This Week In Securities Litigation (April 24, 2009)

There is increasing sentiment in Congress to provide additional funds for SEC enforcement. Not only did the administration propose an increased budget for the Commission, but now a new bill has been introduced in the Senate calling for the Commission to receive an additional $20 million. Enforcement activity is increasing, according to a new NERA report. It shows a significant increase in settlements by the Commission in the first quarter of this year, compared to the prior quarter and the first quarter of last year.

This week the SEC obtained settlements in two previously filed insider trading cases, while bringing three new actions based on fraudulent investment funds and an action against an investment advisor for failing to conduct adequate due diligence. In criminal securities cases, a jury returned a verdict of guilty against six defendants in the “squawk box” case, while charges were filed against a confederate of attorney Marc Dreier and, in another case, against the principle of an investment fund.

In private actions, a settlement in a derivative suit based on option backdating claims received preliminary approval. In addition, a damage suit by the Refco trustee was dismissed.

Finally, new academic articles discuss the question of reforming SEC enforcement and the rationale for private securities damage actions.


The Fraud Enforcement and Recovery Act was introduced in the Senate on April 21, 2009. The bill proposed to give the SEC an additional $20 million to hire about 60 more staffers and funds to improve technology to support enforcement efforts. The bill has bipartisan support, having been introduced by Senators Charles Schumer (D. N.Y.) and Richard Shelby (R. Ala.). Chairman Schapiro, who was present at a press conference announcing the bill, noted that she plans to add additional enforcement staff, hire more examiners to expand inspections of credit rating agencies and bolster “risk-based surveillance” and the examination of investment advisers. Compliance Week, April 22, 2004.

According to a new report by NERA, the number of cases resolved by the SEC in the first quarter of 2009 exceeded the number of settlements in the prior quarter and for the first quarter of last year. This year, the SEC settled 182 cases in the first quarter compared to 157 during the same time period in 2008. In the fourth quarter of 2008, the Commission settled 123 cases.

The report also details the ten largest settlements in terms of dollar amounts. The top ten ranges from the UBS AG case, discussed here, at $200 million to the action for micro cap fraud against Tecumseh Holdings Corporation at $6.4 million. The second largest settlement was against Halliburton Co. for FCPA violations, discussed here. It involved the payment of $177 million. After these two settlements, both of which involved parallel criminal actions brought by the Department of Justice, the amounts drop off significantly to $34 million in the E*Trade Capital Markets case.

SEC enforcement

Insider trading: The SEC settled with two additional defendants in an insider trading case centered on the acquisition of Galyan’s Trading Company by Dick’s Sporting Goods. This week final judgments were entered against Joseph Queri, Jr. and Kyle Kaczowski in two separate actions. SEC v. Queri, Jr., Case No. 2:08-CV-01361 (W.D. Penn. Oct. 1, 2008); SEC v. Queri, Jr., Case No. 2:08-CV-01367 (W.D. Penn. Oct. 1, 2008). Mr. Queri, a senior vice president of real estate at Dick’s, is alleged to have tipped his close friend Gary Gosson and his father. Mr. Gosson, in turn, tipped nine friends, all of whom traded. Mr. Gosson traded through the account of a friend and shared his trading profits of over $218,000 with two other friends. Mr. Queri Sr., tipped six friends, including Mr. Kaczowski who traded and made a profit of over $20,000.

Messrs. Queri, Jr. and Kaczowski each settled by consenting to the entry of a permanent injunction prohibiting future violations of Sections 10(b) and 14(e). In addition, Mr. Queri, Jr. also agreed to pay disgorgement of $1.00 to preserve the Commission’s ability to establish a fair fund and to pay a civil penalty of $218,026.00. Mr. Kaczowski agreed to pay disgorgement of over $20,000, prejudgment interest and a penalty in the amount of $30,133.00.

The two complaints were initially filed in October 2008 and named sixteen individuals for insider trading in advance of the take over. Five defendants settled at the time of filing. See Litigation Release No. 20765 (Oct. 1, 2008). An additional four defendants settled earlier this year. See Litigation Release No. 20895 (Feb. 10, 2009).

The Commission also resolved another insider trading case, SEC v. Gallahair, Civil Action No. 4:08-CV-05134 (N.D. Cal. Nov. 12, 2008). Here, William Gallahair, formerly a vice president at McKesson Corporation, is alleged to have misappropriated inside information from his company about its planned acquisition of D&K Healthcare Resources, Inc., through a tender offer. Prior to the public announcement, Mr. Gallahair purchased 20,000 shares of D&K stock. Following the announcement, he sold the shares for a profit of over $120,000. To resolve the case, Mr. Gallahair consented to the entry of a permanent injunction prohibiting future violations of Sections 10(b) and 14(e), agreed to pay disgorgement and prejudgment interest of over $152,000 and to pay a civil penalty of $120,000.

Investment fund/Ponzi scheme cases: The SEC brought three more investment fund fraud cases this week:

SEC v. Founding Partners Capital Management Company, Case No. 2:09-CV-229 (M.D. Fla. Filed April 23, 2009) is an action brought against William L. Gunlicks and his firm, Founding Partners. The SEC alleges that the defendants misrepresented the nature of the investments which would be made with investor funds, misused those funds for their personal benefit, falsely claimed their financial statements were audited and failed to inform investors that there was a prior Commission order issued against them. The court granted the SEC’s request for an emergency freeze order. The case is in litigation.

SEC v. Young, Case No. 09-cv-01634 (E.D. Pa. Filed April 20, 2009) charges an investment adviser and its principal with misappropriating millions of dollars in client assets. The SEC’s complaint alleges that over the last four years Donald Young, through Acorn Capital Management, a registered investment adviser he controlled, misappropriated over $23 million from investors. Investor funds were, in part used to pay other investors. Other investor funds were used for Mr. Young’s benefit. Funds had been obtained from about 40 investors. The SEC obtained a temporary freeze order. The case is in litigation.

SEC v. Williams, Civil Action No. CV 09-2709 (C.D. Cal. Filed April 20, 2009) alleges that David Williams, the owner and CEO of Morgan Peabody, a California based broker dealer formerly registered with the SEC, misappropriated millions of dollars of investor funds raised in three securities offerings. According to the complaint, Mr. Williams used two controlled entities to offer debentures and promissory notes to more than 100 customers who were told that they were investing in the broker dealer. In fact, the $9 million raised was used for the lavish lifestyle of Mr. Williams. The case is in litigation.

Investment advisers: In the Matter of Hennessee Group LLC and Charles J. Gradante, Adm. Proc. File No. 3-13454 (April 22, 2009) is a settled administrative proceeding against an investment adviser and its principal. Here, Respondents Hennessee Group LLC, a registered investment adviser which acts as a hedge fund consultant, and Mr. Gradante, its president, CEO, chief investment officer and managing principal, were charged with failing to comply with the procedures they told investors they follow in recommending hedge funds to investment clients. Essentially, the Group touted its extensive pre-recommendation due diligence procedures, claiming that it would not recommend investments in hedge funds that did not satisfy all phases of its due diligence program as discussed here. Nevertheless, Respondents failed to comply with its own due diligence procedures in recommending that clients invest in the Bayou fund, which turned out to be a massive fraud.

To resolve the matter, Respondents agreed to adopt polices and procedures to ensure proper disclosure of its evaluating and monitoring processes and furnish all clients with a copy of the Order for Proceedings. The Respondents also consented to the entry of a censure and an order requiring the payment of over $549,000 in disgorgement along with prejudgment interest and to pay a civil penalty of $100,000.

Criminal cases

In U.S. v. Mahaffy, Case No. 1:05-cr-00613 (E.D.N.Y. Filed Aug. 11, 2005), also known as the “squawk box case,” a jury returned guilty verdicts on the retrial of six defendants on a single count of conspiracy to commit securities fraud. The defendants were from Merrill Lynch, Lehman Bros., and A.B. Watley.

The case was based on the claim that the former Merrill and Lehman brokers engaged in a scheme to permit day traders at A.B. Watley to listen to confidential information regarding large orders over the squawk box of the firms. This permitted the day traders to front run the orders.

A prior trial ended with a partial verdict and a mistrial was declared when jurors failed to reach a verdict on the conspiracy count. The Second Circuit rejected arguments that the government was precluded from retrying the case. Merrill Lynch entered into a settlement with the SEC in a related administrative proceeding earlier this year as discussed here.

In U.S. v. Kovachev, Case No. 1:09-cr-00403 (S.D.N.Y. Filed April 22, 2009), Kosta Kovachev was charged with participating in the fraudulent scheme of attorney Marc Dreier, discussed here. Specifically, Mr. Kovachev is alleged to have directly participated in three schemes in which Mr. Dreier defrauded hedge funds in connection with the sale of fraudulent promissory notes. In once scheme, after the notes were not paid, Mr. Kovachev met with note holders and falsely pretended to be a representative of the company which issued the notes. He responded to questions about the finances of the company, providing the note holders with false information. In a second, he contacted the founder of a hedge fund to tell him about notes Mr. Dreier had for sale. Later, the hedge fund executive was introduced to Mr. Dreier and induced to purchase $13.5 million in notes. In a third scheme, Mr. Kovachev posed as the CEO of a developer that had issued notes Mr. Dreier was offering for sale. Mr. Kovachev discussed financial information with the prospective purchaser.

Mr. Kovachev has been charged with one count of conspiracy to commit securities fraud and wire fraud, one count of securities fraud, and one count of wire fraud.

In U.S. v. Grigg, Case No. 3:09-cr-0089 (M.D. Tenn. Filed April 22, 2009) mail and wire fraud charges were returned against Gordon Grigg, the former Franklin financial advisor and the owner of ProTrust Management, Inc. The information alleged that Mr. Grigg operated a scheme to defraud investors by soliciting funds claiming that they would be safely invested in certificates of deposit, corporate notes, debentures and similar items. Mr. Grigg also reportedly told investors that funds would be pooled toward the purchase of TARP guaranteed debt. In fact, the investments were fictitious Mr. Grigg is alleged to have solicited money from about 60 investors, raising about $6.6 million. Those funds were diverted to the personal benefit of Mr. Grigg.

Previously, the SEC brought an action, discussed here, and obtained an emergency freeze order.

Circuit courts

In U.S. v. The Williams Companies, Inc., Case No. 08-5203 (D.C. Cir. April 17, 2009), the court considered the question of whether the production of materials covered by the attorney work product doctrine from an internal corporate investigation remained privileged if produced to the government in response to a grand jury subpoena. Although the company produced the materials under cover of a letter which provided that no privileges were waived as to third parities, and DOJ argued that production did not result in a waiver, the court ordered the materials produced. While not every production of work product materials results in a waiver, when they are produced to an adversary the very basis of the privilege is undercut and, accordingly, there is a waiver as discussed here.

Private actions

In In re Scansource, Inc. Derivative Litig., Case No. 6:06-cv-03312 (D.S.C. Filed Nov. 21, 2006), the court gave preliminary approval to a settlement in a derivative suit based on option backdating claims. Under the terms of the settlement, company officials will forfeit over $2 million, including remediation payments to the company, the repricing of options and reimbursement payments to federal tax officials. In addition, more than 1,000 outstanding options were forfeited and new procedures for the issuance of options will be adopted. Plaintiffs’ counsel will receive $1.3 million in fees.

Previously, the SEC closed its investigation into the option granting practices of the company.

In Kirschner v. Grant Thornton LLP, Case No. 1:07-cv-11604 (S.D.N.Y. Filed Dec. 28, 2007), the court dismissed a complaint brought by the liquidating trustee of Refco which collapsed in a scandal as discussed here. The action named Mayer Brown, Grant Thornton, Ernst & Young, Credit Suisse Securities and others as defendants. The court concluded that Refco had benefited from the acts alleged in the complaint by the Trustee. Since the Trustee stands in the shoes of Refco, it is fundamental that it cannot recover for the wrongful acts of the company.

New academic studies

Jill Fisch, “Top Cop or Regulatory Flop? The SEC at 75” (April 15, 2009) (to be published in the June 2009 issue of the Virginia Law Review). This paper argues that the failures of the SEC are not the result of the regulatory system. Rather, “the SEC has failed to maintain its functional effectiveness in a time of increased financial market complexity.” That complexity, the author contends, demonstrates the shortcoming of self regulation and places an “enhanced premium on the SEC’s core competencies, particularly maintaining effective financial disclosure.” Ms. Fisch concludes that the regulatory system need not be overhauled. The SEC’s effectiveness however, needs to be improved “through a renewed emphasis on leadership, increased independence, and enhanced oversight and analysis of market developments.”

Jill Fisch, “Confronting the Circularity Problem in Private Securities Litigation,” 2009 Wisconsin L. Rev. 333. This paper rejects the argument that private securities litigation fails to effectively deter corporate misconduct or to compensate defrauded investors. Rather, Ms. Fisch argues that the “corporate governance rationale for securities regulation is more powerful than most recognize.” Informed investors play a critical role in enhancing market efficiency which, in turn, allows the capital markets to “discipline management” improving corporate governance. This justifies compensating informed traders for their fraud based losses, Ms. Fisch concludes.


On April 29, 2009 at noon, the ABA will sponsor a live program in Washington, D.C., which will also be webcast nationally, on insider trading. The program features speakers from the SEC, DOJ, FINRA, NYSE Regulation and the private sector who will discuss current enforcement efforts in the area as well as practical compliance steps.