Securities Law Prof Blog

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

Saturday, March 5, 2011

Tenth Circuit Addresses Broker-Dealer Exemption from Definition of Investment Adviser

The Investment Advisers Act of 1940 excludes from its broad definition of "investment adviser" broker-dealers that provide advice "solely incidental to" their conduct as broker-dealers and receive no "special compensation" for their service.  Despite much controversy over the scope of the exemption, there is little caselaw interpreting it: hence, the importance of a recent 10th Circuit opinion Thomas v. Metropolitan Life (No. 09-6257, 02/02/11).

In this purported class action, plaintiffs allege that a Met representative conducted a suitability analysis and subsequently recommended a variable life insurance policy, for which he received a $500 "production credit."  Disappointed with the product, they assert that the representative was an "investment adviser" who purchased his fiduciary duty by failing to disclose the strong financial incentives to sell Met's proprietary products.  The Court of Appeals affirmed the district court's grant of summary judgment to the defendants on the basis of the statutory exemption:

Specifically, the district court held that the phrase "solely incidental to" means "solely attendant to" or "solely in connection with," as opposed to "solely a minor part of" or "solely an insignificant part of." ...Thus, the court held that applicability of the exemption depends not on the quantum or importance of the broker-dealer's advice, but rather on whether the broker-dealer gives advice in connection with the sale of a product. ... With regard to the second prong, the district court held that "special compensation" requires a clearly definable charge attributable to investment advice. ... Thus, according to the district court, compensation in the form of brokerage commissions—which is received for the sale of a product—is not "special compensation," even when the transaction leading to the sale involved investment advice.

On appeal, the plaintiffs argued that the advice was not "solely incidental to" the broker-dealer's business when it comprised an important part of it.  Like the district court, however, the Court of Appeals rejected this interpretation:

Dictionary definitions of the word "incidental" differ somewhat. However, all definitions establish that the word "incidental" has  two components. To be considered incidental, two actions or objects must be related in a particular way—the incidental action or object must occur only as a result of or in connection with the primary. Additionally, the incidental action or object must be secondary in size or importance to the primary.

Plaintiffs emphasize the second component of the definition, arguing that "dictionary definitions of 'incidental' universally support Plaintiffs' interpretation of the term as 'inconsequential,' 'non-central,' or 'non-mandatory.'" Yet, the relational aspect is equally important and cannot be ignored—to be considered incidental, an action or object must be of lesser size or importance and be undertaken in connection with the primary action or object. The district court's interpretation acknowledges both components of "incidental," while the Plaintiffs' proposed interpretation would have us focus on the quantum or importance of the advice without regard to its relationship with the broker-dealer's business.

Further, the phrase "solely incidental to," when read as a whole, makes more sense under the district court's interpretation. "Solely," of course, means "exclusively or only." Webster's Unabridged Dictionary 1815 (2d ed. 2001). This compliments the relational aspect of "incidental": "solely" modifies "incidental to," and the phrase as a whole renders  the exemption applicable only when the broker-dealer gives advice in connection with the sale of a product. Under Plaintiffs' proposed reading, application of the exemption would hinge upon the quantum or importance of the broker-dealer's advice. Besides creating a difficult problem of line-drawing—how much advice is too much, and how could we measure the importance of the advice?—under Plaintiffs' interpretation "solely" would not meaningfully modify "incidental to" and would be superfluous. We are unwilling to adopt such an interpretation.

The Court also found that SEC interpretations and legislative history supported this construction.

With respect to the "special compensation" prong, the Court interpreted it to mean:

compensation received by a broker-dealer  is "special" only when (1) the compensation is received specifically in exchange for giving advice, as opposed to some other service, and (2) the compensation takes a form other than a commission or analogous transaction-based compensation received for the sale of a product.

The unfortunate outcome, therefore, is that the court did not address any disclosure obligation imposed on the broker to disclose specifically and upfront the financial incentives in selling the product.  (The prospectus did disclose the payment of a percentage of the premium as a sales fee.)  It is hoped that the SEC study on professional standards of care for both broker-dealers and investment advisers will result in improved disclosure of costs and fees sometime soon.

March 5, 2011 in Judicial Opinions | Permalink | Comments (2) | TrackBack (0)

District Court Issues TRO to Restrain Arbitrations that may Deplete Settling Defendants' Assets

Susanne Craig's article in today's New York Times (Financial Fraud Case Pits Arbitration vs. Class Actions) highlights a knotty issue involving the relationship between arbitration and class action litigation.  The article focuses on the plight of customers whom Securities America brokers talked into investing the bulk of their investment funds into two risky investments.  Many of these investors have filed claims in FINRA arbitration to recover their losses; at least one Securities America customer has already obtained an award of nearly $1.2 million.  Securities America is also the defendant in a class action involving the same allegations of misconduct.  A federal district court has thrown into doubt whether those investors who filed their claims in arbitration can even proceed with their claims, much less ever recover their losses.  A judge hearing the class action granted plaintiffs' request for a TRO to restrain the individual arbitration hearings, citing his power under the All Writs Act (Billitteri v. Securities America, Feb. 18, 2011, N.D. Tex.).  The judge received notice that the parties have reached a settlement that would end the class action; the plaintiffs argued that the ongoing arbitrations could deplete defendant Securities America's assets.  In granting the TRO, the court stated that it was necessary to restrain the arbitrations "to ensure the conditions for reaching a Settlement Agreement remain in place as the Court considers the Motion for Preliminary Approval." 

It's important to remember that customers of brokerage firms can always bring an individual arbitration claim against their broker-dealer.  The FINRA forum does not hear class actions, and customers remain free to bring class actions in court (to the extent permitted by the PSLRA and SLUSA).  Customers remain free to opt out of the class action and pursue their claim in arbitration.  If the district court ultimately decides that it has the authority to enjoin the arbitrations in favor of the class action (and if it is upheld on appeal), the court has substantially disrupted the brokerage customers' choice of remedies set forth in the FINRA rules.  The next court hearing is set for March 18.

March 5, 2011 in Judicial Opinions, News Stories | Permalink | Comments (0) | TrackBack (0)

Friday, March 4, 2011

Schapiro Testifies on OTC Derivatives Regulation

SEC Chairman Mary L. Schapiro testified on Implementation of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act by the U.S. Securities and Exchange Commission, before the United States Senate Committee on Agriculture, Nutrition and Forestry on March 3, 2011.

March 4, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Proposes Rule on Incentive-Based Compensation at Financial Institutions

The SEC proposed a rule that would require certain financial institutions to disclose the structure of their incentive-based compensation practices and prohibit such institutions from maintaining compensation arrangements that encourage inappropriate risks.  The proposed rule stems from Section 956 of Dodd-Frank, which requires the SEC and several other agencies to jointly write rules and guidelines in this regard. The SEC-regulated financial institutions affected by the rulemaking include broker-dealers and investment advisers with $1 billion or more in assets.

The SEC’s proposed rules for certain financial institutions would:

  • Require reports related to incentive-based compensation that they would file annually with SEC.
  • Prohibit incentive-based compensation arrangements that encourage inappropriate risk-taking by providing excessive compensation or that could lead to material financial loss to the firm.
  • Provide additional requirements for financial institutions with $50 billion or more in assets, including deferral of incentive-based compensation of executive officers and approval of compensation for people whose job functions give them the ability to expose the firm to a substantial amount of risk.
  • Require them to develop policies and procedures that ensure and monitor compliance with requirements related to incentive-based compensation.

Public comments on the rule proposal should be received within 45 days after it is published in the Federal Register.

March 4, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Former Colonial Bank Executive Charged with Securities Fraud Scheme

The SEC charged Catherine L. Kissick, a former vice president at Colonial Bank who was the head of its mortgage warehouse lending division, with conducting a $1.5 billion securities fraud scheme.  According to the SEC, Kissick enabled the sale of fictitious and impaired mortgage loans and securities from the mortgage warehouse lending division’s largest customer – Taylor, Bean & Whitaker Mortgage Corp. (TBW) – to Colonial Bank, and she caused these securities to be falsely reported to the investing public as high-quality, liquid assets.  The SEC previously charged former TBW chairman and majority owner Lee B. Farkas in June 2010, and charged TBW’s former treasurer Desiree E. Brown last week.

In a related action today, Kissick pleaded guilty to criminal charges filed by the Department of Justice in the Eastern District of Virginia.

According to the SEC’s complaint filed in U.S. District Court for the Eastern District of Virginia, Kissick along with Farkas and Brown perpetrated the fraudulent scheme from March 2002 to August 2009, when Colonial Bank was seized by regulators and Colonial BancGroup and TBW each filed for bankruptcy. Because TBW generally did not have sufficient capital to internally fund the mortgage loans it originated, it relied on financing arrangements primarily through Colonial Bank’s mortgage warehouse lending division to fund such mortgage loans.

The SEC alleges that when TBW began to experience liquidity problems and overdrew its then-limited warehouse line of credit with Colonial Bank by approximately $15 million each day, Kissick, Farkas and Brown concealed the overdraws through a pattern of “kiting” in which certain debits were not entered until after credits due for the following day were entered. In order to conceal this initial fraudulent conduct, Kissick, Farkas, and Brown created and submitted fictitious loan information to Colonial Bank and created fictitious mortgage-backed securities assembled from the fraudulent loans. By the end of 2007, the scheme consisted of approximately $500 million in fake residential mortgage loans and approximately $1 billion in severely impaired residential mortgage loans and securities. These fictitious and impaired loans were misrepresented as high-quality assets on Colonial BancGroup’s financial statements.

Kissick consented to an order barring her from acting as an officer or director of any public company.  Kissick also consented to an order prohibiting her from serving in a senior management or control position at any mortgage-related company or other financial institution.

March 4, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Former UBS Adviser Settles SEC Charges He Stole Customers' Funds

The SEC charged Steven T. Kobayashi, a former financial adviser at UBS Financial Services LLC, with misappropriating $3.3 million in a scheme that included bilking investors in a private investment fund he established.  According to the SEC, Kobayashi created a pooled investment fund to invest in life insurance policies. But he wound up stealing much of the money to support his extravagant lifestyle. Kobayashi concealed his fraud by liquidating his customers’ securities and funneling the money back to the fund and its investors.

In a parallel action, the U.S. Attorney’s Office for the Northern District of California today filed criminal charges against Kobayashi arising from some of the same alleged misconduct.

Kobayashi agreed to settle the SEC’s charges against him without admitting or denying the allegations.  The amount of ill-gotten gains and monetary penalties that Kobayashi will be required to pay will be determined by the court at a later date.

March 4, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Beazer Homes CEO Agrees to Clawback of Bonuses and Stock Profits

The SEC settled charges with Ian J. McCarthy, the CEO of Beazer Homes USA Inc., an Atlanta-based homebuilder, to recover several million dollars in bonus compensation and stock profits that he received while the company was committing accounting fraud.  According to the SEC, McCarthy previously failed to reimburse Beazer for bonuses, other incentive-based or equity-based compensation, and profits from Beazer stock sales that he received during the 12-month periods after his company filed fraudulent financial statements during fiscal year 2006.

The SEC brought previous enforcement actions against the company and its former chief accounting officer who perpetrated the fraud. While not personally charged for the misconduct, McCarthy is still required under Section 304 of the Sarbanes-Oxley Act to reimburse the issuer for incentive-based compensation and stock sale profits received during that fraudulent period. The settlement with McCarthy is subject to court approval.

Without admitting or denying the SEC’s allegations, McCarthy agreed to reimburse Beazer $6,479,281 in cash, 40,103 restricted stock units (or its equivalent), and 78,763 shares of restricted stock (or its equivalent). This reimbursement represents McCarthy’s entire fiscal year 2006 incentive bonus ($5,706,949 in cash and 40,103 in restricted stock units), $772,232 in stock sale profits, and 78,763 shares of restricted stock granted in 2006.

Section 304 of the Sarbanes-Oxley Act requires reimbursement by certain senior corporate executives of any bonus or other incentive-based or equity-based compensation received during a period in which a company was in material non-compliance with financial reporting requirements due to misconduct, as well as profits from stock sales during that same period. This can include an individual who has not been personally charged with the underlying misconduct or alleged to have otherwise violated the federal securities laws.

According to the SEC’s complaint against McCarthy, Beazer was required to prepare accounting restatements for the fiscal year ended Sept. 30, 2006 and first three quarters of fiscal 2006 due to its fraudulent conduct, which consisted of a manipulation of Beazer’s land development and house cost-to-complete accounts as well as the improper recording of certain model home financing transactions as sales for the purpose of increasing Beazer’s income.

Beazer settled an SEC enforcement action in September 2008, and the SEC charged its former chief accounting officer Michael T. Rand in July 2009. The litigation against Rand is still ongoing.

March 4, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Reopens Comment Period on Reg MC

The SEC reopened the comment period on its proposed rule on Ownership Limitations and Governance Requirements for Security-Based Swap Clearing Agencies, Security-Based Swap Execution Facilities, and National Securities Exchanges with Respect to Security-Based Swaps under Regulation MC, which is designed to mitigate potential conflicts of interest at clearing agencies that clear security-based swaps, security-based swap execution facilities and national securities exchanges that post or make available for trading security-based swaps. The proposal was originally published in Securities Exchange Act Release No. 63107 (October 14, 2010), 75 FR 65882 (October 26, 2010) (“Regulation MC Proposing Release”).  According to the SEC's release:

The Commission is reopening the period for public comment to solicit further comment on Regulation MC in light of other more recent proposed rulemakings that concern conflicts of interest at security-based swap clearing agencies and SB SEFs.

Comments should be received on or before April 29, 2011.

March 4, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Proposes Rule on References to Credit Ratings in Investment Company Rules

The SEC has posted on its website a proposed rule on REFERENCES TO CREDIT RATINGS IN CERTAIN INVESTMENT COMPANY ACT RULES AND FORMS.  According to the SEC release:

The Commission is proposing amendments to two rules and four forms under the Investment Company Act and the Securities Act that contain references to credit ratings. The proposed amendments would give effect to provisions of the Dodd-Frank Act that call for the amendment of Commission regulations that contain credit rating references. In addition, the Commission is proposing a new rule under the Investment Company Act to establish a standard of credit-worthiness in place of a statutory reference to credit ratings in that Act that the Dodd-Frank Act removes.

 Comments should be received on or before April 25, 2011.

March 4, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

DOL Holds Hearings on Expanded Fiduciary Definition

The Department of Labor held hearings on March 1-2, 2011, on its proposed rule to expand the definition of fiduciary applicable to advisers that provide investment advice to an employee benefit plan or its participants.  The proposal would amend a thirty-five year old rule that limits the types of investment advice relationships that give rise to fiduciary duties on the part of the investment advisor.  Specifically, the current regulation creates a 5-part test that must be satisfied in order for a person to be considered a fiduciary by reason of giving investment advice. According the DOL, the changes set forth in the proposed regulation are intended to more closely conform such determinations to the statutory definition, as well as take into account the significant changes in both the financial services industry and the expectations of plan officials and participants who receive investment advice.


Testimony of Kenneth E. Bentsen, Jr. on behalf SIFMA (proposed "regulation is far broader than the aims it seeks to address" and "would appear to be in conflict with recent action by Congress")

Testimony of Paul Schott Stevens, President and CEO, Investment Company Institute ("need to make very clear the line between commonplace financial market interactions and true advisory relationships")


March 4, 2011 in News Stories | Permalink | Comments (0) | TrackBack (0)

Law Profs File Amicus Brief in Halliburton in Support of Petitioners

A group of law professors, spearheaded by Eric Gerding (University of New Mexico), filed an amicus brief (Download 09-1403 tsac Law Professors) in support of petitioners in Erica P. John Fund, Inc. v. Halliburton Co. (No. 09-1403), which will be argued before the Supreme Court next term.  This case addresses the loss causation burden at the class certification stage.  The Fifth Circuit holds that plaintiffs must prove by a preponderance of evidence both the efficiency of the market (in order to invoke the fraud on the market presumption of reliance) and loss causation at the class certification stage.  The brief argues that loss causation presents issues that predominate with respect to the proposed class, thus rendering loss causation an improper condition to class certification under FRCP 23.  Moreover, requiring a mini-trial on loss causation at the class certification stage imposes an inappropriately high burden on plaintiffs.

March 4, 2011 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Tuesday, March 1, 2011

SEC Takes Up Incentive-Based Compensation Arrangements

SEC's Open Meeting Agenda for March 2, 2011 Meeting

Item 1: Incentive-Based Compensation Arrangements
Office:  Division of Trading and Markets and Division of Investment Management
Item 2: Clearing Agency Standards for Operation and Governance
Office:  Division of Trading and Markets
Item 3: Ownership Limitations and Governance Requirements for Security-Based Swap Clearing Agencies, Security-Based Swap Execution Facilities, and National Securities Exchanges with Respect to Security-Based Swaps Under Regulation MC
Office:  Division of Trading and Markets
Item 4: References to Credit Ratings in Certain Investment Company Act Rules and Forms
Office:  Division of Investment Management

March 1, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

New Mexico Real Estate Magnate Indicted for Operating a Ponzi Scheme

A federal grand jury in Albuquerque, New Mexico indicted former real estate magnate, Douglas F. Vaughan, for operating an approximately $75 million Ponzi scheme and for knowingly providing false documents to the SEC in the course of its investigation into Vaughan’s conduct in the fall of 2009.  The SEC filed a civil complaint against Vaughan and two of his entities on March 23, 2010, alleging violations of the antifraud and securities registration provisions of the federal securities laws and obtained a preliminary injunction, which remains in force. The SEC’s action is pending.

The federal criminal indictment alleges that, between 1993 and 2010, Vaughan raised approximately $75 million from investors through the issuance of promissory notes from his now-defunct real estate company, The Vaughan Company Realtors (“Vaughan Company”) and through the sale of interests in a separate entity called Vaughan Capital, LLC (“Vaughan Capital”). In both instances, the indictment alleges, Vaughan falsely told investors, among other things, that their funds would be used for real estate-related investments, when, in fact, he used their money to make principal and interest payments to earlier investors, to cover Vaughan Company’s mounting operating losses, and to support his own extravagant lifestyle, which included a mansion overlooking a golf course, a Ferrari, and frequent travel to Las Vegas, Nevada.

March 1, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

California Hedge Fund Manager Settles Charges He Misappropriated Investors' Funds

The SEC today settled charges that  Lawrence R. Goldfarb, a hedge fund manager,concealed more than $12 million in investment proceeds that he owed investors in his fund.  The SEC alleges that Goldfarb and his company, Baystar Capital Management LLC (BCM), diverted the cash to other entities he controlled, ultimately funding a real estate venture and a San Francisco record company. Goldfarb also comingled investor funds in a bank account that he used to pay for unauthorized personal expenses including entertainment and charitable donations.

According to the SEC’s complaint, Goldfarb and BCM were able to carry out their fraud in part because the investment was maintained in a “side pocket” into which investors in the hedge fund – Baystar Capital II, L.P. – had limited visibility. A side pocket is a type of account that hedge funds use to separate particular investments that are typically illiquid from the remainder of the investments in the fund. Goldfarb’s side pocket investment became profitable in 2006, but he diverted the proceeds for other uses rather than paying the fund’s investors. None of his transactions were authorized by the fund’s partnership agreement or offering documents.

Without admitting or denying the SEC’s allegations, Goldfarb and BCM consented to permanent injunctions against violations of certain provisions of the federal securities laws and to pay disgorgement of $12,112,416 and prejudgment interest of $1,967,371, which will be distributed to the fund’s investors. Goldfarb also agreed to pay a $130,000 penalty, be barred from associating with any investment adviser or broker (with the right to reapply in five years), and be barred from participating in any offering of penny stock.

March 1, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Charges Former Goldman and Current P&G Director with Involvement in Galleon Insider Trading Ring

The SEC today announced insider trading charges against Rajat K. Gupta, a business consultant who has served on the boards of directors at Goldman Sachs and Procter & Gamble, for illegally tipping Galleon Management founder and hedge fund manager Raj Rajaratnam with inside information about the quarterly earnings at both firms as well as an impending $5 billion investment by Berkshire Hathaway in Goldman.

According to the SEC, Gupta, a friend and business associate of Rajaratnam, provided him with confidential information learned during board calls and in other aspects of his duties on the Goldman and P&G boards. Rajaratnam used the inside information to trade on behalf of some of Galleon’s hedge funds or shared the information with others at his firm who then traded on it ahead of public announcements by the firms. The insider trading by Rajaratnam and others generated more than $18 million in illicit profits and loss avoidance. Gupta was at the time a direct or indirect investor in at least some of these Galleon hedge funds, and had other potentially lucrative business interests with Rajaratnam.

The SEC has previously charged Rajaratnam and others in the widespread insider trading scheme involving the Galleon hedge funds.

In the order that institutes administrative and cease-and-desist proceedings against Gupta, the SEC’s Division of Enforcement alleges that, while a member of Goldman’s Board of Directors, Gupta tipped Rajaratnam about Berkshire Hathaway’s $5 billion investment in Goldman and Goldman’s upcoming public equity offering before that information was publicly announced on Sept. 23, 2008. Gupta called Rajaratnam immediately after a special telephonic meeting at which Goldman’s Board considered and approved Berkshire’s investment in Goldman Sachs and the public equity offering. Within a minute after the Gupta-Rajaratnam call and just minutes before the close of the markets, Rajaratnam arranged for Galleon funds to purchase more than 175,000 Goldman shares. Rajaratnam later informed another participant in the scheme that he received the tip on which he traded only minutes before the market close. Rajaratnam caused the Galleon funds to liquidate their Goldman holdings the following day after the information became public, making illicit profits of more than $900,000.

The SEC’s Division of Enforcement alleges that Gupta also illegally disclosed to Rajaratnam inside information about Goldman Sachs’s positive financial results for the second quarter of 2008. Goldman Sachs CEO Lloyd Blankfein called Gupta and various other Goldman outside directors on June 10, when the company’s financial performance was significantly better than analysts’ consensus estimates. Blankfein knew the earnings numbers and discussed them with Gupta during the call. Between that night and the following morning, there was a flurry of calls between Gupta and Rajaratnam. Shortly after the last of these calls and within minutes after the markets opened on June 11, Rajaratnam caused certain Galleon funds to purchase more than 5,500 out-of-the-money Goldman call options and more than 350,000 Goldman shares. Rajaratnam liquidated these positions on or around June 17, when Goldman made its quarterly earnings announcement. These transactions generated illicit profits of more than $13.6 million for the Galleon funds.

The Division of Enforcement further alleges that Gupta tipped Rajaratnam with confidential information that he learned during a board posting call about Goldman’s impending negative financial results for the fourth quarter of 2008. The call ended after the close of the market on October 23, with senior executives informing the board of the company’s financial situation. Mere seconds after the board call, Gupta called Rajaratnam, who then arranged for certain Galleon funds to begin selling their Goldman holdings shortly after the financial markets opened the following day until the funds finished selling off their holdings, which had consisted of more than 120,000 shares. In discussing trading and market information that day with another participant in the insider trading scheme, Rajaratnam explained that while Wall Street expected Goldman Sachs to earn $2.50 per share, he had heard the prior day from a Goldman Sachs board member that the company was actually going to lose $2 per share. As a result of Rajaratnam’s trades based on the inside information that Gupta provided, the Galleon funds avoided losses of more than $3 million.

Gupta served as a Goldman board member from November 2006 to May 2010, and has been serving on Procter & Gamble's board since 2007.

As it pertains to insider trades by the Galleon funds in the securities of Procter & Gamble, the Division of Enforcement alleges that Gupta illegally disclosed to Rajaratnam inside information about the company financial results for the quarter ending December 2008. Gupta participated in a telephonic meeting of P&G’s Audit Committee at 9 a.m. on Jan. 29, 2009, to discuss the planned release of P&G’s quarterly earnings the next day. A draft of the earnings release, which had been mailed to Gupta and the other committee members two days before the meeting, indicated that P&G’s expected organic sales would be less than previously publicly predicted. Gupta called Rajaratnam in the early afternoon on January 29, and Rajaratnam shortly afterward advised another participant in the insider trading conspiracy that he had learned from a contact on P&G’s board that the company’s organic sales growth would be lower than expected. Galleon funds then sold short approximately 180,000 P&G shares, making illicit profits of more than $570,000.

The administrative proceedings will determine what relief, if any, is in the public interest against Gupta, including disgorgement of ill-gotten gains, prejudgment interest, financial penalties, an officer or director bar, and other remedial relief.

March 1, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Monday, February 28, 2011

Sutherland Releases Annual Survey of FINRA Sanctions

Sutherland Asbill & Brennan LLP announced that it completed its annual Sutherland FINRA Sanction Study – a review of the disciplinary actions brought by the Financial Industry Regulatory Authority (FINRA) against broker-dealers and associated persons.  The Study found that in 2010 FINRA reported a significant increase in the number of cases despite a slight decrease in the total amount of fines.  Sutherland also identified the top enforcement issues for FINRA in 2010, as well as trends in enforcement cases.

February 28, 2011 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)


On February 24, 2011, the SEC charged Francis E. Wilde and Matrix Holdings LLC, an entity he controls, with orchestrating two fraudulent “high yield” or “prime bank” investment schemes that defrauded investors out of more than $11 million. Wilde is the CEO of Riptide Worldwide, Inc. (“Riptide”), a public company that is quoted on the OTC Market Group Inc.’s OTC Pink quotation service. The SEC alleges that Wilde started the fraudulent schemes when Riptide began experiencing financial difficulties. The SEC also charged Steven E. Woods, Mark A. Gelazela, and entities they control, for participating in the larger of the two schemes, and Bruce H. Haglund, a California-based attorney, for aiding in that scheme.

According to the SEC’s complaint, filed in the U.S. District Court for the Central District of California, the first scheme began in April 2008 when Wilde obtained a U.S. Treasury bond with a market value of nearly $5 million from an investor. He secured the investment by knowingly making false and misleading promises of outsized returns from what he claimed was a “private placement program.” Using a credit line obtained with the investor’s bond, Wilde promised to acquire a $100 million financial instrument and to pay the investor $12 million within 5 days as well as a prorated share of proceeds from the private placement program. Wilde also guaranteed the return of the bond if the $12 million payment was not made on time. Wilde (through Matrix) then used the bond to secure a line of credit that he drew down to pay personal expenses, to pay investors, creditors and debt holders of Riptide, and to make failed attempts to acquire fictitious prime bank instruments or to invest in high yield programs. Wilde’s bank closed the credit line after he attempted to deposit a fraudulent financial instrument into the account. After the bond serving as collateral for the credit line was sold, Wilde transferred about $2.1 million to another bank account and exhausted the rest of the investor’s funds. Wilde strung along the investor, continuing to misrepresent the status and whereabouts of the investment, the SEC alleges.

The SEC further claims that, beginning in October 2009, Wilde concocted another fraudulent scheme with Woods and Gelazela in the form of a “bank guarantee funding” program using the services of Haglund as escrow attorney. Between October 2009 and mid-March 2010, Woods and Gelazela signed contracts with 24 investors who sent over $6.3 million to Haglund’s trust account. Gelazela raised more than $5 million and Woods raised more than $1 million. The investment contracts stated that a “bank guarantee” with a denomination of at least $100 million would be leased “for the purpose of Private Placement Program enhancements” and fifteen percent of the credit line value would be paid weekly to the investor for a term of 40 weeks. Wilde, Gelazela and Woods later sought to pacify investors with additional misstatements as the scheme unraveled in 2010.

According to the SEC, Haglund knowingly and substantially aided and abetted the fraud perpetrated by Wilde, Woods and Gelazela. Haglund controlled the trust account into which investors were instructed to wire their funds. Haglund then wired those funds out of the account according to instructions from Wilde, thus allowing Wilde to utilize funds for undisclosed purposes. Wilde transferred millions of dollars to bank accounts controlled by Gelazela, Woods, Haglund, Wilde and Wilde’s wife. Haglund pocketed nearly $500,000 in “legal services” fees for making wire transfers, payments that were not disclosed to investors. Haglund also knowingly made, and Wilde knowingly authorized, Ponzi-like payments to old investors using new investor deposits.

The SEC seeks permanent injunctions, disgorgement of ill-gotten gains with prejudgment interest thereon, financial penalties, and accountings, against each defendant, as well as officer and director bars against Wilde and Haglund.


February 28, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

FINRA Won't Discipline Schwab for ARS Sales

On February 11, FINRA notified Charles Schwab that it has decided not to bring a disciplinary action against it related to sales of auction rate securities.  Schwab previously reported that in November 2009 FINRA issued a Wells notice in connection with the ARS.  A complaint filed by the New York AG around the same time is still pending against the firm.  InvNews, Finra backs down, won't discipline Schwab over ARS sales

February 28, 2011 in Other Regulatory Action | Permalink | Comments (1) | TrackBack (0)

SEC Charges Former Outside Directors at DHB Industries with Complicity in Accounting Fraud

The SEC today charged DHB Industries ((now known as Point Blank Solutions), a major supplier of body armor to the U.S. military and law enforcement agencies, with engaging in a massive accounting fraud. The agency separately charged three of the company’s former outside directors and audit committee members for their complicity in the scheme.

The SEC alleges that DHB engaged in pervasive accounting and disclosure fraud through its senior officers and misappropriated company assets to personally benefit the former CEO. The SEC further alleges that outside directors Jerome Krantz, Cary Chasin, and Gary Nadelman were willfully blind to numerous red flags signaling the accounting fraud, reporting violations, and misappropriation at DHB.  The SEC previously charged former DHB CEO David Brooks as well as two other former DHB senior officers for their roles in the fraud.

The SEC filed two separate complaints in U.S. District Court for the Southern District of Florida against DHB and the former outside directors. According to the SEC’s complaint against Krantz, Chasin, and Nadelman, their willful blindness to red flags allowed senior management to manipulate the company’s reported gross profit, net income, and other key figures in its earnings releases and public filings between 2003 and 2005. The company overstated inventory values, failed to include appropriate charges for obsolete inventory, and falsified journal entries. By ignoring red flags, the three outside directors also facilitated the misconduct by Brooks, who diverted at least $10 million out of the company through fraudulent transactions with a related entity that he controlled. Their willful blindness to red flags additionally facilitated DHB’s improper payment of millions of dollars in personal expenses for Brooks, including luxury cars, jewelry, art, real estate, extravagant vacations, and prostitution services. Despite being confronted with the red flags indicating fraud, Krantz, Chasin, and Nadelman approved or signed DHB’s false and misleading filings.

The SEC’s complaints against DHB, Krantz, Chasin, and Nadelman charge them with violating or aiding and abetting the antifraud, reporting, books and records, and other provisions of the federal securities laws. DHB has agreed to settle with the SEC and agreed to a permanent injunction from future violations. The proposed settlement took into account the remedial measures already taken by the company. The company is currently in bankruptcy and its settlement with the SEC is pending the approval of the bankruptcy court. The SEC seeks injunctive relief, disgorgement of ill-gotten gains, monetary penalties, and officer and director bars against Krantz, Chasin, and Nadelman.

The U.S. Attorney’s Office for the Eastern District of New York previously filed criminal charges against Brooks, Hatfield, and Schlegel based on the same misconduct. On Sept. 14, 2010, a jury convicted Brooks and Hatfield of, among other things, multiple counts of securities fraud, insider trading, and obstruction of justice, including obstructing the SEC’s investigation. Brooks and Hatfield are awaiting sentencing. Schlegel previously pled guilty to criminal charges pursuant to a plea agreement. The SEC’s civil actions against Brooks, Hatfield, and Schlegel are stayed pending the full resolution of the criminal actions.

February 28, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

42 Law Profs Support Extending Dodd-Frank's Extraterritorial Test to Private Claims

The SEC recently asked for comments on its study on extraterritorial private rights of action, required by Dodd-Frank.  As you may recall, the U.S. Supreme Court in Morrision v. NAB rejected the longstanding conduct-effects approach and instead held that “Section 10(b) reaches the use of a manipulative or deceptive device or contrivance only in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.” In response to Morrison, Congress reinstated the conduct-effects test for government actions and directed the SEC to study whether private rights of action should similarly be restored.

A group of 42 law professors, spearheaded by Frank Partnoy (San Diego), filed comments.  As the letter states:

We differ in our views of private rights of action: some of us have significant doubts about the efficacy of securities class actions, while others believe shareholder litigation rights should be strengthened. Nevertheless, as a group we believe reform efforts should be applied consistently and logically to both domestic and affected foreign issuers, and we therefore support extending the test set forth in Section 929P of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to private plaintiffs.

With the prospect of a merger of Deutsche Boerse and NYSE Euronext, the extraterritoriality of the federal securities laws is a timely and pressing issue.  As the comment states:

Assuming that merger happens, there is the potential for most trades between U.S. buyers and sellers to occur offshore, likely in London. Even those of us who are deeply skeptical about extending U.S. securities law to its fullest reach agree that it would make little sense to apply the approach in Morrison to preclude application of the securities laws to those trades.

A number of comments have been filed, some of which support maintaining the distinction between private and government actions.

February 28, 2011 | Permalink | Comments (0) | TrackBack (0)