Settling enforcement actions is becoming more difficult. The SEC and the Department of Justice both had courts refuse to approve settlements this week. SEC enforcement did resolve its first ever fraud action against a state, an insider trading case, a financial fraud action and an investment fund action. FINRA filed two settled actions and the Third Circuit rejected the fraud-made-the-market theory proposed by a plaintiff seeking class certification.


SEC v. Citigroup, Inc., Civil Action, No. 10-cv-127 (D.D.C. Filed July 29, 2010), discussed here, is a disclosure fraud case against the bank. One current and one former employee were named as Respondents in the related administrative proceeding.

The district court refused to enter the consent degree proposed by the SEC and the bank. In an August 17, 2010 order, the court directed the SEC to file a memorandum on or before September 13, 2010 addressing a series of questions including: 1) what evidence support the charges that the defendant “committed fraud via negligence;” 2) who are the individuals referred to throughout the complaint as “senior management;” 3) why the SEC chose to bring actions only against Gary Crittenden and Arthur Tildesley, Jr.; 4) why the $75 million civil penalty is fair, adequate, reasonable and in the public interest; 5) how the proposed penalty compares to others; 6) what the SEC’s economic analysis showed regarding the value of the pecuniary gain to the defendant from the misconduct; 7) the source of the money that will compose the fair fund; and 8) who is a “harmed” shareholder.

The action against the bank stems from false statements made regarding its exposure to the sub-prime market. The firm agreed to settle with the entry of a consent decree based on Securities Act Sections 17(a)(2) & (3) and the payment of a $75 million fine. In a related administrative proceeding, the former employee and current officer agreed to the entry of cease and desist orders and the payment of fines. In support of the proposed settlement, the SEC originally filed a Memorandum which offers little insight into the case or the settlement.

U.S. v. Barclays Bank Plc, Case No. 10-cr-218 (D.D.C. Filed Aug. 16, 2010) is an action against the bank for violating the International Emergency Economic Powers Act and the Trading with the Enemy Act. Companion cases were brought by the New York County District Attorney and the Office of Foreign Assets Control. Essentially, the claims allege that Barclays implemented practices to evade U.S. sanctions for the benefit of sanctioned countries. The court documents claim that from about the mid-1990s until September 2006 the bank knowingly and willfully moved or permitted to be moved hundreds of millions of dollars through the U.S. financial system on behalf of banks from Cuba, Iran, Libya, Sudan and Burma and persons listed as parties or jurisdictions sanctioned by OFAC in violation of U.S. economic sanctions.

The court rejected a proposed settlement in the case. That settlement called for the resolution of the case with a two-year deferred prosecution agreement and the forfeiture of $298 million, with $149 million being paid to the U.S. and $149 million to New York state. The court found the terms of the settlement inadequate – essentially, a sweetheart deal.

SEC enforcement actions

Fraud in offering: In the Matter of State of New Jersey, Adm. Proc. File No. 3-14009 (Aug. 18, 2010) is the SEC’s first fraud action against a state. The Order for Proceedings alleges fraud in violation of Securities Act Section 17(a)(2) & (3) in connection with 79 municipal bond offerings from August 2001 through April 2007 for $26 billion. The cases center on the failure of the state to make certain disclosures regarding the financial condition of two large pension funds, the Teachers’ Pension and Annuity Fund and the Public Employees’ Retirement System. Specifically, the state created the fiscal illusion, according to the SEC, that the two pension funds were being adequately funded when in fact they were severely under funded.

New Jersey was aware of the underfunding, according to the Order, but took no steps to correct the misleading documents used in connection with the bond offerings. During this period, the state did not have any written policies and procedures regarding the review or update of the bond offering documents and no training was given to its employees regarding disclosure obligations. To resolve the proceeding the state consented to the entry of a cease and desist order from commencing or committing or causing any violations and any future violations of the Sections on which the Order is based.

Insider trading: SEC v. Gansman, Civil Action No. 08-CV-4918 (S.D.N.Y. Filed May 29, 2008) is an insider trading case against a former attorney at the Transaction Advisory Services group of Ernst & Young, James Gansman, and his former stock broker and close friend, Donna Murdoch. The Commission alleged, as discussed here, that Mr. Gansman tipped Ms. Murdoch concerning at least seven different acquisition targets of E&Y clients. Ms. Murdoch traded in the securities of each and also tipped her father and recommended trading in two stocks to others, all of who traded. Previously, Mr. Gansman was convicted on parallel criminal charges and sentenced to serve a year and a day in prison. Ms. Murdoch pleaded guilty to a seventeen-count superseding information in December 2008 and is awaiting sentencing. To settle with the SEC, each defendant consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 14(e). Mr. Gansman also agreed to pay disgorgement of $233,385 along with prejudgment interest while Ms. Murdoch will disgorge $339,110 along with prejudgment interest. Mr. Gansman consented to the entry of an order barring him from appearing or practicing as an attorney before the Commission in a related administrative proceeding. Ms. Murdoch agreed to the entry of an order barring her from association with any broker or dealer in a related administrative proceeding.

Investment fund fraud: SEC v. Thompson Consulting, Inc., Case No. 2:08-cv-00171 (D. Utah Filed March 4, 2008) is an action against hedge fund adviser Thompson Consulting and its principals Kyle Thompson, David Condie and Sherman Warner discussed here. The complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) & (2). The defendants are alleged to have made undisclosed high risk investments in sub-prime and similar investments which caused the near collapse of two funds and deviated from the stated investment policy. This week the Commission settled with each defendant consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) & (3). In addition, Thompson agreed to the entry of an injunction based on Advisers Act Section 206(2) and to pay disgorgement of $400,000.

Investment fund fraud: SEC v. Amante Corp., Civil Action No. 09-CIV-61716 (S.D. Fla. Filed Oct. 29, 2009) (discussed here). The complaint names as defendants Amante, Commonwealth Capital Management, Inc. and their president Edward Denigris along with William Dyer who sold shares. It alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b) and 15(a). The Commission claimed that for about a year and a half prior to filing the complaint investors paid about $2.3 million for unregistered Amante shares based on false representations of large returns from an imminent IPO. In fact there was no IPO and much of the money was diverted by Mr. Denigris.

Messrs. Amante and Dyer settled with the Commission. Mr. Amante consented to the entry of a permanent injunction prohibiting future violations of the sections cited in the complaint. Mr. Dyer consented to the entry of an injunction prohibiting future violations of Exchange Act Section 15(a). Mr. Amante also agreed to the entry of a penny stock bar, to disgorge $806,349 and pay prejudgment interest along with a penalty of $130,000. Mr. Dyer agreed to disgorge $10,000 and to pay prejudgment interest and a penalty equal to the amount of the disgorgement.

Financial fraud: SEC v. Schott, Case No. 4:10-cv-01500 (E.D. MO. Filed Aug. 13, 2010) is an action against Kevin Schott, the former CFO of Zoltek Corporation, discussed here. Mr. Schott circumvented the internal controls of the company and ignored the explicit directions of its CEO in making two payments of $250,000 to an outside financing consultant. In the process he lied to the controller of a foreign subsidiary to make the payments, created false documents including entries in the books and records and made false and misleading certifications to the auditors and the public. Mr. Schott had informed the CEO that the payments were due from a prior arrangement with a consultant. The CEO rejected the claim. The case was resolved with Mr. Schott’s consent to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 132(b)(5) and the related rules and an agreement to pay a $25,000 penalty.


Suitability: HSBC Securities (USA) Inc. was fined $375,000 by the regulatory authority for recommending unsuitable securities to retail customers. Specifically, the firm’s representatives recommended Collateralized Mortgage Obligations and inverse floating CMOs to unsophisticated retail customers in 43 instances. FINRA has advised firms since 1993 that inverse floating rate CMOs are only suitable for sophisticated investors with a high risk profile. The firm failed to give its brokers sufficient guidance and training regarding the risks of these securities the regulator concluded. In addition, in making the sales FINRA found that HSBC failed to comply with a rule requiring that investors be offered educational materials about the securities in connection with a transaction.

Notices on sales charge discounts: Merrill Lynch was filed $500,000 for failing to provide customers with sales charge discounts on eligible purchases of Unit Investment Trusts. FINRA has informed members since 2004 that such notices must be given to customers. The regulatory authority concluded that Merrill did not have an adequate supervisory system. Merrill also agreed to provide remediation of more than $2 million to affected customers.

Court of Appeals

Malack v. BDO Seidman, LLP, Case No. 09-4475 (3rd Cir. Aug. 16, 2010) is a securities class action in which the district court denied class certification. The Third Circuit affirmed. The case arose from a note offering by American Business Financial Services, Inc., a sub-prime mortgage originator. Defendant BDO issued an unqualified audit opinion on the financial statements. After issuance American Business collapsed and was liquidated. The notes became worthless. Plaintiffs brought suit against BDO claiming fraud in violation of Exchange Act Section 10(b). The question before the circuit court was whether reliance could be established using the fraud-made-the-market theory.

Plaintiffs argued that the securities were legally unmarketable and that, but for the fraud, there would be no securities and no market. The circuit court rejected the fraud-made-the-market theory and baseless, noting that if the availability of the securities on the market suggests that they are genuine, there must be some entity involved in the issuance process that “acts as a bulwark against fraud.” There is not. The SEC’s review of securities is not based on merit but disclosure. If this theory were credited investors would be free to rely only on the fact that the securities have been issued. In effect the theory, would create a kind of investor insurance policy. That notion is contrary to the basic premise of securities regulation.