by T. GormanPosted on Posted in SECActions

The Department of Justice, in conjunction with 19 states and the District of Columbia, resolved market crisis era suits in a $1.375 billion settlement. The DOJ suit named as defendants rating agency Standard & Poor’s Financial Services LLC and its parent McGraw-Hill Companies, Inc. The case focused on ratings given to traunches of residential mortgage backed securities or RMBS and collateralized debt obligations or CDS. It centered on a period beginning in 2004 and continuing through the unraveling of the U.S. economy as the securities S&P once rated AAA turned to junk. U.S. v. McGraw-Hill Companies, Inc., Case No. CV 13-00779 (C.D. Cal. Filed Feb. 4, 2013).

The DOJ complaint was based on the Financial Institutions Reform, Recover, and Enforcement Act of 1989 or FIRREA, an S&L era statute designed to protect federally insured institutions. Alleging wire fraud, mail fraud and financial institution fraud, the suit was central on the interests of a number of federally insured institutions ranging from Citibank and Bank of America to the Easter Financial Florida Credit Union, which purchased the RMBS and CDOs based on the lofty ratings given the securities by S&P, one of the nation’s premier rating agencies.

The scheme alleged was straight forward. The complaint detailed an on-going scheme to defraud purchasers of securities by S&P in a series of transactions over years. It involved repeated representations that the firm’s credit ratings of RMBS and CDO traunches were objective, independent, uninfluenced by any conflicts that might compromise S&P’s analytic judgment. In making these assertions the firm knew that its prominent reputation and ratings were critical to the sale of the securities. It knew that the ratings assigned by the firm were relied on by the financial institutions and others who purchased the securities the complaint claimed. It also knew that the assertions were false, the DOJ asserted.

The motive for the scheme was equally straight forward: The firm acted in the interests of the securities sellers who retained it and to maintain and grow its market share and profits, according to the complaint. This is evidenced by the fact that:

· Weakened standards: Beginning in September 2004, and continuing through the period, the firm “limited, adjusted, and delayed updates to the ratings criteria and analytical models . . .” used in formulating its ratings which had the effect of weakening the standards heading into the market crisis.

· Revised criteria to minimize downgrades: In 2006 analysts in RMBS at the firm began noticing rising delinquencies in the mortgages underlying non-prime RMBS that S&P had rated. To deal with the problem new criteria were developed to test their assumptions after which those assumptions with lead to the desired results – fewer downgrades – were selected.

· Ignored increasing risk: Beginning in March 2007 the firm disregarded “the true extent of the credit risks associated with those non-prime RMBS tranches in issuing and/or confirming ratings for CDOs with exposure to those non-prime RMBS tranches . . .” knowing that the ratings did not reflect the actual credit risk of the securities.

· Disregarded announced policies: As the markets continued to deteriorate during the summer of 2007, the firm disregarded policies it announced to reassure the public that the ratings accounted for market conditions. In selected instances S&P worked with issuers on an issue by issue basis to achieve the desired rating.

The complaint demanded civil money penalties in an unspecified amount and other relief. A number of states joined the DOJ in its suit.

S& P vigorously litigated the action. At one point it claimed that the suit was the result of the agency downgrading the credit rating of the United States.

Under the terms of the settlement S&P acknowledged conduct associated with its ratings of RMBS and DCOs during 2004 to 2007 in an agreed statement of facts. The firm also agreed to formally retract its allegation that the U.S. filed the lawsuit in retaliation for the decision regarding the credit rating of the United States. In addition, Standard & Poor’s agreed to comply with the consumer protection statutes of each of the settling states and the District of Columbia and to respond in good faith to any requests for information or material concerning possible violations of those laws.

Under the terms of the settlement half of the sum paid, or $687.5 million, is a penalty that will be paid to the U.S. It is the largest penalty of its type ever paid by a ratings agency. The remaining half of the settlement will be divided among the 19 states and the District of Columbia.

Last month Standard & Poor’s settled three similar, but much more limited, actions with the SEC. In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan., 21, 2015); In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16348 (Jan. 21, 2015); and In the Matter of Standard & Poor’s Ratings Services, Adm. Proc. File No. 3-16346 (Jan. 21, 2015). A related action is being set for hearing. In the Matter of Barbara Duka, Adm. Proc. File No. 3-16349 (Jan. 21, 2015). The three cases are discussed here.

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by T. GormanPosted on Posted in SECActions

Financial fraud is an enforcement priority of the SEC. A financial fraud task force was formed in July 2013 to focus on this traditional staple of enforcement. A data analysis group was formed at the same time to give the task force a new big data type approach under which computers would aid with prospecting for fraudulent financial statements. Some commentators dubbed this Robocop. While the group may be working on approaches to creating Robocop, to date that has not happened. With or without Robocop, the SEC continues to focus on financial fraud actions.

One financial fraud action brought last year is In the Matter of AirTouch Communications, Inc., Adm. Proc. File No. 3-16033 (August 22, 2014). The SEC has now partially settled that action and an Order entered.

The proceeding named as Respondents the firm Hideyuki Kanakubo, its founder and former CEO, and Jerome Kaiser, its former CFO. The shares of AirTouch are quoted on the OTC Pinks. The shares are not registered with the SEC under the Exchange Act. It develops and sells telecommunications equipment designed to integrate mobile phones into landline systems within a consumer’s home.

The scheme alleged in the Order has two facets. The first involved improper revenue recognition. Specifically, in early 2012 the company developed a new product called U250. AirTouch was designed for sale to Mexico’s largest provider of landline telephone services.

In July 2012 AirTouch entered into a contract with a Florida based provider of logistics and fulfillment services regarding the product. Under the arrangement about $1.7 million in U250 product would be held by the Florida entity. That entity would execute a Purchase Order for the equipment. At the same time AirTouch and the Florida firm executed an Agreement under which no product would be delivered, and no payment due, unless and until the Mexican entity actually ordered and paid for the product.

In October 2012 AirTouch’s controller provided the firm’s outside independent accountant with a copy of the Purchase Order from the Florida company. The accountant was not provided with a copy of the related Agreement. Messrs. Kanakubo and Kaiser did not inform the outside accountant or the independent directors on the board about the Agreement when discussing the Purchase Order from the Florida entity. AirTouch did not receive any payment from the Florida company.

On November 14, 2012 the firm voluntarily filed a Form 10-Q for the third quarter of the year. It reported net revenues of $1,031,747, recognizing revenue from the Purchase Order. If that sum had not been recognized, the firm would not have had positive revenue. Recognizing the revenue under the circumstances here, however, was contrary to the firm’s stated revenue recognition policies and GAAP.

In the second part of the scheme, AirTouch used the Purchase Order to secure a $2 million loan from a shareholder. During 2012 Messrs. Kanakubo and Kaiser solicited a short term bridge loan from an AirTouch Shareholder. That Shareholder was told in an October 2012 e-mail about the shipment of product under the Purchase Order to the Florida firm. The Shareholder was also furnished with a copy of the Purchase Order, but not the related Agreement. The firm and Shareholder entered into an agreement under which $2 million was loaned to AirTouch in return for a promissory note and stock options.

Subsequently, Mr. Kanakubo approved a $15,000 bonus to Mr. Kaiser for his work on raising capital. He also awarded himself a bonus in the same amount in connection with unused vacation time.

In January 2013 the AirTouch board of directors initiated an internal investigation regarding the net reported revenues in the Form 10-Q for the third quarter of 2012. At the time Mr. Kaiser furnished the chairman of the audit committee with the Purchase Order but not the related Agreement. When the board of directors finally received the Agreement a restatement of the third quarter was directed. In February 2013 the firm filed a Form 8-K announcing the errors in revenue recognition and stating its intention to file an amended Form 10-Q. That filing has not been made.

The Order alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b).

AirTouch and Mr. Kanakubo consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, for a period of five years Mr. Kanakubo is prohibited from serving as an officer or director of any issuer whose shares are registered pursuant to Section 12 of the Exchange Act or that is required to file reports pursuant to Section 15(d) of that Act. He also agreed to pay a civil money penalty of $50,000 and disgorgement of $15,000 which represents the profits gained on the conduct described, according to the Order. The Order does not provide for the payment of prejudgment interest.

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