The Financial Crisis Inquiry Commission issued its report
this week noting that the crisis was avoidable, there was a widespread failure
of financial regulation and a systematic breakdown in accountability and
ethics. At the same time the SEC continued to issue regulations under
Dodd-Frank and sent a study to congress on standards for those who give
investment advice.
Insider trading continued to be a key focus of regulators
with more Galleon related cases being filed. A prison sentence was handed down
in an FSA insider trading case. The SEC also settled another FCPA action.
The CFTC conducted a sweep, filing suits against fourteen
firms in four courts. These are the first suits to enforce the new forex
regulations which went into effect last fall.
Market reform
The Financial Crisis Inquiry Commission issued its report on the financial
crisis. The report details the findings of the Commission regarding the causes
of the crisis. The Commission was not charged by congress with making
recommendations for legislation.
The overall conclusions of the Inquiry Commission are:
- The crisis was avoidable
- Widespread failures in financial regulation and
supervision proved devastating to the stability of the nation's financial
markets
- A combination of excessive borrowing, risky investment,
and lack of transparency put the financial system on a collision course with
crisis
- The government was ill-prepared for the crisis, and its
inconsistent response added to the uncertainty and panic in the financial
markets
- There was a systemic breakdown in accountability and
ethics
- Mortgage-lending standards and the mortgage
securitization pipeline lit and spread the flame of contagion and crisis
- Over-the-counter derivatives contributed significantly
to this crisis
- The failures of credit rating agencies were essential
cogs in the wheel of financial destruction
The SEC continued to issue rules to implement Dodd-Frank
this week. These include:
- Say-on-Pay: The Commission adopted rules regarding
shareholder approval of executive compensation and golden parachute
compensation arrangements. Under these rules companies will be required to
specify that say-on-pay votes will occur at lest every three years. They will
also be required to hold a "frequency" vote at least every six years to permit
shareholder to decide how often they want to be presented with the say-on-pay
vote. Additional disclosures will also be required regarding "golden parachute"
compensation.
- Accredited investors: The SEC proposed rules for the
adoption of new standards for accredited investors which would exclude the
value of the investor's primary residence in determining net worth.
- Disclosure by private funds: The Commission proposed
rules which would require a registered investment adviser who manages one or
more private funds to periodically furnish certain information which would
remain confidential. The information is for use by the Financial Stability
Oversight Council in monitoring risk to the U.S. financial system.
The Commission also released a staff Study Recommending a
Uniform Fiduciary Stand of Conduct for Broker-Dealers and Investment Advisers.
The study proposes that the standard be at least as stringent as the current
standard for investment advisers under the Advisers Act. Commissioners Kathleen
Casey and Torey Paredes opposed the release of the study arguing it does not
fulfill the statutory mandate of Section 913 of Dodd-Frank which requires it to
evaluate the effectiveness of existing legal and regulatory standards on this
subject.
SEC Enforcement
Insider trading: SEC v. Cardillo, Civil Action No. 11-CV-11 civ 0549
(S.D.N.Y. Filed Jan 26, 2011). Michael Curdillo, a former trader at Gelleon
Management, LP is alleged to have traded while in possession of inside
information in violation of Exchange Act Section 10(b). The information
concerned the acquisitions of 3Com and Axcan. As a result of that trading the
fund made over $730,000 in trading profits. The information traces to two Ropes
and Grey associates, Arthur Cutillo and Brien Santarias, who misappropriated
it. They then tipped Zivi Goffer, a former trader at Schottenfeld Group LLC
known as "Octopussy" because of his many sources of information. Mr. Goffer in
turn furnished the information to a trader who worked in the Galleon offices,
who furnished it to Mr. Cardillo. Previously, Mr. Cardillo pleaded guilty to
criminal charges. The SEC case is in litigation.
Insider trading: SEC v. Smith,
Civil Action No. 11-CV-0535 (S.D.N.Y. Filed Jan. 26, 2011) is an action against
Adam Smith, a former portfolio manger of the Galleon Emerging Technology funds.
The complaint states that Mr. Smith obtained inside information about the take
over of ATI Technologies, Inc. by Advanced Micro Devices Inc. The information
came from a source that Mr. Smith had known for years. While in possession of
the information Mr. Smith caused the Galleon funds he advised to purchase ATI
shares. Those shares were later sold at a profit of over $1.3 million. The
complaint alleges a violation of Exchange Act Section 10(b). The case is in
litigation.
In the matter of Merrill Lynch, Pierce,
Fenner & Smith, Inc., Admin. Proc. File No. 3-14204 (Jan.
25, 2011) alleges that the firm misused customer order information, charged
certain customers undisclosed trading fees and failed to maintain proper
records in violation of Exchange Act Sections 15(c)(1)(A), 15(g) and 17(a). The
conduct on which the Order is based occurred from 2002 through 2007 and centers
on three types of transactions. The first concerned the use of certain customer
order information by the firm's proprietary Equity Strategy Desk. The second
involved improper mark-up and mark-down charges on orders for certain
institutional and high net worth individuals, contrary to the firm's
representations to those customers. Finally, in some instances during the time
period Merrill agreed to guarantee a customer a specific per-share execution
price or a price tied to an agreed upon benchmark. The firm however failed to
record them in writing as required by Section 17(a)(1). As a result of this
conduct Merrill violated not only the Sections cited above but it also failed
to reasonably supervise persons subject to its supervision as required by
Section 15(b)(4)(E). To resolve the matter Merrill consented to the entry of a
cease and desist order and agreed to pay a $10 million civil penalty.
Market manipulation: SEC v. Metcalf,
Civil Action No. 11 Civ 0493 (S.D.N.Y. Filed Jan. 24, 2011) is an action
against Christopher Metalf, Bonzidar Vukovich and Pantera Petroleum, Inc.
alleging violations of Securities Act Section 17(a) and Exchange Act Section
10(b). The complaint claims that Mr. Metcalf, the president and CEO of Pantera,
and Mr. Vukovich engaged in a scheme to manipulate the price of Pantera shares.
Specifically, the Commission alleged that in March and August 2008 defendant
Vukovich provided detailed instructions to a person identified only as
Individual A to purchase blocks of Pantera stock using matched trades.
Individual A, and the registered representatives he supposedly represented,
claimed to have discretion over the accounts of wealthy individuals. The
individual defendants promised Individual A a 30% kickback on the transactions.
The case is in litigation.
Insider trading: SEC v. Nacchio,
Civ. No. 05-cv-480 (D. Colo.) is an action against former Quest Communications
CEO Joseph Nacchio, discussed here. This week the court entered a final
judgment against Mr. Nacchio. In the settlement Mr. Nacchio consented to the
entry of a permanent injunction prohibiting future violations of Securities Act
Section 17(a) and Exchange Act Sections 10(b), 13(b)(5) and from aiding and
abetting violations of Sections 13(a), 13(b)(2). He also agreed to disgorge
$44,632,464 and interest. No penalty was assessed in view of the result in the
related criminal case.
Insider trading: SEC v. Fan,
Case No. C11-0096 (W.D. WA. Filed Jan. 18, 2011) is an action against
Defendants Zizhong (James) Fan and Zishen (Brandon) Fan and relief defendant
Junhua Fan, all relatives (here). James was employed at biotech company Seattle
Genetics as the manager of clinical programming. Brandon resides in Chino
Hills, California while Junhua lives in Beijing, China. James and his team were
involved in clinical trials for a drug known as SGN-35, a product to treat
Hodgkin's lymphoma. His direct reports had access to data about the trials in
July and August 2010. Between August 24 and September 24, 2010 Brandon is
alleged to have purchased over 2,750 Seattle Genetics options at a cost of
$360,000. The contracts were acquired through Junhua's account. During this
same period James repeatedly attended meetings involving the key trial on the
drug and the late September deadline for disclosing those results to the
public. On September 27 the company issued a press release and conducted a
webcast to disclose the results The price for company shares increased about
18%. Brandon liquidated the options at a profit of $803,000 over the next
month. Subsequently the SEC staff contacted both defendants on January 13,
2011. Over the next few days there were repeated efforts to transfer the money
first to a domestic account and later to a bank in China. James also announced
he was leaving for China. The Commission filed an action alleging violations of
Exchange Act Section 10(b) and obtained a temporary freeze order. The case is
in litigation.
Sale of unregistered securities: SEC v. Wall
Street Communications, Inc., Civil Action No. 8:09-cv-1046 (M.D.
Fla.) is an action against Howard Scalia and his company, Wall Street
Communications as well as Ross Barall and Donald McKelvey. The complaint
alleged manipulative schemes including one in which Wall Street and Mr. Scalia
acquired large blocks of thinly-traded microcap companies for little or no
consideration and then created a market for the shares using either spam emails
or coordinated manipulative trading with accounts controlled by Mr. Barall. The
second scheme was alleged to have involved the illegal acquisition of 8.6
million shares of Telco-Technology under a Form S-8 registration statement.
After acquiring the shares they were allegedly sold in a fraudulent
unregistered offering with half of the proceeds going to a company controlled
by Mr. McKelvey. The complaint alleged violations of Securities Act Sections 5
and 17(a) and Exchange Act Sections 10(b). This week the Commission settled
with Defendant McKelvey who agreed to the entry of a permanent injunction
prohibiting future violations of Securities Act Sections 5, 17(a)(2) and
17(a)(3). Questions regarding disgorgement, prejudgment interest and a civil
penalty are reserved for the court. The Commission dropped all scienter based
charges.
Rule 105, Reg M: In the Matter of Horseman
Capital Management, L.P., Adm. Proc. File No. 3-14202 (Jan. 24,
2011) is a proceeding naming as a Respondent Horseman Capital, a London based
partnership which manages four funds, two of which are in the U.S. The firm is
registered with the FSA in the U.K. According to the Order, from the middle of
2007 through the summer of 2008 Respondent maintained short positions in the
stocks of several financial institutions including Merrill Lynch. On July 29,
2008 Merrill shares were sold in a follow-on offering. During the restricted
period Respondent increased its short position in Merrill by 75,000 shares.
This violated Rule 105 of Reg M which generally prohibits the purchase of
securities in an offering if that person sold short the security during the
restricted period. To resolve the proceeding Respondent consented to the entry
of an order directing that it cease and desist from committing or causing any
violations and any future violations of Rule 105 of Regulation M. The order
also directed Respondent to pay disgorgement of $1,295,138 along with
prejudgment interest and to pay a civil penalty of $65,000.
CFTC
The Commission filed actions against fourteen foreign
currency firms in a nationwide sweep. The actions were brought simultaneously
in Chicago, the District of Columbia, Kansas City and New York. Twelve of the
cases allege that the firm acted as a Foreign Exchange Dealer without
registering with the Commission. Each of the cases claims that the defendant
solicited or accepted orders from U.S. investors to enter into forex
transactions in violation of the Act. These are the first actions brought by
the FTC to enforce the new forex regulations which became effective in October
2010. The cases are in litigation.
Criminal cases
U.S. v. Lang
(E.D.N.Y.) is an action naming as defendant William Lang, president of Harbor
Funding Group, Inc. and Joseph Pascua, the president of Black Sand Mine, Inc.
The indictment charges each defendant with conspiracy to commit securities and
wire fraud and securities and wire fraud. It is based on two alleged schemes.
One is an advance fee scheme in which the defendants told land developers who
had clients seeking to build houses in regions affected by Hurricane Katrina
that Harbor Funding had funds to lend in return for the payment of an advance
fee. About $9 million was raised from 300 individuals. In fact the defendants
did not have the funds to lend but kept the fees. In the second the defendants
induced investors to invest in Black Sand Mine claiming it was starting to mine
gold and other precious metals on Sitkinak Island in Alaska. The marketing was
done through webinars and in person presentations. The representations were
fraudulent.
FCPA
SEC v. Jennings,
Case No. 1:11-cv-00144 (Filed Jan. 24, 2011) is a settled FCPA action against
Paul W. Jennings, the former CFO and CEO of Innospec, Inc. The complaint
focuses on two key schemes. One involves Iraq and in part the U.N. Oil for Food
Program while the other is based on bribes paid in Indonesia. In Iraq the
company began paying bribes to sell its fuel additive as early as 2000. In 2001
it began paying bribes in connection with the U.N. program. In Iraq the company
paid bribes, according to the court papers, totaling over $1.6 million and
promised more than $880,000 in illegal payments. The company also paid for
gifts, entertainment and travel. In Indonesia Innospec is alleged to have paid
bribes from about 2000 through 2005 to obtain about $48.5 million in contracts
from state owned oil and gas companies. Defendant Jennings is alleged to have
been involved with some of the bribery schemes beginning in late 2004. He also
failed to report the bribes involved in the U.N. program to the auditors after
learning about them. Mr. Jennings settled the action by consenting to the entry
of a permanent injunction prohibiting future violations of Exchange Act
Sections 30A, and 13(b)(5) and from aiding and abetting Innospec's violations
of Exchange Act Sections 30A, 13(b)(2)(A) and 13(b)(2)(B). He also agreed to
disgorge $116,092 along with prejudgment interest and to pay a civil penalty of
$100,000. The settlement considers the cooperation of Mr. Jennings.
Antonio Perez, the former controller of a Florida based
telecommunications company, was sentenced to twenty-four months in prison based
on FCPA violations. The court also directed that Mr. Perez serve two years of
supervised release following the prison term and forfeit $36,375. Mr. Perez
admitted that he conspired to bribe officials from Telecommunications D'Hati to
obtain business. He also admitted to conspiring with Juan Diaz and Robert
Antoine, the former director of International relations for Telecommunications
D'Hati. Mr.Perez stated that he was personally involved with two bribe payments
totaling the amount of the forfeiture.
Court of appeals
Dronsejko v. Grant Thornton,
Nos. 09-4222 and 10-4074 (10th Cir. Jan. 20, 2011) is a securities class action
against the auditors of iMergent. The complaint centered on an alleged improper
revenue recognition scheme at the company between October 2002 and October 2005
which materially overstated revenue and resulted in a restatement of the
financial statements. Specifically, the claims were based on the revenue
recognition policy of the company. Under that policy revenue could be
recognized on the sale of licenses based on Extended Payment Term Arrangements
under certain circumstances. GAAP permits such recognition if there is
persuasive evidence of an arrangement, the delivery of the product has
occurred, the fee is fixed and determinable and collectability is probable.
Here the company recognized 100% of the revenue from these arrangements despite
the fact that it collected on average only 53% of the total purchase price. In
its 2003 and 2004 10Ks the firm stated that 47% of its extended payment term
sales were uncollectable. The SEC had told the company that the collection rate
had to be substantially more than 50% to recognize the revenue. Plaintiffs
claimed that the unqualified audit opinions of the defendant were false and
misleading. The district court dismissed the case, concluding that plaintiffs
had failed to adequately plead a strong inference of scienter. The circuit
court affirmed.
Initially the circuit court noted that the third, fourth,
sixth and ninth circuits had developed a recklessness standard specifically for
Section 10(b) claims involving outside auditors. This standard is "especially
stringent" and requires "a mental state so culpable that it approximates an
actual intent to aid in the fraud being perpetrated by the audited company."
(internal quotes omitted). Here the court concluded that it need not consider
this issue since under any standard the complaint is deficient. The issue
raised here is based on a claim that although the audit firm knew the facts
about the collection rate, that it was reckless in concluding that a 53%
collection rate constituted "probable collectability" under the applicable
principles which do not define those terms. While various sources use different
definitions of "probable collectability" the court held that the failure of the
audit firm to use those sources does not constitute recklessness. Likewise the
magnitude of the restatement is of no import since it does not speak to the
issue of recklessness. Indeed, it is well established that GAAP violations only
support a claim of scienter when coupled with evidence of the defendant's
fraudulent intent to mislead investors. That is not the case here.
FSA
Suitability: Barclays Bank plc
was fined about $11.5 million by the agency for failures in relation to the
sale of two funds. From July 2006 through November 2008 the bank sold Aviva's
Global Balanced Income Fund and Global Cautious Income Fund to 12,331 investors
for over $1 billion. In connection with these sales the bank failed to ensure
the funds were suitable for customers, did not give adequate training to its
sales staff, failed to ensure that materials provided to customers clearly
explained the risks and did not have adequate procedures to monitor the sales
process. Approximately one in seven investors have complained. Barclays has
been conducting a review of the sales and has paid over $25 million in
compensation. The FSA estimates up to $65 million more may need to be paid to
customers
Insider trading:
Neil Rollins, former senior manager of PM Onboard Limited, was sentenced
following a verdict finding him guilty of insider trading. Mr. Rollins has been
found guilty on five counts of insider dealing and four counts of money
laundering. The trading followed the acquisition by Mr. Rollins of information
suggesting his company would have poor financial results. He traded in shares
of his company prior to the announcement of the results. He also encouraged his
wife to do the same. When the FSA began its inquiry he laundered the proceeds
in an effort to conceal his activities. The court sentenced him to 27 months in
prison and order him to pay almost $300,000 in confiscation.
For
more news involving securities issues, visit SEC Actions, a
blog by Thomas Gorman