Securities Law Prof Blog

Glen on The Predictive Power of Form 4 Filings

The Efficient Capital Market Hypothesis, Chaos Theory, and the Insider Filing Requirements of the Securities and Exchange Act of 1934: The Predictive Power of Form 4 Filings, by Patrick J. Glen, Department of Justice, Civil Division, Office of Immigration Litigation, was recently posted on SSRN.  Here is the abstract:

This article is primarily an examination of whether the filing of form 4's under the '34 Act has a particular effect on the movement of securities prices. The ultimate results are then analyzed under traditional market theories, which are introduced earlier in the paper. The main question presented is the worth of information for traders. If chaos theory is correct in the weight it gives to information, then the filing requirements become very important, as does any movement that could be associated with those requirements. The paper is an initial step in an area that has not been addressed to a large extent, and could serve as the departure point for more rigorous empirical study of the questions presented.

Gerding on the Subprime Crisis

The Subprime Crisis and the Link between Consumer Financial Protection and Systemic Risk, by Erik F. Gerding, University of New Mexico - School of Law, was recently posted on SSRN.  Here is the abstract:

This Article will appear in a May 2009 symposium issue of the Florida International University Law Review on the global financial crisis.

This Article argues that the current global financial crisis, which was first called the “subprime crisis,” demonstrates the need to revisit the division between financial regulations designed to protect consumers from excessively risky loans and safety-and-soundness regulations intended to protect financial markets from the collapse of financial institutions. Consumer financial protection can, and must, serve a role not only in protecting individuals from excessive risk, but also in protecting markets from systemic risk. Economic studies indicate it is not merely high rates of defaults on consumer loans, but also unpredictable and highly correlated defaults that create risks for both lenders and investors in asset-backed securities.

Consumer financial regulations can mitigate these risks in three, non-exclusive ways: (1) by reducing the level of defaults on consumer loans, (2) by making defaults more predictable, and (3) by reducing the correlation of defaults. The Article argues that:

¶ “predatory lending” can constitute a collective action failure by lenders;
¶ consumer behavioral biases may frustrate predictions of consumer defaults; but
¶ consumer financial rules that take into account these biases and address the “menu design” of consumer loan choices may not only protect consumers, but make the risk of consumer defaults more predictable.

The Article also draws tentative conclusions on the implications of the link between consumer protection and systemic risk for the institutional reform of financial regulation by:

¶ arguing against federal preemption of state consumer regulation; and
¶ providing a rough analysis of regulatory reform proposals for creating either a single financial regulator or a “Twin Peaks” model of separate regulators for consumer protection and systemic risk regulation.

Litvak on Cross-Listing Premia

The Relationship Among U.S. Securities Laws, Cross-Listing Premia, and Trading Volumes, by Kate Litvak, University of Texas at Austin School of Law, was recently posted on SSRN.  Here is the abstract:

This paper studies the relationship among the U.S. securities laws, the premia that non-U.S. firms obtain by subjecting themselves to U.S. laws, overall U.S. share prices, and a cross-listed firm’s U.S. trading volume. I report three main sets of findings. First, for exchange-traded (NYSE and NASDAQ) cross-listed firms, pair premia and pair returns (premia and returns not explained by valuation and returns for similar non-cross-listed firms from the same home country) are strongly correlated with U.S. stock indices. There is a visually apparent “bubble” in pair premia for these firms, which peaks in early 2000, at the same time as U.S. stock indices. In contrast, pair premia and pair returns for cross-listed firms traded OTC or on PORTAL are not correlated with U.S. indices. The correlation between pair returns and U.S. indices only exists for firms with an above-median ratio of U.S.-based to total trading volume, and is triggered by cross-listing; there is no significant correlation before listing. Second, pair premia for level-23 firms, relative to premia for level-14 firms (“relative pair premia”), exist only in firms with above-median ratio of U.S. to total trading volume. Firms with below-median ratio of U.S. trading have no relative pair premia, regardless of listing level. Third, there are important time variations in relative pair premia. Relative pair premia decline significantly for all firms during the first 6 years after listing, and disappear after year six. The decay is most pronounced for firms with below-median ratio of U.S. trading volume.

These results, taken together, weaken the law-based explanation for cross-listing premia (bonding to U.S. securities regime) and strengthen the non-law-based explanations (liquidity and visibility). They also suggest a behavioral explanation: U.S. investors treat high trading volume, exchange traded firms partly like U.S. firms, but treat OTC firm, Portal firms and low-trading-volume exchange-traded firms like other foreign firms.

Bebchuk & Spamann on Regulating Bankers' Pay

Regulating Bankers’ Pay, by Lucian A. Bebchuk, Harvard University - Harvard Law School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI), and Holger Spamann, Harvard University - Harvard Law School, was recently posted on SSRN.  Here is the abstract:

This paper contributes to understanding the role of executive compensation as a possible cause of the current financial crisis, to assessing current legislative and regulatory approaches meant to discourage bank executives from taking excessive risks, and to identifying how bankers’ pay and banks should be regulated going forward. Although there is now wide recognition that executives’ decisions might have been distorted by the short-term focus of pay packages, we identify a separate and critical distortion that has received little attention. Because bank executives have been paid with shares in bank holding companies or options on such shares, and both banks and bank holding companies issued much debt to bondholders, executives’ payoffs have been tied not to the value of banks’ capital but to highly levered bets on this value. These highly levered structures gave executives powerful incentives to under-weight downside risks. We show that current legislative and regulatory attempts to discourage bank executives from taking excessive risks fail to address this identified factor. In particular, recently adopted requirements aimed at aligning the interests of executives tightly with those of the common shareholders of bank holding companies – through emphasizing awards of restricted shares in these companies and introducing 'say on pay' votes by these shareholders – miss the mark. The common shareholders of bank holding companies, especially now that the book value of their investment has decreased so much, would be better served by much more risk-taking than would be in the interest of the government as preferred shareholder and guarantor of some of the bank’s obligations. Finally, having identified the problems with current attempts and proposals, we analyze how best to implement recent legislative mandates that require banks receiving financial support from the government to avoid providing executives with incentives to take excessive risks. Beyond banks receiving governmental support, we put forward a novel strategy for banking regulation; we argue that monitoring and regulating bankers’ pay should be an important element of banking regulation in general, and we analyze how banking regulators should assess and regulate bankers’ pay.

SEC Settles FCPA Charges Against Former ACL Technologies President

On May 29, 2009, the SEC settled charges against Thomas Wurzel, the former President of ACL Technologies, Inc. (ACL), formerly a subsidiary of United Industrial Corporation (UIC), which provided aerospace and defense systems. The Commission’s complaint alleges that Wurzel authorized illicit payments to an Egyptian-based agent while he knew or consciously disregarded the high probability that the agent would offer, provide, or promise at least a portion of such payments to Egyptian Air Force officials for the purpose of influencing these officials to award business to UIC related to a military aircraft depot in Cairo, Egypt. The Commission charged Wurzel with violations of the anti-bribery, books and records and internal controls provisions of the Foreign Corrupt Practices Act (FCPA), and with aiding and abetting UIC’s violations of the anti-bribery and books and records provisions of the FCPA.

The Commission’s complaint alleges that in late 2001 to 2002, Wurzel authorized three forms of illicit payments to the agent: (1) payments to the agent ostensibly for labor subcontracting work; (2) a $100,000 advance payment to the agent in June 2002 for “equipment and materials;” and (3) a $50,000 payment to the agent in November 2002 for “marketing services.” Furthermore, Wurzel later directed his subordinates to create false invoices to conceal the fact that the $100,000 “advance payment” in June 2002 was never repaid. As a result, UIC, through ACL, was awarded a contract with gross revenues and net profits of approximately $5.3 million and $267,000, respectively.

Without admitting or denying the allegations in the complaint, Wurzel has consented to the entry of a final judgment permanently enjoining him from future violations of Sections 30A and 13(b)(5) of the Securities Exchange Act of 1934 ("Exchange Act") and Exchange Act Rule 13b2-1 and from aiding and abetting violations of Exchange Act Sections 30A and 13(b)(2)(A) and ordering him to pay a $35,000 civil penalty.

In a related action, the Commission also instituted, on May 29, 2009, a settled administrative proceeding against UIC. The Commission’s Cease-and-Desist Order finds that beginning in late 2001, and continuing through 2002, UIC violated Sections 30A, 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act. Without admitting or denying the Commission’s findings, UIC agreed to a Commission order requiring it to cease and desist from committing or causing violations and any future violations of the foregoing provisions and ordered UIC to pay $337,679.42 in disgorgement and prejudgment interest. See Exchange Act Release No. 34-60005 (May 29, 2009); Accounting and Auditing Enforcement Release No. 2981.

SEC Settles Two Proceedings Involving Undisclosed Marketing Agreements

The SEC settled two administrative proceeding involving an undisclosed marketing arrangement between BISYS Fund Services, a mutual fund administrator, and AmSouth Bank (AmSouth), a mutual fund adviser.  In one, J. David Huber, former BISYS Fund Services, Inc. (BISYS), president and former chairman of the AmSouth Funds' board of trustees, settled charges that he facilitated the marketing agrement.  According to the SEC, acting through Huber and others, BISYS entered into a 1999 side agreement with AmSouth pursuant to which BISYS was to rebate a portion of its administration fee to the fund advisers in exchange for their promise to continue recommending BISYS as an administrator to the funds’ boards of trustees. Following execution of the side agreement, BISYS paid for marketing expenses incurred by the advisers to promote the funds. Occasionally, the fund adviser also used the money dedicated by BISYS to pay expenses unrelated to marketing. Huber executed the 1999 side agreement with AmSouth, on behalf of BISYS. Huber, however, did not disclose either the existence of the 1999 side agreement or its terms to the boards of trustees or shareholders for the AmSouth mutual funds. As part of his settlement, Huber agreed to pay a total of $18,000 in disgorgement and prejudgment interest.

The other proceeding involved an attorney, Melissa M. Hurley, who was senior vice president and general counsel of BISYS from May 1998 to approximately 2002, and executive vice president and general counsel of BISYS from approximately 2002 through 2006.  According to the SEC, Hurley reviewed draft side agreements, including AmSouth’s 1999 and 2000 side agreements, and knew that the marketing arrangement should be disclosed to fund trustees and shareholders. Hurley did not disclose the terms of the side agreements to the fund trustees or shareholders. In 2003, Hurley also drafted a disclosure template concerning the marketing arrangements for certain fund shareholders, and reviewed and commented on a disclosure template for certain fund boards of trustees. These disclosure templates did not disclose material facts such as the written nature of the agreements, the exchange of a portion of the administration fee for a recommendation to the fund boards, or the source of funds used for marketing.  The SEC charged that Hurley willfully aided and abetted and caused AmSouth Asset Management’s violations of Sections 206(1) and 206(2) of the Advisers Act.  As part of her settlement, Hurley agreed to pay $15,000 in disgorgement, prejudgment interest, and a $15,000 civil penalty.

Connecticut Plans to Regulate Hedge Fund Managers

Tired of waiting for the federal government to regulate hedge funds, Connecticut, home to many hedge funds, may enact legislation requiring fund managers that have not registered with the SEC as investment advisers to disclose material conflicts of interest.  The legislation, which would apply to funds located or doing business in the state, has passed the Senate and is pending in the House.  WSJ, Can Connecticut Stay Hedge-Fund Haven?

SEC Charges Pegasus Wireless Officers with Pump & Dump Scheme

The SEC filed securities fraud charges against Pegasus Wireless Corporation, former CEO Jasper Knabb, and CFO Stephen Durland alleging they defrauded investors by illegally selling millions of Pegasus shares they secretly controlled and lying about the transactions in company filings.  According to the SEC's complaint, Knabb and Durland created Pegasus from a dormant shell company and then touted several acquisitions in a series of press releases, causing Pegasus' stock price to soar and briefly giving it a market capitalization of over $1.4 billion. Unbeknown to investors, however, Knabb and Durland secretly controlled millions of Pegasus shares through nominees. The nominees unloaded the shares and funneled the proceeds to Knabb, Knabb's wife, and Durland. Knabb and Durland together reaped more than $30 million through their scheme. Pegasus, meanwhile, saw its share price steadily decline to under a penny and filed bankruptcy.

As alleged in the complaint, Knabb and Durland reported none of these nominee transactions in reports with the SEC and instead falsely told investors they owned only minimal amounts of stock. The SEC further alleges that Knabb and Durland falsely claimed in numerous SEC filings that much of the stock was issued to satisfy a business debt, when in reality this "debt" was entirely fabricated through phony documentation.

The SEC's complaint, filed in federal court in San Francisco, alleges Pegasus, Knabb, and Durland violated, or aided and abetted violations of, both the Securities and Securities Exchange Act.

NASAA Supports Hedge Fund Adviser Registration Act

NASAA today endorsed proposed bipartisan legislation that would require hedge fund advisers to register with the Securities and Exchange Commission under the Investment Advisers Act of 1940.  The Hedge Fund Adviser Registration Act of 2009 (H.R. 711) is sponsored by Reps. Michael E. Capuano (D-MA) and Michael Castle (R-DE).

FINRA & SEC Bring Fraud Charges Against Brookstreet Securities Brokers for Sales of CMOs to Retail Investors

FINRA today announced charges against six brokers formerly associated with Brookstreet Securities Corporation, a now-defunct nationwide brokerage firm based in Irvine, CA, including fraud and making unsuitable recommendations to retail customers in the sale of collateralized mortgage obligations (CMOs). 

FINRA's complaint alleges that from June 2004 through May 2007, the brokers sold CMOs to retail customers when the brokers themselves lacked a basic understanding of these complex and illiquid securities. The complaint alleges that the brokers failed to adequately investigate the CMO investments prior to selling the products and misrepresented or failed to disclose important information about the risks associated with an investment in CMOs. As a result, many customers were unaware of the speculative nature of the CMOs and suffered considerable losses. The complaint alleges that these brokers led their customers to believe that the CMOs were safe, government-backed securities. Customers were also told that they could achieve consistently high annual returns, in some cases up to 15 percent, regardless of market conditions. In fact, the complaint alleges that the CMOs purchased for the respondents' customers were generally not guaranteed by the government and were subject to uncertain cash flows and maturities, based on changes in interest rates.

 According to the complaint, the customers generally acquired small "odd-lot" positions that could not be easily sold in the marketplace unless sold at a substantial discount or combined with other positions as part of a larger block. Moreover, the complaint charges that the respondents recommended the CMOs to their customers, many of whom were retired and/or unsophisticated, without carefully assessing whether these were suitable investments in light of the customers' investment objectives, financial situation and other factors. Many of the respondents' customers were seeking a safe, secure investment, including those who used retirement funds to invest in the CMOs. Instead, many suffered substantial losses to their retirement savings.

 In a parallel action, the SEC today charged ten additional Brookstreet brokers with similar fraud.  According to the Commission’s complaint, the defendants told their customers that the CMOs in which they would invest were safe, secure, liquid investments that were suitable for retirees and investors with conservative investment goals. The complaint alleges that contrary to these representations, the defendants invested in risky types of CMOs that: (1) were not all guaranteed by the United States government; (2) jeopardized customers’ yield and principal; (3) were largely illiquid; and (4) were only suitable for sophisticated investors with a high-risk investment profile. The complaint alleges that the defendants received $18 million in commissions and salaries related to CMO investments.

The complaint also alleges that some defendants told customers that they would use margin, or the ability to borrow money to purchase CMOs, only sparingly, when in fact they heavily margined customers’ accounts, resulting in losses of over $36 million.

The Commission’s complaint specifically alleges that the defendants violated the antifraud provisions of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The Commission seeks permanent injunctive relief, disgorgement of ill-gotten gains with prejudgment interest, and civil monetary penalties.

Committee on Capital Markets Regulation Sets Forth Recommendations for Regulatory Reform

On May 26, the Committee on Capital Markets Regulation released The Global Financial Crisis: A Plan for Regulatory Reform.  The complete report, as well as the Executive Summary, is available at its website.  Here is an excerpt from the Executive Summary:

Several key themes emerge from our Report. The first theme is that our goal
must be effective regulation. Although we recommend introducing regulation in some
previously unregulated areas, the crisis has shown that the most precarious sectors of
our financial system are those already subject to a great deal of regulation—regulation
that has proven woefully ineffective. Our call to advance effective reform means that
new or revised regulations should be based on solid principles—chief among them
being the reduction of systemic risk. A second theme of this Report is the need to
increase investor protection through greater transparency in the financial system. More
information enables the market to price assets, risk, and other relevant inputs more
accurately. Much of the present crisis can be attributed to a lack of critical information
(and perhaps, in some cases, misinformation). The necessity of building a U.S. financial
regulatory structure able to achieve these goals is a third theme of this Report. Simply
put, our regulatory structure must be entirely reorganized in order to become more
integrated and efficient. A final theme is that a global crisis demands a global solution.
The U.S. financial system is best viewed as an integral part of the overall global
financial system. No longer can the United States regulate in a vacuum. Coordination
with other national regulators and cooperation with regional and international
authorities is required.

The Report goes on to set forth 57 specific recommendations for reform.

Investment Adviser Censured for Failure to Provide Fund Directors with Information in Contract Renewal Process

On May 27, the SEC settled charges against investment adviser New York Life Investment Management LLC (NYLIM) for failing to provide the Board of the Mainstay Equity Index Fund (Equity Index Fund), a mutual fund NYLIM advises, with information during the investment advisory contract renewal process and for making false or misleading statements in filings with the Commission. The Equity Index Fund seeks to replicate the movements of the S&P 500 index before expenses and has a "Guarantee" feature, under which a NYLIM affiliate guarantees that the value of a shareholder's investment on the tenth anniversary of purchase will be at least equal to the initial investment if all distributions are reinvested.

According to the SEC, from March 2002 through June 2004, the disinterested members of the Board of Trustees as well as the Board of Trustees of The MainStay Funds, approved the renewal of three investment advisory contracts between NYLIM and the Equity Index Fund. For each contract renewal process, the Board of Trustees received information showing that the management fees NYLIM charged to the Equity Index Fund were among the highest of the Equity Index Fund's peer-group of mutual funds. NYLIM urged the Board of Trustees to consider the Guarantee feature of the Equity Index Fund in evaluating the management fees NYLIM proposed, but, in violation of Section 206(2) of the Investment Advisers Act of 1940 (Advisers Act) and Section 15(c) of the Investment Company Act of 1940 (Investment Company Act), failed to provide the Board of Trustees information reasonably necessary to evaluate the cost of the Guarantee. Moreover, at the same time that NYLIM was claiming that the Guarantee should be considered to justify the Equity Index Fund's management fees, NYLIM was filing with the Commission, in violation of Section 34(b) of the Investment Company Act, prospectuses, annual reports, and registration statements in which it misrepresented that there was "no charge" to the Equity Index Fund or its shareholders for the Guarantee.

NYLIM consented, without admitting or denying the Commission's findings, to the issuance of the Commission's Order. NYLIM was censured and ordered to pay disgorgement of $3,950,075, prejudgment interest of $1,350,709, and a penalty of $800,000. NYLIM was also ordered to distribute the disgorgement, prejudgment interest, and penalty to affected shareholders of the Equity Index Fund.

SEC Suspends Former Kmart VP from Practicing before SEC

On May 27, the SEC issued an Order under Rule 102(e) of the Commission's Rules of Practice against John T. McDonald, who was Vice President and Treasurer of Kmart Corporation prior to the company's bankruptcy, suspending him from appearing or practicing before the Commission as an accountant with a right to apply for reinstatement after three years. This action resulted from a May 1, 2009 final judgment entered against McDonald, permanently enjoining him from future violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder and aiding and abetting violations of Sections 13(a) and Rules 12b-20 and 13a-13 thereunder, in the civil action entitled Securities and Exchange Commission v. Charles C. Conaway and John T. McDonald, Case No. 2:05-CV-40263 in the United States District Court for the Eastern District of Michigan. McDonald was ordered to pay a $120,000 civil penalty and barred from serving as an officer or director of a publicly traded company for five years. The Commission's complaint alleged, among other things, that McDonald was responsible for materially false and misleading disclosure about the financial condition of Kmart in the Management's Discussion and Analysis section of the company's Form 10-Q and in a conference call with analysts and investors.

McDonald consented to the issuance of the Order without admitting or denying any of the findings in the Order.

SEC Settles Accounting Charges Against Three Former Cardinal Health Officers

The SEC settled charges against three former finance executives of Cardinal Health, Inc. (Cardinal), a pharmaceutical distribution company based in Dublin, Ohio, that they engaged in a fraudulent revenue and earnings management scheme. Cardinal’s former chief financial officer, Richard J. Miller, former controller and principal accounting officer, Gary S. Jensen, and former senior vice president of finance, Michael E. Beaulieu, without admitting or denying the allegations, consented to the entry of an injunction and agreed to pay a total of $245,000 in civil penalties.

The Commission’s Complaint alleges that, at different times from September 2000 through March 2004, the former Cardinal executives engaged in the misconduct in order to present a false picture of Cardinal’s operational results to the financial community and the investing public – one that matched Cardinal’s publicly disseminated earnings guidance and analysts’ expectations, rather than its true economic performance. The Complaint alleges that as a result of these actions, Cardinal materially overstated its operating revenue, earnings, and growth trends in public earnings releases and filings with the Commission.

In addition, separately, without admitting or denying the Commission’s findings, Miller has consented to the institution of administrative proceedings pursuant to Rule 102(e)(3) of the Commission’s Rules of Practice, suspending him from appearing or practicing before the Commission as an accountant, with a right to re-apply after five years, based on the anticipated entry of the injunction. Without admitting or denying the Commission’s findings, Jensen and Beaulieu also have consented to the institution of administrative proceedings pursuant to Rule 102(e)(3), suspending them from appearing or practicing before the Commission as accountants, with a right to re-apply after three years, based on the anticipated entry of the injunctions.

On July 26, 2007, the Commission filed a related action against Cardinal, in which it consented to the entry of an order enjoining it from violating the antifraud, reporting, record-keeping, and internal controls provisions of the federal securities laws and agreed to pay a $35 million penalty.

Judge Sotomayor's Securities Law Opinions

My RA has found eleven Second Circuit opinions authored by Judge Sotomayor dealing with securities issues.  Here is the list of the cases and a very brief description of the issue:

Securities Investor Protection Corp v. BDO Seidman, LLP, 222 F. 3d 63, (2nd Cir. 2000)
Discussed the "fraud on the regulatory process" theory as it pertains to reliance

U.S. v. Falcone, 257 F.3d 226 (2nd Cir. 2001)
Addressed the misappropriation theory in regards to insider trading

In re NYSE Specialists Securities Litigation, 503 F.3d 89 (2nd Cir. 2007)
Considered liability for a national security exchange and relevant immunity

Dabit v. Merrill Lynch, Pierce, Fenner & Smith Inc., 395 F.3d 25, (2nd Cir. 2005)
Biased research/investment claim and the applicability of the Securities Litigation Uniform Standards Act preemption (reversed by Supreme Court)

Press v. Quick & Reilly, Inc., 218 F.3d 63 (2nd Cir. 2000)
Addressed binding nature of SEC determination on broker/dealer conduct

LNC Investments, Inc. v. First Fidelity Bank, N.A. New Jersey, 173 F.3d 454 (2nd Cir. 1999)
Bondholders' action for breach of fiduciary duty against trustees

Official Committee of Unsecured Creditors of Worldcom v. SEC, 467 F.3d 73 (2nd Cir. 2006)
Addressed SEC distribution of bankruptcy settlement funds after fraud action

Gerber v. MTC Electronic Technologies CO., LTD, 329 F.3d 297 (2nd Cir. 2003)
Discussed Settlement and Private Securities Litigation Reform Act applicability

Lerner v. Fleet Bank, N.A., 318 F.3d 113 (2nd Cir. 2003)
RICO case involving a ponzi scheme

LNC Investments, Inc. v. National Westminster Bank, New Jersey, 308 F.3d 169 (2nd Cir. 2002)
Applicability of Trust Indentures Act regarding bankruptcy proceedings

Moore v. PaineWebber, Inc., 306 F.3d 1247 (2nd Cir. 2002)
Class Certification in a life insurance fraud action

CSK Auto Settles Accounting Fraud Charges

The SEC today instituted settled cease-and-desist proceedings against CSK Auto Corporation (CSK), an auto parts retailer headquartered in Phoenix, Arizona, finding that the company violated the anti-fraud, reporting, books and records, and internal control provisions of the federal securities laws in connection with its false financial statements in its annual reports filed with the Commission for fiscal years 2002, 2003, and 2004. CSK filed false financial statements materially overstating its pre-tax income for fiscal year 2002 by approximately 47%, or $11 million; fiscal year 2003 by approximately $34 million, thereby reporting pre-tax income instead of a pre-tax loss; and fiscal year 2004 by approximately 65%, or $21 million.

This is the second enforcement action arising out of the Commission's investigation into CSK's financial fraud. In March 2009, the Commission filed a civil injunctive action in federal court against CSK's former president and chief operating officer, former chief financial officer, former controller, and former director of credits and receivables. See SEC v. Fraser, et al. (Lit Rel. No. 20933). In the pending federal court action, the SEC seeks a permanent injunction from future violations, disgorgement, prejudgment interest, and civil penalties against all defendants, and an order barring certain defendants from serving as a director or officer of a public company.

In the settled cease and desist proceedings against CSK, the Commission found that CSK materially overstated its income by (1) failing to write off vendor allowance receivables that it knew, or should have known, were not collectible, and (2) during fiscal year 2003, improperly recognizing certain vendor allowances. The Commission also found that CSK engaged in several private debt offerings while its false financial statements were outstanding and that it failed to implement internal accounting controls sufficient to provide reasonable assurances that accounts were accurately stated in accordance with Generally Accepted Accounting Principles. The Commission found that, as a result of its conduct, CSK violated Section 17(a) of the Securities Act of 1933 (Securities Act) and Sections 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Securities Exchange Act of 1934 (Exchange Act) and Rules 10b-5, 12b-20, and 13a-1 thereunder.

Based on the above, the Commission ordered CSK to cease and desist from committing or causing any violations and any future violations of Section 17(a) of the Securities Act and Section 10(b), 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Exchange Act and Rules 10b-5, 12b-20, and 13a-1 thereunder. CSK, in agreeing to the settlement, neither admitted nor denied the Commission's findings. (Rels. 33-9032; 34-59973; AAE Rel. 2974; File No. 3-13485)

SEC Alleges Foreign Currency Software Program Fraud

On May 21, 2009, the SEC filed a civil action against PrivateFX Global One Ltd., SA, 36 Holdings, Ltd., Robert D. Watson, and Daniel J. Petroski alleging their involvement in a multi-million dollar foreign-currency software program fraud. The U.S. District Court for the Southern District of Texas entered a temporary restraining order against the defendants, froze their assets, and appointed a receiver over them and all affiliated entities.  The SEC release identifies Watson as a Texas A&M finance professor and Petroski as a Houston lawyer and certified public accountant.

The SEC’s complaint alleges that Watson and Petroski raised more than $19 million from investors and claimed they would earn profits through “Alpha One,” a foreign-currency trading software program purportedly owned by their firm PrivateFX Global One Ltd. They claimed they would employ the services of 36 Holdings Ltd., a so-called “deal clearing company” owned and controlled by Watson. The SEC alleges that Watson and Petroski misrepresented to investors that it had millions of dollars in bank accounts in the U.S. and Switzerland and that their foreign exchange trading business had achieved an annual return of more than 23 percent since its inception and has never had a losing month. 

The SEC’s complaint also alleges that in response to Commission investigative subpoenas, Watson and Petroski produced phony records purporting to show that 36 Holdings held an account at Deutsche Bank, where it earned more than $2 million for Global One in 2009 by trading foreign currencies. In fact, 36 Holdings did not even have an account at Deutsche Bank. The SEC’s complaint also alleges that the defendants provided the Commission staff with phony bank statements from a Swiss bank and falsely claimed that 36 Holdings had almost $70 million on deposit there, including $11 million of Global One funds.

Specifically, the Commission alleges that the defendants violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission’s investigation is continuing.

Supreme Court Grants Cert in "Inquiry Notice" Statute of Limitations Case

The Supreme Court accepted cert in a securities fraud action from the Third Circuit today, In re Merck & Co. Securities Deriv. & ERISA Litig., 543 F.3d 150 (3d Cir. 2008).  In the action the plaintiffs charge that the drug manufacturer made misstatements about the safety and commercial viability of Vioxx.  The district court had dismissed the complaint, holding that the plaintiffs were put on inquiry notice more than two years before filing the complaint, but the Third Circuit (2-1) reversed.  The question presented is:

 Did Third Circuit err in holding, in accord with Ninth Circuit but in contrast to nine other courts of appeals, that under "inquiry notice" standard applicable to federal securities fraud claims, the statute of limitations does not begin to run until investor receives evidence of scienter without benefit of any investigation?

Romano on Sarbanes-Oxley

Does the Sarbanes-Oxley Act Have a Future? by Roberta Romano, Yale Law School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI), was recently posted on SSRN.  Here is the abstract:

Although the enactment of the Sarbanes-Oxley Act (SOX) received nearly unanimous congressional support, only a few years thereafter its wisdom was increasingly questioned and its supporters had to stave off attempts to recraft the legislation. The financial crisis of 2008 has sidelined efforts to alter the legislation’s most costly provision, as Congress’s attention has turned to overhauling the regulatory regime for financial institutions. There is, nonetheless, much to be learned about financial regulation and SOX’s future, from an in-depth examination of the interplay of the government and private commissions created with an eye to revising the legislation, media coverage of those entities, and congressional responses. That interaction provides a map of political fault lines and assists in forecasting the prospects for recrafting SOX’s most costly provision. It also serves as a cautionary tale regarding significant regulation enacted in the midst of a financial market crisis. The ongoing financial crisis has sidelined SOX, but its burdensome costs suggest that it might well, in due course, reemerge on the legislative agenda.

Fotak et alia on Naked Short Selling

Naked Short Selling: The Emperor’s New Clothes?, by Veljko Fotak, University of Oklahoma - Division of Finance, Vikas Raman, University of Oklahoma - Division of Finance, and Pradeep K. Yadav, University of Oklahoma - Division of Finance, was recently posted on SSRN.  Here is the abstract:

Regulatory and media concern has focused heavily on the potentially manipulative distortion of market prices associated with naked short selling. However, naked shorting can also have beneficial effects for liquidity and pricing efficiency. We empirically investigate the impact of naked short-selling on market quality, and find that naked shorting leads to significant reduction in positive pricing errors, the volatility of stock price returns, bid-ask spreads, and pricing error volatility. We study naked shorting surrounding the demise of financial institutions hardest hit by the financial crisis in 2008 and find no evidence that stock price declines were caused by naked shorting. We also find that naked short-selling intensifies after rather than before credit downgrade announcements during the 2008 financial crisis. In general, we find that naked short sellers respond to public news and intensify their activity after price declines rather than triggering these price declines. We study the impact of the SEC ban on naked short selling of financial securities during July and August 2008, and find that the ban did not slow the price decline of those securities and had a negative impact on liquidity and pricing efficiency. Finally, after examining the speeds of mean reversion of pricing errors and order imbalances, we infer that Regulation SHO was successful in curbing the impact of manipulative naked short selling, and this reduction in the impact of manipulative naked shorting has continued through the 2008 financial crisis. Overall, our empirical results are in sharp contrast with the extremely negative pre-conceptions that appear to exist among media commentators and market regulators in relation to naked short-selling.