Lessons From A Loss In A Financial Fraud Case

A ruling in a financial fraud case last week should serve as a reminder of the care which must be taken in bringing SEC enforcement actions. Last week, the District Court in SEC v. Goldsworthy, Civil Action No. 06-cv-10012 (D. Mass. Filed Jan. 4, 2006) rejected most of the Commission’s claims brought against former Applix, Inc. CEO Alan Goldsworthy and former CFO Walter T. Higler. The court rejected the SEC’s accusations of intentional fraudulent conduct amounting to “cooking the books,” finding only negligent conduct.

In its complaint, the Commission claimed that Messrs. Goldsworthy and Hilger, along with then-current director of world-wide operations Mark Sullivan, engaged in two separate schemes to inflate the revenue of Applix. The first scheme, according to the Commission, involved the premature recognition of about $890,000 in revenue for the fiscal year ended December 31, 2001. The second concerned improperly reported revenue of about $341,000 for a transaction with a German customer.

The Commission claimed that the defendants violated Section 17(a) of the Securities Act, Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act along with Exchange Act Rules 10b-5, 12b-20, 13a-1, 13a-11, 12a-13 and 13b-2-1. In addition, the complaint claimed that Messrs. Goldsworthy and Higler violated Exchange Act Section 13(b)(5), which prohibits knowing falsification of books and records and Rule 13b2-2, which prohibits officers of a company from lying to auditors.

Based on the findings of a jury made after a four-week trial, the court concluded that the Commission established its claims only as to alleged violations of Section 17(a)(3) and Rule 13b2-1 as to Mr. Hilger. The court concluded that the SEC failed to establish all of the other claimed violations by Messrs. Higler and Goldsworthy. Accordingly, the court imposed a $5,000 penalty on Mr. Higler. No injunction was entered.

The results in this case should serve as a reminder to the care which must be exercised when bringing an enforcement action. The SEC has vast investigative powers. Before it elects to bring an enforcement action, the division typically conducts an extensive inquiry to ascertain the facts. When the division conducts a full investigation there is little excuse for not having the facts to support its claims. Here, it clearly did not.

To be sure, the SEC, like every other litigant, will lose cases. Here, however the SEC suffered what can only be viewed as an almost complete loss. The Commission’s efforts to dress it up in its press release by claiming that it won a fraud finding, while technically true, misses the point. The accusation was intentional fraudulent conduct, not a negligent act meriting only a small fine and no injunction.

It is of little consequence that the company settled in a related administrative proceeding. There, the company consented to the entry of a cease and desist order and agreed to implement certain undertakings it included in its offer of settlement. Those undertakings included retaining an independent financial consultant and implementing the recommendations of that consultant. In the Matter of Applix, Inc., Adm. Proc. File No. 3-12138. But companies often settle with the SEC as a simple matter of pragmatic business judgment.

In the end, the results in this case suggest that the Commission must renew its efforts to carefully consider the facts and applicable legal principles before making an accusation in a complaint or administrative order. The SEC knows well that its power to accuse is all too often the power to convict. That the injury caused to the good name and reputation of persons by its accusations of intentional fraudulent conduct are irreparable and only compounded by the years of litigation it takes to demonstrate that the claim is wrong. In the future, it is essential that the Commission renew its efforts to carefully assess the factual and legal basis for its enforcement actions before bringing an action.

This Week In Securities Litigation (November 14, 2008)

This week, the calls for regulatory reform continued, this time from the Acting Chairman of the CFTC and, again, from the Chairman of the SEC. The Commission dropped a long-running financial fraud case against a former AOL executive while filing another settled financial fraud case. Insider trading cases continued, with two involving former partners of major accounting firms, two SEC enforcement actions centered on a take over and the UK FSA fined a former high ranking British government official and his friend. Finally, the SEC’s San Francisco office cleared out its inventory of option backdating cases, filing a settled action.

Regulatory reform

The on-going market crisis continues to yield calls for regulatory reform. This week Walter Lukken, Acting Chairman of the Commodity Futures Trading Commission made his contribution in a speech to the FIA Futures and Options Expo in Chicago. Mr. Lukken would replace the CFTC and SEC with three new regulators. One would focus on risk, another on market integrity and a third on investor protection. The current roles of the CFTC and SEC would be folded into these new regulators.

Under this plan, the risk regulator would police the financial system for hazards which could have a broad economic impact. The market integrity regulator would focus on the safety of key financial institutions. The investor protection regulator would protect investors and business conduct of all firms. Mr. Lukken labeled this approach regulation by objective, rather than function.

This proposal contrasts with that of Treasury Secretary Paulson and SEC Chairman Cox. Both of their proposals call for the merger of the CFTC and the SEC, no small feat given the different approaches used by the two agencies. In addition, Mr. Cox has repeatedly called on Congress to give the SEC authority over investment bank holding companies – an entity which does not exist at the moment – and credit default swaps. As discussed here, the SEC staff is currently working with market participants on the creation of a centralized trading mechanism for CDSs. At the same time, the Federal Reserve is reportedly seeking control over that market.

SEC Chairman Cox also reiterated his calls for market reform. In a speech before the 40th Annual Securities Regulation Institute in New York on November 12, the Chairman called for the formation of a select committee to study how best to go about m reform. He also highlighted the SEC’s current efforts in this area and called for a strong enforcement program to ensure the integrity of the markets. Earlier, in another speech, Mr. Cox emphasized the increasing internalization of enforcement as discussed here.

While Mr. Cox was calling for stronger enforcement trends from SEC enforcement, statistics compiled by NERA Economic Consulting suggest that the number of cases brought against issuers is declining. At the same time, as discussed here, the dollar value of corporate settlements which are primarily penalties rather than disgorgement are also declining.

Financial fraud cases

The SEC dismissed financial fraud claims against a former AOL executive in a long-running case, while filing another settled financial fraud case. In SEC v. Johnson, Case No. 1:05-cv-00036 (D.D.C. Filed Jan. 10, 2005), the Commission dismissed with prejudice all claims against John Tuli, AOL’s former Vice-President of Business Development for NetScape. According to the complaint, Mr. Tuli participated in a scheme to falsify the books and records of a Las Vegas-based internet company by repeatedly confirming or causing others to confirm to the outside auditors of that company that services had been completed and accepted by AOL. Those audit confirmations were false, according to the complaint.

For Mr. Tuli, the dismissal of the SEC’s claims brings more than three years of litigation to a close. In 2005, he had been acquitted after a three-month jury trial in the Eastern District of Virginia on ten counts of securities fraud in a criminal trial.

In SEC v. Evans, Case No. 07-cv-10027 (D. Mass Filed Jan. 8, 2007), the Commission settled with two defendants regarding their alleged role in a financial fraud at Aspen Technology, Inc., a Cambridge, Massachusetts software company. The SEC’s complaint alleged that Lawrence Evans, founder and Chairman of the company, and David McQuillin, former CEO, participated in a fraudulent scheme to inflate the revenue of the company along with the former CFO. Specifically, the complaint claims that from 1999 to 2002 the defendants caused the company to improperly and prematurely recognize revenue in violation of GAAP to inflate earnings.

To resolve the case, the two defendants consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions. Mr. McQuillin also agreed to an order requiring him to pay an $85,000 penalty and over $28,000 in disgorgement and prejudgment interest. That order also included an officer/director bar. Mr. Evans agreed to pay a $75,000 penalty and over $21,000 in disgorgement and prejudgment interest. Previously, Mr. McQuillin pled guilty in a related criminal case and was sentenced to three years of probation and a $12,000 criminal fine.

The Second Circuit Court of Appeals affirmed the dismissal of a securities class action based on the application of the statute of limitations in a summary order this week. The Court left open the possibility that plaintiffs would amend their complaint since the district court order was not with prejudice. City of Pontiac General Employees’ Retirement System v. Capone, Case No. 07-1117-cv (2nd Cir. Nov. 12, 2008).

The Court’s order affirms a decision by the district court which concluded that the plaintiffs failed to timely file under SOX Section 804 which imposes a two and five year limitation period. The court concluded that plaintiffs had notice of a 1998 financial fraud from a 2002 market report and failed to file suit until years later as discussed here.

The circuit courts have split over the proper test to use when applying the statute of limitations. The Supreme Court is currently considering whether it will hear a case which could resolve that split as discussed here.

Inside trading

In a most unusual insider trading case, accounting giant Deloitte LLP sued its former partner and vice chairman Thomas Flanagan. According to the complaint, the thirty-year veteran of the firm traded on inside information regarding twelve different clients over a three-year period. The complaint, discussed here, does not identify the clients. The SEC reportedly is investigating.

At the same time, a former EY partner had his criminal insider trading case set for trial in April. James Gansman, a former EY partner, is accused of tipping a friend about pending deals involving firm clients, according to the eleven-count indictment. U.S. v. Gansman, Case No. 1:08-cr-00471 (S.D.N.Y. Filed May 27, 2008).

The SEC filed two insider trading cases this week based on the take over of D&K Healthcare Resources, Inc. by McKesson Corporation. One is settled, the other is in litigation. SEC v. Gallahair, Civil Action No. CV 08-5134 (N.D. Cal. Nov. 13, 2008); SEC v. Wilson, Civil Action No. CV08-5133 (N.D. Cal. Nov. 12, 2008). Mr. Gallahair is a former Vice President of Sales at McKesson. Mr. Wilson, who settled with the SEC, is a former senior manager in McKesson’s finance department.

According to the complaints, each defendant misappropriated inside information about the takeover. Mr. Wilson is alleged to have learned about the planned tender offer by overhearing his supervisor’s meetings and phone calls and viewing documents. Subsequently, he purchased over 17,000 shares of D&K in twelve different brokerage accounts belonging to various family members. After the public announcement, Mr. Wilson had unrealized gains of over $117,000. To resolve the case, Mr. Wilson consented to the entry of a permanent injunction and agreed to disgorge his trading profits. The SEC chose not to seek a penalty and waived prejudgment interest claims based on his financial condition.

Mr. Gallahair is also alleged to have learned about the transaction by overhearing a telephone conversation of his supervisor. After hearing the conversation, Mr. Gallahair purchased 20,000 shares of D&K stock which he liquidated after the announcement for a profit of over $120,000. This case is in litigation.

The UK Financial Services Authority fined a former Governor of the Falkland Islands and British ambassador to Peru for insider trading. Richard Ralph, chairman of Monterrico Metals, had a friend trade in the shares of his company while it was engaged in takeover talks in which he participated with Zijin, a Chinese mining company. Mr. Ralph was fined over 117,000 pounds while his friend, who also traded, was fined over 81,000 pounds.

Option backdating

The SEC filed the last of its option backdating cases this week – at least the ones being handled by the San Francisco office. SEC v. Blue Coat Systems, Inc., Case No. CV 08 5127 (N.D. Cal. Nov. 12, 2008). The SEC’s complaint alleges that from 2000 to 2005 the company concealed millions of dollars in compensation expenses associated with option backdating. The complaint names the company and its former CFO, Robert Verheecke, as defendants.

To resolve the case both defendants consented to the entry of injunctions prohibiting future violations of the antifraud, proxy and books and records provisions. In addition, Mr. Verheecke, who is alleged to have personally exercised backdated options for $30,000 in excess profits, agreed to disgorge his profits and prejudgment interest and to pay a penalty of $150,000.