Disturbing Questions About the SEC’s Enforcement Program

Earlier this month the SEC lost another key ruling involving short sales, PIPE offerings and hedge funds. Losing a court ruling is not necessarily news worthy. What is significant, however, is that not only did the SEC lose another ruling on its claims that a hedge fund engaged in fraud and the sale of unregistered securities by selling an issuer’s stock short after entering into a PIPE offering, but that for the second time in this series of cases the Court criticized the agency for a lack of candor in arguing its position.

In SEC v. Lyon, Civil Action No. 06 CV 14338 (S.D.N.Y. Filed Dec. 12, 2006), the Commission brought an action against the managing partner and chief investment officer of a group of funds. The action is one of a series of similar cases discussed here.

In Lyon, the complaint alleged that the defendant engaged in an unlawful trading scheme between 2001 through 2004 from which they realized more than $6.5 million in ill-gotten gains by investing in 36 PIPE offerings without incurring market risk. Specifically, the complaint alleged that the defendants entered into PIPE offerings which required them to keep the offering confidential, sold the securities of the issuer short and later covered the short position with the shares from the PIPE after the resale registration statement became effective. Based on these allegations, the SEC alleged insider trading, fraud in connection with the offerings and the sale of unregistered securities.

In a January 2, 2008 Judge Sidney H. Stein in the Southern District of New York granted in part defendants’ motion to dismiss. First, the court declined to dismiss the insider trading claims. Defendants argued that the SEC failed to properly allege a confidential relationship which is the predicate for an insider trading claim. While the SEC pointed to language in the offering documents requiring participants to maintain the confidentiality of the transaction, defendants denied that this provision was in the documents they executed. In refusing to dismiss these claims the court noted that at this stage of the proceeding the SEC’s allegations were sufficient. At the same time, the court made it clear that this issue would be critical later in the case.

Second, the court dismissed with prejudice the SEC’s claims of fraud and sale of unregistered securities. These claims were based on the SEC’s theory that, at the time of the short sale, the defendants effectively sold the shares of the issuer which they would later obtain after the resale registration statement became effective. Since the resale registration statement was not in effect at the time of the short sale, the SEC argued that defendants’ sold unregistered securities. By making the short sale at the time of entering into the transaction, the SEC also argued that defendants falsely represented that they had the requisite investment intent in entering into the private placement portion of the transaction (PIPE transactions are discussed here).

In rejecting the SEC’s argument the court held:

“According to the SEC, the means that an investor uses to close his short position determines what security was actually sold when the short sale was executed. Consider an investor who shorts the common stock of a company and then covers his short position by converting convertible bonds into the common stock owned. Under the SEC’s theory, that investor sold convertible bonds – not common stock – through his short sale. The Court finds this characterization of a short sale inaccurate and not reflective of what occurs in the market. Indeed, the buyer on the other side of that hypothetical short sale received common stock, not convertible bonds. Accordingly, from the Court’s perspective, a short sale of a security constitutes a sale of that security. How an investor subsequently chooses to satisfy the corresponding definite in his trading account [from the short sale] does not alter the nature of the sale.”

The court went on to note that not only was the SEC’s position based on an “inherent logical implausibility,” but it also “does not advance the purposes that animate section 5’s registration requirement.” In making this ruling, the court rejected the SEC’s claim that a series of its administrative releases supported its position, finding that “the SEC quotes selectively – and in the Court’s view misleadingly …” from them.

This is not the first lost on this theory the SEC has suffered. As discussed earlier here, the court in SEC v. Mangan, Civil Action No. 3:06-CV-531 (W.D.N.C. Filed December 28, 2006) made a similar ruling. In that case, as in Lyon the court chastised the SEC for its lack of candor.

What is most disturbing about these cases is not the fact that the SEC lost. To be sure there are inherent difficulties with the legal theory on which the agency is basing its fraud and Section 5 claims in these cases, as Judge Stein pointed out. No doubt the SEC should have carefully evaluated those difficulties before bringing an enforcement action. An enforcement action, as the SEC well knows, should be brought to enforce the law, not try out novel theories. This is particularly true in view of the impact caused by a government accusation of wrongful conduct.

The most disturbing aspect of Lyon however, is that it is the second time in these cases that a court has criticized the SEC for a lack of candor. There simply is no excuse for such conduct by any litigant. This is particularly true of a government agency such as the SEC. The SEC cannot enforce the law by slight of hand. Such tactics compromise not only the SEC’s distinguished reputation, but also undermine its ability to monitor the market place in accord with its statutory duty.

In addition, the repeated use of improper tactics in making the same argument against similar defendants involving similar facts suggests that perhaps something more is at work in these cases than meets the eye. Regardless, it is time that the SEC not only reconsider the legal theory in these cases, but also its tactics. It simply will not due for courts to continually criticize the agency for a lack of candor.

This Week In Securities Litigation: Last Year’s Issues That Will Impact This Year

This is the first week of a new year. A new beginning for all. At the same time, key securities litigation issues linger from last year and will have a significant impact as this year moves forward. These include the prosecution standards which will be used in the on-going options backdating scandal, the renewed global war on insider trading, the increasing number of FCPA investigations and cases, the impact of corporate cooperation standards on officers and directors, and the scope of liability in private civil damages actions which is currently being considered by the Supreme Court.

Option Backdating

While the SEC has worked through about half of its reported inventory of option backdating cases, many issuers, directors, corporate officers and advisors remain under scrutiny. The key question, of course, is the prosecution standards which will be applied in evaluating those under investigation. Those charged to date have typically been directly involved in the claimed securities law violations. The cases have usually been based on intentional conduct. The Reyes case, where former Brocade chairman Gregory Reyes was convicted on multiple counts, is a good example. If this and similar cases are the model for future enforcement efforts (as discussed here), only a relative handful of cases should be expected later this year, with few facing prosecution. If, on the other hand, SEC v. Maxim Integrated Products and its negligence standard (discussed here) is the model for future prosecution, many more should be concerned. The Maxim standard could significantly broaden the prosecutorial net. Backdating cases brought early this year should give an indication of what standards the SEC and DOJ will use.

Insider Trading

Insider trading is another key area of emphasis from last year which will carry forward into this year. Last year, the SEC and DOJ brought a number of ambitious and high profile insider trading cases including those involving the TXU acquisition, the News Corp/Dow Jones deal and the Guttenberg case, which many believe is the most significant insider trading case in years. These and a number of other important insider trading cases discussed in our occasional series which began here, are in litigation and will move forward this year. Many of these cases were brought very quickly, often within days of the event which spurred the alleged insider trading. While insider trading cases are notoriously difficult to prove, these may be even more difficult since the agency did not have time before filing to conduct its usual painstaking investigation. The ability of the SEC to prevail in these cases may have a significant impact on its renewed war on insider trading.

A related issue is the repeated warnings of the Enforcement staff about Rule 10b5-1 plans. While the plans were created to give corporate executives a safe harbor from insider trading charges when selling their stock, statements by the Director of the Division of Enforcement last year (discussed here) have had an unsettling effect. In those statements, Ms. Thomsen cautioned that executive trading under the plans is being scrutinized. That scrutiny could result in enforcement actions later this year.

Foreign Corrupt Practices Act

Another area of renewed emphasis is the FCPA. While this has long been an important enforcement area, last year there was a significant increase in the number of FCPA investigations and actions discussed here. This trend will undoubtedly carry forward into this year, suggesting that all issuers should carefully review their compliance programs.

Cooperation Standards

Corporate cooperation standards in SEC and DOJ investigations were also critical issue in 2008. The Business Roundtable, the ABA and others claimed the standards were creating a “culture of waiver,” stripping issuers of fundamental rights in the name of cooperation. The court in U.S. v. Stein (discussed here) held portions of the DOJ standards unconstitutional. Congress has sought to address these issues in the Attorney Client Protection Act of 2007, which passed the House and is due for consideration by the Senate later this year (discussed here).

While cooperation standards are typically of concern to issuers, directors and corporate executives should, as the year proceeds, carefully monitor developments in this area. Many believe that the recently revised DOJ standards are little different that their predecessor. The SEC has refused to modify its position (discussed here). Yet, in view of these standards, directors and officers caught up in an SEC or DOJ investigation could find themselves without indemnification rights and thus without counsel or with little or no access to corporate materials critical to their representation in an internal investigation or government inquiry. It is questionable at best whether the pending legislation will remedy these difficulties.

Tellabs and Stoneridge and the scope of liability

Finally, another key issue to watch from last year is the scope of liability in private securities damage actions. Last year the number of securities class actions increased. The amount paid in settlements increased (discussed here). Last year, the Supreme Court decided a key case in this area, defining a critical pleading standard for bringing these cases. Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct. 2499 (2007) (discussed here).

This year the Supreme Court will hand down a decision in Stoneridge Investment Partners v. Scientific-America, Inc., defining the scope of liability under antifraud Section 10(b), the key provision on which most securities class actions are based (the development of this case is discussed in an occasional series which began here). The ruling in this case could significantly impact not only who can be held liable but how issuers do business (discussed here). For these reasons, many consider this case to be the most important to come before the high court in years (see discussion here). Regardless of the precise ruling made by the Court, there should be little doubt that the Stoneridge decision, along developments in the option backdating area, insider trading, the FCPA and cooperation standards will have a significant impact on issuers and their directors and executives in 2008.