This Week In Securities Litigation (Week ending March 1, 2013)

The Supreme Court handed down two significant securities law decisions this week. In the first the High Court, in unanimous opinion, rejected the contention of the SEC that the five year statute of limitations for seeking a penalty can be extended by invoking a discovery rule. In the second, the Court concluded that a securities law class action plaintiff need not establish materiality at the class certification stage to invoke the fraud on the market theory. Rather, materiality is a merits issue.

The SEC filed two new enforcement actions this week. One involved a PRC based issuer formed by a reverse merger charged with falsifying its financial statements by failing to include related party transactions and an off-books account. The second focused on claims that a hedge fund manager amended the structure to give certain shareholders a liquidation preference and then sold additional shares without disclosing this fact.

Finally, the SEC Chairman and three Commissioners addressed the annual SEC Speaks Conference, focusing on market safety and structure, regulatory measures to promote the stability of markets, disclosure policy and regulatory burdens and raising questions about the independence of the agency in view of certain provisions in Dodd-Frank. Chairman Walter was honored at a dinner held in connection with the conference of ASECA, the alumni association of former SEC staff.


Remarks: Chairman Elisse Walter addressed the SEC Speaks Conference (Washington, D.C. Feb. 22, 2013) in remarks titled “Making the Markets Safe for Informed Risk-Taking.” Her remarks focused on minimzing the risks in the market (here).

Remarks: Commissioner Luis Aguilar addressed the SEC Speaks Conference (Washington, D.C. Feb. 22, 2013). His remarks focused on regulatory measures to promote market stability (here).

Remarks: Commissioner Daniel Gallagher addressed the SEC Speaks Conference (Washington, D.C. Feb. 22, 2013). His remarks focused on regulatory action that is impacting the Commission’s independence (here).

Remarks: Commissioner Tory Paredes addressed the SEC Speaks Conference (Washington, D.C. Feb. 22, 2013). His remarks focused on disclosure policy in contrast to the regulatory burdens of Dodd-Frank (here).


Remarks: Chairman Gary Gensler addressed the Global Financial Markets Association (Feb. 28, 2013). His remarks focused on the need to transition from LIBOR in wake of recent actions involving that benchmark rate (here).

Testimony: Chairman Gary Gensler testified before the Senate Committee on Agriculture, Nutrition & Forestry (Feb. 27, 2013). His testimony reviewed the recent swaps market reforms including the impact of those reforms on the markets, the LIBOR enforcement actions and the agency’s budget request and the necessity to fund it (here).

The Supreme Court

Statute of limitation: Gabelli v. SEC, No. 11-1274 (S.Ct. Decided Feb. 27, 2013). The Supreme Court rejected the SEC’s effort to extend the five year statute of limitations for imposing a civil penalty by engrafting a discovery exception onto the statute. Chief Justice Roberts, writing for a unanimous Court, held that under Section 2462 of Title 28, the statute of limitations begins when there is a cause of action. The decision is a straight forward reading of the plain statutory language. The ruling came in a case where the Commission claimed a portfolio manager and the COO made false statements regarding an arrangement made with one hedge fund adviser which permitted it to market time while others were banned from using the practice. Although the complaint was filed in April 2008 following an investigation that began in 2003, the underlying conduct occurred from 1999 to 2002. The complaint alleged violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2). The district court granted in part the defendants’ motion to dismiss based on 28 U.S.C. Section 2462, the five year statute of limitations for penalties in government actions. The Second Circuit reversed, concluding that the claim did not accrue until it was discovered or could reasonably have been discovered.

The Supreme Court reversed. Writing for a unanimous Court Chief Justice Roberts stated that “the ‘standard rule’ is that a claim accrues “when the plaintiff has a complete and present cause of action.” That rule has governed since the 1830s when the predecessor to the current Section was written. It is also consistent with the definition of the word “accrued” in standard legal dictionaries. In addition, this reading of the text ensures a fixed date when exposure under the statute begins. While the “discovery rule” advocated by the SEC traces to the eighteenth century, it has never been applied in a context where the plaintiff has not been defrauded. Indeed, the discovery rule is designed to aid plaintiffs seeking recovery for an injury, not a penalty as here.

Class certification: Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, No. 11-1085 (Decided Feb. 27, 2013) is a case in which the Court held in a 6 to 3 decision that a securities class action plaintiff need not prove materiality at the class certification stage to rely on the fraud-on-the market presumption. This case focuses on the interaction of Rule 23, Federal Rules of Civil Procedure, and the Court’s holding in Basic Inc. v. Levinson, 485 U.S. 224 (1988) which adopted the fraud-on-the-market theory is securities fraud class actions. In the underlying case the Ninth Circuit Court of Appeals affirmed a ruling by the district court, holding that the plaintiffs did not have to establish materiality to prevail on a Rule 23 motion for class certification. Rather, the question of materiality, necessary to the invocation of the Basic presumption, is reserved for the merits. At the certification stage it is sufficient to “take a peek at the merits” by ensuring that materiality is plausibly pleaded.

The Supreme Court affirmed in an opinion was written by Justice Ginsburg and joined by Chief Justice Robert, and Justices Breyer, Alito, Sotomayor and Kegan. To obtain class certification , Justice Ginsburg wrote, plaintiff must meet the requires of 23 which, among other things, requires that the questions of law or fact common to the class members predominate over any questions affecting only individual members. Those requirements are distinct from those needed to establish a claim under Exchange Act Section 10(b), one of which is reliance. That element can be demonstrated by the Basic fraud-on-the market presumption.

Although the Court has directed that the certification process be “rigorous” and noted that it may “entail some overlap with the merits of the plaintiff’s underlying claim,” the Rule does not give courts a “license to engage in free-ranging merits inquiries at the certification stage.” In considering the requirements of the Rule the focus is on common questions. Materiality under Basic is an objective test viewed in the context of a reasonable investor. It can be established through evidence common to the class. If established the claim may proceed for the class, assuming the other elements of a cause of action are also proven. If not, the claim fails for the class. In either case the determination is a common question. As a common question it meets the Rule 23 test. Whether it can be proven is, in contrast, a merits question.

Justice Alito joined the majority but also wrote a separate concurring opinion. There he noted that it may be appropriate to reconsider the Basic presumption in view of recent economic studies on market efficiency which suggest that it is not a binary question. While the issue was raised by Petitioners, the question was not properly before the Court.

Justice Scalia dissented. In his view the “Basic rule of fraud-on-the-market . . . governs not only the question of substantive liability, but also the question of whether certification is proper. All of the elements of that rule, including materiality, must be established if and when it is relied upon to justify certification. The answer to the question before us today is to be found not in Rule 23(b)(3), but in the opinion of Basic.”

Justice Thomas, dissenting, also concluded that the requirements of Basic must be met to certify the class. In this regard, Justice Thomas noted that the majority “depends on the following assumption: Plaintiffs will either (1) establish materiality at the merits stage, in which case the class certification was proper because reliance turned out to be a common question, or (2) fail to establish materiality, in which case the claim would fail on the merits, notwithstanding the fact that the class should not have been certified in the first place because reliance was never a common question. The failure to establish materiality retrospectively confirms that fraud on the market was never established, that questions regarding the element of reliance were not common under Rule 23(b)(3), and, by extension, that certification was never proper.” Accordingly, plaintiffs cannot meet their Rule 23 burden without also meeting the requirements of Basic the Justice reasoned.

SEC Enforcement: Filings and settlements

Weekly statistics: This week the Commission filed 2 civil injunctive actions and no administrative proceedings (excluding tag-along-actions and 12(j) actions).

Financial fraud: SEC v. Keyuan Petrochemicals, Inc., Civil Action No. 13-cv-00263 (D.D.C. Filed Feb. 28, 2013) is an action against the company, a China based issuer formed through a reverse merger, and its CFO, Aichun Li. Keyuan systematically failed to disclose related party transactions involving the company, its CEO, controlling shareholders and entities controlled by or affiliated with those person and other entities controlled by management from May 2010 to January 2011. The transactions involved the sale of products, purchases of raw materials, loan guarantees and short term cash transfers for financing purposes. The company also operated an off-balance sheet cash account that was used to pay for various items including cash bonuses for senior officers, fees to consultants, to reimburse the CEO for business expenses and to pay for gifts to Chinese government officials. As a result, in October 2011 the company restated its financial statements for the second and third quarters of 2010. As the CFO Ms. Li encountered several red flags that should have indicated the related party transactions were not disclosed, according to the Commission. Each defendant settled. The company consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3) and Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The company also agreed to pay a civil penalty of $1 million. Ms. Li consented to the entry of a permanent injunction based on Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(5). She also agreed to pay a civil penalty of $25,000 and consented to being suspended from appearing or practicing before the Commission as an accountant with a right to reapply after two years. See also Lit. Rel. No. 13-cv-00263 (D.D.C. Filed Feb. 28, 2013).

Market manipulation: SEC v. Dynkowski, Civil Action No. 1:09-361 (D. Del.) is an action filed in 2009 against Pawel Dynkowski, Adam Rosengard and others for manipulating the price of penny stock Xtreme Motorsports of California, Inc. in 2007. Mr. Dynkowski is alleged to have orchestrated the manipulation which centered on using wash sales, matched orders and other manipulative trading. Mr. Rosengard acted as a nominee account holder in the scheme and gave Mr. Dynkowski access to an account used in the sales. Mr. Rosengard settled with the SEC, consenting to the entry of a final judgment which permanently enjoins him from violating Securities Act Section 5, requires the payment of $165,646 in disgorgement along with prejudgment interest and bars him from participating in any offering of a penny stock. No civil penalty was imposed and a part of the disgorgement obligation was waived in view of his financial condition. See also Lit. Rel. No. 22626 (Feb. 27, 2013).

Financial fraud: SEC v. Espuelas, Civil Action No. 06 cv 2435 (S.D.N.Y.) is an action centered on an alleged financial fraud at StarMedia Network, Inc., a now defunct company, in 2000 and the first two quarters of fiscal 2001. The action was brought against Peter Morales, the former controller, and others. Mr. Morales settled with the Commission, consenting to the entry of a permanent injunction prohibiting future violations and from aiding and abetting violations of Exchange Act Sections 13(a) and 13(b)(2)(A). In addition, he was ordered to pay a civil penalty of $100,000. See also Lit. Rel. No. 22624 (Feb. 26, 2013).

Fraudulent concealment: SEC v. New Stream Capital, LLC, Case No. 3:13-cv-00264 (D. Conn. Filed Feb. 26, 2013) is an action against a hedge fund manager and its principles for secretly altering the structure of the funds for the benefit of select investors and then raising additional funds without disclosing this to the new investors. The New Stream hedge fund complex raised capital from investors and made loans backed by real estate, life insurance policies, oil and gas interests and commercial assets. Its primary investment vehicle was a Master Fund which began receiving investments in 2003. In 2005 the Bermuda Feeder was created to raise money from investors not subject to the U.S. tax laws. In 2008 the complex was restructured, adding two additional Feeder funds. When Gottex Fund Management Ltd., the largest single investor in the Bermuda Feeder, objected to the loss of its preference rights on liquidation as a result of the new structure, the complex was restructured to give the adviser and select others preferences. Subsequently, New Stream raised nearly $50 million from new investors without telling them about the deal with Gottex and select others. As the financial crisis continued in 2008 the complex collapsed into bankruptcy. The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1) and (2) and Section 206(4). Director of marketing and investor relations Tara Bryson, who was charged in counts based on Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Section 206(4), settled with the Commission, consenting to the entry of a permanent injunction based on those Sections. She also agreed to be barred from the securities industry. The other defendants are litigating the case.

Option backdating: SEC v. Mercury Interactive, LLC, Civil Action No. 07-2822 (N.D. Cal. Filed May 31, 2007) is an option backdating case, The Commission alleged that from 1997 through 2005 defendants Amnon Landan, the former Chairman and CEO of the company, Sharlene Abrams, the former CFO, Douglas Smith, also a former CFO and Susan Skaer, the former general counsel, participated in a fraudulent scheme in which they awarded themselves and other employees hundreds of millions of dollars in backdated stock options. The company did not report the $258 million compensation expense from these grants, thus fraudulently overstating its revenue and income.

This week Messrs. Landan and Smith settled with the Commission. Mr. Landan consented to the entry of a permanent injunction prohibiting him from violating and/or aiding and abetting violations of Securities Act Section 17(a) and Exchange Act Section 10(b) as well as the financial reporting, record-keeping, internal controls, false statements to auditors and proxy provisions of the federal securities laws. In addition, he agreed to a five year officer/ director bar, to pay disgorgement of $1,252,822 (the in-the money component of the options), prejudgment interest and a $1 million civil penalty. He will also reimburse the company $5,064,678 for cash bonuses and profits from stock sales under SOX Section 304. Mr. Smith consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3). He also agreed to pay disgorgement of $451,200 (the in the money component of the options), prejudgment interest and a penalty of $100,000. Under SOX Section 304 he will reimburse the company $2,841,687. That amount will be deemed satisfied by his prior payment to the company of $451,200 and his agreement not to exercise certain options. Previously, Ms. Abrams and the company settled. Ms. Skaer is the sole remaining defendant. She recently lost her effort to have the case resolved in her favor on dispositive motions. The court’s ruling on that motion cleared the way for the case to proceed to trial.

Criminal cases

Insider trading: U.S. v. Perna (S.D.N.Y.) is an action against financial adviser Damian Perna in which the defendant is charged with conspiracy to commit insider trading. Mr. Perna is alleged to have obtained draft earnings reports for several public companies prior to their public release through a contact at an investor relations firm. In one meeting Mr. Perna sold an advance copy of an earnings report to an undercover FBI agent and was paid $7,000 in cash. The case is pending.

Investment fund fraud: U.S. v. Banuelos (N.D. Cal.) is an action in which Michael Banuelos was charged with twelve counts of wire fraud and one count of money laundering in connection with an investment fund fraud. In the scheme investors participated in fraudulent contracts Mr. Banuelos claimed to have arranged for a musical group to open for a famous band and for recording. The scheme yielded about $2 million, most of which Mr. Banuelos diverted to his personal use. In a separate scheme he raised over $200,000 from investors, falsely claiming that he was a successful money manager. Sentencing is set for May 21, 2013.

Stock manipulation: Defendants Blake Williams and Derek Lopez were sentenced by Judge Ed Kinkeade (N.D. Tx.), to serve, respectively, 32 and 24 months in prison for their roles in a stock manipulation scheme. Mr. Williams was an employee of TBeck Capital Inc., an investment banking firm. Mr. Lopez was a securities broker at the firm. The two men admitted trading in their name and through other accounts in a manner designed to create the illusion of interest in the stock as part of a manipulation. Mr. Williams was paid in cash for his participation while Mr. Lopez received free trading shares and cash payments. Collectively the co-conspirators are alleged to have made over $1 million from the manipulation.


The Board released its report titled “Report on 2007-2010 inspections of Domestic Firms that Audit 100 or Fewer Public Companies.” The Board is required under Sarbanes-Oxley to inspect firms which audit 100 or fewer public companies every three years. Overall the Report concluded that the rate of significant audit performance deficiencies – instances where there are significant performance deficiencies where the audit firm cannot issue an opinion because of a lack of evidentiary matter – continued to decline compared to earlier periods.


The regulator announced that three men have been arrested in connection with an insider trading and market abuse scheme. Six search warrants were executed in the London area in connection with the investigation.

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