The Commission brought a series of high profile cases this week. Perhaps the most significant is the insider trading action brought in conjunction with the Manhattan U.S. Attorney against a former Goldman Sachs and Procter & Gamble director for allegedly tipping the convicted founder of the Galleon hedge funds, Raji Rajaratnam.

The SEC also brought its first enforcement action against a dark pool. A third high profile case was brought against a large Portuguese bank in conjunction with the NY AG while another named FINRA as a defendant in a case centered on altering documents.

All of these cases may however be overshadowed by the order entered in the Commission’s Citigroup market crisis case (here). The settlement in that case was submitted for approval to Judge Rakoff in the Southern District of New York. The court has raised questions about the terms of the settlement. The questions in the order include the predicate for the negligence based charges and settlement and the reasons for the amount of the fine and not naming additional individuals as defendants. A hearing is scheduled for November 9, 2011.

The Commission

Larger fund reporting: The Commission adopted a rule requiring large hedge fund traders and other private funds to report certain information to the Financial Stability Oversight Council. Large funds are defined as those with at least $150 million in private fund assets under management. The reporting on new Form PF is pursuant to Sections 404 and 406 of Dodd-Frank (here).

SEC Enforcement: Filings and settlements

Document alteration: In the Matter of Financial Industry Regulatory Authority, Inc., Adm. Proc. File No. 3-14605 (Oct. 27, 2011) is an action against FINRA based on the alteration of certain documents prior to their submission to the staff of the SEC’s Chicago office. Specifically, in August 2008 the Regional Director of FINRA’s Kansas City District Office altered three documents of staff meeting minutes shortly before producing them to the Commission inspection staff. Subsequently, a whistleblower complaint brought this to the attention of the regulator. An internal investigation was conduct and FINRA self-reported and implemented a series of remedial steps. This is the third time in the last eight years that FINRA or its predecessor engaged in such conduct. The Order finds that FINRA violated Exchange Act Section 17(a)(1). The matter was resolved with FINRA consenting to the entry of a cease and desist order based on the Section cited in the Order and agreeing to the entry of an order which requires it to implement a series of remedial steps including the retention of a consultant.

Investment fund fraud: SEC v Hicks, Civil Action No. 1:11-cv-11888 (D. Mass. Filed Oct. 26, 2011) is an action against Andrey Hicks and his controlled fund, Locust Offshore Management, LLC. According to the complaint, Mr. Hicks raised at least $1.7 million from 10 investors by claiming that their funds would be invested in his quantitative hedge fund. To facilitate the scheme, Mr. Hicks is alleged to have falsely enhanced his reputation by claiming he attended Harvard University, worked at Barclays Capital where he successfully built a book of business, that E&Y is the auditors of the fund and that its prime broker is Credit Suisse. At least part of the investor funds were diverted to personal use. The complaint alleges violations Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(4). The Commission obtained an emergency freeze order.

Free riding: SEC v. Kupersmith (D.N.J. Filed Oct. 26, 2011) is an action against Scott Kupersmith and Frederick Chelly. The defendants are alleged to have falsely represented to brokerage firms that they were money managers for hedge funds or private investors. They opened a number of brokerage accounts in which they purchased and sold the same quantity of the same security, often simultaneously. When the trades were profitable, they kept the money. When they were not successful, they walked away from the accounts. This was possible because the defendants used delivery versus payment/receipt versus payment accounts. To open the accounts the defendants falsely represented that they held securities and other assets in a custodial account with a third party custody bank. As a result of this scheme the defendants are alleged to have made over $600,000 in trading profits. The complaint alleges violations of Exchange Act Section 17(a) and Exchange Act Section 10(b). The case is in litigation.

Dark pools: In the Matter of Pipeline Trading Systems LLC, Adm. Proc. File No. 3-1460 (Oct. 24, 2011) is the SEC’s first action involving a dark pool. It named as Respondents Pipeline Trading Systems, LLC, a registered broker dealer and an alternative trading system, Fred Federspiel, founder and CEO, and Alfred Berkley, Chairman. The Order alleges violations of Securities Act Section 17(a)(2) and the pertinent rules under Regulation ATS.

Pipeline, which began operation in 2004 as an alternative trading system and dark pool, assured potential users that its proprietary system was designed to prevent users from uncovering customer order information which could be used to trade in front of those orders. Customers were also assured that all were treated equally. Orders were to be filled through “natural” liquidity. These representations were false. The vast majority of the trades executed in the ATS were with Milstream Strategy Group LLC, a wholly owed affiliate of the pool. Milstream filled orders by trying to anticipate the trading of customers and at times had proprietary information from the system. The Respondents resolved the action by consenting to the entry of a cease and desist order based on the sections and rules cited in the Order. In addition, Pipeline agreed to pay a civil penalty of $1 million while Respondents Federspiel and Berkeley each agreed to pay a penalty of $100,000.

Financial fraud: SEC v. Koss Corporation, Civil Case No. 2:11-cv-00991 (E.D. Wis. Filed Oct. 24, 2011) is an action against the company and its CEO and former CFO, Michael Koss. The case centers on the accounting fraud implemented to conceal the embezzlement of over $30 million from Koss over a four year period beginning in 2005 by Sujata Sachdeva, the firm’s former principal Accounting Officer who was assisted by Julie Mulvaney, a former senior accountant. The Commission’s complaint alleges that the fraud was facilitated by the failure of the company to implement proper internal controls. The company and Mr. Koss resolved the case by consenting to the entry of permanent injunctions based on Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The order as to Mr. Koss also directed that under SOX Section 304 he reimburse the company for the incentive based compensation he received from 2008 to 2010, portions of which he had previously repaid.

Registration violations: In the Matter of Banco Expirito Santo S.A., Adm. Proc. File No. 3-14599 (Oct. 24, 2011). The SEC and the New York Attorney General settled actions against Banco Expirito Santo S.A. or BES, a major Portuguese Bank, based on violations of, respectively, the registration federal securities laws and the New York Martin Act. The Commission case centers on alleged violations of Securities Act Section 5, Exchange Act Section 15(a) and Advisers Act Section 203(a). The New York case is based on alleged violations of the broker dealer and investment adviser registration provisions of the Martin Act.

BES, a commercial bank in Lisbon, Portugal, is the principal subsidiary of Espirito Santo Financial Group, a Luxembourg based financial services business. Beginning in 2004, and continuing through 2009, BES offered and provided brokerage services and investment advice to about 3,800 U.S. residents who were customers of the bank. Generally, those customers were Portuguese immigrants. Throughout the period BES offered and sold a variety of securities to its U.S. customers. Many of those securities were not registered or exempt. BES settled with the SEC, consenting to the entry of a cease and desist order based on the sections cited in the Order. The bank also agreed to pay disgorgement of $1,650,000 along with prejudgment interest and a civil penalty of $4,950,000. In addition, BES entered into a series of undertakings regarding its U.S. clients. To settle with the State of New York the bank agreed to the entry of a cease and desist order from further violations of the Martin Act along with certain Sections of the Executive Law and will offer to make its customers whole for all securities unlawfully sold in addition to disgorging all profits. The bank will also pay a fine of $975,000. The disgorgement will be made to the SEC.

Insider trading: SEC v. Peterson, Civil Action No. 11-cv-5448 (S.D.N.Y. Filed Aug. 5, 2011). In an amended complaint the Commission added as defendants, Drew Brownstein, the founder and chief executive officer of the registered investment adviser and hedge fund management firm Big 5 Asset Management LLC and that firm. The initial action centered on tips about the acquisition of Mariner Energy by Clayton Peterson, then a director, to his son Drew who traded in a number of accounts. Drew Peterson also repeatedly tipped Mr. Brownstein about the impending acquisition according to the amended complaint. Defendant Brownstein and his hedge fund traded making almost $5 million in profits.

Previously, the father and son pleaded guilty to criminal charges. Specifically, Clayton Peterson and his son Drew each pleaded guilty to criminal charges on August 5, 2011 of conspiracy to commit securities fraud and securities fraud. They are scheduled to be sentenced on January 12, 2012. The amended SEC complaint against the Petersons, Mr. Brownstein and his hedge fund is pending.

Criminal cases

Insider trading: U.S. v. Gupta, Case No. 11 crim 907 (S.D.N.Y. Unsealed Oct. 26, 2011); SEC v. Gupta, Civil Action No. 11 Civ 7566 (S.D.N.Y. Filed Oct. 26, 2011).

Former Goldman Sachs and Procter & Gamble director Rajat Gupta was charged with insider trading. The criminal and civil charges allege that he repeatedly tipped Raji Rajaratnam who is also named as a defendant in the Commission’s complaint. The criminal indictment contains one count of conspiracy to commit securities fraud and five counts of securities fraud. The SEC’s complaint alleges violations by each defendant of Exchange Act Section 10(b) and Securities Act Section 17(a).

The indictment and the enforcement complaint center on three key transactions involving information Mr. Gupta obtained at either Goldman Sachs or Proctor & Gamble board meetings which he allegedly passed to his long time friend and business partner, Raji Rajaratnam for trading: (1) the $5 billion investment by Berkshire Hathaway in Goldman Sachs in September 2008; (2) The fourth quarter 2008 Goldman Sachs earnings release which announced the firm’s first quarterly loss after going public; and (3) P&G’s second quarter 2008 results which were below guidance. The court papers do not claim that Mr. Gupta directly and personally profited from the insider trading. Rather, the indictment alleges he furnished the inside information to enhance his relationship with Mr. Rajaratnam and that there was a financial interest. While there are no quotes in the papers from wire taps, the indictment as well as testimony from the Galleon trial, describe conversations of Mr. Rajaratnam with others that appear to reference Mr. Gupta. The criminal trial is scheduled to begin before Judge Rakoff on April 19, 2012.


Short selling: UBS Securities was fined $12 million for violations of Regulation SHO and supervisory failures. Regulation SHO requires firms to obtain and document “locate” information before a short sale occurs to reduce the number of potential failure to deliver claims. It also requires that the broker-dealer mark sales of equity securities as long or short. Here FINRA found that the supervisory system used by UBS to comply with SHO was deficient. Millions of short sale orders were made without locates. In addition, millions of sale orders were mismarked as long resulting in additional violations.


Inadequate controls: Credit Suisse was fined ?5.95 million for failing to have adequate systems and controls regarding the assessment of risk to its customers. The action stems from the sale of structured capital at risk products which provide customers with income for a period but also carry significant risk of a partial, or in some circumstances a total, loss. Bank customers invested in over ?1 billion in these products. Credit Suisse was found to have poor controls in place to assess whether the risk of these securities was appropriate for the customer. As part of the resolution of this matter the bank agreed to carry out a past business review overseen by a third party to identify customers for whom this investment was inappropriate. Those customers will be given redress. Credit Suisse was given a 30% discount on its fine for early cooperation.

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