Part XIII: SEC Enforcement Trends And Priorities, 2008

Backdated options has been a key focus of the SEC and its enforcement division since at least late 2005 when academic studies on the subject were first were discussed in a Wall Street Journal article. Additional articles followed in the Journal as well as the New York Times in early 2006 detailing the findings of the studies: executives receiving stock option grants had abnormal returns which at least implied that the grants may have been backdated. While backdating option grants does not violate the law, if the accounting is not done correctly and/or proper disclosure is not made, the practice can adversely impact the financial statements and disclosure of the company and violate the law.

Within months the SEC, DOJ and others were actively investigating backdated options. At one point there were reportedly 140 companies under investigation related to backdated options. Over 200 companies disclosed that they were conducting internal investigations into option granting practices. A scandal had been born.

The initial cases were filed simultaneously by the SEC and DOJ following a joint press conference in San Francisco. SEC v. Reyes, Civil Action No. C-06-4435 (N.D. Cal. July 20, 2006); U.S. v. Reyes, Case No. CR06-556CRB (N.D. Cal). These cases were brought against the former CEO and human resources director of Brocade Communications. Both the SEC’s complaint and the criminal indictments alleged intentional wrong doing. Eventually, former CEO Reyes and former human resources director Jensen would be convicted on criminal charges.

Reyes was followed one month later with SEC and DOJ actions involving option grants at Comverse Technologies. Again, the cases alleged option backdating based on fraudulent, scienter-based conduct. SEC v. Alexander, Case No. 1:06-cv-03844 (E.D.N.Y. Aug. 9, 2006); U.S. v. Alexander, Case No. 1:06-cr-00628 (E.D.N.Y. Sept. 20, 2006). Mr. Alexander, the former CEO of Comverse, is currently a fugitive in Namibia and is fighting extradition.

Subsequent cases are keyed to fraudulent, scienter-based, conduct. Examples of those cases include:

? SEC v. Mercury Interactive, LLC, Case No. 07-2822 (N.D. Cal. May 31, 2007). The complaint named the company, its chairman and CEO, former CEO and former general counsel as defendants. The company settled by consenting to a statutory injunction and agreeing to pay a $28 million civil penalty.

? SEC v. Brocade Communications System, Inc., Case No. 0728-21 (N.D. Cal May 31, 2007). The company settled by consenting to a statutory injunction and agreeing to pay a civil penalty of $7 million.

? SEC v. Heinen, Case No. 07-2214 (N.D. Cal April 24, 2007). The complaint named as defendants the former general counsel of Apple and its former CFO. Mr. Anderson, the former CFO, settled by consenting to a statutory injunction and agreeing to pay $3 million in disgorgement, prejudgment interest and fines.

? SEC v. McGuire, Civil Action No. 07-CV-4779 (D. Min. Dec. 6, 2007). Defendant William W. McGuire, M.D. is the former chairman and CEO of United Healthcare Group. This is the first case to use a SOX Section 304 clawback. Dr. McGuire agreed to settle the action by consenting to a statutory injunction and a 10 year officer/director bar. In addition, he agreed to disgorge over $10 million and to pay prejudgment interest and a civil penalty of $7 million. The SEC announced the settlement as a huge $600 million deal. Most of the relief obtained however, was in the parallel class and derivative suits which settled in conjunction with the SEC suit.

Since 2006 the SEC has brought 24 cases based on backdated options. A number of companies have been given closing letters. A number of companies are still under investigation. The key question regarding those cases is the prosecution standards – will future cases be brought on scienter based conduct or a lesser standard?

Next: Prosecution standards in option backdating cases in the future

The SEC Files One Insider Trading Case And Settles Another

The SEC continues to focus on insider trading. On Monday, a new case was filed against three individuals, while it settled another which has been in litigation since 2005.

First, the SEC filed an insider trading case against Dr. Zachariah P. Zachariah, Dr. Mammen P. Zachariah and Dr. Sheldon Nassberg. According to the complaint, shortly after Dr. Z. P. Zachariah became a director of IVAX, a Florida pharmaceutical company, he learned from the Chairman and former CEO that the company had entered into a tentative agreement with Teva Pharmaceuticals Limited to be acquired. Almost immediately after Z. P. Zachariah received the telephone call from the Chairman, he initiated a series of trades in the stock of the company despite the fact that there was a trading black out period in effect. Later, Z. P. Zachariah tipped his brother, M. P. Zachariah, who also traded. In total, Z. P. Zachariah purchased 35,000 shares of IVAX stock at a cost of $730,000. His brother purchased 2,000 shares at a cost of about $46,000. After the announcement, each defendant sold his shares. Z. P. Zachariah made a profit of about 20% or about $150,000, while his brother, who purchased the day before the announcement, made a profit of about 10% or $4,600.

The complaint claims that, previously Dr. Z. P. Zachariah either traded on or misappropriated inside information about the acquisition of Correctional Services Corporation by GEO Group, Inc. According to the complaint, Z. P. Zachariah purchased about $200,000 of Correctional Services stock during the time the take over was being negotiated. During that period, the complaint claims he had multiple potential sources of inside information: his companies were a consultant to GEO; he was a long time personal friend of GEO’s chairman and chief executive officer; and his son Zachariah P. Zachariah, Jr. (known as Reggie) worked as a financial analyst in GEO’s mergers and acquisitions group and worked extensively on the deal. According to the complaint, Z. P. Zachariah either acquired the inside information or misappropriated it from one of these sources and traded while in possession of it. He also passed the information to his brother Mammen and a friend, Dr. Sheldon Nassberg. In total, the three men purchased more that $390,000 of Correctional stock.

None of the defendants settled. This case is in litigation. SEC v. Zachariah, Civil Action No. 08-60698 (S.D. Fl. May 12, 2008). The Commission’s Litigation Release on the matter is here.

Second, the SEC settled an insider trading case based on the 2004 takeover of Charter One Financial, Inc., by Citizens Bank. SEC v. Tom, Civil Action No. 05-CV-11966 (D. Mass. Filed Sept. 29, 2005). The SEC’s complaint was brought against Global Time Capital Management, LLC, an investment adviser, its portfolio manager and principal, Michael Tom, former Citizens employee Shengnan Wang and her husband Hai Liu and Michael Tom’s brother, David Tom. The U.S. Attorney’s Office filed related criminal charges against Shengnan and her husband.

According to the complaint, Shengnan Wang learned of the potential takeover transaction during final due diligence and tipped her husband, who in turn told Mr. Tom, a former Citizen’s employee who was then running a hedge fund in which her husband had invested. Subsequently, defendant Tom purchased Charter One call options for his personal account and that of the hedge fund. Mr. Tom also purchased Charter One stock in a joint account he managed for his wife and in-laws. Collectively, his trading yielded $743,505 in profits following the announcement. Mr. Tom and Hai Liu also tipped their brothers, David Tom and Zheng Liu, respectively. Both brothers traded in Charter One.

On Monday, the Commission announced that Michael Tom and Global Time Capital Management settled the action by consenting to the entry of statutory injunctions prohibiting future violations of Section 10(b) and Rule 10b-5. In addition, Mr. Tom also agreed to pay disgorgement of over $543,000 plus prejudgment interest of over $107,000 and a civil penalty of $150,000. Global Time Capital agreed to pay a penalty of about $39,000 and relief defendant GTC Growth Fund agreed to pay over $189,000 in disgorgement and prejudgment interest of bout $23,000.

Previously, in June 2006, Shengnan Wang, her husband Hai Liu and his brother Zheng Liu settled. Each defendant consented to the entry of statutory injunctions and the payment of disgorgement, prejudgment interest and civil penalties.