This Week In Securities Litigation (Week ending April 22, 2016)

The Commission prevailed at trial in a market manipulation case. The trial followed a series of settlements and a grant of summary judgment in the Commission’s favor as to one defendant. The remaining defendant, a former NFL football player, was found liable by a jury.

The SEC also filed two financial fraud actions this week against the issuers, their executives and one audit engagement partner. In addition, two actions were brought against investment advisers for cherry picking while another case focused on an investment fund fraud.


Testimony: Continued Oversight of the SEC’s Offices and Divisions. Mark Flannery, Director and Chief Economist, Division of Economic and Risk Analysis; Marc Wyatt, Director, Office of Compliance Inspections and Examinations; Thomas Butler, Director, Office of Credit Ratings; and Sean McKessy, Chief, Office of the Whistleblower, testified before the House Committee on Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises (April 21, 2016). Generally the testimony reviewed the operations of the respective divisions and offices (here).

Order: The Commission issued an order modifying and extending the pilot period for the National Market System plan to address extraordinary market volatility (here).

Rules: The Commission adopted business conduct standards for security-based swap dealers and major security-based swap participants (here).

SEC Enforcement – Litigated Actions

Manipulation: SEC v. Heart Tronics, Inc., Case No. 11-cv-01962 (C.D. Cal. Filed Dec. 20, 2011). The case centered on an alleged fraudulent, manipulative scheme. Named as defendants were J. Rowland Perkins, Mark Nevdahl, Willie Gault, Mitchell Stein, Martin Carter and Ryan Rauch. The complaint alleged that Heart Tronics repeatedly announced millions of dollars in sales over a two year period beginning in 2006. The firm, however, never had any real sales. In 2008 Heart Tronics installed co-celebrity CEOs — Mr. Gault, a well-known athlete, and Mr. Perkins, a founder of a well-known talent agency. Mr. Stein continued to execute the scheme, retaining promoters who touted Heart Tronics stock on the internet. Mr. Nevdahl, a former registered representative, served as a trustee for a number of entities to create the illusion that the shares were traded by an independent trustee. Tracey Stein, wife of Mitchell, was a major shareholder. She directed the sale of over $5.8 million worth of stock. The complaint alleged violations of Securities Act Sections 5(a), 5(c), 17(a) and Exchange Act Sections 10(b), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). A parallel criminal case was filed.

Mr. Gault proceeded to trial after each of the other defendants either settled or lost on summary judgment based on convictions in the parallel criminal action. A jury found that he was involved in a fraudulent scheme and misappropriated investor funds that were lost as a result of his stock trading. He was also found to have knowingly circumvented, or failed to implement, internal accounting controls at the company and to have filed a Form 10-Q in 2008 that made false SOX certifications. The Court imposed a permanent injunction based on Securities Act Section 17(a)(3) and Exchange Act Section 13(b)(5). The Court’s order bars Mr. Gault from serving as an officer or director of any pubic company until he affirmatively demonstrates that he has become knowledgeable regarding the obligations of those who hold such positions under the securities laws and is competent to hold such a position. In addition, he was directed to pay $101,000 in disgorgement, prejudgment interest and $78,000 in penalties. See Lit. Rel. No. 23522 (April 15, 2016).

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 2 civil injunctive actions and 5 administrative proceedings, excluding 12j and tag-along proceedings.

Cherry picking: In the Matter of Bruce A. Hartshorn, Adm. Proc. File No. 32075 (April 20, 2016) is a proceeding which named Mr. Hartshorn, a registered investment adviser representative, as a Respondent. He is the founder of registered adviser Hartshorn & Co., Inc. The firm’s trade allocation policies, as disclosed in its Form ADV, provided that when it aggregates client orders the executions would be equitably distributed to all accounts. The Commission’s analysis of its trade allocations from January 2010 through March 2011 demonstrated that the policy was not followed. During the period Mr. Hartshorn purchased blocks of securities in the Firm’s omnibus account at a brokerage that had custody of the accounts. Allocations were not made until later in the day. Then Mr. Hartshorn allocated a greater proportion of trades which had a positive first-day return to proprietary accounts. A greater proportion of trades that had a negative first-day return were allocated to client accounts. An analysis of the trades during the period demonstrated when allocating the entire block trade to proprietary accounts the transaction was profitable 85% of the time. When the allocation was solely to client accounts, however, the transaction was unprofitable 100% of the time. When the allocations were split among the accounts the results were the same. Specifically, when the block purchased had positive first day returns, 68% of the securities were allocated to proprietary accounts. When there were negative first day returns Mr. Hartshorn allocated 81% of the securities to client accounts. As a result of these practices the proprietary accounts had an average first day gain of 0.26% while client accounts had an average first day loss of 1.02%. The Order alleges violations of Exchange Act Section 10(b) and Advisers Act Section 201(1). Respondent resolve the proceeding, consenting to the entry of a cease and desist order based on the Sections cited in the Order. In addition, he is barred from the securities business and will pay a penalty of $75,000.

Cherry picking: In the Matter of TPG Advisors LLC, Adm. Proc. File No. 3-17216 (April 19, 2016) is a proceeding which names as Respondents the firm, a registered investment adviser, and its owner and principal, Larry M. Phillips. The firm’s trade allocation policies, as reflected in its Form ADV as well as its internal written policies and procedures, required that trades be allocated in the most equitable manner possible. From January 2010 through August 2014 the firm failed to adhere to its disclosed trade allocation policies by favoring six accounts held by four favored clients, according to the Order. Mr. Phillips placed trades in a master account without making any specific allocation. If the security could be bought and sold in a day for a profit, the position would be closed in the master account. The profits would be allocated to a favored account. If the position could not be closed for a gain that day it was usually allocated to one of the disfavored accounts. The favored clients had first day profits on day trades that were virtually impossible to have been achieved by chance, according to the Order. Certain accounts had a large proportion of day trades while others had almost none. For the six favored accounts over 90% of the trades were day trades that had single day profits. In eleven accounts which had only a small proportion of the day trades, the vast majority had unrealized first day losses. The likelihood that the profitability of the favored accounts occurred by random chance is less than 1%, according to the Order. In contrast, the performance in each of the eleven disfavored accounts is a statistical anomaly. Random change would have given them a better performance with a probability exceeding 99%. The third party broker that held the accounts warned the adviser about the allocations. On at least 21 instances during the period, the adviser was warned about suspicious trades. The Order alleges violations of Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 207. The proceeding will be set for hearing.

Financial fraud: In the Matter of Logtech International, S.C., Adm. Proc. File No. 3-17212 (April 19, 2016); SEC v. Bardman, Civil Action No. 3:16-cv-02023 (N.D. Cal. Filed April 18, 2016). The company and Michael Doktorczyk, formerly a v.p. of finance at the firm, and Sherralyn Bolles, formerly a director of accounting and financial reporting, are Respondents in the administrative action. Erik Bardman, formerly v.p. of finance and CFO at the firm, and Jennifer Wolf, formerly a director of finance, are defendants in the civil injunctive action. In late 2010 Logitech launched a new product called “Revue.” It was a television set-top device that provided for internet usage and video streaming. While the firm had high hopes for the device, by the end of the fourth quarter only about half of the projected units sold. With a substantial inventory of unsold units, the firm stopped production. Consideration was given to halting the product. To avoid this result the firm calculated its inventory valuation by falsely assuming that the component parts in the manufacturing process would be built into completed units, a misrepresentation made to the auditors. Logitech also misrepresented the amount of write-down to be taken on finished goods in inventory – a key problem with the product was its high price compared to competitors. Mr. Bardman, a participant in these actions, then certified the 2011 financial statements furnished to the auditors and the public. The Order alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). To resolve the proceeding the company consented to the entry of a cease and desist order based on each of the Sections cited in the Order except Section 13(b)(5). The company also agreed to pay a $7.5 million fine. Mr. Doktorczyk consented to the entry of a cease and desist order based on each Section cited in the Order except Section 10(b). He also agreed to pay a civil penalty of $50,000. Ms. Bolles consented to the entry of a cease and desist order based on the same sections as Mr. Doktorczyk, excluding Section 13(b)(5). She agreed to pay a penalty of $25,000. The complaint against Mr. Bardman and Ms. Wolf alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5) and for reimbursement under SOX Section 304(a). The case is pending. See Lit. Rel. No. 23523 (April 20, 2016).

Financial fraud: In the Matter of Ener1, Inc., Adm. Proc. File No. 3-17213 (April 19, 2016). The Order names as Respondents, in addition to the firm, three executives: Charles L. Gassenheimer, CEO; Jeffrey A. Seidel, CFO; and Robert R. Kamischke, CAO. In 2010 one of Ener1’s largest customers was Think, a manufacturer of electric cars. Ener1 held the voting rights to almost 50% of Think’s equity. Indeed, its Form 10K for the year ended December 31, 2010 the firm reported an investment in Think of $58.6 million. That represented about 15% of Ener1’s total assets. The investment was carried at cost on the balance sheet. It was not impaired despite the fact that Think could not pay its creditors and after year end, but before the issuance of the Form 10-K, the company which manufactured cars for Think halted production. Ener1 also failed to conduct an impairment analysis of loans and accounts receivable from Think. In its Form 10-K for 2010 Ener1 reported that its loans receivable from Think were $14 million. That represented 3.5% of the firm’s assets. The loans were not impaired. In fact the firm did not conduct any meaningful analysis of the question. The same Form 10-K also reported that Ener1 had receivables from Think of $13.6 million of which about $8.5 million were past due. This represented 3.4% of Ener1’s assets. Again the asset was not impaired. Finally, in the 2010 Form 10-K Ener1 recognized $18.8 million in revenue from Think. The revenue was from the shipment of batteries to the company. While Ener1 did not have any formal written revenue recognition policy, no analysis for sufficient reasonable assurance of collectability was made. This resulted in the overstatement by 14% of its revenue. Overall, the firm had numerous deficiencies in its system of internal accounting controls. The Order alleges violations of Securities Act Section 17(a)(2) and (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). To resolve the proceeding each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, each individual Respondent agreed to pay a penalty of: Mr. Gassenheimer, $100,000; Mr. Seidel, $50,000; and Mr. Kamischke, $30,000. See also In the Matter of Robert D. Hesselgesser, CPA, Adm. Proc. File No. 3-17214 (April 19, 2016)(proceeding against PWC audit engagement partner for the firm alleging violations of Rule 102(e)(1)(iv); resolved by denying Respondent the privilege of appearing and practicing before the Commission with the right to apply for readmission after two years).

Investment fund fraud: SEC v. PLCMGT LLC, Civil Action No. 2:16-cv-02594 (C.D. CA. Filed April 15, 2016). Defendant PLCMGMT, dba Prometheus Law was founded by attorney James Catipay. The firm’s president and chief marketing officer was, for a portion of the relevant period here, defendant David Aldrich. In 2013 Mr. Aldrich, using PLC VA as an investment vehicle, solicited investments for legal marketing to locate potential mass tort plaintiffs. Later that year Mr. Catipay, a tax attorney, agreed to join with Mr. Aldrich in his endeavor. Mr. Catipay revamped his firm’s website, soliciting investors and Attorney A entered into an arrangement with the Catipay Law Firm and Prometheus. The focus would be mass tort litigation. Investors were solicited to purchase what were called “prepaid forward contracts.” The investments had a fixed principal amount and a set date when the initial investment and a guaranteed return would be paid back to the investor. The investments offered returns that ranged from 100% to as much as 300% depending on the length of time. Investors were told that the investment was safe with security for the principle. The claims were false. Nevertheless, prior to February 2015 when Messrs. Catipay and Adrich got into a dispute, about $8.54 million was raised in approximately 1,018 investments. Subsequently, Mr. Catipay took sole ownership of Prometheus and filed suit against Mr. Aldrich. The complaint alleged that his former business associated had converted over $3 million of Prometheus’ assets to personal use. Mr. Catipay continued soliciting investors. Overall about $11.7 million was raised from investors. Of that amount only 35% was used on legal marketing expenses. Mr. Aldrich took about $3.7 million. Mr. Catipay took about $1.87 million by early 2016. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 10(b) and 15(a). The case is pending.


Alert: Board published a Staff Audit Practice Alert on Improper Alteration of Audit Documents (here).

Inspections: The Board released an inspection brief that previews the results of 2015 inspections. The most frequent audit deficiencies continue to be in three areas: Internal controls; assessing and responding to risks of material misstatement; and auditing accounting estimates, including fair value measurements (here).

Hong Kong

Remarks: Ashley Alder, CEO of the Securities and Futures Commission, delivered remarks titled “The SFC’s Investment Fund Strategy for Hong Kong,” at the HKIFA Luncheon (April 18, 2016). His remarks focused on the SFC’s ambition to make Hong Kong a global, full-service asset management center, complete with ancillary services (here)

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