This Week In Securities Litigation (March 6, 2009)

The market crisis continued to generate new bills in Congress this week. One, introduced in the Senate, seeks to add 1,000 FBI agents to the Bureau, dedicated to financial fraud. Another, introduced in the House of Representatives, seeks tax relief for the victims of Ponzi schemes.

In litigation, the SEC lost a week long jury trial where it had asserted market manipulation claims, prevailed in a preliminary injunction hearing against a hedge fund on claims the fund defrauded investors and lost a request for a freeze order against a nursing home operator claimed to have defrauded investors. The Commission also settled a small, years old options backdating case and filed fourteen settled actions against specialists which were based on claims that each violated their duties by putting their own interests ahead of the public.

Finally, indictments were unsealed which allege FCPA violations by two UK citizens in connection with the KBR bribery scheme. And, in a criminal case based on the Broadcom options backdating scheme, the court suppressed statements given to company lawyers conducting an internal inquiry by the former CFO of the company because of violations of the attorney client privilege.

The market crisis

Two more bills were introduced in Congress related to the market crisis. The first is S 2484, a bill to authorize additional Federal Bureau Investigation field agents to investigate financial crime. The bill, which was referred to the Judiciary Committee, would authorize $150 million for each fiscal year from 2010 to 2014 to fund approximately 1,000 additional FBI field agents to investigate financial fraud.

The second would extend certain tax relief to victims of Ponzi scheme which are being discovered with increasing regularity. H.1159 proposes to amend the Internal Revenue Code to provide special rules for investor with losses from fraudulent Ponzi-type schemes. Under the proposed legislation, investors would be able to recoup taxes paid on phantom income reported in earlier years.

SEC enforcement

In SEC v. Competitive Technologies, Inc., Civil Action 304-CV-1331 (D. Conn. Filed August 11, 2004), a jury found against the Commission after a week long trial and in favor of defendant Richard Kawak, formerly a registered representative. The SEC’s complaint claimed that Mr. Kawak and others manipulated the share price of Competitive Technologies from July 1998 through June 2001 through various trading techniques. Previously, the SEC prevailed in a trial against defendant Sheldon Strauss, a former registered representative from Cleveland, Ohio. An earlier trial against Mr. Kwak and Stephen Wilson ended in a hung jury. Mr. Wilson prevailed in a second trial and has filed suit against the Commission. Three other defendants settled with the SEC.

In SEC v. Lawton, Civil Case No. 09-368 (D. Minn. Filed Feb. 18, 2009), discussed in detail here, the Commission obtained a preliminary injunction against hedge fund Paramount Partners, Crossroad Capital Management, its investment advisor, and John Lawton who runs Crossroad. The Commission’s complaint alleged that the defendants had raised about $ 9 million from 50-60 investors through a series of misrepresentations. Defendants claimed they had substantially more assets than they in fact had and that they could achieve returns which ranged from 65% to 19%. When the Commission requested confirmation of the fund’s assets, it was provided with bank documents to a closed account.

SEC v. Sunwest Management, Inc., Case No. CV-06056 (D. Ore. Filed March 2, 2009). This action was brought against Sunwest Management, Inc., a large operator of retirement facilities in 34 states and its primary shareholder and former president Jon Harder, and Canyon Creek Development, Inc., a captive broker-dealer.

The Commission’s complaint claimed the defendants raised at least $300 million from more than 1,300 investors through fraudulent offerings of tenancy-in-common interests based on claims that the investment in a specific retirement home would pay a 10% annual return. Contrary to the representations made to investors, Defendants ran Sunwest as a single integrated enterprise, commingling all investor cash into a single fund. Returns were made to investors from a variety of sources, not just the particular retirement home designated. By misrepresenting the nature of the investment, the SEC claims, defendants concealed the fact that the profitability of each specific investment depended on the success of other properties and defendants’ ability to continue the operations of the entire enterprise.

As credit tightened in 2007 and 2008, the complaint claims, the entire enterprise began to unravel and, according to the SEC, was run like a Ponzi scheme. By January 2009, over 100 retirement homes had been placed in foreclosure, receivership or bankruptcy. This eliminated any interest of the investors. The SEC’s request for an asset freeze order was denied.

In SEC v. Pediatrix Medical Group, Inc., Case No. 09-80366–CIV (S.D. Fla. Filed March 5, 2009), the Commission filed a settled options backdating case against a physician services provider in Sunrise, Florida. According to the SEC’s complaint, between 1997 and 2000, the now deceased CFO of the company backdated stock options without properly recording the corresponding expense. This resulted in an overstatement of pretax income of $8.8 million (6.7%) over the period. To settle the case, the company consented to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions of the federal securities laws. The SEC acknowledged the cooperation of the company although it did not identify what steps the company took. Likewise it is not apparent what cooperation credit was obtained. While no financial penalty was levied, it would appear that the statute of limitations would preclude such a sanction.

The specialists cases: The SEC six settled civil injunctive actions and eight settled administrative proceedings against specialists for improper proprietary trading. Those named in the civil injunctive actions are Automated Trading Desk Specialists, E*Trade Capital Markets, Melvin Securities, Sydan, LP and TradeLink as discussed here. Those named in the administrative proceedings are: Botta Capital Management, Equitec Proprietary Markets, Group One Trading, Knight Financial Products, Goldman Sachs Execution & Clearing, Susquahanna Investment Group and TD Options.

The complaints in the civil injunctive actions and the administrative orders charge essentially the same improper conduct in which the specialists disregarded their duties and took advantage of the public to the detriment of the public and for the benefit of the specialist firms. The practices included trading ahead, interpositioning and trading ahead of unexecuted open or cancelled orders. The events in the cases generally focused on the time period 1999 through 2005.

In the administrative proceedings, which were based on alleged violations of Section 11(b) of he Exchange Act, Rule 11b-1 thereunder and various exchange rules, the eight firms agreed to settle with each consenting to the entry of a cease and desist order. The firms also agreed to pay a total of $22.7 million in disgorgement and over $4.3 million in civil penalties. In the civil injunctive actions, which alleged violations of Exchange Act Section 17(a) and Rule 17a-3(a)(1) thereunder and certain exchange rules, each defendant consented to the entry of a permanent injunction and the payment of disgorgement and a civil penalty. The total disgorgement paid was approximately $35.7 million while the penalties totaled about $6.7 million.


The Justice Department unsealed two more indictments related to the FCPA violations of Kellogg, Brown and Root, discussed here. Jeffrey Tessler and Wojciech Chodan, both residents of the U.K, were indicted for FCPA violations. Specifically, each was charged with one count of conspiracy to violate the FCPA and ten counts of violating the FCPA. The indictment, returned in the Southern District of Texas, also seeks the forfeiture of $130 million. The scheme centered on paying bribes to Nigerian government officials to obtain contracts regarding the construction of a natural gas facility in Nigeria.


The district court in U.S. v. Nicholas, Case No. 8:08-cr-000139 (C.D. Cal. Filed June 4, 2008), a criminal case against former Broadcom executives based on option backdating related claims, suppressed the statements of former company CFO William Ruehle. The court concluded that the production was not authorized. Mr. Ruehle obtained the suppression of statements he made to the law firm of Irell & Manella because they were produced to prosecutors and others in violation of the attorney client privilege and without his consent. The statements had been taken when Irell attorneys, outside counsel for the company, were investigating the option practice at the company. Although attorneys for the firm testified that they gave Mr. Ruehle “corporate Miranda” warnings, at the time they were representing him and the company in two other suits. Mr. Ruehle claimed that the statements were privileged. The warnings given to Mr. Ruehle were not reduced to writing.