcement

In SEC v. Grigg, Civil Action No. 3 09 0087 (MDTN Filed Jan 28, 2009), the Commission filed a complaint alleging that the defendants defrauded at least 27 investors out of about $6.5 million by selling them securities which do not exist. According to the SEC’s complaint, the defendants told investors, among other things, that they were investing their funds in government guaranteed commercial paper and bank debt as part of the Troubled Asset Relief Program. Defendants have consented to the entry of a temporary restraining order and an asset freeze as well as an order requiring an accounting.

As discussed here, in SEC v. Manterfield, Claim No. HQ08X00798 (High Court of Justice, Queen’s Bench Division, Royal Courts of Justice, Feb. 29, 2008), the Commission prevailed in an appeal from the entry of a freeze order it had obtained in a U.K. court. That order froze certain assets in the UK pending the conclusion of a related enforcement action pending in the U.S. The assets belonged to one of the defendants in SEC v. Lydia Capital, LLC, Civil Action No. 07-10712 (D. Mass. Filed April 12, 2007).

In Lydia Capital the Commission’s complaint claimed that the defendants engaged in a scheme to defraud more than 60 investors who had put over $34 million in Lydia Capital Alternative Investment Fund LP, an unregistered hedge fund managed by Lydia. The SEC’s complaint claimed that the defendants materially overstated, and in some instances fabricated, the Fund’s performance and misled investors about the assets of the fund. The Commission initially obtained an asset freeze order in this case which had been extended by consent prior to the initiation of the UK litigation.

In SEC v. Cucuz, Civil Action No. 2:06-CV-11935 (E.D. Mich. Filed April 25, 2006), the SEC concluded a financial fraud action. The case arose out of the financial fraud at Hayes Lemmerz International, Inc. This week, the court entered judgments against Ranko Cucuz, the former CEO, and William D. Shovers, the former CFO of the company as discussed here.

The action centered on a financial fraud which took place at Hayes from 1999 through 2001. The complaint alleged violations of the antifraud provisions of the Securities Act and the Exchange Act, as well as various reporting provisions. The company and other former employees settled with the Commission. Messrs. Cucuz and Shovers were found liable following a jury trial.

The judgment against Mr. Shovers imposed a permanent injunction prohibiting future violations of the antifraud and reporting provisions of the federal securities laws, barred him from acting as an officer or director for a period of five years and imposed a civil penalty of $50,000. The judgment against Mr. Cucuz also contained a permanent injunction which barred him from future violations but only of the antifraud provision of the Securities Act. The judgment as to Mr. Cucuz, SEC v. Cucuz, Civil Action No. 2:06-CV-11935 (E.D. Mich. Filed April 25, 2006) also imposed a $10,000 civil penalty.

In SEC v. Mintz, Civil Action No. H-07-1027 (S.D. Tex. Filed March 28, 2007), the Commission settled a civil action against Jordan Mintz and Rex Rogers. Mr. Mintz was an Enron vice president and the general counsel of its Global Finance Group. Mr. Rogers was Enron’s former vice president and associate general counsel. The complaint charged each defendant with participating in a fraudulent scheme to conceal Enron’s related party transactions with partnerships controlled by the CFO of the company, Andrew Fastow. Each defendant 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 proxy and reporting provisions. Each defendant was ordered to pay $1 in disgorgement and a $25,000 civil penalty. In related administrative proceedings, Mr. Mintz and Mr. Rogers consented to the entry of an order under Rule 102(e) suspending their right to practice before the Commission for two years.

FCPA

Halliburton Co. issued press releases and filed a Form 8-K with the SEC announcing a tentative settlement in the FCPA investigation at its former subsidiary KBR by the Department of Justice and the SEC. In April 2007, Halliburton separated from Huston-based KBR, an energy industry construction firm and government contractor. In the agreement, Halliburton agreed to accept responsibility if FCPA inquiries resulted in fines or other payments. According to company filings, the government has uncovered evidence of improper payments made to Nigerian officials in connection with a project KBR managed for Royal Dutch Shell in Nigeria. Subsequently, Albert Stanley, a former chairman of what is now KBR, pled guilty to participating in a bribery scheme as discussed here.

Under the tentative settlement, Halliburton has agreed to pay $382 million on behalf of KBR to DOJ and another $17 million to the SEC. Total payments by the company under the settlements would be $560 million. This would be the second biggest FCPA settlement.

Private actions

Brocade Communications settled the shareholder class actions filed against the company based on option backdating claims. In re Brocade Sec. Litig., No. 05-cv-2042 (N.D. Calif). The $160 million settlement was approved at a court hearing on January 23, 2009. Approximately $40 million of the settlement was for attorney fees. Previously, the company settled with the SEC and its chairman, Gregory Reyes, who was also convicted of criminal charges as discussed here.

In Laborers Int. Union v. Bailey, No. 07-56461 (9th Cir.), the court affirmed the dismissal of a shareholder derivative suit against the directors of Computer Sciences. The suit was based on allegations of improper option backdating. The district court dismissed the suit for failure to plead demand futility with sufficient particularity.

PCAOB

The Public Company Accounting Oversight Board on Friday published “An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements: Guidance for Auditors of Smaller Public Companies.” This staff guidance explains how auditors can apply the principles of Auditing Standard No. 5 to audits of smaller public companies.