Securities litigation last week was dominated by the filing of new criminal charges in the on-going investigation by the U.S. Attorney’s Office in the Southern District of New York. Insider trading charges were filed against fourteen individuals, in addition to those lodged against five individuals who pleaded guilty. Like the earlier charges which are part of this investigation centered on the founder of Galleon, the criminal allegations are based on informants, confidential witnesses, wiretaps and taped conversations sending a new shudder through an already jittery Wall Street and the hedge fund industry. The SEC brought parallel cases. While it is unclear when additional charges will be brought, it seems certain the continuing investigation will spawn more charges.

Market reform

S. 1964, titled a bill to require disclosure of financial relationships between brokers and dealers and mutual fund companies, was introduced in the Senate this week. Its purpose, according to the sponsor, is to provide investors with disclosure regarding the financial relationships between brokers and mutual fund companies. A similar bill was introduced in 2003, which did not pass.

SEC Commissioner Luis Aguilar delivered a speech titled “Investors Deserve Sustainable Reform – Not More of the Same” to the Emerging Regulatory Landscape: A Roundtable Conference at George Washington University on November 6, 2009, available at During his remarks, Commissioner Aguilar was critical of The Investor Protection Act of 2009, which, in part, would repeal SOX Section 404 as to so-called small businesses. In part, the Commissioner noted that these are not “mom and pop” entities, but public companies and that to repeal this section now would “throw away a substantial amount of work done by regulators, companies, and private organizations to make compliance with 404(b) more cost-effective.”

Commissioner Aguilar also expressed concern about a portion of the proposed legislation that would transfer oversight of a substantial number of investment advisers from the SEC to FINRA. The main issue here, the Commissioner noted, is one of resources. Since the driving force for the provision is a claimed lack of resources by the SEC, the critical question is whether Congress will give the agency the proper resources and strengthen it or weaken the SEC by taking away its authority.

Supreme Court

The High Court heard oral argument in Jones v. Harris Associates, L.P., Case No. 08-586 concerning Adviser fees as discussed here. During the argument the Justices focused on four key points.

• First, the open ended nature of the statute. Justice Scalia, for example, commented to the laughter of all, that the language of the statute is open ended to the point of offering little if any guidance.

• Second, the role of the key players. A number of questions from the court centered on the role of the SEC and the board of directors.

• Third, the meaning of the term fiduciary duty. The Justices repeatedly raised the question regarding the meaning of this key concept and whether it is the same under the statute as in other contexts.

• Finally, the procedure. There were a number of questions regarding the record and whether summary judgment was appropriate in this case.

While none of the parties supported the disclosure approach adopted by the Seventh Circuit, discussed here, and the arguments seemed to center on variations of the second circuit approach (Gartenberg v. Merrill Lynch, 694 F.2d 923 (2d Cir. 1982)). The high court did not give any clear indication of the approach it will choose, although the Court’s approach to crafting a standard here may echo the one used in Tellabs, discussed here, where a similar problem was posed.

SEC enforcement actions

Short selling: In the Matter of Rhino Trading, LLC, Adm. Proc. File No. 3-013677 is an a settled administrative proceeding against two CBOE market makers, Rhino Trading and Fat Squirrel Trading Group, and their principals, respectively, Damon Rein and Steven Peter. According to the Order, the respondents violated Regulation SHO’s then fail to deliver provisions through a series of transactions in 2007 which involved two types of trades. The first, known as a reverse conversion, involved selling a put option and buying a call potion, a so-called synthetic long, while selling short the underlying stock. The short sale acts as a hedge to the long and permits the trader to profit on the spread between the price of the put option and that of the call.

In the second, known as a reset, a trader who has a threshold security buys shares of that security while selling call options (or buying put options) from the counterparty to the share purchase. This creates the illusion that the trader has satisfied Reg. SHO’s close obligations. In fact, the shares apparently purchased are never delivered since after executing the reset the option is either exercised if it is a call or assigned if it is a put, transferring the shares back to the party that appeared to have sold them the previous day. At the time of these transactions, Rule 203(b)(3) required clearing firms to immediately close out any fail to deliver positions in a threshold security. At that point the regulation required the trader to purchase securities of like kind and quantity.

Under a CBOE Decision Accepting Offer of Settlement: Respondents Rhino and Rein will pay a fine of $150,000; Respondents FSTG, Rein and Peter will pay a fine of $30,000; Respondent Rein is required to furnish the SEC with an affidavit after his three month suspension confirming that he will fully comply with the sanctions. To settle the proceeding, Rhino and Mr. Rein agreed to pay a fine of $150,000. In addition, Messrs. Rein and Peter will provide the Commission with affidavits after their three month suspensions affirming that they will comply with the applicable regulations. Accordingly, the SEC entered a cease and desist order against each respondent, censured the two entities and suspended each individual Respondent for three months.

Misappropriated assets: In the Matter of Value Line, Inc., Adm. Proc. File No. 3-13675 (Filed Nov. 4, 2009) is a settled administrative proceeding which named as Respondents VLI, a registered investment adviser, VLS, its subsidiary with is a registered broker dealer, Jean Bernhard Buttner, Chairman and CEO of VLI and David Henigson, who held various positions with VLI. The Order essentially states that from 1986 through 2004 Respondents defrauded the Value Line Family of Mutual Funds by inflated brokerage commissions paid to VLS through various means in violation of Securities Act Section 17(a), Exchange Act Section 10(b), and Sections 206 and 207 of the Advisers Act. To resolve the action, a cease and desist order was entered as to VLI, VLS and Messrs. Buttner and Henigson. In addition, VLI agreed to disgorge approximately $24.1 million, plus prejudgment interest and pay a penalty of $10,000,000. Mr. Buttner agreed to pay a penalty of $1 million while Mr. Henigson agreed to pay $250,000.

Financial fraud: SEC v. Merge Healthcare Inc., Case No. 1:09-cv-1036 (E.D. Wis. Filed Nov. 4, 2009) is a settled financial fraud action against Merge Healthcare and two of its officers, Richard Linden and Scott Veech. The complaint alleges that from 2002 through 2005, the two officers facilitated fraudulent accounting practices at the company to increase revenues. These included improperly recognizing revenue where there were promises of specific future software enhancements, sales contingencies and unexecuted contracts. Mr. Linden is also alleged to have interfered with the audit confirmation process in an effort to avoid the discovery of the side agreements. All three defendants settled with the SEC. The company consented to the entry of a permanent injunction prohibiting future violations of the internal controls and books and records provisions while the two individuals consented to injunctions prohibiting violations of the antifraud provisions. Mr. Linden agreed to pay disgorgement of over $382,000 plus prejudgment interest and a $90,000 penalty. Mr. Veech agreed to pay $180,000 in disgorgement, prejudgment interest and a $50,000 penalty. He also consented to an order suspending his right to appear and practice before the SEC as an accountant with a right to reapply after three years. See also Litig. Rel. 21282 (Nov. 4, 2009).

Insider trading: In SEC v. Galleon Management, L.P., the Commission amended its complaint filed last month based on the insider trading investigation being conducted by the USAO in New York (see below), discussed here, to add thirteen new defendants including Roomy Khan, Deep Shah, Aki Far, Choo-Beng Lee, Far & Lee LLC, Spherix Capital LLC, Ali Hariri, Zvi Goffer, David Late, Gautham Shankar, Schottenfeld Group LLC, Steven Fortuna and S2Capital Management LP. It alleges insider trading in twelve securities, two more than in the original case. The Commission also filed a second case arising out of that investigation, SEC v. Cutillo, Case No. 09-09208 (S.D.N.Y. Filed Nov. 4, 2009).

Pay-to-play: In the Matter of J.P. Morgan Securities Inc., Adm. Proc. File No. 3-13673 (Filed Nov. 4, 2009); SEC v. LeCroy, Civil Action No. CV – 09-U/B 2238-S (N.D. Ala. Filed Nov. 4, 2009). These actions, discussed here, allege that in 2002 and 2003 the securities firm, through former managing directors Charles LeCroy and Douglas MacFaddin, paid more than $8.2 million at the direction of local county commissioners essentially to obtain business. In return for the payoffs, the county commissioners were instrumental in directing the offering and swap business to J.P. Morgan Securities. The firm did not disclose the payments in offering documents. The “payoffs” were incorporated into higher swap interest rates charged to the county thereby increasing the transaction costs for the government and the taxpayers.

To settle the administrative proceeding, which charges violations of Securities Act Sections 17(a)(2) & (2), Exchange Act Section 15B(c)(1) and MSRB Rule G-17, J.P. Morgan agreed to make a $50 million payment to Jefferson county and to terminate all obligations of the county to make any payments to J.P. Morgan Chase Bank under the swap agreements. The firm also consented to the entry of a cease and desist order, a censure and to pay a penalty of $25 million which will be placed in a Fair Fund.

The civil injunctive action alleges violations of Section 17(a) of the Securities Act and Sections 10(b) and 15B(c)(1) of the Exchange Act as well as of the rules of the Municipal Securities Rulemaking Board. See also Litig. Rel. 21280 (Nov. 4, 2008). This case is currently in litigation.

Financial fraud: SEC v. Symbol Technologies, Inc., Case No. 04-CV 2276 (E.D.N.Y. Filed June 3, 2004) is a long running financial fraud case. This week, the SEC settled with defendants Kenneth Jaeggi, the former CFO, Christopher DeSantis, the former VP of sales finance and James Heuschneider, the former director of customer services. The settlements here follow the entry of guilty pleas by Messrs. Jaeggi and DeSantis in the parallel criminal case. The underlying SEC complaint alleges that over a period of five years beginning in 1998 the defendants fraudulently inflated the revenue of the company. Mr. Jaeggi, to settle, consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions. He also agreed to pay disgorgement of over $3 million (including prejudgment interest) and a civil penalty of $250,000. Mr. DeSantis agreed to the entry of a similar injunction and to the payment of a civil penalty of $40,000 (along with $1 of disgorgement). Mr. Heuschneider agreed to the entry of a permanent injunction and to pay disgorgement of $2,280 along with prejudgment interest. See also Litig. Rel. 21277 (Nov. 4, 2009).

Option backdating: SEC v. Treacy, Civil Action No. 08 CV 4052 (S.D.N.Y. April 30, 2008) is an option backdating case against the former president and COO of Monster Worldwide, Inc. The complaint claims that Mr. Treacy participated in a scheme that began in 1997 to fraudulently backdate stock options at the company. To resolve the matter, Mr. Treacy consented to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions. See also Litig. Rel. 21278 (Nov. 4, 2009). The SEC withdrew its request for disgorgement and a civil monetary penalty in view of the sentence, forfeiture and restitution orders in the related criminal case. U.S. v. Teacy, 08 CR 0366 (S.D.N.Y.).

Insider trading: SEC v. Tang, Case No. CV 09 05146 (N.D.CA. Filed Oct. 30, 2009). The case centers on two key traders, Chen Tang who was the CFO of a private equity fund (“PEF”) in 2007 and 2008 and his brother-in-law, Ronald Yee who was the CFO of a venture capital fund (“VCF”) from 2005 to 2007. Zisen Yu, Ming Siu, Joseph Seto, James Tang and Eddie Yu are also named as defendants. The case centers on trading based on information obtained from PEF in the shares of Tempur-Pedic International, Inc. first concerning the possible purchase of a stake in that company by the fund and later the failure of that company to meet an earnings forecast. It also involved trading based on information obtained from VCF in the stock of Acxiom Corporation first concerning a take over of that company and later the collapse of that deal as discussed here. The case is in litigation. See also Litig. Rel. 21271 (Oct. 30, 2009).

False filings: SEC v. China Holdings, Inc., Case No. 1:09-CV-02045 (D.D.C. Filed Oct. 30, 2009) is an action against the company and its CEO, Julianna Lu. The complaint alleges that in 2008 and 2009, the defendants made false filings with the Commission. The false filings included audit reports filed without the authorization of the audit firm and without making corrections to the filings the firm had requested. In addition, a Form 8-K and two Form 8-K/As falsely represented that the auditors had been dismissed and that there were no disagreements with the audit firm. In fact, the firm had resigned and a letter attached to an amended filing which purported to be from the auditors was fabricated. It also falsely stated that the audit firm agreed with the representations of the company. The complaint alleges violations of Section 10(b). The case is in litigation. See also Litig. Rel. 21272 (Oct. 30, 2009).

Financial fraud: SEC v. Cotton, Civil Action No. SA CV-06-905 AG (C.D. Cal. Filed Sept.28, 2006) alleges that defendant Steven Cotton, the former CFO of Lantronix, Inc., a California technology company, engaged in a scheme in 2001 and 2002 to falsify the revenues and earnings of the company. Specifically, Mr. Cotton employed a channel stuffing scheme, according to the SEC, and undisclosed rights of returns, among other things, to falsely inflate the revenues of the company by as high as 21%. To resolve the case Mr. Cotton consented to the entry of a permanent injunction prohibiting future violations of the antifraud and record keeping provisions and to pay disgorgement of over $344,000 plus prejudgment interest and a penalty of $120,000. He also agreed to the entry of a ten year officer and director bar. See also Litig. Rel. No. 21281 (Nov. 4, 2009).

Criminal cases

Insider trading: U.S. v. Goffer, Case No. 09 Mag 2438 (S.D.N.Y. Filed Nov. 4, 2009), U.S. v. Hariri, Case No. 09 Mag 2436 (S.D.N.Y. Filed Nov. 4, 2009) and U.S. v. Shah, Case No. 09 Mag 2437 (S.D.N.Y. Filed Nov. 4, 2009 are the latest in a series of blockbuster insider trading cases stemming from an investigation being conducted under the direction of the USAO in the Southern District of New York, discussed here. To date, five defendants have pleaded guilty.

The Goffer case names seven individuals as defendants. One defendant, Zvi Goffer, a registered representative formerly employed at Schottenfeld Group and currently at Echotrade LLC, was known as “Octopussy” because of his multiple sources of inside information. According to the criminal complaint, one source of information was ultimately Arthur Cutillo, who furnished information on four corporate transactions in which his firm was involved. Mr. Cutillo funneled information through defendant Goldfarb, another attorney. A second source of inside information is identified as CC-1. That source furnished inside information regarding transactions involving Kronos, Inc. and Hilton Hotels, both of which are involved in the initial criminal cases filed last month. Many of the key conversations here were taped. The ring also has several downstream tippees.

The Shah case involves trading in the securities of Hilton Hotels based on inside information. Here again, the information was supplied by a cooperating witness. Similarly, Hariri involved trading based on inside information about Atheros Communications, which was supplied by a cooperating witness. Both of these securities were involved in the initial criminal cases filed last month. The investigation is on-going.

Audit failure: U.S. v. Friehling, Case No. 1:09-mj-00729 (S.D.N.Y. Filed July 17, 2009). David Friehling, auditor through Bernard L. Madoff Investment Securities LLC and its predecessor, pleaded guilty to a nine-count criminal information and agreed to certain forfeitures as discussed here. The information essentially states that the defendant did not do any audit work. Mr. Friehling also entered into a cooperation agreement with the government. Comments at the time of the plea suggest he will implicate others in the fraud, although he apparently denied knowing about the Ponzi scheme. The court agreed to his release on bond.

In the parallel SEC action, Mr. Friehling consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions of the Securities Act, the Exchange Act and from aiding and abetting violations of certain provisions of the Investment Advisers Act. The resolution of all monetary issues has been deferred. SEC v. Friehling, Case No. 09 CV 2467 (S.D.N.Y. Filed March 18, 2009); See also Litig. Rel. 21274 (Nov. 3, 2009).

Stock fraud: U.S. v. Zanic, Case no. 1:08-mj-02012 (S.D.N.Y. Filed Oct. 31, 2009) is an action in which defendant Shay Karen pleaded guilty to an information charging that he engaged in a conspiracy to bribe stock brokers. Specifically, the defendant admitted participating in a scheme to defraud investors in Guyana Gold Corporation by paying secret cash bribes to an undercover FBI agent who posed a middleman. The agent was suppose to recruit brokers who would buy the securities and sell them to their retail customers. Two other defendants previously pleaded guilty.

Circuit courts

In re Constar International Inc., Sec. Litig., No. 08-2461 (3d Cir. Oct. 29. 2009) is a securities class action, discussed here, based on a claim under Section 11 of the Securities Act arising out of a 2002 IPO. The complaint alleged that the prospectus was false because it failed to disclose the true financial condition of the company which emerged the next year causing the share price to plummet. The district court granted class certification in an order affirmed by the Third Circuit. In doing so, the court drew a sharp distinction between the requirements of a claim under Securities Act Section 11 and Exchange Act Section 10(b). The court rejected defendants’ primary argument that plaintiffs could only meet the dictates of Federal Civil Rule 23(b)(3), requiring that the questions of law or fact common to class members predominate, if they established the efficiency of the market for the securities. The court also rejected defendants’ related contention that absent an efficient market, questions of materiality, loss causation and injury would need to be decided on an individual basis thus requiring reversal of the certification order.


In the U.K., a father and son were found guilty in an insider trading scheme. The father is a dentist and the son a former City intern. The son tipped his father about upcoming deals at the City firm he worked at, reputedly using a secret code based on Chinese food. The father in turn traded thousands of shares in the cases reaping substantial profits. The two were convicted following a jury trial.