Financial fraud and insider trading have long been priorities for SEC enforcement. Years of enforcement experience should give the agency expertise in these matters. That expertise coupled, with a judicious use of prosecutorial discretion, and a recognition of the impact that allegations of wrongful conduct by a federal agency have, should mean that when a case is filed it is firmly grounded in the facts and law. Recent trial results suggest otherwise and counsel a careful re-evaluation of the process used to evaluate cases before they are filed.
One case is SEC v. Delphi Corporation, Civil Action No. 2:06-cv-14891 (E.D. Mich. Filed Oct. 30, 2006)(discussed here). Following a trial which began in October against former Delphi CEO J.T. Battenberg III and former Chief Accounting Officer Paul Free, the jury rejected all of the Commission's fraud charges. Both defendants were found liable on other charges.
In its complaint the Commission charged that Delphi engaged in a pattern of fraudulent conduct between 2000 and 2004. In addition to the company, there were thirteen individuals named as defendants.
The complaint centered on what is claimed to be four fraudulent schemes used to improperly boost the revenue of the company: 1) In 2000 two schemes were used to conceal a $237 million warranty claim asserted by its former parent company; 2) in the fourth quarter of 2000 Delphi entered into two round trip sham inventory deals which inflated cash flow from operations by $200 million; 3) in the fourth quarter of 2001 the company improperly booked a $20 million payment as if it were a nonrefundable rebate rather than a loan; and 4) from 2003 to 2004 the company hid up to $235 million in factoring or sales of accounts receivables.
Messrs. Batenberg and Free were charged with violations of Securities Act Sections 17(a) and Exchange Act Sections 10(b), 13(b)(5) and aiding and abetting violations of 13(a) and 13(b)(2)(A). The jury rejected the fraud charges while finding for the Commission on others.
To be sure, violations of the books and records provisions and making misstatements to the accountants are serious matters. These charges are not however the same as intentional fraud which is core of the action here. The fact that the company and others chose to settle with the SEC does not validate the exercise of prosecutorial discretion here. Companies frequently settle as a matter of business judgment. Likewise individuals settle for a variety of reasons which may have little to do with the merits of the case. The case centered on fraud charges. The fraud charges failed.
The court's rejection of all of the SEC's claims in its insider trading case against Dr. Zachariah P. Zachariah is even more disturbing. SEC v. Zachariah, Case No. 08-60698 (S.D. Fla. Filed May 12, 2008)(discussed here). There the Commission brought insider trading charges against Dr. Zachariah P. Zachariah, his brother Dr. Mamen P. Zachariah and his friend and colleague, Dr. Sheldon Nassberg.
The complaint centered on two transactions. The first involves the acquisition of IVAX by Teva Pharmaceuticals Ltd., announced on July 25, 2005. According to the SEC, Dr. Zachariah learned about the possible deal in a telephone call from its chairman shortly after joining the board of IVAX. He then purchased IVAX shares despite the fact that a black out period was in effect. Later he tipped his brother who unlawfully traded and profited according to the complaint.
In the second, the Commission claimed that Doctor Zachariah misappropriated material non-public information regarding the acquisition of Correctional Services Corporation or CSC by GEO Group, Inc., announced on July 14, 2005. Here the SEC claimed that from May through July 2005 Dr. Zachariah and his brother and his friend Dr. Nassberg each made purchases of the stock using inside information. According to the complaint, that inside information came from either the chairman of the company, his son or his consulting arrangement with the company.
As in the Delphi case, each of the defendants except Dr. Zachariah settled with the SEC. As in Delphi after trial which here lasted twelve days, the court rejected each of the SEC's fraud charges. In lengthy findings of fact and conclusions of law the Court found in favor of Dr. Zachariah and against the Commission on each claim.
According to the Court's findings, Dr. Zachariah was invited to join the IVAX board by its chairman, Dr. Phillip Frost. He attended his first board meeting on April 29, 2005. Prior to that time Dr. Zachariah, who had a very substantial income and net worth, had a history of trading securities including IVAX. He had little experience as a director but was knowledgeable about drugs being developed by the company. While IVAX had on and off acquisition discussions with Teva for a considerable period of time, the testimony established that this subject was not discussed at the board meeting.
The SEC's evidence center around telephone calls made by Dr. Frost on July 6, 2005. Following a meeting with Teva in New York Dr. Frost telephoned certain directors he considered his "inner circle" to inform them that the company was considering making a bid at $26 per share. The phone calls were made from his private plane and channeled through his Miami office.
The testimony established that defendant Zachariah was not in the "inner circle." Dr. Frost testified that he did not recall any telephone call from the plane to Dr. Zachariah. Phone records from his company office however showed that a call was made at 2:02 p.m. to the main line of Dr. Zachariah's medical offices which lasted 3 minutes and 18 seconds. There was no evidence about who answered the phone or any conversation. Telephone records from the plane also reflected a call at 2:04 to Dr. Frost's office. That calls was, according to the records, made while the 2:02 call from his office was in progress. According to Dr. Zachariah's trading records on July 6 at 2:04 he purchased shares in IVAX while the blackout period was in effect.
The court rejected the SEC's claim these phone calls and the trade supported their claim. Not only was there no direct evidence that the two men spoke, but, more importantly, Dr. Frost could not have been talking to Dr. Zachariah from the plane on the 2:02 call and make another call at 2:04 while the first was in progress. This, the Court concluded was not possible. While it is true that Dr. Zachariah did in fact trade during the black out period, there is no evidence that he had any inside information. Indeed, the undisputed evidence established that the trade was part of a number of purchases Dr. Zachariah made to increase his holdings in company shares to equate with those of other directors - a practice which is consistent with that of other directors. It also demonstrated he was not aware of the black out period.
In final argument the Commission claimed that the telephone records from the plane were off by three minutes. The Court found however that "no witness, whether from one of the phone service provides or otherwise, testified to reconcile the apparent discrepancies in the phone records. This simply underscores the unreliability of this pone record evidence for use in drawing the inferences that the SEC seeks to draw."
The Court also rejected the Commission's misappropriation claim regarding trading in the shares of CSC. Here the record demonstrates that all three defendants periodically discussed securities transactions and traded. Dr. Zachariah had traded in the shares of companies in the correctional services industry including CSC. He also recommended the stock to others and had done research on it. His largest purchase of CSC shares was on May 19, 2005, the day after he printed out information from his computer about the company. That same day there was a spike in the volume of trading for the company.
At trial the SEC presented what the Court called "a multiple choice theory" as to how Dr. Zachariah obtained inside information prior to the July 14, 2005 deal announcement. One option was his relation with George Zoley, CEO of the company; a second was his son who worked at GEO; the third, his consulting role for the company.
The multiple choice theory failed. First, the Court noted that the SEC had not charged George Zoley or the defendant"s son, Reggie Zachariah. Second, there was no credible evidence that Mr. Zoley tipped the Doctor. Both men testified and denied this claim. Other testimony established that Mr. Zoley would in fact protect confidential information. While the SEC claimed that Mr. Zoley may have tipped Dr. Zacharriah in a May 18 telephone call or during a trip the men took to Washington on June 13 - 15, after which the defendant purchased more shares, the evidence does not support this claim. Indeed, the trading records demonstrate that the shares the Commission claimed were purchased after the trip were actually acquired with a limit order place on June 10 before the travel.
Reggie did in fact have access to information about the deal. The Court found his denials of wrong doing credible however. He is currently employed as a law clerk to a federal judge. Indeed, during the SEC's lengthy cross examination his testimony was candid according to the Court. And, the fact that he spoke to his father on the phone as argued by the SEC is of little moment since the father and son spoke daily on the telephone.
Finally, the Court rejected the SEC's claim that Dr. Zachariah had access to inside information from his consulting work. That was a limited engagement and the "work had nothing to do with CEO's planned acquisition of CSC . . . " the Court found.
Two trials. Two losses for the SEC. The individuals were found not liable of fraud. Yet those individuals have had their reputations not just tarnished but forever damaged. Dr. Zachariah and Messrs. Battenberg and Free have had to endure being viewed by the world as fraudsters - an allegation of wrongdoing by law enforcement officials such as the SEC is typically treated in the market place as proof of wrongful conduct. That "proof" never goes away.
To be sure it is important that the SEC and other law enforcement officials be aggressive and file charges when appropriate. At the same time the SEC has significant investigative authority to gather the facts. It has experienced and very talented lawyers and professionals to sift that evidence carefully to make sure any action brought is firmly grounded in the facts. As it undertakes that process it is critical that the agency recall the impact of its charging decisions. It is also critical, in view of the impact of that impact, that any error be made on the side of not bringing a case to avoid the injustice and injury that flows from a wrongful decision and accusation.
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