This Week in Securities Litigation (Week ending September 20, 2013)

The Commission obtained its second settlement under its new policy which requires admissions in select, settling enforcement actions. This time JPMorgan settled books, records and internal control charges stemming from the so-called London Whale trading debacle. The settlement was based on admissions made by the financial institution in connection with the settlement.

The SEC continued to implement Dodd-Frank this week. In one proposal the agency issued for comment rules to implement the Dodd-Frank provisions requiring the disclosure of a ratio of executive pay to the mean of firm employees. The vote was 3-2 to issue the proposal for comment. In another, the Commission adopted rules establishing a permanent registration requirement for municipal advisors in accord with Dodd-Frank.

Enforcement emphasized compliance with Rule 105 of Regulation M regarding illegal short selling, announcing 23 actions under the provision. The announcement coincided with the issuance of an Alert on the subject from the National Exam Program. Enforcement also brought an action against a group abusing energy credits available under the Independence and Security Act of 2007, a municipal bond related proceeding against quasi-governmental agency Public Health Trust and a case centered on false statements regarding potential FDA approval of a new breast cancer process.


Pay ratio rule: The Commission issued for comment a proposed rule under Section 953(b) of Dodd-Frank which would require issuers to disclose the ratio of the compensation of its CEO to the median of its employees. The vote was 3-2 (here).

Municipal advisors: The agency adopted rules establishing a permanent registration requirement for municipal advisors pursuant to Section 975 of Dodd-Frank (here).

Risk Alert: The SEC’s National Exam Program issued a Risk Alert on illegal short selling (here). At the same time the agency announced the filing of twenty-three actions centered on Rule 105 of Regulation M. All but one of the proceedings was settled.


Remarks: Chairman Gary Gensler addressed the ISDA European Conference (Sept. 19, 2013). In his remarks the Chairman reviewed select market events including increased transparency, swap dealer oversight, international coordination, and the actions relating to benchmark interest rates (here).

Remarks: Commissioner Bart Chilton delivered remarks titled “The Brutality of Reality” to the Michigan Agri-Business Association, Mackinac Island, MI (Sept. 14, 2013). Topics covered included position limits, user fees, increased penalty authority and prohibiting banks from owning commodities (here).

JP Morgan Settlement

The Commission settled its second case under the new “admissions in select cases” settlement policy. In the Matter of JPMorgan Chase & Co., Adm. Proc. File No. 3-15507 (September 19, 2013) is an action arising out of the so-called “London Whale” debacle in which the financial institution suffer a loss of about $6 billion from its trading book. At the same time the financial institution also settled with the Federal Reserve, the Comptroller of the Currency and Financial Conduct Authority in the U.K., agreeing in total to pay penalties of $960 million. Previously, the U.S. Attorney in Manhattan and the SEC filed actions against two of the traders involved based on cover-up allegations.

This proceeding is based on alleged violations of the books, records and internal control provisions of the federal securities laws. Specifically, the Order alleges violations of Exchange Act Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) and the related Rules. The facts and claims on which the Order is based are straight forward. It alleges that:

Initial disclosure: On May 10, 2012 the bank disclosed a trading loss of $2 billion during the quarter in its Synthetic Credit Portfolio held by the Chief Investment Officer. The quarterly report stated that the bank’s disclosure controls and procedures were effective.

The loss increases: The loss, which grew to nearly $6 billion, was not fully reported. The internal control function in the CIO was ineffective. Specifically, the Valuation Control Group or VCP “was unequipped to cope with the increase in the size and complexity of the . . . “ Synthetic Credit Portfolio. The actual price-testing mythology used was subjective and insufficiently independent from the traders, allowing those persons to influence the process. The unit failed to give sufficient information to the CIO and senior management.

Lack of communication: There was inadequate communication between JPMorgan’s Senior Management and the Audit Committee. This impacted the financial institution’s response to the trading losses. Before the report on May 10, Senior Management did not adequately update the Audit Committee regarding the facts learned during the reviews of the CIO and Valuation Control Group.

Restatement: On July 13, 2012 the financial institution announced that it would restate the results for the first quarter of 2012. It also disclosed a material weakness in internal control over financial reporting at the CIO as of March 31, 2012. That was based on deficiencies in the CIO-SCP process.

Inadequate procedures: On August 9, 2012 JPMorgan filed an amended Form 10-Q with restated results for the first quarter tied to the trading losses. The filing also disclosed that the firm’s disclosure controls and procedures at the end of the first quarter were not effective and that management’s prior conclusion disclosed on May 10 was incorrect.

As a result of it failure to maintain effective control over financial reporting, JPMorgan violated the Sections cited in the Order.

JPMorgan settled the action, consenting to the entry of a cease and desist order based on the Sections cited in the Order. The financial institution also agreed to pay a civil penalty of $200,000. The Commission acknowledged the cooperation of JPMorgan.

In settling with the Commission JPMorgan did not admit the facts and allegations in the Order. Annex A to the Order, however, states, that “JPMorgan Chase & Co. admits to the facts set forth below and acknowledges that its conduct violated the federal securities laws.” The Annex goes on to present a detailed chronology of the events surrounding the matter.

The Annex does not identify any individuals. It does not allege or otherwise state that any specific provision of the federal securities laws was violated.

SEC Enforcement: Filings and settlements

Filings this week: This week the Commission filed 4 civil injunctive actions and 3 administrative proceeding (excluding follow-on actions and 12(j) proceedings).

Bribery: SEC v. Axius, Inc., Civil Action No. 12 Civ. 3338 (E.D.N.Y.) is a previously filed action against the firm, Roland Kaufmann and Jean-Pierre Neuhaus. The complaint alleges that beginning in January 2012 the defendants engaged in a scheme to manipulate the shares of Axius through a broker bribery scheme. This week the Court entered a final judgment by consent against defendant Roland Kaufmann. The final judgment prohibit future violations of Securities Act Section 17(a) and Exchange Act Sections 9(a)(1) and 10(b). The final judgment also directs Mr. Kaufmann to pay disgorgement and prejudgment interest of $50,368.17, which is deemed satisfied by the forfeiture order entered against him in a parallel criminal action, and bars him from serving as an officer or director of a public company and participating in a penny stock offering. See Lit. Rel. No. 22802 (Sept. 19, 2013).

Undisclosed conflict: In the Matter of Shadron L. Stastney, Adm. Proc. File No. 3-15500 (September 18, 2013) is a proceeding against Mr. Stastney, a founder, managing member and COO and Head of Research at registered investment adviser Vicis Capital LLC. Mr. Stastney’s friend sold a basket of securities to the fund for $7.5 million. Although Mr. Stastney disclosed this fact to the Fund he did not informed the Fund or its Trustee that he would receive over $2.7 million from the sale. By failing to disclose this material conflict of interest, Respondent breached his fiduciary duty and violated Advisers Act Sections 206(2)( and (3), according to the Order. To resolve the proceeding Mr. Stastney consented to the entry of a cease and desist order based on the Sections cited in the complaint. He also agreed to pay disgorgement of $2,033,710.46, prejudgment interest, a penalty of $375,000 and to the entry of an order barring him from the securities business with a right to apply for reentry after eighteen months.

Fraudulent federal credits: SEC v. Imperial Petroleum, Inc., Civil Action No. 1:13-cv-01489 (S.D. Ind. Filed September 18, 2013) is an action against six individuals and three entities centered on a fraudulent biofuels scheme. The scheme focused on obtaining certain credits under the Energy Independence and Security Act of 2007 by falsely certifying blended biodiesel as pure biodiesel to obtain the credits. Imperial Petroleum, Inc, whose chairman was Jeffrey Wilson, both defendants, acquired E-biofuels, LLC or Ebio on May 24, 2010 from the original owners of the company which included defendants Craig Ducey, Chad Ducey and Brian Carmichael. At the time Imperial and its CEO believed they were purchasing a profitable biodiesel firm. The business was a fraud. Since at least 2009 Defendants Joseph Furando and Evelyn Patterson, along with one or more of their companies, which include defendants Caravan Trading, LLC, CIMA Green, LLC and CIMA Energy Group, had been selling blended biodiesel to Ebio under false documents which facilitated relabeling the fuel as pure biodiesel. The arrangement had been made with the owners of Ebio. Within weeks of Ebio’s acquisition by Imperial, Mr. Wilson discovered the fraud. He did not halt it. Rather, it continued. Revenue spiked from about $1 million to $110 million from the illegal business. The financial results were reported in filings made with the Commission. By late 2011 rumors circulated in the industry that Ebio was a fraud. In early 2012 its business was all but gone. The company sunk into bankruptcy. Customers of the company lost about $55 million; the Internal Revenue Service is exposed to as much as $35 million in false claims; and shareholders of the company, who once had a high flying stock, were left with a bankrupt company. By April 2012 the company collapsed into bankruptcy. The Commission’s complaint alleges violations of Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(5) and 20(a). A parallel criminal cases allege 88 counts which include conspiracy, wire fraud, false tax claims, false statements under the Clean Air Act, obstruction of justice, money laundering and securities fraud. The cases are pending.

False statements: SEC v. Imaging Diagnostic Systems, Inc., Civil Action No. 0:13-cv-62025 (S.D. Fl. Filed September 13, 2013) is an action against the company and its CEO Linda Grable and CFO, Allan Schwartz. The Commission’s complaint alleges that in 2008 and 2009 the company repeatedly disclosed in filings and letters to shareholders that it expected to file by specific deadlines a premarket approval application with the FDA to obtain permission to market and sell a diagnostic system for breast cancer. In fact there was no reasonable basis for making such projections since the company did not have sufficient cancer cases to finish the clinical trials and could not pay for clinical sites. The company also failed to disclose in its MD&A that it did not pay payroll taxes. The complaint alleges violations of Securities Act Section 17(a)(2) and Exchange Act Sections 10(b) 13(a), 13(b)(2)(A), 13(b)(2)(B), 14(a) and 16(b). The case is pending. See Lit. Rel. No. 3486 (Sept. 18 2013).

Municipal bonds: In the Matter of Public Health Trust of Miami-Dade County, Florida, File No. 3-15472 (September 13, 2013). Respondent Public Health Trust is a quasi-governmental agency that operates the public health system in Miami-Dade County Florida under a local ordinance and state law. In early 2009 the System began discussions with the County regarding a new bond issue. The County would be the issuer of the bonds. Repayment would come solely from the revenue of Public Health Trust. At the same time the System had a rising level of patient accounts receivable, declining cash available and significant questions about its receivables. The 2009 bond offering was made before those questions were resolved. The Official Statement for the offering contained a projection representing that absent corrective action, the System would experience a $56 million non-operating loss for fiscal year 2009. There was no reasonable basis for this projection, according to the Order. The Official Statement also claimed to contain financial information for an eight month period ended May 31, 2009 but in fact it was for the period ended April 30, 2009. As a result a loss from operations reported as $255 million was in fact $290 million. Finally, the System failed to account for an adverse arbitration award involving patient accounts in 2008. That award was omitted from the 2008 audited financial statements which were thus incorrectly represented as being prepared in accord with GAAP. The Order alleges violations of Securities Act Sections 17(a)(2) and (3). To resolve the proceeding Public Health Trust consented to the entry of a cease and desist order based on the Sections cited in the Order. The Commission took into account the remedial efforts of the System including the fact that it retained an outside consultant.

Investment fund fraud: SEC v. Scott, Civil Action No. CV 13-5113 (E.D.N.Y. Filed September 13, 2013) is an action against registered investment adviser Fredrick Scott. The Commission’s complaint alleges violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Advisers Act Sections 203(a) and 207. The claims center on allegations that Mr. Scott used his status as a registered investment adviser to raise money from investors which he then misappropriated. A more detailed discussion of the allegations in this action is contained in the discussion of U.S. v. Scott below. The Commission’s case is pending.

Excessive fees: In the Matter of Sarkauskas and Associates, Inc., Adm. Proc. File No. 3-15471 (Sept. 13, 2013) is a proceeding against registered investment adviser Sarkauskas and Associates (registration withdrawn because AUM fell below the minimum level) and its founder, James M. Sarkauskas. The Order alleges that over a three year period beginning in August 2009 the Respondents collected excessive fees by purchasing unit investment trust units bearing transactional sales charges in client accounts when the identical units were available at net asset value with no transactional sales charges. Those actions were in violation of Advisers Act Sections 206(1) and (2). To resolve the proceeding the Respondents consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, Mr. Sarkauskas is barred from the securities business and from participating in any penny stock offering. Respondents will jointly and severally be responsible for the payment of disgorgement in the amount of $331,433.98 along with prejudgment interest. Mr. Sarkauskas will also pay a penalty of $100,000 within one year of the date of the Order.

Criminal cases

Investment fund fraud: U.S. v. Hatfield, CR 09 1195 (N.D. Calif.) is an action against Rodney Hatfield and Lloyd Myers. Previously, Mr. Hatfield pleaded guilty to conspiracy to commit wire fraud. Through Landmark Trading Company, LLC Mr. Hatfiled is alleged to have solicited members of his Jehovah’s Witness congregation to invest in trading foreign currency. Initially, he did in fact invest in currency. After quickly suffering losses Mr. Hatfield began distributing false account statements to investors to conceal the losses. While some investors were repaid others suffered losses. Overall investors lost about $1 million. Mr. Hatfield was sentenced to serve 30 months in prison this week.

Investment fund fraud: U.S. v. Scott (E.D.N.Y.) is an action in which SEC registered investment adviser Frederick Scott pleaded guilty to a two-count information charging him with conspiracy to commit wire fraud and making false statements to the SEC. Mr. Scott’s firm, ACI Capital Group LLC claimed to have about $3.7 billion in assets under management. Mr. Scott is alleged to have engaged in a scheme which caused over $1million in investor losses. Working with intermediaries who helped search for investors, Mr. Scott promised that funds invested would be used to provide short-term financing to businesses associated with ACI. Investors would be paid very high rates of return. In fact Mr. Scott misappropriated the funds. The date for sentencing has not been set. The SEC filed a parallel case, cited above, which is pending.

Circuit courts

Section 5 liability: SEC v. CMKM Diamonds, Inc., Nos. 11-17021, 11-17025 (9th Cir. Decided September 10, 2013) is an action in which the Court reversed a grant of summary judgment against Global Stock Transfer, LLC and its owner Helen Bagley.

The case centered on the issuance of shares in CMKM Diamonds, a company with no business, whose shares were quoted in the Pink Sheets. Principals of the company arranged for the number of authorized shares to be increased to 800 billion. Over the two year period about 622 billion shares were issued. The transfer agent was Global Stock Transfer and its owner Helen Bagley. During 2003 and the first half of 2004 Ms. Bagley relied on opinion letters authored by attorney and defendant Brian Dvorak. In June 2004 Ms. Bagley requested that the Dvorak opinions be confirmed by another law firm, Edwards & Angell LLP. That firm confirmed the opinions. Nevertheless, the SEC filed a complaint against Global, Ms. Bagley and others alleging violations of Securities Act Section 5. It alleged violations of Securities Act Section 5. The district court granted the Commission’s motion for summary judgment.

The Ninth Circuit reversed. Section 5 of the Securities Act makes it unlawful for any person to sell or offer to sell an unregistered security. Liability under the Section is not limited to the person or entity who ultimately passes title. Rather, the Section reaches those who are the proximate cause of a sale. Here the undisputed facts do not establish that Global and Ms. Bagley were substantial participants as a matter of law. The firm and its owner reviewed the opinion letters of two law firms. It issued the unrestricted shares. Those facts, the Court held, are insufficient to establish “that Global and Bagley were substantial factors as a matter of law. Based upon this evidence, a reasonable jury could conclude that Global and Bagley were not substantial participants in the CMKM scheme.


Controls: The Financial Conduct Authority settled with JPMorgan based on the London Whale trading debacle, discussed above. The firm paid a fine of £137,610,000.

Suitability: The FCA fined AXA Wealth Services Ltd. £1,802,200 for failing to ensure it gave suitable investment advice to customers. From mid-September 2010 to the end of September 2012 the firm sold about 37,000 investment products to 26,000 retail customers without always ensuring that the products were suitable for the customers, that they could handle the risk and without informing them of the reasons for the investment recommendation. Customers will be notified, compensated for losses and given an opportunity to avoid future losses if they still retain the product.


The Australian Securities and Investments Commission announced that the former CEO of West Australian hotel chain Compass Hotel Group Ltd., Bryan Nortcote, had been sentenced to serve two years in prison. Mr. Nortcote pleaded guilty to breaching his duties as a director and submitting misleading documents to the ASIC. The charges stem from the fact that in 2007 and 2008 Mr. Nortcote failed to disclose to the board of directors that a company he owned entered into an arrangement with a hotel broker whereby it would receive 50% of all the sales commissions paid by Compass Hotel Group and that through that arrangement he was paid over $1 million dollars either directly or through his companies.

Hong Kong

The Securities and Futures Commission commenced disciplinary proceedings against Wong Yuk Kwan, the chairman of Peral Oriental Oil Limited, and Ma Yueng-Lin, Li Jiong Jenny, Yip Sui Kuen Kitty and Yik Siu Hung. The allegations center on a claim that Mr. Kwan, with the assistance of the others, attempted to circumvent that Takeover Code by avoiding the obligation to make a general solicitation to all shareholders when he consolidated his control over the company. The arrangement traces to late 2009 when Mr. Wong and Ms. Yik sold a U.S. gas and oil filed to the company in return for shares. While Mr. Wong had a significant stake in the company, and the new shares would have triggered in obligations under the statue, through a series of sham transactions with the other defendants he made it appear that his holdings were below the required threshold for a general solicitation.

Program: Celesq and West Legal Ed present: Financial Fraud: Avoiding the Path of the New SEC Investigative Priority, online on September 25, 2013 at 12:00 p.m. EST (here).

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