The Week In Review (October 12-18, 2007): A Typical Week Ends With Lingering Questions About SEC Charging Policies

The week looked like many others.  A settlement in a large options backdating class action suit; the filing of a settled financial fraud case by the SEC with a significant penalty despite cooperation; another case against a hedge fund; and a settled insider trading case.  The end of the week was hardly typical however:  a dropped two year old fraud action in favor of a settled Section 5 C&D which again raised significant questions about SEC charging policies.  

First, the typical. Last Friday, Hewlett-Packard agreed to settle a two year old shareholder suit related to stock options backdating at Mercury Interactive, a business software company H.P. acquired.  While the company confirmed the agreement it did not acknowledge press reports (here, registration required) that suit settled for $117.5 million.    

The SEC announced the settlement of a financial fraud suit against Nortel Networks Corporation.  According to the SEC’s complaint, in late 2000 and early 2001, the company altered its revenue recognition policies that did not conform to GAAP to accelerate revenue into 2000 to meet revenue targets.  In addition, the company improperly established and maintained excessive reserves in 2002, according to the complaint.  The company settled the case by consenting to a statutory injunction and an order requiring it to pay a civil penalty of $35 million.  This settlement reflects what the SEC called “substantial remedial efforts and cooperation,” a comment which leads one to wonder about the value of cooperation.  SEC v. Nortel Networks Corporation, Civil Action No. 07-CV-8851 (S.D.N.Y. October 15, 2007).  The Commission’s Litigation Release is here.    

In SEC v. Colonial Investment Management LLC, Civil Action No. 07-Civ. 8849 (S.D.N.Y. Filed October 15, 2007), the Commission brought another in a series of actions against hedge funds.  Here, the SEC alleged that a hedge fund, its adviser and its managing director engaged in illegal trading in connection with eighteen public offerings.  According to the complaint, defendants violated Rule 105 which prohibits short sales made five days before an offering from being covered with shares from the offering.  The complaint alleges that defendants profited because the shares in the offerings sold at prices lower than those from the short sales.  This case is in litigation.  The Commission has brought several similar cases earlier this year against hedge funds, typically based on PIPE offerings (discussed previously here).  The Commission’s Litigation Release in Colonial Investment is here.    

The Commission also continued its campaign against insider trading, filing another settled case.  SEC v. Lenzner, Civil Action No. 07-cv-01404 (W.D.P.A. Filed October 17, 2007).  In this settled action the SEC alleged that NSD Bancorp director Charles Lenzner tipped Michael Pitterich about a merger between NSD and F.N.B. Corporation according to the complaint.  Mr. Pitterich traded while in possession of material non-public information about the transaction prior to the announcement.  Both defendants consented to the entry of statutory injunctions.  Mr. Pitterich also agreed to the entry of an order requiring him to pay disgorgement, prejudgment interest and a penalty equal to the trading profits. Mr. Lenzner consented to the entry of an order requiring him to pay a penalty equal to the trading profits.  The Lenzer case is discussed here.       

Now, the not so typical.  The week ended with the case which apparently should not have been brought – at least not as originally filed.  The saga of, Inc. began over two years ago with the filing of a fraud complaint by the SEC charging six individuals and four companies.  Specifically, the complaint alleged a fraudulent pump and dump scheme claimed to have involved manipulative trading, false publicity, misrepresentations and a cover up.  The statutory violations were alleged to include Section 10(b) (fraud), Section 17(a) (fraud), Section 5 (registration), Section 17(b) (touting) and a failure to file Schedule 13D, a failure to report beneficial ownership per Section 16(a), filing misleading issuer’s reports in violation of Section 13(a), failure to make and keep accurate books and record in violation of 13(b)(2)(A) and various aiding and abetting claims.  SEC v., Inc., Civil Action No. 3:05cv1747 (D. Conn. Filed November 16, 2005).  The original Litigation Release in that matter from 2005 is here.     

After two years in litigation (and since the events at issue occurred in late 1999 and early 2000, a presumably lengthy pre-filing investigation), the SEC dismissed the civil action with prejudice.  At the same time, a settled administrative proceeding was filed against Inc. and all but three of the original defendants against whom all claims were dropped.  The remaining defendants agreed to settle the administrative proceeding by consenting to the entry of a C&D based on Section 5 violations and entry of orders requiring disgorgement.  The Commission’s Litigation Release regarding the settlement is here.     

In the settlement, not only did the SEC drop the civil injunctive action but, in addition, virtually all of its key claims. Gone were the claims of pump and dump.  Gone were the fraud charges.  Gone were the claims of touting.  Gone were the false books claims.  Gone were the allegations of failure to file required schedules and reports.  Gone were all the key elements of the SEC’s original case.  

Left, however, were lingering questions such as how with all of its vast investigative powers did the SEC get the facts so wrong?  How with its vast expertise, did the SEC so grossly overcharge the claimed violations of law?  Why did it take two years of litigation after the investigation for the SEC to finally figure out the actual facts and correct charges? And, perhaps more importantly, how many other times does this happen where the company or individuals simply capitulate to charges which are inappropriate or perhaps worse because of the burden and expense of fighting with the SEC or perhaps even worse, the DOJ?  

The sad saga of is not, unfortunately, the first instance of getting the charges wrong.  It also will not be the last, unless the SEC carefully reviews and reforms its charging processes.  In view of the impact of its allegations and the potential for wrongful charges and settlements, the SEC cannot start this reform process to soon.