This Week In Securities Litigation (June 5, 2009)

While Capital Hill debated the future course of regulation, and rumors swirled that the Administration would announce its plan for regulatory reform on June 16th, the SEC brought its highest profile market crisis case to date: a disclosure fraud and insider trading case against three senior officers of Countrywide Financial. The Commission also prevailed in jury trial against the former head of Kmart in a financial fraud case.

This week, the SEC also sought to re-establish itself as the protector of investors and the markets with the formation of an investor’s advisory committee and a blueprint for reform offered by Commissioner Aguilar. The Enron debacle trudged toward a conclusion with another guilty plea by a former company official.


Investor Committee: The SEC announced the creation of an Investor Advisory Committee discussed here. The Committee is designed to give investors a greater voice in the work of the SEC. Commissioner Luis A. Aguilar will serve as the SEC’s primary sponsor of the Committee, which will be co-chaired by Richard Hisey, President of AARP Financial Inc., and AARP Funds, and Hye-Won Choi, Senior Vice President and Head of Corporate Governance for TIAA-CREF.

Remarks by Commissioner Aguilar: Commissioner Luis Aguilar delivered a speech at the Compliance Week Annual Conference titled “Reversing Course — Putting Investors First in Regulatory Reform.”

In regulatory reform, investors must be put first, the Commissioner emphasized. In his remarks, Commissioner Aguilar emphasize four points, also discussed here. First, there must be a searching inquiry into the causes of the current market crisis. Second, there must be a reversal of philosophy in regulation with “modernization,” meaning investors first, not the financial services industry as in the past. Third, any regulatory reform must prioritize the needs of investors while ensuring that the U.S. capital markets remain pre-eminent. Finally, Commissioner Aguilar called for the creation of an Integrated Capital Markets Regulator to be fashioned by merging the SEC, CFTC and Department of Labor’s Employee Benefits Security Administration, although a separate CFTC could retain oversight of agricultural commodity derivatives.

Congressional testimony: In testimony before the Senate Subcommittee on Financial Services and General Government on Tuesday, Chairman Schapiro recounted recent efforts to reinvigorate the enforcement program and improve investor protection.

A critical point in Ms. Schapiro’s testimony was a series of statistics, discussed here, amplified by graphs in an appendix that illustrated the need for additional funding for the agency. While the task of the SEC has grown significantly over the years, its budget has not. Just to keep pace with the markets the SEC requires significant additional funding.

GAO report: A recently released GAO report states that the short sale measures taken by the SEC in 2008 appear to have helped to curb abusive short selling. The report goes on to note however, that additional and clearer guidance is required for the brokerage industry. The SEC’s short sale measures are discussed here.

FinCEN report: A recently released report by the Financial Crimes Enforcement Network notes that the number of Suspicious Activity Reports filed increased in 2008 by about 22% to over 1,800 reports filed in the prior year.

SEC enforcement – the market crisis

The SEC brought what is clearly its highest profile market crisis case to date, an action centered on the collapse of sub-prime lending giant Countrywide Financial. SEC v. Mozilo, Case No. CV 09-03994 (C.D. Cal. Filed June 4, 2009). The action was named as defendants former Countrywide CEO Angelo Mozilo and two of his top lieutenants, David Sambol, former COO, and Eric Sieracki, former CFO.

The complaint, alleging violations of the antifraud and reporting provisions, centers on “disclosure fraud.” Specifically, the complaint alleges that from 2005 through 2007 the defendants held Countrywide “out as primarily a maker of prime quality mortgage loans, qualitatively different from competitors who engaged primarily in riskier lending.” The defendants, however, misled investors by failing to disclose substantial negative information regarding the loan products of the company. This information included: increasingly lax underwriting guidelines; the pursuit of a “matching strategy” in which the terms of any loan being offered in the market were matched; the high percentage of loans it originated that were outside its already widened underwriting guidelines; the fact that the definition of “prime” loans included loans for persons with low credit scores; the high percentage of loans that had a loan to value ratio of 100%; and other significant risk factors.

The complaint also accuses Mr. Mozilo of insider trading. He is alleged to have exercised over 5.1 million stock options and sold the underlying shares for total proceeds of over $139 million. The sales were through a Rule 10b5-1 plan adopted in late 2006 and amended in early 2007. The complaint claims that Mr. Mozilo was in possession of material non-public information at the time the plan was amended.

The SEC is seeking a permanent injunction prohibiting future violations of the antifraud and reporting provisions, officer and director bars, financial penalties and disgorgement. The case is in litigation.
SEC enforcement

ARS: The SEC finalized three more settlements in the auction rate securities markets. SEC v. Banc of America Securities LLC, Civil Action No. 09-CIV-5170 (S.D.N.Y. June 3, 2009); SEC v. RBC Capital Markets Corp., Civil Action No. 09-CIV-5172 (S.D.N.Y. June 3, 2009); SEC v. Deutsche Bank Securities Inc., Civil Action No. 09-CIV-5174 (S.D.N.Y. June 3, 2009). These settlements are substantially similar to the earlier ARS settlements. Accordingly, they call for Bank of America, RBC and Deutsche Bank to: 1) purchase at par all auction rate securities from essentially retail customers and charities; 2) use its best efforts to provide liquidity solutions to larger customers; and 3) pay eligible customer who sold their ARS below par the difference between par and the sales price. See also Press Release of New York Attorney General Andrew Cuomo regarding the ARS inquiries by his office.

Financial fraud: In SEC v. Conaway, Case No. 05 Civ. 40263 (E.D. Mich. Filed Aug. 23, 2005) a jury returned a verdict in favor of the SEC and against former Kmart CEO Charles Conaway in a financial fraud case centered on false and misleading statements in the MD&A section of a Form 10-Q filing and related statements in an investor call. The case is based on events leading to the bankruptcy filing in January 2002 by Kmart as discussed here.

The SEC claimed that in the summer of 2001 Kmart made a massive inventory overbuy which Mr. Conaway later called “reckless.” To try to manage the ensuing liquidity crisis, the company implemented a project under which it delayed payment of vendor invoices. By October 31, 2001, the company was in a cash crunch with over $570 million in past due vendor invoices and some vendors refusing to ship to the company.

In its MD&A on Form 10 for the third quarter Kmart stated that it had experienced an increase in its account payable, but failed to disclose that at least $570 million of that increase resulted from the delayed payments. The MD&A also failed to adequately discuss the massive inventory build up or the fact that the company effectively borrowed money from its vendors, all of which rendered the filing false and misleading in violation of Section 10(b).

Shortly prior to trial John T. McDonald, Jr., Kmart’s former CFO, settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations of the antifraud and reporting provisions, a five year officer, director bar and to the payment of a $120,000 civil penalty and a Rule 102(e) bar for three years. The court will consider the question of remedies regarding the former CEO at a future hearing.

Financial fraud: In the Matter of Dyadic International, Inc., Adm. Proc. File No. 3-13504 (Filed June 4, 2009) is a settled administrative proceeding against a biotech company that was delisted from trading on the AMEX in January 2008. The Order alleges that from the end of 2005 through 2006 the company filed financial statements with the SEC that were materially incorrect. Specifically, those statements improperly recognized revenue, overstated accounts receivable balances and failed to disclose material related party transactions. To resolve the matter, the company consented to the entry of a cease and desist order precluding further violations of the books and records provisions. The Commission acknowledged the remedial acts of the company and its cooperation.

Investment fund cases: This week the SEC filed two new investment fund cases:

SEC v. Hamlin, Case No. 1:09-CV-483 (W.D. Mich. Filed May 26, 2009) alleging that about $2 million was raised from at least 90 investors through a fraudulent, unregistered offer and sale of securities. This action was settled with the defendants consenting to the entry of a permanent injunction and an order requiring the payment of about $1.2 million in disgorgement along with prejudgment interest. Payment was waived along with the imposition of a penalty based on the financial condition of the defendants. See also Litig. Release No. 21064 (May 29, 2009).

SEC v. Ruskjer, Civil Action No. CV 09-00237 (D. Haw. Filed May 29, 2009) charged the defendants with fraudulently raising $16 million from at least 140 investors in a Ponzi scheme. The case is in litigation. See also Litig. Release No. 21062 (May 29, 2009).


SEC v. Wurzel, Civil Action No. 09-Civ-01005 (D.D.C. Filed May 29, 2009); In the Matter of United Industrial Corporation, Adm. Proc. File No. 3-13495 (Filed May 29, 2009). The case involved United Industrial Corporation, its indirect wholly owned subsidiary ACL Technologies, Inc. and Thomas Wurzell, then president of ACL as discussed here.

Beginning in late 2001 and continuing through 2002, UIC, through ACL, made payments to a former Egyptian Air Force official retained as an agent, in connection with a military aircraft depot the subsidiary was building for the Egyptian Air Force in Cairo, Egypt. Mr. Wurzel authorized the payments to the agent although he knew or disregarded the fact that the payments were going to Egyptian Air Force officials. As a result, ACL was awarded a Contract Engineering Technical Services contract. Gross revenue from that contract was $5.3 million while net profits were $267,571.

UIC lacked meaningful controls to prevent or detect the illicit payments to the agent. Although UIC instituted policies in late 1999 requiring any employee seeking to engage a foreign agent to submit due diligence forms for the agent to corporate counsel prior to the retention of the agent, ACL did not submit the appropriate forms until 2002. The forms submitted at that time were largely prepared by the agent. In addition, the legal department of UIC approved the retention of the agent, despite the fact that the person had been previously used by the company, without adequate due diligence and contrary to company policy.

To resolve the administrative proceeding, UIC consented to the entry of a cease and desist order from committing or causing any violations of Sections 30A, 13(b)(2)(A) and 13(b)(2)(B). The company also agreed to disgorge the profits from the contract along with prejudgment interest. Mr. Wurzel consented to the entry of a permanent injunction prohibiting future violations of Sections 30A and 13(b)(5) and from aiding and abetting violations of Sections 30A and 13(b)(2). He also agreed to pay a $35,000 civil penalty.

Criminal cases

U.S. v .Howard, Case No. 4:03-cr-00093 (S.D. Tex. Filed March 26, 2009). Kevin Howard, former CFO and vice president of finance for Enron Broadband Services, pled guilty to falsifying books and records. Mr. Howard admitted that in November 2000 he and others at EBS structured a transaction to prematurely and improperly recognize revenue so that the company could meet its earnings targets. Mr. Howard also admitted that he failed to inform outside auditors Arthur Anderson of key facts about the deal because he knew they would not permit the revenue to be recorded. As a result Enron’s Form 10K was false.

Previously, Mr. Howard was found guilty under an indictment which charged him with conspiracy to commit wire fraud and falsify books and records, wire fraud, including honest services wire fraud and falsifying books and records. His conviction was vacated when the Fifth Circuit Court of appeals handed down its decision in U.S. v. Brown, (discussed here) relating to honest services wire fraud. Under the terms of the plea agreement Mr. Howard faces a maximum sentence of up to 12 months of home confinement.

Private actions

Midwestern Teamsters Pension Trust Fund v. Deaton, Civil Action No. H-08-1809 (S.D. Tex.) is a shareholders derivative suit against current and past board members and certain officers of Baker Hughes, Incorporated. The action is based on the FCPA cases previously brought against the company by DOJ and the SEC. As discussed here, those actions centered on violations of the bribery and books and records and internal control provisions of the FCPA. At the time the actions were resolved the total settlement was the largest in FCPA history. The derivative suit was dismissed for failing to make a demand as required by Federal Rule of Civil Procedure 23.1


C.S. Cheng, Henry Huang, Gerald Lobo & Yinghau Li, “Institutional Monitoring Through Shareholder Litigation, J. of Financial Economics, Forthcoming, Available at SSRN here. The authors studied a large sample of securities lawsuits from 1996 to 2005. Based on their study they conclude that overall securities litigation is an effective disciplining tool for institutional owners. The complaint is less likely to be dismissed and more likely to have a larger monetary settlement if the lead plaintiff is an institutional investor rather than an individual the authors conclude. This effect applies to various types of institutions including public pension funds. In addition, defendant companies in suits lead by an institutional investor are more likely to experience greater improvement in their board independence following the suit.