This Week In Securities Litigation (Holiday edition – period from December 23, 2016 to January 6, 2017)
Questions regarding the validity of SEC ALJs continue to be a key focus for SEC enforcement. The Tenth Circuit concluded that the retention of SEC ALJs violated the Constitution’s Appointment Clause, setting up a potential conflict in the circuits that could result in Supreme Court review.
During holidays the Commission, along with the DOJ, concluded its investigation of General Cable Corporation regarding FCPA issues. The inquiry found that the firm had paid bribes in six countries yielding over $51 million in profits. Separately, the SEC settled with the firm on internal control issues.
During the period the SEC also brought actions centered on failed audits, offering frauds and insider trading.
SEC Enforcement – Filed and Settled Actions
Statistics: Last week the SEC filed 3 civil injunctive cases and 3 administrative proceedings, excluding 12j and tag-along proceedings.
Audit failure: In the Matter of Elliot B. Berman, CPA, Adm. Proc. File No. 3-17180 (January 3, 2017) is a proceeding which names as Respondents Mr. Berman and his firm Berman & Co. C.P.A. The action centers on the audits by the firm of MusclePharm Corporation’s 2010 and 2011 financial statements. In those engagements Respondents issued reports despite a lack of independence. Respondents failed to conclude that a major client of the firm was a related party. As a result the required disclosures were not made. Respondents also inappropriately relied on management representations and failed to account properly for sales incentives, advertising and promotions. In addition, Respondents failed to recognize that the company did not properly disclose its sponsorship commitments and international sales as required by GAAP. The Order alleges violations of Exchange Act Section 13(a) and Rule 13a-1 thereunder and Rule 2-02(b)(1) of Regulation S-X. To resolve the proceeding each Respondent consented to the entry of a cease and desist order based on the Section and Rules cited in the Order. Each Respondent is denied the privilege of appearing before the Commission as an accountant with the right to apply for re-instatement after two years. Respondents will jointly and severally pay a penalty of $25,000.
Internal controls: In the Matter of General Cable Corporation, Adm. Proc. File No. 3-17754 (December 29, 2016) is an action which names as a Respondent the global manufacturer of copper, aluminum and fiber optic wire and cable products. From 2008 through 2012 the firm materially misstated its financial statements due to improper accounting for inventory at its Brazil subsidiary. The improper accounting was the result of inadequate internal controls. Specifically, executives at the firm manipulated the accounting systems which were highly manual and presented financial reporting risks by creating false entries for missing inventory values to cover up the missing inventory. When this was reported to the company’s Rest of World segment CEO and CFO they concealed the inventory misstatements from executive management. In October 2012, when the firm announced it had identified the inventory accounting issue, a restatement was undertaken. That restatement determined that from 2008 to the second quarter of 2012 the firm overstated inventory by about $46.7 million. That resulted in the overstatement of net income by 21.6%, 11.3% and 29.8% for the annual periods ended December 31, 2011, 2010 and 2009 and by 8.8% and 13.8% for the quarterly periods ended June 30 and March 31, 2012 respectively. A second restatement was undertaken in October 2013 because the Brazil subsidiary also failed to implement sufficient internal accounting controls relating to revenue recognition. The Order alleges violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The firm self-reported (see also FCPA case below), cooperated, and undertook a series of remedial actions. It also agreed to implement certain undertakings. To resolve the proceeding the company consented to the entry of a cease and desist order based on the Sections cited in the Order. General Cable also agreed to pay a penalty of $6.5 million.
Offering fraud: SEC v. AJN Investments, LLC, Civil Action No. 0:16-cv-63036 (S.D. Fla. Filed December 28, 2016) is an action which names as Defendants AJN and its founder, Jason Ogden. The action centers on an EB-5 offering, the immigration program that offers a permanent green card to those who make certain investments in the U.S. which create a specified number of jobs. Between October 2011 and April 2015 Defendants raised about $6.7 million from 14 foreign nationals who were promised that for a $550,000 investment they would each receive a 5% return and the necessary number of jobs would be created. The business plan called for the creation of two franchised stores. In mid-stream Mr. Ogden changed the business model to focus on kiosks, a smaller unit that might not create the requisite number of jobs. Those who invested prior to the switch were not informed of the change while others solicited after received a stale PPM. Portions of the investor funds were misappropriated. The complaint alleges violations of Exchange Act Section 10(b) and Securities Act Sections 17(a), 5(a) and 5(c). To resolve the action Mr. Ogden agreed to repay the money he used for his own benefit (another operator has taken over the businesses) which totaled $1,008,681 along with interest of $41,024 and pay a penalty of $160,000. See Lit. Rel. No. 23714 (December 28 2016).
Offering fraud: SEC v. Francisco, Civil Action No. 8:16-cv-02257 (C.D. Ca. Filed December 27, 2016) is an action which names as defendants attorney, Emilio Francisco, his controlled entity, PDP Capital Group, LLC, and a series of related entities. The action centers on fraud in connection with the offering of securities in the form of limited partnership units tied to the EB-5 immigration program. Specifically, the Defendants conducted 19 offerings involving 131 investors, raising in excess of $72 million over a three year period beginning in 2013. The offerings were made in assisted living facilities, Cafe Primo restaurants and a packaging facility, primarily to investors in China. In several of the offerings investors were specifically told that their entire $500,000 investment would be used to develop a specific project and that a related administrative fee would be available to pay the of the limited partnership until the project was completed. The claim that the funds would be dedicated to a specific project was a misrepresentation. For two of the offerings the investor funds were not disbursed to the bank accounts of the limited partnerships. Portions of the funds were misappropriated. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending.
Insider trading: SEC v. Hong, Civil Action No. 16 cv 9947 (December 27, 2016) is an action which names as defendants two Chinese nationals, Iat Hong and Hung Chin. Sou Cheng Lui was named as a relief defendant. By at least July 2014, and continuing over the next year, defendants hacked into the computer systems of two New York law firms and misappropriated confidential, non-public information, regarding pending merger and tender offer transactions. The information was used to trade in the stocks, yielding about $3 million in illegal profits. Specifically, defendants were able to secure inside information on a transaction involving: InterMune, Inc. prior to the August 24, 2014 announcement date; a transaction involving Intel Corporation, Inc. and Altera, Inc., announced on March 27, 2015; and a deal involving Pitney Bowes, Inc., and Borderfree, Inc., announced on May 5, 2015. In the first, their trading profits were about $393,000 while in the second they made over $1.63 million and in the third, where their trading at times represented about 25% of the transactions in Borderfree shares, about $850,000. The complaint alleges violations of Exchange Act Sections 10(b), 14(e) and 20(b). The U.S. Attorney’s Office for the Southern District of New York parallel charges against all three men. Both cases are pending. See Lit. Rel. No. 23711 (Dec. 27, 2016).
General Cable Corporation, a Kentucky based global manufacturer of copper, aluminum and fiber optic wire and cable products, resolved FCPA charges with the DOJ and the SEC (along with unrelated internal control and books and records charges as noted above with the Commission). The firm entered into a non-prosecution agreement with the DOJ, making certain admissions regarding bribes it made and paying a $20 million criminal fine. With the SEC, the firm consented to the entry of a cease and desist order based on the bribery, books and records and internal control provisions and paid disgorgement of $51,174,237 along with over $4.1 million in prejudgment interest. The DOJ and the SEC acknowledged the cooperation of the firm which included self-reporting, substantial cooperation and remedial efforts. The Department noted that the criminal fine represented a 50% discount from the amount calculated to be the bottom of the penalty range under the sentencing guidelines. See In the Matter of General Cable Corporation, Adm. Proc. File No. 3-17755 (December 29, 2016).
The underlying conduct stems from a twelve year period beginning in 2003 and related to efforts to secure business in Angola, Thailand, China, Indonesia, Bangladesh and Egypt. Overall the firm is alleged to have made over $51 million on sales to SOEs while making payments directly to foreign government officials or through third party agents. In making the payments General Cable failed to: ensure that anticorruption due diligence was conducted regarding the retention of third-party agents and distributors; secure proof that services had been rendered by third parties prior to payment; and did not conduct proper oversight of the payment process to ensure that payments made were in accord with firm policies and were reasonable and legitimate.
General Cable had a code of ethics that prohibited any consideration being given to a public official unless it was authorized by law and made in accord with the FCPA. The code cautioned against excess payments to an individual arranging contracts with government officials since the amount could be illegal or unethical. The code also required that all transactions be executed only with management authority in compliance with the federal securities laws. These provisions were not adhered to here.
Specifically, the firm’s subsidiaries in Portugal and Angola sold wire and cable product to SOEs. From 2003 through 2013 the two subsidiaries made 81 improper payments through commissions, which totaled over $9 million, either directly to employees of SOEs in Angola or to a third party agent, resulting in over $34 million in profits. The commissions were approved by senior management in the subsidiaries and concealed from the firm’s executive management.
Similarly, from January 2008 through the beginning of 2013, the firm’s Thailand subsidiary made more than $5.4 million in improper payments to a Thailand firm and made over $13 million in profits. That same subsidiary made an improper commission payment in 2013 of over $43,000 to a third-party agent on the sale of products to a Bangladeshi SOE. From late 2012 through the fall of 2015 General Cable’s China subsidiary made improper payments of over $500,000 to third-party distributors or agents, typically in the form of special discounts, technical service fees, design institute fees or rebates in connection with sales to SOE customers. Likewise, over a five year period beginning in late 2010, the Egypt subsidiary gave, or offered to give, over $80,000 in improper payments in various forms to employees of certain customers or suppliers, some of which were Egyptian SOEs. See also In the Matter of Karl J. Zimmer, Adm. Proc. File No. 3-17756 ( December 29, 2916)(settled proceeding naming as Respondent the Senior Vie President of the firm’s Europe and Africa Supply Chain and Global Supply Chain responsible for sales and marketing in region; charged with approving improper commission payments re Angola and thus causing violations of the books and records and internal control provisions; settled with a consent to a cease and desist order based on those Sections and the payment of a $20,000 penalty).
U.S. v. Ray, 4:16-cr-00409 (S.D. Tx.) is an action in which Douglas Ray and Victor Hugo Valdez Pinon each pleaded guilty to one count of conspiracy to violate the FCPA and one count of conspiracy to commit wire fraud. Previously, Kamta Ramnarne and Daniel Prez each pleaded guilty to one count of conspiracy to violate the FCPA. Defendants Ramnarine and Parez are scheduled to be sentenced on January 30, 2016. Defendants Ray and Valdez Pinon are scheduled to be sentenced on February 23, 2016.
According to the plea agreements, Defendants Ray and Valdez, along with others, conspired to bribe Mexican officials. The purpose was to secure business relating to the sale of aircraft parts. They bribed Ernesto Hernandez Montemayor, formerly an official at a Mexican state owned firm. In addition, Mr. Hernandez, a Mexican citizen and Ramiro Ascencio Nevarez, formerly an employee of a Mexican state owned university, each admitted to accepting bribes in pleading guilty to one count each of conspiracy to commit money laundering. Overall, conspirators paid about $2 million to Messrs. Montemayor, Nevanez and others to secure business. See also U.S. v. Nevanez, No. 7:16-cr-00252 (S.D. Tex.).
Court of Appeals
Constitutionality of SEC ALJ appointments: Bandmere v. SEC, No. 15-9586 (10th Cir. December 27, 2016) is an action in which David Bandmere was found to have violated the federal securities laws following a hearing before an ALJ. Mr. Bandemere was then directed to cease and desist from further violations of certain provisions of the federal securities laws. He was also barred from the securities business for life. The SEC affirmed. In ruling on his claim that the ALJ had not been appointed in accord with the requirements of the Constitution’s Appointments Clause, the SEC agreed but concluded that the ALJ was not an inferior officer within the meaning of the Clause. Thus, the Appointments Clause does not apply to SEC ALJs the Commission concluded.
The Tenth Circuit granted the Petition for Review ,finding that under Frytag v. Commissioner of Internal Revenue, 501 U.S. 868 (1993) SEC ALJs are inferior officers within the meaning of the Clause. First, the court reviewed a number of decisions in which officials at other agencies had been held to be inferior officers within the meaning of the Appointments Clause. Those included a district court clerk, an assistant-surgeon, a commissioner of the circuit court, Federal Election Commission commissioners, and others.
Second, the court concluded that Frytag, in which special trial judges at the Tax Court were held to be inferior officers within the meaning of the Clause, to be dispositive. There the Court found three factors, taken together, determinative of the question. Those factors are: 1) if the position was created by law; 2) whether the duties, salary and means of appointment for that office are specified by statute; and 3) the nature of the duties performed – are they more than ministerial. No one factor is dispositive under this approach.
In this case, three factors taken together establish that SEC ALJ’s are inferior officers. As the court held: “In sum, SEC ALJs closely resemble the STJs described in Frytag. Both occupy offices established by law; both have duties, salaries, and means of appointment specified by statute; and both exercise significant discretion while performing important functions that are more than ministerial tasks . . . Further, both perform similar adjudicative functions. . . We therefore hold that the SEC ALJs are inferior officers who must be appointed in conformity with the Appointments Clause.” (internal quotations and citations omitted).
In reaching this conclusion the court rejected the SEC’s claim that because SEC ALJs cannot make a final decision, they are not inferior officers. That approach would make one factor dispositive a the expense of the others. Such an approach is not consistent with Frytag, the court concluded.
Unauthorized transactions: The Securities and Futures Commission banned for life Lam Yuk Wai, formerly staff of HSBC Broking Securities (Asia) Ltd., for conducting over 100 unauthorized transactions in the accounts of seven clients. He then concealed the conduct from the clients and the firm. Overall HSBC estimates it has paid over $70 million to affected clients.