SEC Chair Mary Jo White declared that 2014 will be a very busy year for the Division of Enforcement. At the same time fellow Commissioner Michael Piwowar discussed the actions of banking regulators on issues being considered by the Commission.
The Commission brought a series of cases this week. Those included actions regarding: false advertising by an investment adviser; the failure of a broker to have systems adequate to respond to staff requests for information; an insider trading case; a proceeding against an investment adviser for conducting improper cross trades and a second action for not notifying clients of an error that caused certain losses; and an action against an audit firm for a violation of the independence requirements. The SEC also issued a Report of an investigation discussing auditor independence and moved to dismiss without prejudice a subpoena enforcement action against a PRC based affiliate of an international audit firm in view of the documents produced and cooperation.
Finally, the Second Circuit clarified the source of the law underlying the classic theory of insider trading. In a private action alleging insider trading, the Court held that it is federal common law.
Remarks: Chair Mary Jo White addressed the 41st Annual Securities Regulation Institute, Coronado, California (Jan. 27, 2014). Her remarks reviewed the 2014 agenda for the agency including technology, rule making and enforcement (here).
Remarks: Commissioner Michael Piwowar delivered remarks titled Advancing and Defending the SEC’s Core Mission to the U.S. Chamber of Commerce, Washington, D.C. (Jan. 7, 2014). His remarks discussed the Commissioner’s prior proposals regarding a study of equity market structure and a pilot program regarding tick size, a review of regulations, the intrusion of banking regulators into areas of Commission responsibility and the need for money market reform (here).
Alert: The Commission issued an Alert titled Investment Advisers’ Due Diligence Processes for Selecting Alternative Investments. It reviews current industry trends and deficiencies observed during several examinations (here).
Remarks Commissioner Scott O’ Malia delivered remarks titled We Can Do Better: It’s Time to Review Our Rules and Make Necessary Changes as the Keynote address to the Industry 2014 Conference, Commodity Markets Council (Jan. 27, 2014). In his remarks the Commissioner discussed improvements in the use of data by the agency, progress on swap trade execution and the need to aid end users (here).
SEC Enforcement – Filed and Settled Actions
Statistics: This week the Commission filed or announced the filling of 2 civil injunctive, DPAs, NPAs or reports and 5 administrative proceedings (excluding follow-on and Section 12(j) proceedings).
False advertising: In the Matter of Navigator Money Management, Inc., Adm. Proc. File No.. 3-15707 (Jan. 30, 2014) is a proceeding against the registered investment adviser and its principal, Mark Grimaldi who served as president and CCO. From about 2008 through 2012 the Respondents issued false and misleading advertising regarding its investment advice, the performance of a mutual fund managed by the adviser and its ratings by Morning Star. The Order alleges violations of Securities Act Section 17(a), Advisers Act Sections 206(4-1(a)(2), 206(4)-1(a)(5) and 206(4)-8 and Investment Company Act Section 34(b). To resolve the proceeding the firm agreed to implement a series of undertakings which include the retention of an independent compliance consultant, an agreement to adopt the recommendations of that consultant and to provide notice to advisory clients. In addition, each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order and to a censure. Mr. Grimaldi will pay a civil penalty of $100,000.
False statements: SEC v. Rothman, Civil Action No. 2:12-cv-5412 (E.D. Pa.) is a previously filed action against registered representative David Rothman. The complaint alleged that he falsified client account statements and then, when discovered, tried to cover it up by offering to pay the clients the sums reflected in the statements. When he could no longer make the payments he misappropriated funds from anther client for whom he acted as a trustee. The action was resolved and the court entered a final judgment against Mr. Rothman, prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). In addition, the order requires Mr. Rothman to pay disgorgement of $505,431. See Lit. Rel. No. 22914 (Jan. 30, 2014).
Data systems: In the Matter of Scottrade, Inc., Adm. Proc. File No. 3-15702 (Jan. 29, 2014) is a proceeding against the brokerage firm for failing to produce complete blue sheet information in response to staff requests during enforcement investigations. Specifically, from 2006 through 2012 the broker furnished the agency incomplete blue sheet data due to a coding error in its systems. The error was discovered following a 2011 request by the staff for certain data which was determined to be incomplete. As a result the firm willfully violated Exchange Act Section 17(a) and the related rules thereunder, according to the Order. To resolve the proceeding the broker admitted “the Commission’s jurisdiction over it and the subject matter of these proceedings.” Scottrade agreed to implement a series of undertakings including the retention of a consultant and essentially agreed to implement recommendations included in the report that is to be prepared. In addition, the firm consented to the entry of a cease and desist order based on the Sections and rules cited in the Order, to the entry of a censure and to pay a civil money penalty of $2.5 million.
Insider trading: SEC v. Dombrowski, Civil Action No. 1:14-cv-00622 (N.D. Ill. Filed Jan. 28, 2014) is an action against Steven Dombrowski, a CPA who worked in the corporate audit department of Allscripts Healthcare Solutions, Inc. Through his position with the firm Mr. Dombrowski learned that the firm’s first quarter financial results would be below expectations. During a trading black out period imposed by the firm, and prior to the April 26, 2012 announcement date of the financial results, he shorted the firm’s shares and purchased options. After the announcement date he covered his short position and sold the options, yielding illegal profits of $286,211.55. The trades were done through his wife’s account who is named as a relief defendant. The complaint alleges violations of Exchange Act Section 10(b) and each subsection of Securities Act Section 17(a). The case is in litigation. The U.S. Attorney for the Northern District of Illinois announced a parallel criminal case. See Lit. Rel. No. 22913 (Jan. 29, 2014).
Audit work papers: SEC v. Deloitte Touche Tohmatsu CPA Ltd., Civil Action No. 1:11-MC-00512 (D.D.C. Filed Sept. 8, 2011) is a previously filed subpoena enforcement action brought against the PRC based audit firm. It sought the audit work papers regarding former firm client Longtop Financial Technologies Ltd. The staff recently received a substantial volume of documents called for by the subpoena including audit work papers and certain other documents. In view of this, and the cooperation of the audit firm, the parties have agreed to request that the Court dismiss the proceeding without prejudice. See Lit. Rel. No. 22911 (Jan. 27, 2014).
Improper cross-trades: In the Matter of Western Asset Management, Co., Adm. Proc. File No. 3-15688 (Jan. 27, 2014). This action against the registered investment adviser centers on improper cross trades that took place from 2007 through 2010. Generally, Sections 17(a)(1) and (2) of the Investment Company Act prohibit any affiliated person of a registered investment company from knowingly selling a security to, or purchasing a security from, the investment company absent first obtaining an order from the Commission. Excluded are certain transactions that meet the requirements of Rule 17a-7 regarding the parties and pricing. ERISA also prohibits investment advisers from engaging in cross trades unless certain criteria are met. In a number of instances during the financial crisis, the firm engaged in unlawful cross trades. Specifically, Western Asset engaged in pre-arranged trades through a dealers’ representative. Under that arrangement the dealer would purchase securities from Western Asset’s selling clients and then resell the same securities to the purchasing clients. The firm did not seek an order from the Commission permitting the transactions. By interposing the dealer, the firm caused the affected client accounts to engage in prohibited cross trades. The transactions also violated ERISA. The cross-trades involving the dealer also were not priced in accord with Rule 17a-7. Rather, the sale transactions were executed at the highest current independent bid and the repurchase transactions at a small prearranged markup over the sale price. Under this method one client was favored over another with the full benefit allocated to the buying clients. By not exposing the cross trades to the market, Western Asset saved market costs of about $12.4 million. The selling clients were deprived of their share of the market saving, about $6.2 million. During the period the firm’s compliance systems and controls failed to identify the impermissible cross trading. The Order alleges violations of Sections 17(a)(1) and (2) of the Investment Company Act as well as Sections 206(2) and 206(4) of the Advisers Act. The firm resolved the proceeding, implementing certain remedial acts which include an agreement to distribute $7,440,881 to compensate certain impacted clients. In addition, Western Asset consented to the entry of a cease and desist order based on the Sections cited in the Order and to a censure. The firm will pay a civil money penalty of $1 million.
Failure to notify clients of error: In the Matter of Western Asset Management Co., File No. 3-15689 (Jan. 27, 2014). In January 2007 the registered investment adviser purchased $50 million of the initial offering of Glen Meadow, a $500 million private placement. The preliminary prospectus stated that an eligible purchaser excluded employee benefit plans subject to ERISA. Through a coding error Western Asset’s automated compliance system, relied on to ensure compliance with restrictions regarding the type of securities that could be acquired for various accounts, incorrectly stated that the Glen Meadow securities were ERISA eligible. In October 2008 the firm learned from an email sent by a former institutional client that the Glen Meadow securities were not ERISA eligible. Western Asset identified the accounts impacted but did not notify the clients. Eventually the securities were sold at a loss. Clients were never informed of the error. The Order alleges that the firm violated Advisers Act Sections 206(2) and 206(4). The firm should have promptly disclosed the error to clients no later than December 2008, according to the Order. The firm also failed to have adequate compliance policies and procedures requiring the notification of clients. To resolve the matter the firm agreed to implement a series of undertakings. The firm also consented to the entry of a cease and desist order based on the Sections cited in the Order, to a censure and agreed to pay disgorgement of $8,111,582, prejudgment interest and a civil money penalty of $1 million.
Independence: In the Matter of KPMG LLP, Adm. Proc. File No. 3-15687 (Jan. 24, 2014); SEA Release No. 71390, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: KPMG, LLP (Jan. 24, 2014). The proceeding centers on questions of independence. Rule 2-01 of Regulation SX specifies that auditors be independent of their SEC audit clients in fact and appearance. It contains a non-exhaustive list of non-audit service which an auditor cannot provide to its audit clients. The proceeding focuses on the relationship of the audit firm with three unidentified audit clients. First, with respect to Company A, and SEC audit client, beginning in late 2008 and continuing through the end of 2009, KPMG hired an employee who recently retired from a senior position with a company affiliate and loaned that person back to the same affiliate. The loaned employee performed essentially the same function after being loaned back as before. This arrangement violated the independence rules. Second, the Order alleges that with respect to Company B the audit firm provided prohibited non-audit services to an affiliate. KPMG was the outside auditor to Company B from 2005 through December 2011. In September 2006 Company B became an affiliate of a large financial services firm when one of that firm’s subsidiaries acquired all the shares of a controlling affiliate of Company B. At the same time the financial services firm became the owner of Company B’s General Partner which owned and controlled Company B. The audit firm’s failure to identify the independence issue for a period resulted in a violation. Finally, with respect to Company C, KPMG also provided prohibited non-audit services to an audit client such as bookkeeping and payroll services. The Order alleged violations of Rule 2-02(b) of Regulation S-X, Rule 10A-2 and of the Exchange Act and Section 13(a) and the related rules. As a result the firm engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) of the Commission’s Rules of Practice. To resolve the matter the audit firm agreed to implement certain undertakings it proposed which include enhancing its ability to educate and monitor compliance by its personnel with respect to independence requirements and to the retention of an independent consultant with whom the firm will fully cooperate. KPMG also consented to the entry of a cease and desist order based on the Sections and Rules cited in the Order and a censure. In addition, the firm will pay disgorgement of $5,266,347, prejudgment interest and a civil money penalty of $1,775,000.
The related Report focuses on the question of loaned staff by audit firms. Specifically, the investigation found that from 2007 through 2011 KPMG entered into loaned staff engagements with multiple SEC audit clients. Those arrangements involved loaned staff of non-management level KPMG professionals who performed junior level tasks related to tax compliance. With respect to the issues raised by the actions of KPMG, the Report makes three points: First, an auditor “may not provide otherwise permissible non-audit services . . . to an audit client in a manner that is inconsistent with other provisions of the independence rules . . .” Second, an auditor is not independent when a current “professional employee of the accounting firm is employed by the audit client.” Third, the provisions of Rule 2-01 regarding “acting as an employee” require careful consideration of “whether the relationship or service in question would cause the accounting firm’s professionals to resemble, in appearance and function . . . the employees of the audit client.” Finally, each case must be viewed based on the specific facts and circumstances, according to the Report. The question of independence is not just a legal issue but also an ethical duty. Thus in certain situations, even if the legal requirement is not implicated, in view of the ethical requirements the “best course may be for the accountant to recuse himself or herself from an audit engagement” or, alternatively decline the non-audit engagement.
Manipulation: U.S. v. Fernandez, No. 1:11-cr-00062 (S.D.N.Y.) is a proceeding in which David Levy and Donna Levy were convicted following a jury trial of orchestrating a pump and dump scheme. Mr. Levy was also convicted of money laundering. This week Mr. Levy was sentenced to serve nine years in prison. Donna Levy will be sentenced on February 5, 2014. In the pump and dump scheme the defendants offered to coordinate marketing and investor relations for companies in return for shares. They then engaged in campaigns using false publicity. As the share price rose they dumped their stock. The process was repeated over and over until the shares were worthless. In addition, Mr. Levy, in an effort to conceal over $2.3 million in proceeds from the schemes in Panamanian shell company bank account wired transferred $150,000 in fraud proceed to a Panamanian shell company bank account through a New York account. He also carried over $2 million in checks which were part of the scheme proceeds to Panama and caused it to be deposited into the shell company accounts.
AML procedures: The regulator fined Baronte-lxe Securities International, Ltd. $475,000 for having inadequate anti-money laundering systems and procedures and for failing to register about 200 to 400 foreign finders. It also suspended for thirty days the firm’s AML Officer and CCO, Brian Simmons. The firm is based in NYC and services Mexican clients investing in the U.S. The finders interact with the firm’s Mexican clients. As a result of the failures, the firm opened an account for a corporate customer owned by an individual with reputed ties to a drug cartel. It also failed to detect, investigate or report the suspicious rapid movement of $28 million in and out of the account. If the firm had done a standard Google search in response to the movement of funds it would have learned that one of the owners of the corporate customer had been arrested by Mexican authorities in February 1999 for alleged ties to a Mexican drug cartel.
Court of appeals
Insider trading: Steginsky v. Xcelera, Inc., Nos. 13-1327-cv; 13-1892-cv (2nd Cir. Jan. 27, 2014). This is an action arising out of the purchase of plaintiff’s shares by the defendants. It alleges manipulation and insider trading. Plaintiff Gloria Steginsky is a former minority shareholder of Xcelera Inc., a Cayman Islands holding corporation based in Connecticut. Each of the individual defendants is an officer and or director of Xcelera: Alexander Vik, is COB and CEO; Gustav Vik, Director, EVP, secretary and treasurer; and Hans Erik Olav is a director. The two corporate defendants are controlled by the Vic defendants. VBI Corporation, owned by Alexander Vick and Erik Vik (Gustav’s father) is the controlling shareholder of the firm. OFC Ltd. was created in 2010 by the Vick defendants as a vehicle to acquire the share of Xcelera.
The complaint alleges that the shares of Xcelera, which at one time were listed on the American Stock Exchange and traded as high as $110 per share, were driven down in value by the defendants when they stopped making periodic filings with the Commission. That resulted in the revocation of its registration statement and a $0.25 share price. At that point plaintiffs sold her shares to OFC. Plaintiff then filed a complaint alleging a series of claims including violations of Exchange Act Sections 10(b) and 14(e). The district court dismissed the complaint.
The Second Circuit affirmed the dismissal of a market manipulation and Section 14(e) claims while vacating the dismissal of the insider trading claim under Section 10(b).
First, the market manipulation claim is time barred the Court ruled. A securities fraud claim must be filed not later that the earlier of either two years after discovery of facts constituting the violation or five years after that violation. Here the alleged manipulation was the failure to make SEC filings which caused the price to plummet. That began in 2004, more than five years before the complaint was filed.
Second, plaintiffs can assert a claim for insider trading under Section 10(b). Under the classic theory of insider trading Section 10(b) is violated when a corporate insider trades in the securities of his or her company on the basis of material, nonpublic information. Here the complaint alleges that the defendants, while in control of the company, purchased the shares without disclosing any information about the firm. That is adequate under the classic theory – the misappropriation theory, which “targets non-insiders, is not applicable here. The district court’s conclusion that the defendants had no duty to disclose under the circumstances here because the shares are not registered and Cayman Island law governs the company is incorrect. By its plain terms the statute applies to any securities transaction. Furthermore, the duty of insiders is derived from federal common law, not state law.
Finally, the Court affirmed the dismissal of the Section 14(e) claim. That Section, and the related rule, provide that if any person has taken substantial steps toward a tender offer it is unlawful for another person who is in possession of inside information relating to the tender offer to trade. In this instance, however, the complaint alleges not that someone possessed inside information about the tender offer but that the offer itself was made by corporate insiders who possessed material nonpublic information. Accordingly, the Court remanded the Section 10(b) claim to the district court.
The Australian Securities and Investments Commission announced charges against Knstoffer John Wells, a day trader, for market manipulation. Specifically, on three occasions in 2011 and 2012 Mr. Wells entered into positions known as a contract for a difference in relation to certain securities. In each instances he created a false or misleading appearance with respect to the price for the traded securities. A contract for a difference is an agreement between an investor and a CFD issuer which allows a trader to speculate on future price movements in a financial product. The value of the CFD correspondents to that of the product. Here the defendant traded through a direct market access account. The CFD issuer hedged its exposure to the client trading position by causing an equivalent position to be taken in the underling security on the exchange.
Due diligence failures: The Securities and Futures Appeals Tribunal affirmed the decision of the Securities and Futures Commission to reprimand brokerage Sun Hung Kai International Ltd., suspend its license to provide advisory services on corporate finance for one year and to the imposition of a fine of $12 million. The sanctions were imposed in connection with the failure of the firm to conduct adequate due diligence regarding the listing of Sino-Life Group Ltd. on the Growth Enterprise Market Board of the Stock Exchange of Hong Kong Ltd. The due diligence failures included not adequately assessing the completeness of the information provided, failing to determine the existence of certain encumbrances and selectively disclosing information to the exchange.
Insider trading: The SFC initiated proceedings against the former chairman of Asia TelMedia Ltd., Lu Ruifeng, and three former executives, Yui Hoi Ying, Marian Wong Nam and Cecilia Ho King Lin, for insider trading. Specifically, the agency alleged that the defendants had material non-public information regarding a wind up petition for the firm based on a debt that would make the firm insolvent. While in possession of that information they traded in firm shares, avoiding losses of over $50,000. Eventually the firm went into liquidation.
For more commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.
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