The SEC and the CFTC continue to implement the directive in the Treasury White Paper to harmonize their respective regulatory schemes, announcing two meetings in September to consider public comment on the question. The SEC also issued another proposed short selling rule, a variation of the previously proposed uptick rule.

SEC enforcement suffered another set back with the dismissal of a financial fraud complaint as to two defendants for failing to plead facts sufficient to demonstrate primary liability. DOJ however obtained the conviction of a former UBS broker for defrauding customers in connection with investments in auction rate securities. The New York Attorney General filed an action against Charles Schwab claiming fraudulent sales practices in connection with the sale of ARS.

Finally, the Ninth Circuit court reversed the conviction of former Brocade CEO Gregory Reyes and remanded his case for a new trial. The reversal was for prosecutorial misconduct.

Regulatory reform

Harmonizing standards: The SEC and the CFTC announced that they will hold joint meetings to seek input on harmonizing their regulatory approaches, a directive to the agencies in the Treasury White Paper discussed here. The first meeting is scheduled for September 2, 2009 with the second the next day.

Derivatives: CFTC Chairman Gary Gensler sent a letter to Senate Agriculture Committee Chairman Tom Harkin and Saxby Chambliss, the ranking Republican on the committee, asking that the Treasury proposals regarding derivatives be strengthened. Mr. Gensler essentially asked that certain exemptions from regulation in the proposed legislation be eliminated.

Short selling: The SEC issued for public comment a variation of its previously proposed uptick rule. The new alternative approach would allow short selling only at an increment above the national best bid. The Commission made this proposal suggesting it may be more effective and easier to implement that its earlier proposals.

FASB interpretive release: The SEC issued an interpretative release regarding the FASBs Accounting Standards Codification. On June 30, 2009, the FASB issued Statement No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles. This replaces Statement No. 168 and has an impact on certain SEC rules, regulations, releases and staff bulletins. The release is designed to avoid any confusion between the action of the FASB and the Commission’s rules and staff guidance. The release also notes that the Commission is embarking on a long term rulemaking and updating initiative to “revise comprehensively specific references to specific standards under U.S. GAAP in the Commission’s rules and staff guidance.”

SEC enforcement

SEC v. Khanna, Case No. 09cv1784 (S.D. Cal. Filed Aug. 20, 2009) claims that Mohit Khanna and his related entities raised as much as $70 million from about 300 investors in an investment scheme fraud. According to the SEC, the defendants solicited investors claiming that their funds would be invested in commercial paper, foreign currency trading products and other investments. Investors were also told that the fund was FDIC and SIPC insured and covered by insurance policies. These claims were false and in fact investor funds were expended for Mr. Khanna’s personal use, according to the complaint. The district court granted a temporary freeze order. The case is in litigation. See also Litig. Rel. No. 21181 (Aug. 20, 2009). The CFTC and the state of California filed an action against the same defendants shortly before the SEC. CFTC v. Khanna, Case No. 09 CV 1783 (S.D. Ca. Filed Aug. 17, 2009).

SEC v. Fraser, CV–09-00443 (D. Ariz. Filed March 6, 2009), discussed here, is an action against four senior officers of CSK Auto Corporation. The complaint alleges that from 2002 through 2004 the defendants improperly inflated the financial results of the company. The scheme centered on allegations that the defendants obtained allowances from vendors which were used to decrease the cost of goods sold and thus increased pre-tax income. Defendants however, improperly failed to write off these allowances when they became uncollectible.

The court dismissed the SEC’s amended complaint as to two defendants for, among other things, failing to adequately plead facts to establish primarily liability based on the Ninth Circuit’s “substantial participation” test. Under this test, the defendant may be primarily liable under Sections 10(b) and 17(a) where he or she substantially participates in, or is intricately involved in, the preparation of financial statements.

Here, the complaint alleges that defendant Fraser was a member of CSK’s disclosure team, attended meetings of that group, and that he reviewed the company’s 10-K filings for the three years on which the complaint is based. These allegations, without more, are not sufficient, the court held. Vague assertions that Mr. Fraser and a co-defendant were somehow involved were not enough. The court also rejected the SEC’s effort to use a scheme liability theory for the same reason — failure to plead facts specifically identifying what actions were taken. The SEC will have an opportunity to file a second amended complaint.

Criminal cases

U.S. v. Duncan, Case No. 4:09-cr000516 (E.D. Mo. Filed August 13, 2009) named as Aaron W. Duncan as a defendant in an indictment which contains four counts of wire fraud, seven counts of mail fraud and nine counts of money laundering. Mr. Duncan is reputed to have run The Duncan Group, an investment fund that falsely claimed to have large returns from investing in foreclosure and rental properties. The fund allegedly raised about $2.5 million and in fact is a Ponzi scheme, according to the indictment.

U.S. v. Tzolov, Case No. 1:08-cr-00370 (E.D.N.Y. Filed Aug. 20, 2008), discussed here, named as defendants two former UBS brokers, Julian Tzolov and Eric Butler. Mr. Butler was convicted of conspiracy and securities fraud following a three week trial. The indictment alleges that Messrs. Butler and Tzolov defrauded investors in connection with the purchase of action rate securities by telling them they were purchasing ARS backed by student loans on the basis that they were safe, conservative investments. Then, without any disclosure the defendants switched the investments into much riskier higher-yield mortgage backed collateralized debt obligations which paid higher commissions. The scheme was discovered in August 2007 when the market for mortgage backed CDO’s collapsed. Investor losses were about $1 billion. Mr. Tzolov previously pleaded guilty. See also SEC v. Tzolov, Case No. 08 civ 7699 (S.D.N.Y. Filed Sept. 3, 2008).

U.S. v. Green, Case No. 1:09-mj-01880 (S.D.N.Y. Filed August 14, 2009) charges Stephen Green, Chairman and CEO of Mayfair Capital Group, with securities and wire fraud. The indictment alleges that defendant Green solicited and obtained about $2.75 million in investments from an institutional investor for his funds. In fact, the investments were fraudulent.

Circuit courts

In U.S. v. Reyes, No. 08-10047 (9th Cir. Filed August 18, 2009), the court reversed the conviction of former Brocade CEO Gregory Reyes and remanded his case for a new trial as discussed here. It also reversed the sentence of Stephanie Jensen, former V.P. of Human Resources for the company.

Both cases are based on what was alleged to be a massive option backdating scheme at the company. At trial, the primary defense offered by Mr. Reyes, who signed-off on the backdated grants, was that he did so without any intent to deceive. Mr. Reyes argued that he relied on the finance department. The government countered by presenting testimony from a lower level finance department employee who stated she did not know about the backdating scheme. In final argument, the government reiterated that testimony, arguing that it should not have to bring in everyone from the department to establish the point. It went on to argue that in fact the finance department did not know about the backdating scheme.

The court concluded that the government misled the jury. In fact, it knew from FBI interviews that senior finance department officials knew about the option backdating. Accordingly, the court revered the conviction of Mr. Reyes and remanded the case for a new trial.

The sentence of Ms. Jensen was reversed because the court inappropriately added enhancements. Prior to trial, Ms. Jensen’s counsel won a severance of her case from that of Mr. Reyes based on a claim that Mr. Reyes would testify in here case. He did not. The district court found that the severance had been granted on a false premise. Although Ms. Jensen’s attorney took responsibility, the court added sentencing enhancements for obstruction. The circuit court reversed, concluding that the record demonstrated that her counsel was responsible for the act, not Ms. Jensen.

Fenner v. Belo Corporation, Case No. 08-10576 (5th Cir. Decided Aug. 12, 2009) affirmed the denial of class certification for failure to establish loss causation as discussed here. The case involved a securities fraud suit against Belo which owned, among other things, The Dallas Morning News. The complaint claimed that the company engaged in a fraudulent scheme designed to inflate the circulation figures for the newspaper.

Several months after announcing declining circulation, Belo issued a press release stating that an internal investigation revealed questionable circulation practices. According to the release, the claimed fraudulent practices resulted in a decline in daily and Sunday circulation. It also stated that the declines were coupled with the circulation declines announced earlier and with lower than anticipated circulation for the next six months. The next day the price of the stock dropped at the open by about $5.

In this case, the key question is the proof required to establish loss causation when there are multiple sources of negative information. Under such circumstances the plaintiff must demonstrate that it is more probable than not that it is the negative statement revealing the truth, and not others, which caused the price decline. The district court correctly rejected the plaintiff’s initial effort to establish loss causation without expert testimony because it was “little more than well-informed speculation.” While the analysts’ reports and similar information submitted were helpful, “the testimony of an expert — along with some kind of analytical research or event study — is required to show loss causation,” the court held.

Subsequently, plaintiffs offered expert testimony but it was flawed the court concluded. The event study on which it is based viewed the key press release as having only one piece of news. This is incorrect, the court held because in fact, on its face, it has three distinct items of information. Without the event study, the testimony is not sufficient and plaintiffs fail to establish the necessary link between the inflated price and the claimed loss.


FINRA and the SEC issued a warning to investors titled “Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors.” ETFs are designed to track the performance of an index or benchmark. Inverse ETFs do the reverse. According to the release, both leveraged and inverse ETFs use a range of investment strategies through the use of swaps, futures contracts and other derivatives. Most leveraged and inverse ETFs reset each day meaning that they are designed to meet their objectives in that time period. Over long periods of time their performance can differ significantly from the underlying index.

State enforcement cases

The People of the State of New York v. Charles Schwab & Co., (S.Ct. NY. Filed Aug. 17, 2009) alleges, as discussed here, that investors were sold auction rate securities based on representations that they were safe and liquid when in fact they were not. After identifying specific misrepresentations made to investors from tape recorded conversations the complaint claims that Schwab failed to ensure its brokers and sales force were property equipped to tell investors about the liquidity risks of auction rate securities that were known to the firm. Because of Schwab’s misleading sales practices many of its customers purchased ARS based on false assurances of liquidity and without having been provided with basic information about the securities. The complaint seeks, among other things, the repurchase of the securities along with penalties and costs. This case is in litigation.

New academic studies

Insider trading: A new paper by Karl Muller, Monica Neamtiu and Edward Riedl titled “Insider Trading Preceding Goodwill Impairments” considers whether insiders strategically sell shares prior to the disclosure of good will impairment losses. According to the study “Overall, the results are consistent with corporate insiders being able to profit from their private information relating to a specific financial reporting element, goodwill impairments, prior to its incorporation by the equity market or recognition by the firm’s accounting system.” Harvard Business School Working Paper 10-007.

Option backdating: A new paper by Rick Edelson and Scott Whisenant titled “A Study Of Companies With Abnormally Favorable Patterns Of Executive Stock Option Grant Timing” concludes that most companies that improperly backdated stock options never were caught by regulators or confessed to the practice. The study identified 141 companies with advantageous options-granting practices. Ninth two of those companies were never publicly linked to the investigations or announced earnings restatements related to backdating. The paper is available at the Bauer College of Business, University of Houston and here.

Private actions

Kevin LaCroix, author of the excellent D&O Diary, reports in an August 20, 2009 post that Madoff related cases are reaching into new areas. A class action has been filed by an investor who claims to have lost $8.5 million. The defendant is AIG. The complaint claims the insurer wrongfully denied coverage under a home owner’s insurance policy. According to the complaint a policy provision called Fraud SafeGuard covers the investment loss. With new Ponzi schemes and other fraudulent schemes being discovered almost daily, this could spark a new round of investor suits.