This Week In Securities Litigation (Week ending April 3, 2015)

The Second Circuit rejected a petition for rehearing by the U.S. Attorney’s Office in the Newman case. There the Court reversed and dismissed the insider trading actions against two traders based on the failure of the court to provide the jury with proper instructions on the personal benefit test relating to tipping and in view of the inadequacy of the proof on that key element. In the District Court the Government was able to convince the Judge that such an instruction was not necessary despite what may have long believed was required by the Supreme Court’s decision in Dirks. At the same time the U.S. Attorney had an unbroken string of insider trading convictions in cases where a personal benefit instruction had been given. In seeking rehearing the U.S. Attorney told the Court of Appeals, in part, that the Newman ruling would be detrimental to law enforcement.

The SEC filed its first action last week regarding whistleblower protections. Specifically, the Commission brought a proceeding challenging a firm practice which required those involved in internal investigations to sign a statement agreeing to keep the interview and its substance confidential. The SEC alleged in the settled proceeding that this improperly impinged on the ability of such persons to report wrong doing under its whistleblower program. The SEC also brought an action against a high profile investment adviser alleging fraud in the valuation of fund assets resulting the overpayment of fees. The enforcement action drew another civil action against the Commission based on its continued use of administrative proceedings. In addition, the SEC filed actions based on insider trading, financial fraud, perks and an offering fraud.

Finally, the CFTC filed an action against Kraft Foods and a subsidiary alleging market manipulation. The complaint claims that the defendants manipulated the price of certain wheat contracts, causing the prices to fall. It also alleges violations of position limits.


Remarks: Commissioner Daniel M. Gallagher delivered remarks titled “Grading the Commission’s Record on Capital Formation: A+, D, or Incomplete?” at the Vanderbilt Law School’s 17th Annual Law and Business Conference, Nashville, TN (March 27 2015). In his remarks the Commissioner discussed Reg A+, crowdfunding, Reg D exemptions and other capital formation issues (here).

Remarks: Commissioner Kara M. Stein delivered remarks titled “International Cooperation In a New Data-Driven World,” at the Brooklyn Law School International Business Law Breakfast Roundtable (March 26, 2015). The Commissioner’s remarks discussed the need for international cooperation, swaps regulation and better global disclosure standards (here).


Remarks: Commissioner Sharon Y. Bowen delivered remarks to the 17th Annual OpRisk North America conference (March 25, 2015). The Commissioner discussed cybersecurity, risk management and culture (here).

Accounting Cases

Report on accounting cases: The number of accounting class actions filed last year increased by 47% compared to the prior year despite the fact that the number of securities class actions filed was down slightly, according to a new report by Cornerstone Research (here). More than one in four of the cases referred to an SEC inquiry while those tied to a restatement reached their highest level in seven years.

In 2014 there were 69 new accounting class action cases. That compares to 47 in the prior year. Overall there were 101 class actions filed last year compared to 119 in 2013. Viewed as a percentage of all cases filed last year, accounting cases represented 41% of the total actions. In contrast, 70% of the settled actions last year were accounting cases, the highest since 2010 when it was 72%. Last year 42% of the accounting cases filed were tied to a restatement. That is the highest percentage in the last six years.

SEC Enforcement – Litigated Actions

Misappropriation: SEC v. Kokesh, Civil Action No. 6:09-cv-1021 (D. N.Mex.) is an action against Charles Kokesh who controlled two registered investment advisers that, in turn, controlled four business development companies. The complaint alleges that from 1995 through July 2007 Mr. Kokesh misappropriated investor funds by having the business development companies pay illegal distributions, performance fees, bonuses and expense reimbursements to the advisory firms which he then used for his own purpose. The scheme was implemented through misleading proxy statements and false reports to the SEC. A jury returned a verdict in the Commission’s favor, finding that Mr. Kokesh violated Investment Company Act Section 37, Advisers Act Sections 205, 206(1) and 206(2) and Exchange Act Sections 13(a) and 14(a). The Court entered a permanent injunction prohibiting future violations of those Sections and directing that the defendant pay a civil penalty of $2,354,593 and disgorgement and prejudgment interest of $53,004,432. See Lit. Rel. No. 23228 (April 2, 2015).

Microcap fraud: SEC v. StratoComm Corporation, Civil Action No. 1:11-cv-1188 (N.D. N.Y.) is an action against the firm, its CEO, Roger Shearer, and its IR director, Craig Danzig. The complaint alleged that the defendants issued false public statements about the firm, claiming that it was manufacturing and selling telecommunications systems for use in underdeveloped countries. In fact the firm had no product. Investors were sold more than $4 million in unregistered stock. The Court granted summary judgment in favor of the Commission and entered an amended judgment. The Court entered an order prohibiting the defendants from future violations of Securities Act Sections 5 and 17(a) and Exchange Act Sections 10(b) and 15(a)(1). In addition, the firm and Mr. Shearer were directed to pay $4,968,709.68 in disgorgement and prejudgment interest. The firm was also ordered to pay a civil penalty of $100,000 while Messrs. Shearer and Danzig will pay, respectively, penalties of $50,000 and $25,000. See Lit. Rel. No. 23226 (March 31, 2015).

SEC Enforcement – Filed and Settled Actions

Statistics: During this period the SEC filed 2 civil injunctive action and 6 administrative proceeding, excluding 12j and tag-along-actions.

Insider trading: SEC v. Kanodia, Civil Action No. 15-cv-00479 (D. Conn. Filed April 2, 2015) is an action which names as defendants Amit Kanodia and Iftikar Ahmed, two close friends. The action centers on the potential acquisition of Cooper Tire and Rubber Company by Apollo Tyres Ltd, which was announced on June 12, 2013 but never consummated. During the negotiations which led to the announcement, Mr. Kanodit was married to the general counsel of Apollo. He misappropriated inside information about the deal from his wife and gave it to Mr. Ahmed who shared it with another Trader. Both Mr. Ahmed and Trader purchased shares of Cooper. When the deal was announced the share price of Cooper increased by 41% compared to its prior day closing price. After liquidating his shares Mr. Ahmed had trading profits of about $1.1 million while Trader netted about $170,000. Each paid a portion of those profits to a firm controlled by Mr. Kanodia. The complaint alleges violations of Exchange Act Section 10(b). The case is pending. The U.S. Attorney for the District of Connecticut filed parallel criminal charges.

Whistleblowers: In the Matter of KBR, Inc., Adm. Proc. File No. 3-16466 (April 1, 2015) is a proceeding focused on the whistleblower protection provisions of Dodd-Frank. Specifically, KBR adopted a procedure prior to Dodd-Frank in which it used a form confidentiality statement in conjunction with its internal investigations. That form was not required by policy, although it was enclosed with the KBR Code of Business Conduct Investigations Procedures manual. Firm investigators had witnesses sign the statement at the beginning of an interview. It stated in part that “I understand that in order to protect the integrity of this review, I am prohibited from discussing any particulars regarding this interview and the subject matter discussed . . . without the prior authorization of the Law Department.” The Order alleges that this violates Exchange Act Section 21F and Rule 21F-17 thereunder. That Rule provides that “No person may take any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation including enforcing . . . a confidentiality agreement . . .” KBR resolved the proceeding by amending its policy and agreeing to take reasonable steps to contact those who executed the prior policy and inform them of its amendment. The firm also consented to the entry of a cease and desist order based on the Section and Rule cited in the Order. KBR will pay a civil penalty of $130,000.

Financial fraud: In the Matter of Timothy Edwin Scronce, Adm. Proc. File No. 3-16471 (April 1, 2015); In the Matter of Michael Hedrick, Adm. Proc. File No. 3-16470 (April 1, 2015); In the Matter of Marc J. Mize, Adm. Proc. File No. 3-16469 (April 1, 2015). Each of these actions centers on the sale of assets of PCTelWorx, Inc. and its three subsidiaries in 2012 to PCTEL, Inc., a public company. Mr. Sconce was the majority owner and CEO of PCTelWorx and continued to operate the merged entities. Prior to the deal Mr. Scronce is alleged to have inflated the value of the assets sold to PCTEL by overvaluing the inventory and prematurely recognizing revenue prior to sales and concealing these facts. As a result the financial statements of PCTEL, incorporated in Commission filings after the deal, were materially false. Messrss. Hendrick, the controller of PCTelWorx, and Mize, a v.p. of sales for the firm, are alleged to have participated in the scheme. The Order as to Mr. Scronce alleges violations of Exchange Act Sections 10(b), 20(b), 13(a), 13(b)(2)(A) and 13(b)(5). The Order as to Mr. Hedrick alleges violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(5). The Order as to Mr. Mize alleges violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(5). Each Respondent settled. Each agreed to the entry of a cease and desist order based on the Sections cited in the respective Order. In addition, Mr. Scronce is barred for ten years from serving as an offer or director of a public company and will pay disgorgement of $376,007, prejudgment interest and a penalty of $140,000. Mr. Hedrick will pay disgorgement of $25,000, prejudgment interest and acknowledged that a penalty was not imposed based on his cooperation. Mr. Mize will pay a penalty of $25,000.

Internal controls/perks: In the Matter of Polycom, Inc., Adm. Proc. File No. 3-15464 (March 31, 2015); SEC v. Miller, Civil Action No. 3:15-cv-01461 (N.D. Cal. Filed March 31, 2015). Andrew Miller was the President and CEO of Polycom, Inc. from May 2010 to July 19, 2013 when he resigned. He was also a member of the board of directors during a portion of that period. Beginning in January 2010 Mr. Miller submitted, or directed others to submit, to his firm requests for reimbursement of personal expenses. The submissions falsely claimed that the charges were for business expenses. In fact the charges were for personal items. Overall Polycom paid for about $190,000 of Mr. Miller’s personal expenses. Mr. Miller used a variety of devices to conceal these charges. Essentially he circumvented the policies and procedures as well as the internal controls of the firm with, in many instances, false documents. He also signed financial reporting questionnaires which were false because they omitted the perks. As a director Mr. Miller solicited proxies from investors for the annual meetings in 2011, 2012 and 2013 which were false and misleading. Firm proxy statements omitted many of the perks he received. In addition, he signed and certified the firm’s annual reports which incorporated by reference the false proxy statements. Eventually Mr. Miller’s conduct was discovered and he admitted wrong doing to investigators working for the audit committee. Polycom settled the administrative proceeding, agreeing to a series of undertakings regarding its future cooperation. It also consented to the entry of a cease and desist order based on Exchange Act Sections 13(a), 13(b)(2)(A), 13(b)(2)(B) and 14(a). Polycom will pay a penalty of $750,000. The complaint alleges violations of Exchange Act Section 10(b), each subsection of Securities Act Section 17(a), and Exchange Act Sections 14(a), 13(a), 13(b)(2)(A) and 13(b)(5). The case is pending. See Lit. Rel. No. 23225 (March 31, 2015).

Valuation: In the Matter of Lynn Tilton, Adm. Proc. File No. 3-16462 (March 30, 2015). Ms. Tilton has managed what are called the Patriarch entities for years. Those entities, named as Respondents, are: Patriarch Partners, LLC (Patriarch), Patriarch Partners VIII, LLC, Patriarch Partners XIV, LLC and Patriarch Partners XV, LLC. Each is indirectly owned by either Ms. Tilton or the manager and a trust for the benefit of her daughter. Ms. Tilton, the CEO of Patriarch, and their employees, run the business of the three other Patriarch Partners entities, each of which is a registered investment adviser and a collateral manager for the Zohar Funds. The Zohar Funds are CLOs, a securitization vehicle in which a special purpose entity raises capital by issuing secured notes. They invested in private, mid-sized distressed companies. Part of the management fees were tied to valuation. The indenture for each Zohar CLO contained certain numeric tests that must be met each month. If the specified ratios fall below certain levels, the investors control over the fund can increase and result in the early repayment of the principal. The indenture also requires the collateral manager to categorize each asset every month which is tied to value. Rather than following the dictates of the indenture, Ms. Tilton used her discretion to determine how an asset should be categorized. The failure to properly classify these assets resulted in the overpayment of almost $200 million in Subordinated Fees to Respondents. Ms. Tilton’s discretionary approach was not disclosed to investors. The Order alleges willful violations of Advisers Act Sections 206(1), 206(2) and 206(4). The proceeding will be set for hearing.

Offering fraud: SEC v. Macquarie Capital USA), Inc., Civil Action No. 15 cv 02304 (S.D.N.Y. Filed March 27, 2015). Puda Coal, Inc. is the product of a Chinese reverse merger. Its primary asset at the time it entered the U.S. markets in 2009 and was listed on the NYSE was Shanxi Coal, a Chinese coal mining company established under the laws of the PRC in 1995. Defendant Macquarie is a Commission registered broker-dealer. The firm served as lead underwriter for Puda’s follow-on public stock offerings. Defendants Aaron Black and William Fang are both employees of the broker-dealer or its affiliates. In September of 2009 Puda’s chairman caused its 90% interest in Shanxi Coal to be transferred to himself without the approval or knowledge of the public shareholders or the board of directors. In 2010 the firm conducted two secondary offerings, raising over $110 million without disclosing the primary asset of the company had been transferred. Prior to offering Macquarie hired Kroll Associates Inc., an investigative firm, to prepare a report on Puda and its officers and directors. Kroll identified documents showing that Shanxi was owned by others. Although Mr. Fang read the report and Mr. Black reviewed portions of it, neither told the firm about Kroll’s findings. In April 2011 an internet report on Puda disclosed some of the facts regarding the transactions of Mr. Zhao and others. A subsequent investigation by the audit committee uncovered the fraud which was then reported on a Form 8-K. The Commission’s complaint alleges violations of Securities Act Sections 17(a)(2) and (3). The firm settled, agreeing to pay a penalty of $15 million and fund the costs of establishing a fairfund. See Lit. Rel. No. 23222 (March 27, 2015).


Manipulation: CFTC v. Kraft Foods Group, Inc., Civil Action No. 1:15-cv-02881 (N.D. Ill. Filed April 1, 2015) is an action against Kraft and Mondelez Global LLC, then another subsidiary of Kraft, alleging market manipulation. The complaint claims that in response to very high wheat prices in the summer of 2011 the two firms developed a strategy to buy up to $90 million of wheat futures – a six month supply – and not take delivery but rather bet that the positions would depress the prices and strengthen the spread between the December and March contracts. In fact it did, yielding $5.4 million in profits the firms split. The complaint also claims that the two firms violated position limits. It alleges violations of CEA Sections 6(c)(1), 6(c)(3), 9(a)(2), 4a(a) and 4c(a)(1) and (2). The action is pending.


Independence/audit failure: The Board announced the resolution of four proceedings centered on either independence or audit failure violations. They are:

  • In the Matter of Dustin M. Lewis, CPA, No. 105-2015-005 (April 1, 2015) a proceeding which named as Respondents Mr. Lewis and Eric Bullinger, partners in L. L. Bradford & Co. ,who violated the audit partner rotation requirements with respect to six reviews of public companies. Mr. Lewis was barred from associating with a PCAOB registered firm with a right to petition for removal of the bar after two years. He was also fined $10,000. Mr. Bullinger was censured and barred with a right to seek removal of the bar after one year.
  • In the Matter of Hazel-Leilani De Los Rayes Bradford, No. 105-2015-006 (April 1, 2015) is a proceeding in which the Board concluded that the Respondent, while a partner at L.L. Bradford & Co., substantially contributed to violations of PCAOB quality control standards for obtaining sufficient assurance of compliance with the independence requirements by assuming the role of quality control partner despite a lack of experience and knowledge. She was censured, barred from associating with a PCAOB registered public company with a right to petition for removal after two years, and directed to pay a penalty of $25,000.
  • In the Matter of Gordon Brad Beckstead, CPA, No. 105-2015-007 (April 1, 2015) is a proceeding in which the Board concluded that while an engagement partner on an L.L. Bradford & Co. audit of a public company, Mr. Beckstead violated multiple PCAOB standards resulting, in essence, in a audit failure. The Board suspended Respondent from association with a PCAOB registered public company for one year and limited his activities regarding a public company for an additional year. Respondent was also censured and directed to complete certain professional education courses.
  • In the Matter of Suzanne M. Herring, No. 105-2014-008 (April 1, 2015) is a proceeding in which the Board concluded that Ms. Herring, while a partner at L.L. Bradford & Co., violated the independence standards by providing bookkeeping and financial statement preparation services for two public companies on which she served on the audit engagement teams. The Board censured Ms. Herring, barred her from association with a PCAOB registered public company with a right to petition for removal of the bar after two years and imposed a $5,000 civil money penalty.

Criminal cases

False books: U.S. v. Marshall (D. N.J.) is an action in which Michael Marshall, a former trader at ConvergEx Global Markets Ltd. pleaded guilty to conspiracy to falsify the books and records of a broker dealer. This is the latest in a series of actions based on a fraudulent mark-up scheme. In the scheme investors purchased securities with G-Trade Services, LLC, a registered U.S. broker dealer which is a subsidiary of ConvergEx Group. G-Trade then routed the orders to another subsidiary, CGM Limited. When that was done additional mark-ups were added to the price of the securities and entered in the books and records of the firm. Previously, the head trader and a sales representative from another subsidiary pleaded guilty to conspiracy and wire fraud charges. The date for sentencing has not been set.

False records: U.S. v. Shabudin, Case No. 4:11-cv-00664 (N.D. Cal.) is an action in which a jury returned verdicts of guilty following a six week trial against Ebrahim Shabudin, the COO and Chief Credit Officer of United Commercial Bank in 2008 and 2009. UBC was the ninth largest bank to fail. The jury found Mr. Shabudin guilty of conspiracy to commit securities fraud, securities fraud, falsifying corporate books, false statement to accountants, circumventing internal controls, conspiracy to commit false bank entries and false bank entries. The action was based on the falsification of records filed with the SEC and FDIC related to the third and fourth quarters of 2008 regarding the bank’s Allowance for Loan Losses and its quarterly and year-end earnings per share as announced to the public. Previously, Thomas Yu, the bank’s senior vice president, pleaded guilty to conspiracy charges. The date for sentencing has not been set. See also SEC v. Wu, Civil Action No. 4:11-cv-04988 (N.D. Cal.).


Inadequate procedures: The regulator imposed fines on H. Beck, Inc., LaSalle St. Securities, LLC and J.P. Turner & Co., LLC of, respectively, $425,000, $175,000 and $100,00 for having inadequate supervision of consolidated reports furnished to customers. Those reports combine information about most customer financial holdings in a single document. During the course of routine exams FINRA concluded that registered representatives of the firms prepared and disseminated these reports to customers without adequate review or any prior review by a principal. For example, H. Beck and J.P. Turner did not have any written procedures specifically addressing the use and supervision of these reports. LaSalle did have procedures but failed to enforce them or provide proper training.

Hong Kong

Internal controls: The Securities and Futures Commission reprimanded and fined Merrill Lynch Far East Ltd $2 million related to control failures and position limits. Specifically, the SFC concluded that Merrill Lynch International held 14,181 contracts in the Hang Seng China Enterprises Index on May 30, 2013, contrary to the position limits. While the firm had internal controls with regard to this in place, they were ineffective.


Insider dealing: The U.K. Financial Conduct Authority imposed a fine of £35,212 on Kenneth Carver for insider dealing. The action centered on the potential takeover of Logica Plc, announced on May 31 2012 by CGI Inc., a publicly traded entity. Prior to that date Mr. Carver learned about the deal from Ryan Willmott, a family friend who knew about the transaction through his employment. Mr. Carver traded and had profits of £24,206.70. Mr. Carver’s fine was substantially reduced because of his cooperation and early admission. Otherwise it would have been £122,212. Previously, Mr. Willmott pleaded guilty to insider dealing and was sentenced to 10 months imprisonment.

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