SEC ENFORCEMENT TRENDS 2011: Financial Fraud

This is the tenth in a series of articles that will be published periodically analyzing the direction of SEC enforcement.

Financial fraud has long been a staple of SEC enforcement. While the Commission continues to concentrate enforcement resources in this area there are indications of an altered focus. In part that may stem from the market crisis from which some of these cases were developed. In part it may be a product of the overall enforcement environment. To examine these trends three points will be considered: 1) The line between civil and criminal cases; 2) the liability of directors and officers; and 3) selected financial fraud cases.

The line between criminal and civil cases

As in other areas under the federal securities laws, the division between criminal and civil violations of the law is suppose to be governed by the willfulness standard written into the statutes by congress when they were first passed. In practice the line has all but vanished in the view of many commentators. Court decisions defining criminal “willful” to include “willful blindness” and “conscious avoidance” and civil “scienter’ to encompass “reckless disregard” blur the division to the point of being virtually a distinction without a difference as discussed in an earlier part of this series.

In the context of these court decisions the dividing line between criminal and civil financial fraud becomes a function of prosecutorial discretion. This is typically measures in terms of the egregiousness of the underlying conduct. For example, the collapse of mortgage lender Taylor, Bean & Whitaker and bullet proof vest manufacturer DHB Industries, Inc. resulted in SEC enforcement actions as well as criminal prosecutions against former offers of each company. By virtually any definition the conduct in each case was egregious. SEC v. Farkas, Civil Action No. 1:10 cv 667 (E.D. Va. Filed June 16, 2010); U.S. v. Farkas, 10-cr-00206 (E.D. Va. Filed June 16, 2010); SEC v. DBH Industries, Inc., Civil Action No. 0:11-cv-60431 (S.D. Fla. Filed Feb. 28, 2011) ;SEC v. Brooks, Civil Action No. 07-61526 (S.D. Fla. Filed Oct 25, 2007); SEC v Schlegel & Hatfield, Civil Action No. 06-61251 (S.D. Fla. Filed Aug. 17, 2006); U.S. v. Brooks (E.D.N.Y).

The criminal charges against Lee Farkas center on the collapse of the company he founded and ran, Taylor Bean, and its affiliate, the Colonial Bank. The sixteen count indictment alleges a $1.9 billion scheme which contributed to the collapse of both companies and involved an attempt to defraud the Troubled Asset Relief Program. In one part of the fraudulent scheme Mr. Farkas is alleged to have shuffled money between Taylor Bean and the lender to conceal huge cash shortages. Another facet of the scheme involved the alleged misappropriation of hundreds of millions of dollars from a related loan facility and misrepresentations to the government in an effort to secure TARP funds. Mr. Farkas is currently on trial on criminal charges while others previously employed at the company have pleaded guilty. The SEC’s case is pending.

The conduct underlying the collapse of DHB Industries, and which is at the center of the SEC’s actions as well as the criminal prosecutions, is similar in character. In those cases former company CEO David Brooks and his lieutenants have been charged with essentially looting the company and using millions of dollars for their personal benefit. Mr. Brooks, along with former COO Sandra Hatfield have been convicted of criminal securities charges following a jury trial. The SEC’s action is pending. See also SEC v. Collins, Case No. 07 cv 11343 (S.D.N.Y. Filed Dec. 18, 2007)(financial fraud action settled following criminal conviction of the former Mayer Brown attorney who participated in accounting fraud which lead to the financial collapse of Refco). SEC v. General Re Corporation, Case No. 10 CV 458 (S.D.N.Y. Filed Jan. 20, 2010)(settled financial fraud action which is one of a series of civil and criminal cases based on two fraudulent financial schemes). Cf. SEC v. Styam Computer Services Ltd., Case No. 1:11-cv-00672 (D.D.C. filed April 5, 2011)(settled financial fraud action which alleged that a group of officers fabricated documents to falsify revenues over a period of years; a parallel criminal case is pending in India where the company is based).

The Commission’s civil financial fraud actions are also typically based on allegations of intentional wrong doing. See, e.g., SEC v. Diebold, Inc., Civil Action No. 1:10-CV 00908 (D.D.C. Filed June 2, 2010) and SEC v. Gupta, Civil Action No. 8:10-cv-00100 (D. Neb. Filed March 15, 2010). The former is a settled financial fraud action which alleged that over a five year period the manufacturer of automated teller machines improperly inflated revenue on certain transactions by recognizing revenue on lease transactions that were subject to buy back agreements, contrary to GAAP. The company is also alleged to have manipulated its reserved and improperly capitalized expenses. As a result Diebold was required to restate its financial statements. The complaint alleged violations of the antifraud and books and records provisions. The settlement was based on a consent to an injunction based on those provisions and the payment of a civil penalty.

The latter is one of a series of financial fraud actions centered on alleged violations of the antifraud, proxy and reporting provisions by Vinod Gupta, the founder, and former chairman of infoUSA Inc. The case focused on claims that over a four year period Mr. Gupta received about $9.5 million in unauthorized and undisclosed compensation. In addition the company, and another Mr. Gupta controlled, engaged in millions of dollars of undisclosed related party transactions. The case was settled with a consent to the entry of a permanent injunction prohibiting future violations of the antifraud, proxy and reporting provisions along with the payment of disgorgement and a civil penalty.

While neither Diebold or Gupta involves the kind of misconduct in the Taylor Bean or DBH Industries cases, both center on years long intentional misconduct. The difference is one of degree.

In some instances what appears to be blatant financial fraud turns out to be much less. This is precisely what happened in SEC v. Collins & Aikman, Civil Action No. 07-CV-2419 (S.D.N.Y. Filed Mar. 27, 2007). There the SEC brought a financial fraud action against former OMB director and former CEO and Chairman of the company David Stockman as well as the company and other senior officials and board members. At the same time criminal charges were brought against Mr. Stockman. All of the claims centered on a claimed financial fraud which supposedly involved multiple fraudulent schemes. In January 2009 the U.S. Attorney voluntarily dismissed its case.

The SEC however continued to litigate its action for over a year before dropping all of the intentional fraud claims against and settling for negligence based injunctions under Securities Act Sections 17(a)(2) & (3). While Mr. Stockman did agree to pay disgorgement, prejudgment interest and a civil penalty most of the sum was offset by payments made to settle parallel class actions. If the settlement is little more than a face saving effort by the agency, as it appears, it raises significant questions about prosecutorial discretion.

The liability of directors and officers

Financial fraud actions are typically brought against the company and in many instances the officers alleged to have been involved. Comparatively few actions are brought against individuals for their role as a corporate director. SEC v. Krantz, Civil Action No. 0:11-cv-60432 (S.D. Fla. Filed Feb. 28, 2011) is however an action brought against the outside directors of DBH Industries, Inc.

Like criminal financial fraud actions, the complaint in Krantz is based on what is claimed to be egregious conduct. Although each defendant was an outside director, the SEC claims that the independence of each was compromised by their personal relationships to the now convicted former CEO of the company, David Brooks. The complaint goes on to detail a series of blatant red flags presented to the board regarding the looting of the company by Mr. Brooks. These included concerns expressed by the auditors, a material weakness letter, and other indications of the fraud. In each instance the directors failed to take any meaningful action according to the complaint. The complaint alleges violations of the antifraud and reporting provisions of the federal securities laws. The case is in litigation.

More typical is the complaint in SEC v. Conaway, Case No. 05 cv 40263 (E.D. Mich. Filed Aug. 23, 2005) which is a financial fraud action against the former CEO of Kmart Corporation in which the SEC obtained certain ancillary relief last year after prevailing at trial in 2009. The civil fraud clams against Mr. Conaway centered on a scheme to cover up deteriorating financial conditions at the company which stemmed in part from a massive inventory overbuy paid for on credit. At the time the company was suffering from liquidity problems. Despite the scheme, which included effectively borrowing millions of dollars from vendors by initiating a program of delayed payments and false statements in SEC filings about the liquidity of the company, Kmart eventually collapsed in bankruptcy. A jury found the defendant liable for violations of Exchange Act Sections 10(b) among other things. See also SEC v. Morrice, Civil Action No. CV 09-01426 (C.D. Cal. Filed Dec. 7, 2009)(fraud action against the former senior officers of subprime lender New Century Financial settled in February 2011 in part by consents to injunctions based on the antifraud provisions as discussed earlier in this series).

In other financial fraud actions the complaint alleges what is, or at least appears to be, intentional conduct. The resolution of the case however is based on negligence rather than scienter based fraud injunctions. The Commission’s financial fraud case against computer giant Dell Inc. and its founder, Chairman and CEO Michael Dell is illustrative. SEC v. Dell Inc., Civil Action No. 1:10 cv 01245 (D.D.C. Filed July 22, 2010). Dell had picture perfect results for years, according to the complaint, meeting street expectations quarter after quarter and year after year. The company told investors and the markets this came from superior products and management.

In fact from 2003 through 2007 a large portion of the company’s revenues came not from what the markets were told but from what they were not told – payments from chip maker Intel not to use the product of a competitor. Likewise, when the payments were curtailed in 2007 investors were told that the sharp drop in income resulted from other causes, not a cut in Intel payments.

To resolve this case the company, Mr. Dell and other officers consented to the entry of a permanent injunction based in part on negligent fraud under Securities Act Section 17(a)(2)&(3). Penalties were of course paid and those who were accountants were suspended from practice before the Commission. See also SEC v. Imhoff, Case No. 1:10 – cv -01464 (D.D.C. Filed Aug. 2, 2010)(settled financial fraud actions against additional two additional Dell officers on similar terms); SEC v. Abernathy, Civil Action No. CV 11-01308 (C.D. Cal. Filed Feb. Filed Feb. 11, 2011)(financial fraud action settled based on negligent fraud where action arose out of failure of lender IndyMac; the action was against the former CFO who failed to update boiler plate disclosures about loan portfolio to show serious loan origination difficulties as market crisis unfolded); but see SEC v. Perry, Case No. CV 11-01309 (C.D. Cal. Filed Feb. 11, 2011)(scienter based fraud action against two other IndyMac officers which is in litigation).

The SEC’s settlements in the Citigroup are similar. SEC v. Citigroup Inc., Civil Action No. 1:10-cv-01277 (D.D.C. July 29, 2010); In the Matter of Gary L. Crittenden, Adm. Proc. File No. 3-13985 (Filed July 29, 2010). These actions center on a claim that the bank misrepresented its exposure to the sub-prime market as the market crisis was unfolding. Citi told investors that its exposure was about $13 billion when in fact it was about $56 billion. The bank failed to disclosure two groups of sub-prime loans valued at $43 billion. Repeated false disclosures were made despite the fact that the two officers named in the administrative proceeding were repeatedly informed about the true facts. All of the settlements were based on Securities Act Sections 17(a)(2) & (3) . The settlements included penalties.

When presented with the settlement papers in Citigroup, the court initially refused to execute the consent decrees. Following a hearing the Judge ultimately, but reluctantly, deferred to the Commission. It was perhaps the mismatch between the allegations of what appeared to be intentional misconduct with the resolution of the actions that triggered the court’s reluctance.

Other selected financial fraud actions

The Commission also brought a number of other financial fraud actions during 2010 and early 2011. Those include:

Related part transactions:

SEC v. Escala Group, Inc., Case No. 09 CV 2646 (S.D.N.Y. March 23, 2009) is a settled action against the former chairman of Escla, an international company in the collectables business. The case centered on a series of related party transactions made by defendant Gregory Manning. Those transactions were disclosed as being at arms length and were used to improperly boost the value of the company just before a merger. Mr. Manning settled by consenting to an injunction based on the Exchange Act antifraud and books and records and internal control provisions and an officer director bar for ten years. He also agreed to pay disgorgement, prejudgment interest and a penalty.

SEC v. Priddy, Civil Action No. 1:10-cv-00739 (D.Md. filed Mar. 25, 2010) is a settled action against Richard Priddy, the former CEO and President of TVI Corporation, Charles Sample, the former EVP of the company and their personal accountant J. Michael Broullire. The case alleged that Messrs. Priddy and Sample sold product to the company through undisclosed related party transactions which netted them significant profits. In another facet of the fraud Mr. Priddy increased the compensation of Mr. Sample which was then paid back to him in undisclosed kickbacks. Messrs. Priddy and Sample settled, consenting to the entry of permanent injunctions prohibiting future violations of Exchange Act Sections 10(b) and 14(a) and from aiding and abetting violations of Section 13(a). Mr. Brullire consented to the entry of a similar injunction based only on Sections 10(b) and 13(a). A related criminal case is pending.

Revenue recognition

SEC v. International Commercial Television, Inc., Case No. 3:10-cv-05555 (W.D. Wash. Filed Aug. 9, 2010) is a settled action against the company centered on premature revenue recognition. International Commercial Television is alleged to have recognized revenue on sales of its primary product made through Home shopping Network prior to the actual sale. It also carried receivables on its books from the claimed sale of product prior to the actual sale and improperly recognized revenue on sales with a right of return. The company settled, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). See also SEC v. Redekopp, Case No. 3:10-cv-05557 (W.D. Wash. Filed Aug. 9, 2010)(pending action against the former CFO of the company); In the Matter of Dohan + Company CPAs, Adm. Proc File No. 3-13997 (Aug. 9,2010)(pending proceeding against outside auditors, founding partner, engagement partner and audit manager).

SEC v. Lapine, Case No. 10 Civ. 1842 (N.D. Ca. Filed Sept. 27, 2001) is a settled action against Jay Lapine, former General Counsel to HBOC and, after its merger with McKesson to the HBOC division of McKesson HBOC. The complaint claimed that after learning the company was improperly falsifying its books by inflating revenue he participated in the scheme rather than halting it. The case was settled with the consent to the entry of a permanent injunction based on the antifraud and reporting provisions, a five year officer/director bar and the payment of a $60,000 fine.

Finally, the SEC has brought actions under the clawback provision of the Sarbanes-Oxley Act against officers who fail to repay certain incentive compensation when there is a restatement of the company financial statements. SEC v. Jenkins, Case No. CV 09-01510 (D. Ariz. Filed July 22, 2009); SEC v. O’Del, Civil Action No 1:10-CV-00909 (D.D.C. Filed June 2, 2010). Section 304 applies regardless of whether the executive was involved in the underlying conduct according to the Commission. That view has been upheld by the Second Circuit. Cohen v. Viray, Case No. 3860-cv (2nd Cir. Sept. 30, 2010).
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