This Week In Securities Litigation (July 18, 2008)

This week continues to be dominated by the on-going market crisis. The SEC’s extraordinary intervention in the markets is perhaps the talk of Wall Street. At the same time, the Enforcement program continued with what seems to be its signature cases, another insider trading case and a years-old financial fraud action.

The market crisis

This week, the SEC took the extraordinary step of banning short selling in the shares of Fannie Mae, Freddie Mac and primary dealers at commercial and investment banks unless specific conditions are met. Specifically, the rule will require any short seller of the shares of the nineteen designated entities to arrange before the trade to borrow the securities and deliver them at settlement. This will preclude naked short selling in the shares of the designated issuers.

The rule, which goes into effect on July 21, 2008, is aimed at unlawful manipulation through false rumors and naked short selling according to the SEC as discussed here. It applies to those entities the Treasury Secretary asked Congress to back in the wake of rumors about their financial status – Freddie Mac and Fanny Mae – and a list of designated commercial and investment banks.

The agency does not have evidence that anyone is circulating false rumors to drive down the price Freddie Mac, Fanny Mae or the other covered entities, according to SEC Chairman Cox. Rather, the rule is prospective and intended to prevent such action.

The SEC is also initiating sweeping inspections of Wall Street firms to review their internal compliance and control procedures regarding the spreading of false rumors. At the same time, the Division of Enforcement has reportedly issued dozens of investigative subpoenas to Wall Street players as part of its related investigation.

If the intent of the SEC is to quell manipulative rumors tied to short selling which could drive down the share price of the covered entities, its preemptive strike should suffice or at least inhibit such conduct. If the intent of the SEC is to demonstrate that it is on top of the current market crisis, there is little doubt that the agency at least has everyone on Wall Street talking.

At the same time, there is no doubt that the SEC’s strike will inhibit short selling and perhaps trading on rumors, a normal market function. To the extent those normal market functions would have depressed share prices, the SEC’s actions will inhibit that result.

While the SEC was launching its attack, Senator Patrick Leahy (D-Vt.), chairman of the Senate Judiciary Committee, scheduled hearings on the Supreme Court’s pro-business decisions last term. According to the release the hearings are on “Courting Big Business: The Supreme Court’s Recent Decisions on Corporate Misconduct and Laws Regulating Corporations.” The hearings are scheduled for July 23, 2008 at 10:00 a.m.

Key decisions in the securities area which the Judiciary Committee might consider are Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761 (Jan. 15, 2008), rejecting scheme liability and Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S.Ct 2499 (2007), defining the test for pleading a strong inference of scienter. Stoneridge, as discussed here, has had a significant impact on huge class actions such as Enron and Homestore. The impact of Tellabs, which many initially called pro-business, is at best debatable as discussed here.

Enforcement cases

SEC v. Rauch, Case No. CV 08 3416 (N.D. Cal. filed July 15, 2008) is a settled insider trading case brought against the current mayor of Beaufort, South Carolina as discussed here. The complaint charges Mr. Rauch with insider trading in the shares of Advanced Cell Technology, Inc., a penny stock company for which he was acting as a consultant. Mr. Rauch made profits of about $20,000, trading through accounts established for his children.

To settle the case, Mr. Rauch consented to the entry of a permanent injunction prohibiting future violations of Section 10(b) and Rule 10b-5 and the entry of an order requiring that he pay more than $20,000 in disgorgement, over $2,500 in prejudgment interest and a penalty of $20,708.

SEC v. El Paso Corporation, Civil Action No. 4:08-CV-02191 (S.D. Tex. July 11, 2008) is a settled financial fraud case brought against the company, two of its subsidiaries and five former officers of the company. According to the complaint, defendants inflated the company’s financial results by falsifying reports related to its reserves and failing to reduce reserves despite negative drilling and production data from 1999 to 2003. In 2004 the company restated its financial statements.

To resolve the case, the company and two defendants who supervised the three alleged to have falsified the reserve information consented to the entry of permanent injunctions prohibiting violations of Section 17(a)(2) and various books and records provisions. In addition, the two individuals consented to the entry of orders requiring the payment of financial penalties.

The two subsidiaries and remaining three individual defendants consented to the entry of fraud and books and records injunctions. In addition, the three individuals consented to the entry of orders requiring the payment of financial penalties.