THIS WEEK IN SECURITIES LITIGATION (October 21, 2011)
Eight SEC Enforcement attorneys were recognized by the Counsel of the Inspector General on Integrity for Excellence in connection with their work regarding the investigation of a significant market crisis case.
The Commission filed its third significant enforcement action stemming from the sale of interests in complex and largely synthetic entities tied to the residential housing market. As with prior cases, Citigroup, the entity creator, hand picked the collateral without disclosing that fact or that it was betting on the failure of the entity to investors. Those investors lost when the entity did fail while Citigroup profited. Other cases filed this week include additional investment fund fraud actions and a case against the operator of a company that taught option trading.
In one criminal case a former FDA chemist pleaded guilty to insider trading charges based on his use of confidential agency data regarding drug applications to trade in the shares of the related pharmaceutical companies. The case stems from an SEC referral. In another, the former CFO of a wireless company was sentenced to prison for a fraudulent scheme he created centered on fake promissory notes he claimed were company obligations and which he used to pay himself and his family and friends about $25 million though the issuance of company stock.
Finally, the PCAOB issued an unusual statement explaining its release of portions of an inspection report criticizing a major accounting firm. The reports are confidential but when the firm fails to take corrective action within the allotted time, the Board may release the sections of the report discussing the deficiencies according to the release.
The Commission
Testimony: Eileen Rominger, Director, Division of Investment Management, testified before the Senate Banking, Housing and Urban Affairs Committee, Subcommittee on Securities, Insurance and Investment. The testimony is titled: Market Micro-Structure: An Examination of ETFs (here).
Awards: Eight members of the SEC’s Enforcement Staff were given the 2011 Award for Excellence in Investigations by the Council of the Inspectors General on Integrity and Efficiency. The awards are for their work on the investigation related to the collapse of Taylor, Bean & Whitiker Mortgage Corp. and Colonial BancGroup, Inc. (here).
SEC Enforcement: Filings and settlements
Insider trading; SEC v. Cutillo, Civil Action No. 09-CV-9208 (S.D.N.Y) is one of the Galleon related insider trading cases. This week defendants Arthur Cutillo and Jason Goldfarb, both former associates at the law firm of Ropes & Gray LLP, settled with the Commission. The complaint alleged that the two settling defendants misappropriated inside information regarding pending corporate take-over transactions from the firm and tipped Zvi Goffer who in turn tipped others. Messrs. Cutillo and Goldfarb settled with the SEC, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b). Each defendant also agreed to pay disgorgement of $32,500 together with prejudgment interest. In related administrative proceedings each agreed to the entry of an order under Rule 102(e) suspending them from appearing and practicing before the Commission as an attorney. Previously, each defendant pleaded guilty to charges of securities fraud and conspiracy to commit securities fraud in the related criminal cases. Mr. Cutillo was sentenced to 30 months in prison and ordered to pay criminal forfeiture of $378,608. U.S. v. Cutillo, 10-CR-0056 (S.D.N.Y.). Mr. Goldfarb was sentenced to serve three years in prison and ordered to pay a $32,500 fine and a criminal forfeiture of $1,103,131. U.S. v. Goldfarb, 10-CR-0056 (S.D.N.Y.).
Breach of fiduciary duty/fraud: SEC v. Copeland, Civil Action No. 11-08607 (C.D. Cal. Filed Oct. 20, 2011) is an action against Charles Copeland, Copeland Wealth Management, A Financial Advisory Corporation (“CWM”) and Copeland Wealth Management, A Real Estate Corporation (“Copeland Realty”) for breach of fiduciary duty and fraud. CWM is a registered investment adviser which manages about $125 million that is largely invested in mutual funds and real estate funds. Copeland Realty is an unregistered investment adviser. The firm is the general partner for 21 limited partnerships which are primarily invested in real estate. Charles Copeland is a certified public accountant and the founder and co-owner of each entity. From 2003 through May 2011 the defendants raised over $62 million from over 100 investors by selling interests in limited partnerships operated by CWM and Copeland Realty. The Commission alleges that the sales were based on false representations regarding the use of investor funds, conflicts of interest, guaranteed returns, the unauthorized trading of options and the payment of undisclosed real estate commissions. The three defendants partially resolved the case by consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a), Exchange Act Section 10(b), and Advisers Act Sections 206(1) and (2). The defendants also agreed to the appointment of a receiver and an order prohibiting the destruction of documents. Issues regarding disgorgement and civil penalties will be resolved at a later date.
Market crisis: SEC v. Citigroup Global Markets, Inc., Case No. 11-Civ-7388 (S.D.N.Y. Filed Oct. 19, 2011) is an action against Citigroup stemming from its role in the creation and marketing of a largely synthetic collateralized debt obligation or CDO called Class V Funding III. Having determined that the residential real estate market would drop significantly, Citigroup decided in late 2006 to construct a CDO-squared – a CDO collateralized by tranches of other CDOs rather than instruments such as bonds – tied to the residential real estate market. The collateral would be largely CDO tranches left from earlier deals. As collateral manager Citigroup engaged Credit Suisse Alternative Capital, Inc. or CSAC. An experienced collateral manager was essential to selling the notes. Citigroup selected most of the collateral for Class V, although CSAC did select some. The marketing material featured CSAC and its experience without disclosing Citibank’s role in selecting the collateral or that it had a $500 million short position against the Class V collateral it selected. Class V collapsed only months after the notes were sold, leaving investors with millions of dollars in losses. Citigroup made $34 million in fees for structuring the entity and $160 million in net profits on its positions. Citigroup settled the action, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3). Citigroup also agreed to disgorge $160 million and pay $30 million in prejudgment interest and $95 million as a penalty for a total of $285 million which will be placed in a fair fund. The settlement requires Citigroup to take certain remedial action related to its review and approval of offerings of certain mortgage related securities. The settlement is subject to approval by Judge Rakoff.
See also, In the Matter of Credit Suisse Alternative Capital, Adm. Proc. File No. 3-14594 (Filed Oct. 19, 2011) which is the settled action against the administrator and its lead employee in the deal, Samir Bhatt. Respondents settled, consenting to the entry of a cease and desist orders based on Securities Act Sections 17(a)(2) and Advisers Act Section 206(2). The entity Respondents also agreed to pay $1 million in disgorgement which was the fee for the deal plus prejudgment interest and a civil penalty of $1,250,000. Mr. Bhatt agreed to be suspended from association with any investment adviser for a period of six months. SEC v. Stoker, Case No. 11Civ. 7388 (S.D.N.Y. Filed Oct. 19, 2011) is the action against the lead Citigroup employee in the deal. This case is in litigation.
Stock option backdating: SEC v. Berry, Case No. 07-cv-4431 (N.D. Cal.) is an action against Lisa Berry, the former General Counsel of KLA-Tencor Corp. and Juniper Networks, Inc. The complaint claimed that Ms. Berry participated in illegal option backdating at both companies. Ms. Berry resolved the action, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a) and 14(a) and the related rules. She also agreed to pay a civil penalty of $350,000 and disgorgement of $77,120 including interest. In a related administrative proceeding Ms. Berry agreed to be suspended from appearing and practicing as an attorney before the Commission with a right to apply for reinstatement in five years.
Investment fund fraud: SEC v. Temme, Civil Action No. 4:11-cv-00655 (E.D. Tex. Filed Oct. 18, 2011) is an action against James Temme and his entity, Stewardship Fund LP which alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). According to the complaint, the defendants raised about $35 million beginning in 2008 from investor groups by securing references from various persons such as an investment adviser at a major bank. Investors were told that their funds would be used to acquire tapes of non-performing mortgages at a discount and then pay returns based on principal and interest payments he collected. In some instances he falsely claimed to own mortgages which he in fact never acquired. The Commission obtained an emergency freeze order. The case is in litigation.
Misrepresentations: SEC v. Kivisto, Civil Action No. 11-CV-641 (N.D. Ok. Filed Oct. 18, 2011) is an action against Thomas Kivisto, a co-founder of SemGroup, L.P. which sold petroleum products and also traded crude oil and related commodities and derivatives. It is the parent and largest customer of SemGroup Energy Partners, L.P or SGLP which went public in 2007. The Commission’s complaint alleges that Mr. Kivisto mislead investors in SGLP by misrepresenting the risks of investing in the company. Specifically, he represented that its revenue stream was stable and predictable and protected from the volatility of oil prices. In fact the defendant’s energy trading increasingly drained SemGroup’s credit facilities and resources until July 2008 when lenders cancelled those facilities and the entity filed for bankruptcy. Investors were never told of these risks. Mr. Kivisto resolved the case by consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3), agreeing to pay a civil penalty of $225,000 and forfeiting 150,000 units awarded to him under the long term incentive plan of the company.
Investment fund fraud: SEC v. Welliver, Civil Action No. 0:11cv3076 (D. Minn. Filed Oct. 18, 2011) is an action against investment adviser David Welliver and his advisory firm Dblaine Capital, LLC. The complaint centers on a claim that the defendant improperly entered into a $4 million loan pursuant to an undisclosed quid pro quo with the lender. Specifically, in exchange for loans, defendants had committed to invest funds in certain alternative investments. In violation of various investment restrictions and policies, the assets of the fund were put in a private placement offering affiliated with the lender. Later when that investment became worthless the defendants failed to disclose this fact to the investors. The complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b), Advisers Act Sections 206 and Investment Company Act Sections 17(a)(2), 17(e)(1, 22(e) and 34(b). The case is in litigation.
False statements/cooperation: SEC v. Long Term-Short Term, Inc., Civil Action No. 1:11-cv-1127 (E.D.Va. Filed Oct. 18, 2011) is an action against the company and its co-founder and president Freddie Rick alleging violations of Exchange Act Section 10(b). The defendants sell products which are designed to teach the trading of options. Those include seminars, workshops and software that facilitates options trading. The complaint claims that the defendants, in 2007 and 2008, claimed that their instructors were highly successful options traders without having verified the accuracy of those claims and despite red flags to the contrary. They also used marketing materials which falsely claimed that Mr. Rick became wealthy through options trading when in fact that wealth came from company operations. To resolve the case each defendant consented to the entry of a permanent injunction prohibiting future violations of Section 10(b). The defendants also agreed to continue implementing certain compliance guidelines designed to prevent future violations. The company agreed to pay a civil penalty of $750,000 while Mr. Ricks will pay $150,000. The Commission acknowledged the cooperation of the defendants noting that they retained counsel who evaluated the operations of the company. Following the evaluation the company instituted policies and detailed guidelines to prevent a reoccurrence of the violations.
Criminal cases
Investment fraud: U.S. v. Labiner (E.D.N.Y.) is an action against Alan Labiner in which he pleaded guilty to charges of conspiracy to commit securities, mail and wire fraud. The charges were based on operating a boiler room in Brooklyn. According to the court papers, from 2004 to 2009 the defendant and others raised over $6 million from at least 50 investors by selling them fraudulent securities in four different investment schemes. Investors were induced to purchase the securities as a result of misrepresentations. Mr. Labiner and the others involved then misappropriated the investor funds. The date for sentencing has not been set.
Insider trading: U.S. v. Laing, 8:11-mj-1236 (D. Md. Filed March 28, 2011) is the action against FDA Chemist Cheng Yi Laing who is alleged to have engaged in insider trading by accessing agency computers to obtain information regarding drug applications and then trading in the shares of those companies. Cheng Yi Laing pleaded guilty plea to one count of securities fraud and one count of making a false statement. He also agreed to forfeit approximately $3.7 million representing his trading profits. Sentencing is scheduled for January 9, 2012.
Stock fraud: U.S. v. Durland (N.D. Cal.) is an action in which Stephen Durland, the former CFO of Pegasus Wireless Corporation, pleaded guilty to one count of conspiracy to commit securities fraud. According to the court papers, Mr. Durland executed a scheme in which he created 31 fake promissory notes which he claimed were debts of the company. He then arranged to have the notes satisfied by issuing company stock which was sold. The sale proceedings went to the defendant, his family and friends. Between May 2005 and January 2008 Pegasus issued more than 75% of its outstanding shares in connection with this scheme, netting the defendant and other over $25 million. Mr. Durland was sentenced to serve 33 months in prison.
Court of appeals
Investment fund fraud: SEC v. Brown, Case No. 10-2479 (8th Cir. Oct. 13, 2011). The case is an appeal from a grant of summary judgment in favor of the Commission in an investment fund fraud action. Defendant Sherwin Brown controlled investment adviser Jamerica Financial, Inc. which managed funds held by another controlled entity, Brawta Ventures, LLC,. The fund had $1.62 million from 53 clients. The SEC’s complaint alleged that defendant Brown diverted substantial portions of the investor funds to his own use in violation of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 204 and 206(1) and (2). After a freeze order and a preliminary injunction were entered a Chapter 7 proceeding was initiated in which a receiver was appointed who filed suit for the investors. The bankruptcy court granted summary judgment in favor of the receiver and the investors. The district court granted summary judgment in favor of the SEC in its action, disregarding Mr. Brown’s interrogatory answers because he invoked his Fifth Amendment rights. An injunction was entered and Mr. Brown was ordered to pay disgorgement of $869,633 along with prejudgment. The Eight Circuit affirmed in a per curiam opinion. The court found that the district court’s adoption of the magistrate’s report on disgorgement was appropriate and that the grant of summary judgment was supported by the record.
Circuit Judge Loken concurred in affirming the grant of summary judgment but dissented from the decision to affirm the disgorgement order. First, Judge Loken concluded that the award of disgorgement was punitive rather than remedial because the district court failed to properly consider if the remedy was necessary in view of the other proceedings. Second, Judge Loker found the disregard of the interrogatory answers error because the court again failed to consider available options to remedy the situation such as staying the criminal case. The error however was harmless on the record of this case.
FINRA
Investor alert: The regulator issued an investor alert titled: “Why Leave Money on the Table—Make the Most of Your Employer’s 401(k).” The alert, available here, urges employees to make the most of matching employer contributions, noting that many fail to contribute enough to their plans to obtain the maximum matching contribution by their employer.
PCAOB
The Board issued a “Statement Regarding Publication of Inspection Report Quality Control Criticisms.” In the statement the Board explained that when it issues an inspection report which identifies quality control issues it gives the audit firm 12 months to take the appropriate corrective action. This process is non-public as is the inspection process. If however the firm fails to make “sufficient progress” in the allotted period the “Board can and does make the relevant criticisms pubic . .. “ The statement was issued following the release of portions of a report stating that Deloitte & Touche lacked adequate quality control.
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