SEC Injunctions: When Is This Extraordinary Remedy Necessary?

Injunctions are extraordinary remedies, invoking the equitable power of the courts to prevent future violations of the law in SEC cases. The Commission, at times, uses them to halt claimed fraudulent conduct. In its recent campaign against insider trading for example, it has brought several actions within days of the corporate announcement which triggered the claimed insider trading — typically a merger — and obtained emergency injunctive relief to halt the dissipation of the claimed illegal trading profits. Typical of these cases is SEC v. De Colli, filed in May 2008 and discussed here. There, the Commission brought the action and won an asset freeze order within days of the announcement of the corporate transaction involved in the Wall Street Journal and after interviewing Mr. De Colli, an Italian national residing in Italy. No doubt, injunctive relief was necessary and appropriate.

Financial fraud cases are a different story. All too often, the conduct is these cases is years and years old, not infrequently dating to last century or the very early years of this one. By the time of the SEC’s case, frequently a restatement giving anyone who cares to look a road map to the fraud has been on file for years and the executives involved are gone. SEC v. El Paso, filed earlier this year and discussed here, is not untypical. In that financial fraud case, the books were cooked between 1999 and 2003. The company restated is financial statements in 2004. Four years after that restatement, five years after the fraud ended and nine years after it began, the SEC filed a settled civil case with an injunction. Just why this case took so long to investigate and resolve and, even more importantly, the reason an injunction was necessary, is something of a mystery.

Now consider SEC v. Crowley, Civil Action No. 08-cv-1388 (S.D. Cal. Filed Aug. 1, 2008) and SEC v. Burdick, Civil Action No. 08-cv-1390 (S.D. Cal. Filed Aug. 1, 2008). Both of these cases are based on a financial fraud at SeraCare Life Sciences, Inc. a supplier and manufacture of biological product for the biotechnology and pharmaceutical industry. Defendant Michael Crowley was the former chief executive officer of the company. Defendant Jerry Burdick was a member of the board and the interim chief financial officer.

The complaints allege that Mr. Crowley failed to disclose in a Form 10Q and an earnings release that the day before the earnings call the company learned that a bill and hold sale representing about 11% of the company’s pretax quarterly income had been cancelled. Nevertheless, Mr. Crowley subsequently executed the SOX certification covering the incorrect earnings.

Mr. Burdick, according to the complaint, improperly released reserves in two quarters. As a result, the quarterly earnings were improperly inflated by 20% in one quarter and 17% in another.

Both men settled the actions, consenting to the payment of financial penalties and Section 17(a)(2)&(3) and books and records injunctions. Mr. Burdick also agreed to a Rule 102(e) one-year suspension from practice before the Commission. Neither was barred from being an officer and director.

Now what is perhaps most interesting about these cases is the fact that the conduct involved occurred in 2005 — only three years ago. And, there was no restatement to give the Commission a roadmap to the improper accounting as in so many cases. Of course, by the time of the action both men were gone and the company had moved from the west coast in Oceanside, California to Milford, Massachusetts. Nevertheless, three years is far quicker than in many financial fraud cases — but one still has to wonder if an injunction was really necessary under the circumstances, particularly one based on negligent conduct.

This Week In Securities Litigation (August 1, 2008)

This week, SEC Chairman Cox adopted a new, aggressive stance regarding the prospect of rewriting regulatory authority in the wake of the current market crisis, arguing that the SEC should be given jurisdiction over investment banks. In addition to the SEC settlement with the former Refco chairman who is appealing his sixteen-year prison sentence, litigation was dominated by insider trading cases: the new hearing ordered in the Nacchio appeal by the Tenth Circuit, three new SEC insider trading cases and yet another criminal insider trading case by the U.K.’s FSA, this time a “pillow talk” case.

The market crisis

As the market crisis continues to unfold there have been repeated calls for reform, beginning perhaps with Treasury Secretary Paulson’s plan several weeks ago. Now, SEC Chairman Cox, who many have accused of being lackluster during the crisis, has weighed in with a proposed new role for the SEC: the regulator over investment banks.

In testimony before the House Committee on Financial Services, the SEC Chairman sketched the history of regulation in the financial services area noting the different approaches used for banks and brokers and highlighting the Commission’s efforts to bridge the gap, while noting that Congress should not adopt regulation that crushes investment banks. Rather, the SEC should be given authority over them. This appears to be a new and more aggressive approach for Chairman Cox. Testimony by Chairman Christopher Cox Concerning Reform of the Financial Regulatory System (July 24, 2008).

The Nacchio insider trading case

Earlier this year, the Tenth Circuit Court of Appeals reversed the insider trading conviction of former Quest Communications CEO Joseph P. Nacchio. U.S. v. Nacchio, Case No. 07-1311 (10th Cir. March 17, 2008) (discussed here). Now the court has granted the government’s petition for a rehearing.

In March, the Court reversed Mr. Nacchio’s conviction in a 2-1 decision. The decision turned on the conclusion of the appeals court that a key defense expert witness was improperly precluded from testifying by the district court. The erroneous ruling was based on the district court’s incorrect conclusions about the amount of disclosure required regarding an expert witness under Federal Criminal Rule 16. Although the defense had disclosed the vitae of the witness and the areas of possible testimony, the district court, without any hearing, concluded that disclosure should have been made of the witness’ methodology. The Tenth Circuit reversed, concluding that the district court had improperly confused the dictates of Criminal Rule 16 and that of the Civil Rules regarding expert disclosure.

Now the Tenth Circuit wants four questions addressed:

1) Did the defense have sufficient notice that it was required to present the methodology or request a hearing?
2) Did Nacchio have adequate opportunity to present the methodology or request a hearing?
3) Was the burden to request a hearing Nacchio’s?
4) Did Jude Nottingham abuse his discretion and, if so, would a new trial be the appropriate remedy or could a new evidentiary hearing be held?

Mr. Nacchio remains free on bond.

Refco

Phillip R. Bennett, the former CEO of the company, settled with the SEC this week. The Commission’ complaint was based on the collapse of Refco and Mr. Bennett’s role in concealing the millions of dollars in losses the company had suffered. SEC v. Bennett, 08-cv-1631 (S.D.N.Y. Filed Feb. 19, 2008).

The settlement was somewhat anti-climactic in the wake of the sixteen-year sentence given to Mr. Bennett after he pled guilty to all twenty counts of the indictment returned against him. To settle with the SEC, Mr. Bennett consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions and the entry of an order in a related administrative proceeding which bars him from associating with any broker, dealer, or investment advisor. Mr. Bennett is appealing the sentence in his criminal case.

Insider trading

The SEC filed three insider trading cases last week. The first is based in part on the merger between DRS Technologies, Inc and Finmeccanica S.p.A. Prior to an announcement of discussions between the two companies, one or more unknown traders purchased 1,820 DRS options which, following a Wall Street Journal article discussing the talks, yielded the trader a $1.6 million profit. The same trader also made about $343,000 by trading in the call options of American Power prior the announcement in 2006 that the company would be acquired by Schneider Electric SA. SEC v. One or More Unknown Purchasers of the Call Options for the Common Stock of DRS Technologies, Inc., Civil Action No. 08-cv-6609 (S.D.N.Y. Filed July 25, 2008). The SEC obtained a freeze order over the assets in a UBS AG account used to place the trades.

The two other insider trading cases were settled at the time of filing. In SEC v. Pai, Civil Action No. H-08-2338 (S.D. Tex. Filed July 29, 2008), the Commission filed a settled insider trading case against the former Chairman and Chief Executive Officer of Enron Financial Services. Mr. Pai sold over 338,000 shares of Enron and exercised and sold over 572,000 options when he learned negative information about the company after leaving. The action was settled with the entry of a permanent injunction prohibiting future violations of the antifraud provisions and Mr. Pai’s agreement to the entry of an order requiring him to pay over $30 million is disgorgement, about $11.5 million in prejudgment interest and a $1.5 million penalty.

SEC v. Simchuk, Civil Action No. 08-cv-5728 (S.D.N.Y. July 29, 200) is another settled insider trading case. This action was brought against George Simchuk, the former General Director of Glamis de Mexico, a subsidiary of Glamis Gold, Inc. Mr. Simchuk, a member of the due diligence team for the acquisition of Western Silver, Inc., traded in advance of the deal announcement. He resolved the action by consenting to an antifraud injunction and an order requiring him to pay disgorgement of over $58,000, prejudgment interest of over $10,000 and a civil penalty equal to the disgorgement.

Finally, the U.K. Financial Services Board continued its campaign against insider trading, bringing its third criminal insider trading case (the first and second cases are discussed here). Taking a page for the SEC, the FSA filed a “pillow talk” insider trading case (discussed here as to the SEC) against Matthew and Neel Uberoi. According to the FSA, the couple placed 11 separate trades in May and June 2006 on inside information prior to the announcement that NeuTec Pharma Plc was going to be acquired. Earlier the couple had placed six separate trades on inside information that Gulf Keystone Petroleum Ltd. was going to expand and enter into a partnership with a major oil and gas company. Those trades were placed in August 2006. The case is pending.