This Week In Securities Litigation (March 20, 2009)

Calls for a reinstatement of the uptick rule continued this week, with more legislation introduced to prod the SEC to bring the rule back. At the same time, SEC Commissioner Aguilar offered additional thoughts on reforming the much criticized enforcement program.

The SEC filed two high profile cases this week. One is against the Deputy Controller and Chief Investment Officer in New York based on a pay-to-play kickback scheme and is paralleled by criminal charges brought by the NY AG. The other named the outside auditors of Bernard Madoff’s brokerage firm claiming essentially that the auditors facilitated the Ponzi scheme by failing to conduct any audit, but furnishing the brokerage firm with false audit opinions for filing with the SEC. The U.S. Attorney’s office filed parallel criminal charges. The SEC also filed a settled insider trading case and brought another suit alleging investor fraud against a hedge fund operator.

In private actions, Mayer Brown and its former partner Joseph Collins won dismissal of securities damage claims brought against them in a suit based on the Refco debacle. The court concluded that the firm and its former partner were aiders and abettors and thus outside the reach of securities fraud statutes the Supreme Court’s decision in Stoneridge. And, Cirrus Logic resolved derivative litigation brought against its former officers based on claims of option backdating when the plaintiffs waived-off on their multimillion dollar attorney’s fees claim on condition the fee payment from the D&O carrier be paid to the company.


The uptick rule: A bill was introduced in the Senate to require the SEC to reinstate the “uptick” rule. The bill, S. 605, is titled: A bill to require the Securities and Exchange Commission to reinstate the uptick rule and effectively regulate abusive short selling activities. This is the latest bill seeking a return of the rule.

The uptick rule was dropped by the SEC in 2007 based on a determination that it had little impact after having been in effect since the 1930s. Essentially, the rule prevented traders from initiating a short sale unless the price of a stock in its most recent trade was higher than the previous price. The SEC has scheduled a meeting for April 8 to vote on a return of the rule.

SEC enforcement: SEC Commissioner Louis A. Aguilar, speaking at a DC Bar program co-chaired by Stephen Crimmins (Mayer Brown) and Peter Bresnen (Simpson Thacher) outlined key points for rejuvenating the enforcement program. In addition to those actions taken to date by the new Chairman (discussed here), Commissioner Aguilar make five key points: 1) there is a need to improve the distribution process of funds to investors; 2) the SEC needs to make better use of technology to facilitate the work of the staff; 3) the corporate penalty guidelines issued in 2006 should be revised to focus more on the nature of the violation; 4) the SEC should be given the authority to punish obstruction of its investigations and, in certain instances, bring criminal cases when DOJ elects not to proceed; and 5) the Commission should be self-funding.

SEC internal controls: The agency which regularly brings suit against issuers for failing to have proper internal controls is having problems with its own controls. A report by the GAO issued on March 16, 2009 notes that the SEC has only corrected 18 of 34 weaknesses identified in its earlier report. In making this assessment, GAO also identified 23 new weaknesses “in controls intended to restrict access to data and systems, as well as weaknesses in other information security controls that continue to jeopardize the confidentiality, integrity, and availability of SEC’s financial and sensitive information and information systems.”

SEC Enforcement

Kickback scheme: The SEC filed civil fraud charges against David Loglisci, former Deputy Comptroller and Chief Investment Officer of the New York State Common Retirement Fund, Henry Morris, the top political advisor and chief fundraiser for former New York State Controller Alan Hevesi, and three entities controlled by Mr. Morris. SEC v. Morris, Case No. 09 CV 2518 (S.D.N.Y. Filed March 19, 2009). According to the SEC, Messrs Loglisci and Morris caused billions of dollars to be invested with private equity firms and hedge fund managers in return for the payment of millions of dollars in sham “finder” fees and “placement agent” fees. Those payments were the result of a quid pro quo arrangement and other similar fraudulent arrangements. Related criminal charges were brought by the New York Attorney General.

The Madoff Ponzi scheme scandal. The U.S. Attorney’s Office for the Southern District of New York and the SEC brought charges against the outside auditors for Bernard L. Madoff Investment Securities LLC, David G. Friehling and Friehling & Horowitz, CPA’s, P.C. U.S. v. Friehling, Case No. 09 mj-00729 (S.D.N.Y. Filed Mar. 18, 2009); SEC v. Friehling, Case No. 09 CV 2467 (S.D.N.Y. Filed Mar. 18, 2009).

From 1991 through 2008, Mr. Friehling and his accounting from were the outside independent auditors of Bernard L. Madoff Investment Securities as discussed here. The Madoff firm was required to file financial statements audited by an outside independent accounting firm with the SEC. The audit firm prepared audit opinions each year which represented that the financial statements of the Madoff firm were prepared in accordance with GAAP and that the accounting firm had audited those statements in accord with GAAS. In fact, both representations were false, as well as the assertion that the firm was independent according, to the SEC and DOJ. Although the false audit opinions facilitated the Madoff fraud, neither the SEC nor DOJ claimed the auditors knew about the Ponzi scheme.

Insider trading: SEC v. Biello, Civil Action No. 4:09-CV-00752 (S.D. Tex. Filed March 13, 2009) is a settled insider trading case centered on the takeover of ACR Group, Inc. by Watsco, Inc., as discussed here. The complaint alleges that defendant Michael Biello, an accountant with ACR Supply, a subsidiary of ACR Group, learned in April 2007 that the company was considering a possible merger with Watsco, a fact confirmed to him by later events. Subsequently, Mr. Biello tipped his brother who traded prior to the announcement of the transaction.

To settle the case, Mr. Biello consented to the entry of a permanent injunction and agreed to pay disgorgement of just over $6,000 plus prejudgment interest and a civil penalty equal to the amount of the trading profits. An action has not been brought against the brother.

Investment frauds: The SEC continued to bring investment fraud cases this week, filing SEC v. Hu, Case No. 09-01177 (N.D. Cal. Filed March 18, 2009). In this case, the SEC alleged that defendant Albert K. Hu, a hedge fund manager, misappropriated investor funds. Mr. Hu is alleged to have raised more than $5 million from investors and transferred significant portions of the funds to foreign banks. The money was raised in part based on false representations that prominent attorneys, auditors and other professionals were overseeing the fund operations. Related criminal charges are being filed. Mr. Hu was arrested in Hong Kong earlier this week.

Private actions

In re Refco, Inc. Securities Litigation, Case No. 05 Civ. 8626 (S.D.N.Y.), the court dismissed defendants Mayer Brown LLP and its former partner Joseph P. Collins from this private damage action based on the Refco debacle, discussed here. Essentially, former trading giant Refco collapsed shortly after an IPO, revealing huge related party transaction debts. At the end of each quarter, Mr. Collins and a team of attorneys from his firm were alleged to have facilitated “round trip” transactions in which the debt was shuffled from Refco to a related entity to conceal it. Mr. Collins and the firm also are alleged to have worked on the filing of the papers for the IPO.

The court held that “[a]lthough the Complaint alleges facts that, if true, would make the Mayer Brown Defendants guilty of aiding and abetting the securities fraud that harmed the plaintiffs, the Supreme Court and Congress have declined to provide a private right of action for victims of securities fraud against those who merely — if otherwise substantially and culpably — aid a fraud that is executed by others.” The court based its ruling on Stoneridge, Inv. Partners, LLC v. Scientific-America, Inc., 128 S.Ct 761 (2008) which is discussed here.

In In re: Cirrus Logic Inc., Case No. 1:07-cv-212 (W.D. Tex.), the court approved a revised settlement put forth by the company in derivative litigation based on option backdating claims. An earlier settlement proposal had been rejected by the court. Under the terms of the new settlement, the company adopted certain corporate governance procedures and revised option granting procedures. In addition Plaintiffs agreed to waive their request for $2.85 million in attorney’s fees on condition that the money from the carrier be given to the company.

The suit was brought against the officers of Cirrus Logic, Inc. based on claims of option backdating. The complaint claims that the defendants engaged in a scheme and course of conduct which manipulated Cirrus Logic stock option grant dates to maximize profits for themselves. An investigation by a special committee however, found that of 148 stock option grants, 114 had been backdated. That committee concluded that the grant dates were the result of administrative deficiencies or process errors and not intentional manipulation. In fact, just under half of the grants reflected strike prices that were unfavorable to the option recipients according to the committee. The SEC closed its investigation without bringing an enforcement action.

New publications

Bhattacharya, Utpal and Marshall, Cassandra D., Do They Do It For The Money? (March 9, 2009), available at SSRN here.

The authors, both professors in the Department of Finance at Indiana University, studied data regarding management convicted of insider trading to “explore the economic rationality of this white-collar crime.” While they initially thought that lower management was well as upper management would engage in this conduct if it was committed with the expectation that the benefits would exceed the costs, they found that the convictions were among the “richer” management. This led them to conclude that “we cannot rule out psychological motives (like hubris) or sociological motives (like company culture) behind this white-collar crime.”