This Week In Securities Litigation (Week ending August 22, 2014)

The Second Circuit upheld SEC Rule 10b-5-2 which defines certain types of relationships as the predicate for insider trading. In reaching its conclusion the Court rejected an argument that an insider trading claim must be based on a breach of fiduciary duty.

This week the Commission brought a second action against Bank of America tied to the market crisis. This action, based on the sale of residential mortgages and RMBS years ago, was resolved with admissions, a cease and desist order and the payment of a penalty. The action was tied to the overall DOJ settlement with the bank. The agency also brought another insider trading case tied to golf; an offering fraud action; a pump and dump manipulation case; and a proceeding based on the failure to implement procedures to protect confidential information.


Remarks: Rick Fleming, Investor Advocate, addressed the 38th Annual Southwest Securities Conference, Dallas, Texas (August 19, 2014). The remarks focused on the functions of the Office and user fees (here).

Exam initiative: The Office of Compliance Inspections and Examinations announced that it is launching an examination initiative directed at newly regulated municipal advisors (here).

SEC Enforcement – Litigated Actions

Remedies: SEC v. Nocella, Case No. 4:12-cv-1051 (S.D. Tx. Opinion August 11, 2014) is a financial fraud action against two former bank officers, CEO Anthony Nocella and CFO J. Russell McCann. The complaint centered on what was claimed to be the efforts of Messrs. Nocella and McCann to prop-up Franklin Bank Corp., a Texas based savings and loan holding company. By the second quarter of 2007 the loan portfolio of the financial institution began to deteriorate as the financial crisis unraveled. Messrs. Nocella and McCann crafted three plans to improve the appearance of the loan portfolio and thus the operating results of the bank: Fresh Start, Strathmore modifications and Great News. Each program essentially brought the loans current through various devices which were either inconsistent with bank practice or the appropriate accounting. The complaint alleged violations of Exchange Act Sections 10(b), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5). It requested a permanent injunction, disgorgement, prejudgment interest, civil penalties, officer and director bars and repayment under SOX 304.

The Court considered the question of remedies against Messrs. Nocell and McCann in ruling on a summary judgment motion. After reviewing the facts regarding the loan programs, the Court turned to the question of whether an officer or director bar should be imposed. Here the violations were not egregious, the Court found. Neither officer profited and both are first time offenders. While they were senior officers of the bank, many at the institution participated in the programs which were disclosed to the FDIC. Likewise, neither defendant acted with the intention to defraud the shareholders. When the FDIC disagreed with the Strathmore loan classifications, the pertinent corrections were made. Indeed, the acts involved here appear to stem from “a good-faith attempt to manage a floundering bank during a recession. Finally, neither defendant is in a position to violate the securities laws in the future. Mr. Nocella retired and Mr. McCann works for a private bank.

Based on these findings the Court declined to enter an officer and director bar as to either defendant concluding: “This court recognizes that it is wrong that Franklin Bank Corporation improperly accounted for modified mortgages under their management. It is abusive to seek a permanent bar against two executives who were working for a troubled company in a troubled time without adequate evidence that they were responsible for the improper accounting.”

SEC Enforcement –Filed and Settled Actions

Statistics: This week the Commission filed 3 civil injunctive actions and 2 administrative proceedings (excluding 12j and tag-along proceedings).

Market crisis: In the Matter of Bank of America Corporation, Adm. Proc. File No. 3-16028 (August 21, 2014) is the second action brought by the Commission against the bank tied to the market crisis. Between 2004 and 2008 the bank and certain acquired entities sold about $2.1 trillion of mortgage loans and RMBS. About $1.1 of those were mortgage loans sold to GSEs, primarily Fannie Mae and Freddie Mac. In connection with those transactions various representations were made. If there was a breach of those representation the issue would have to be resolved and could result in a recession of the transaction. When Fannie Mae went into conservatorship it adopted a more aggressive policy regarding how breach claims were handled. That resulted in a rise in the number of contested or impasse situations. The bank failed to disclose this known uncertainty. In addition, through an acquisition the Bank acquired about $160 million of RMBS with monoline insurance. The bank did not create a reserve. The bank thus failed to disclose these known uncertainties in the MD&A section of its Forms 10Q for the second and third quarters of 2009 which were incorporated by reference into a registration statement. The Order alleges violations of Exchange Act Section 13(a) along with Rules 12b-20 and 13a-13. To resolve the proceeding the bank made certain admissions regarding the transactions and stated that its conduct violated the federal securities laws. The bank also agreed to the entry of a cease and desist order based on the Section and Rules cited. In addition, Bank of America will pay a civil penalty of $20 million which will be deemed satisfied by its payment in accord with the terms of a settlement with DOJ.

Procedures: In the Matter of Monness, Crespi, Hardt & Co., Inc., Adm. Proc. File No. 3-16025 (August 20, 2014) is a proceeding which names as a Respondent the registered broker dealer. Over a period of six years, beginning in 2006, the firm failed to properly implement portions of its procedures regarding confidential information. Specifically, it failed to require employees to submit reports of their securities transactions and to maintain a restricted list. It also did not adopt policies for certain of its programs which posed the risk of disclosure regarding material, nonpublic information about up coming analyst reports. The Order alleges violations of Exchange Act Section 15(g). The firm adopted the necessary procedures when notified by the staff. It resolved the proceeding by consenting to the entry of a cease and desist order based on the cited Section as well as a censure. The firm will pay a civil penalty of $150,000.

Insider trading: SEC v. O’Neill, Civil Action No. 1:14-cv-13381 (D. Mass. Filed August 18, 2014). The action names as defendants Patrick O’Neill and Robert Bray. It focuses on the June 29, 2010 announcement that Wainwright Bank & Trust Company was going to be purchased by Eastern Bank Corporation. Mr. O’Neill was the Eastern Bank Senior Vice-President and Senior Credit Officer. Mr. Bray was an affiliate of R&B Construction Company. When Mr. O’Neill joined Eastern Bank in early 2010 he read and acknowledged the insider trading policy of the bank. A few days later the bank asked him to also execute a confidentiality agreement which stated in part that Eastern was involved in a possible transaction regarding Wainwright and that he would likely receive confidential information. It also noted that he likely would conduct due diligence on the proposed deal and that the information he would obtain was “inside information” under the applicable securities laws. Subsequently, Mr. O’Neil conducted due diligence on Wainwright’s loan portfolios. That work was completed by June 28, 2010. Messrs. O’Neill and Bray had been friends for many years. Both were golfers and members of the same local country club. Both socialized at the country club bar. On one or more days between May 20 and June 13 the two men were together, according to the complaint. On Monday June 14, 2010 Mr. Bray sold the shares of three other stocks in his brokerage account for total proceeds of over $261,000. He used the proceeds to purchase Wainwright shares. Over a period of days beginning on June 14 he accumulated 31,000 shares of Wainwright stock at a cost of over $288,000. When the deal was announced the share price spiked up 94% giving Mr. Bray profits of almost $300,000. The Commission’s complaint alleges violations of Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 230790 (August 18, 2014).

Offering fraud: SEC v. Gamer, Civil Action No. 1:14-cv-02650 (N.D. Ga. Filed August 15, 2014). The defendants are Heidi Ann Gamer and her two controlled entities, Gamer Economic Systems, LLC and Gamer Media Partners. Interests in each entity were marketed using claims that interactive software and technology, including applications for smartphones, would be developed. Investors were told about a product called “StoryMap.” This app supposedly permitted television viewers to look up the episodic history of a show and purchase items seen on the set. In some sales pitches potential investors were told of a $100,000 contract with Dartmouth College and a deal with the Atlanta Falcons. Between August 2012 and May 2013 Ms. Gamer sold interest to 27 investors, raising over $370,000 for interests in GMP. Over $700,000 was raised from marketing both entities. In fact the money was not used as represented and much of it was diverted to personal use. The complaint alleges violations of each subsection of Securities Act Section 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 23071 (August 19, 2014).

Manipulation: SEC v. Farmer, Civil Action No. 4:14-cv-02345 (S.D. Tx. Filed August 14, 2014) is an action against Andrew Farmer, Charles Grob, Jr., Carolyn Austin, Baldemar Rios and Chimera Energy Corporation. The complaint alleges that from August 2011 through November 2012 the defendants engaged in a pump and dump manipulation scheme. Specifically, Mr. Farm first conducted an IPO for Chimera, a shell company, and gained control of its outstanding stock. Then a series of false press releases were issued touting the company as having a revolutionary new technology that supposedly enabled production of shale oil and gas without the perceived environmental impact of hydraulic fracturing. As the stock price increased Mr. Farmer sold his shares, reaping at least $4.58 million in profits. The complaint alleges violations of Securities Act Sections 5(a) and (c) and 17(a) and Exchange Act Sections 10(b) and 15(d). The case is in litigation. See Lit. Rel. No. 23072 (August 21, 2014).

Court of appeals

Insider trading: U.S. v. McGee, No. 13-3183 (3rd Cir. Decided August 14, 2014) the Court rejected a claim that the SEC exceeded its authority when enacting Rule 10b5-2 because it did not require a fiduciary duty. Timothy McGee was convicted by a jury of insider trading. That conviction is based on the misappropriation theory. Between June and July 2008 he obtained material non-public information regarding the then pending sale of Philadelphia Consolidated Holding Corporation or PHLY from Christopher Maguire, an insider at the company. Mr. McGee then borrowed about $226,000 to purchase 10,750 shares of PHLY. After the deal announcement he had trading profits of $292,128. A jury convicted him of insider trading based in part on Rule 10b5-2.

On appeal Mr. McGee challenged Rule 10b5-2(2), arguing that it exceeds the SEC’s authority since a fiduciary duty is required. Turing to the question of whether the SEC is entitled to difference under Chevron, the Court first sought to determine if Section 10(b) is ambiguous on the precise question. That Section, the Court concluded, is ambiguous since it does not define “deceptive device” and, in fact, does not mention insider trading much less define the necessary type of relationship.

The critical question then becomes whether judicial precedent foreclosed the action taken by the SEC. Mr. McGee claimed that Supreme Court precedent precluded the action taken by the SEC with respect to the Rule. The Court disagreed, however, noting that O’Hagan and other decisions by the Supreme Court in this area do not specifically define the type of relationship necessary. While those decisions frequently discuss fiduciary relationships, they do not require such a relationship.

Since there is no specific judicial precedent defining the necessary relationship, the question is if the SEC’s construction is one it permissibly could have adopted. Considering the purpose of the Act the Court determined that “Rule 10b5-2(2) is based on a permissible reading of ‘deceptive device[s]’” under Section 10(b) of the Exchange Act. The Court concluded by noting that “Although we are not without reservations concerning the breath of misappropriation under Rule 10b5-2(2), it is for Congress to limit its delegation of authority to the SEC or to limit misappropriation by statute.”


Market access: The regulator brought a proceeding against Wedbush Securities, Inc. centered on market access and supervisory issues. Specifically, Wedbush is one of the largest market access providers. From January 2008 through August 2013 the firm failed to dedicate sufficient resources to ensure supervise the customers. As a result the U.S. exchanges were flooded with numerous potentially manipulative trades.

Alert: The regulator issued a warning to investors of Viral Disease Stock Scams (here).

Criminal cases

Investment fund fraud: U.S. v. Kretz, 3:09-cr-00262 (M.D. Tenn.) is an action against Terry Kretz, formerly the CEO of Hanover Corporation. The indictment alleged that Mr. Kretz solicited investors over a two year period beginning in early 2004 to purchase promissory notes in the firm. The notes supposedly paid a high rate of interest. The funds were to be used to invest in stock options and startup companies. In fact much of the money was used to repay earlier investors and for salaries and overhead as well as personal items. Mr. Kretz pleaded guilty to counts of conspiracy, securities fraud and wire fraud. He was sentenced this week to serve 14 years in prison followed by three years of supervised release. He was also ordered to pay $14,784,983.75 in restitution. Two co-conspirators previously pleaded guilty and are awaiting sentencing.

Hong Kong

Report: The Securities and Futures Commission issued a report summarizing its activities for the period April to June 2014 (here).

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