High speed trading and conflict of interest in the market place were the topics of the week. Two Senate committees held hearings on the issues which were the focus of the Michael Lewis book Flash Boys and its claim that the markets are rigged.
The Senate Permanent Subcommittee on Investigations heard testimony on conflicts in the market from witnesses which include Bradley Katsuyama, President of IEX Group, Inc., a dark pool, and the central character in the book by Mr. Lewis. In his written testimony Mr. Katsuyama noted certain conflicts but did not claim the markets were rigged.
The Senate Subcommittee on Securities, Insurance and Investment heard testimony from witnesses regarding the impact of high speed trading on the markets. Hal Scott, a Harvard Law School Professor, told the subcommittee in his oral testimony that HFT has not “negatively affected our secondary markets.”
The SEC brought three actions this week. One was its first concerning whistleblowers. The Commission also brought an action centered on a serial insider trading ring and an investment fund case.
SEC Enforcement – Filed and Settled Actions
Statistics: This week the Commission filed, or announced the filing of, 2 civil injunctive actions, DPAs, NPAs or reports and 1 administrative proceeding (excluding follow-on and Section 12(j) proceedings).
Insider trading: SEC v. Lazorchak, Civil Action No. 12-07164 (D. N.J.) is a previously filed action against Michael Pendolino, Lawrence Grum and Michael Castelli. It alleged insider trading over a five year period involving illegal tips by insiders at Celgene Corporation, Sanofi-Aventis Corporation and Stryker Corporation. The three defendants each previously pleaded guilty to charges of conspiracy to commit securities fraud and/or securities fraud and have been sentenced. This week the Court entered judgments against each by consent, which permanently enjoin each defendant from future violations of Exchange Act Sections 10(b) and 14(e). Messrs. Pendalino, Grum and Castelli were each ordered to pay disgorgement and prejudgment interest in the amount of, respectively, $68,862.12, $838,758.75 and $716,208.90. See Lit. Rel. No. 23024 (June 17, 2014).
Whistleblowers: In the Matter of Paradigm Capital Management, Inc., Adm. Proc. File No. 3-15930 (June 16, 2014) names as Respondents Paradigm, a registered investment adviser, and Candace King Weir, its founder, director, president and CIO. Ms. Weir also owns about 74% of C.L. King & Associates, Inc., a registered broker dealer. Paradigm advises a hedge fund. Beginning in 2009, and continuing for the next two years, Paradigm sought to reduce the tax liability of Fund investors. A plan was implemented under which securities with unrealized losses were either sold into the open market or to a trading account at C.L. King. The trading losses were then used to offset realized gains. Since all of the transactions between Paradigm and C.L. King were principal transactions, written disclosure was required to the Fund. The Fund did not have a board of directors to receive the disclosures and consent. Accordingly, a Conflicts Committee was established to review the transactions. It had conflicts since a member was the CFO of both Paradigm and the broker. Thus effective notice was not given. Pardigm’s former head trader voluntarily made a whistleblower submission to the Commission. Later he informed his employer and was effectively forced to resign. The Order alleges violations of Exchange Act Section 21F(h), and Sections 206(3) and 207 of the Advisers Act.
To resolve the proceeding Respondents agreed to implement a series of undertakings, including an obligation to distribute $1.7 million to compensate certain investors in the Fund for administrative fees paid in connection with the principal transactions. The firm will also retain a consultant whose recommendations on procedures will be adopted. Paradigm consented to the entry of a cease and desist order based on the Sections cited in the Order. Ms. Weir consented to the entry of a similar order but based on Section 206(3) of the Advisers Act. In addition, Respondents agreed to pay, jointly and severally, disgorgement of $1.7 million, prejudgment interest and a civil penalty of $300,000. The $1.7 million payment will be deemed satisfied by the distribution to investors in the undertakings.
Insider trading: SEC v. Khan, Civil Action No 14-cv-2743 (N. D. Cal. Filed June 13, 2014) is an action against Saleem Khan, Ammar Akbari, Roshanlal Chaganlal and Ranjan Mendonsa. Mr. Khan, at one time a registered broker, met Messrs. Mendonsa and Aldari through his employment. Mr. Chaganlal was employed first as a director and later as the senior director of shortage control in the finance department of Ross Stores, Inc. He met Mr. Khan when the two men were employed at the same company in the late 1990s. Over a three year period beginning in June 2009, Messrs. Khan, Chaganlal and Mendosa participated in a serial insider trading ring, repeatedly trading on inside information regarding the financial condition of Ross. Through his position with the company Mr. Chaganlal had access to material non-public information regarding its sales which were announced monthly. Prior to each monthly sales announcement from August 2009 through December 2012 – over 40 monthly reports — Mr. Chaganlal furnished material non-public information to Mr. Khan, according, to the Commission. Prior to each announcement there was a series of telephone calls between the men. Prior to each announcement Mr. Khan traded Ross options in his brokerage account and another held in the name of his brother-in-law, Shahid Khan. The profits for both accounts totaled nearly $12 million, with $5.4 million in Defendant Kahn’s account and $6 million in the account of his brother-in-law. Mr. Khaganlal was terminated by Ross in December 2012 which is when trading ended. During the scheme Mr. Khan also tipped his Messrs. Mendonsa and Akbari. Each traded, reaping profits of, respectively, $800,000 and $2,000. Mr. Khan also engaged in a second insider trading scheme. He traded while in possession of inside information in the shares of Taleo Corporation. That firm was acquired on February 9, 2012 by Oracle Corporation. Prior to the announcement of the transaction, Mr. Kahn learned about the deal from a friend at Oracle. Six days prior to the deal announcement he began purchasing Oracle options. Ultimately, after the deal announcement, he had profits of $450,000. The Commission’s complaint alleges violations of Exchange Act Section 10(b). The case is in litigation.See Lit. Rel. No. 23022 (June 13, 2012).
Prior to the filing of the Commission’s complaint, Mr. Khan was charged in a criminal case with making false statements to a financial institution and bank fraud. The indictment alleged that his hardship letter seeking agreement from a bank on a proposed “short sale” of residential real estate failed to disclose the profits from the illegal securities trades Mr. Khan pleaded guilty to both counts of the indictment and was sentenced to serve 21 months in prison and directed to pay a $60,000 criminal fine. U.S. v. Khan, CR 12 860 (N.D. Cal.).
Investment fund fraud: SEC v. Schmidt, Civil Action No. 1:14-cv-01002 (D.D.C. Filed June 12, 2014) is an action against Lawrence P. Schmidt, Futuregen Company, Commercial Equity Partners Limited and seven other controlled entities. Mr. Schmidt has a long and well documented history as a law violator. His current scheme began in May 2008 with the formation of Commercial Partners. The firm had a website which described its leadership team, listing their names and background. The individuals listed do not exist, according to the complaint. Mr. Schmidt was listed only as the Senior Vice President of the Tax Lien Department. The firm sold unregistered notes to investors. Investor funds were to be used for the purchase of tax liens. The next year Mr. Schmidt formed FutureGen and the FutureGen funds. The company issued debt securities which promised payment of a fixed rate of return. The investor funds were supposed to be invested in tax liens, commercial mortgages and distressed debt. While the entities controlled by Mr. Schmidt were supposed to be separate, in fact they were not. FutureGen serviced clients of Commercial Partners. The investor funds were co-mingled. While portions of the investor funds were invested as claimed, other portions were not. Mr. Schmidt also took substantial sums of the money for his personal expenses. Over time the corporate defendants could not meet their obligations to investors as they became due, although about $22 million had been raised from investors. Eventually Mr. Schmidt fled the country. The Commission’s complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b), 20(a) and 20(e). The case is pending. See Lit. Rel. No 23021 (June 13, 2014).
Fund fees: Merrill Lynch was fined $8 million by the regulator and has or will repay $89 million to retirement accounts and charities that were overcharged. Typically Class A mutual fund shares, which have lower fees that other classes, charge an up-front fee. Many waive that fee for retirement accounts and charities. Most of the funds available at Merrill Lynch have such waivers. Since 2006 Merrill Lynch did not provide the waivers. As a result about 41,00 small business retirement plan accounts, 6,800 charities and 43 retirement accounts available to ministers and employees of public schools either paid sales changes when purchasing Class A shares or purchased other share classes that unnecessarily subjected them to higher ongoing fees and expenses. Although Merrill Lynch learned its small business retirement plan customers were overpaying the firm continued to sell the accounts the more costly shares and did not report the issue to FINRA for more than five years. The firm’s supervisory procedures provide little information on the point.
Selective disclosure: The Australian Securities and Investments Commission filed an action against Newcrest Mining Limited. The action alleges that in two instances the firm briefed analysts on material inside information prior to releasing it to the public. In one instance the information concerned the mine production of the firm. I the other, the information focused on the firm’s financial results. The company admitted liability. The parties recommended penalties totaling $1.2 million to the Court. The final decision on penalties is reserved for the Court.
Accounting: The European Securities and Market Authority published a report on the application of accounting requirements for business combination in IFRS financial statements. It is based on a review of 56 issuers. The report calls for improvement in the information furnished by providing: Additional relevant information about the factors determining the amount of goodwill or reasons for bargain purchases; furnishing more granular disclosure on the assets and liability recognized; applying consistent assumptions in the initial recognition and subsequent measurement of assets and liabilities; and improving the information furnished on valuation techniques and assumptions when measuring fair value of assets and liabilities.
Failure to secure written instructions: The Securities & Futures Commission banned Li Tak Wa, formerly affiliated with Kaiser Securities Ltd., from re-entering the securities industry for fifteen months. The penalty was imposed for knowingly recording incorrect information about a client in account opening forms; effecting transactions in the client account without obtaining written permission; and conducting more than two day trades and opening short positions without obtaining the specific, written authorizations as required. While there was evidence the client gave oral approval for the trades, this fails to comply with the requirement for written authorization which can be reviewed by the firm. In addition, more than two day trades and a short position require a specific written approval.
The Securities and Exchange Surveillance Commission recommended to the prime minister and the commissioner of the Financial Services Agency that a penalty of 15 million yen be imposed on Airex Inc. The recommendation is based on making false statements with regard to filings in which the firm recorded fictitious sales, overstated inventory and overstated assets.
Corruption: The Serious Frauds Office prevailed in its first overseas corruption trial, securing a jury verdict in its favor and against two former Innospec executives. The case stems from a referral by the DOJ following FCPA actions by the Department and SEC. The SFO’s case was brought against Dennis Kerrison and Mitiades Papachristos. Mr. Kerrison is a former CEO of Innospec Limited. Dr. Papachristos is the former Regional Sales Director for the Asia Pacific region. Both were charged with, and convicted of, conspiracy to commit corruption. The underlying scheme took place over a six year period beginning in 2002. During that period bribes were paid to government officials in Indonesia in connection with the sale of Innospec products which included Tetraethyl Lead or TEL. That substance is a highly dangerous compound created as an octane booster to be added to engine fuel. Leaded fuel that contained the substance was banned in the U.K. in 2000. Although the Indonesian government wanted to eliminate the use of TEL, the bribery scheme significantly extended its use in that country. Both defendants were implicated in the bribes. Previously, the company and two executives pleaded guilty. The sentencing for Messrs. Kerrison and Papachristos, and the two executives who previously pleaded guilty, is expected to take place on July 25, 2014. This will conclude the SFO’s investigation related to Innospec.
Promotional advertising: The Financial Conduct Authority fined Credit Suisse and Yorkshire Building Society, respectively, £2,398,100 and £1,429,000 for financial promotional failures. The failures related to the Credit Suisse Cliquet Product. It was designed to provide capital protection and a guaranteed minimum return with the potential for more based on the performance of the FTSE 100. The probability of achieving only the minimum return was 40 to 50% and of obtaining the maximum, close to 0%. The product was marketed to conservative, unsophisticated investors emphasizing the maximum. In addition, Credit Suisse failed to have procedures in place to periodically review its promotional materials.
For more news and commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.
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