Regulatory reform remained a key topic on Capitol Hill this week, with SEC Chairman Mary Schapiro appearing before Senate and House Committees to discuss the Administration’s financial regulatory reform proposals.

SEC enforcement suffered a high profile loss in the Mark Cuban insider trading case and a win in the computer hacker case before the Second Circuit Court of Appeals. The Commission also filed its first SOX clawback case, where the defendant is not alleged to have participated in the fraud. Finally, a criminal insider trading case which went to the Supreme Court on a sentencing issue concluded with the defendant again being sentenced in the district court.

Regulatory reform

SEC Chairman Mary Schapiro appeared twice on Capitol Hill this week. On July 23, she testified before the Senate Committee on Banking, Housing and Urban Affairs about the regulation of systemic risk. On July 22 Ms. Schapiro appeared before the House Financial Services Committee to testify regarding the Administration’s financial regulatory reform proposals.

Before the Senate Committee, the Chairman began by discussing different types of systemic risk — the risk of sudden, near-term systemic seizures and the longer term risk that the system will tend to favor large systemically important institutions over smaller ones. These risks are addressed through two types of regulation — traditional oversight and a new macro-prudential regulation designed to identify and minimize systemic risk. The best way to minimize systemic risk is by closing the gaps in regulation and establishing a single Systemic Risk Regulator, the Chairman noted.

In the area of traditional oversight, Ms. Schapiro discussed filling regulatory gaps to ensure that the same rules apply to the same or similar products; improving market transparency in areas such as dark pools; and active enforcement. Macro-prudential oversight requires that a Systemic Risk Regulator and Financial Stability Oversight Counsel be established. Finally, Ms. Schapiro stated that she agrees with the Administration and the FDIC that there is a need for a credible resolution mechanism for unwinding systemically important institutions. The testimony is available at:

Before the House Committee, Ms. Schapiro focused on the Administration’s proposals for Regulatory Reform which are outlined in the Treasury White Paper issued in mid-June 2009 and discussed here. Essentially Ms. Schapiro reiterated her support for the regulation of OTC derivatives and the harmonization of the approaches used by the SEC and CFTC. She also discussed the proposed regulation of hedge funds and the specific proposals regarding broker dealers and investment advisers and certain enhancements for enforcement regarding whistleblowers, expanded sanctions in the form of industry bars and adding aiding and abetting authority under the Securities Act and the Investment Company Act. Ms. Schapiro concluded her testimony by discussing increased oversight for credit rating agencies and the role of the proposed Financial Stability Oversight Counsel. The testimony is available at:

SEC enforcement

Clawback case: SEC v. Jenkins, Case No. CV 09-1510 (D. Ariz. Filed July 23, 2009) is the first clawback action filed under SOX Section 304 against an executive not alleged to have participated in the fraud. The defendant, Maynard Jenkins is the former CEO of CSK Auto Corporation. During the period that the company and other executives engaged in financial fraud which resulted in two restatements, Mr. Jenkins was paid bonuses and other incentive compensation of over $2 million. He also made in excess of $2 million on stock sales. The complaint seeks the reimbursement of those amounts. The complaint does not claim Mr. Jenkins engaged in the fraud. He did however, execute SOX certifications. See also Lit. Rel. 21149 (Jul. 23, 2009). The case is in litigation.

The Commission previously brought an action against four company executives based on the fraud, discussed here. SEC v. Fraser, Case No. 2:09-cv-00442 (D. Ariz. Filed March 6, 2009) (Lit. Rel. 20933) and a settled administrative proceeding against the company, In the Matter of CSK Auto Corp., Adm. Proc. File No. 313485 (Filed May 26, 2009).

Financial fraud: SEC v. West Marine, Inc., Case No. CV 09-3379 (N.D. Cal. Filed July 23, 2009) is a settled financial case against a Northern California boat supply retailer. The action is based on undisclosed accounting changes made by the company in 2003 which rendered its financial statements for that year incorrect. Specifically, after announcing earnings for fiscal year 2003, the company changed the valuation method for its inventory resulting in a significant drop in earnings. Rather than disclosing this change, the company capitalized certain expenses as an offset. These changes in methodology were not in accord with GAAP and were not disclosed to the company auditor. The case was resolved when the company consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a)(2) and (3) and various books and records provisions. See also Lit. Rel. 21150 (July 23, 2009).

Sham tender offers: SEC v. Al-Braikan, Case No. 09 civ 6533 (S.D.N.Y. Filed July 23, 2009) is a fraud action based on a hoax tender offer. Specifically, the SEC’s complaint alleges that defendant Hazem Khalid Al-Braikan and related entities acquired a position in Harman International Industries. On July 19, 2009, a press release announcing a tender offer for the company was sent to media outlets. The next day it was posted on the internet. The phony offer cased the share price to climb by 40%. After the company repudiated the offer the share price dropped significantly. Two of the entities traded around a similar phony tender offer in April 2009. The complaint claims that Al-Braikan traded in an account in his name and that accounts for the three entities also traded. A freeze order was obtained at the time the complaint was filed over $5 million in alleged illegal trading profits. The case is in litigation. See also Lit. Rel. 21152 (July 23, 2009).

Qwest financial fraud case: SEC v. Graham, Civil Action No. 03-cv-0328 (D. Colo) settled with three defendants in an action arising out of the accounting fraud at Qwest Communications. The three executives consented to the entry of permanent injunctions prohibiting future violations of the antifraud and reporting provisions. In addition, defendant Grant Graham consented of an officer/director bar for a period of five years and agreed to pay a civil penalty of $50,000; defendant Richard Weston also agreed to pay a civil penalty of $20,000; and no penalty was assessed against Defendant Joel Arnold. All claims were dismissed against defendant John Walker. See also Lit. Rel. 21148 (Jul. 23, 2009).

ARS: SEC v. Morgan Keegan & Co., Inc., Civil Action No. 09-CV-1965 (N.D. Ga. Filed July 21, 2009), discussed here, centers on claims that the broker dealer made misrepresentations when selling auction rate securities to its customers between November 1, 2007 to March 20, 2008. The complaint alleges that during the period shortly prior to the crash of the auction rate securities market, the firm misrepresented the risks of ARS, selling them as safe and highly liquid investments comparable to money market funds. Morgan Keegan failed to tell its customers that there were increasing concerns about the safety of the ASR market in the months before the crash and that there were auction failures. Rather, the complaint, which alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(c), claims that the firm sold over $900 million ARS during this period. The case is in litigation. See also Lit. Rel. 21143 (Jul. 21, 2009).

Schedule 13D: In the Matter of Perry Corp., Adm. Proc. File No. 3-13561 (July 21, 2009), also discussed here, focuses on a claim that the investment adviser intentionally failed to file a Schedule 13D after acquiring nearly a 10% stake in Mylan Laboratories, Inc., which was in discussions to acquire another company. Perry failed to file, according to the Order for Proceedings, because it did not want to alert the marketplace about its holdings. Rather, Perry was engaged in “merger arbitrage” by which the firm sought to profit from the spread in value between the shares of the acquirer and the target company. As part of the transaction, Perry entered into a series of swap transactions designed to fully hedge its financial exposure from the Mylan shares. Through these swap transactions Perry was able to acquire the voting rights to nearly 10% of Mylan’s shares without any economic risk. Perry chose not to file a Schedule 13D based on advice it obtained after shopping for legal opinions during which its usual outside counsel told the firm to file a Schedule 13D, but another did not based on statements that the securities were for investment purposes only.

To settle the action, Perry consented to the entry of a censure and a cease and desist order from committing or causing any violations and any future violations of Section 13(d) and Rule 13d-1. In addition, the firm agreed to pay a civil penalty of $150,000.

Insider trading: SEC v. Leyva, Case No. 09 cv 1565 (S.D. Cal. filed July 20, 2009), discussed here, is an insider trading case brought against the former Director of Strategic Marketing Analysis at Qualcomm, Inc. The complaint claims that Mr. Leyva made over $34,000 in trading profits by purchasing options just prior to the announcement of a new licensing agreement between Qualcomm and Nokia Corp. stemming from the settlement of a long running legal dispute between the companies. The trades by Mr. Leyva followed months of discussions between Qualcomm and Nokia to settle a long running dispute. Mr. Leyva had participated in the collapsed talks as a financial analyst. Just before a trial was to commence on a key case in the dispute, Nokia significantly improved its settlement offer. Mr. Leyva was called to run the numbers. After making the calculations and before any confirmation that the dispute was settled he purchased 80 Qualcomm call options priced at $0.39 each with a strike price of $50. Later that day, the settlement was confirmed. When it was announced the share price shot up 17%, giving Mr. Leyva a profit of over $34,000 on his options. The case is in litigation. See also Lit. Rel. 21140 (July 20, 2009).

Insider trading: SEC v. Cuban, Civil Action No. 3:09-CV-2050 (N.D. Tex. Decision Filed July 17, 2009), discussed here, is an insider trading action in which the court granted the defendant’s motion to dismiss. The complaint alleged that Mr. Cuban, who held a 6.3% stake in the company, sold all of his holdings after learning that the company,, Inc., was conducting a PIPE offering. At the time of the sale, Mr. Cuban did not inform the company although he had told its CEO that he would keep information about the offering confidential at the time he was solicited to participate.

In dismissing the complaint, the court rejected Mr. Cuban’s contention that the SEC was required to plead a fiduciary or similar relation between him and the company. Rather, the court held that an agreement between the parties requiring confidentiality and prohibiting the personal use of the information would be sufficient. Here, the failure to plead facts establishing such an agreement resulted in dismissal.

Criminal cases

Insider trading: U.S. v. Tom, Case No. 05-10361 (D. Mass. Filed Dec. 28, 2005) is a criminal insider trading case based on the acquisition of Charter One by Citizens Financial Group in 2004. At the time, defendant Tom was a senior analyst at Citizens with portfolio analyst Shengnan Wang. In the spring of 2004 Ms. Wang told Mr. Tom that her group was doing due diligence on an acquisition target in Cleveland, Ohio. Defendant Tom purchased securities in three Cleveland based banks, one of which was Charter One. In May 2004 Citizens announced it was acquiring Charter One. Subsequently, Mr. Tom pleaded guilty to five counts of securities fraud and was sentenced to three years probation. The government appealed that sentence to the First Circuit which reversed. Subsequently, defendant Tom petitioned the Supreme Court which granted certiorari and vacated the First Circuit judgment, remanding to the district court. That court sentenced the defendant to one year and a day in prison See also Lit. Rel. 21147 (Jul. 23, 2009).

Fraudulent investment advice: U.S. v. Tzolov, Case No. 1:08-cr-00370 (E.D.N.Y. Filed June 3, 2008) is an action against two former Credit Suisse brokers, Julian Tzolov and Eric Butler. The indictment claims that the two former brokers defraud their clients by selling them higher risk auction rate securities backed by mortgages when the clients sought lower risk ARS backed by student loans. The fraud involved an estimated $400 million. Mr. Tzolov plead guilty to conspiracy, securities fraud, wire fraud and bail jumping — he initially fled and was arrested in Marbella, Spain.

Circuit Courts

Insider trading: SEC v. Dorozhko, Case No. 08-0201-cv Slip op. (2nd Cir. July 22, 2009), discussed here, is the “computer hacker” case. The Second Circuit reversed the denial of a preliminary injunction and remanded for further proceedings. The case centers on a claim that the defendant, Oleksandr Dorozhko traded on inside information in the securities of IMS Health, Inc. obtained from hacking a computer at Thomson Financial and obtaining an earnings report shortly before its release. On the same day Thomson’s computer was hacked, and shortly before the aftermarket release of earnings, defendant purchased over $41,000 work of IMS put options. After the close of the market, IMS announced its EPS were 28% below street expectations. When the market opened the next morning, IMS shares went down 28%. Within six minutes of the market opening defendant sold all of his options, realizing a profit of over $286,000.

The district court initially granted an assets freeze when the SEC filed its action several days after the trading. Later however, the court rejected the Commission’s request for a preliminary injunction, concluding that the complaint failed to allege the breach of a fiduciary duty and thus there was no deception.

The Second Circuit reversed. There, the SEC argued that a fiduciary duty was not required because the case was based on a misrepresentation. That misrepresentation is the computer hacking which essentially deceives the computer being hacked to gain entry. The Second Circuit noted that this type of conduct would fall within the standard definition of deception, but since the district court had not considered the issue the case was remanded for further proceedings on that issue.

Regulation: American Equity Investment Life Ins. Co. v. SEC, No. 09-1021 (D.C. Cir. Decided July 21, 2009) is an action challenging SEC Rule 151A, discussed here, over index annuities. According to the SEC, fixed indexed annuities are not annuity contracts within the meaning of the Securities Act, meaning that they are not exempt from federal regulation. As a result, the fixed income annuities are subject to “the full panoply of requirements” set forth in the Securities Act. The court rejected this challenge, finding that the SEC’s interpretation of annuity contract is reasonable. However, because the SEC failed to properly consider the effect of the rule upon efficiency, competition, and capital formation it was remanded for reconsideration.

Investment advice: South Cherry Street, LLC v. Hennessee Group, LLC, Case No. 07-3658 (2nd Cir. Decided July 14, 2009), discussed here, was dismissed by the district court, whose order was affirmed by the second circuit. The suit was brought by South Cherry, an investor in Sam Israel’s Ponzi scheme fund, Bayou Accredited Fund, LLC. The investment was made on the advice of defendant Hennessee Group which claimed to be an expert in hedge fund investments and to have a proprietary due diligence and monitoring system. Eventually, South Cherry lost its entire remaining investment of $1.15 million.

The district court dismissed the suit in part for a failure to adequately plead scienter under the PSLRA. The Second Circuit affirmed. In its opinion, the court retraced the evolution of its motive and opinion test for pleading a strong inference of scienter and updated and harmonized it with the current approach of the Supreme Court. Essentially, the court concluded in reviewing the complaint that it failed to allege any facts suggesting the defendant was on notice or missed red flags about the Ponzi scheme — the complaint sounded in negligence, not fraud.

Private actions

Option backdating: In re Maxim Integrated Pds., Inc. Sec. Litig., Case No. 5:08-cv-00832 (N.D. Cal. Filed Feb. 6, 2008) is a securities class action based on option backdating claims. On January 31, 2007, the company announced the findings of an internal investigation into its backdating practices. The company noted that certain financial statements would have to be corrected. However, the share price did not drop for another eight months. The court dismissed this claim for failing to plead loss causation, noting that the time lag was too long. The court however left other option backdating claims stand.