This Week in Securities Litigation (August 9 – 30, 2013)

The recent outage at NASDAQ, the latest difficulty at an exchange, is a current focus of regulators. The SEC is investigating, reportedly examining the reasons a system for distributing stock quotes and prices was not adequate, according to a Reuters report (, Aug. 27, 2013). SEC Chair Mary Jo White has vowed to enhance regulatory safeguards, a process which begins by advancing certain rules proposed earlier this year.

Other significant events in securities enforcement litigation during the period include:

New settlement policy: The first cases were settled under the new policy requiring admissions in selected actions;

London whale: Parallel criminal and civil cases were brought against two individuals involved in a claimed cover-up of the losses while the “whale” himself entered into an agreement under which he will not be prosecuted;

Rule 38a-1(c): The Commission brought its first case under this provision which precludes making misrepresentations to the COO of an investment company; and

Conrad Black: The Commission settled its long running litigation with Mr. Black which centered on claims he and others essentially looted the company he directed.


Rulemaking: The Commission, along with five other agencies, issued a notice of proposed rulemaking for rules which concern the interest those who sponsor securitization transactions must retain in those transactions, the so-called “skin in the game” requirement (here).

Alert: The SEC’s Office of Compliance Inspections and Examinations issued a Risk Alert on business continuity and disaster planning for investment advisers. The Alert was prompted by events following Hurricane Sandy (here).

SEC rule making

Conflict mineral rules: National Association of Manufacturers v. SEC, Civil Action No. 13-cv-635 (D.D.C. Filed July 23, 2013) is an action in which plaintiffs challenged the SEC’s new conflict mineral rules enacted under Section 1502 of Dodd-Frank. The Section requires companies to disclose annually to the SEC if the minerals in their products “originated or may have originated in Congo” to help ensure activities involving such minerals do not finance or benefit armed groups. If so, then the company must file an additional report with the SEC with a description of the products manufactured using the minerals. The Commission developed rules which require issuers to conduct a “reasonable country of origin inquiry” regarding their conflict minerals. If, after the inquiry, the company determines that its conflict minerals did not originate in the covered countries, the issuer must disclose that conclusion to the SEC along with its predicate. If the issuer concludes that the conflict minerals did originate from a covered country – or if it cannot make that determination – a report must be prepared and filed.

Plaintiffs challenged the validity of the rules, asserting two key claims. First, they challenge the rules under the Administrative Procedure Act (“APA”). Second, they argue that the rules violate the First Amendment. The Court rejected both claims. Initially, the Court concluded that the Commission’s rules do not violate the APA. The test is whether the action of the agency is arbitrary, capricious and an abuse of discretion. Here Sections 3(f) and 23(a)(2) of that Act do not mandate the type of analysis Plaintiff’s claim. Under those provisions the only obligation of the SEC is to consider the impact that a rule or regulation may have on various economic related factors. In this instance the SEC did just that. The Court also rejected Plaintiffs’ claim that the rules were overly broad. Finally, plaintiffs’ claim the rules contravene the First Amendment because they require that issuers make public disclosure of the information about their use of conflict minerals on their website is incorrect. Rather, the disclosure required is only that the issuer make available on its website the materials filed with the SEC.

SEC Enforcement: Litigated cases

Sale of unregistered securities: SEC v. Gilchrist, Civil Action No. 4:13-cv-00163 (S.D. Tex.) is an action in which the Court granted summary judgment in favor of the Commission and against defendant Jonathan C. Gilchrist. The Court found that Mr. Gilchrist, the president and chairman of Mortgage Xpress, Inc. (renamed The Alternative energy Technology Center, Inc.) authorized the issuance of six million shares of company stock to himself and two affiliated companies. The shares were not registered or eligible for an exemption. Mr. Gilchrist then affected matched trades to drive the price up after a reverse stock split and arranged for promoters to tout the company. Overall the price increased from $1.00 per share to $3.75 before the Commission suspended trading. Prior to that time however, Mr. Gilchrist sold 229,661 unregistered shares. The final judgment imposes D&O and penny stock bars, precludes Mr. Gilchrist from acting as a broker or dealer and requires him to pay disgorgement of $842,493.40 along with prejudgment interest. See Lit. Rel. No. 22788 (August 27, 2013).

The Falcone settlement

The Commission settled its actions against hedge fund manager Philip Falcone based in part on admissions demanded under its new settlement policy. The two cases which recently settled on this bases are:

SEC v. Falcone, Civil Action No. 12 CIV 5027 (S.D.N.Y. Filed June 27, 2012) an action against Mr. Falcone along with two controlled entities, Harbinger Capital Partners Offshore Manager, LLC and Harbinger Capital Partners Special Situations GP, LLC. The complaint centered on a 2006 short squeeze involving trading in a series of distressed high-yield bonds issued by MAAX Holdings, Inc. Mr. Falcone, according to the complaint, crafted a scheme to punish the Wall Street Firm by manipulating the market using a short squeeze after acquiring more than all of the outstanding bonds. The complaint alleged violations of the antifraud provisions of the Securities Act and the Exchange Act.

SEC v. Harbinger Capital Partners LLC, Civil Action No. 12 CIV 5028 (S.D.N.Y. Filed June 27, 2012) is a second action involving Mr. Falcone who is a defendant along with Harbinger Capital Partners LLC and Philip Jensen, the onetime COO of Harbinger. The complaint alleges two schemes. In the first, Mr. Falcone and Harbinger, aided by Mr. Jenson, was alleged to have misappropriated $113.2 million from a Harbinger fund. The money was used to pay Mr. Mr. Falcone’s taxes. In the second, Harbinger Fund and Mr. Falcone granted select large investors favorable redemption and liquidity terms in return for their vote to approve more stringent redemption restrictions on investors. This scheme was concealed from the board. The complaint alleged violations of the antifraud provisions of the Securities Act, the Exchange Act and the Advisers Act.

To resolve these actions the defendants admitted to a series of facts contained as an annex to the consent. Those admissions track many of the allegations in the complaints. As part of the settlements Mr. Falcone also agreed to the entry of an order which requires him to pay $6,507,574 in disgorgement along with prejudgment interest and a $4 million penalty. The entity defendants agreed to pay a $6.5 million penalty. In addition, Mr. Falcone will be barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization with the right to reapply after five years.

Two other cases brought in conjunction with these which were settled at the time of filing. They are:

SEC v. Harbert Management Corporation, Civil Action No. 12 CIV 5029 (S.D.N.Y. Filed June 27, 2012), an action against Harbert Management Corporation, HMC-New York, Inc., and HMC Investors, LLC. Harbert Management is an investment management company that created Master Fund and Special Situations Fund and hired Mr. Falcone to manage its investments. HMC Investors was a managing member of the Master Fund. HMC-New York, Inc. was a managing member of the general partner for the Special Situations Fund. Essentially, the complaint claims that the defendants had the ability to halt the short squeeze executed by Mr. Falcone and described in the action against him. The complaint alleged control person liability under Exchange Act Section 20(a). The defendants settled this action, agreeing to pay a civil penalty in the amount of $1 million. The Harbert defendants also consented to the entry of a judgment enjoining them from violations of Exchange Act Section 10(b).

In the Matter of Harbinger Capital Partners, LLC, File No. 3-14928 (Filed June 27, 2012) is a settled proceeding against Harbinger Capital Partners LLC. It centered on the purchase of shares in three public offerings in April and June 2009 after having sold the shares short during the restricted period. This violated Rule 105 of Regulation M which establishes a restricted period prior to an offering during which the shares cannot be shorted by specified persons. Harbinger made profits of $857,950 on the transactions. To resolve the action the Respondent consented to the entry of a cease and desist order based on Rule 105 of Regulation M and a censure. The firm also agreed to disgorge its trading profits, pay prejudgment interest and a civil penalty of $428,975 in addition to adopting certain procedures.

SEC Enforcement: Filings and settlements

Filings this week: During this three week period the Commission filed 12 civil injunctive actions and 5 administrative proceedings (excluding follow-on actions and 12(j) proceedings).

Investment fund fraud: SEC v. Dearman, Civil Action No. CV-553 (N.D. Okla. Filed August 27, 2013) is an action against Larry Dearman and Marya Gray. Mr. Dearman was a representative of a Commission registered investment Adviser from November 1, 2003 until August 24, 2012 when he was terminated. Ms. Gray is a licensed realtor in Oklahoma. She is the majority owner and President of Bartnet Wireless Internet, Inc. and the sole owner of The Property Shoppe, Inc. and Quench Buds Holding Company, LLC. Each of the entities is named as a relief defendant. From December 2008 through August 2012 the defendants raised about $4.7 million from more than 30 investors. In soliciting the funds Mr. Dearman told investors that their investment would be placed in various entities owned or controlled by Ms. Gray. A variety of misrepresentations and omissions were used to induce investors to part with their hard earned cash, depending on which of Ms. Gray’s entities was being used as an investment vehicle. While Mr. Dearman was largely responsible for soliciting the funds, Ms. Gray also played a key role since the investor money went into accounts that she controlled. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 22789 (August 27, 2013).

False securities reports: In the Matter of Carl D. Johns, Adm. Proc. File No. 3-15440 (Filed August 27, 2013) is a proceeding against Carl Johns, an employee of Bolder Investment Advisers, LLC, who also performed services for its affiliate, Boulder Investment Advisers, LLC. The two advisers provided investment advisory services to four affiliated, closed-ended management investment companies registered with the Commission. Mr. Johns assisted in the management of the portfolios for, and served as an officer of, several registered investment companies. During the course of his employment Mr. Johns engaged in active personal trading in securities, including those held by the funds. Rule 17j-1(d) of the Investment Company Act required that Mr. Johns submit quarterly reports of his personal transactions and annual reports of his holdings. The Code of Ethics of the advisers imposed additional restrictions regarding pre-clearance and trading. It also required an annual certification. From 2006 through 2010 Mr. Johns failed to comply with Rule 17j-1(d) and the Code of Ethics. He failed to clear 640 trades, including 91 transactions in securities held, or to be acquired by, the funds. To conceal these violations Mr. Johns submitted false quarterly and annual reports and certifications. In late 2010 the CCO raised questions about the documents submitted by Mr. Johns. When questioned, Mr. Johns misled the COO, falsely claiming that certain brokerage accounts were closed. He also accessed previously submitted documents regarding his trading and altered them in a manner designed to demonstrate compliance. The Order alleges violations of Section 17(j) of the Investment Company Act and Rules 17j-1 and 38a-1. To resolve the proceeding Mr. Johns consented to the entry of a cease and desist order based on the Sections and Rules cited in the complaint. In addition, he agreed to the entry of an order barring him from the securities business with a right to apply for reentry after five years and agreed to pay disgorgement of $231,169 along with prejudgment interest and a civil money penalty of $100,000. This is the Commission’s first action under Rule 38a-1(c).

Investment fund fraud: SEC v. Marcum, Case No. 1:13-cv-01361 (S.D. Ind. Filed August 26, 2013) is an action against John Marcum and his controlled entity, Guaranty Reserves Trust, LLC. Beginning in 2010 Mr. Marcum raised about $6 million from 37 investors who purchased notes in his company. Investors were told that their funds would be secure and that they would receive high rates of return from day trading. In fact Mr. Marcum invested little of the money, lost portions of it in start-up companies and spent other portions of it. The scheme unraveled when investors demanded the return of their funds. The complaint alleges violations of Securities Act Sections 5(a) and (c), each subsection of Section 17(a) and Exchange Act Section 10(b). The case is in litigation.

Stop order: In the Matter of The Registration Statement of Counseling International, Inc., File No. 3-15437 (August 22, 2013). The Order alleged that a Form S-1 registration statement for the IPO of the company failed to properly disclose the identity of control persons and promoters of the firm. In addition, an amendment falsely described the circumstances under which the CFO of the company departed. The company settled, agreeing to certain undertakings, and the entry of a stop order.

Misrepresentations: In the Matter of Chariot Advisors, LLC, Adm. Proc. File No. 3-15433 (Aug. 21, 2013). Respondent Chariot Advisors is a registered investment adviser founded by sole owner and Respondent, Elliott Shifman. Shortly after founding Chariot Advisors, Mr. Shifman began developing the Chariot Fund which would have a short-term, fixed income and algorithmic currency trading strategy. Mr. Shifman then convinced Northern Lights, a registered open-ended series management investment company, to create a series based on the proposed fund after providing the board with materials outlining the proposal which he reiterated in a meeting. At the time the fund was launched a registration statement and prospectus also detailed the proposed investment strategy.It was never implemented however and, in fact, Respondents did not have the ability to do so. The Order alleges willful violations of Sections 15(c) and 34(b) of the Investment Company Act and Sections 206(1), (2) and (4) of the Advisers Act. The proceeding will be set for hearing.

Kickbacks: SEC v. Baldassarre, Civil Action No. 11 Civ. 5970 (E.D.N.Y.) is a previously filed action against Giuseppe Baldassarre, Robert Mouallem and Malcolm Stockdale. The defendants are alleged to have engaged in a kickback and stock manipulation scheme. Specifically, the complaint claims that the defendants bribed brokers to engage in a manipulation scheme involving the common shares of Dolphin Digital Media, Inc. Defendants Baldassarre and Mouallem settled with the Commission under an order that was recently entered by the Court. Under that order each defendant was permanently enjoined from violating Securities Act Section 17(a) and Exchange Act Section 10(b). In addition, the defendants were directed to pay combined disgorgement and prejudgment interest of $21,932.03 which is deemed satisfied by forfeiture orders in the parallel criminal action. Each defendant was also barred from participating in any penny stock offering and Mr. Baldassarre is prohibited from serving as an officer or director of a public company. See Lit. Re. No. 22785 (August 21, 2013).

Market crisis: SEC v. Wu, Civil Action No. CV-11-2988 (N.D. Cal. Filed Oct. 11, 2011) is a previously filed action against the COO of UCBH Holdings, Inc., Ebrahim Shabudin, as well as its CEO, Thomas Wu, senior officer Thomas Yu and CFO Craig On. The case centered on claims that there were improper delays in the recording of loan losses suffered at the end of 2008 and in the first quarter of 2009. Specifically, Messrs. Wu, Yu and Shabudin learned that that as the real estate market deteriorated during the market crisis, there were increasing loan delinquencies and decreasing collateral values for the bank’s portfolio of commercial and construction loans. Defaults were increasing. Messrs. Wu, Yu and Shabudin concealed this information from investors and the auditors, according to the complaint. Although the bank owned by UCHB received assistance from TARP, eventually it failed. This was one of the largest commercial bank failures. This week Mr. Shabudin settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 13(b)(5) and Securities Act Sections 17(a)(1) and (3) and from aiding and abetting violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). He did not admit or deny the allegation in the complaint. Mr. Shabudin was also barred from serving as an officer or director of a public company and has been ordered to pay a penalty of $175,000. That penalty was partially reduced by the amount paid as a penalty in a related action brought by the FDIC. See also Lit. Rel. Nos. 22786 (August 22, 2013) and 22121 (October 11, 2011).

Misrepresentations: In the Matter of Brian Williamson, Adm. Proc. File No. 3-15430 (August 20, 2013) is a proceeding which names as a Respondent Brian Williamson, an employee of Oppenheimer & Co., Inc., and a number of related entities. He has also been the sole owner and Managing Director of ROC Resources, LLC, a registered investment adviser that is a sub-adviser to Oppenheimer Global Resources Private Equity Fund I, L.P. From September 2009 through mid-October 2009 Mr. Williamson caused investors in OGR to receive misleading marketing materials because they did not show the fees and expenses charged which lowered the reported internal rate of return. He also misrepresented to investors the basis on which the fund’s assets were valued and took steps to conceal his role in that process. The Order alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Section 206(4). The proceeding will be set for hearing.

Misappropriation: SEC v. Richards, Civil Action No. 1:13-CV-1729 (N.D. Ga.) is a previously filed action against Blake Richards, a registered representative at a broker dealer. Beginning in 2008 Mr. Richards is alleged to have misappropriated at least $2 million from seven investors, largely by taking their retirement funds and the proceeds of certain life insurance policies. He is also alleged to have fraudulently obtained funds from investors by having them write checks to entities he controlled based on the promise that the money would be invested. In fact the defendant misappropriated the funds. Mr. Richards settled and, in an order entered by the Court, has been enjoined from future violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2). Questions regarding disgorgement and penalties will be resolved on a motion to be filed motion by the Commission. Mr. Richards will be precluded from arguing that he did not violate the federal securities laws in responding to that motion. See Lit Rel. No. 22784 (August 20, 2013).

False statements: SEC v. Cook, Civil Action No. 13-cv-1312 (S.D. Ind. Filed Aug. 19, 2013) is an action against Timothy Cook. The charges center on claims that Mr. Cook fraudulently offered and sold shares of Xytos, Inc. Beginning in 2010, and continuing until early 2013, Mr. Cook falsely claimed to investors that the firm was an operational biomedical company specializing in cancer treatment. He also sold private placement shares, raising about $100,000, which he misappropriated. During the period he sold his shares raising, over $400,000 from the open market transactions. The complaint alleges violations of Exchange Act Section 10(b) and Securities Act Sections 5(a), 5(c) and 17(a). The case is in litigation. See Lit. Rel. No. 22783 (August 19, 2013).

Investment fund fraud: SEC v. Narvett, Civil Action No. 1:13-cv-00927 (E.D. Wis. Filed August 16, 2013) is an action against Robert Narvett and Shield Management Group, Inc. The complaint alleges that Mr. Narvett raised about $940,000 from twenty investors in Shield based on false claims that they would receive substantial returns. In fact Mr. Narvett misappropriated the investor funds. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is in litigation. See Lit. Rel. No. 22782 (August 19, 2013).

Misappropriation of fees: In the Matter of North East Capital, LLC, Adm. Proc. File No. 3-15429 (August 16, 2013) is a proceeding which names as Respondents the unregistered investment adviser and its founder, Anthony Vicidomine. From late 2011 through the first quarter of 2012 Mr. Vicidomine received unauthorized fees totaling $189,415 from North East Capital Fund LP. That firm is a pooled investment vehicle he created and offered interests in to investor through North East Capital. He also made false statements to investors in connection with the sale of interests in the fund, according to the Order. The Order alleges violations of Securities Act Sections 5(a), 5(c) and 17(a), Exchange Act Sections 10(b) and Advisers Act Sections 206(1), 206(2) and 206(4)-8. To resolve the action each Respondent consented to the entry of a cease and desist order based on the Sections cited in the complaint. In addition, Mr. Vicidomine is barred from the securities business with a right to apply for reentry after five years. Respondents were also ordered to pay disgorgement of $189,415, prejudgment interest and a penalty of $150,000 on a joint and several basis.

Fraudulent related party transactions: SEC v. Black, Civil Action No. 10:04 CV 7377 (N.D. Ill.) is the previously filed action against the former CEO and Chairman of Hollinger International, Inc., Conrad Black. Previously, the district Court granted summary judgment against Mr. Black, based on the Commission’s claims that he and others, in essence, used related party transactions to loot the company. On appeal the case was settled through the Court’s mediation process. Under the terms of that settlement Mr. Black is permanently enjoined from future violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(5), and 14(a). In addition, he will pay disgorgement of $2,546,585.99 along with prejudgment interest. The money will be paid to Chicago Newspaper Liquidation Corporation. He is also barred from serving as an officer or director of a public company. See Lit. Rel. No. 22781 (August 15, 2013).

Fraudulent trading scheme: SEC v. Martin-Artago, Civil Action No. 13-cv-5677 (S.D.N.Y. Filed August 14, 2013) is an action against two JP Morgan traders, Javier Martin-Artago and Julien Grout, in connection with the so-called “London Whale” trading scheme. The complaint alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(5) and 13(b)(2)(A). The factual allegations center on concealing certain trading losses in early 2002 as more fully described below in the discussion of the parallel criminal complaints brought by the U.S. Attorney’s Office in Manhattan.

Kickbacks/manipulation: SEC v. Freedman, Civil Action No., 0:13-cv-61764 (S.D. Fla. Filed August 14, 2013); SEC v. Schultz, Civil Action No. 0:13-cv-61763 (S.D. Fla. Filed August 14, 2013); SEC v. Martin, Civil Action No. 9:13-cv-80806 (S.D. Fla. Filed August 14, 2013); SEC v. Simon, Civil Action No. 9:13-cv-80808 (S.D. Fla. Filed August 14, 2013); SEC v. Gaffney, Civil Action No. 9:13-cv-61765 (S.D. Fla. Filed August 14, 2013); SEC v. Balbirer, Civil Action No. 0:13-cv-61781 (S.D. Fla. Filed August 14, 2013); SEC v. Molinari, Civil Action No. 9:1`3-cv-80807 (S.D. Fla. Filed August 14, 2013). This is a group of cases charging seven CEOs and their respective companies, along with five penny stock promoters, with engaging in illicit kickback and market manipulation schemes involving microcap stocks. Generally, the schemes involved the payment of kickbacks to a pension fund manager or hedge fund principal in return for the fund’s purchase of restricted shares in a microcap company. Some of the schemes also involved the manipulation of the stock of several microcap issuers. The complaints allege violations of Securities Act Section 17(a)(1) and Exchange Act Section 10(b). The actions are pending. See Lit. Rel. No. 22780 (August 14, 2013).

Criminal cases

Investment fund fraud: U.S. v. Callardo (E.D.N.Y. Sentencing Aug. 23, 2013) is an action in which defendant Hector Gallardo was sentenced to serve 60 months in prison following his wire fraud conviction. The charge was based on a scheme which took place over a 10 month period beginning in January 2007 during which the defendant, a registered representative at Orion Trading LLC in New York, solicited business as “Brokerlatino.” In that role he solicited investments from two representatives of an investment firm in Bolivia. That firm bundled investments from about 350 Bolivian retail investors. Those investors, who put up about $1.15 million, were promised large investment returns. In fact most of the money was stolen by the defendant with small portions used to make payments to investors as so-called profits. The scheme crashed when investors demanded copies of the pertinent documentation.

Investment fund fraud: U.S. v. Hollingsworth (N.D. Cal. Sentencing Aug. 21, 2013) is a case in which Douglas Hollingsworth was sentenced to serve 64 months in prison following his guilty plea to one count of wire fraud and one count of money laundering. He was charged in a superseding indictment with 2 counts of mail fraud, 21 counts of wire fraud and 4 counts of money laundering. According to the plea agreement, between June 2007 and July 2010 Mr. Hollingsworth solicited investors for his business entities. He promised that if they loaned money they would have substantial returns from securities trading activity based on a sophisticated computer system that permitted the defendant to identify financial market trends. In fact the defendant misappropriated the funds for his personal use.

False prices: U.S. v. Leszczynski, 1:12-cr-00923 (S.D.N.Y. Plea Aug. 20, 2013) is an action in which Marek Leszczynski pleaded guilty to one count of conspiracy to commit securities and wire fraud. The charge was based on allegations that from 2005 through December 2008 the defendant, employed in the London office of an international broker, purchased and sold securities on behalf of institutional clients at false prices. Specifically, when securities were purchased the prices reported to clients were marked up from those actually paid and when there was a sale the prices reported were marked down below the actual transaction price. This yielded the firm millions of dollars in improper profits and bonuses for the defendant and his fellow conspirators. Sentencing is set for December 19, 2013. See also SEC v. Leszczynski, Civil Action No. 1:12-cv-07488 (S.D.N.Y. Filed October 5, 2012).

Looting: U.S. v. Schlegel, No. 2:06-cr-00500 (E.D.N.Y. Sentencing Aug. 15, 2013) is a case in which David H. Brooks, former CEO of DHB Industries, Inc., was sentenced to serve 17 years in prison. Mr. Brooks, the founder of the company which made bullet proof vests for the military, was convicted on 14 counts of conspiracy, mail and wire fraud, securities fraud, obstruction of justice and lying to auditors. He also pleaded guilty to conspiracy to defraud the IRS and filing false tax returns. The proof at trail demonstrated that Mr. Brooks essentially looted the company, concealed his control of a related company used to channel money from DHB to himself, falsified certain corporate records to inflate profits, lied to auditors and engaged in insider trading.

Fraudulent trading: U.S. v. Martin-Artago, 13 Mag 1975 (S.D. N.Y. Filed August 14, 2013); U.S. v. Grout, 13 Mag. 1976 (S.D.N.Y. Filed August 14, 2013) are actions against two traders at JP Morgan alleged to have been involved in the so-called London Whale trading. Javier Martin-Artijo, Managing Director and Head of Credit and Equity Trading for the Chief Investment Office, and Julien Grout, Vice President and derivatives trader in the CIO, were charged with conspiracy to conceal certain trading losses, false books and records, wire fraud and false filings with the SEC. The charges center on trading for a portfolio known as the Synthetic Credit Portfolio. The portfolio has been used to manage the bank’s excess deposits since 2007. The portfolio had been created by JP Morgan’s Chief Investment Officer as a hedge against adverse credit events. It invested in various credit derivative indices and tranches. The positions in the portfolio have to be marked to the market at fair market value each day. While the positions are historically difficult to value, JP Morgan’s policy called for them to be marked at the mid-point between the price at which the market-makers were willing to buy or sell a security. In early 2012 however, the investments in the portfolio began to decline in value as the market moved against the positions. As the value of the portfolio declined, the defendants sought to conceal the increasing losses by ignoring the bank’s historic valuation methods, although they kept a spread sheet showing those values. The losses continued and eventually required the bank, which incorporated the values into its books and records, to restate its quarterly financial statements to show a pre-tax loss of $660 million. The SEC brought parallel civil actions cited above.

Manipulation: U.S. v. Winick, No. 1:13-cr-00452 (E.D.N.Y. Unsealed August 13, 2013) is an action in which the defendants are Sandy Winick, Gary Kersliner, Joseph Manfredonia, Cort Poyner, Songkram Roy Shachaisere and William Seals. The defendants were charged in what is being called one of the largest international microcap manipulation fraud conspiracies. Overall nine defendants have been charged with 24 counts of securities fraud, wire fraud and false impersonation of IRS employees in connection with two key schemes. One was a pump and dump scheme in which several of the defendants orchestrated one of the largest international penny stock frauds in history. This was done by gaining control of large interests in worthless stock, then pumped the share prices through fraudulent sales campaigns and eventually dumping their shares, leaving investors with millions of dollars in losses. In a second scheme several defendants engaged in an advance fee scheme. Here investors were told that for the payment of an advance fee they would be able to either sell securities to others or join lawsuits to reclaim losses. In reality, neither opportunity existed. The fees were taken by the defendants.

Court of appeals

Insider trading: SEC v. Bauer, No. 12-2860 (7th Cir. Decided July 22, 20123) is an action centered on the issue of whether an employee of a mutual fund engages in insider trading by redeeming shares in the fund at a time when the trading window is open. Defendant Jilaine Bauer was employed at Heartland Advisors, Inc., as an investment adviser and broker-dealer. Heartland advised a series of funds, two of which focused on municipal bonds. Those bonds can be difficult to price. Ms. Bauer was the general counsel and chief compliance officer to the adviser. Beginning in 1999, and continuing through August 2000, the funds had substantial net redemptions. This created liquidity problems. In mid-August 2000 the co-manager of the municipal bond funds tendered his resignation. Ms. Bauer imposed trading restrictions on Heartland personnel aware of that event. On September 28, 2000 a press release announcing the co-manager’s resignation was issued. At the time the municipal bond funds continued to struggle. After the close of business Ms. Bauer lifted the trading ban as approved by the board of directors.

On October 3, 2000 Ms. Bauer redeemed all of her shares in one of the municipal bond funds. At the time the two municipal bond funds continued to have liquidity problems. The SEC named Ms. Bauer in an insider trading complaint. The district court granted summary judgment in favor of the Commission. That ruling was based on the stipulation of the parties that Ms. Bauer was an insider who possessed non-public information at the time of the redemptions and the Court’s conclusion that there was no dispute of fact as to the materiality of that information. The Circuit Court reversed and remanded with instructions. The Seventh Circuit began by noting that the SEC had abandoned the classic theory of insider trading and now must proceed on the misappropriation theory. The Court then concluded that this is the first case to consider if insider trading applies to mutual fund redemptions. In view of that point and, since the issue was not addressed by the district court, the case was remanded to that Court for consideration of the issue.


Best execution: Morgan Stanley Smith Barney LLC and Morgan Stanley & Co. were fined $1 million and ordered to pay $188,000 in restitution plus interest for failing to provide best execution to certain customers. Specifically, the firms failed to ensure best execution in 116 customer transactions involving corporate and agency bonds and 165 transactions involving municipal bonds.

Investor alert: The regulator issued an alert entitled “Marijuana Stock Scams” which cautions investors about possible pump and dump schemes involving companies claiming to be in the marijuana business.


Broker-dealer auditor inspections: The Board released its second progress report under the interim inspection program for broker and dealer auditors instituted under Dodd-Frank. Board inspectors reviewed 43 audit firms covering portions of 60 audits of brokers and dealers registered with the SEC. Deficiencies were noted in audits of all of the firms inspected. The deficiencies most frequently noted involved procedures related to the computations of customer reserves and net capital requirements and those tied to related financial statement areas including the testing of revenue, related party and risk of material misstatement due to fraud. In addition, independence violations were found for about one third of the audits selected for inspection with some auditors involved in the preparation of the financial statements they audited.


Regulation: The Securities and Futures Commission issued a release outlining the regulation of collective investment schemes (here).

Manipulation: The SFC announced that Au Wai Lok was sentenced to serve 100 hours of community service after pleading guilty to six counts of false trading in the shares of Xi’an Haitian Antenna Technologies Limited between May 10, 2010 and May 31, 2010. During that period the defendant marked the close by trading within 90 seconds of market close on five trading days and on one day engaged in simultaneous matched orders which accounted for about 95% of the trading volume.

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