This Week In Securities Litigation (July 25, 2008)

This week in securities litigation, the Second Circuit Court of Appeals handed down a significant decision in a criminal securities case against an exchange specialist discussing the requirement of deception under Section 10b. The SEC brought a settled financial fraud case in which the former CFO defendant concealed his fraudulent conduct while leaving a trail of notes behind seemingly asking to get caught. Notably, in settling the case, the former CFO agreed in part to be barred from practice before the SEC, despite the fact that he is not a professional.

This week, the options backdating scandal also continued to unfold with a guilty plea in one case and a civil settlement in another. At the same time, foreign regulators continued to pursue insider trading, with the first criminal conviction for insider trading in Hong Kong and the first criminal insider trading case against a financial services professional in the U.S.

Deception

In U.S. v. Finnerty, Docket No. 07-1104-cr (July 18, 2008), the Second Circuit handed down a significant decision on the requirement of deception under Section 10(b) discussed here. The Circuit Court affirmed the ruling of the district court granting a post trial motion for acquittal following a jury verdict of guilty. The defendant, a New York Stock Exchange specialist, was charged with securities fraud in violation of Exchange Act Section 10(b) for “interpositioning or engaging in arbitrage of the gap between customer orders to buy and sell shares.”

To establish a violation of Section 10(b) and Rule 10b-5, the government must prove the use of any “manipulative or deceptive device or contrivance.” Citing the Supreme Court’s decision last term in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 128 S. Ct. 761 (2008) (discussed here), the Court concluded that conduct can violate the Section, even absent a specific oral or written statement. However, there must be some act which gives the victim a false impression.

Here, the government failed to identify any way in which defendant Finnerty communicated “anything to his customers, let alone anything false.” In reaching its conclusion, the Court rejected claims by the government that Mr. Finnerty violated Section 10(b) because he may have violated NYSE Rules on which some members of the public may have relied. Even if the public relied on these rules, the Circuit Court concluded that did not constitute reliance on a statement of Mr. Finnerty. While Mr. Finnerty’s conduct may have been unfair, the Circuit Court noted that “‘not every instance of financial unfairness constitutes fraudulent activity under Section 10(b)’” quoting Chiarella v. United States, 445 U.S. 222, 232 (1980).

Financial Fraud

In SEC v. Hirth, Case No. 08CV 13 13139 (E.D. Mich. Filed July 22, 2008), the SEC filed a settled financial fraud case in which former division CFO of ProQuest Company was alleged to have participated in a years long financial fraud which he took steps to cover up while leaving handwritten notes evidencing his guilt (discussed here). In Hirth, Scott Hirth, a former division CFO for the company, entered a series of manual entries just prior to the closing of accounting periods from 2001 to 2005. As a result, the company overstated pre-tax income by over $129 million. To ensure that he was not caught, he took steps to cover up the fraudulent entries, including manipulating the computer programs to conceal his entries.

Apparently Mr. Hirth’s desire to evade detection was not as strong as his inclination to get caught. He left behind a series of handwritten notes commenting on his fraudulent activities and suggesting possible explanations he could give when caught. The explanations did not work. To settle the action, Mr. Hirth consented to the entry of a fraud and books and records injunction, the payment of portions of his salary as disgorgement and a fine. In an unusual entry, Mr. Hirth also consented to be barred from practice before the Commission, a remedy usually reserved for professionals who practice before the SEC. The company, also named as a defendant, consented to the entry of an injunction prohibiting violations of the books, records and internal control provisions.

Option backdating

Last week, the former CEO of Engineered Support, Michael Shanahan Sr. pled guilty in a criminal option backdating case. U.S v. Lerhardt, Case No. 4:07-cr-00175 (E.D. Mo.). Mr. Shanahan had been charged in a multiple count indictment based on claims that he, his son Michael Shanahan Jr., a former board and compensation committee member, Gary Lerhardt, former CFO and Steven Landmann, former controller of the company, engaged in a scheme to backdate options at the company. According to the indictment, the trio backdated millions of dollars with of options. Mr. Shanahan Sr. is claimed to have made a personal profit of $8.9 million.

Mr. Shanahan Sr. agreed to plead guilty to one count of the indictment, alleging that he prepared false documents in connection with the scheme. In return, the remaining counts in the indictment were dismissed and the government agreed not to prosecute his son. Previously Mr. Landmann pled guilty. Mr. Gerhardt is set to begin trial on the charges against him in September. See media coverage regarding the case here.

The SEC also brought actions involving these individuals. SEC v. Shanahan, Sr., Case No. 407-CV-1262 (E. D. Mo. July 12, 2007); SEC v. Landmann, Civil Action No. 4:07-CV-270 (E.D. No. Feb. 6, 2007) (settled civil injunctive action); SEC v. Lerhardt, Civil Action No. 4:07-CV-271 (E.D. Mo. Feb. 6, 2007).

In SEC v. HCC Insurance Holdings, Inc., Civil Action No. 4:08 CV 2270 (S.D. Tex. Filed July 21, 2008), the Commission filed a settled option backdating case. The action was brought against the company, its former CEO Stephen Way and its former General Counsel Christopher Martin. According to the SEC’s complaint, the defendants backdated option grants between 38 and 58 times from 1997 to 2005.

To resolve the action, the company consented to the entry of a permanent injunction prohibiting future violations of the books and records provisions. Mr. Way consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions and an order requiring him to pay a civil fine of $200,000 and barring him from being an officer or director for fine years. Mr. Martin consented to the entry of a permanent injunction prohibiting future violations of Section 17(a)(2) & (3) and the books and records provisions. He also agreed to the entry of an order requiring him to pay a $50,000 civil penalty and suspending him from practice before the Commission for two years.

Insider trading

The SEC in Hong Kong obtained its first criminal conviction in an insider trading case. The action was brought against Vicky Hung, an employee of a division of Sino Golf Holdings Ltd. Ms. Hung is alleged to have sold 180,000 shares of the company prior to the announcement of negative news and thereby avoiding a loss. The defendant pled guilty and received a suspended six month sentence and was ordered to pay a fine of HK $200,000. (See Wall Street Journal Article here, registration required).

In the U.K., the FSA brought its first criminal insider trading case against a financial services employee and its second criminal insider trading case. A twelve-count indictment was brought against a former stockbroker, Malcolm Calvert. Mr. Calvert is alleged to have traded in the shares of six different companies based on inside information from 2003 to 2005. The case is pending.

An Act To Regulate The Use Of Deferred And Non-Prosecution Agreements

An increasing number of criminal investigations involving business organizations are resolved with non-prosecution or deferred prosecution agreements. Consider, for example, the increasing numbers of Foreign Corrupt Practice Act cases. While many of these case end with prosecutions as to individuals, those involving business organizations are frequently resolved with either a non-prosecution or deferred prosecution agreement. The difference between the two types of agreements is significant. At the same time, there is little doubt that from the organization’s prospective, either agreement is preferable to the consequences which can follow from an indictment.

In view of the increasing use of these agreements, legislation has been introduced in the U.S. House of Representatives to regulate the use of the agreements. The proposed legislation, H.R. 6492, titled Accountability in Deferred Prosecution Act of 2008, is being co-sponsored by Representatives Pascrell, Pallone, Sanches and Conyers.

The Act has three key sections. Section 4 requires the Attorney General to issue written guidelines for the use of the two types of agreements to promote uniformity. Accordingly, the guidelines would: define when and why it would be appropriate to enter into a non-prosecution agreement, rather than a deferred prosecution agreement; identify the terms and conditions which should be included in an agreement; identify the circumstances in which an independent monitor is warranted; define the process by which DOJ decides that the organization has successfully satisfied the terms of the agreement; and describe what constitutes cooperation, if any, that might be required under the agreement with respect to on-going criminal prosecutions.

Another section of the Act focuses on judicial oversight. Section 7 would require that the government file each deferred prosecution agreement in the appropriate District Court. The Act specifies that “the court shall approve the agreement if the court determines the agreement is consistent with the guidelines for such agreements and is in the interests of justice.” In addition, the parties to the agreement and any independent monitor would be required to submit quarterly reports to the court.

Finally, Section 8 of the Act would require public disclosure of the terms of the agreement. Each agreement would be available on a public website of the Department of Justice. Overall, the proposed legislation seeks to provide uniformity and add transparency to the use of deferred prosecution agreements and non-prosecution agreements.