Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, December 21, 2010

SEC Charges Investment Adviser Firms and former Officers with Hedge Fund Fraud

The SEC charged two San Francisco-based investment adviser firms along with their former CEO, former general counsel, and former portfolio manager with defrauding investors in a $100 million hedge fund that invested in subprime automobile loans.  The SEC found that former CEO Benjamin P. Chui and former portfolio manager Triffany Mok — who managed the American Pegasus Auto Loan Fund — together with former general counsel Charles E. Hall, Jr., engaged in improper self-dealing, misused client assets, and failed to disclose conflicts of interest.

The firms — American Pegasus LDG and American Pegasus Investment Management —and Chui, Hall, and Mok settled the SEC’s charges by agreeing to sanctions including bars from the industry and more than $1 million in penalties and repayments to the fund.

The SEC’s order instituting administrative proceedings finds that unbeknownst to investors, in mid-2007, Chui used more than $18 million in loans and advances from the Auto Loan Fund to buy the fund’s sole supplier of auto loans for himself, Hall, and Mok. This created a pervasive conflict of interest as Chui, Hall, and Mok had a duty to maximize the fund’s performance while at the same time had an interest in generating profits for the loan supplier they secretly owned.

The SEC also found that Chui used millions in cash borrowed from the Auto Loan Fund to prop up other hedge funds he managed. By late 2008, roughly 40 percent of the Auto Loan Fund’s assets consisted of “loans” to the fund managers’ related businesses — with fund investors being charged fees based on these undisclosed related-party payments.

According to the SEC’s order, Chui, Hall, and Mok then essentially wiped much of this debt to the fund off the books by selling assets to the fund at a 300 percent mark-up. Chui, with help from Hall and Mok, purchased an auto loan portfolio for $12 million in February 2009 — then sold it to the Auto Loan Fund the same day for more than $38 million. The fraudulently inflated sale was used to erase money owed to the fund for the various related-party transactions.

The Commission’s order finds violations of multiple antifraud statutes by Chui, Hall, Mok, and their two adviser firms. Without admitting or denying the SEC’s findings, the respondents agreed to the following settlement terms. Chui, who lives in San Carlos, Calif., agreed to pay a $175,000 penalty and be barred from associating with an investment adviser for five years. Hall, who lives in Carlisle, Penn., agreed to pay a $100,000 penalty and be barred from associating with an investment adviser for three years and from appearing or practicing before the Commission as an attorney for three years. Mok, who lives in Fremont, Calif., agreed to pay a $75,000 penalty and be suspended from associating with an investment adviser for one year. The two adviser firms must disgorge $850,000 in management fees deemed improper by the SEC.

December 21, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

New York Sues Ernst & Young Alleging Involvement in Lehman Fraud

As the Wall St. Journal earlier predicted, today the New York Attorney General sued accounting firm Ernst & Young LLP (“E&Y”), charging the firm with helping Lehman Brothers Holding, Inc. (“Lehman”) engage in an accounting fraud involving the surreptitious removal of tens of billions of dollars of fixed income securities from Lehman’s balance sheet in order to deceive the public about Lehman’s true liquidity condition.  (Contrary to some earlier reports, the complaint does not name individual defendants.)

The Attorney General’s lawsuit claims that for more than seven years leading up to Lehman’s bankruptcy filing in September 2008, Lehman had engaged in so-called “Repo 105” transactions, explicitly approved by E&Y. The transactions purpose was to temporarily park highly liquid, fixed-income securities with European banks for the sole purpose of reducing Lehman’s financial statement leverage, an important financial metric for investors, stock analysts, lenders, and others interested in Lehman.

Specifically, Repo 105 transactions involved transfers by Lehman of fixed income securities to European counterparties in return for cash - often at the end of a financial quarter - with the binding understanding that Lehman would shortly repurchase the equivalent securities from these counterparties only a few days later for more money. Lehman then used the cash to pay down liabilities and improve its leverage and balance sheet metrics, while failing to disclose to the investing public the obligation to repurchase the securities at a higher price. Lehman did so, with E&Y’s explicit approval, by characterizing these financing transactions as “sales.” Indeed, the sole purpose of characterizing these transactions as “sales” was to reduce Lehman’s leverage on its financial statements and public filings, thereby deceiving the investing public.

The complaint alleges that E&Y was fully aware of Lehman’s fraudulent Repo 105 transactions, specifically approved of Lehman’s use of them, and gave Lehman an unqualified audit opinion every year from 2001 to 2007, despite knowing that they concealed the Repo 105 transactions. Further, the lawsuit alleges that in 2007 and early 2008, when Lehman was facing demands to reduce its leverage, Lehman rapidly accelerated its use of Repo 105 transactions, removing up to $50 billion from its balance sheet on a quarterly basis without disclosing the use of the Repo 105 transactions.

The complaint also alleges that E&Y failed to object when Lehman misled analysts on its quarterly earnings calls regarding its leverage ratios, and that E&Y did not inform Lehman’s Audit Committee about a highly-placed whistleblower’s concerns about Lehman’s use of Repo 105 transactions.

The Attorney General seeks the return of the entirety of fees E&Y collected for work performed for Lehman between 2001 and 2008, exceeding $150 million, plus investor damages and equitable relief.

December 21, 2010 in News Stories, Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

Monday, December 20, 2010

SEC Finds Auditor Engaged in Improper Conduct in China Energy Fraud

On December 20, the SEC issued an Order Instituting Public Administrative and Cease-and-Desist Proceedings Pursuant to Section 8A of the Securities Act of 1933 and Section 4C of the Securities Exchange Act of 1934 and Rule 102(e) of the Commission's Rules of Practice, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order against Moore Stephens Wurth Frazer & Torbet LLP (MSWFT) and Kerry Dean Yamagata.  In the Matter of Moore Stephens Wurth Frazer & Torbet LLP and K. Dean Yamagata, CPA

The Order finds that Respondents Yamagata and MSWFT engaged in improper professional conduct and violated the document retention and auditor independence requirements of Regulation S-X, in connection with annual audits and quarterly reviews of the 2004 and 2005 financial statements of China Energy Savings Technology, Inc. (China Energy), a U.S. issuer with operations in China. The Order further finds that although Respondents determined that the China Energy engagement involved high risk, they did not exercise professional skepticism and due professional care. The Order finds that Respondents violated applicable professional standards by: (i) failing to obtain sufficient competent evidential matter regarding China Energy's revenues to afford a reasonable basis for MSWFT's opinion regarding the company's financial statements for fiscal year 2005; (ii) failing to exercise professional skepticism and due professional care regarding revenues in the performance of the audit of China Energy for fiscal year 2005; (iii) failing to document significant findings or issues, actions taken to address them, and the basis for the conclusions reached in the fiscal year 2005 audit; (iv) failing to properly supervise assistants, including assistants engaged from outside the firm, in the fiscal year 2004 audit of China Energy; and (v) failing to ensure the independence of MSWFT in connection with the audit of China Energy's earnings per share calculation in fiscal year 2004.

Based on the above, the Commission's Order censures Respondent MSWFT and denies Respondent Yamagata the privilege of appearance and practice before the Commission as an accountant with the ability to request that the Commission consider reinstatement after two years. In addition, the Order requires the Respondents to disgorge $100,000 in audit fees and $29,500 in prejudgment interest.

Under the Order, MSWFT undertakes to retain an independent consultant to review and evaluate the firm's audit and interim review policies concerning, among other things, client acceptance and retention, auditor independence, document retention, use and supervision of affiliate firms and personnel in other jurisdictions, and training in the detection of client fraud. MSWFT has also undertaken that the firm will not accept any new clients with operations in China until all of the consultant's recommendations have been adopted. Respondents consented to the issuance of the Order without admitting or denying its findings.

This is the Commission's fourth enforcement action concerning the China Energy fraud

December 20, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Proposes Permanent Rule for Municipal Advisers

The SEC proposed a rule creating a new process by which municipal advisors must register with the SEC.  The proposed rule, required by Dodd-Frank, would replace a temporary rule the Commission adopted in September.

Municipal advisors provide advice to state and local governments and other borrowers involved in the issuance of municipal securities or with respect to the investment of governmental monies. Municipal advisors also solicit business from a state or local government for a third party. Subject to certain exemptions, the definition of municipal advisor under the Dodd-Frank Act includes financial advisors, guaranteed investment contract brokers, third-party marketers, placement agents, solicitors, finders, and certain swap advisors that provide municipal advisory services.

Under the proposed permanent registration regime, municipal advisors would have to submit more detailed information than is currently required and certify that they have met or will meet the qualifications and regulatory obligations required of them.

In particular, the proposed rule would require:

  • A municipal advisory firm to submit a Form MA to register.
  • An individual municipal advisor to submit a Form MA-I to register.
  • A municipal advisory firm or individual municipal advisor to submit a Form MA-W to withdraw from registration.
  • A non-resident municipal advisory firm (and any non-resident general partner or managing agent of a municipal advisory firm) to submit a Form MA-NR in order to appoint an agent for service of process.
  • Like the temporary form required of municipal advisors (Form MA-T), the registration forms envisioned by the proposed rule would require municipal advisors to provide identifying and contact information, and to disclose — by selecting from a list — the municipal advisory activities in which they engage.

Municipal advisors also would be required to provide disciplinary history information similar to the information that the SEC obtains from registered broker-dealers and investment advisers. Individual municipal advisors would be required to amend the form whenever any of the required information has become inaccurate in any way; and municipal advisory firms would be required to amend the form annually, and whenever identifying and contact information or disciplinary information has become inaccurate.

Public comments on the proposed rule should be received by the Commission within 45 days of publication of the rule in the Federal Register. The temporary rule will expire by no later than Dec. 31, 2011.

December 20, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Requests Public Comment on Standardizing Credit Ratings Terminology

The SEC is requesting public comment to help inform its study pursuant to Section 939(h) of the Dodd-Frank Act on the feasibility and desirability of: standardizing credit ratings terminology, so that all credit rating agencies issue credit ratings using identical terms; standardizing the market stress conditions under which ratings are evaluated; requiring a quantitative correspondence between credit ratings and a range of default probabilities and loss expectations under standardized conditions of economic stress; and standardizing credit rating terminology across asset classes, so that named ratings correspond to a standard range of default probabilities and expected losses independent of asset class and issuing entity.

December 20, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Charges Former Carter's Executive with Financial Fraud

The SEC today charged Joseph M. Elles, a former Executive Vice President of children's clothing marketer Carter's Inc., for engaging in financial fraud and insider trading. The SEC alleges that Elles's misconduct caused an understatement of Carter's expenses and a material overstatement of its net income in several financial reporting periods.

The SEC also announced that it has entered a non-prosecution agreement with Carter's under which the Atlanta-based company will not be charged with any violations of the federal securities laws relating to Elles's unlawful conduct. The non-prosecution agreement reflects the relatively isolated nature of the unlawful conduct, Carter's prompt and complete self-reporting of the misconduct to the SEC, its exemplary and extensive cooperation in the investigation, including undertaking a thorough and comprehensive internal investigation, and Carter's extensive and substantial remedial actions. This marks the first non-prosecution agreement entered by the SEC since the announcement of the SEC's new cooperation initiative earlier this year.

According to the SEC's complaint filed in U.S. District Court for the Northern District of Georgia, Elles conducted his scheme from 2004 to 2009 while serving as Carter's Executive Vice President of Sales. The SEC alleges that Elles fraudulently manipulated the dollar amount of discounts that Carter's granted to its largest wholesale customer — a large national department store — in order to induce that customer to purchase greater quantities of Carter's clothing for resale. Elles then concealed his misconduct by persuading the customer to defer subtracting the discounts from payments until later financial reporting periods. He created and signed false documents that misrepresented to Carter's accounting personnel the timing and amount of those discounts.

The SEC further alleges that Elles realized sizeable gains from insider trading in shares of Carter's common stock during the fraud. Between May 2005 and March 2009, Elles realized a profit before tax of approximately $4,739,862 from the exercises of options granted to him by Carter's and sales of the resulting shares. Each of these stock sales occurred prior to the company's initial disclosure relating to the fraud on Oct. 27, 2009, immediately after which the company's common stock share price dropped 23.8 percent.

The SEC is seeking permanent injunctive relief, disgorgement of ill-gotten gains with prejudgment interest, financial penalties, and an officer and director bar against Elles.

December 20, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Sunday, December 19, 2010

Kim on The Legal Profession and Gatekeeping

Naked Self-Interest? Why the Legal Profession Resists Gatekeeping, by Sung Hui Kim, UCLA School of Law, was recently posted on SSRN.  Here is the abstract:

This Article asks and answers the following question: why does the legal profession resist gatekeeping? Or, put another way, why do lawyers resist duties that require them to act to avert harm to their corporate client, its own shareholders, and – possibly – the capital markets? While acknowledging that the economic self-interest of the profession is an undeniable force fueling the bar’s opposition to gatekeeping, this Article argues that the characterization of naked rent-seeking behavior is too simplistic. It argues that economic self-interest exerts a more subtle influence than the conventional story would suggest. In addition, the legal profession’s resistance to gatekeeping is grounded in lawyers’ internalization of attitudes held by the corporate managers serving as the clients’ representatives and lawyers’ lack of empathy for potential shareholder-victims. In short, under-examined psychological forces other than economic self-interest loom large in the profession’s resistance to gatekeeping.

December 19, 2010 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Salter on Gaming & Institutional Corruption

Lawful But Corrupt: Gaming and the Problem of Institutional Corruption in the Private Sector, by Malcolm S. Salter, HBS Negotiations, Organizations and Markets Unit, was recently posted on SSRN.  Here is the abstract:

This paper describes how the gaming of society’s rules by corporations contributes to the problem of institutional corruption in the world of business. “Gaming” in its various forms involves the use of technically legal means to subvert the intent of society’s rules in order to gain advantage over rivals, maximize reported earnings, maintain high credit ratings, preserve access to capital on favorable terms, and reap personal rewards - just mention several possible motives. It is one of the most corrosive forms of institutional corruption in business. “Institutional corruption” refers to company-sanctioned behavior and relationships that may be lawful but either harm the public interest or weaken the capacity of the institution to achieve its primary purposes. The most salient consequence of institutional corruption is diminished public trust in the governance of the institution. In this paper, I describe the twin phenomena of gaming and institutional corruption - and how the former contributes to the latter, often with the support of professional advisors at law and auditing firms. I illustrate these phenomena with examples from Enron, which (apart from outright fraud) pursued one of the greatest gaming strategies of all time. I also point to the implementation of the Dodd-Frank Act as an excellent source of clinical data pertaining to gaming in a more contemporary setting. I then discuss how gaming and other trust-destroying behavior have been encouraged by the short-term decision-making horizons of both corporate executives and managers of large investment funds, how those time horizons are largely driven by ways in which the performance of operating executives and investment fund managers is measured and rewarded, and how the directors of these entities become complicit in the gaming of society’s rules and the spreading of institutional corruption. I end by suggesting possible remedies for curbing the ill effects of continued gaming of society’s rules and restoring much needed public trust in the offending institutions.

December 19, 2010 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Cohn & Swick on Bio-Pharms and Securities Class Actions

The Sitting Ducks of Securities Class Action Litigation: Bio-Pharmas and the Need for Improved Evaluation of Scientific Data, by Stuart R. Cohn, University of Florida - Fredric G. Levin College of Law, and Erin M. Swick, White & Case LLP, was recently posted on SSRN.  Here is the abstract:

 Rule 10b-5, a powerful weapon against any publicly-listed company whose share price drops on adverse news, is particularly skewed against pharmaceutical and other bio-technology companies (bio-pharmas). It is not a coincidence that there is a disproportionate number of class actions filed against bio-pharmas. The volume and complexity of data underlying most bio-pharma cases create enormous outcome uncertainties, settlement pressures, and potentially huge contingent liabilities over substantial periods of time. The vulnerability and risks that bio-pharmas face in Rule 10b-5 class actions are unique among all publicly-traded industries, yet many cases proceed along traditional grounds without courts employing either their statutory or inherent powers to obtain objective expert assessment of the data underlying plaintiffs' claims. Most judges have neither the training nor the capacity to differentiate between the positions of opposing experts or to reach their own independent assessment of the research data.

The unstated premise of the Supreme Court's Daubert v. Merrell Dow Pharmaceuticals opinion is that courts have an obligation to fully understand the evidence prior to any decision-making, and that the use of court-appointed experts will allow judges to decide motions to dismiss with greater confidence and accuracy. The early appointment of such experts may also have the salutary effect of causing plaintiffs to pause and consider whether the claims are sufficient to warrant the up-front imposition of court-appointed expert costs. If courts begin to recognize in greater numbers the importance of obtaining objective expert testimony, we believe that a more level playing field will evolve to reduce the disproportionate vulnerability of bio-pharmas to securities law class actions.

December 19, 2010 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)