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
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
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
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
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.
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
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.
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.
For more commentary on developing securities
issues, visit SEC Actions, a blog by Thomas
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