Part VI: SEC Enforcement Trends, 2009 — Financial Fraud

Financial fraud has long been an enforcement priority. Last year was no exception. The commission brought a significant number of financial fraud cases. Key trends to consider in this area are: 1) An increasing number of these cases have international aspects, a trend discussed previously regarding insider trading cases; 2) Few cases litigated and even fewer went to trial; 3) Some cases reflect the increasing use of derivatives in the market; 4) A number of the cases brought in this area are years old and may be considered stale; and 5) The financial fraud investigations from the current market crisis are, for the most part, still under investigation.

First, an increasing number of financial fraud cases have international aspects. One example of this trend is the Manterfield litigation in which the Commission recently prevailed in an action brought in the U.K. In SEC v. Manterfield, Claim No. HQ08x00798 (High Court of Justice, Queens Bench, Royal Courts of Justice, Feb. 29, 2008) the SEC obtained the dismissal of an appeal by Glenn Manterfield, a UK citizen, of an assets freeze order the Commission obtained over his U.K. assets in the High Court of Justice in London on May 16, 2008.

The initial enforcement action was commenced in the U.S. against Lydia Capital, LLC, a registered investment advisor based in Boston and its two principals, Glenn Manterfield and Evan Anderson. SEC v. Lydia Capital, LLC, Civil Action No. 07-10712 (D. Mass. Filed April 12, 2007). The complaint claimed that defendants engaged in a scheme to defraud more than 60 investors who had put over $34 million in Lydia Capital Alternatives Investment Fund LP, an unregistered hedge fund managed by Lydia. Defendants had materially overstated and, in some instances, fabricated the Fund’s performance, as well as invented business partners, according to the SEC.

On April 12, 2007, the SEC obtained a temporary restraining order that froze the assets of the defendants in the U.S. enforcement action. On February 29, 2008 the SEC filed the UK action to freeze about $1 million in assets. That request was granted and later, after an evidentiary hearing, extended until the conclusion of the U.S. enforcement action. Mr. Manterfield attempted to have that order overturned in his unsuccessful appeal. The case is currently in litigation.

Another case with international aspects is SEC v. Zurich Financial Services, 08 Civ. 10760 (S.D.N.Y. filed Dec. 11, 2008); In the Matter of SCOR Holdings (Switzerland) Ltd. formerly known as Converium Holdings AG, File No. 3-13307 (filed Dec. 11, 2008). Zurich is a Swiss based reinsurance company. Its shares are traded on the SWX Swiss Exchange and its ADRs are traded on the Over-the-Counter Bulletin Board and the Pink Sheets. Converium was organized under the laws of Switzerland by Zurich in 2001. It initially operated as a subsidiary. In March 2001, Zurich spun off Converium and, following an IPO, it was no longer affiliated with Zurich. Its shares and ADRs were registered with the SEC for trading. Later, the company was acquired by SCOR SE, a French reinsurer.

The SEC claimed that beginning in 1999 and before the IPO, Zurich developed three reinsurance transactions which ended with falsified financial statements for Converium that were used in its IPO. Those transactions were crafted to make it appear to transfer risk to third-party reinsurers when in fact no actual risk was insured outside the Zurich group of companies. As a result, the financial statements used in the IPO were false and materially misleading. Converium understated its pre-tax loss by about 57% or $100 million in 2000 and by 1% or about $3 million in 2001.

To settle the case both Zurich and Converium consented to the entry of cease and desist orders. In addition, in the civil action, Zurich agreed to pay a $25 million civil penalty. The SEC acknowledged the cooperation of each company.

Second, few Commission enforcement actions go to trial. Perhaps even fewer financial fraud cases are tired. Three financial fraud cases were tried last year, with the Commission prevailing in two. In a third, the SEC lost, while a fourth which had long been in litigation was dropped.

In SEC v. Miller, Civil Action No. 1:04-cv-1655 (N.D. Ga. filed June 14, 2004), the jury returned a verdict in favor of the Commission, concluding that John Miller, the former president, CEO and COB of Master Graphics, Inc., violated the antifraud and books and records provisions of the securities laws.

The SEC claimed that Mr. Miller devised and implemented a scheme to inflate income to meet Wall Street expectations. Specifically, the company reclassified rent and salary expense that had been paid to division presidents in the first quarter to assets on the balance sheets. As a result, Master Graphic’s net income was over stated by 628%, 46% and 10% in the first, second and third quarters respectively in its 1999 filings.

Previously, the CFO and Chief Accounting Officer had settled with the Commission. See In the Matter of Paul Melvin Henson, Jr., Rel. No. 8425 (May 19, 2004); In the Matter of Lance Turner Fair, Rel. No. 8424 (May 19, 2004); SEC v. Henson, Civil Action No. 04-2394 (W.D. Tenn. filed June 2, 2004).

The Commission also prevailed in SEC v. Stanard, Case No. 06 Civ. 7736 (S.D.N.Y. filed Sept. 27, 2006). There, the court found in favor of the SEC and against James N. Stanard, former CEO of RenaissanceRe Holdings, Ltd., following a six day trial.

The Commission’s complaint alleged that Mr. Stanard participated in a financial fraud to smooth RenRe’s earnings by engaging in a round trip sham transaction. Specifically, the company purported to assign a discount of $50 million of its recoverables to Inter-Ocean Reinsurance Company, Ltd. for $30 million in cash, a net transfer to the company of $20 million. RenRe booked income of $30 million at the time the agreements were executed. The second contract appeared to be a reinsurance agreement with Inter-Ocean. In fact, it lacked any substance. The agreement was used to refund the $20 million paid under the first agreement to RenRe at a later date.

As a result of this transaction, the company materially understated income in 2001 and materially overstated income in 2002, at which time it made a so-called claim under the sham agreement and received the $20 million payment Inter-Ocean had held all along for RenRe. Previously, the SEC settled with the company and two other defendants.

In contrast, the SEC lost at trial in SEC v. Goldsworthy, Civil Action No. 06-cv-10012 (D. Mass. filed Jan. 4, 2006). The court rejected most of the claims brought against former Applix, Inc. CEO Alan Goldsworthy and former CFO Walter T. Hilger following a four week jury trial. While the court rejected claims of intentional fraud, it did find negligent fraud as to Mr. Hilger. Mr. Godlsworthy was found not liable on all claims.

The complaint claimed that Messrs. Goldsworthy, Hilger and another engaged in two separate schemes to inflate revenue. The first involved the premature recognition of about $890,000 in revenue for the fiscal year ended December 31, 2001. The second concerned improperly reported revenue of about $341,000 for a transaction with a German customer.

Based on the findings of the jury, the court concluded that defendants had violated Section 17(a)(3) of the Securities Act and Rule 13b2-1. It rejected SEC claims that there were violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) along with Rules 10b-5, 12b-20, 13a-1, 12a-11, 12a-13 and 13b-2-1.

The company previously settled. See In the Matter of Applix, Inc., Adm. Proc. File No. 3-12138 (Jan. 4, 2006).

Finally, after years of litigation, the SEC dismissed all claims in SEC v. Johnson, Case No. 1:05-cv-00036 (D.D.C. filed Jan. 10, 2005) against former AOL executive John Tuli. According to the complaint, Mr. Tuli participated in a scheme to falsify the books and records of a Las Vegas-based internet company by repeatedly confirming, or causing others to confirm, to the outside auditors of the company that services had been had been completed and accepted by AOL. Those audit confirmations were false according to the complaint. Mr. Tuli had previously been acquitted following a three month jury trial on criminal charges based on similar allegations.

Third, some cases reflect the increasing role of derivatives in the market. For example, in SEC v. Lee, Civil Action No. 08-CIV-9961 (S.D.N.Y. filed Nov. 18, 2008), the Commission brought an action based on a fraudulent scheme keyed to derivatives. It named as defendants, David Lee, a former commodity option trader at a subsidiary of Bank of Montreal, and Kevin Cassidy, Edward O’Connor and Scott Connor, all former employees of Optionable, a commodity brokerage whose shares are traded on the OTC Bulletin Board.

The complaint alleged a scheme which victimized the shareholders of the bank and the brokerage firm as well as the New York Mercantile Exchange. According to the SEC, the bank’s shareholders were defrauded in a “u-turn” scheme. There, when Mr. Lee could not obtain market prices for trading positions in natural gas options, he inserted prices or marks which were verified by the Optionable defendants. As a result, the financial statements were falsified.

The shareholders of Optionable were also victims. The periodic reports of this company were false. Those reports touted the “synergistic benefits of the derivatives valuation services …” that the company provided to multiple brokerage clients, but failed to disclose that the primary client was Bank of Montréal and that the services provided were fraudulent.

The third victim was the New York Mercantile Exchange. Optionable sold the exchange over $10 million of its shares based on its periodic reports. Those reports were materially false.

Mr. Lee has pled guilty to federal and state criminal charges. Mr. Cassidy is under indictment. Mr. Lee also consented to the issuance of a Consent Order of Prohibition with the Federal Reserve Board.

Fourth, frequently financial fraud cases are years old, raising questions as to whether they should have been brought in the first place — particularly at a time when the Commission has scarce resources. SEC v. Prudential Financial, Inc., Civil Action No. 08 Civ. 3916 (D.N.J. Aug. 6, 2008) is an example of such an action. This settled case alleges a scheme to falsify revenue. According to the SEC, a subsidiary of Prudential entered into round-trip transactions with reinsurance giant General Re. The transactions had no substance or purpose other than to build up and then draw down off-balance sheet sums. The complaint does not allege a material impact in period from 1997 to 2002 when the scheme took place. The company did not restate its financial statements. And, there is little likelihood of a reoccurrence since the subsidiary involved was sold five years ago. Nevertheless, the SEC filed this action and settled it with a consent injunction prohibiting future violations of the books and records provisions.

Another example of a case which raises questions about prosecutorial discretion and the use of scarce resources is SEC v. Hozhabri, Civil Action No. 08-CV 1359 (D.D.C. filed Aug. 6, 2008). Defendant Ali Hozhabri, a former project manager for ABB Network Management, fraudulently submitted $468,714 in cash and check disbursement requests to his employer between 2002 and 2004. There is no allegation that the conduct had any impact on the financial statements of the company. The SEC settled for a consent decree containing an injunction which prohibits future violations of the books and records provisions after Mr. Hozhabri pled guilty to criminal charges.

Finally, the current market crisis will clearly serve to reemphasize this traditional enforcement area. The subprime and large financial institutions working groups, two of the key enforcement groups focused on market crisis events, are both financial fraud investigations. Key questions in those inquiries focus on the use of reserves, the valuation of assets, loan quality, credit risk and related disclosure and internal control issues. While few cases have been brought by these and the other task forces to date, in view of the large number of investigations being conduct and the significant amount of resources being employed there should be little doubt that financial fraud cases will be a high priority in coming months.