The Financial Crisis Inquiry Commission issued its report this week noting that the crisis was avoidable, there was a widespread failure of financial regulation and a systematic breakdown in accountability and ethics. At the same time the SEC continued to issue regulations under Dodd-Frank and sent a study to congress on standards for those who give investment advice.

Insider trading continued to be a key focus of regulators with more Galleon related cases being filed. A prison sentence was handed down in an FSA insider trading case. The SEC also settled another FCPA action.

The CFTC conducted a sweep, filing suits against fourteen firms in four courts. These are the first suits to enforce the new forex regulations which went into effect last fall.

Market reform

The Financial Crisis Inquiry Commission issued its report on the financial crisis. The report details the findings of the Commission regarding the causes of the crisis. The Commission was not charged by congress with making recommendations for legislation.

The overall conclusions of the Inquiry Commission are:

• The crisis was avoidable

• Widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets

• A combination of excessive borrowing, risky investment, and lack of transparency put the financial system on a collision course with crisis

• The government was ill-prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets

• There was a systemic breakdown in accountability and ethics

• Mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis

• Over-the-counter derivatives contributed significantly to this crisis

• The failures of credit rating agencies were essential cogs in the wheel of financial destruction

The SEC continued to issue rules to implement Dodd-Frank this week. These include:

• Say-on-Pay: The Commission adopted rules regarding shareholder approval of executive compensation and golden parachute compensation arrangements. Under these rules companies will be required to specify that say-on-pay votes will occur at lest every three years. They will also be required to hold a “frequency” vote at least every six years to permit shareholder to decide how often they want to be presented with the say-on-pay vote. Additional disclosures will also be required regarding “golden parachute” compensation.

• Accredited investors: The SEC proposed rules for the adoption of new standards for accredited investors which would exclude the value of the investor’s primary residence in determining net worth.

• Disclosure by private funds: The Commission proposed rules which would require a registered investment adviser who manages one or more private funds to periodically furnish certain information which would remain confidential. The information is for use by the Financial Stability Oversight Council in monitoring risk to the U.S. financial system.

The Commission also released a staff Study Recommending a Uniform Fiduciary Stand of Conduct for Broker-Dealers and Investment Advisers. The study proposes that the standard be at least as stringent as the current standard for investment advisers under the Advisers Act. Commissioners Kathleen Casey and Torey Paredes opposed the release of the study arguing it does not fulfill the statutory mandate of Section 913 of Dodd-Frank which requires it to evaluate the effectiveness of existing legal and regulatory standards on this subject.

SEC Enforcement

Insider trading: SEC v. Cardillo, Civil Action No. 11-CV-11 civ 0549 (S.D.N.Y. Filed Jan 26, 2011). Michael Curdillo, a former trader at Gelleon Management, LP is alleged to have traded while in possession of inside information in violation of Exchange Act Section 10(b). The information concerned the acquisitions of 3Com and Axcan. As a result of that trading the fund made over $730,000 in trading profits. The information traces to two Ropes and Grey associates, Arthur Cutillo and Brien Santarias, who misappropriated it. They then tipped Zivi Goffer, a former trader at Schottenfeld Group LLC known as “Octopussy” because of his many sources of information. Mr. Goffer in turn furnished the information to a trader who worked in the Galleon offices, who furnished it to Mr. Cardillo. Previously, Mr. Cardillo pleaded guilty to criminal charges. The SEC case is in litigation.

Insider trading: SEC v. Smith, Civil Action No. 11-CV-0535 (S.D.N.Y. Filed Jan. 26, 2011) is an action against Adam Smith, a former portfolio manger of the Galleon Emerging Technology funds. The complaint states that Mr. Smith obtained inside information about the take over of ATI Technologies, Inc. by Advanced Micro Devices Inc. The information came from a source that Mr. Smith had known for years. While in possession of the information Mr. Smith caused the Galleon funds he advised to purchase ATI shares. Those shares were later sold at a profit of over $1.3 million. The complaint alleges a violation of Exchange Act Section 10(b). The case is in litigation.

In the matter of Merrill Lynch, Pierce, Fenner & Smith, Inc., Admin. Proc. File No. 3-14204 (Jan. 25, 2011) alleges that the firm misused customer order information, charged certain customers undisclosed trading fees and failed to maintain proper records in violation of Exchange Act Sections 15(c)(1)(A), 15(g) and 17(a). The conduct on which the Order is based occurred from 2002 through 2007 and centers on three types of transactions. The first concerned the use of certain customer order information by the firm’s proprietary Equity Strategy Desk. The second involved improper mark-up and mark-down charges on orders for certain institutional and high net worth individuals, contrary to the firm’s representations to those customers. Finally, in some instances during the time period Merrill agreed to guarantee a customer a specific per-share execution price or a price tied to an agreed upon benchmark. The firm however failed to record them in writing as required by Section 17(a)(1). As a result of this conduct Merrill violated not only the Sections cited above but it also failed to reasonably supervise persons subject to its supervision as required by Section 15(b)(4)(E). To resolve the matter Merrill consented to the entry of a cease and desist order and agreed to pay a $10 million civil penalty.

Market manipulation: SEC v. Metcalf, Civil Action No. 11 Civ 0493 (S.D.N.Y. Filed Jan. 24, 2011) is an action against Christopher Metalf, Bonzidar Vukovich and Pantera Petroleum, Inc. alleging violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The complaint claims that Mr. Metcalf, the president and CEO of Pantera, and Mr. Vukovich engaged in a scheme to manipulate the price of Pantera shares. Specifically, the Commission alleged that in March and August 2008 defendant Vukovich provided detailed instructions to a person identified only as Individual A to purchase blocks of Pantera stock using matched trades. Individual A, and the registered representatives he supposedly represented, claimed to have discretion over the accounts of wealthy individuals. The individual defendants promised Individual A a 30% kickback on the transactions. The case is in litigation.

Insider trading: SEC v. Nacchio, Civ. No. 05-cv-480 (D. Colo.) is an action against former Quest Communications CEO Joseph Nacchio, discussed here. This week the court entered a final judgment against Mr. Nacchio. In the settlement Mr. Nacchio consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(b)(5) and from aiding and abetting violations of Sections 13(a), 13(b)(2). He also agreed to disgorge $44,632,464 and interest. No penalty was assessed in view of the result in the related criminal case.

Insider trading: SEC v. Fan, Case No. C11-0096 (W.D. WA. Filed Jan. 18, 2011) is an action against Defendants Zizhong (James) Fan and Zishen (Brandon) Fan and relief defendant Junhua Fan, all relatives (here). James was employed at biotech company Seattle Genetics as the manager of clinical programming. Brandon resides in Chino Hills, California while Junhua lives in Beijing, China. James and his team were involved in clinical trials for a drug known as SGN-35, a product to treat Hodgkin’s lymphoma. His direct reports had access to data about the trials in July and August 2010. Between August 24 and September 24, 2010 Brandon is alleged to have purchased over 2,750 Seattle Genetics options at a cost of $360,000. The contracts were acquired through Junhua’s account. During this same period James repeatedly attended meetings involving the key trial on the drug and the late September deadline for disclosing those results to the public. On September 27 the company issued a press release and conducted a webcast to disclose the results The price for company shares increased about 18%. Brandon liquidated the options at a profit of $803,000 over the next month. Subsequently the SEC staff contacted both defendants on January 13, 2011. Over the next few days there were repeated efforts to transfer the money first to a domestic account and later to a bank in China. James also announced he was leaving for China. The Commission filed an action alleging violations of Exchange Act Section 10(b) and obtained a temporary freeze order. The case is in litigation.

Sale of unregistered securities: SEC v. Wall Street Communications, Inc., Civil Action No. 8:09-cv-1046 (M.D. Fla.) is an action against Howard Scalia and his company, Wall Street Communications as well as Ross Barall and Donald McKelvey. The complaint alleged manipulative schemes including one in which Wall Street and Mr. Scalia acquired large blocks of thinly-traded microcap companies for little or no consideration and then created a market for the shares using either spam emails or coordinated manipulative trading with accounts controlled by Mr. Barall. The second scheme was alleged to have involved the illegal acquisition of 8.6 million shares of Telco-Technology under a Form S-8 registration statement. After acquiring the shares they were allegedly sold in a fraudulent unregistered offering with half of the proceeds going to a company controlled by Mr. McKelvey. The complaint alleged violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b). This week the Commission settled with Defendant McKelvey who agreed to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 5, 17(a)(2) and 17(a)(3). Questions regarding disgorgement, prejudgment interest and a civil penalty are reserved for the court. The Commission dropped all scienter based charges.

Rule 105, Reg M: In the Matter of Horseman Capital Management, L.P., Adm. Proc. File No. 3-14202 (Jan. 24, 2011) is a proceeding naming as a Respondent Horseman Capital, a London based partnership which manages four funds, two of which are in the U.S. The firm is registered with the FSA in the U.K. According to the Order, from the middle of 2007 through the summer of 2008 Respondent maintained short positions in the stocks of several financial institutions including Merrill Lynch. On July 29, 2008 Merrill shares were sold in a follow-on offering. During the restricted period Respondent increased its short position in Merrill by 75,000 shares. This violated Rule 105 of Reg M which generally prohibits the purchase of securities in an offering if that person sold short the security during the restricted period. To resolve the proceeding Respondent consented to the entry of an order directing that it cease and desist from committing or causing any violations and any future violations of Rule 105 of Regulation M. The order also directed Respondent to pay disgorgement of $1,295,138 along with prejudgment interest and to pay a civil penalty of $65,000.


The Commission filed actions against fourteen foreign currency firms in a nationwide sweep. The actions were brought simultaneously in Chicago, the District of Columbia, Kansas City and New York. Twelve of the cases allege that the firm acted as a Foreign Exchange Dealer without registering with the Commission. Each of the cases claims that the defendant solicited or accepted orders from U.S. investors to enter into forex transactions in violation of the Act. These are the first actions brought by the FTC to enforce the new forex regulations which became effective in October 2010. The cases are in litigation.

Criminal cases

U.S. v. Lang (E.D.N.Y.) is an action naming as defendant William Lang, president of Harbor Funding Group, Inc. and Joseph Pascua, the president of Black Sand Mine, Inc. The indictment charges each defendant with conspiracy to commit securities and wire fraud and securities and wire fraud. It is based on two alleged schemes. One is an advance fee scheme in which the defendants told land developers who had clients seeking to build houses in regions affected by Hurricane Katrina that Harbor Funding had funds to lend in return for the payment of an advance fee. About $9 million was raised from 300 individuals. In fact the defendants did not have the funds to lend but kept the fees. In the second the defendants induced investors to invest in Black Sand Mine claiming it was starting to mine gold and other precious metals on Sitkinak Island in Alaska. The marketing was done through webinars and in person presentations. The representations were fraudulent.


SEC v. Jennings, Case No. 1:11-cv-00144 (Filed Jan. 24, 2011) is a settled FCPA action against Paul W. Jennings, the former CFO and CEO of Innospec, Inc. The complaint focuses on two key schemes. One involves Iraq and in part the U.N. Oil for Food Program while the other is based on bribes paid in Indonesia. In Iraq the company began paying bribes to sell its fuel additive as early as 2000. In 2001 it began paying bribes in connection with the U.N. program. In Iraq the company paid bribes, according to the court papers, totaling over $1.6 million and promised more than $880,000 in illegal payments. The company also paid for gifts, entertainment and travel. In Indonesia Innospec is alleged to have paid bribes from about 2000 through 2005 to obtain about $48.5 million in contracts from state owned oil and gas companies. Defendant Jennings is alleged to have been involved with some of the bribery schemes beginning in late 2004. He also failed to report the bribes involved in the U.N. program to the auditors after learning about them. Mr. Jennings settled the action by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 30A, and 13(b)(5) and from aiding and abetting Innospec’s violations of Exchange Act Sections 30A, 13(b)(2)(A) and 13(b)(2)(B). He also agreed to disgorge $116,092 along with prejudgment interest and to pay a civil penalty of $100,000. The settlement considers the cooperation of Mr. Jennings.

Antonio Perez, the former controller of a Florida based telecommunications company, was sentenced to twenty-four months in prison based on FCPA violations. The court also directed that Mr. Perez serve two years of supervised release following the prison term and forfeit $36,375. Mr. Perez admitted that he conspired to bribe officials from Telecommunications D’Hati to obtain business. He also admitted to conspiring with Juan Diaz and Robert Antoine, the former director of International relations for Telecommunications D’Hati. Mr.Perez stated that he was personally involved with two bribe payments totaling the amount of the forfeiture.

Court of appeals

Dronsejko v. Grant Thornton, Nos. 09-4222 and 10-4074 (10th Cir. Jan. 20, 2011) is a securities class action against the auditors of iMergent. The complaint centered on an alleged improper revenue recognition scheme at the company between October 2002 and October 2005 which materially overstated revenue and resulted in a restatement of the financial statements. Specifically, the claims were based on the revenue recognition policy of the company. Under that policy revenue could be recognized on the sale of licenses based on Extended Payment Term Arrangements under certain circumstances. GAAP permits such recognition if there is persuasive evidence of an arrangement, the delivery of the product has occurred, the fee is fixed and determinable and collectability is probable. Here the company recognized 100% of the revenue from these arrangements despite the fact that it collected on average only 53% of the total purchase price. In its 2003 and 2004 10Ks the firm stated that 47% of its extended payment term sales were uncollectable. The SEC had told the company that the collection rate had to be substantially more than 50% to recognize the revenue. Plaintiffs claimed that the unqualified audit opinions of the defendant were false and misleading. The district court dismissed the case, concluding that plaintiffs had failed to adequately plead a strong inference of scienter. The circuit court affirmed.

Initially the circuit court noted that the third, fourth, sixth and ninth circuits had developed a recklessness standard specifically for Section 10(b) claims involving outside auditors. This standard is “especially stringent” and requires “a mental state so culpable that it approximates an actual intent to aid in the fraud being perpetrated by the audited company.” (internal quotes omitted). Here the court concluded that it need not consider this issue since under any standard the complaint is deficient. The issue raised here is based on a claim that although the audit firm knew the facts about the collection rate, that it was reckless in concluding that a 53% collection rate constituted “probable collectability” under the applicable principles which do not define those terms. While various sources use different definitions of “probable collectability” the court held that the failure of the audit firm to use those sources does not constitute recklessness. Likewise the magnitude of the restatement is of no import since it does not speak to the issue of recklessness. Indeed, it is well established that GAAP violations only support a claim of scienter when coupled with evidence of the defendant’s fraudulent intent to mislead investors. That is not the case here.


Suitability: Barclays Bank plc was fined about $11.5 million by the agency for failures in relation to the sale of two funds. From July 2006 through November 2008 the bank sold Aviva’s Global Balanced Income Fund and Global Cautious Income Fund to 12,331 investors for over $1 billion. In connection with these sales the bank failed to ensure the funds were suitable for customers, did not give adequate training to its sales staff, failed to ensure that materials provided to customers clearly explained the risks and did not have adequate procedures to monitor the sales process. Approximately one in seven investors have complained. Barclays has been conducting a review of the sales and has paid over $25 million in compensation. The FSA estimates up to $65 million more may need to be paid to customers

Insider trading: Neil Rollins, former senior manager of PM Onboard Limited, was sentenced following a verdict finding him guilty of insider trading. Mr. Rollins has been found guilty on five counts of insider dealing and four counts of money laundering. The trading followed the acquisition by Mr. Rollins of information suggesting his company would have poor financial results. He traded in shares of his company prior to the announcement of the results. He also encouraged his wife to do the same. When the FSA began its inquiry he laundered the proceeds in an effort to conceal his activities. The court sentenced him to 27 months in prison and order him to pay almost $300,000 in confiscation.