This Week In Securities Litigation (January 2, 2009)

The market crisis and the Madoff scandal continue to be the dominant events this week, with the SEC publishing its mark-to-market study as required by Congress and Mr. Madoff providing the SEC with a listing of assets. SEC Chairman Cox defended the response of the Commission to the current market crisis. In the interview, Mr. Cox termed the imposition of the short sale ban earlier this year as his biggest mistake, blaming the Treasury Secretary and Fed Chairman for the move. Mr. Cox also reiterated his earlier assertion that the failure to uncover the Madoff matter sooner is not his fault, while insisting that enforcement under his tenure is robust. Ironically, two new academic studies show that the short sale ban by the SEC and other regulators has not had a negative impact on price discovery and that the number of prosecutions for securities fraud have declined significantly.

The market crisis

Mark-to-market accounting study: The SEC published its Report on Mark-to Market Accounting this week. The report was mandated by the Congress in the Emergency Economic Stabilization Act of 2008. In essence the study recommends that fair value accounting continue to be used but with improvements. The Report contains eight key recommendations:

1) SFAS No. 157 should be improved and not suspended;

2) Existing fair value and mark-to-market requirements should not be suspended;

3) Additional measures should be taken to improve the application and practice related to existing fair value requirements;

4) The accounting for financial asset impairments should be readdressed;

5) Further guidance is needed to foster the use of sound judgment in this area;

6) Accounting standards should continue to be established to meet the needs of investors;

7) Additional formal measures to address the operation of existing accounting standards in practice should be established; and

8) There is a need to simplify the accounting for investments in financial assets.

Chairman’s interview: SEC Chairman Christopher Cox defended the actions of the SEC during the current market crisis in comments made during a recent interview (available here, registration required). Mr. Cox stressed that the restrained approach taken by the agency to the financial crisis has been the correct one. Two other key points during the interview:

• His biggest mistake during his tenure, Mr. Cox noted, was imposing the short sale ban earlier this year. He took that action at the request of Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke.

• Mr. Cox reiterated his earlier comments that he is not responsible for the failure to detect the alleged fraudulent scheme of Bernard Madoff.

At the same time, Mr. Cox noted that enforcement has been effective under his tenure claiming that the agency has been a strong cop on the beat.

The Madoff scandal

Investigators continued to focus on trying to unwind the actions surrounding the alleged $50 billion Ponzi scheme of Bernard Madoff. On New Year’s Eve Mr. Madoff filed an accounting in the SEC’s civil action against him. That accounting, produced under the terms of a consent decree entered in the SEC’s case, is supposed to identify all of the assets Mr. Madoff and his entities controlled. Many of those assets are offshore, according to some reports. If the report is complete, it should provide SEC investigators with significant insights into the workings of investment fund managed by Mr. Madoff. Eventually it may aid investors with trying to recover at least part of their losses.

Suits also continued to be filed by investors. Some of these actions are investor suits filed against the so-called “feeder funds.” Those are the investment funds which channeled huge sums of money to Mr. Madoff. One suit, which probably reflects investor frustrations more than legal merit, was brought against the SEC.

Additional investors suffering huge losses also continue to appear. According to some reports, an Australian bank will have to be bailed out by the government of that country as a result of its losses.

Congress is now set to look into the Madoff matter. Next week, a House committee is scheduling hearings and the SEC inspector general is set to testify. The inspector general is currently conducting an internal investigation to determine why the agency did not discover the alleged fraud sooner.

Private actions

A class action fraud suit was filed which names, among others, Mary Schapiro, the nominee to be the next SEC Chairwoman. The suit claims misrepresentations were made by the defendants about payments made to NASD Members to induce them to vote in favor of the transactions between the NASD and the New York Stock Exchange Group, Inc. which created FINRA. Benchmark Financial Services, Inc. v. Financial Industry Regulatory Authority, Inc., Case No. 1:08-cv-11193 (S.D.N.Y. Filed Dec. 23, 2008).

Studies

Securities fraud prosecutions down: A new study by Syracuse University using Department of Justice data shows that there has been a significant decline in the number of securities fraud cases brought during the first eleven months of this fiscal year. According to the study, there were 133 prosecutions for securities fraud during that time period. In contrast in 2000 there were 437 securities fraud cases. The highest number of securities fraud cases was 513 in 2002.

At the SEC prosecutions for securities fraud dropped from 69 in 2000 to just 9 in 2007, a decline of 87% according to the study.

No impact from short sale restrictions: A study of the impact of the emergency short sale rules imposed by the SEC and other regulators around the world has concluded that the restrictions did not change the behavior of stock returns. Specifically, the study concluded that the short selling restraints did not have any detrimental impact in terms of reduced efficiency of pricing. The study was done by professors at London’s Cass Business School.

A Brief Look At 2008

On this last day of the year it is appropriate to take a look back at some of the events and cases which shaped this year in securities litigation. A more comprehensive analysis of the year will be the subject of an occasional series early next year. For now however, here is a brief look at some events and cases of note from this year in chronological order by topic.

The market crisis

The market crisis has dominated most of the news for the year. Events related to that crisis have taken center stage. Perhaps none is larger than the Madoff cases and the revelation that former NASD chairman Bernard Madoff has conducted a years’ long Ponzi scheme which may be the largest in history, involving as much as $50 billion. The impact of this on the markets and investors around the world is just beginning to be understood. The effect on the SEC, whose Chairman took the unusual step of blaming the staff while forgetting Harry Truman’s adage that “the buck stops here” (i.e., at the top), is yet to be seen. Next month however, a U.S. House committee will begin hearings.

Naked shorts: The SEC issued a temporary rule essentially banning naked short selling in view of the market turmoil and concerns about possible bear raids. The controversial rule has now expired. Other regulators, such as those in the U.K., instituted similar bans which are still in effect.

ARS settlements: The SEC, in conjunction with the New York Attorney General’s office and other state regulators, settled with Citigroup, Merrill Lynch and number of other major participants in the auction rate securities markets. The settlements call for the firms to repurchase the auction rate securities of essentially small investors. Large market participants are offered little under the terms of the various agreements other an undertaking by the firms to use their best efforts to bring liquidity to the collapsed ARS market.

Fair value accounting: On December 30, 2008, the SEC delivered a report to Congress mandated by the Emergency Economic Stabilization Act of 2008 on fair value accounting, viewed by many as a culprit of the market collapse. The report recommends against a suspension of fair value accounting.

The future: Next year, Congress will undoubtedly hold hearings on the market crisis and the adequacy of current regulation. Those hearings hold the promise of significantly reshaping the laws and agencies that currently regulate the markets to try and avoid a repetition of the current crisis.

Policy initiatives

Two key policy initiatives this past year are the SEC’s publication of its Enforcement Manual and DOJ’s most recent revision of its cooperation standards.

The Enforcement Manual: For the first time, the SEC published a Enforcement Manual which details many, but not all, of the internal policies and procedures followed by the Enforcement Division when conducting an investigation. The Manual adds transparency to the work of the Division.

The Filip chapter: Under threat by Congress to pass the Attorney Client Protection Act, the Department again revised its cooperation policies. This revision, adding as a new chapter to the U.S. Attorney’s Manual, bars prosecutors from requesting privilege waivers. It also suggests that companies use non-lawyers to conduct internal investigations so that the facts can be furnished to the government without a privilege waiver.

Select SEC cases

SEC v. Lyon, Civil Action No. 06 CV 14338 (S.D.N.Y. Filed Dec. 12, 2006), is one of three litigated hedge fund cases where the court rejected the Commission’s Section 5 claim based on covering short sales made in connection with a PIPE offering.
SEC v. Wong, Civil Action No. 07 Civ. 3628 (S.D.N.Y. Filed May 8, 2007) is a case in which a rapidly filed insider trading complaint based on the News Corp/Dow Jones merger lead to an asset freeze and later a significant settlement involving a director of New Corp.

SEC v. Talbot, Case No. 06-55561 (9th Cir. June 30, 2008) is a significant victory in the Circuit Court for the SEC. Here, the appellate court reversed the dismissal of an insider trading complaint, where a director of a company which owned 10% of another traded on non-public information about a potential acquisition of the 10% owned company.

SEC v. Kohavi, Case No. 08-43-48 (N.D. Cal Sept. 17, 2008) is a settled enforcement action based on allegations of option backdating at Mercury Interactive. The case is significant because the three defendants were former outside directors of the company.

SEC v. UnitedHealth Group, Inc., Case No. 08-CV-6455 (D. Minn. Filed Dec. 22, 2008), is a settled option backdating case which is noteworthy for its discussion of cooperation in the SEC’s release.

Criminal cases

U.S. v. Nacchio, No. 7-1311 (10th Cir. March 17, 2008) in which the Circuit Court reversed the insider trading and securities fraud conviction of former Quest CEO Joseph Nacchio. The court subsequently reheard the case en banc. A decision is pending.

U.S. v. Dreier, 1:08-mj-02676 (S.D.N.Y. Filed Dec. 4, 2008) and SEC v. Dreier, Civil Action No. 08-Civ. 10617 (S.D.N.Y. Filed Dec. 8, 2008), are perhaps the most unusual cases of the year. Here, an attorney is charged with implementing a scheme in which he sold phony promissory notes of a former client to hedge funds in an elaborate charade.

Parallel proceedings

In U.S. v. Stringer, No. 06-30100 (April 4, 2008), the Ninth Circuit Court of Appeals reversed the dismissal of a criminal case where the SEC essentially acted at the behest of the U.S. Attorney’s Office. The SEC concealed the criminal investigation while collecting evidence for the USAO. The court found the warnings in SEC Form 1662 adequate.

FCPA

In the Mater of Faro Technologies, Inc., Adm. File No. 3-13059 (June 5 2008) is a settled administrative proceeding in which the Commission charged FCPA violations based on the conduct of an employee in a Chinese subsidiary who, contrary to instructions from superiors, paid bribes. A related DOJ case was settled with a non-prosecution agreement, a fine and the appointment of a monitor.

U.S. v. Siemens Aktiengesellschaft, Case No. 08-367 (D.D.C. Filed Dec. 15, 2008) (and related cases) in which Siemens and its subsidiaries agreed to a $1.6 billion payment of disgorgement and penalties to settle an FCPA case. This is the largest FCPA settlement of all time.

Private litigation

In Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., Case No. 06-43 (Jan. 15, 2008), the Court rejected an SEC created theory of scheme liability which plaintiff invoked in a suit against third party vendors who allegedly helped the issuer cook the books.

The significant impact of the Supreme Court’s decision in Tellabs v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007) continues to evolve as evidenced by the following circuit court cases upholding the dismissal of complaints for failing to meet the Tellabs pleading requirements:

• Bucks County Retirement Board v. Home Depot, Inc., Case No. 07-13810 (11th Cir. Oct. 8, 2008);

• Elam v. Neidoff, Case No. 07-2833 (8th Cir. Oct. 16, 2008); and

• Cozzarelli v. Inspire Pharmaceuticals, Inc., Case No. 07-1851 (4th Cir. Dec. 12, 2008).

But see Frank v. Dana Corp., No. 07-235 (6th Cir. Decided Nov. 19, 2008) where the circuit court concluded that Tellabs actually reduced the pleading burden on plaintiffs. This ruling is consistent with those in the First and Ninth Circuits.

Morrison v. National Australia Bank, Ltd., Case No. 07-0583-cv (2nd Cir. Oct. 23, 2008) is the circuit’s first “foreign cubed” decision in which it affirmed the dismissal on jurisdictional grounds of a securities fraud complaint.