THIS WEEK IN SECURITIES LITIGATION (January 14, 2011)
This week the Supreme Court heard argument in one securities case while agreeing to review another. The cases involve critical questions regarding materiality and the application of loss causation in the class certification process.
The Commission brought another insider trading case which is an outgrowth of the seemingly ever expanding Galleon investigations and another against a corporate officer and his tippees. Other actions brought by Enforcement focus on events during the market crisis, financial fraud and investment fund fraud.
Finally, the PCAOB entered into an important agreement with its counterpart in the U.K. Under the new agreement the Board will be able to conduct inspections of U.K. based audit firms that perform audits on companies whose securities are traded in the U.S.
Matrixx Initiatives v. Siracusano (S/Ct. No.09-1156). This week the Court heard oral argument in this case. The question the Court will consider focuses on whether a pharmaceutical manufacturer must disclose adverse drug reports which are statistically immaterial. The Ninth Circuit reversed the dismissal of the complaint by the district court, holding that the reports are material. The circuit court rejected the statistical standard adopted from the Second Circuit by the district court (here).
Erica P. John Fund, Inc. v. Halliburton Co, No. 09-1403. The Supreme Court agreed to hear this case in which the question is: “Whether, in a private action under Section 10(b) of the Securities Exchange Act of 1934 . . a plaintiff who invokes the fraud-on-the market presumption of reliance must prove loss causation in order for the suit to be maintained as a class action” (here). The case arises from a decision of the Fifth Circuit Court of Appeals in The Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., No. 08-11195 (5th Cir. Feb. 12, 2010). The complaint in that case is based on three categories of claimed misstatements relating to Halliburton’s acquisition of Dresser Industries. The Fifth Circuit affirmed the district court’s denial of class certification, concluding that plaintiffs had failed to establish loss causation by a preponderance of the evidence.
Insider trading: SEC v. Holle (D.N.J. Filed Jan. 13, 2011) names as defendants George Holly, co-founder of Home Diagnostics, Inc., and its former chairman, and two of his friends and business associates Steven Dudas and Phairot Iamnaita. The complaint alleges that prior to February 3, 2010 when there was a public announcement of the acquisition of Home Diagnostics by Nipro Corporation, Mr. Holly tipped Defendants Dudas and Iammaita along with four others identified only as Traders 1,2,3 and 4. Each traded and profited from the 89% increase in the share price which followed the deal announcement. Collectively the tippees realized profits of over $250,000. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). The case is in litigation.
Trading/compensation: SEC v. CytoCore, Inc., Civil Action No. 1:11-c-00246 (N.D. Ill. Jan. 13, 2011) names as defendants the company and Daniel Burns, its former COB and CEO and CFO Robert McCullough, Jr. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 14(a), 15(a) and 16(a). It focuses on Mr. Burns, alleging that he: issued a press release touting his stock ownership in the company and then secretly sold his shares while in possession of material, non-public information; received hundreds of thousands of dollars in improper compensation from acting as an unregistered broker for the sale of company shares; and failed to report over 100 stock transactions. Mr. McCullough also failed to properly report his stock sales according to the Commission. The company and Mr. McCullough settled, consenting to the entry of injunctions. The company also agreed to certain undertakings. Mr. McCullough agreed to pay a $100,000 civil penalty and to the entry of a twelve month suspension from association with a broker-dealer or investment adviser. The case is in litigation as to Mr. Burns.
Financial fraud: SEC v. Nutracea (D. Az. Filed Jan, 13, 2011) is an action against NutraCea, a manufacturer of health food, its former CEO and director Bradley Edson, former CFO Todd Crow, former controller Joanne Kline, former director of financial services Scott Wilkison and former senior v.p. and secretary, Margie Adelman. The complaint alleges that the company concealed its true operating results using two fraudulent transactions. In one it booked $2.6 million in sales from a sham transaction. In the other it improperly recorded about $1.9 million in sales from a book and hold transaction. The complaint alleges violations of the antifraud and books and records provisions.
The company settled by consenting to the entry of an injunction prohibiting future violations of Securities Act section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). Mr. Edson consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books, records and internal control provisions along with the payment of a $100,000 civil penalty, an agreement to repay a $350,000 bonus and an officer/director bar. Ms. Adelman also consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 15(b)(5) and the books and records provisions. She also agreed to the entry of a five year officer and director bar. Messrs. Kline and Wilkinson consented to the entry of permanent injunctions prohibiting future violations of Exchange Act Section 13(b)(5). Each also agreed to pay a penalty of $25,000. Each man agreed to the entry of an order in an administrative proceeding based on Rule 102(e) which will prohibit them from appearing and practicing before the Commission as an accountant with a right to reapply after one year. The case against Mr. Crow is continuing.
Investment fund fraud: SEC v. Nadel, Civil Action No. 11-CV-0215 (E.D.N.Y. Filed Jan. 13, 2011) is an action against Warren Nadel, his broker-dealer, Warren D. Nadel & Co. and his investment advisory firm, Registered Investment Advisers, LLC. The complaint centers on claims that clients were fraudulently induced to invest millions of dollars in an investment program that was suppose to be liquid and generate capital appreciation or dividends. In fact the funds were put in instruments that were not liquid. The defendants overstated the value of the investments and their liquidity. They also generated over $8 million in commissions and fees by largely trading back and forth among themselves without disclosing these facts to the investor clients who were told the trades were made in the open market. The complaint charges violations of Securities Act Sections 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), (2), (3) and 207. The case is in litigation.
Misappropriation: SEC v. Sachdeva, Civil Case No. 10-CV-747 (E.D. Wis. Filed Aug. 31, 2010) is an action against the former Principal Accounting Officer, Secretary and Vice-President of Finance of Koss Corporation. The complaint centers on a claim that Mr. Koss embezzled $30 million from the company (here). Mr. Koss settled the case by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 13(b)(5) and from aiding and abetting violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The order also bars him from serving as an officer or director. In a related criminal case the defendant pleaded guilty to six counts of wire fraud and was ordered to pay $34 million in restitution and sentenced to 11 years in prison.
Insider trading: SEC v. Macdonald, Civil Action No. 09-CV-5352 (S.D.N.Y. Filed June 10, 2009) is an action against Canadian attorney Phillip Macdonald and others. As to Mr. Macdonald, the complaint alleges that he traded in advance of the public announcement on business combination deals between January and June 2005 while in possession of inside information. He obtained that information, according to the Commission, from co-defendant Michael Goodman who misappropriated it from his wife, an administrative assistant with Merrill Lynch Canada, Inc. (here). Mr. Macdonald settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 10(b) and 14(e). He also agreed to pay disgorgement of $810,000. Two co-defendants previously settled.
Disclosure fraud: SEC v. NIC, Inc., Civil Action No. 2:11-CV-02016 (D. Ka. Filed Jan. 12, 2011); SEC v Kovzan, Civil Action No. 2:11-CV-02017 (D. Da. Filed Jan. 12, 2011). These actions were brought against NIC, a company which manages government websites, and its former CEO, Jeffery Fraser, current CEO, Harry Herington, former CFO, Eric Bur and current CFO, Stephen Kovzn. The complaints allege violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), 13(b)(5), 14(a) and Securities Act Section 17(a). The cases center on claims that from 2002 through 2005 Mr. Fraser falsely claimed that he worked essentially for free while charging many of his expenses to the company. Those included $4,000 per month to live in a ski loge in Wyoming, monthly cash payments for rent for a home owned by an entity he controlled, travel costs, and other perquisites. Mr. Kovzan, as then Chief Accounting Officer, authorized the payments and knew or was reckless in not knowing that they circumvented company policy. Mr. Herington learned of the problems and failed to address them. The reporting problems, which are reflected in Commission filings, continued even after a whistleblower complaint and the initiation of the SEC’s investigation.
The company settled, consenting to an injunction prohibiting future violations of the Sections cited in the complaint and agreed to hire an independent consultant to recommend new policies. Mr. Fraser also consented to the entry of a substantially similar injunction and agreed to pay disgorgement in the amount of $1,184,246 along with prejudgment interest, a $500,000 civil penalty and the entry of an officer director bar. Mr. Herington also settled, consenting to the entry of an injunction on similar terms and agreed to pay a civil penalty of $200,000. He also consented to the entry of an order in an anticipated administrative proceeding which will prohibit him from practicing before the Commission as an accountant with a right to reapply after one year. Mr. Bur also settled, consenting to the entry of an injunction prohibiting future violations of Exchange Act Rules 13a-14 and 13b-1 and aiding and abetting NIC’s violations of Exchange Act Sections 13(a), 13(b)(2)(A), 13(b)(2)(B) and 14(a) and the related rules. He also resolved an anticipated administrative proceeding by consenting to the entry of an order prohibiting him from appearing or practicing before the Commission as an accountant with a right to reapply after one year. The case against Mr. Kovzan is in litigation.
Boiler room: SEC v. Petroleum Unlimited, LLC, Civil Action No. 9:11-CV-80038 (S.D. Fla. Filed Jan. 12, 2011) is an action alleging violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a) and naming as defendants the company, and Petroleum Unlimited II, LLC along with Roger Kimmel, Jr. and Harry Nyce and the claimed managers of their boiler room Michel-Jean Geraud, Robert Rossi and Joseph Valko. The complaint alleges that over a five month period beginning in March 2008 the individual defendants conducted offerings using private place memoranda which were materially false and misleading to sell interests in the entities. The funds purportedly were to explore for oil and gas. About $2.9 million was raised. The offering circulars failed to inform investors that commissions would range from 49% to 74% while claiming that they could be paid annual returns of 14% to 141% without any reasonable basis. Ultimately little of the money raised was used for drilling. To resolve the case, the two entities and Mesrs. Kimmel, Nyce and Petitti consented to the entry of permanent injunctions. The two companies and Mr. Kimmel agreed that issues regarding disgorgement and penalties would be resolved by the court. Mr. Nyce agreed to pay disgorgement of $242,339 along with prejudgment interest and a penalty of $65,000. Mr. Petitti also consented to the entry of an injunction and agreed to pay a civil penalty of $25,000. See also In the Matter of Michael Geraund, Adm. Proc. File No. 3-14187 (Jan. 12, 2011)(Order is based on Respondent’s criminal convictions for conspiracy to commit mail fraud and conspiracy to defraud the U.S. in an income tax evasion scheme).
In the Mater of Charles Schwab Investment Management, Adm. Proc. File No. 3-14184 (Jan. 11, 2011); SEC v. Charles Schwab Investment Management Inc., Civil Action No. CV-11-0136 (N.D. Cal. Jan. 11, 2011). The two actions are against: Charles Schwab Investment Management (CSIM), a registered investment adviser; Charles Schwab & Co., Inc. (CS&Co.), the distributor and transfer agent for the YieldPlus Fund; and Schwab Investments, a no-load, open ended management investment company organized as a series investment company registered under the Investment Company Act. The YieldPlus Fund is a series issued by Schwab Investments. The actions center on four primary claims (here). First, the SEC alleged that investors were not properly informed about the risks of the Fund. Second, the Fund violated its concentration policy as the market spiraled down during the crisis. Third, misrepresentations were made to investors about the Fund as its NAV began to decline in mid-2007. Finally, the Commission claimed that there were insufficient policies and procedures reasonably designed to prevent the misuse of material, non-public information about the Fund.
The SEC’s complaint and the Order allege violations by: CSIM and CS&Co. of Securities Act Sections 17(a)(2) and (3) and aiding and abetting and causing violations of Investment Company Act Section 34(b); by CSIM of Advisers Act Section 206(4); by Schwab Investments of Investment Company Act Section 13(a); and by CS&Co. of Exchange Act Section 15(g). To settle the civil action CSIM and CS& Co. agreed to pay a total of $118,944,996 including $52,327,149 in disgorgement of fees by CSIM, a penalty by CSIM of $52,327,149, a penalty of $5,000,000 by CS&Co. and prejudgment interest. CSIM’s disgorgement obligations can be satisfied in part by payment within 60 days in a related FINRA proceeding of up to about $26.9 million. The Commission is seeking to establish a Fair Fund. In the related administrative proceeding CSIM, CS&Co. and Schwab Investments consented to the entry of an order requiring them to cease and desist from committing or causing future violations of the sections cited above. CSIM and CS&Co, were also censured and required to retain an independent consultant. Each Respondent was directed to comply with its undertakings.
Two other related actions were brought based on similar allegations. One names as defendant Kimon Daifotis, the former Senior Vice President and Chief Investment Officer-Fixed Income of CSIM and Randall Merk, a former Executive Vice President at Charles Schwab Corporation and an Executive Vice President at CS&Co. The charges in the complaint include violations of Exchange Act Section 10(b), Securities Act Section 17(a), Advisers Act Section 206(4) and Investment Company Act Section 34(b). The case is in litigation. SEC v. Daifotis, Case No. CV-11-0137 (N.D. Cal. Jan. 11, 2011).
The second was brought by FINRA. The agency ordered Charles Schwab & Company, Inc. to pay $18 million into a Fair Fund established by the SEC. That sum represents the $17.5 million in fees Schwab collected on the sales of Fund shares plus a fine of $500,000.
Insider trading: SEC v. Feinblatt, Civil Action No. 11-CV-0170 (S.D.N.Y. Filed Jan 10, 2011)(here) is an action which is an outgrowth of the Galleon investigation. It is against Robert Feinblatt and the company he co-founded, Trivium Capital Management LLC, Jeffrey Yokuty, an analyst at the company, Sunil Bhalla, formerly a Senior Vice President and General Manager of Polycom, and Shammara Hussain, formerly an employee of investment relations firm Market Street Partners which did work for Google. The SEC’s complaint asserts insider trading claims which focus around five key events: 1) Trading in advance of the announcement of Polycom’s fourth quarter 2005 earnings based on a tip from Mr. Bhalla of Pollycom to Ms. Kahn. She then tipped Messrs. Feinblatt and Yorkuty, each of whom traded along with Trivium. Ms. Kahn also tipped Raj Rajaratnam who traded. 2) Trading in advance of the announcement of Polycom’s first quarter 2006 earnings announcement. Again Mr. Bhalla tipped Ms. Khan who in turn told Mr. Rajaratnam about the information. Ms. Khan traded as did Mr. Rajaratnam for Galleon. 3) Trading prior to the announcement of Hilton’s takeover by Blackstone Group: Deep Shah, a Moody’s analyst tipped Ms. Kahn who told Messrs. Feinblatt and Yokuty about the transaction. Ms. Kahn along with Messrs. Feinblatt and Yokuty and Trivium traded. Ms. Kahn also tipped Mr. Rajaratnam who traded for Galleon. 4) Trading prior to the announcement that Google for the second quarter of 2007 would not meet expectations. Mr. Hussain, an employee of a firm doing work for Google, tipped Ms. Khan who traded and passed the information to Messrs. Feinblatt and Yokuty who traded for Trivium. Ms. Kahn also tipped Thomas Hardin, a former Managing Director of Lanexa Management, a hedge fund, and Gautham Shankar, a trader at Schottenfeld Group LLC, who traded. Mr. Rajaratnam was also tipped by Ms. Kahn. He traded for Galleon. 5) Trading before the announcement that Kranos would be acquired by a private equity firm: Deep Shah tipped Ms. Khan who traded and tipped Messrs. Feinblatt and Yokuty who traded for Trivium. Ms. Hussain was also tipped by Ms. Kahn and traded. The case is in litigation.
Internal controls: In the Matter of Hudson Highland Group, Inc., Adm. Proc. File No. 3-14182 (Jan. 10, 2011) is an action based on alleged violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B) by Hudson Highland Group. The company was spun off from Monster Worldwide in 2003. Since that date the company has repeatedly failed to comply with the tax laws which require it to collect sales taxes from its customers. As a result the company, which provides professional staffing and talent management services, had to pay virtually all the uncollected tax. That amounted to about $3.9 million. The failures result from not having proper internal controls. The case was resolved with Hudson consenting to the entry of a cease and desist order based on the two Sections cited in the Order. Hudson also agreed to pay a civil penalty of $200,000.
Investment fund fraud: SEC v. Kowalewski, Civil Action No. 1:11-cv-0056 (N.D. Ga. Filed Jan. 7, 2011) is an action alleging violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), (2) and (4) by Stanley Kowaleski and the company he controls, registered investment adviser SJK Investment Management LLC. According to the complaint the defendants raised about $65 million for to hedge funds based on claims that the money would be invested in a number of funds using complex investment strategies. Small fees would be charged. Instead, almost immediately the money was diverted into another fund which entered into a series of self-dealing transactions such as buying Mr. Kowaleski’s home and paying his personal expenses. The Commission obtained a temporary freeze order.
Investment fund fraud: SEC v. Morris, Civil No. 2:11-cv-00021 (D. Utah Filed Jan. 6, 2011) names as defendants Raymond P. Morris, James Haley, Jay Lindford, attorney Luc Nguyen and a series of controlled entities. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b). It alleges that Mr. Morris, assisted by the other defendants, sold unregistered promissory notes from March 2007 through January 2009 based on a series of misrepresentations. Investors were told they were purchasing high yield noted and that the funds would be deposited in a secure account. In fact Mr. Morris diverted portions of the money to his personal use and made Ponzi type payments with other investor funds. The case is in litigation.
In the Matter of Kimball L. Young, File No. 3-1418 (Jan. 7, 2011); In the Matter of Thomas S. Albright, File No. 3-14179 (Jan. 7, 2011)(here). Respondents managed The Tax Free Fund for Utah. Beginning in 2003 they started charging issuers of certain securities purchased by the Fund a “credit monitoring fee” based on the face value of the instruments. The Respondents told those charged that the fees went to the Fund. In fact they kept the money without telling the board. According to the Order, the payments violated Exchange Act Section 17(e)(1). With respect to Respondent Young, who reviewed documents which falsely stated that the fee would be paid to the Fund, the Order also states that he willfully violated Section 206(1) of the Advisers Act and Section 206(2). To resolve the actions each Respondent consented to the entry of and order directing that they cease and desist from committing or causing any violations and any future violations of the Sections cited in the Order in their respective cases. Mr. Young also agreed to the entry of an order barring him from association with any broker, deal or investment adviser with a right to reapply after five years and to pay disgorgement of $260,313 along with prejudgment interest and a civil penalty of $75,000. Mr. Albright will be similarly barred with a right to reapply after one year. He will also pay disgorgement of $260,313 along with prejudgment interest and a civil penalty of $50,000.
Option backdating: U.S. v. Karatz, 2:09-cr-00203 (C..D. CA.) is the option backdating case against former KB Home, Inc. CEO Bruce Karatz (here). In March 2009 Mr. Karatz was convicted on four counts of mail fraud and making false statements in connection with the backdating of stock options at the company. The government at sentencing demanded a six and one half year prison term and a fine of $7.5 million. It appealed the sentence of 8 months of house arrest, five years of probation a $1 million fine and 2,000 hours of community service. Mr. Karatz cross appealed. Both sides agreed to drop their appeal.
The Public Company Accounting Board concluded a cooperative agreement with its counter part in the U.K., the Professional Oversight Board. The agreement will permit the PCAOB to resume inspections of U.K. audit firms that are registered with the board and that audit or participate in the audit of companies whose securities are traded in the U.S.
The Sarbanes Oxley Act requires that the PCAOB oversee and periodically inspect all accounting firms that regularly audit companies whose securities are traded in U.S. markets. From 2005 through 2008 those inspections were carried out in the U.K. Since that time the Board had not been able to perform inspections despite the fact that there are 59 registered firms in the U.K. One of the obstacles to those inspections was removed by Dodd-Frank which authorized the PCAOB to share confidential information with its foreign counterparts under certain circumstances.
Currently there are 890 audit firms registered with the Board in 87 countries outside the U.S.