This Week In Securities Litigation (May 8, 2009)

This week, SEC Enforcement Director Robert Khuzami made his first appearance before Congress, providing testimony outlining the recent activities of the Division and providing a glimpse of things to come. The GAO released a report on SEC enforcement, reviewing the Division’s compliance with past recommendations and adding four new proposals for future improvements and reforms. The Commission also brought two enforcement actions which are “firsts.” One was against the principals of the first money market fund to “break the buck” and the second was an insider trading case based on credit default swaps. A new criminal securities case was brought in what is now a recurring theme of the market crisis — investment fund fraud — while FINRA announced additional ARS settlements.


Congressional testimony re enforcement: In testimony before the Senate Banking, Housing and Urban Affairs subcommittee, Robert Khuzami discussed the Commission’s enforcement program. After reviewing recent cases brought by the Commission, the new Director noted that despite several years of flat or declining budgets, the Commission, under its new chairman, is moving forward aggressively. To illustrate the point, he details statistics revealing that since the end of January, the Commission: has filed 27 emergency temporary restraining orders compared to 7 last year during a similar period; opened 287 investigations compared to 217 last year; and issued 138 formal orders compared to 57 last year. To move forward in an effective manner however, the Division needs additional resources, a theme echoing the GAO report issued this week and discussed below. This includes more administrative and paralegal support, additional technology and more trial attorneys. The Division also needs to hire a COO to manage the administrative, information technology, project management and human resource issues.

According to Mr. Khuzami, the Division is also carefully conducting a self-analysis with a view toward improving its operations. Critical questions under consideration include: 1) Specialization – whether there should be more specialized groups organized along product, market or transactional lines; 2) Management – if a different management structure with fewer mangers would facilitate investigations; 3) Approvals and procedures – if the Division can streamline its approval processes for various matters; and 4) Cooperation – if further cooperation with other law enforcement organizations and regulators will aid in leveraging the resources of the Division.

Mr. Khuzami concluded his testimony by noted that the Commission is preparing a package of legislative proposals which will be forwarded to Congress shortly. He also informed the Senators that he noted that he agreed with each of the recommendations in the GAO report.

GAO Report: The GAO issued a report on Enforcement, “Securities and Exchange Commission Greater Attention Needed to Enhance Communication and Utilization of Resources in the Division of Enforcement” (March 2009). In the initial sections of its report, the GAO reviewed the progress the SEC made in implementing recommendations made two years ago. Those recommendations focused on the procedures for the approval of new investigations, establishing procedures for a new investigative information system, closing inactive investigations and improving the management of the Fair Funds program. The GAO concluded that the agency has developed procedures for the review and approval of new investigations and for closing inquiries. It has also adopted an investigation management information system called the HUB and improved the management of the Fair Funds program by creating the Office of Collections and Distributions. That office however, appears to have an inefficient management structure.

Despite a decline of 11.5% in the number of investigative attorneys who have primary responsibility for developing enforcement cases since 2004, enforcement activity in terms of the number of cases brought has been relatively constant. The case backlog during that period has declined. At the same time, “Enforcement management and investigative attorneys agree that resource challenges have affected their ability to bring enforcement actions effectively and efficiently.” Overall however, the Division suffers from inadequate administrative, paralegal, and information technology support as well as from the unavailability of specialized services and expertise – all themes developed by the new Division Director in his Senate testimony discussed above. Enforcement is also burdened with a time consuming and slow internal review process. The policy on corporate penalties and the former Chairman’s now abolished pilot program for reviewing corporate penalty cases hindered these actions and undermined the use of corporate penalties.

The report makes four new recommendations: 1) That an alternative organizational structure be used for the new Office of Collections and Distributions; 2) That the current approval process within the Division be reviewed along with the mix of resources available in view of the ability to bring timely enforcement actions; 3) That the corporate penalty policy be reviewed; and 4) That the Commission “take steps to ensure that … in creating, monitoring, and evaluating its policies, [it] follows the agency strategic goal and other best practices for communication with, and involvement of, the staff affected by such changes.” This is was not for the most part done, for example, in establishing the policies on corporate penalties.

Broker-dealers/Investment advisers: Commissioner Elisse Walter discussed the regulation of broker-dealers and investment advisers in a speech to the Mutual Fund Directors Forum Conference on May 5, 2009. In her remarks, Commissioner Walter noted that the lines have blurred between investment advisers and broker dealers. Nevertheless, the regulations governing each are quite different, stemming from the fact that they were drafted in a different time period. As a basic principle, the regulations should focus on what the person does, not how the fee is charged, Commissioner Walter noted.

Under current authority, the Commission, in its rule making efforts, should attempt to harmonize the regulations: “Specifically, using current statutory authority, I believe the Commission should try to harmonize, among other things, the registration process, disclosure obligations, supervisory responsibilities, and record keeping requirements of broker-dealers and investment advisers.” If there is to be a legislative approach, Commissioner Walter recommended that Congress effectively rewrite the statutes.

Commission policies: Senator Charles E. Grassley sent a letter to SEC Chairman Mary Schapiro dated May 5, 2009, expressing concern that a recently posed SEC internal policy may be “too broad a standard and is likely to chill SEC employees from exercising their rights under the U.S. Constitution and whistleblower statutes to communicate information about waste, fraud, abuse and mismanagement to Congress.” The letter refers to an internal memorandum posted at the SEC dated April 2, 2009, titled “Loose Lips Sink Ships.” The memo cautions employees about rules “at the SEC that prohibit you from disclosing nonpublic information unless you have prior authorization … .” The memo goes on to note that this policy applies to discussions with “other people,” which includes outside visitors, other SEC employees and virtually anyone. Senator Grassley requested that the policy be modified.

SEC Enforcement

Insider trading/CDS: The SEC brought its first insider trading case based on trading in credit default swaps, SEC v. Rorech, Civil Action No. 09 CV 4329 (S.D.N.Y. Filed May 5, 2009). According to the complaint, Renato Negrin, a former portfolio manager at investment adviser Millennium Partners, L.P., and Jon-Paul Rorech, a salesman at Deutsche Bank Securities, Inc., engaged in insider trading regarding the credit default swaps of VNU N.V., a privately held Dutch media conglomerate now known as the Nielsen Company. According to the SEC, Mr. Rorech learned about a restructuring of a bond offering related to VNU through his employment at Deutsche Bank in July 2006. In a series of phone calls, Mr. Rorech told Mr. Negrin about the transaction. At the time of these conversations, there was a limited supply of bonds and an increase in the supply would result in more exposure and demand for the credit default swaps, increasing their market price according to the complaint.

Based on the information, Defendant Negrin purchased about 20 million euros worth of VNU CDS on behalf of a hedge funds advised by Millennium in two transactions at a time when the information about the restructuring was non-public. Mr. Negrin’s transactions netted his employer about $1.2 million after the announcement of the restructuring. The case, which alleges violations of Section 10b and Rule 10(b)-5, is in litigation.

Financial fraud: In SEC v. Reserve Management Company, Inc., Case No. 09 CV 4346 (S.D.N.Y. Filed May 5, 2009) the Commission brought an enforcement action against the principals the Reserve Primary Fund, the first money market fund to “break the buck.” The complaint, which alleges violations of the antifraud provisions, claims that the defendants failed to provide material information to Primary Fund’s investors, board and rating agencies after the bankruptcy of Lehman Brothers on September 15.

At the time Lehman filed for bankruptcy, the Fund held $785 million in Lehman Debt securities. Following Lehman’s bankruptcy filing, the Fund was overwhelmed by redemption demands. By mid-morning on September 15th the Fund’s custodian bank suspended its overdraft privileges because of massive redemption requests. Redemptions halted, as the defendants knew.

In an effort to reassure investors, the Fund’s Board of Trustees and the rating agencies, and to avoid breaking the buck, defendants made a series of false and misleading statements, including claims that the Fund would not break the buck, that redemptions were being made, that a credit arrangement was being put in place and that it had requested a “no action” position from the SEC. As a result of these misrepresentations, the process the board used to strike the NAV for the Fund up to 4:00 p.m. on September 16th was flawed. This advantaged some investors and disadvantaged others. By the end of the day on September 16, the Fund was forced to disclose that it had broken the buck. Although the Fund adopted a liquidation process, the SEC is seeking to compel distribution of the remaining assets on a pro rata basis. The case is in litigation.

False legal opinions: In SEC v. Rasch, Jr., Case No. 1:09-CV-1190 (N.D. Ga. Filed May 5, 2009), the SEC brought an action against an attorney, his associate and the owner of 144 Opinions, Inc., alleging that during 2007 defendants operated a legal opinion mill. The operation is alleged to have issued fraudulent legal opinions used by promoters in various pump-and-dump schemes. According to the SEC’s complaint, 24 such opinions were issued in this fashion. The case, which alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b), is in litigation.

Primary violator: In SEC v. Lucent Technologies, Inc., Civ. No. 04-2315 (S.D.N.Y. Filed May 17, 2004), the court granted summary judgment in favor of four defendants, rejecting the SEC’s claims of primary liability in a financial fraud case. The complaint alleges that Lucent’s books and records were inaccurate, essentially because they improperly recognized revenue.

The primary claim against each defendant is that they authorized or approved verbal side agreements, credits or other incentives in connection with sales. These deals were made to induce Lucent’s customer to purchase equipment but made the recording of the revenues improper under GAAP. As a result Lucent materially overstated pre-tax income. While each of the defendants was involved in deals where these arrangements were part of the transaction, none had direct responsibility for the preparation of the financial statements. One defendant however, executed a management representation letter for one quarter which acknowledged responsibility for the fair presentation of the financial statements and falsely stated that there were no oral side agreements, while another defendant knew about the improprieties, but failed to object.

In rejecting the SEC’s claims of primary liability, the court relied on the “bright line” test evolved by the Second Circuit. That test requires that to be a primary violator the person must actually make a false or misleading statement communicated to the public. In this case, it is clear that the defendants are not primary violators because they did not make any misrepresentation to the public. While the defendants were involved in a chain of events that ultimately led up to the claimed fraud, that is not sufficient under the bright line test to establish primary liability.

Criminal cases

Investment fraud: In U.S. v. Fishman, Case No. 09-mj-01989 (S.D.N.Y. Filed April 30, 2009) and U.S. v. Ledven, Case No. 09-mj-1088 (S.D.N.Y. Filed April 30, 2009), Alan Fishman and Gary Gelman were charged with securities fraud and wire fraud. From 2003 through February 2006 Alan Fishman, Gary Gelman and Daniel Ledven are alleged to have fraudulently solicited investors to invest in A.R. Capital Group, Inc., a company they controlled. The offering memorandum falsely stated that the fund invested in international real estate companies and leveraged trading. Over a three year time period about $20 million was raised from investors of which $18 million was wired to various bank accounts in Ukraine. The Fund ceased operations when the SEC commenced an investigation. Messrs. Ledven and Fishman have been arrested, while Mr. Gelman remains at large.

Insider trading: U.S. v. Bouchareb, Case No. 1:08-mj-02777 (S.D.N.Y. Filed Dec. 17, 2008) is a criminal securities case in which Jamil Bouchareb, a day trader, pled guilty to trading in inside information received from a friend, Matthew Devlin. The information had been misappropriated from Mr. Devlin’s wife, a New York public relations executive specializing in mergers. Mr. Devlin, a former Lehman Brothers Holdings, Inc. salesman pled guilty to insider trading in December. U.S. v. Devlin, Case No. 1:08-cr-01307 (S.D.N.Y. Filed Dec. 29, 2008). Five individuals were charged in this scheme which is alleged to have made about $4.8 million in trading profits from March 2004 to July 2007. See also U.S. v. Bowers, Case No. 1:08-mj-02779 (S.D.N.Y. Filed Dec. 17, 2008); U.S. v. Holzer, Case No. 1:08-mj-02778 (S.D.N.Y. Filed Dec. 17, 2008); SEC v. Devlin, Case No. 1:08-cv-11001 (S.D.N.Y. Filed Dec. 18, 2008).


The Financial Industry Regulatory Authority announced settlements with four additional firms regarding their auction rate securities sales practices. The firms are NatCity Investments, Inc., which was fined $300,000; M&T Securities, Inc., fined $200,000; Janney Montgomery Scott LLC, fined $200,000; and M&I Financial Advisors, fined $150,000. In addition, each firm agreed to settlements which are similar to those announced earlier by the SEC and the New York Attorney General in this area discussed here. Under those settlements, generally the firms agreed to a repurchase program for essentially retail investors and the use of a special FINRA arbitration procedure.

FINRA also announced that SunTrust Investment Services, Inc., and SunTrust Robinson Humphrey, Inc. decided not to conclude previously announced settlements in principle. The investigations of those firms are continuing.