This Week In Securities Litigation (June 13, 2008)

This week, a private action based on a proxy fight raised a key question regarding the innovation of Wall Street, the application of disclosure rules under the securities laws and the position of the SEC. At the same time, the government continued to emphasize FCPA enforcement, while the option backdating scandal continued to trudge to conclusion. A final note of interest comes from a Canadian regulator in an insider trading case which was settled in a very different manner from what is typically seen in U.S. enforcement actions.

Disclosure obligations

CSX v. Children’s Investment Fund, (S.D.N.Y.) raises a key question concerning the continual creation of new products on Wall Street and the application of government regulations. In CSX, Judge Lewis Kaplan concluded that two hedge funds engaged in a bitter proxy contest violated Exchange Act Section 13(d). While the court entered an injunction prohibiting future violations of the Section, Judge Kaplan concluded that he could not enjoin the two hedge fund defendants from voting the shares at issue in the proxy contest under existing Second Circuit precedent.

The suit was brought by rail company CSX against two off-shore hedge funds, the Children’s Investment Fund and 3G Capital Partners. The complaint alleges that the hedge funds violated Section 13(d) by failing to disclose their ownership of CSX shares. Generally, Section 13(d) requires the filing of a Schedule 13D disclosing when a person or group of persons acting together owns 5% or more of a class of equity securities. The purpose is to alert the marketplace of the holdings and the intent the beneficial owner of the securities.

CSX claimed, since that the funds were acting as a group, they should have filed a Schedule 13D disclosing this fact. In view of their failure to do so, CSX requested that the funds be precluded from voting the shares in the coming proxy contest. The hedge fund defendants denied that they constituted a Section 13(d) group. At issue are potentially five seats on the CSX board, a minority, but substantial position.

The controversy centers on a Wall Street innovation called equity swaps. In essence, these swaps permit the separation of legal ownership and voting rights from the financial benefits. In the swaps at issue here, the two funds held the right to the financial benefits of CSX shares which were owned by brokerage firms that retained the voting rights.

CSX contended that the since the brokerage firms had no real economic interest in the shares, effectively the two funds controlled the voting. The funds, which are coordinating closely in the proxy contest, contended that since the voting rights legally remained with the brokerage firms, they were not a group for 13D purposes.

Judge Kaplan held that two hedge funds violated Section 13(d), noting that there was persuasive evidence establishing that the funds beneficially owned at least some, if not all, of the shares. In his lengthy opinion, Judge Kaplan stated that “some people deliberately go close to the line dividing legal from illegal if they see a sufficient opportunity for profit in doing so. A few cross that line and, if caught, seek to justify their actions on the basis of formalistic legal arguments even when it is apparent that they have defeated the purpose of the law. This is such a case.”

Although Judge Kaplan asked the SEC to file an amicus brief, its General Counsel informed the court that there was not sufficient time to seek the views of the Commission and prepare such a brief. However, the Deputy Director of the Division of Corporation Finance submitted a letter generally supporting the position of the Funds.

Perhaps the real question going forward – absent an appeal – is how equity swaps and other esoteric creations of Wall Street will mesh with disclosure rules such as Section 13(d). Another key question is whether the SEC will adopt the position of the staff in view of Judge Kaplan’s ruling.


The SEC and DOJ continued to bring cases in this key area enforcement area. As previously discussed here, the SEC brought an action against Faro Technologies, Inc. The complaint in hat case claimed Faro violated the anti-bribery provisions of the FCPA by paying bribes in China. According to the SEC, employees in the China sub requested authority to do business “the Chinese way” – that is, pay bribes. After securing a local legal opinion suggesting that such payments would probably violate Chinese anti-bribery laws, the parent company told its sub employees not to make the payments. Nevertheless, the payments were made.

The key to the SEC case seems to have been the fact that the company did not have an FCPA compliance program. Likewise, the company did not have an FCPA education program for its employees, despite doing business in what is clear a high risk area of the world. The SEC case was settled when the company consented to an injunction and the adoption of a compliance program.

DOJ also brought an action against Faro, who settled that case by entering into a non-prosecution agreement. The company agreed to pay a $1.1 million fine and consented to the appointment of a monitor.

Option backdating

The option scandal at Broadcom continued last week with the indictment of founder and former CEO Henry Nicholas and former senior company executive William Ruehle. The indictment is based on claims that between 1999 and 2005 the company backdated options resulting in a $2 billion restatement. U.S. v. Nicholas, Case No. 8:08-cr-00139 (C.D.Ca. June 4, 2008).

Previously, the company settled an option backdating option with the SEC. Also, former HR chief Nancy Tullos pled guilty to obstruction of justice charges (here).

A second indictment was brought against Mr. Nicholas alleging illegal drug use.

Marvel Technologies reached a tentative settlement last week in a derivative suit which was also based on option backdating. The settlement provides for certain corporate governance changes and the payment of legal fees and expenses. The company also has a class action pending against it based on backdating. Previously, Marvel settled similar claims with the SEC.

Insider trading

While the SEC clearly has emphasized insider trading enforcement, last week it was securities regulators in Alberta, Canada which settled an insider trading case. The action was against Paul Norman Oliver, a former CV Technologies executive who traded in the shares of his company to avoid a potential loss of about $250,000. The case was resolved with the payment of $375,000 and an additional $25,000 toward expenses.

A noteworthy feature of the settlement is its basis. SEC settlements are on the basis of neither admitting nor denying the claims. But here, Mr. Norman admitted in the settlement that he traded based on inside information.