This Week In Securities Litigation: Option Backdating, Insider Trading and Self Dealing

This week the SEC continued to reduce its inventory of option backdating cases, filing one which raises questions about prosecution standards and notifying another company that it was closing the investigation. At the same time the SEC continued its war on insider trading and brought a self –dealing case against a corporate manger.

Options Backdating

SEC v. Tullos, Civil Action No. SACV 08-242 AG (C.D. Calif. Filed March 4, 2008) is the SEC’s latest stock option backdating case. There, the Commission brought an action against Nancy M. Tullos, the former vice president of human resources of Broadcom Corporation. According to the Commission’s complaint, Ms. Tullos participated in a scheme from 1998 to 2003 to backdate options at Broadcom. As part of the scheme grants were backdated to the low closing price for the company’s stock. Ms. Tullos communicated false grant dates within the company, provided spreadsheets of stock option allocations for the backdated grants to the finance and shareholder services departments knowing that they would use the information to prepare Broadcom’s books and records and periodic filings with the SEC and personally profited.

To settle the case, Ms. Tullos consented to the entry of a statutory injunction prohibiting future violations of Section 17(a)(3) of the Securities Act of 1933, as well as Section 13(b)(5) of the Securities Exchange Act of 1934 and the pertinent rules there under. In addition, Ms. Tullos consented to the entry of an order which required her to pay over $1.3 million in disgorgement and prejudgment interest to be offset by the value of her exercisable stock options which were cancelled and the payment of a $100,000 civil penalty.

This case, like the SEC’s case last year against former Maxim Integrated Products CEO and Chairman, John F. Gifford, raises questions about the prosecution standards used in option backdating cases. In contrast to many option backdating cases Tullos and Gifford are based on negligence, not intentional fraudulent conduct.

In contrast, on the same date Tullos was announced, semiconductor developer Circus Logis, Inc disclosed that the SEC had ended its investigation of the company regarding backdated stock options. Following notification of an informal inquiry by the SEC into its options issuances practices, Circus Logis undertook an internal investigation. Based on that inquiry the company concluded that the accounting measurement dates for some options granted between January 1, 1997 and December 31, 2005 differed from the recorded measurement dates. As a consequence the company restated its financial statements for the fiscal years from 1997 to 2001, adding about $32 million in compensation expenses. This resulted, according to the investigative findings of the company, because it had “limited controls” and it did not have a “definitive processes for stock option granting and approval,” all of which permitted the use of “hindsight” to select grant dates for options. Private actions have been filed against the company as a result of its disclosures.

Insider trading

In SEC v. Beahm, Civil Action No. 08 CV 02209 (S.D.N.Y. Filed March 5, 2008) the SEC again demonstrated that it is not the amount in question but the conduct. In this settled civil injunctive action the SEC alleged that Mr. Beahm, a consultant for Church and Dwight, Inc., traded in advance of the acquisition of Del Labs by Kelso & Co. and Church and Dwight. This trading yielded $2,928.84 in illegal profits. Mr. Beahm also tipped his friend James P. Crilly who traded. Mr. Crilly’s trading was more profitable, yielding $11,388 in illegal profits.

Both men agreed to settle with the SEC consenting to statutory injunctions prohibiting future violations of Section 10(b). In addition, Mr. Beahm consented to the entry of an order which requires him to disgorge his profits and the pre-judgment interest as well as those of Mr. Crilly (along with the prejudgment interest) and to the payment of a civil fine equal to his disgorgement payment. Mr. Crilly consented to the entry of an order also requiring him to disgorge his trading profits, prejudgment interest and to pay a civil fine equal to the amount of his disgorgement payment.

In SEC v. Manne, Civil Action No. 08-CV-1068 (E.D. Pa. Filed March 4, 2008) the Commission alleged that Stanley Manne traded on inside information in the securities of Valley Forge Scientific, Inc. Specifically, the SEC’s complaint alleges that Mr. Manne learned about the possibility of a merger between Valley Forge and Synergetics when the chief operating officer of Valley Forge asked his long time friend Stanley Manne to become a company director. In that conversation the chief operating officer “told Manne that Valley Forge was involved in discussions with several potential sale or merger partners, including Synergetics, and that, as a director, Manne would be involved in these matters. The Chief Operating Officer told Manne that this information was confidential and that he could not trade on the information, and Manne agreed” according to the complaint.

According to the complaint, Mr. Manne misappropriated the information given to him and executed 45 trades in Valley Forge common stock and purchasing a total of 105,680 shares. The complaint alleges that Mr. Mane traded in Valley Forge securities on the basis of material nonpublic information in breach of a duty of trust and confidence to the chief executive officer. Those trades made Mr. Manne $85,601 in alleged illegal trading profits, although he did not immediately sell his shares after the merger announcement according to the complaint. By breaching his pledge to his friend the SEC alleges Mr. Manne violated Section 10(b) and Rule 10b-5.

Mr. Manne settled the action by consenting to a statutory injunction prohibiting future violations of Section 10(b). In addition, he consented to an order requiring him to disgorge the trading profits plus prejudgment interest and to pay a penalty equal to the trading profits.

Executive self-dealing

SEC v. Jenson, Civil Action No. 08-0241 (C.D. Cal. Filed March 5, 2008) is a civil injunctive action brought against the former chief executive and financial officer of Merisel Inc. for self-dealing. The Commission’s complaint alleges that in two instances Mr. Jenson caused Merisel to sell assets to entities he controlled without disclosing his relationship to the buyer substantially below their actual value. Specifically, in one transaction Mr. Jenson is alleged to have caused the company to sell certain software licensing assets and real property to a company he controlled at over $2.6 million below value. In a second he caused a dormant company subsidiary to be sold to an entity he controlled for $1,000 despite the fact that the subsidiary sold held over $952,000 in assets. According to the complaint, Mr. Jenson misrepresented or failed to disclose the related party nature of these transactions in Merisel’s filings and earning press release. This case is in litigation.

The FCPA: The New SEC and DOJ Enforcement Priority – Part V, Recent Court Decisions

Although the FCPA is now thirty years old, there are relatively few court decisions interpreting its provisions. Last year however there were three decisions, one defining a key anti-bribery element while two others construed defenses.

First, in two decisions in the same case the Fifth Circuit Court of Appeals gave an expansive reading to the key anti-bribery element of “obtaining or retaining” business. The indictment alleged that the defendants had bribed Haitian customs officials to accept false documents to understate shipments by about one third to reduce taxes. The district court dismissed the indictment which, as to the “obtain or retain” business element pled only the statutory language. The district court concluded that payments to reduce taxes were not prohibited by the statute.

The Fifth Circuit reversed. U.S. v. Kay, 359 F. 3d 738 (2004)(Kay I). The circuit court reasoned that the FCPA only criminalizes certain payments, essentially those where there is a “quid pro quo.” After an extensive review of the legislative history the court concluded that “Congress intended for the FCPA to apply broadly to payments intended to assist the payor . . . “ in business. While not every bribe to reduce taxes is prohibited and increased profit margins by themselves are insufficient, when tax savings and other facts are coupled with other facts the conduct may come within the meaning of obtaining or retaining business. Accordingly the case was remanded to the district court.
After conviction the case came back to the Fifth Circuit based on claims of a lack of fair notice as to what conduct is prohibited, among others. The Circuit Court again rejected the appeal. 2007 WL 3088140 (5th Cir. Oct. 24, 2007)(Kay II). On the key question of obtaining/retaining business the court held that “Paying taxes and customs duties is inherent to foreign business, and decreasing these payments through bribery, as defendants have admitted, was common practice in Haiti. If bribery to obtain favorable tax and customs obligations was as common as established in the record, then it is reasonable to imply that businesses viewed these practices as one of the only guarantees of maintaining a successful business in Haiti in the 1990’s. It is not therefore a novel application of the law for the district court to find that defendants made these payments for the purpose of ‘retaining business.’”

The expansive view of the Fifth Circuit appears to be shared by the SEC. See, e.g., In the Matter of Bristow Group, Inc., Admin. Proc. File No. 3-12833, SEC Release 56533 (Sept. 26, 2007)(Settled administrative proceeding where the Order alleged the Bristol Group made improper payments to Nigerian state government officials in return for a reduction in employment taxes. Respondent consented to a cease and desist order as to the anti-bribery, books and records and internal control provisions).

A second decision last year involved the statute of limitations defense. In U.S. v. Kozeny, the defendants were indicted for engaging in a scheme to bribe officials in Azerbaijan to ensure that the state-owned oil company would be privatized so they could share in the profits from the transaction.
DOJ had sought assistance from two foreign governments in gathering evidence. After the five year limitation period expired the department obtained an order under 18 U.S.C. Section 3292 extending the limitation period.

The district court dismissed the indictment as time barred. In making this ruling the court held that the general five-year limitation period applies to FCPA cases. In seeking to extend that period under Section 3292 the court concluded that the time of the order, not the request is key. Since the order followed the expiration of the time period the claims were time barred. 493 F. Supp. 2d 518 (S.D.N.Y. 2007). Subsequently, on reconsideration the court reinstated three counts where it appeared that there may have been conduct within the limitation period. 493 F. Supp. 2d 693 (S.D.N.Y. 2007). Kozeny is currently pending before the Second Circuit on appeal by the government.

Finally, U.S. v. Griffen, 473 F. 3d 30 (2nd Cir. 2007) concerns the public authority defense. In this case the Second Circuit Court of Appeals dismissed a government appeal from what it claimed was the denial of a motion in limine in and FCPA case where the defendant appeared to be raising a public authority defense.

Although the Court held it had no jurisdiction to hear the case, it made certain “observations” about the defense. In what is essentially an advisory opinion the court noted that the “public authority” defense has two branches, actual authority and one based on estoppel.
The actual authority branch “exists where a defendant has in fact been authorized by the government to engage in what would otherwise be illegal activity.” A proffer must disclose facts establishing actual or apparent authority.

In contrast the entrapment by estoppel branch of the defense “can be established without the defendant having received actual authorization. It depends on the proposition that the government is barred from prosecuting a person for his criminal conduct when the defendant, by its own actions, induced him to do those acts and led him to rely reasonably on his belief that his actions would be lawful by reason of the government’s seeming authorization.” Again specific facts must be presented in a proffer.

Finally, the court noted that a related doctrine of negation of intent is not an affirmative defense. Rather, it is an attempt to negate the government’s proof of intent, demonstrating that the defendant acted in good faith. Only the Eleventh Circuit has adopted this position. While the court indicated it had great difficulty with this theory, it “assumed” that there are some circumstances where it might apply.

Next: A year of record fines