This week the Supreme Court heard argument in one securities
case while agreeing to review another. The cases involve critical questions
regarding materiality and the application of loss causation in the class
certification process.
The Commission brought another insider trading case which
is an outgrowth of the seemingly ever expanding Galleon investigations and
another against a corporate officer and his tippees. Other actions brought by
Enforcement focus on events during the market crisis, financial fraud and
investment fund fraud.
Finally, the PCAOB entered into an important agreement
with its counterpart in the U.K. Under the new agreement the Board will be able
to conduct inspections of U.K. based audit firms that perform audits on
companies whose securities are traded in the U.S.
Supreme Court
Matrixx Initiatives v. Siracusano (S/Ct. No.09-1156). This week the
Court heard oral argument in this case. The question the Court will consider
focuses on whether a pharmaceutical manufacturer must disclose adverse drug
reports which are statistically immaterial. The Ninth Circuit reversed the
dismissal of the complaint by the district court, holding that the reports are
material. The circuit court rejected the statistical standard adopted from the
Second Circuit by the district court (here).
Erica P. John Fund, Inc. v. Halliburton Co,
No. 09-1403. The Supreme Court agreed to hear this case in which the question
is: "Whether, in a private action under Section 10(b) of the Securities
Exchange Act of 1934 . . a plaintiff who invokes the fraud-on-the market
presumption of reliance must prove loss causation in order for the suit to be
maintained as a class action" (here).
The case arises from a decision of the Fifth Circuit Court of Appeals in The
Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., No. 08-11195
(5th Cir. Feb. 12, 2010). The complaint in that case is based on three
categories of claimed misstatements relating to Halliburton's acquisition of Dresser
Industries. The Fifth Circuit affirmed the district court's denial of class
certification, concluding that plaintiffs had failed to establish loss
causation by a preponderance of the evidence.
SEC Enforcement
Insider trading: SEC v. Holle
(D.N.J. Filed Jan. 13, 2011) names as defendants George Holly, co-founder of
Home Diagnostics, Inc., and its former chairman, and two of his friends and
business associates Steven Dudas and Phairot Iamnaita. The complaint alleges
that prior to February 3, 2010 when there was a public announcement of the
acquisition of Home Diagnostics by Nipro Corporation, Mr. Holly tipped
Defendants Dudas and Iammaita along with four others identified only as Traders
1,2,3 and 4. Each traded and profited from the 89% increase in the share price
which followed the deal announcement. Collectively the tippees realized profits
of over $250,000. The complaint alleges violations of Exchange Act Sections
10(b) and 14(e). The case is in litigation.
Trading/compensation: SEC v. CytoCore,
Inc., Civil Action No. 1:11-c-00246 (N.D. Ill. Jan. 13, 2011) names as
defendants the company and Daniel Burns, its former COB and CEO and CFO Robert
McCullough, Jr. The complaint alleges violations of Securities Act Section
17(a) and Exchange Act Sections 10(b), 14(a), 15(a) and 16(a). It focuses on
Mr. Burns, alleging that he: issued a press release touting his stock ownership
in the company and then secretly sold his shares while in possession of
material, non-public information; received hundreds of thousands of dollars in
improper compensation from acting as an unregistered broker for the sale of
company shares; and failed to report over 100 stock transactions. Mr.
McCullough also failed to properly report his stock sales according to the
Commission. The company and Mr. McCullough settled, consenting to the entry of
injunctions. The company also agreed to certain undertakings. Mr. McCullough
agreed to pay a $100,000 civil penalty and to the entry of a twelve month
suspension from association with a broker-dealer or investment adviser. The
case is in litigation as to Mr. Burns.
Financial fraud: SEC v. Nutracea (D.
Az. Filed Jan, 13, 2011) is an action against NutraCea, a manufacturer of
health food, its former CEO and director Bradley Edson, former CFO Todd Crow,
former controller Joanne Kline, former director of financial services Scott
Wilkison and former senior v.p. and secretary, Margie Adelman. The complaint
alleges that the company concealed its true operating results using two
fraudulent transactions. In one it booked $2.6 million in sales from a sham
transaction. In the other it improperly recorded about $1.9 million in sales
from a book and hold transaction. The complaint alleges violations of the
antifraud and books and records provisions.
The company settled by consenting to the entry of an
injunction prohibiting future violations of Securities Act section 17(a) and
Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B). Mr. Edson
consented to the entry of a permanent injunction prohibiting future violations
of the antifraud and books, records and internal control provisions along with
the payment of a $100,000 civil penalty, an agreement to repay a $350,000 bonus
and an officer/director bar. Ms. Adelman also consented to the entry of a
permanent injunction prohibiting future violations of Exchange Act Sections
10(b) and 15(b)(5) and the books and records provisions. She also agreed to the
entry of a five year officer and director bar. Messrs. Kline and Wilkinson
consented to the entry of permanent injunctions prohibiting future violations
of Exchange Act Section 13(b)(5). Each also agreed to pay a penalty of $25,000.
Each man agreed to the entry of an order in an administrative proceeding based
on Rule 102(e) which will prohibit them from appearing and practicing before
the Commission as an accountant with a right to reapply after one year. The
case against Mr. Crow is continuing.
Investment fund fraud: SEC v. Nadel,
Civil Action No. 11-CV-0215 (E.D.N.Y. Filed Jan. 13, 2011) is an action against
Warren Nadel, his broker-dealer, Warren D. Nadel & Co. and his investment
advisory firm, Registered Investment Advisers, LLC. The complaint centers on
claims that clients were fraudulently induced to invest millions of dollars in
an investment program that was suppose to be liquid and generate capital
appreciation or dividends. In fact the funds were put in instruments that were
not liquid. The defendants overstated the value of the investments and their
liquidity. They also generated over $8 million in commissions and fees by
largely trading back and forth among themselves without disclosing these facts
to the investor clients who were told the trades were made in the open market.
The complaint charges violations of Securities Act Sections 17(a), Exchange Act
Section 10(b) and Advisers Act Sections 206(1), (2), (3) and 207. The case is
in litigation.
Misappropriation: SEC v. Sachdeva,
Civil Case No. 10-CV-747 (E.D. Wis. Filed Aug. 31, 2010) is an action against
the former Principal Accounting Officer, Secretary and Vice-President of
Finance of Koss Corporation. The complaint centers on a claim that Mr. Koss
embezzled $30 million from the company (here). Mr. Koss settled the case by
consenting to the entry of a permanent injunction prohibiting future violations
of Exchange Act Sections 10(b) and 13(b)(5) and from aiding and abetting
violations of Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). The order also bars
him from serving as an officer or director. In a related criminal case the
defendant pleaded guilty to six counts of wire fraud and was ordered to pay $34
million in restitution and sentenced to 11 years in prison.
Insider trading: SEC v. Macdonald,
Civil Action No. 09-CV-5352 (S.D.N.Y. Filed June 10, 2009) is an action against
Canadian attorney Phillip Macdonald and others. As to Mr. Macdonald, the
complaint alleges that he traded in advance of the public announcement on
business combination deals between January and June 2005 while in possession of
inside information. He obtained that information, according to the Commission,
from co-defendant Michael Goodman who misappropriated it from his wife, an
administrative assistant with Merrill Lynch Canada, Inc. (here). Mr. Macdonald settled with
the Commission, consenting to the entry of a permanent injunction prohibiting
future violations of Exchange Act Sections 10(b) and 14(e). He also agreed to
pay disgorgement of $810,000. Two co-defendants previously settled.
Disclosure fraud: SEC v. NIC, Inc., Civil
Action No. 2:11-CV-02016 (D. Ka. Filed Jan. 12, 2011); SEC v Kovzan, Civil
Action No. 2:11-CV-02017 (D. Da. Filed Jan. 12, 2011). These actions were
brought against NIC, a company which manages government websites, and its
former CEO, Jeffery Fraser, current CEO, Harry Herington, former CFO, Eric Bur
and current CFO, Stephen Kovzn. The complaints allege violations of Exchange
Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B), 13(b)(5), 14(a) and
Securities Act Section 17(a). The cases center on claims that from 2002 through
2005 Mr. Fraser falsely claimed that he worked essentially for free while
charging many of his expenses to the company. Those included $4,000 per month
to live in a ski loge in Wyoming, monthly cash payments for rent for a home owned
by an entity he controlled, travel costs, and other perquisites. Mr. Kovzan, as
then Chief Accounting Officer, authorized the payments and knew or was reckless
in not knowing that they circumvented company policy. Mr. Herington learned of
the problems and failed to address them. The reporting problems, which are
reflected in Commission filings, continued even after a whistleblower complaint
and the initiation of the SEC's investigation.
The company settled, consenting to an injunction
prohibiting future violations of the Sections cited in the complaint and agreed
to hire an independent consultant to recommend new policies. Mr. Fraser also
consented to the entry of a substantially similar injunction and agreed to pay
disgorgement in the amount of $1,184,246 along with prejudgment interest, a
$500,000 civil penalty and the entry of an officer director bar. Mr. Herington
also settled, consenting to the entry of an injunction on similar terms and
agreed to pay a civil penalty of $200,000. He also consented to the entry of an
order in an anticipated administrative proceeding which will prohibit him from
practicing before the Commission as an accountant with a right to reapply after
one year. Mr. Bur also settled, consenting to the entry of an injunction prohibiting
future violations of Exchange Act Rules 13a-14 and 13b-1 and aiding and
abetting NIC's violations of Exchange Act Sections 13(a), 13(b)(2)(A),
13(b)(2)(B) and 14(a) and the related rules. He also resolved an anticipated
administrative proceeding by consenting to the entry of an order prohibiting
him from appearing or practicing before the Commission as an accountant with a
right to reapply after one year. The case against Mr. Kovzan is in litigation.
Boiler room: SEC v. Petroleum Unlimited, LLC, Civil Action No.
9:11-CV-80038 (S.D. Fla. Filed Jan. 12, 2011) is an action alleging violations
of Securities Act Section 17(a) and Exchange Act Sections 10(b) and 15(a) and
naming as defendants the company, and Petroleum Unlimited II, LLC along with
Roger Kimmel, Jr. and Harry Nyce and the claimed managers of their boiler room
Michel-Jean Geraud, Robert Rossi and Joseph Valko. The complaint alleges that
over a five month period beginning in March 2008 the individual defendants
conducted offerings using private place memoranda which were materially false
and misleading to sell interests in the entities. The funds purportedly were to
explore for oil and gas. About $2.9 million was raised. The offering circulars
failed to inform investors that commissions would range from 49% to 74% while
claiming that they could be paid annual returns of 14% to 141% without any
reasonable basis. Ultimately little of the money raised was used for drilling.
To resolve the case, the two entities and Mesrs. Kimmel, Nyce and Petitti consented
to the entry of permanent injunctions. The two companies and Mr. Kimmel agreed
that issues regarding disgorgement and penalties would be resolved by the
court. Mr. Nyce agreed to pay disgorgement of $242,339 along with prejudgment
interest and a penalty of $65,000. Mr. Petitti also consented to the entry of
an injunction and agreed to pay a civil penalty of $25,000. See also In the
Matter of Michael Geraund, Adm. Proc. File No. 3-14187 (Jan. 12,
2011)(Order is based on Respondent's criminal convictions for conspiracy to
commit mail fraud and conspiracy to defraud the U.S. in an income tax evasion
scheme).
In the Mater of Charles Schwab Investment
Management, Adm. Proc. File No. 3-14184 (Jan. 11, 2011); SEC v.
Charles Schwab Investment Management Inc., Civil Action No. CV-11-0136
(N.D. Cal. Jan. 11, 2011). The two actions are against: Charles Schwab
Investment Management (CSIM), a registered investment adviser; Charles Schwab
& Co., Inc. (CS&Co.), the distributor and transfer agent for the YieldPlus
Fund; and Schwab Investments, a no-load, open ended management investment
company organized as a series investment company registered under the
Investment Company Act. The YieldPlus Fund is a series issued by Schwab
Investments. The actions center on four primary claims (here). First, the SEC alleged that
investors were not properly informed about the risks of the Fund. Second, the
Fund violated its concentration policy as the market spiraled down during the
crisis. Third, misrepresentations were made to investors about the Fund as its
NAV began to decline in mid-2007. Finally, the Commission claimed that there
were insufficient policies and procedures reasonably designed to prevent the
misuse of material, non-public information about the Fund.
The SEC's complaint and the Order allege violations by:
CSIM and CS&Co. of Securities Act Sections 17(a)(2) and (3) and aiding and
abetting and causing violations of Investment Company Act Section 34(b); by
CSIM of Advisers Act Section 206(4); by Schwab Investments of Investment
Company Act Section 13(a); and by CS&Co. of Exchange Act Section 15(g). To
settle the civil action CSIM and CS& Co. agreed to pay a total of
$118,944,996 including $52,327,149 in disgorgement of fees by CSIM, a penalty
by CSIM of $52,327,149, a penalty of $5,000,000 by CS&Co. and prejudgment
interest. CSIM's disgorgement obligations can be satisfied in part by payment
within 60 days in a related FINRA proceeding of up to about $26.9 million. The
Commission is seeking to establish a Fair Fund. In the related administrative
proceeding CSIM, CS&Co. and Schwab Investments consented to the entry of an
order requiring them to cease and desist from committing or causing future
violations of the sections cited above. CSIM and CS&Co, were also censured
and required to retain an independent consultant. Each Respondent was directed
to comply with its undertakings.
Two other related actions were brought based on similar
allegations. One names as defendant Kimon Daifotis, the former Senior Vice
President and Chief Investment Officer-Fixed Income of CSIM and Randall Merk, a
former Executive Vice President at Charles Schwab Corporation and an Executive
Vice President at CS&Co. The charges in the complaint include violations of
Exchange Act Section 10(b), Securities Act Section 17(a), Advisers Act Section
206(4) and Investment Company Act Section 34(b). The case is in litigation. SEC
v. Daifotis, Case No. CV-11-0137 (N.D. Cal. Jan. 11, 2011).
The second was brought by FINRA. The agency ordered
Charles Schwab & Company, Inc. to pay $18 million into a Fair Fund
established by the SEC. That sum represents the $17.5 million in fees Schwab
collected on the sales of Fund shares plus a fine of $500,000.
Insider trading: SEC v. Feinblatt,
Civil Action No. 11-CV-0170 (S.D.N.Y. Filed Jan 10, 2011)(here) is an action which is an
outgrowth of the Galleon investigation. It is against Robert Feinblatt and the
company he co-founded, Trivium Capital Management LLC, Jeffrey Yokuty, an
analyst at the company, Sunil Bhalla, formerly a Senior Vice President and
General Manager of Polycom, and Shammara Hussain, formerly an employee of
investment relations firm Market Street Partners which did work for Google. The
SEC's complaint asserts insider trading claims which focus around five key
events: 1) Trading in advance of the announcement of Polycom's fourth quarter
2005 earnings based on a tip from Mr. Bhalla of Pollycom to Ms. Kahn. She then tipped
Messrs. Feinblatt and Yorkuty, each of whom traded along with Trivium. Ms. Kahn
also tipped Raj Rajaratnam who traded. 2) Trading in advance of the
announcement of Polycom's first quarter 2006 earnings announcement. Again Mr.
Bhalla tipped Ms. Khan who in turn told Mr. Rajaratnam about the information.
Ms. Khan traded as did Mr. Rajaratnam for Galleon. 3) Trading prior to the
announcement of Hilton's takeover by Blackstone Group: Deep Shah, a Moody's
analyst tipped Ms. Kahn who told Messrs. Feinblatt and Yokuty about the
transaction. Ms. Kahn along with Messrs. Feinblatt and Yokuty and Trivium
traded. Ms. Kahn also tipped Mr. Rajaratnam who traded for Galleon. 4) Trading
prior to the announcement that Google for the second quarter of 2007 would not meet
expectations. Mr. Hussain, an employee of a firm doing work for Google, tipped
Ms. Khan who traded and passed the information to Messrs. Feinblatt and Yokuty
who traded for Trivium. Ms. Kahn also tipped Thomas Hardin, a former Managing
Director of Lanexa Management, a hedge fund, and Gautham Shankar, a trader at
Schottenfeld Group LLC, who traded. Mr. Rajaratnam was also tipped by Ms. Kahn.
He traded for Galleon. 5) Trading before the announcement that Kranos would be
acquired by a private equity firm: Deep Shah tipped Ms. Khan who traded and
tipped Messrs. Feinblatt and Yokuty who traded for Trivium. Ms. Hussain was
also tipped by Ms. Kahn and traded. The case is in litigation.
Internal controls: In the Matter of Hudson
Highland Group, Inc., Adm. Proc. File No. 3-14182 (Jan. 10, 2011)
is an action based on alleged violations of Exchange Act Sections 13(b)(2)(A)
and 13(b)(2)(B) by Hudson Highland Group. The company was spun off from Monster
Worldwide in 2003. Since that date the company has repeatedly failed to comply
with the tax laws which require it to collect sales taxes from its customers.
As a result the company, which provides professional staffing and talent
management services, had to pay virtually all the uncollected tax. That
amounted to about $3.9 million. The failures result from not having proper
internal controls. The case was resolved with Hudson consenting to the entry of
a cease and desist order based on the two Sections cited in the Order. Hudson
also agreed to pay a civil penalty of $200,000.
Investment fund fraud: SEC v. Kowalewski,
Civil Action No. 1:11-cv-0056 (N.D. Ga. Filed Jan. 7, 2011) is an action
alleging violations of Securities Act Section 17(a), Exchange Act Section 10(b)
and Advisers Act Sections 206(1), (2) and (4) by Stanley Kowaleski and the
company he controls, registered investment adviser SJK Investment Management
LLC. According to the complaint the defendants raised about $65 million for to
hedge funds based on claims that the money would be invested in a number of funds
using complex investment strategies. Small fees would be charged. Instead,
almost immediately the money was diverted into another fund which entered into
a series of self-dealing transactions such as buying Mr. Kowaleski's home and
paying his personal expenses. The Commission obtained a temporary freeze order.
Investment fund fraud: SEC v. Morris, Civil No. 2:11-cv-00021 (D. Utah
Filed Jan. 6, 2011) names as defendants Raymond P. Morris, James Haley, Jay
Lindford, attorney Luc Nguyen and a series of controlled entities. The
complaint alleges violations of Securities Act Sections 5 and 17(a) and
Exchange Act Section 10(b). It alleges that Mr. Morris, assisted by the other
defendants, sold unregistered promissory notes from March 2007 through January
2009 based on a series of misrepresentations. Investors were told they were
purchasing high yield noted and that the funds would be deposited in a secure
account. In fact Mr. Morris diverted portions of the money to his personal use
and made Ponzi type payments with other investor funds. The case is in
litigation.
In the Matter of Kimball L. Young,
File No. 3-1418 (Jan. 7, 2011); In the Matter of Thomas S. Albright,
File No. 3-14179 (Jan. 7, 2011)(here).
Respondents managed The Tax Free Fund for Utah. Beginning in 2003 they started
charging issuers of certain securities purchased by the Fund a "credit
monitoring fee" based on the face value of the instruments. The Respondents
told those charged that the fees went to the Fund. In fact they kept the money
without telling the board. According to the Order, the payments violated
Exchange Act Section 17(e)(1). With respect to Respondent Young, who reviewed
documents which falsely stated that the fee would be paid to the Fund, the
Order also states that he willfully violated Section 206(1) of the Advisers Act
and Section 206(2). To resolve the actions each Respondent consented to the
entry of and order directing that they cease and desist from committing or
causing any violations and any future violations of the Sections cited in the
Order in their respective cases. Mr. Young also agreed to the entry of an order
barring him from association with any broker, deal or investment adviser with a
right to reapply after five years and to pay disgorgement of $260,313 along
with prejudgment interest and a civil penalty of $75,000. Mr. Albright will be
similarly barred with a right to reapply after one year. He will also pay
disgorgement of $260,313 along with prejudgment interest and a civil penalty of
$50,000.
Criminal cases
Option backdating: U.S. v. Karatz,
2:09-cr-00203 (C..D. CA.) is the option backdating case against former KB Home,
Inc. CEO Bruce Karatz (here).
In March 2009 Mr. Karatz was convicted on four counts of mail fraud and making
false statements in connection with the backdating of stock options at the
company. The government at sentencing demanded a six and one half year prison
term and a fine of $7.5 million. It appealed the sentence of 8 months of house
arrest, five years of probation a $1 million fine and 2,000 hours of community
service. Mr. Karatz cross appealed. Both sides agreed to drop their appeal.
PCAOB
The Public Company Accounting Board concluded a cooperative
agreement with its counter part in the U.K., the Professional Oversight Board.
The agreement will permit the PCAOB to resume inspections of U.K. audit firms
that are registered with the board and that audit or participate in the audit
of companies whose securities are traded in the U.S.
The Sarbanes Oxley Act requires that the PCAOB oversee
and periodically inspect all accounting firms that regularly audit companies
whose securities are traded in U.S. markets. From 2005 through 2008 those
inspections were carried out in the U.K. Since that time the Board had not been
able to perform inspections despite the fact that there are 59 registered firms
in the U.K. One of the obstacles to those inspections was removed by Dodd-Frank
which authorized the PCAOB to share confidential information with its foreign
counterparts under certain circumstances.
Currently there are 890 audit firms registered with the
Board in 87 countries outside the U.S.
For more news involving securities issues, visit SEC Actions, a blog by Thomas
Gorman