Yesterday the SEC settled with the former general counsel of Comverse Technology Inc., William Sorin.  Previously, on November 2, 2006 Mr. Sorin plead guilty to a one-count felony information charging conspiracy to commit securities fraud, mail fraud, and wire fraud.  At that hearing, Mr. Sorin admitted conspiring with “Kobi” Alexander, the former Chief Executive Officer, to conceal stock option backdating at Comverse and to approving false proxy statements and SEC filings.  Mr. Sorin told the Judge, “I deeply regret my conduct, I failed as a lawyer and disserved our shareholders.” He will be sentenced on February 23.  According to the U.S. Attorney’s office, the conspiracy charge carries a maximum sentence of five years’ imprisonment and a fine of up to $250,000, or twice the gain or loss from the offense and requires restitution in an amount to be determined by the Court at sentencing, currently estimated at up to $51 million.

According to the SEC release, Mr. Sorin agreed to pay $3 million in civil penalties, disgorgement, and prejudgment interest, and consented to the entry of a permanent injunction, an officer-and-director bar, and an order suspending him from appearing or practicing before the Commission as an attorney. 

The SEC’s complaint alleged that Mr. Sorin created false company records for Comverse and one of its public subsidiaries reflecting compensation committee approvals of stock options that never occurred.  Like the allegations in the Brocade case, here the stock option backdating allegations are coupled with overt acts of concealment. 

Director of the SEC’s Enforcement Division, Linda Chatman Thomsen, took the opportunity to remind the public and the bar that attorneys are not exempt from prosecution, stating, “Today’s settlement signals that the Commission will vigorously pursue those responsible for backdating schemes wherever the investigation may lead, even, as appropriate, into the offices of corporate counsel.” 

No doubt attorneys and others are not exempt nor should they be.  The key question, however, is not whether anyone is exempt but rather the direction the SEC and DOJ will take with the dozens of on-going option investigations.  While the exact number of companies under inquiry is unclear, there is little doubt that a large number of issuers being scrutinized.  To date the cases brought have been clear cut frauds according to the government, involving falsified documents and cover-ups.  The Comverse case and Mr. Sorin’s role in it, for example, are the extreme.  Like the Brocade case, this stock option backdating scheme is not about mere errors, negligence or similar conduct, rather it is about active fraud and concealment.  

Ms. Thomsen’s comments are intended to signal a hard stance on pursuing all of the SEC’s backdating investigations; yet, what does all of this signal for the dozens of other cases under inquiry.  In may of those cases there may be a range of conduct from simple errors to negligence.  What, for example, does this say about the case of Apple and its superstar CEO Steve Jobs?  The Washington Post today reports that although Apple claims that Mr. Jobs did not benefit from the options he helped backdate, in fact he received restricted stock valued at about $650 million.  Given the complexity of the issues in that case, as well as others, it is difficult to project from the sad case of Comverse and Mr. Sorin how the remaining SEC and DOJ inquiries will be resolved.   In the meantime there seems to be no end in sight for the continuing options scandal. 

On Thursday, January 4, 2006, the SEC filed another settled civil injunctive action involving short selling in connection with a PIPE offering. SEC v. Joseph J. Spiegel, Civil Action No. 1:07CV00008 (RCL) (D.D.C.)  Last month the SEC brought and action against Friedman Billings & Ramsey and certain officers of that company alleging violations of the registration provisions of the Securities Act by entering into a contract to purchase securities in a PIPE offering, selling those securities short, and then covering the short position with the shares acquired in the PIPE offering once the resale registration statement became effective.  See blog posting December 22, 2006 “Unique Theory on Sale of Unregistered Securities – Investment Banker’s Short Sales Prior to a PIPE Offering”; see also SEC v. Friedman, Billings, Ramsey & Co., Inc. et. al., Civil Action No. 06-cv-02160; In the Matter of Scott E. Dreyer, Administrative Proceeding File No. 3-12510 

Last week, the SEC brought an action against Joseph Spiegel, former portfolio manager for Spinner Asset Management, LLC, an investment advisor to hedge fund Spinner Global Technology fund, Ltd. (The SEC brought a related action against Spinner on December 20, 2006  Following the pattern set forth in the Friedman Billings case, the SEC’s complaint alleged that the trader and hedge fund entered into contracts to purchase shares in a PIPE offering and then sold those shares short.  The complaint claims this violates Section 5 because the trader and Fund intended to cover the short position with shares acquired in the PIPE offering once the resale registration statement became effective.  The trader and Fund attempted to hide their conduct by engaging in basically wash sales and making false statements in entering into the PIPE agreement.  In that agreement they stated that they were not acquiring the shares for redistribution.  

According to SEC, the key to these transactions is linking the short sale to the shares acquired in the PIPE offering.  The Order for Proceedings naming the Fund states: “Many PIPE investors ‘hedge’ their investment by selling short the PIPE issuer’s securities before the resale registration statement is declared effective.  There is nothing per se illegal about ‘hedging’ a PIPE investment by selling short the issuer’s securities.  Such short sales do not violate the registration provisions of the Securities Act if, among other things, the investor closes out the short position with shares purchased in the open market.  An investor violates Section 5 of the Securities Act, however, when it covers its pre-effective date short position with the actual shares received in the PIPE.  This is because shares used to cover a short sale are deemed to have been sold when the short sale was made.”  Stated differently, the basis for the Section 5 violation is the intent by the short seller at the time of making the short sale to cover with securities acquired later, despite the fact that at the time of the cover transaction the shares were registered.  

The SEC’s position in these cases is particularly interesting in view of its current rules and rule making activity.  Presently Rule 105 under Regulation M prohibits a trader from selling short after the filing of a registration statement but prior the effective date.  Rule 105 is an anti-manipulation rule based on the theory that “by selling the security short with the knowledge that they are very likely to be able to cover their short positions with offering shares that they are allocated, these persons may drive down the price despite their true belief regarding the appropriate price for that security.  The likelihood of being allocated offering shares provides these persons with an advantage over other persons, which they may exploit to the detriment of pricing efficiency.  Not only is this conduct harmful to the market and current security holders, but it can reduce the proceeds the issuer or the selling security holder receives from the securities offering.”  Exchange Act release No. 34-54888 at 7  As that Release makes clear, the SEC has brought a number of enforcement actions based on alleged violations of Rule 105. 

Presently the SEC is soliciting comments on amending Rule 105 to eliminate various schemes used to try and circumvent the Rule.  In the rule making Release, the SEC solicited comments on whether Rule 105 should be amended to cover situations such as the Friedman and Spinner cases:  “Should the Rule [105] address short sales effected during the period following the entry into of a PIPE transactions and before a registration statement for resale of the restricted securities acquired in the PIPE transaction is declared effective, or short sales that are effected at any time in connection with the PIPE transactions?”  Exchange Act release No. 34-54888 at 17  Clearly Rule 105 does not presently prohibit such transactions.  Rather, the current enforcement cases are dependent on the intent of the short trader to cover with shares from the PIPE transaction.  Yet, as the SEC noted in the Order for Proceedings in Spinner, hedging a PIPE investment is a standard practice.  The only difference between the valid PIPE hedge and one which violates Section 5, according to the SEC, is the trader’s intent, linking the hedge to the cover.  Since there is no harm to the market from hedging a PIPE investment and there is an effective registration statement giving the market all material facts about the PIPE shares at the time the short sale is covered, the SEC’s position seems to emphasize form over substance. This circular argument is akin to former President Jimmy Carter’s lust in his heart comment.  [“Christ said, I tell you that anyone who looks on a woman with lust has in his heart already committed adultery. I’ve looked on a lot of women with lust.” Jimmy Carter interview, Playboy, Nov. 1976]