This Week In Securities Litigation (October 17, 2008)

This week, SEC enforcement actions focused on market manipulation and insider trading. The Second Circuit handed down a decision which may be of increasing importance as the current market crisis continues to spawn litigation, while the option backdating scandal inched closer to a close. The exchanges and the SEC continued to focus on short selling and events related to the current market crisis.

SEC enforcement actions

The SEC lost one market manipulation case, while filing two others, one of which settled. The Commission also settled an insider trading case.

On October 14, 2008, the jury returned a verdict against the SEC and in favor of defendant Stephen J. Wilson in a market manipulation case. SEC v. Competitive Technologies, Inc., Civil Action No. 304 CV 1331 (D. Conn. Filed Aug. 11, 2004). Mr. Wilson is a former registered representative of a broker-dealer in Media, Pennsylvania. The Commission’s complaint alleged that Mr. Wilson and others engaged in a scheme to manipulate the price of CTT stock from at least July 1998 to June 2001. The defendants included CTT and its former CEO along with six former registered representatives.

According to the SEC’s allegations, the defendants created a false or misleading appearance with respect to the market for CTT stock through a series of manipulative practices. Those included placing buy orders at or near the close of the market to inflate the closing price, “painting the tape” by placing successive buy orders in small amounts at increasing prices and placing matched trades by using controlled accounts or serviced accounts to place pre-arranged buy and sell orders in virtually identical amounts.

Previously, the SEC obtained a favorable verdict against one defendant and a hung jury as to another. That case will be retried. Four other defendants settled with the Commission.

In SEC v. Excellency Investment Realty Trust, Inc., Case No. 308 CV 1583 (D. Conn. Filed Oct. 16, 2008), the Commission brought a market manipulation case against a publicly traded real estate investment trust and its CEO, David Mladen. The complaint claims that Mr. Mladen “noticed that there was very little interest in Excellency stock and he wanted to show shareholders of Excellency that others were interested in Excellency stock.” Accordingly, between July 2006 and September 2006, he entered a series of trades at increasing prices. In addition, he engaged in a series of wash sales. All of this activity caused the price of the stock to increase from about $8 per share to over $24 per share. The complaint, which alleges violations of Section 10(b) and Rule 10b-5, seeks injunctive relief, the imposition of civil penalties and an officer and director bar as to Mr. Mladen. The case is in litigation.

The Commission also filed a settled administrative proceeding based on a market manipulation scheme called “portfolio pumping.” In In the Matter of Medcap Management & Research LLC, Adm. Proc. File No. 3-13276 (Filed Oct. 16, 2008), the Order alleged that investment adviser MedCap Management and its principal Charles Frederick Toney, Jr. misled fund investors with a fraudulent scheme which artificially inflated the value of the portfolio. According to the Order, Mr. Toney made numerous end of the quarter purchases of a thinly traded penny stock which was a significant portion of the fund’s portfolio. The trades artificially inflated the value of the stock which permitted respondents to report inflated results to investors. The scheme sought to avoid a run on the fund by investors because of large losses.

To resolve the action defendants agreed to the entry of a cease and desist order. MMR also agreed to disgorge the about $70,000 in inflated management fees it received as a result of the scheme and to a censure. Mr. Toney agreed to pay a civil penalty of $100,000 and to a bar from association with any investment adviser with a right to reapply after one year.

Finally, the SEC settled with two defendants in an insider trading case filed last month. SEC v. Zeglis, Civil Action No. 08-CV-5259 (N.D. Ill. Filed Sept. 16, 2008). The complaint named as defendants James Zeglis, Gautum Gupta, Lance McKee and Jim Dixon as discussed here. The case centered on trading in advance of the acquisition of Georgia Pacific by Koch Industries. According to the complaint, Mr. Zeglis misappropriated inside information from his brother, a member of Georgia Pacific’s board of directors, and then tipped Messrs. Gupta and Dixon. Mr. Gupta later tipped Mr. McKee. All three tipees traded prior to the public announcement.

Messrs. Dixon and McKee settled with the Commission. Both consented to the entry of a permanent injunction, prohibiting future violations of the antifraud and tender offer provisions of the Exchange Act. Mr. Dixon was also ordered to disgorge over $116,000 in trading profits along with over $22,000 in prejudgment interest and to pay a civil penalty of $50,000. Mr. McKee was directed to pay disgorgement of over $7,100 and prejudgment interest of over $1,300. Mr. McKee was also ordered to pay a civil penalty equal to his trading profits.

Circuit court decisions

The Second Circuit Court of Appeals handed down a decision which may become of increasing interest as the current market crisis continues. In Teamsters Local 445 Freight Division Pension fund v. Bombardier, Inc., Case No. 06-3794 (2nd Cir. Oct. 14, 2008), discussed here, the court clarified plaintiff’s burden on class certification, concluding that they must establish the requirements of Fed. R. Civ. P. 23 by a preponderance of the evidence.

The court went on to clarify the use of the fraud-on-the market theory on class certification in a case which involved thinly traded “certificates” backed by mortgages on mobile homes. In concluding that the presumption from Basic, Inc. v. Levinson, 485 U.S. 224 (1988) could not be used because the market was not efficient the court focused on three key points: 1) whether financial analysts followed the security; 2) if market makers followed the security; and 3) whether the security reacted immediately to news of unexpected corporate events. Here, the court held the market was not efficient, the presumption could not be used and thus the predominance requirement of Rule 23 had not been met.

Private litigation

The option backdating cases continued to move toward conclusion. Last week, the former General Counsel of McAfee Kent Roberts was acquitted on criminal fraud charges based on claims of option backdating as discussed here. This week, the preliminary approval of a settlement of derivative litigation involving allegations of option backdating at McAfee over the objections of Mr. Roberts and George Samenuk, the former CEO of the company and Kevin Weiss, former president. Under the settlement, there will be a freeze and cancellation of about 1.7 million vested in-the-money options held by certain defendants. The grants were alleged to have been backdated. The company also agreed to a package of corporate governance reforms. The settlement includes a federal derivative case and a related state court derivative case. In re McAfee, Inc. Derivative Litigation, Case No. 5:07-cv-04048 (N.D. Cal. Filed May 31, 2006).

Market crisis

According to the Wall Street Journal, the exchanges are considering a “circuit breaker” which would halt short selling if the share price closed 20% lower than its close on the prior day. Under the proposal, short selling would be prohibited for three days. The proposed rule, which may be issued by NYSE Euronext and Nasdaq, would exempt bona fide hedging. Wall Street Journal On-line, Oct. 11, 2008.

The SEC also continued to focus on short selling. The Commission extended a temporary market rule regarding short selling. Under the rule, discussed here, large institutional investment managers are required to disclose certain short sales and positions. The extension continues until August 1, 2009.

In addition, Erik Sirri, Director of the Division of Trading and Markets, testified on October 15, 2008, before the House Committee on Agriculture about credit default swaps as also discussed here. In his testimony, Mr. Sirri reiterated the Commission’s request for additional authority over credit default swaps. He also told the Committee about current discussions of market regulators and participants regarding a possible central counterparty for credit default swaps. In addition, Mr. Sirri discussed the current difficulties the Commission is encountering in its enforcement investigations regarding events in this market.

Finally, the SEC announced the parameters of its mark-to-the market accounting study which was congressionally mandated, as discussed here, under the Emergency Economic Stabilization Act of 2008. By the end of the week the Commission had announced the first of a series of public roundtables to discuss issues relating to the study of FAS 157.