On Capital Hill, the debate continues regarding financial reform, as CFTC Chairman Gary Gensler continued to champion new regulation for OTC derivatives. The SEC brought another case in its on-going investigation regarding kickbacks relating to the New York state pension fund and another investment fund fraud case. Two circuit court decisions focused on the question of fraudulent omissions, while a district court concluded that there is no private right of action under the anti-pyramiding provisions of the Investment Company Act.

Market reform

CFTC Chairman Gary Gensler, in remarks to the Council of Institutional Investors on April 13, 2010, outlined what he views as the key provisions necessary for reform in this area and commented on the existing House and Senate bills. The essential elements of regulation in this area begin with comprehensive regulation of any entity that deals in derivatives. This includes Wall Street banks as well as other non-bank dealers. All standardized over-the-counter derivatives must be brought onto transparent, regulated exchanges or similar trading venues. This will lower risk and improve pricing in the marketplace. Finally, to further lower risk all standardized OTC derivatives must be brought into central clearinghouses.

For derivatives that are not standardized, but rather are tailored to the needs of a particular hedger, the contracts should not be subject to a clearing requirement Mr. Gensler noted. New regulation should ensure that the dealer regulation and capital requirements account for the risks of these transactions. At the same time, it is critical that as many over-the-counter derivatives transactions as possible are moved into the central clearing houses. This means that there should not be broad exemptions. These key elements are incorporated into the Senate Banking Committee bill and the current House legislation. Moving forward, it is critical that each of these key elements be incorporated into the final legislation.

SEC enforcement actions

Kickbacks: SEC v. Quadrangle Group LLC, Case No. 10-cv-3192 (S.D.N.Y. Filed Apr. 15, 2010) is an action against Quadrangle Group and Quadrangle GP Investors II which alleges that Quadrangle obtained a $100 million investment in 2005 from the New York Retirement Fund by paying kickbacks. Specifically, the Quadrangle is alleged to have agreed to distribute a low budget DVD David Loglisci, the former New York State Deputy Comptroller. In addition, the firm agreed to pay a $1 million fee to Henry Morris, the top political advisor and chief fundraiser for former New York State Comptroller Alan Hevesi. To resolve the case, each defendant consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a)(2) and to an order requiring them to pay a financial penalty. See also Litig. Rel. 21487 (Apr. 15, 2010).

Fraudulent unregistered offering: SEC v. Integrity Financial AZ, Case No. 1:10-cv-00782 (N.D. Ohio Filed Apr. 15, 2010) is an action against Steven Long and Walter Knitter, the former owners of Integrity Financial AZ and two of its salesmen, Walter Knitter and Robert Koeller. Between February 2008 and September 2009, the defendants raised about $8 million from 58 investors in a fraudulent unregistered offering. Investors were promised guaranteed returns of 10 to 20% in promissory notes that were alleged to have been secured by real estate. The promotional materials falsely promised that the investments were secure, low risk and non-pooled. The funds were to be used to build homes in Tonopah, Arizona. In fact, most of the money was diverted to other projects. The complaint alleges violations of the registration and anti-fraud provisions. The case is in litigation. See also Litig. Rel. 21488 (Apr. 15, 2010).

Bank conversion fraud: In the matter of Haberman Management Corp., Adm. Proc. File No. 3-13859 (Apr. 13, 2010) is a proceeding against Ross Haberman and two controlled entities for fraud in connection with bank conversions. Beginning in 2004 and continuing through the first quarter of 2009, Mr. Haberman misrepresented the true beneficial owner of certain accounts used in connection with the conversion of bank ownership. To participate in financial institution conversions from being mutually owned to a stock form of ownership, Mr. Haberman maintained accounts and certificates of deposits at 200 institutions and maintained several dozen accounts in his name but with assets from Haberman Value Fund L.P. He falsely represented that he would be the beneficial owner of the stock and not the firm. The misrepresentations deprived others of the opportunity to participate in the transactions.

To resolve the action, Respondents consented to the entry of a cease and desist order from future violations of Exchange Act Section 10(b) and Advisers Act Section 206 as well as a censure. The order also barred Respondent Haberman from association with any investment adviser with the right to reapply after three years. The fund was ordered to pay disgorgement of $1919,943 along with prejudgment interest. Mr. Haberman agreed to pay disgorgement of $91,317 along with prejudgment interest and a penalty of $100,000.

Investment fund fraud: SEC v. Farah, Case No. 1:10-CV-00135 (D. NH Apr. 9, 2010) is an action against Scott Farah, Donald Dodge and their controlled entities, which alleges that over 150 investors were defrauded since 2005 out of at least $20 million. The defendants told investors that their funds would be used to invest in specific real estate loans in segregated accounts and that they would receive returns ranging from 12 to 20%. In fact, the funds were not segregated and were used for a variety of purposes. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b). The case is in litigation. See also Litig. Rel. 21482 (Apr. 9, 2010).

Investment fund fraud: SEC v. Brown, Civil Action No. 10-CV-1207 (D. Minn. Apr. 8, 2010) is an action against Renee Brown, an investment adviser and her controlled entity, Investors Income Fund X, LLC. According to the SEC, from July 2009 through March 2010, Ms. Brown fraudulently raised more than $1.1 million from six investors by convincing them to invest in Fund X which is suppose to be a “bond fund” with a fixed annual return. According to the complaint, Fund X is a sham and Ms. Brown misappropriated most of the money she raised. The complaint, which alleges violations of Securities Act Section 17(a), Exchange Act Sections 10(b) and 15(a) and Advisers Act Section 206, is in litigation. See also Litig. Rel. 21483 (Apr. 8, 2010).

Criminal cases

Kickbacks: U.S. v. Zangari (E.D.N.Y.) is a case in which Salvatore Zangari, a former stock loan trader at Morgan Stanley and Bank of America Securities pleaded guilty to conspiracy charges based on a kickback and bribery scheme. In exchange for kickbacks, Mr. Zangari directed the stock loan business from each of his employers to Paloma Securities and Swiss American Securities. The agreement resulted in sham finder’s fees being paid to Anthony Lupo, a purported stock loan finder doing business as Clinton Management. Mr. Lupo paid kickbacks to Mr. Zangari and others. This is the 32nd conviction in an industry wide investigation. Sentencing has not been scheduled.

Investment fund fraud: U.S. v. Mathis (M.D. Tenn.) is an action against Barron Mathis, former Vice President and portfolio manager for J.C. Reed & Co., a failed financial services company. Mr. Mathis pleaded guilty to wire fraud in connection with a scheme in which he induced investors to deposit over $11 million with the investment firm between January 2006 and October 2008. The scheme centered on promises to invest and manage the deposited funds in growth oriented investments with a fixed annual return. Investors were encouraged to put their money in the stock of the financial services firm. They were assured the firm was as a safe investment and that it was profitable. The representations were false and investors lost their money. Sentencing has not been scheduled.

Circuit courts

U.S. v. Schiff, No. 08-1903 & 08-1990 (3rd Cir. April 7, 2010) is a case in which securities fraud charges were brought against the former CFO of Bristol-Myers Squibb, Frederick Schiff, and Richard Lane, another company executive, as discussed here. The fraud charges are based on statements made in an earnings call and corporate filings regarding a sales strategy implemented by the drug manufacturer. The district court dismissed the charges as to Mr. Schiff.

The circuit court affirmed. First, the court rejected the government’s claim that Mr. Schiff had a fiduciary duty to rectify the alleged misstatements of another executive. Second, the court rejected the government’s theories of liability based on Mr. Schiff’s statements. Here the government argued three theories: 1) “all of a piece;” 2) duty to update; and 3) duty to correct. Under the “all of a piece” theory, the government claimed that statements made at the analysts calls were tied together with the statements in the SEC filing as essentially one event. The government, however, had stipulated that its theory of liability was based only on omissions, not misrepresentations. Under these circumstances the court held that that it was “not logical” to conclude that an utterance in an analyst conference call must have other words written into it from a later made SEC filing. The court also rejected claims of a duty to update and correct. A duty to update arises only when a statement was reasonable at the time, but later became misleading when viewed in the context of other events. This is not the predicate of the government’s claim here. A duty to correct arises when a historical statement that at the time was true is revealed by subsequent events to be incorrect. Again this is not the case hear. Accordingly the district court’s order dismissing the charges is affirmed.

Vladimir v. Bioenvision, Inc., Case No. 09-3487 –cv (2nd Cir. April 7, 2010) is a class action which alleged that several statements made by the defendants were materially false and misleading because the defendant Bioenvision, Inc. was engaged in merger negotiations with Genzyme Corporation which were not disclosed. The district court dismissed the complaint. The Second Circuit affirmed, finding there was no duty to disclose. The fraud claims in the complaint are based on omissions. For an omission to be actionable there must be a duty to disclose the information. Since the defendants are not alleged to have traded, that duty can only come from either a statute or regulation or as a result of an ongoing duty to avoid rendering existing statements misleading by failing to disclose material facts. There is no express duty to disclose merger negotiations as opposed to a definitive merger agreement. Since silence is not actionable absent a duty to disclose the complaint was properly dismissed.

Private actions

The Gabelli Global Multimedia Trust, Inc. v. Western Investment LLC., Civil No. RBD 10-0557 (D. Md.) is an action by closed end fund Gabelli Global Multimedia Trust, Inc. alleging violations of the anti-pyramiding provisions of the Investment Company Act by Arthur Lipson and a group of investment companies he controlled. The complaint was dismissed for lack of standing. The complaint alleged violations of Section 12(d)(1)(A) of the Investment Company Act. Following the Supreme Court’s decision on implied remedies in Alexander v. Sandoval, 532 U.S. 275 (2001) and the Second Circuit’s in Olmsted v. Pruco Life Ins. Co. , 283 F.3d 429 (2nd Circ. 2002), the court concluded that there was no private cause of action under the section.