by T. GormanPosted on Posted in SECActions

The SEC: On Friday the SEC announced the conclusion of a case arising out of the financial fraud at Hayes Lemmerz International, Inc. The court entered judgments against Ranko Cucuz, the former CEO, and William D. Shovers, the former CFO of the company.

The action centered on a financial fraud which took place at Hayes from 1999 through 2001. According to the Commission’s complaint, senior officers of the company engaged in a scheme to meet earnings targets and disguise the declining operating results at the company. Key elements of the scheme included: 1) inappropriately deferring operating expenses to balance sheet accounts; 2) failing to process vendor invoices; 3) understating employee fringe benefits; and 4) improperly recording certain customer discounts to balance sheet accounts. As a result, Hayes made materially false filings with the Commission for the fiscal years 1999 and 2000 and the first quarter of 2001.

On April 25, 2006, the Commission brought an enforcement action against the company and four former senior officers. In addition to Messrs. Cucuz and Shovers, the SEC named as defendants Ronald Kolakowski, former President of the North American Wheel Group, and Jesus Bonilla-Valdez, former Vice President of the Aluminum Wheel Group. SEC v. Cucuz, Civil Action No. 2:06-CV-11935 (E.D. Mich. Filed April 25, 2006)

The company settled at the time the complaint was filed, consenting to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and internal control provisions of the federal securities laws. Mr. Kolakowski also settled at that time, consenting to the entry of a permanent injunction prohibiting future violations of the same statutory sections as the company. In addition, Mr. Kolakowski consented to the entry of an order baring him from being an officer or director for ten years and requiring him to the pay a $75,000 civil penalty. Defendant Jesus Bonilla-Valdez settled with the Commission on January 14, 2007. He consented to the entry of a permanent injunction containing the same provisions as the earlier settlements. In addition, he consented to the entry of an order requiring him to pay a $30,000 civil penalty. Four other employees settled with the Commission in administrative proceedings. These actions are listed in Release No. 20864.

Messrs. Cucuz and Shovers were found liable by a jury on August 20, 2008. Based on the verdict of the jury, the court entered final judgments against each defendant. 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 also imposed a $10,000 civil penalty. The Commission’s complaint had charged Mr. Cucuz with violations of a the antifraud and reporting provisions of the Securities Exchange Act including Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) as well as Rule 13b2-2, lying to auditors.

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.

by T. GormanPosted on Posted in SECActions

Earlier this month, the Ninth Circuit Court of Appeals handed down a decision on pleading a strong inference of scienter under the Private Securities Litigation Reform Act (“PSLRA”). Zucco Partners, LLC v. Digmarc Corporation, Case No. 06-3558 (9th Cir. Jan. 12, 2009) (rejecting motive and opportunity evidence as insufficient and requiring a showing of intentional conduct or deliberate recklessness). While the decision purported to harmonize the circuit’s prior case law with the teachings of Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007), in fact the court seems to have reaffirmed its earlier case law while effectively ignoring the Supreme Court, as discussed here.

Now, the same question might be asked of the Second Circuit. In ECA and Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co., Case No. 0-1786-cv (2nd Cir. Jan. 21, 2009), the Second Circuit affirmed the dismissal of a class action securities complaint brought against JP Morgan Chase Co. The complaint was based on claims that the financial institution defrauded its shareholders, causing its share price to be improperly inflated. The alleged fraud centered on claims that JP Morgan “created disguised loans for Enron and concealed the nature of these transactions by making false statements or omissions of material fact …” in its accounting statements and SEC filings. The district court dismissed the complaint for, among other things, failing to comply with the pleading standards of the PSLRA.

The Second Circuit affirmed the dismissal of the case. In considering the question of whether a strong inference of scienter had been pled, the court turned to Tellabs and recited the holding of the case – that on a collective basis the inference of scienter must be at least as strong as that of any opposing inference. It then went on to note that “[t]he requisite scienter can be established by alleging facts to show either (1) that defendants had the motive and opportunity to commit fraud, or (2) strong circumstantial evidence of conscious misbehavior or recklessness.” After reviewing each of the allegations in the complaint, the court concluded that the district court had properly dismissed the complaint.

While Tellabs sought to resolve a split among the circuits regarding the pleading of a strong inference of scienter which, at the time, included the Second and Ninth Circuits. Prior to Tellabs, the Second Circuit, along with others, employed its two prong motive and opportunity/strong circumstantial evidence test to asses whether a strong inference of scienter had been pled under the PSLRA. See, e.g., Press v. Chem. Inv. Serv. Corp., 166 F.3d 529 (2nd Cir. 1999). The Ninth Circuit found the Second Circuit motive and opportunity test insufficient, opting for its standard of intentional conduct or deliberate recklessness in Silicon Graphics, 183 F.3d 970 (9th Cir. 1999).

Tellabs resolved the split among the circuits on pleading a strong inference of scienter within the meaning of the PSLRA. Now however, it appears that Tellabs in fact may have not resolved the split between the Second and Ninth Circuits. Both circuits cite Tellabs and purport to apply its teachings. In doing so however, each circuit has incorporated its pre-Tellabs case law into the analysis. As JP Morgan demonstrates, the Second Circuit is still using its two prong motive and opportunity/strong circumstantial evidence test. The Ninth Circuit, as Digmarc Corporation demonstrates, still rejects the motive and opportunity test in favor of Silicon Graphics.

The decisions of the Second and Ninth Circuit can be harmonized with Tellabs if they are read as interpreting the definition of scienter rather than the provisions of the PSLRA. In that instance JP Morgan and Digmarc Corporation are not inconsistent with Tellabs, since the Supreme Court did not consider the definition of scienter. That reading of the circuit court decisions is difficult to reconcile with the fact that both circuits based their test on a reading of the PSLRA statutory language and its difficult and complex history. Under either reading of the Second or Ninth Circuit, there is a split over a key pleading standard which will require resolution by the Supreme Court.