August 16, 2005
Criminal and Civil Charges Against Four Brokers for Aiding "Front-Running" by Day-Traders
The U.S. Attorney's Office for the Eastern District of New York and the SEC filed charges against four brokers for allowing day-traders to listen in on market analysis and customer order information through the brokerage firms' internal communications systems, known as the "Squawk Box." The brokers worked at major Wall Street firms: Kenneth Mahaffy (Merrill Lynch and Citigroup), Timothy O'Connell (Merrill), Ralph Casbarro (Citigroup), and David Ghysels (Lehman Brothers). By hearing what the firms' brokers were being told about upcoming orders, the day-traders could buy and sell stocks ahead of transactions that would affect the price of the shares being traded. According to a press release issued by the U.S. Attorney's Office (here):
As alleged in the indictment, between January 2002 and December 2003, the defendants routinely provided day traders at two New York City based day trading firms, A.B. Watley, Inc. ("A.B. Watley") and Millennium Brokerage, LLC ("Millennium"), with material, non-public customer order information, which was disseminated through internal speaker systems at Merrill, Citigroup and Lehman known as "squawk boxes." Specifically, the defendants placed telephone calls to the day traders and left the telephones off the hook next to squawk boxes at their respective brokerage firms so that the day traders were able to hear the customer orders that were being broadcast. In exchange for access to the squawk box information, the day traders paid substantial amounts of money to the defendants in the form commissions from "wash trades" (simultaneously buying and selling the same amount of a security at the same price for the sole purpose of generating commissions) that were generated through brokerage accounts that the day traders opened with the defendants at Merrill, Citigroup and Lehman. Some of the defendants also accepted cash bribes from the day traders in exchange for squawk box access.
The indictment alleges that the day traders profited from the scheme by trading in front of the large orders that were broadcast through the squawk boxes. For example, when the squawk boxes disseminated information concerning a large buy order for a particular stock, the day traders would purchase shares of the same stock before the larger order was executed. Alternatively, when the squawk boxes disseminated information concerning a large sell order for a particular stock, the day traders would "short sell" the same securities before the larger order was executed. In either circumstance, the day traders profited from the subsequent movement in price that the large customer order caused. The day traders generated profits of over $600,000 by engaging in this illicit trading activity through proprietary accounts at A.B. Watley and Millenium.
The case has already yielded guilty pleas by other former Merrill employeess related to obstruction of the government's investigation for lying investigators (see here). The SEC's Litigation Release is here.
Front-running presents an interesting issue for a securities fraud case because the information is available to the entire firm. Even when the information is about a large order to buy or sell shares, it does not involve information received from the company that is otherwise undisclosed (i.e. classic inside information), and is based on the decision of a customer of the brokerage firm that is not related directly to the company's operations. Is market information subject to the antifraud prohibition of Section 10(b) and Rule 10b-5? The SEC has taken an aggressive view of front-running, in a case a couple years ago involving leaks of information about the sales of federal bonds. The issue may get played out in the criminal prosecution with its heavier burden of proof. For the defendants, however, arguing that they helped someone make "free money" to the tune of $600,000 but no one got hurt may not play well with a jury. (ph)
Stupidity Is Not a Crime . . . Yet
Of the many corporate collapses of the past few years, K-Mart's bankruptcy was among the largest. The pay and perks of its last CEO, Charles Conaway, drew the attention of the DOJ and SEC because he received $23 million for a little less than two years work while the company went down the drain. In the environment created by Enron, WorldCom, Adelphia Communications, etc., many thought it was safe to assume that K-Mart must have been riddled with fraud, just like those other companies. That has not turned out to be the case. Aside from one criminal prosecution against two mid-level executives that went awry during the testimony of the government's second witness, resulting in the dismissal of the charges, there have not been any criminal prosecutions related to K-Mart's decline -- although federal prosecutors state that the investigation is continuing. The SEC filed a civil suit related to the lone criminal case, but subsequently dropped it. Now, an arbitration proceeding by the bankruptcy trustee against Conaway for breaching his fiduciary duty has resulted in a clear ruling in his favor, according to an AP story (here). The arbitration panel stated: "This is not a case of fraud, deliberate mismanagement or corporate looting . . . The evidence shows that Conaway acted at all times in good faith and in what he believed to be the best interests of Kmart." Well-paid and wildly unsuccessful is not a crime, at least at this point, and not even the basis for a civil claim. (ph)
UPDATE (8/15): A more extensive treatment of the arbitration panel's decision is available from the Detroit News here. (ph)
August 15, 2005
Cooked Books Al Dente at American Italian Pasta Co
The American Italian Pasta Co. announced that an internal investigation of the company's accounting would require a $60.7 million charge this quarter, and it was delaying filing its current 10-Q because the investigation is ongoing and the financials cannot be issued. According to a press release (here), AIPC said that the largest amount was an impairment charge ($36.7 million) related to intangible assets, inventory write-downs ($ 5.2 million), and "other financial statement adjustments" ($18.8 million) related to the dreaded internal control weaknesses. The press release notes that this is only the beginning of the process:
The internal investigation has not yet been completed and the Company indicated
that financial statement adjustments might be necessary in addition to those
outlined in this release. Until the internal investigation is completed by the
Audit Committee and any financial statement adjustments and their causes are
determined, the Company's third quarter results and any impact on prior period
results cannot be finalized.
When a company reveals internal control weaknesses, members of the SEC's Enforcement Division are sure to come knocking. To make matters even worse for the company, the press release notes that the securities exchanges have inquired about suspicious trading in AIPC shares around the time of earnings annoucements, which may mean there's a tipper floating around somewhere in its ranks, just to spice things up. (ph -- thanks to Scott Lawder for passing along the information)
Christmas Show Fraud Nets 87-Month Prison Term
The U.S. Attorney's Office for the Southern District of Florida announced that David Ellisor received an 87-month prison term for defrauding a number of South Florida schools into paying $10 per child for a show called "Christmas Around the World" that was completely fictitious. According to the press release (here):
[T]he evidence presented at trial and during the sentencing hearing, Ellisor targeted students and teachers at Miami-Dade County public and private schools for a "once in a lifetime" Christmas show at the Coconut Grove Convention Center. Ellisor promised that the event would be attended by Ambassadors from over 28 countries, and promised that students attending the event would receive raffle tickets to win "thousands of dollars of sponsored gifts." Over 2,700 victims, from 22 Miami-area schools, paid the $10 per person fee demanded by Ellisor, and made arrangements to attend the event, supposedly scheduled for December 3-5, 2003. Local businesses also provided money to Ellisor based upon his promises about the event. When the first group of students arrived at the Convention Center on the morning of December 3, they found the building locked, with no information about the event, and Ellisor nowhere to be found.
Ellisor spent the morning of December 3 emptying the show's bank account of over $4,000 and using some of that money to complete the purchase of a Jaguar automobile. Ellisor collected thousands of dollars in fees for the event, but did not meet the requirements to stage an event at the Convention Center. Instead, he used the money for personal expenses such as a hotel suite, luxury rental cars, special-order clothing, and a watch whose value he estimated at $5000. The Court found at sentencing that Ellisor had in the past failed to provide refunds for non-existent shows targeted toward children at various locations throughout the United States.
2,700 schoolchildren as victims is sure to trigger a substantial prison term. (ph)
Hedge Fund Fraud in Tony Palm Beach
The New York Times has a long article in the Sunday business section (here) detailing the alleged fraud involving KL Group, which operated out of southern California and West Palm Beach. The firm touted its outsized, and apparently overblown, returns on its investments, asserting it had a 70% return in 2003 and a 40% return in 2004, and gathered approximately $200 million in assets from investors, most of which is long gone. According to the Times, the firm's entree into the Palm Beach set came through a local trust and estate attorney, Ronald Kochman, who invited his clients to invest and later became a principal of the firm. Its collapse finally came in March 2005 when investigators from the SEC appeared at the firm's offices and demanded documents; a few days later, the Commission filed for and received an emergency freeze order on its assets after it discovered the fraud, although only about $11 was in its accounts (see Litigation Release here).
Kochman will face some difficult issues explaining his role in the firm to his clients, especially if he did not explain completely his conflict position in recommending to clients that they invest in a company in which he had a financial interest. That type of conduct tends to get the bar authorities interested, to say nothing of the malpractice and breach of fiduciary duty claims. His conduct perhaps may even peak the interest of the SEC and the U.S. Attorney's Office regarding the exact nature of his involvement in KL Group (he joined the firm after its formation), and whether he misled his law firm clients to entice their investments. Hedge funds are lightly regulated, with only minimal disclosure duties compared to more common investment vehicles, and some are wildly successful. But the lure of easy money and minimal oversight also makes the field one that is attractive to scam artists, such as the founders of KL Group described in the Times article, to ply their trade. (ph)
Attorneys in Trouble Over Taxes
Two attorneys in Texas have run afoul of the IRS and DOJ for filing false tax returns. Odessa attorney Stephen Ashley entered a guilty plea to one count of filing a false estate tax return in connection with the settlement of his father's estate (press release here):
Ashley was the executor of his father’s estate and assumed responsibility for filing all pertinent tax documents with the Internal Revenue Service concerning the estate’s affairs. By pleading guilty, Stephen Ashley admitted that during the preparation of the tax return of his father’s estate he directed his secretary to type four (4) backdated Gift Deeds falsely reflecting that his father, Connell D. Ashley, had deeded a certain portion of a ranch he owned to his sons in 1989, 1990, 1991, and 1992, when in fact his father had not truly begun to deed portions of the ranch to him and his brothers until 1993. He also had his father’s former secretary forge his signature on the false deeds and had false notary records created.
Houston attorney James Quay was sentenced to a 15-month term of imprisonment for filing a false tax return in 1997 involving transfers from an off-shore trust related to an abusive tax shelter (see press release here):
[Quay] filed a U.S. Individual Income Tax Return (Form 1040) for calendar year 1997 with the Internal Revenue Service Center in Austin, Texas (“Quay's 1997 Tax Return”), which included a Schedule C deduction for administrative services expense in the amount of $221,000 that he knew to be false. This deduction shifted, or expatriated, income in the amount of $221,000 from his personal return to an offshore company via intervening transfers to intermediary domestic and foreign trusts under a foreign tax shelter program called “Aegis,” which envisioned the return, or repatriation, of that income to Quay through tax-exempt payments on debt, called “basis notes” created when the transferee entities were formed. Under the terms of the Aegis tax shelter program, basis note payments were supposed to be made from deposits to an account of the offshore company corresponding in amount to the amount of income expatriated. Quay did not deposit, and never intended to deposit, into an account of his offshore company an amount of cash corresponding to the amount of income expatriated. Rather, Quay deposited only $25,000 into an offshore account by the end of 1997, well short of the $221,000 expatriated. By the time he had filed his 1997 tax return in October 1998, Quay had used all but a few thousand dollars of those funds to pay credit card charges rather than any “basis note.”
In sentencing Quay, the district judge found that he used his special skills as an attorney in committing the offense.
An interesting question will be how long these two defendants will lose their law licenses. Each violated the law through their actions as an attorney, which calls into question their fitness to represent clients and appear before the courts. Should they be allowed to continue to practice law, and if so, how long should they be removed from legal practice? The bar authorities are all over the map on the amount of time a lawyer convicted of a crime related to their role as a lawyer (as opposed to a personal capacity) should lose the license to practice. (ph)
August 14, 2005
In Mississippi the Clarion-Ledger reports that State Supreme Court Judge Diaz was found not guilty on all counts. (see here) Other defendants in this case had somewhat mixed verdicts - with some counts being not guilty and others ending in a hung jury. None of the defendants prosecuted by the government in this case were convicted. What some might call - not a good day for the prosecution team. Others, however, would note that the government always wins even when the verdict is "not guilty" as prosecutors are ministers of justice and not mere advocates.
Another major southern trial, the trial of former Mayor Bill Campbell, has a new attorney and has requested a continuance of the trial originally set for September. Joining Atlanta lawyer Jerry Froelich on the case, is Billy Martin of Washington. (see AJC here). It is odd to see the US Attorneys objecting to the continuance as they took a very long period of time before they indicted Campbell. (See post here)
White Collar Sentences in China Tougher than in US
The New York Times reports here that a leading banker in China, convicted of embezzlement, has been given a sentence of death. The sentence was suspended.
So for those, like me, who thought Bernard Ebbers, Jamie Olis, and the Rigas' sentences were too high - I guess they certainly weren't according to the standards used in China.
Former Bayer Execs Charged with Antitrust Violation
Two former executives of Bayer have been indicted for price-fixing. The Department of Justice press release reports here that:
"The former Bayer executives were charged with carrying out the conspiracy with their co-conspirators by:
- Participating in meetings among major rubber chemical producers to discuss the prices of rubber chemicals to be sold in the United States and elsewhere;
- Agreeing, during those discussions and meetings, to increase prices of rubber chemicals to be sold in the United States and elsewhere;
- Participating in discussions and meetings concerning implementation and adherence to the agreement reached; and
- Issuing price announcements and price quotations in accordance with the agreements reached."
Both individuals indicted are German citizens. It appears from this press release that the conduct occurred extraterritorially. It seems likely that the government is using the principle of "objective territoriality" to acquire jurisdiction. Whether this is in fact the case, and whether jurisdiction will be contested by the accused, remains to be seen. One of the concerns that needs to be considered here is whether the prosecution of non-US businesspeople will open the door tor other nations prosecuting individuals from the US who are doing business abroad.