This Week In Securities Litigation (June 26, 2009)

The proposals in the Treasury White Paper for market reform gathered momentum this week. SEC Chairman Schapiro and CFTC Chairman Gensler testified on Capitol Hill in favor of the regulatory proposals in the paper regarding OTC derivatives. The SEC also moved forward with rule making proposals discussed in the White Paper for money market funds.

As Mr. Madoff’s sentencing approaches, two actions were brought against those the SEC claims helped feed the Ponzi scheme. At the same time, DOJ brought criminal charges against Mr. Stanford and his confederates, while the SEC amended its complaint to add parties and claims. SEC enforcement also brought insider trading and financial fraud cases, as well as more investment fund actions. DOJ also obtained a guilty plea in an investment fund case while Jones Soda won dismissal of class actions brought against the company and its officers based on allegations of financial fraud.

Market reform

Last week the Treasury Department issued its White Paper regarding market reform as discussed here. The proposals, in part, called for increased regulation over OTC derivatives. That authority would be shared by the SEC and CFTC. This week, SEC Chairman Mary Schapiro and CFTC Chairman Gary Gensler both testified before Congress in support of such legislation.

The Treasury White Paper also called for the SEC to continue its efforts to strengthen the regulation of money market funds. This week the Commission put out for comment proposed rules for those funds. Generally, the proposals focus on increasing liquidity and improving disclosure in the wake of the Reserve Primary Fund case (discussed here). Consideration is also being given to whether funds should continue to maintain a stable $1 per share NAV. Both Chairman Schapiro and Commissioner Aguilar made statements regarding the proposed rules in an open meeting on June 24, 2009.

Ms. Schapiro also outlined future Commission priorities in a speech before the New York Financial Writers Association this week. Those priorities include: 1) Target date funds — determining how to improve the disclosure regarding the operation of these funds; 2) Municipal securities — improving the quality, quantity and timeliness of information about these investments; 3) Fiduciary duties for professionals who give investment advice — this question, addressed in the Treasury White Paper, is a key concern for the protection of investors; and 4) Dark pools — improving the disclosure regarding the operation of these pools which the Chairman defined as “automated trading systems that do not display quotes in the public quote stream.”

The Madoff case

Two new Madoff related cases were filed this week, SEC v. Cohn, Civil Action No. 09 cv 5680 (S.D.N.Y. Filed June 22, 2009) and SEC v. Chais, Civil Action No. 09 cv 5681 (S.D.N.Y. Filed June 22, 2009). The Cohn case names as defendants New York broker dealer Cohmad Securities, its chairman Maurice Cohn and registered representative Robert Jaffee. The firm is owned in part by Bernard Madoff. For more than two decades the defendants in Cohn facilitated Mr. Madoff’s fraudulent operations by aggressively marketing the Ponzi scheme. The firm’s extensive dealings with Mr. Madoff were concealed from regulators by falsifying the broker dealer’s SEC filings.

During their years of marketing the Madoff Ponzi scheme, defendants ignored numerous red flags suggesting the true nature of the fraudulent operations. At the same time they were paid more than $100 million while their investors lost their money. The case, discussed here, is in litigation.

The Chais defendants also fed the Madoff Ponzi scheme. This suit is against a California investment adviser who has funneled money to the Ponzi operation since the early 1970s. Mr. Chais, according to the SEC, held himself out as an “investing wizard, purporting to execute a complex trading strategy on behalf of hundreds of investors . . .” In fact he lacked any real investment skills. The investor funds he solicited were turned over to Mr. Madoff for use in his fraudulent scheme. Despite clear indications of fraud, Mr. Chais continued to distribute account statements to the investors in his three funds based on the purported returns of the Madoff scam. By November 2008, Mr. Madoff claimed that the investors in the three Chais funds had over $900 million invested, all of which has been wiped out. Mr. Chais and his family however made about a half a billion dollars as also discussed here. The case is in litigation.


DOJ filed criminal charges against financier Robert Stanford and his confederates while the SEC amended its complaint, adding new defendants and claims. DOJ’s charges are in two indictments and one criminal information. One indictment named as defendants: Robert Allen Stanford, chairman of Sanford Financial Group (“SFG”); Laura Pendergest-Holt, SFG’s chief investment officer; Gilberto Lopez, the chief accounting officer; Mark Kuhrt, global controller; and Leroy King, the former chief executive officer of the Antigua’s Financial Services Regulatory Commission (“FSRC”). The charges include conspiracy and wire, mail and securities fraud and conspiracy to commit money laundering.

A second separate indictment charges Bruce Perraud, former SFG global security specialist with destruction of records relating to a federal investigation. The information names Mr. Davis, SFG’s CFO, and charges him with conspiracy, mail fraud and conspiracy to obstruct an SEC investigation.

The SEC’s amended complaint adds as defendants Messrs. Kuhrt, Lopez and King. Mr. Stanford, James Davis, Laura Pendergest-Holt and various Stanford controlled entities had been named as defendants in the initial complaint.

According to the court papers Defendants Stanford and Davis, operating a decade long Ponzi scheme under the guise of a bank based in Antigua, raised more than $7 billion from investors to purchase what were suppose to be bank certificates of deposit paying above average returns as well as another $1 billion from a fund program. Profits were supposed to come from the bank’s investment portfolio. In fact, the returns in that portfolio were an illusion — they came from fraudulent, reverse engineered accounting documents. To create those documents, a rate of return was selected and then numbers were backed out to achieve the desired result. Stanford Bank is a Ponzi scheme, according to the SEC. Over a period of years Mr. Stanford has taken over $1 billion of investor funds for his own use, booked as loans but not properly disclosed as related party transactions.

The Commission’s investigation was impeded, according to the charges, by Mr. King, who coordinated the regulatory response from Antigua bank authorities while secretly being on the payroll of Mr. Stanford. As the SEC inquiry developed, the Commission contacted the Antiguan banking authorities. Mr. King, who had assured the local banking authorities for years that the Stanford operation was sound, passed on similar assurances to the SEC.

The SEC’s freeze order over all of the assets of the group remains in effect. The criminal cases and the SEC’s enforcement action are in litigation. See also DOJ Press Release, June 19, 2009; SEC Lit. Release 21092 (June 19, 2009).

SEC enforcement

Insider trading: SEC v. Northern, Civil Action No. 05-CV-10983 (D. Mass.) is a case in which the jury returned a verdict in favor of the SEC. The complaint alleged that defendant Steven Northern, a former Senior Vice President and manager of seven fixed income mutual funds for Massachusetts Financial, traded in U.S. treasury 30 year bonds on inside information. The Commission claimed that defendant Northern was tipped with confidential information from Peter Davis, who obtained the information at a special Treasury Department briefing. Those who attended the briefing agreed not to release the information until 10:00 a.m. The information concerned the Department’s plans to suspend issuance of the 30 year bond. Despite the agreement to embargo, the information Mr. Davis phoned defendant Northern, who traded on the information, yielding $3.1 million in illegal profits. See Lit. Release No. 21099 (June 22, 2009); see also Lit. Releases 18322 (Sept. 4, 2003) (initial action against Mr. Northern and two others), 18453 (Nov. 12, 2003) (co-defendant in original case settles with the commission and pleads guilty in parallel criminal case) and 19223 (May 12, 2005) (case re-filed against Mr. Northern after voluntary dismissal).

Financial fraud: In SEC v. Schroeder, Civil Action No. 4:09-CV-00470 (W.D. Mo.) the former chairman of the board of American Italian Pasta, Horst Schroeder, settled with the Commission. The SEC claimed in its complaint that in 2004 the company booked a $3.4 million receivable that was not collectable. The inflated financials were then incorporated in a Form S-8 registration statement Mr. Schroeder signed. To settle, defendant Schroeder consented to the entry of an injunction prohibiting future violations of Section 17(a)(3) and aiding and abetting violations of Section 13(a) and the related rules. Mr. Schroeder also agreed to pay a $50,000 civil penalty. See also Lit. Release No. 21098 (June 22, 2009).

In a related case, SEC v. Schmidgall, Civil Action No. 4:08-cv-00677 (W.D. Mo.) defendants Warren Schmidgall, former CFO of the company, also agreed to settle. Mr. Schmidgall consented to the entry of a permanent injunction prohibiting future violations of Sections 10(b) and 13(b)(5) of the Exchange Act and aiding and abetting violations of Section 13(a) and related rules. Mr. Schmidgall also agreed to pay disgorgement of $28,500, prejudgment interest and a $100,000 civil penalty. He will also be bared from serving as an officer or director of a public company. See also Lit. Release No. 21097 (June 22, 2009). Mr. Schmidgall had previously pleaded guilty to a one count information. See Lit. Release No. 20715 (Sept. 15, 2008).

Financial fraud: SEC v. Garfinkel, Civil Action No. 99-CV-2851 (E.D. Pa. June 25, 2009) was brought against Steven Garfinkel, the former CFO of DVI, Inc., and Michael O’Hanlon, the former CEO of the company. According to the complaint, over a period of four years the two defendants engaged in a fraudulent scheme to obtain additional funding for, and conceal the true financial condition of, DVI, a firm which made loans to small medical equipment companies. The two defendants manipulated loan paper work, double pledged collateral provided to company lenders and sent them false reports. As a result, the company made false filings with the commission. To settle with the SEC, each defendant agreed to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions and to the entry of an order barring them from serving as an officer or director of a public company. This settlement followed a criminal action in 2006 in which Mr. Garfinkel pleaded guilty to mail fraud and filing false SOX certifications. Mr. Garfinkel was sentenced to 30 months in prison and ordered to pay restitution of $51 million. See also Lit. Release No. 21206 (June 25, 2009).

This week the SEC brought two investment fund fraud actions:

SEC v. Regan & Company, Civil Action No. 09-CIV 5799 (S.D.N.Y. Filed June 24, 2009) is an action against Michael Regan and his firm Regan & Company, discussed here. Over an eight year period, Mr. Regan sold shares in his defunct investment fund, luring more than 70 investors to rely on his claimed stock market expertise. In fact, Mr. Regan has not invested in the stock market for several years. To conceal the fraud investors were furnished with periodic statements documenting their returns at 12%, while redemptions were paid with other investor funds. By the time the fund collapsed, it had only about $101,600 under management.

To resolve the SEC’s case Mr. Regan and his company consented to the entry of permanent injunctions prohibiting future violations of the antifraud provisions. They also agreed to be jointly and severally liable for the payment of approximately $8.7 million in disgorgement and prejudgment interest. Payment is deferred pending the resolution of the criminal case. In a parallel criminal case, Mr. Regan pleaded guilty to a one count information. See also U.S.A.O. (E.D.N.Y) Press Release (June 24, 2009); SEC Lit. Release No 21102 (June 24, 2009).

SEC v. Pacheco, Case No. 09-CV-1355 (S.D. Cal. June 24, 2009) is an action brought against Moises Pacheco and his controlled entities. According to the complaint, Mr. Pacheco claimed to operate five hedge funds which generated returns ranging from 2.5% to 4% per month as also discussed here. Mr. Pacheco raised about $14.7 million from over 200 investors, many of whom were family and friends. Prior to the collapse of the funds, investor returns were paid using other investor money. The SEC’s complaint alleges violations of the antifraud and registration provisions of the securities laws. The case is in litigation. See also Lit. Release No. 21101 (June 24, 2009).

Criminal cases

U.S. v. Stein, Case No. 1:09-cv-03125 (E.D.N.Y. Filed April 1, 2009) is a case in which investment advisor Edward Stein pled guilty on June 22, 2009 to a five count information. In that information he was charged with operating a Ponzi scheme and defrauding clients out of $30 million. From 1998 through 2009, Mr. Stein operated several funds and partnerships for which he solicited investors. Rather than invest their funds, he took portions of the money for himself while using some of the investor cash to pay other investors. To conceal the fraud, Mr. Stein furnished investors with false quarterly statements. Sentencing has not been scheduled.

Private actions

In re Jones Soda Company Sec. Litig., Case No. 07-cv-1366 (W.D. Wash. Filed Sept. 3, 2007) was dismissed for failure to plead a strong inference of scienter as required by the PLSRA and the Supreme Court’s decision in Tellabs, discussed here. In evaluating the question of scienter, the court noted that “there is little consistency within the Circuit Courts regarding the state of mind that is required in private securities litigation and what type of evidence satisfies the PSLRA’s ‘strong inference” requirements . . . the Ninth Circuit . . . [requires] at a minimum, ‘deliberate recklessness” that reflects some strong degree of knowing misconduct . . . plaintiffs may no longer rely on evidence which suggests that the corporation and/or its officers had [only] a motive and opportunity . . .” to defraud. The complaint was based on claimed false statements about agreements with retailers, the allocation of resources and business prospects. Derivative suits based on similar facts are still pending. In re Jones Soda Co. Derivative Litigation, Lead Case No. 07-31254-4 (S.Ct. King Co. Wash); In re Jones Soda Co. Derivative Litig., Case No. 07-1782 (W.D. Wash).

Circuit Courts

A key question in pleading loss causation under the Supreme Court’s decision in Dura Pharmaceuticals v. Broudo, 544 S.Ct. 336 (2005) (discussed here) is how much truth must emerge. In Alaska Electrical Pension Fund v. Flowerserve Corporation, Case No. 07-11303 c/w 08-10071 (5th Cir. Filed June 19, 2009) (discussed here), a per curiam opinion joined by retired Supreme Court Justice O’Connor, the court held that to establish Dura loss causation at least some of the truth must emerge. The action was based on three claimed false earnings statements from 2001. The share price for the company plummeted in July and again in September 2002 when the company announced it would miss guidance, but the fraud was not revealed until a 2004 restatement. The court rejected defendant’s notion that Dura requires each fact to emerge and the plaintiff’s theory that emergence of the financial condition of the company established the causal link. Rather, at least some of the fraud must be revealed, a question the district court could assess on remand.