This Week In Securities Litigation (May 15, 2009)

Treasury Secretary Tim Geithner, along with the Chairman of the SEC and CFTC, announced a new plan this week to regulate OTC derivatives, calling on Congress to enact implementing legislation. The SEC concluded an insider trading trial with a loss, while settling another option backdating action and, in conjunction with DOJ, another FCPA case. The former COO of Monster Worldwide was convicted on option backdating charges, while the former chief investment officer of Stanford Financial Group was indicted for obstruction of justice charges regarding the SEC’s on-going investigation of Stanford Financial. In a rare jury verdict in a securities class action, Household International was found liable in a financial fraud case, while the Attorney General of New York obtained another guilty plea in his “pay to play” inquiry, in addition to an agreement with a manor fund to abide by his new code of conduct.

Market reform

At a joint press conference Treasury Secretary Tim Geithner, along with the Chairman of the SEC and the CFTC announced a blue print for new regulations concerning OTC derivatives. The proposal made by Mr. Geithner is detailed in a letter he sent to Senate Majority Leader Harry Reed and in a Treasury press release. It is based on four key principles to be achieved in bringing regulation to this largely unregulated segment of the market: 1) preventing activities in those markets from posing a risk to the financial system; 2) promoting efficiency and transparency; 3) preventing market manipulation and fraud; and 4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

Under Mr. Geithner’s proposal, all standardized OTC derivatives would be cleared through regulated central counterparties. The regulatory regime would include conservative capital requirements, business conduct standards, reporting requirements and conservative requirements relating to initial margins for all OTC derivatives dealers and all other firms that create large exposures to counterparties. Those trades not cleared by CCPs would be reported to a regulated trade repository which would maintain data on open positions and trade volumes. The data would be available to the public. The SEC and CFTC would also have the authority to impose record keeping requirements and have comprehensive antifraud jurisdiction. The SEC and the CFTC are currently working on proposed amendments to achieve these goals. The SEC’s press release is available here. The statement of the CFTC is available here.

SEC enforcement

Insider trading: In SEC v. Anton, Civil Action No. 06-2274 (E.D. Pa. Decided April 23, 2009), the court held that the Commission failed to prove defendant Frederick W. Anton, III, as COB of PMA Capital, illegally tipped outsider and former company employee David L. Johnson. The tip allegedly concerned a significant increase to the reserves and the elimination of a dividend prior to the public announcement as discussed here. Mr. Johnson, who had seen public information about a possible reserve increase, telephoned Mr. Anton and sold company stock shortly after the phone call as did his son.

The court concluded that Mr. Anton, who was preparing to retire, did not know the amount that was to be added to the reserve or that dividend was being eliminated. Thus, he did not tip Mr. Johnson. The court also concluded that the SEC failed to establish that the information about the reserve was material or that there was a personal benefit. As to the former, there was no evidence that Mr. Anton knew the amount of the increase. As to the latter, the court rejected the SEC’s claim that the information was a gift among friends. The court concluded that, while the two men were long time business acquaintances, they were not personal friends. Mr. Johnson previously settled with the Commission. SEC v. Johnson, Civil Action No. 05-CV-4780 (E.D.Pa. Sept. 7, 2005) (settled with consent injunction and agreement to pay disgorgement, prejudgment interest and penalty of over $786,000, see Lit. Rel. 19363, Sept. 7, 2005).

Proxy voting rule: In the Matter of INTECH Investment Management LLC, Adm. Proc. File No. 3-13463 (Filed May 7, 2009) is a settled administrative proceeding brought against INTECH Investment Management LLC and its former chief operating officer, David E. Hurley. Under Advisers Act Rule 2006(4)-6, registered investment advisers must adopt proxy voting policies and describe them to clients. Those procedures are required to address material conflicts of interest that may arise between the adviser and its clients.

Here, the firm adopted procedures, but they lacked provisions to deal with conflicts and they were not adequately discussed with clients. Rather, clients were told that INTECH used a third-party proxy voting service for this purpose. In fact, the service followed AFL-CIO proxy voting recommendations. INTECH’s policies did not address what the Order for Proceedings called “material potential conflicts that may have arisen between INTECH’s interests and those of its clients who were not pro-AFL-CIO.” The Order alleged that INTECH willfully violated, and that Mr. Hurley willfully aided and abetted and caused violations of, Section 206(4) of the Investment Advisers Act and Rules 206(4)-(6)(a) and (c) thereunder. The action was resolved with a cease and desist order and the agreement by INTECH to pay a penalty of $300,000 and Mr. Hurley a $50,000 penalty.

Option backdating: The SEC settled an option backdating case with Gary Gerhardt, the former CFO of Engineered Support Systems, Inc. SEC v. Gerhardt, Case No. 4:07-cv-01262 (E.D.Mo. Filed Feb. 6, 2007). The SEC’s complaint alleged that between 1997 and 2003 Mr. Gerhardt and others at the company repeatedly backdated stock option. The backdated options increased employee compensation by about $20 million. Mr. Gerhardt made approximately $2 million on the options. As a result of the scheme the company filed false books and records with the SEC and overstated operating income by about 21%.

To resolve the case, Mr. Gerhardt consented to the entry of a permanent injunction, the entry of an officer director bar and agreed to pay a civil penalty of $400,000. Previously, in a related criminal case Mr. Gerhardt pled guilty to one count of securities fraud. He has been sentenced to 15 months in prison and ordered to pay restitution of $1.8 million and a criminal fine of $4 million. U.S. v. Gerhardt, Case No. 4:07-cr-00175 (E.D.Mo. Filed March 15, 2007).

Short selling: The SEC settled an action involving a manipulative short selling scheme based on trading in violation of the now rescinded uptick rule. SEC v. Beardsley, Case No. 1:08-cv-10054 (S.D.N.Y. Filed Nov. 19, 2008). The complaint claimed that Robert Beardsley, through accounts at now defunct broker dealer Redwood Trading, LLC, repeatedly executed short sales while the price was declining and in violation of the uptick rule. He also failed to mark short orders, making them appear to be long.

To resolve the case, Mr. Beardsley consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions and, based on his financial condition, a partial order of disgorgement requiring the payment of $100,000.

Investment funds: The SEC brought two emergency actions regarding investment funds this week. In the first, SEC v. Kiselak Capital Group, LLC, Civil Action No. 4:09-cv-256-A (N.D.Tex. Filed May 11, 2009), the complaint claims that Kiselak Capital Group, a Texas based investment company, and Gemstar Capital Group, a California based venture capital company, could not account for all of the investor funds.

Approximately $24 million had been raised from 14 investors solicited by former Dallas Cowboys player Michael Kiselak according to the SEC. Investors were told that the funds would be put in treasury bills. They were not told that Kiselak Capital took a 35% commission on all trading profits. Contrary to the representations made to investors, about 95% of their funds were transferred to Gemstar Capital. While that firm provided brokerage records to the SEC through, Kiselak Capital, showing that there was over $23 million invested in segregated account, the document was forged. In fact about $3 million was missing and the investor funds were not in segregated accounts. The court granted the SEC’s request for a freeze order. The case is in litigation.

The second case is SEC v. Sherbourne Capital Management, Ltd., Case No. 09-2302 (D.N.Y. Filed May 14, 2008). There, the Commission sought emergency relief in a case where it alleged that Paul G. Bultmyer, Arthur J. Placentini, Sherbourne Capital Management and Sherbourne Financial engaged in a fraud regarding the sale so so-called Prime Certificates of Participation. The website for the defendants claimed that investor funds would be placed in high grade corporate bonds, government securities and private placements. In fact, over $900,000 was transferred to a payroll service company and an aviation company both of which were controlled by one or both of the individual defendants. The court granted the request for expedited relief.


In SEC v. Novo Nordisk A/S, Civil Action No. 1:09-CV-00862 (D.D.C. Filed May 11, 2009), the Commission filed a settled FCPA action against Novo Nordisk, a Danish pharmaceutical company and a leading supplier of insulin. At the same time the company entered into a deferred prosecution agreement with DOJ as discussed here.

The case concerns the payment of bribes on the humanitarian side of the U.N. Oil for Food Program. The company sold insulin and other medicines to the Iraq Ministry of Health through Kimadia, the Iraq State Company for the Importation and Distribution of Drugs and Medical Appliances. Beginning in late 2000 or early 2001 Kimadia advised the agent of the company that a 10% kickback was required to obtain a contract. While the company initially refused, eventually it agreed. Overall, the company made a total of about $1.4 million kickback payments on eleven contracts and agreed to pay about $1.3 million on two additional agreements.

To settle the case, the company agreed to the entry of a permanent injunction prohibiting future violations of each of the Exchange Act Sections cited in the complaint. In addition, Novo Nordisk agreed to disgorge about $4.3 million in profits plus $1.6 million in pre-judgment interest. The company also agreed to pay a $9 million penalty pursuant to the deferred prosecution agreement with the Department of Justice.

Sun Microsystems, Inc. In a Form 10-Q for the quarter ended March 29, 2009, the company stated that it has discovered possible FCPA violations which have been reported to various governmental authorities with whom the company is cooperating. Specifically, the filing states “During fiscal year 1009, we identified activities in a certain foreign country that may have violated the Foreign Corrupt Practices Act (FCPA). We initiated and independent investigation … and took remedial action. We recently made a voluntary disclosure with respect to this and other matters to” DOJ, the SEC and authorities in the foreign country.


Cooperation: Attorney General Eric Holder, speaking at an ABA National Institute in Washington, D.C. this week, discussed the prosecution of corporations and cooperation. During his remarks the attorney general largely reiterated the points contained in the revisions to the Department’s guidelines issued last year as discussed here. The attorney general stressed that prosecutors are not permitted to request or seek the waiver of the attorney client privilege or the work product doctrine. Rather, cooperation will be measured by providing the government with the facts, not privilege waivers. At the conclusion of his remarks, and in response to a question from the audience, the Attorney General noted that he plans to confer with the U.S. Attorneys and work out a method for providing cooperation credit for corporations under uniform standards which will ensure that the amount of credit does not very from office to office and is not determined by just a single prosecutor.

Criminal cases

In U.S. v. Treacy, Case No. 1:08-cr-00366 (S.D.N.Y.), James J. Treacy, former Chief Operating Officer and President of recruitment services for Monster Worldwide, Inc. was convicted of securities fraud and related charges based on option backdating claims. The charges stem from an option backdating scheme at the company which took place between 1997 and 2003.

The scheme caused Monster’s public filings with the SEC during the period between 1997 and 2005 to understate compensation expense by over $300 million. For example, in 2006 the company initially reported net income of over $69 million. Following a restatement which corrected for the compensation expenses related to the backdated options, net income was reduced to about $3.4 million. As part of the scheme, documents were falsified and misrepresentations made to the auditors. Mr. Treacy received over one million backdated options in eight different grants. He exercised about 745,000 of those options for a total gain of over $24 million. He is scheduled to be sentenced August 25, 2009. See also SEC v. Treacy, Case No. 08 CV 4052 (S.D.N.Y. April 30, 2008). Other option backdating cases at Monster Worldwide are discussed here.

In U.S. v. Pendergest-Holt, Case No. 09-mj-56 (N.D. Tex. Filed Feb. 26, 2009), an indictment was returned against Laura Pendergest-Holt, the chief investment officer of Stanford Financial Group. The indictment contains two counts. The first alleges that Ms. Pendergest-Holt conspired to obstruct the SEC investigation while the second is a substantive count of obstruction.

According to the indictment, Ms. Pendergest-Holt lied to the SEC during its investigation regarding a pre-testimony meeting with other company executives in which she planned what to tell the SEC. The indictment also claims that she lied about her knowledge of certain fund finances.

In U. S. v. Dreier, Case No. 1:09-cr-00085 (Filed Jan. 29, 2009), New York attorney Marc Dreier pled guilty to all eight counts in a superseding indictment yesterday. Mr. Dreier, the founder and managing partner of Dreier LLP in New York, is charged in the indictment with an investment scheme in which he defrauded investors in connection with the sale of fraudulent notes as discussed here. According to the U.S. Attorney’s Office there was no plea agreement. The Commission has a parallel civil action. SEC v. Dreier, Case No. 08 Civ. 1061 (S.D.N.Y. Filed Dec. 8, 2008).

State cases

Pay to play: New York Attorney General Andrew Cuomo announced that he had obtained another guilty plea in the on-going pension fund inquiries discussed here. Julio Ramirez, an unlicensed placement agent formerly associated with Wetherly Capital Group, pled guilty to securities fraud under the New York Martin Act. Mr. Ramirez participated in two key fraudulent schemes in which there were kickbacks in exchange for state pension fund business.

Following the guilty plea in the New York action, the SEC amended its complaint in SEC v. Morris, Civil Action 09-CV-2518 (S.D.N.Y. Filed March 19, 2009), discussed here, adding Mr. Ramirez, alleging essentially the same facts.

Mr. Cuomo also announced an agreement with the Carlyle Group in his on-going investigation. The Carlyle Group paid kickbacks to Henry Morris, the former chief political aid to the New York Comptroller Alan Hevesi. A number of those payments are the basis for charges in the NY AG’s related criminal case. The Carlyle Group agreed to adopt Mr. Cuomo’s Public Pension Fund Code of Conduct. That code bars investment firms from hiring, using or paying agents, lobbyists or others to obtain investments.

Subprime lending: Goldman Sachs & Company entered into a settlement with the Attorney General of Massachusetts, Martha Coakley, regarding that office’s investigation into subprime lending practices. Under the agreement Goldman will resolve potential claims regarding subprime lending practices by implementing a loan restructuring program. Under the terms of the deal homeowners will be able to reduce the amount of first mortgages by up to 25-35% and second mortgages by 50% or more. Borrowers whose first mortgage is significantly delinquent will be required to make a reasonable monthly loan payment while seeking refinancing or until their home is sold. This settlement is part of an on-going inquiry into the securitization of subprime loans which began in December 2007.

Private actions

Option backdating: Marvell Technology Group, Ltd., a Santa Clara, California based maker of circuits for data storage and broadband communication devices, received tentative approval to resolve derivative litigation based on option backdating claims. In re: Marvell Technology Group Ltd. Derivative Litig., Case No. 5:06-cv-06286 (N.D.Cal. Filed June 22, 2006). The case alleged that from 2000 to 2006 the company backdated stock options. In October 2006, Marvell recorded a noncash charge of $327 million for the compensation associated with the backdated stock options.

The settlement provides for the cancellation, forfeiture and re-pricing of about 12.1 million stock options. It also includes a number of corporate governance reforms. Previously the court expressed concern about proposed attorney fees of $16 million to plaintiffs. The resolution of that issue was deferred.

Financial fraud: In one of the few securities class actions to proceed to trial, a jury returned a verdict against Household International, Inc. in a securities fraud suit. Lawrence E. Jaffe Pension Plan v. Household International, Inc., Case No. 02-C-5893 (N.D. Ill.). The complaint alleges that the company reported above average returns by engaging in predatory lending practices and accounting fraud over a period beginning in 1997 and continuing through 2002. According to the complaint, Household entered into a $12 million settlement with the California Department of Corrections regarding its improper lending practices which was followed by a 20% drop in its stock price. In addition, the company improperly recorded $600 million in revenue from 1994 through the first quarter of 2002. This resulted in a restatement which for the years 1994 through 2002. The jury returned a verdict in favor of plaintiffs, finding violations of Section 10(b) according to the verdict forms.

False statements: The court in Fort Worth Employers’ Retirement Fund v. Biovail Corp., Case No. 08 Civ. 8592 (S.D.N.Y) dismissed with prejudice a securities fraud suit against Biovail Corporation and four of its current and former officers. The case alleged that defendants did not adequately disclose the risk that the FDA might either not approve or delay approval of the drug a new drug in three different statements. The court dismissed the complaint with prejudice, concluding that plaintiffs failed to plead a strong inference of scienter as required by Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) (discussed here). Plaintiffs also failed to plead loss causation as required by Dura Pharm. Inc. v. Broudo, 544 U.S. 336 (2005) (discussed here) according to the ruling.

In reaching its conclusion the court found that the “Amended Complaint’s allegations of securities fraud … are self-refuting.” Although the complaint claims that Defendants knew, but failed to disclose, that the FDA would likely not approve the new drug unless a “singe-dose study” was done, the amended complaint confirms that such a study was not necessary. Accordingly plaintiffs’ own allegations undermine its theory. In reaching its decision, the court noted that Congress passed the PSLRA in 1995 to deter strike suits. Here, “Plaintiff’s Amended Complaint is a prime exemplar of a legally baseless securities ‘strike suit.'”