This Week In Securities Litigation (May 29, 2009)

The SEC reacted to another scandal this week, imposing new restrictions on employee stock trading. Stories continue to circulate, however, that the SEC will be stripped of some of its authority or merged with the CFTC.

In court actions, the Supreme Court agreed to hear an appeal from the Third Circuit regarding the application of the statute of limitations in securities fraud suit. The Commission brought enforcement actions claiming fraud in the sale of CMOs, based on the duties of investment advisers and centered on financial fraud, as well as a fraudulent stock scheme. In private litigation, the court in the VeriFone litigation dismissed the consolidated class action complaint for failing to plead a strong inference of scienter.


The SEC moved to quell its latest scandal by imposing new rules on stock trades for employees. These rules come in the wake of an SEC IG report suggesting suspicious trading by two enforcement attorneys. That report sparked a criminal probe by the FBI and the U.S. Attorney’s Office for the District of Columbia.

At the same time, news reports continue to circulate that in the coming reorganization of financial regulators the SEC may be stripped of its investor protection role. A front page story in the Washington Post this week states that consideration is again being given to merging the SEC into the CFTC.

H.R. 2622 was introduced in the House of Representatives on May 21, 2009. The bill is to amend the Securities Exchange Act of 1934. It is titled Compliance, Examinations, and Inspections Restructuring Act of 2009. The bill provides for the Commission to delegate its inspection and examination authority to the administrative divisions or offices and then report to Congress every 5 years on the “continuing efficacy, effectiveness, and efficiency of requiring administrative divisions to continue with the inspections.”

The bill would also require during an investigation that the subject of the inquiry be given a status report every 120 days and a written notice within 10 days of the time the inquiry is closed. The Act would also impose notice requirements on sweep examinations or inspections and require the appointment of an ombudsman. One of the duties of the ombudsman would be to “advise and guide such persons through the process of self-reporting, ensuring appropriate and due credit is given to the registrant upon self-reporting.”

The Supreme Court

The Court agreed to hear Merck & Co., Inc. v. Reynolds, Case No. 08-905 (S.Ct. Docketed Jan. 15, 2009). The case is an appeal from the Third Circuit concerning the application of the statute of limitations in securities fraud suits. Specifically, the question the High Court agreed to hear is whether Third Circuit was incorrect in concluding that “under the ‘inquiry notice’ standard applicable to federal securities fraud claims, the statute of limitations does not being to run until an investor receives evidence of scienter without the benefit of any investigation?” According to the Petitioner, the Ninth Circuit is in accord with the ruling by the Third Circuit. However, nine other circuits disagree. The suit is based on Merck’s development and sale of prescription pain medication Vioxx and alleged misrepresentations regarding the drug’s alleged cardiovascular risks. The district court had dismissed the case based on the statute of limitations, but the Third Circuit reversed.

Still pending on the Court’s docket is Trainer Wortham & Co. v. Heide Betz, No. 07-1489 (S.Ct. Docketed May 29, 2008) which raises the same question on an appeal from the Ninth Circuit Court of Appeals. That case, and a discussion of the four approaches taken by the circuit courts on this issue, is discussed here.

SEC enforcement

Fraud in sale CMOs: SEC v. Betta, Case No. 0980803-Civ (S.D. Fla. Filed May 28, 2009) names ten brokers who had been employed by California based Brookstreet Securities Corp. The complaint alleges that from 2004 to 2007 the defendants lured investors to purchase Collateralized Mortgage Obligations with false claims that they were safe liquid investments suitable for retirees and that the investments would not be margined. In fact, the CMOs were margined and very risky investments suitable only for sophisticated investors. Overall, the defendants attracted more than 750 customers with CMO investments of more than $175 million from which they earned about $18 million in commissions and salaries. In early 2007, the CMO market began to fail resulting in significant loses for the investors. By June 2007 the margin calls snowballed to the point where Brookstreet failed to meet its net capital requirements and went out of business. Many of the investors lost their savings, homes and ability to retire or stay retired. Many of the investors owe Brookstreet’s clearing firm hundreds of thousands of dollars. The case, which alleges violations of the antifraud provisions, is in litigation. FINRA brought a related action.

Fund rebate agreements: Two additional settled proceedings were filed which arise out of the undisclosed agreements between BISYS Fund Services, Inc., a mutual fund administrator, and mutual fund advisers, including AmSouth Bank and its two subsidiaries. Under the side agreements, BISYS rebated a portion of its administration fee to the fund advisers in exchange for their promise to recommend BISYS as an administrator to the funds’ boards of trustees as discussed here. One action was brought against Melissa Hurley, formerly a senior vice president and general counsel. In the Matter of Melissa M. Hurley, Adm. Proc. File No. 3013493 (Filed May 28, 2009). The second named as a defendant J. David Huber, former president of BISYS Fund Services. In the Matter of J. David Huber, Adm. Proc. File No. 3-13492 (Filed May 28, 2009). Both respondents resolved the actions by agreeing to the entry of a cease and desist order from causing future violations of Sections 206(1) and 206(2) of the Advisers Act. Ms. Hurley will pay $15,000 in disgorgement plus prejudgment interest and a civil penalty equal to the disgorgement. Mr. Huber will pay disgorgement of $13,800 plus prejudgment interest.

Adviser fees: In the Matter of New York Life Investment Management LLC, Adm. Proc. File No. 3-013487 (Filed May 27, 2009) is a settled administrative proceeding brought against the investment adviser to the Equity Index fund which is a series of The MainStay funds. They are primarily distributed by registered representatives of NYLIFE Securities, Inc. The action alleges a violation of Section 206(2) of the Advisers Act based on the fact that, during the process for renewing three investment advisory contracts between Respondent and the Equity Index Fund, the board of trustees received information showing that the management fees charges were among the highest of the Fund’s peer group. The Adviser urged the board of trustees to consider the guarantee feature (which guaranteed a shareholder’s investment at the level of the original investment under certain circumstances), but failed to provide the information necessary to evaluate it.

At the same time, NYLIM filed with the SEC prospectuses, annual reports and registration statements which misrepresented that there was “no charge” to the Fund or its shareholders for the guarantee in violation of Section 34(b) of the Investment Company Act. The action was settled with consent to the entry of a cease and desist order from committing or causing future violations of Section 206(2) of the Advisers Act and Sections 15(c) and 34(b) of the Investment Company Act. In addition, the respondent agreed to pay disgorgement of approximately $3.9 million along with prejudgment interest and a civil penalty of $800,000.

Fraudulent stock scheme: SEC v. Pegasus Wireless Corporation, Case No. 09-2302 (N.D. Cal. Filed May 26, 2009) is an action brought against the company and two of its senior officers based on a secret stock dumping scheme. According to the complaint, which alleges violations of the antifraud and reporting provisions, the two officers caused about 75% of the stock of the company to be secretly issued to their friends, relatives and nominees using false documents and filings in which it claimed that the stock was issued in regard to a debt. At the same time the company issued press releases touting acquisitions that caused its market cap to soar. As the price increased, the two officer defendants sold their stock into the market. The scheme was concealed with forged documents and false SEC filings. The action is in litigation.

Investment advisers/breach of duty: SEC v. Gendreau & Associates, Inc., Case No. CV 09-03697 (C.D. Cal. Filed May 26, 2009) is an action brought against an investment adviser and its principal, Jacques Gendreau, alleging a breach of fiduciary duty based on placing clients in unsuitable investments, misrepresenting the nature of the investments and, in some instances, acting contrary to the instructions of the clients. Defendants implemented a high risk strategy in late August and early September 2008 by putting a number of clients in preferred shares of Citigroup and Wachovia using significant margin. This strategy was not suitable for may clients and contrary to their instructions. Defendants however, claimed that the investment strategy was “guaranteed” or “practically no risk.” When subsequent margin calls were not met, there were losses of about $12 million equaling about 72% of the assets within days. In the end 42 clients were left owing about $300,000 for the margin losses. The complaint, which alleges violations of Sections 206(1) and (2) of the Advisers Act and of the antifraud provisions by the two defendants and Section 204 of the Advisers Act by the company, is in litigation.

Financial fraud: SEC v. Miller, Civil Action No. 09-CV-4945 (S.D.N.Y. Filed May 27, 2009) is a settled financial fraud action which follows from the Commission’s action against Cardinal Health, Inc. as discussed here. SEC v. Cardinal Health, Inc., Civil Action No. 07 CV 6709 (S.D.N.Y. Filed July 26, 2007) (Settled with a consent injunction, payment of a $35 million penalty and the retention of an independent consultant).

The case this week named as defendants former Cardinal executives Richard Miller, CFO, Gary Jensen, vice president and corporate controller and Michael Beaulieu, corporate vice president, controller and principal accounting officer. A key part of the scheme involved the reclassification of revenue from “bulk” to “operating revenue.” Through this reclassification, Cardinal’s reported operating revenue was inflated by more than $5 billion. Since operating revenue is a key industry metric, this misleads the public and investors. Defendants also manipulated Cardinal’s reported earnings in certain quarters by selectively accelerating payment of vendor invoices and using other improper practices. A resulting restatement reduced Cardinal’s net earnings by a cumulative total of $65.9 million.

To settle the action, each defendant consented to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and internal control provisions of the securities laws. Mr. Miller also agreed to pay a $120,000 civil penalty, an officer director bar for five years and a 102(e) order suspending him from practicing before the SEC as a CPA for three years. Mr. Jensen agreed to pay a $75,000 civil penalty and to an officer/director bar for three years while Mr. Beaulieu agreed to civil penalty of $50,000 and an officer/director bar for three years.

Investment fund frauds: SEC v. PrivateFX Global One, Ltd., SA, Case No. 09-CV-1541 (S.D. Tex. Filed May 26, 2009) named as defendants Texas A&M finance professor Robert Watson and Huston attorney and CPA Daniel J. Petroski along with entities one or both controlled. According to the complaint, from mid-2006 to the present defendants Watson and Petroski have raised at least $19.5 million from more than 60 investors in this country and others. Shares were sold in the venture under a PPM. Defendants claimed the Fund had incredible returns. From August 2006 to February 2009 defendants, for example, claimed that Global One never had a losing month. From inception through February 2009 the Fund claimed it had annualized returns of over 23%. Bank records for the Fund not only failed to substantiate the claims in the PPM, but turned out to be fake. The Commission sought and obtained an emergency asset freeze order. The case is in litigation.

Criminal cases

Market manipulation: Two defendants pleaded guilty last week in U.S. v. Noun, Case No. 1:07-cr-01029 (S.D.N.Y. Filed Nov. 8, 2007). The case centers on the claimed manipulation of the stock of Smart Online, a company which develops and markets internet delivered software and data resources for small businesses. Defendants Alain Lustig and Ruben Serrano were charged with accepting secret cash payments to induce their customers to purchase Smart Online stock. The effect to create a false sense of genuine market interest. Each defendant pled guilty to one count of conspiracy to commit securities and wire fraud and commercial bribery and one count of securities fraud. The other defendants, Dennis Nouri, Smart Online’s CEO, his brother Reza Nouri, a Smart Online employee and Anthony Martin, a broker, are scheduled for trial in June 2009.

Private actions

The court dismissed nine consolidated class actions alleging financial fraud in In re VeriFone Holdings, Inc., Securities Litigation, Case No. C 07-06140 (N.D. Cal. Filed Dec. 4, 2007). The case arises out of a 2007 restatement of the financial statements of VeriFone, a San Jose, California company which designs, markets and services transaction automation systems. In a December 3, 2007 announcement, the company informed its shareholders that its financial statements for the three previous quarters could not be relied on due to accounting errors related to the valuation of in-transit inventory and allocation of manufacturing distribution overhead inventory. The stock price dropped over 45%.

The court granted a motion to dismiss the complaint, concluding that plaintiffs had failed to plead facts establishing a strong inference of scienter. First, the fact that there was a restatement is not sufficient standing alone to create a strong inference of scienter. While falsity may be indicative of scienter where it is combined with allegations regarding a manager’s role in that company that are particular and suggest the defendant had actual access to the dispute information, which is not the case here. Likewise, the mere fact that the SOX CEO/CFO certifications turns out to be incorrect is not sufficient. While that may suggest negligence, that is not sufficient to establish scienter the court concluded. Equally unpersuasive were claims from 10 confidential witnesses that the accounting department was chaotic. While that may be true, none of the witnesses discussed incorrect accounting entries. Finally, stock sales by the individual defendants were insufficient to raise a strong inference of scienter since there was no trading history to provide context. Taken together the allegations are insufficient to raise a strong inference of scienter.