This Week In Securities Litigation (October 10, 2008)
This week, the market crisis continues to dominate the news, even as Treasury races to implement the landmark legislation passed last week. The SEC’s controversial ban on short trading, originally implemented as the market crisis evolved, ended. At the same time, there were new settlements in the auction rate securities probes and the SEC filed an enforcement action centered on subprime mortgages.
Other significant actions focus on traditional securities litigation topics: option backdating, insider trading and financial fraud. Finally, the SEC published for the first time the manual of internal procedures used by its enforcement division.
The market crisis
This week, the SEC’s controversial ban on short selling ended, as the Treasury began working out the details to implement the emergency bail-out legislation. There are mixed approaches to short selling from other regulators around the world, reflecting perhaps the diversity of opinion on the subject. In addition to the SEC, the Ontario Securities Commission ban on short selling in thirteen stocks also expired on October 8. In contrast, the UK ban in 34 financial stocks will continue in effect until January 16, 2009. Likewise, the bans in the Netherlands and France extend until mid-December, while in Germany it will not terminate until year end. Italy and Russia both have indefinite bans. China however recently overturned its ban on short selling.
New settlements in the auction rate securities probes were announced this week by the New York Attorney General and the SEC as discussed here. Those settlements, which are similar to earlier agreements discussed here, were with Bank of America Securities and RBC Capital Markets. The agreements focus on retail customers, who will be made whole and have the option of pursing consequential damages in a special FINRA arbitration proceeding. In addition, both Bank of America Securities and RBC Capital will use their best efforts to provide liquidity for institutional investors. Both settlements are agreements in principle and subject to additional talks and monitoring by the New York AG’s office and the SEC.
SEC v. Ainsworth, Case No. 08-1350 (C.D. Cal. Oct. 3, 2008) is based on claims rooted in the subprime market which underlies the entire market crisis. There, the Commission’s complaint centered on allegations of unscrupulous subprime mortgage lending, discussed in more detail here. The complaint states that the four individual defendants – employed by a complex of entities that acted as a broker dealer, investment advisor and insurer – induced individuals to refinance their homes with subprime negative amortization mortgages to generate cash flow for new unsuitable investments. Each step in the transaction generated fees for the defendants and other charges for their companies which were not disclosed.
Former McAfee General Counsel Kent Roberts was acquitted by a jury of fraud charges based on option backdating claims. The jury was unable to reach a verdict on a false books and records count. Reportedly, the court strongly recommended that prosecutors not pursue further proceedings. U.S. v. Roberts, Case No. 3:07-cr-00100 (N.D. Cal. Filed Feb. 27, 2007). The SEC suit against Mr. Roberts based on similar claims is pending. SEC v. Roberts, Case No. 1:07 cv 00407 (N.D. Cal. Feb. 28, 2007).
While the jury was deliberating on Mr. Robert’s case, former Network Associates, Inc. now known as McAfee) CFO Prabhat Goyal was sentenced following an earlier jury verdict finding him guilty on fifteen securities related counts. The jury concluded on May 10, 2007, that Mr. Goyal had committed securities fraud, filed false reports with the SEC and made false statements to the auditors. The court followed the recommendation of the probation officer, imposing a sentence of a year and a day in prison. The Commission’s complaint against Mr. Goyal, alleging financial fraud and insider trading, is pending. SEC v. Goyal, Civil Action No. C 04-2372 (N.D. Cal. Filed June 16, 2004).
Former Engineer Support Systems CEO Michael Shanahan Sr. was sentenced to three years of probation for his role in the option backdating scheme at the company. In addition, he will be required to pay a fine of $40,000 and repay almost $7.9 million that he obtained from the exercise of the options. As part of his plea bargain, eleven other counts were dropped against him and all charges against his son were dismissed. U.S. v. Gerhardt, Case No 4:07r-00175 (E.D. Mo. Filed March 15, 2007). The SEC’s complaint against Mr. Shanahan is pending. SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo. July 12, 2007).
A shareholders derivative suit was filed against the co-founders of COSCO, its CFO and ten other executives based on option backdating claims. The suit alleges that the defendants were granted backdated options which they exercised, making millions of dollars. Pirelli Armstrong Tire Corp., Retiree Medical Benefits Trust v. Sinegal, Case No. 2:08-cv-01450 (W.D. Wash. Filed Sept. 29, 2008). Previously, a grand jury requested that the company produce records related to option backdating.
The New York Attorney General entered into a settlement with David Aufhauser, former General Counsel of UBS AG and General Counsel of the Investment Bank at UBS AG, discussed here. The case is based on claims that he traded on insider trading in the auction rate securities market. Specifically, the NY AG alleged that after receiving an e-mail detailing significant problems in UBS’s auction rate securities market, Mr. Aufhauser directed the liquidation of his $250,000 portfolio in ARS. That order was confirmed on the next business day.
To settle the matter Mr. Aufhauser agreed to pay $6.5 million to New York State which includes his incentive compensation for 2008 of $6 million and a $500,000 civil penalty. In addition, Mr. Aufhauser agreed that for two years he would not be: associated with any participant in the securities industry; serve as an officer or director of a public company; or practice law in the State of New York.
The SEC filed a settled civil injunctive action against a former vice president of Hardware Restoration and three others based on insider trading allegations. SEC v. Axiaq, Case No. 3:08-cv-04637 (N.D. Cal. Filed Oct. 7, 2008). According to the Commission’s complaint, Ciriaco Rivor learned through his position with Restoration Hardware that the company was about to acquire a private equity firm. Subsequently, Mr. Rivor tipped friends Emmanuel Axiaq and Steven Lusardi and asked Mr. Axiaq to tip his father Francis Axiaq. Each of the tippees traded. Emmanuel Axioq and Steven Lusardi limited their trading in accord with instructions from Mr. Rivor. Francis Axiaq did not.
To resolve the case, Messrs. Rivor, Lusardi and Emmanuel Axiaq consented to the entry of permanent injunctions prohibiting future violations of Section 10(b). Mr. Rivor, who did not trade, agreed to pay a penalty of $68,000. Mr. Lusardi agreed to pay about $8,900 in disgorgement and prejudgment interest and a penalty equal to his trading profits. Emmanuel Axiaq agreed to pay disgorgement of over $90,000 along with prejudgment interest and a penalty of $60,000. Francis Axiaq did not settle.
In SEC v. Lion Gate Capital, Inc., Civil Action No. 08-06574 (C.D. Cal Filed Oct. 7, 2008), the Commission brought a civil injunctive action against the company and its principal, Kenneth Rickel, for illegal short selling. Specifically, the complaint alleges that in fourteen instances the defendants used shares purchased in registered public offerings to cover short sales that occurred during the restricted five business days before the pricing of those offerings in violation of then Rule 105. That rule prohibited covering short sales made during the restricted period with securities purchased in a registered offering. Purchasing shares in this manner would avoid market risk since the shares purchased in the offering would be acquired at a discount. The case is in litigation.
In SEC v. Cuti, Civil Action No. 08 Civ. 8648 (S.D.N.Y. Filed Oct. 9, 2008), the Commission brought a financial fraud case against two former senior executives of Duane Reade, the operator of the largest chain of drug stores in the New York Metropolitan area. The defendants are the former CEO, Anthony Cuti and former Real Estate Administrator and CFO William J. Tennant.
The complaint alleges two schemes which took place from 2000 to 2004 that were used to inflate earnings. One scheme involved the use of sham real estate transactions. The other centered on the use of bogus round trip transactions. Both schemes were disguised through the use of false documents. As a result of the schemes, the company overstated its pre-tax income by about $17.5 million. The SEC case is in litigation. Criminal charges based on these transactions were also filed by the U.S. Attorney for the Southern District of New York.
This week the SEC for the first time published a manual of procedures used by its Enforcement Division. The manual, discussed briefly here, details the internal procedures used by the Division.