2012 Mid-Year Securities Enforcement Update

July 16, 2012

I.   Overview of the First Half of 2012

The first half of 2012 has shown a continuation of the SEC’s aggressive enforcement strategy even after a record-breaking fiscal year 2011 for the U.S. Securities and Exchange Commission (the "SEC" or "Commission"), which resulted in 735 enforcement actions and over $2.8 billion in penalties and disgorgement ordered. During the first six months of 2012, the SEC filed 110 actions in federal court against a collective 308 defendants. It appears, however, that the SEC is beginning to feel the resource costs of pursuing such cases over time. Specifically, the SEC recently disclosed that it is actively litigating approximately 90 cases, which is an increase of more than 50% in the past year.[1] This recent surge in litigation may have been influenced by many factors, including the increased complexity in cases stemming from the financial crisis and a related increase in charges being filed against individuals. Protracted litigation will place an increasing drain on the agency’s limited resources. Nevertheless, as the current administration’s first term comes to a close and as conduct related to the financial crisis becomes more distant in time, we anticipate that the SEC will sustain its aggressive strategy of filing and, if necessary, litigating cases against prominent defendants in order to bolster public confidence in a vigorous enforcement of the securities laws.

Highlights of the past six months include:

• Initial judicial affirmation of "neither admit nor deny" settlements;
• SEC reporting favorable results from its new Whistleblower Program, including increases in the number and quality of tips received;
• The first public announcement of credit to an individual for cooperation in an Enforcement investigation; and
• Continued emphasis on cases related to the financial crisis and insider trading.

          A.   Initial Affirmation of "Neither  Admit Nor Deny" Settlements

At the outset of 2012, the future of the "neither admit nor deny" settlement had been called into question, and it was unclear whether this long-standing method of case resolution would survive. A recent procedural decision by the U.S. Court of Appeals for the Second Circuit, however, has provided clarity on this issue, at least until the full panel issues its opinion.[2]

By way of background, on October 19, 2011, the SEC filed a settled action against Citigroup Global Markets ("Citigroup") relating to the structuring and selling of a collateralized debt obligation, and submitted the $285 million settlement to the district court for approval.[3] On November 28, 2011, after a briefing and a hearing, Judge Jed S. Rakoff rejected the SEC’s settlement with the bank, stating that the allegations were "unsupported by any proven or acknowledged facts." Judge Rakoff’s opinion sharply criticized the SEC’s long-standing practice of entering into settlements under which a defendant neither admits nor denies wrongdoing.[4]

Immediately following Judge Rakoff’s ruling, the SEC publicly opposed the decision, filed an appeal, and requested a stay pending appeal. Judge Rakoff denied the SEC’s motion for a stay pending appeal on December 27, 2011.[5] On the same day, the Second Circuit granted an application for an emergency stay. On March 15, 2012, a three-judge panel of the Second Circuit granted the motions of Citigroup and the SEC to stay district court proceedings so that the appellate court could consider the merits of Judge Rakoff’s rejection of the proposed settlement.

Although not a final decision on the merits, in ruling on whether to grant the stay, the panel found a substantial likelihood that the SEC and Citigroup would prevail on the merits of their appeal. The court considered Judge Rakoff’s three main arguments in turn: that the settlement failed to serve the public interest, that the settlement was unfair to the bank, and that there was an inadequate basis to assess the fairness of the settlement. With respect to the first argument–that the settlement was not in the public interest–the panel emphasized that the court "does not appear to have given deference to the SEC’s judgment on wholly discretionary matters of policy."[6] Even though the district court verbally acknowledged giving the "fullest deference to the SEC’s views," the panel found no indication in the record that the court actually gave deference to those views. With respect to the second concern over unfairness to the bank, the panel questioned "whether it is a proper part of the court’s legitimate concern to protect a private, sophisticated, counseled litigant from a settlement to which it freely consents." With respect to the third argument–the absence of a basis on which to assess the fairness of the settlement–the panel pointed to the extensive factual record developed by the SEC that was freely accessible to the district court.

As a result, the Second Circuit panel has provided affirmation of the SEC’s "neither admit nor deny" settlement policy. In a subsequent Congressional hearing on the SEC’s settlement practices, the SEC received little challenge to its long-standing practice of settling cases on a neither admit nor deny basis.

Nevertheless, the Second Circuit’s panel ruling has not deterred other federal judges from subjecting SEC settlements to heightened scrutiny. In June, Judge Frederic L. Block, a federal judge for the U.S. District Court for the Eastern District of New York, initially expressed reluctance to approve a settlement of the SEC’s pending litigation between the SEC and two former Bear Stearns hedge fund managers shortly before trial was scheduled to commence.[7] Initially, Judge Block expressed concern that the disgorgement and penalty amounts in the proposed settlements were "chump change" compared to the alleged investor losses arising from the collapse of the hedge funds the defendants had managed. On further analysis, Judge Block acknowledged that the SEC’s equitable authority to obtain disgorgement is limited to the defendant’s profits from alleged misconduct, which is often substantially less than investor losses. The SEC lacks authority to recover damages as measured by investor losses.  Judge Block ultimately approved the settlement, but called on Congress to consider expanding the SEC’s authority to seek increased monetary relief in enforcement actions.

          B.   Results of the Whistleblower Program

In May 2011, the SEC adopted final rules to implement the whistleblower bounty program ("Whistleblower Rules") mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act").[8] The SEC recently reported receiving a substantial number of tips from insiders, with approximately eight tips being submitted to the agency per day.[9] More significantly, agency officials have further noted a significant increase in the quality of such tips.[10]

Speaking recently at a conference, George Canellos, Deputy Director of the SEC’s Enforcement Division and former head of the New York Regional Office, explained that in contrast to the two-sentence tips that were common prior to the Dodd-Frank Act, the SEC now regularly receives multipage reports complete with supporting evidence and offers of assistance or cooperation from company insiders. Most of the whistleblower tips received concern alleged violations of the Foreign Corrupt Practices Act, accounting malfeasance, and market manipulation. According to Canellos, "[w]hat’s really clear is the quality of those tips has greatly improved."[11]

Undoubtedly, the substantial financial rewards that the Whistleblower Rules established are a significant incentive for individuals to report tips to the SEC. If a whistleblower employee voluntarily provides the SEC with original information that leads to a successful enforcement action by the SEC, that employee is eligible to receive a bounty of 10 percent to 30 percent of SEC awards greater than $1 million arising out of the same core facts. As a result, companies and their counsel must assume that if they receive an internal complaint of a potential securities law violation, the government is likely to receive the same complaint as well. This heightens the burdens on companies to react quickly to internal complaints in order to be prepared to respond to a potential SEC inquiry and to make timely decisions concerning potential self-reporting.

          C.   Statistics and Trends

For the last five years we have been tracking certain metrics of enforcement activity and have identified noteworthy trends. First, during the first six months of 2012, the SEC filed 110 civil injunctive actions in federal court. This is down slightly from the number of cases filed in the same period in 2011, when the SEC filed 125 civil actions, though comparable to the same period in 2010, when the SEC filed 118 actions. However, this figure is down significantly from the peak number of 167 actions filed by the SEC  in 2009.

Figure 1 – January to June Injunctive Actions Filed

The SEC charged 308 defendants in the first six months of 2012, which is approximately 15% less than the number charged during the same period in 2011. Similar to the number of injunctive actions filed, the number of defendants charged in the first six months of 2012 is comparable to the number charged during the same period in 2010, though this figure is down significantly from the peak of 527 defendants charged during the same period in 2009.

Figure 2 – January to June Number of Defendants Charged

In the first six months of 2012, 25.3% of defendants’ charges were settled at the time of filing. This is down slightly from 2011 when 29%, and up slightly from 2010 when 21.9% of defendants’ charges were settled at the time of filing. Overall, this metric reflects that a substantial proportion of the SEC’s cases are being filed without settlements.  This derives in part from the SEC’s focus on individuals in actions, particularly in cases related to the financial crisis.  In recent Congressional testimony, Robert Khuzami, Director of the SEC’s Division of Enforcement, in an effort to demonstrate the SEC’s willingness to litigate rather than settle cases, noted that, of the cases filed against individuals related to the financial crisis, 75% were filed as litigated actions.  With the financial crisis conduct becoming more aged, and the SEC’s litigation burden increasing, the SEC will be further challenged to maintain its ability to litigate substantial cases without settlements.  

Figure 3 – January to June Percentage of Defendants Settled at Filing

          D.   Significant Cases

                 1.   Financial Crisis

As we approach the five-year anniversary of the onset of the financial crisis that started in 2007, the Enforcement Division staff continues its ongoing focus on financial crisis-related investigations and litigation. In an effort to defend its record in responding to the financial crisis, the SEC has tracked and publicized the results of financial crisis-related cases. Through June 28, 2012, the SEC reports that, in connection with the financial crisis, it has charged 104 entities and individuals (including 55 CEOs, CFOs, and other senior executives), and has recovered over $1.27 billion in civil penalties, over $424 million in disgorgement proceeds, and $355 million in additional monetary relief for harmed investors.[12] This brings the SEC’s total haul for financial crisis enforcement to over $2 billion and counting.

On May 17, 2012, Director Khuzami appeared before the House Committee on Financial Services. In his testimony, Director Khuzami pointed to the record number of enforcement actions brought in fiscal year 2011 (735), and stressed that numerous cases over the past few years have involved extremely complex financial products and market practices, requiring a greater amount of investigatory resources.[13]

During the first half of this year, highlights from financial crisis-related enforcement actions include:

• BankAtlantic: The SEC filed an action against the holding company for one of Florida’s largest banks and its top executive alleging misrepresentations to investors about alleged problems in a significant loan portfolio early in the financial crisis.[14]
• Option One Mortgage Corp.: The SEC filed a settled action against a  subsidiary of H&R Block alleging that the company failed to disclose to investors in subprime mortgage-backed securities that its financial condition was significantly deteriorating, which imperiled its ability to meet repurchase obligations under the terms of numerous offerings.[15]
• Thornburg Executives: The SEC filed an action against the former CEO, CFO, and chief accounting officer of a former top mortgage company alleging a failure to disclose the company’s deteriorating financial condition and overstating the company’s income by over $400 million.[16]
• Bear Stearns Hedge Fund Managers: Bringing a conclusion to one of the first cases related to the financial crisis, the SEC reached a settlement with former managers of two Bear Stearns hedge funds, with the two defendants agreeing to pay just over $1 million in disgorgement.
• Credit Suisse Traders: The SEC charged four former investment bankers and traders with fraudulently overstating subprime bond prices.[17]

                 2.   Insider Trading

The SEC continued its aggressive pursuit of insider trading cases in the first half of 2012. Most notably, in the wake of its successful conviction of hedge fund manager Raj Rajaratnam, both the SEC and the Department of Justice ("DOJ") filed charges against Rajat Gupta, an alleged source of Rajaratnam who previously served as a director for Goldman Sachs Group Inc. and Procter & Gamble Co. On June 15, 2012, the jury returned guilty verdicts on four of the six counts. The relatively swift deliberations in this case can be contrasted with the 12 days it took for a jury to decide to convict Rajaratnam last year. Gupta’s sentencing is set for October 18.

In contrast to the Rajaratnam case, the prosecutors’ case against Gupta was based largely on circumstantial evidence, including a pattern of telephone and trading records and testimony by a number of witnesses. To date, the DOJ has charged 68 traders and their sources across the country. Of those charged, none have won an acquittal, though there are six cases still pending. In a statement, Director Khuzami explained that the Gupta verdict "sends a very strong message to corporate America and to Wall Street that those who engage in insider trading, irrespective of their station in life, can expect to be prosecuted to the fullest extent of the law."

Notably, the government also brought cases against two of the hedge fund management companies, and several individuals, that were subject to search warrants in the fall of 2010, as well as John Kinnucan and his research networking firm Broadband Research Corporation ("Broadband Research").    

In light of its high-stakes and well-publicized victory in the Gupta case, achieved in spite of a lack of the direct evidence on hand in the Rajaratnam case, the SEC and the nationwide criminal authorities will likely continue their aggressive and extremely successful prosecution of insider trading for the foreseeable future.

                 3.   Developments in the SEC’s Cooperation Initiative

The Cooperation Policy Statement issued by the SEC in early 2010 announced a new policy under which individuals could cooperate in an enforcement investigation to avoid a civil enforcement action or receive a lesser sanction.[18] To summarize, the policy statement explained that, although the SEC’s assessment of cooperation will be conducted through a case-by-case analysis of specific circumstances, that analysis will generally be guided by the evaluation of four factors: (1) the assistance provided by the cooperating individual in the SEC’s investigation or related enforcement actions; (2) the importance of the underlying matter in which the individual cooperated; (3) the societal interest in ensuring that the cooperating individual is held accountable for his or her misconduct; and (4) the appropriateness of cooperation credit based upon the profile of the cooperating individual.

One of the challenges we have previously noted with the SEC’s efforts to incentivize individual cooperation is the absence of any public record of the benefits individuals receive from cooperating.  This year, the SEC took steps to address this gap, but did so in a way that still leaves open many questions.

On February 3, 2011, the SEC brought a settled enforcement action against AXA Rosenberg, an institutional money manager that specializes in quantitative investment strategies, alleging that the firm had failed to disclose an error in the computer code of the quantitative investment model that the firm used to manage client assets.[19] On March 19, 2012, as part of its cooperation initiative, the SEC announced that it had credited the substantial cooperation of a former AXA Rosenberg senior executive in the investigation by declining to take enforcement action against him. At the time of the announcement, the SEC stated that the agency had entered into cooperation agreements with 37 individuals since the launch of the cooperation initiative. However, this was the first time since the beginning of the initiative that the SEC has publicly recognized the cooperation of an individual.

In a public statement, Director Khuzami praised the substantial cooperation provided by "a senior executive" of AXA Rosenberg.[20] Director Khuzami emphasized that this situation demonstrates that the SEC "fully recognizes the value of cooperation" in its investigations, and that such cooperation will be rewarded. A corresponding litigation release issued by the staff provided an example of the application of the four cooperation factors to the facts of the case. The document explained that the assistance provided was detailed, credible, and voluntarily provided; that the underlying matter was important, since it was the SEC’s first action arising from errors in a quantitative investment model; that there was little interest in holding the cooperator accountable since he was minimally involved in the alleged concealment; and that the executive had no past disciplinary history and had retired from the finance industry.

The SEC’s announcement is a first step in the right direction in creating a public record of the potential rewards for individual cooperation in an investigation. However, there remains little guidance in the area, and this case is relatively unique because of the technical nature of the violation and the retired status of the former executive. As a result, the decision of whether to cooperate in an investigation remains uncertain and dependent on a range of variables in each individual case. For a more detailed discussion of the AXA Rosenberg case, see Gibson Dunn’s prior alert, "SEC Makes First Public Announcement of Credit to an Individual for Cooperation in an Investigation."[21]

Just over a week after the AXA Rosenberg announcement, on March 27, 2012, the SEC announced another settlement of a case in which it gave credit to an individual defendant for cooperation. The SEC filed a settled complaint against John Cinderey, a former executive vice president at San Francisco-based United Commercial Bank, alleging that Cinderey misled outside auditors that were evaluating financial statements of the bank and its public holding company during the financial crisis in 2008 and 2009. Cinderey agreed to settle the charges without admitting or denying the allegations. The settlement did not require Cinderey to pay any civil damages, in part because of a $40,000 civil penalty he had already paid in an administrative action brought by the FDIC. In its litigation release, the SEC noted that "the terms of the settlement also reflect credit given to Cinderey by the Commission for his substantial assistance in the investigation and the fact that he has entered into a cooperation agreement to assist in an ongoing related enforcement action" against other former executives.[22]

This leaves the AXA Rosenberg case as the only instance in which the SEC publicly disclosed a decision not to charge an individual based on the individual’s cooperation.

          E.   What to Look for in the Second Half of 2012

This year marks the end of the current presidential term.  Regardless of the outcome of the election, the SEC may begin to see turnover among its senior ranks as several of the most senior staff members, many of whom left significant positions in the private sector in 2009, may wish to return to private life.  At the same time, conduct from the financial crisis, which has been a primary focus of staff resources, is becoming increasingly older.  All of these factors combine to suggest that there will be a push to conclude pending investigations related to the financial crisis.

At the same time, the significant increase in litigated cases has created a backlog at the SEC and will continue to serve as a demand on the agency’s resources at a time of fiscal uncertainty. President Obama recently threw his support behind the SEC’s requested $245 million budget increase, threatening to veto a House budget that provided only a $50 million increase.[23] Despite this support, the uncertain budget situation in Congress, combined with the higher level of litigated cases, suggests that the SEC will be under pressure in the near-term future as previously filed cases work their way through litigation and approach trial or result in settlements.

Moreover, in light of the reportedly higher-quality tips coming in from whistleblowers, there is reason to expect that the SEC will pursue an increased amount of complex investigations and litigations in the coming months.

II.   Insider Trading

          A.   Hedge Funds, Expert Networks, and Operation "Perfect Hedge"

In the first half of 2012, the SEC and the U.S. Attorney’s Office continued to bring insider trading charges related to the dissemination of confidential insider information in the hedge fund industry, largely as a result of the FBI’s operation "Perfect Hedge." In particular, the SEC announced cases involving two of the advisory firms that were subject to search warrants in November 2010, when the FBI’s wide-ranging undercover investigation first became public. In January, the SEC announced insider trading charges against hedge fund advisory firms Diamondback Capital Management LLC ("Diamondback") and Level Global Investors LP ("Level Global"), together with four employees of these firms–including the co-founder of Level Global–and three employees of unnamed other investment advisers.[24] The SEC alleged that these defendants participated in a network of hedge fund traders who obtained confidential performance information from companies, including Dell and Nvidia, and illegally traded on such information multiple times. The SEC alleged that Diamondback gained nearly $8 million in illicit profits for funds it managed, and that Level Global earned $72 million in illegal profits from the insider trades.[25] The U.S. Attorney for the Southern District of New York announced simultaneous criminal charges against seven individuals, three of whom pleaded guilty that day; the charges were based on evidence obtained in the FBI’s "Perfect Hedge" investigation.[26]

In announcing the charges, Director Khuzami used the cases to make a broader point about hedge funds reflecting the SEC’s continued concerns about their trading. According to Khuzami, the actions illustrated the "lack of transparency in [hedge fund] trading practices, market power that can give them influence over those who possess insider information, access to leverage and enormous amounts of capital, and the techniques to trade extremely quickly."[27]

Five days after the charges were announced, Diamondback agreed to settle the actions against it for $6 million in disgorgement and $3 million in penalties. Concurrently, Diamondback reached a Non-Prosecution Agreement with the U.S. Attorney’s Office. In conformity with the SEC’s recently announced policy on concurrent settlements with criminal law enforcement, Diamondback was not permitted to use "neither admit nor deny" language and instead admitted the facts alleged by the SEC.[28] The SEC announced that its settlement decision was guided by the "substantial cooperation" provided by Diamondback, including extensive interviews, analysis of complex trading patterns to determine suspicious activity, and presentation of the results of its internal investigation to federal investigators.[29] Importantly, the investigation showed that no other employees had engaged in insider trading.[30] Nevertheless, by the time Diamondback settled the investigation, its assets under management had dropped by around 50% (to $2.5 billion) since the FBI first executed a search warrant at the firm in November 2010. The other three firms searched at that time–Level Global, Loch Capital Management, and Barai Capital–have since shut down.[31]

In February, the SEC and the U.S. Attorney’s Office for the Southern District of New York announced charges against Doug Whitman, the head portfolio manager at hedge fund adviser Whitman Capital, LLC. Between 2007 and 2009, Whitman allegedly bought and sold stock and options for Marvell Technology Group, Ltd. ("Marvell") based on information learned from an independent research consultant, who in turn obtained the information from several Marvell employees. In exchange for the information, Whitman allegedly paid the consultant through a soft dollar arrangement. Whitman also allegedly traded on inside information relating to Polycom, Inc. and Google, Inc. that he obtained from Roomy Khan, a research professional who was a key informant in the case against Raj Rajaratnam. In exchange for the inside information, Whitman allegedly provided Khan with information about other publicly traded technology companies. The SEC’s release asserted that the pattern of insider trading by Whitman was similar to that by Rajaratnam as well as other contacts of Khan.[32]

Also in February, the SEC charged John Kinnucan and his expert consulting firm Broadband Research with insider trading in an additional action related to the ongoing "Perfect Hedge" investigation.[33] The SEC alleged that Kinnucan and Broadband Research claimed to provide clients with legitimate research about publicly traded technology companies, but in reality frequently tipped clients with material, nonpublic information learned from inside sources. Broadband Research’s clients paid significant fees for the information and Kinnucan compensated his confidential sources with money, dinners, and vacations. Kinnucan also faces criminal securities fraud charges. The SEC’s release noted that he was the 22nd defendant charged by the Commission in connection with its expert networks investigation.[34] That same day, former SanDisk Corp. executive Donald Barnetson pleaded guilty to passing nonpublic information to Kinnucan.[35]

In June, retired head of consulting firm McKinsey & Company and former Goldman Sachs director Rajat Gupta was found guilty on four of six charges of insider trading violations in another case that arose out of the FBI’s "Perfect Hedge" investigation.[36] The criminal case against Gupta did not claim that he made any trades himself. Instead, it alleged that he provided to Raj Rajaratnam inside information that he learned as a director of Goldman Sachs and Procter & Gamble, and that Rajaratnam subsequently traded on this inside information. The prosecution alleged that Gupta’s motivation was not easy profits, but instead access to a world where "inside tips are the currency of friendships and elite business relationships."[37] After a month-long jury trial, Gupta was found guilty of conspiracy to commit securities fraud, two counts of securities fraud in his tipping of information that Goldman Sachs would soon receive a $5 billion investment from Berkshire Hathaway, and a count of securities fraud in his tipping of information ahead of Goldman Sach’s December 2008 earnings. (He was found not guilty of claims that he tipped confidential information about Procter & Gamble.)[38] The Gupta conviction was notable in that the prosecution relied largely on circumstantial evidence for the conviction, such as phone records, trading logs, and emails. For example, the phone records showed that Gupta called Rajaratnam within minutes of disconnecting from Goldman Sachs board of directors calls. The case was bolstered by a few wiretapped conversations where Rajaratnam told colleagues that he traded Goldman stock because he had a source within the company providing him with information; however, the prosecution had no recorded conversations in which Gupta participated. The jury’s acceptance of circumstantial evidence in this case may bolster the confidence of future prosecutors.[39]

The New York Times noted that, at the time of his conviction, Gupta was one of 66 individual defendants facing criminal insider trading charges as part of the government’s latest crackdown. More significant, however, is the fact that of the 66 defendants, 60–or 90%–have pleaded guilty or been found guilty.[40] Most of these convictions can be tied to the FBI’s "Perfect Hedge" investigation.[41] Still more striking is a disclosure in a February 2012 Wall Street Journal article indicating that federal authorities are continuing to investigate potential insider trading cases against 120 additional targets.[42] Gupta will be sentenced in October 2012.[43]

Also in June, the SEC brought insider trading charges against Tai Nguyen, the owner of equity research firm Insight Research ("Insight"), in its continuing investigation of the use of expert networks to provide material, nonpublic information to investment firms. The complaint alleges that, between 2006 and 2009, Nguyen traded in the securities of Abaxis, Inc. based on inside information learned from a relative employed at the company. The complaint further claims that Nguyen passed on the information to Insight’s hedge fund clients Barai Capital Management and Boston-based Sonar Capital Management, who used the information to gain millions of dollars in illicit profits for the funds they managed.[44] Portfolio managers of both clients settled SEC charges and pleaded guilty to criminal charges in 2011.[45] Barai Capital Management settled SEC charges as well.[46]

          B.   Insider Trading in the Technology Industry

In May, the SEC announced settled insider trading charges against Robert Kwok, a former Senior Director of Business Management at Yahoo! Inc., and Reema Shah, a former portfolio manager at a subsidiary of Ameriprise Financial. The SEC alleged that Kwok tipped Shah about a search engine partnership agreement reached between Yahoo and Microsoft that would be formally announced in the near future and that Shah then caused funds she managed to purchase Yahoo shares. In return, the SEC alleged, Shah tipped Kwok with material, nonpublic information concerning an upcoming acquisition by Autodesk; this information was allegedly misappropriated by an Autodesk insider and tipped to Shah. Kwok allegedly used this information in purchasing shares of the target company. The two defendants also pleaded guilty to criminal charges in the Southern District of New York and await sentencing.[47]

          C.   Mergers and Acquisitions

In March, the SEC charged five individuals with insider trading in the stock of Philadelphia Consolidated Holding Corp. ("PCH") before the company’s announcement of its impending merger with a Japanese company.[48] The Commission alleged that an executive at PCH passed PCH’s confidential merger information to defendant Timothy McGee, a registered representative at Ameriprise Financial Services ("Ameriprise Financial"). The executive and McGee allegedly knew each other through mutual participation in an Alcoholics Anonymous program, and the tipper told McGee that the stress of the merger was causing him to drink; in response, McGee pressed the tipper for details on the merger. The complaint alleged that McGee subsequently traded in PCH shares for himself and on behalf of family members. He also allegedly provided the merger information to his father, to a fellow registered representative at Ameriprise Financial, and to two friends, each of whom traded on the information and was charged by the SEC. Notably, the two friends were Chinese nationals living in Hong Kong who were charged by the SEC despite being abroad. At the time the complaint was filed, the two Hong Kong residents had agreed to settle the SEC’s charges and pay $1.2 million and $140,000, respectively, in disgorgement, interest, and penalties.

          D.   Confidential Board Information

In May, the SEC filed a settled complaint against movie producer Mohammed Mark Amin and several of his friends and relatives. Amin allegedly learned confidential information in connection with his service on the board of directors of real estate investment trust DuPont Fabros Technology, Inc. ("DFT"). When he learned confidential information about new loans and leases DFT had secured at the height of the financial crisis, he allegedly purchased a substantial number of DFT shares and provided the confidential information to relatives, friends, and business associates who also allegedly traded on the information. In addition to paying disgorgement and penalties, Amin was barred from service as director of an issuer for a period of 10 years.[49]

          E.   The "STOCK Act" Regarding Trading by Government Personnel

In April 2012, President Obama signed into law the Stop Trading on Congressional Knowledge Act ("STOCK Act"), a bill that bars members of Congress and other federal employees in the legislative, executive, and judicial branches from making securities trades on the basis of material, nonpublic information derived from their respective positions or gained from the performance of their official duties. Among other things, the STOCK Act amended the Securities Exchange Act of 1934 and the Commodity Exchange Act to affirm expressly that members of Congress and their staff, federal judges, and judicial and executive branch employees each owe a duty of trust and confidence to the United States Government and to the citizens of the United States with respect to material nonpublic information derived from their respective positions or gained in the performance of their duties, and are not exempt from the insider prohibitions of the federal securities laws. Additionally, the STOCK Act requires that members of Congress and specified members of their staffs, as well as senior employees of the executive branch, report certain investment transactions in a manner that will be available and searchable online. The STOCK Act created several additional ethics requirements for members of Congress and certain high-level government employees, including prohibition of participation in an initial public offering ("IPO") on terms that are not available to the general public.[50]

          F.   Insider Trading Abroad

                 1.   Japan

Since March of this year, Japan’s Securities and Exchange Surveillance Commission ("SESC") has brought four cases against three investment firms in connection with its investigation into seemingly widespread insider trading prior to public share offerings. (For example, in June 2012, Nomura Securities acknowledged that its employees leaked confidential information on three public share offerings in 2010 and "sincerely apologize[d] for the trouble this has caused.")[51] In the SESC’s fourth enforcement action, in June, First New York Securities paid a fine of ¥14.7 million, or $185,000. This was the SESC’s first insider trading action against a foreign firm, and its largest fine to date, but the relatively small penalty drew attention to the lenient means of insider trading enforcement in Japan. First, tippers are not subject to sanction in Japan. Second, Japanese law only allows "primary recipients" of inside information to be punished; nevertheless, the case against First New York Securities showed some flexibility by the SESC, deeming the trader to be a "primary recipient," even though he received the inside information not from the direct source but instead from a consulting firm that acted as a conduit. Third, the official sanctions in Japan are low, as they are limited to the estimated commissions earned on the illegally traded securities. The recent enforcement and low penalties have prompted calls for change, such as handing enforcement responsibilities off to the industry’s self-regulatory organization, the Japan Securities and Dealers Association, or writing harsher punishments into the law.[52]

                 2.   United Kingdom

In January, the U.K. Financial Services Authority ("FSA") fined David Einhorn and his U.S.-based hedge fund Greenlight Capital Inc. ("Greenlight") a total of £7.2 million for market abuse.[53] The charges stemmed from a June 2009 phone call wherein Einhorn learned from a Merrill Lynch broker that Punch Taverns plc ("Punch") was in the advanced stage of an equity fundraising process. Greenlight specifically declined to be made an insider for the purposes of the call and David Einhorn requested that he would not be "wall crossed." A few minutes after the conversation, Einhorn allegedly instructed that Greenlight should sell its entire holding in Punch; prior to these sales, the fund held 13.3% of Punch’s issued shares. Following the announcement of the equity fundraising, the Punch shares dropped nearly 30%; the trading permitted Greenlight to avoid losses of approximately £5.8 million. The FSA accepted that Einhorn’s trading was not deliberate because he did not believe that the information he learned was inside information. However, the FSA contested this belief because it was not reasonable, noting that "[i]nvestment professionals are expected to handle inside information carefully regardless of whether they have been formally wall-crossed."[54] The Merrill Lynch broker was separately charged.[55]  For a more in-depth discussion of this matter, see Gibson Dunn’s prior alert, "A Tale of Market Abuse Highlighting Traps for the Unwary."[56]

In April, the FSA decided to fine the Chairman of Capital Markets at JP Morgan Cazenove[57] £450,000 for market abuse.[58] The FSA’s decision notice stated the agency believed that the defendant disclosed inside information relating to Heritage Oil Plc ("Heritage"), an existing client, to a prospective client. The first disclosure related to a potential offer for Heritage, for whom he was acting as an adviser, and the second disclosure pertained to a new oil find by the company. The FSA stated its belief that the defendant did not set out to commit market abuse but "considers that [his] failings were serious in view of his experience and senior position within JP Morgan."  The defendant resigned from his position and said he would appeal the decision.[59]

In May 2012, three people pleaded guilty to insider dealing in a prosecution brought by the FSA, following guilty pleas by two others. The prosecution alleged that Arnold McClellan, a senior partner in a large U.S. accounting firm, was an insider to a number of mergers and acquisitions transactions that involved U.S. companies listed on the NYSE and NASDAQ.  It was further alleged that Mr. McClellan leaked certain confidential merger and acquisition information he learned in connection with his job to his sister and sister-in-law, who used the information to trade in U.S.-listed securities, and that he encouraged certain clients to do the same. The total profits generated by the defendants were approximately £1.9 million, while the total profits generated by the clients were approximately £10.2 million. On June 20, 2012, defendant James Sanders received the longest-ever insider trading sentence in the U.K. when he was sentenced to four years in prison.[60] The case notably involved a parallel investigation by the SEC and DOJ, together with the FBI. The U.S.-based sister-in-law previously settled with the SEC and pleaded guilty to a criminal charge brought by the DOJ; she is currently serving an 11-month prison sentence.[61]

III.   Investment Advisers

          A.   Developments in Examination and Oversight

As a part of their continuing evaluation of the oversight of investment advisers, Congress and the SEC have proposed and/or adopted several important measures:

SRO for Investment Adviser Oversight

In April, House Financial Services Committee Chairman Spencer Bachus (R-Ala.) introduced a bill, the Investment Adviser Oversight Act, which would move the oversight of investment advisers from the SEC to one or more self-regulatory organizations ("SRO"), such as the Financial Industry Regulatory Authority, Inc. ("FINRA").[62] Chairman Bachus introduced this bill as a result of a January 2011 SEC report which found that the SEC could only review 8% of investment advisers annually. The bill seeks to provide more frequent and in-depth review of investment advisers, but critics contend that the bill may drastically increase compliance costs for small investment advisory firms and eliminate jobs in the sector. Opponents of the bill also assert that there will be costs and a learning curve associated with a new SRO, which prompted Representative Maxine Waters (D-Cal.) to propose increasing SEC funding by permitting the SEC to charge user fees to cover costs associated with examinations of investment advisers.[63] While an increase in funding will allow the SEC to create a more robust review process, Chairman Bachus stated that even with an increase in funding, the SEC may not be able to review more than 10% of investment advisers on an annual basis.[64]

Three-Part Examination Strategy for Newly Registered Private Equity Funds

As a result of the Dodd-Frank Act, the majority of private fund advisers with $150 million or more in assets under management in the U.S. were required to register with the SEC by March 30, 2012. In order to better regulate these new registrants, the SEC’s Office of Compliance Inspections and Examinations ("OCIE") developed a three-part examination strategy which consists of: "(1) an initial phase of industry outreach and education, (2) followed by a coordinated series of examinations covering a significant percentage of the newly registered private fund advisers, and (3) culminating with the publication of a series of ‘after action’ reports, reporting to the industry on the broad issues, risks and themes identified during the examinations."[65] The initial phase of outreach is expected to consist of an "open letter" sent to all new registrants detailing heightened areas of risk, SEC expectations, and an explanation of the examination process.[66] Following the outreach phase, OCIE will conduct tailored examinations of a large portion of new registrants, which are expected to take between 12 and 24 months to complete. New registrants are encouraged to be proactive in their preparation for upcoming OCIE examinations. For a more in-depth discussion of the SEC’s new three-part examination strategy, see Gibson Dunn’s prior alert, "SEC Announces New Three-Part Examination Strategy for Newly Registered Private Fund Advisers."[67]

Office of Compliance Inspections and Examinations Priorities

In a series of recent releases and speeches, OCIE highlighted some of the compliance obligations that are associated with SEC registration, including the "Compliance Rule," the "Books and Records Rule," Form ADV updates, the "Code of Ethics Rule," and the "Advertising Rule."[68] These releases highlight the fiduciary relationship that investment advisers have with their clients and urge investment advisers to consider: (1) possible conflicts of interest, (2) the allocation of fees and expenses, and (3) the implementation of risk management procedures. In one of these speeches, Carlo V. di Florio, the Director of OCIE, provided guidance on how to handle regulatory examinations by noting that the "best way to avoid attracting our attention would be to be very proactive and thoughtful about identifying conflicts" and to take adequate remedial steps through strong risk management policies.[69]

Furthermore, OCIE outlined certain priorities for its inspections and examinations in 2012, including reviewing: (1) the risks associated with complex entities; (2) the sales practices of new or risky products; (3) fund governance risks; (4) the adequacy of compliance, supervision and risk management procedures; (5) activity and risks consistent with fraudulent activity; and (6) the increased risks from performance and advertising practices.[70] As SEC examinations routinely develop into enforcement actions, it is important to take into account risk mitigation strategies such as those discussed in Gibson Dunn’s previous publication on this topic, "Is This an Inspection or an Investigation? The Blurring Line Between OCIE and Enforcement."[71]

On July 3, 2012, the SEC announced that Ken C. Joseph would lead the Investment Adviser/Investment Company Examination Program in the New York Regional Office. Previously, Mr. Joseph has served as a Staff Attorney, Branch Chief, and Assistant Director in the Commission’s Division of Enforcement in both Washington, D.C. and New York.[72]

Developments at the SEC’s Asset Management Unit

Following the departure of former Co-Head of the Asset Management Unit Robert Kaplan, the SEC recently promoted two enforcement attorneys, Julie Riewe and Marshall Sprung, to serve as the new deputy chiefs of that Unit, altering its previous leadership structure. Both Riewe, based out of the Washington office, and Sprung, based out of the Los Angeles office, have extensive experience in the SEC’s enforcement division.[73] As a result of Mr. Kaplan’s departure, Bruce Karpati, based out of the Commission’s New York office, became the sole head of the Asset Management Unit. Through these personnel changes, the SEC is demonstrating the nationwide breadth of the Asset Management Unit and its continued commitment to the regulation of investment advisers.

          B.   Investment Adviser Cases

                 1.   Social Media Scam

In January, the SEC instituted administrative proceedings against Anthony Fields alleging that he offered to sell more than $500 billion in fictitious securities through various social media websites.[74] The SEC also used the case to warn more broadly of the risk of the misuse of social media in the offering of securities and investment advice. In the SEC’s press release announcing the case, Director Di Florio cautioned that "as investment advisers increasingly utilize social media to communicate with clients and potential clients, firms need to be mindful of the applicable standards governing those communications."

                 2.   Pricing of Securities

Also in January, the SEC instituted a settled administrative proceeding against UBS Global Asset Management ("UBSGAM") alleging violations of Rules 22c-1 and 38a-1 of the Investment Company Act of 1940 (the "Investment Company Act").[75] The order alleged that the adviser did not follow its fair valuation procedures in pricing certain illiquid fixed income securities in the portfolios of three mutual funds, resulting in a misstatement of net asset values for a two-week period. According to the order, after the funds purchased the fixed income securities (mostly subordinated tranches of mortgage-backed securities) in mid-June 2008, the adviser used valuations provided by brokers and pricing services that were substantially higher than the purchase prices until revising the valuations at the month-end meeting of the valuation committee. The settlement included a $300,000 penalty.

                 3.   Skin in the Game

In May, in a settled administrative action, the SEC alleged that Quantek Asset Management LLC, two executives at the firm, and its former parent company, Bulltick Capital Markets Holdings LP, misrepresented the extent to which the fund managers had "skin in the game" in its Quantek Opportunity Fund. According to the SEC’s order, the majority of these misstatements were made in response to due diligence questionnaires used to market funds to new investors. The SEC’s order also found that the respondents misled investors about related-party loans made by funds to affiliates of the executives. In the settlement, in addition to monetary penalties, the individuals consented to securities industry bars of five years and one year.[76]

                 4.   Ponzi Schemes

In February, the SEC filed an action against Steve Hamilton, Verde Retirement LLC, Verde FX Nevada, LLC, and Covenant Capital Partners alleging that they defrauded investors out of $1.6 million in a series of illegal Ponzi schemes. The SEC complaint alleged that Hamilton used investor funds to pay personal living expenses and to return capital to investors, while failing to make any investments in real estate loans as advertised to investors.[77]

                 5.   Valuation

In June, the SEC instituted settled administrative proceedings against OppenheimerFunds Inc. relating to statements about the valuation of two of its mutual funds in late 2008. The SEC’s order alleged that the prospectus for a high-yield bond fund did not adequately disclose the fund’s use of leverage through derivative instruments to increase its exposure to commercial mortgage-backed securities. The order also alleged that, in 2008, when market declines triggered liability on the swaps and the adviser moved to reduce exposure to mortgage-backed securities, the adviser issued misleading statements about the fund’s losses and recovery prospects as a result of the exposure. In the settlement, Oppenheimer agreed to pay approximately $35 million in disgorgement and penalties.[78]

                 6.   Marking the Close

In April, the SEC filed an action against RKC Capital Management, LLC, RKC Capital, LLC, and Russell K. Cannon, RKC Capital Management’s founder and manager, alleging the defendants artificially inflated the assets of a hedge fund, RKC Matador Fund LLC, by marking the close, or causing the price of a stock to rise through manipulative trading, of the fund’s largest holding. The complaint also alleges that the defendants inflated the fund’s assets under management and misrepresented the performance returns of the fund for the purpose of obtaining excessive advisory fees and new investments in the fund.[79]

                 7.   Fiduciary Duties and Misuse of Investor Funds

In March, the SEC filed an action against Brian Raymond Callahan and his investment advisory firms alleging that he defrauded investors by promising that funds would be used to invest in liquid assets, but instead used funds to invest in his brother-in-law’s multi-million dollar beach-front property.[80]

In May, the SEC instituted a settled administrative action against Martin Currie, a Scotland-based fund management group. The case demonstrates the potential for conflicts that can arise by the management of multiple advisory clients that invest in the same portfolio companies. The SEC order alleges that the adviser caused one fund client to purchase bonds in a Chinese company in order to reduce the exposure of a separate hedge fund client to the Chinese company’s debt. In an effort to resolve the conflict, the adviser obtained approval for the bond purchase from the fund’s board of directors. However, the SEC’s order alleges that the adviser failed to disclose to the directors that the portfolio company would use the proceeds of the fund’s bond purchase to redeem bonds held by the adviser’s hedge fund client. Martin Currie agreed to pay nearly $14 million to settle the charges brought by both the SEC and FSA.[81]

In June, the SEC filed a settled action against AMMB Consultant Sendirian Berhad ("AMC") alleging that AMC violated, among other provisions, Sections 15(c) and 36(b) of the Investment Company Act by charging a U.S. registered fund for advisory services which AMC did not provide. The SEC complaint alleges that AMC misrepresented its services for more than 10 years and collected advisory fees that it did not provide in breach of its fiduciary duties. In the settlement, AMC agreed to disgorge $1.3 million in advisory fees and pay a $250,000 penalty.[82]

IV.   Broker/Dealers

          A.   Compliance

The SEC and FINRA have continued their focus on perceived compliance failures by attorneys, compliance officers, and broker-dealer entities themselves. Keen on ensuring that compliance remains a priority within broker-dealers, enforcement officials have aggressively prosecuted alleged compliance-related offenses and have, in the process, attempted to expand the pool of enforcement targets.

This effort was exemplified in the Theodore Urban case, which finally came to an end in January of this year. There, the SEC brought charges against Urban, the general counsel for a registered broker-dealer, claiming that he failed reasonably to supervise an individual stock broker who allegedly manipulated a publicly traded stock and who also allegedly engaged in sales practice violations with respect to the accounts of several of his customers.[83] In a 1992 Section 21(a) report,[84] the Commission asserted that a supervisor is one who "has a requisite degree of responsibility, ability or authority to affect the conduct of an employee whose behavior is at issue."[85] But the enforcement staff urged, and the administrative law judge ("ALJ") who heard Urban’s case felt compelled, to adopt a broader theory: although Urban had no power to hire, fire, assign, promote, or assess the broker, he was a supervisor because his "opinions on legal and compliance issues were viewed as authoritative[,] . . . his recommendations were generally followed," and he was a member of the firm’s credit committee that became aware of indicia of the broker’s misconduct. The ALJ found that Urban acted reasonably and recommended dismissal ("This situation is unlike Gutfreund in that Urban was not a bystander, he took actions and he shared information….Urban performed his responsibilities in a cautious, objective, thorough and reasonable manner."). The Division of Enforcement appealed the ALJ’s decision and Urban filed a conditional cross-appeal of the ALJ’s finding that the broker was subject to his supervision. In January, the Commission dismissed the proceeding without issuing any findings or conclusions on a 1-1 vote (three Commissioners recused themselves).[86]

Although this dismissal ended the SEC’s case against Urban, the 1-1 vote left unresolved the important issue of when, if ever, persons who do not report to a general counsel are nevertheless subject to the general counsel’s supervision. Without such clarification, the definition of supervisory liability advanced by the Division of Enforcement remains a trap for the unwary. As Commissioner Daniel Gallagher said in a speech in March, "the finding that a general counsel could be deemed the supervisor of an employee in a business unit is a sobering one."[87] Commissioner Gallagher noted the dangerous dilemma for compliance personnel: by actively engaging in the firm’s compliance efforts, they simultaneously open themselves up to liability for failing to prevent compliance failures.

Though the Urban case captured attention, it was by no means the only compliance-related enforcement action this year. In January, the Commission affirmed a FINRA enforcement action against broker-dealer World Trade Financial Corp. and its three principals for compliance failures involving the sale of restricted securities.[88] FINRA alleged that, rather than perform its own due diligence regarding the securities’ status, the firm’s controls involved looking at whether a stock bore a restrictive legend and relying on the clearing agency to inform it of whether or not the stock was restricted. The Commission’s opinion also noted that the firm’s compliance materials did not provide sales personnel with any meaningful guidance on how to determine whether a proposed sale was exempt from registration, a vital task for a firm that specialized in sales of unregistered securities. In addition to these institutional failings, the principals each personally failed to oversee the trader and ignored various red flags that would have prevented the violations. The Commission affirmed the principals’ overlapping suspensions, even though it left the firm without a principal for a period of six weeks.

The Commission affirmed another FINRA enforcement action in late January against broker-dealer Midas Securities LLC and its CEO, Jay Lee, for failing to prevent a young trader’s illegal sales of unregistered securities.[89] Lee was suspended for two years and fined $50,000 for failing to supervise the trader’s activities. According to the Commission’s decision, Lee was often away from the office, had no retail experience, and relied on others to supervise traders’ activities. Lee unsuccessfully argued that he had delegated supervisory responsibility to another employee; the Commission noted that this employee lacked any power to hire, fire, give raises, or even grant the employee time off. The firm’s written procedures were similarly inadequate because they did not inform traders when to inquire into the registration or exemption status of its securities. The Commission also explained that Lee’s two-year suspension was not excessive because his supervisory failures were a key cause of the trader’s violations.

Also in January, the Commission brought settled administrative charges against AXA Advisors, LLC for failing to supervise and prevent an employee’s fraudulent sales practices.[90] The Commission alleged that the rogue employee fraudulently induced customers to redeem securities held by AXA Advisors and, after representing that the proceeds would be invested in other securities, the employee stole the funds. According to the order, AXA Advisors failed to implement adequate procedures regarding redemptions of clients’ accounts or regarding supervisory review of employees who were on extended leave, such as the rogue employee. Without admitting or denying the allegations, AXA Advisors agreed to an undertaking and censure, and pay a $100,000 civil penalty. When accepting the settlement, the Commission noted AXA Advisors’ cooperation with authorities and prompt reimbursement of clients’ funds.

Section 15(g) of the Exchange Act mandates that "[e]very registered broker or dealer shall establish, maintain, and enforce written policies and procedures reasonably designed…to prevent the misuse…of material, nonpublic information…."[91] (The Investment Advisers Act of 1940 (the "Advisers Act") contains a similar provision for investment advisers.)[92] In recent years, the SEC has on occasion filed claims for violations of Section l5(g) against brokerage firms (and for violations of the parallel requirements of the Advisers Act as to investment advisers) even in the absence of any alleged insider trading.

In April, the SEC instituted a settled administrative proceeding against Goldman Sachs alleging violation of Section 15(g) of the Exchange Act by lacking adequate policies and procedures to address the risk that analysts at the firm could share material, nonpublic information about upcoming research changes during weekly meetings between analysts and traders.[93] The SEC’s order did not allege that any improper trading had occurred. Goldman Sachs referred to these weekly meetings as "huddles." During these "huddles," analysts provided traders with trading ideas, which, according to the SEC, were "later passed [] on to a select group of top clients." The SEC’s order alleged that Goldman had inadequate written policies and procedures and insufficient control over "huddles" between analysts and traders and lacked adequate surveillance of trading as a result of the "huddles." In the settlement, Goldman agreed to pay a $22 million penalty, $11 million of which was paid to FINRA in a related proceeding, and to review and revise relevant written policies and procedures.  Except as to certain facts, Goldman Sachs neither admitted nor denied the SEC’s findings.

Also in April, the Commission brought settled administrative charges against three officials at online broker optionsXpress, including its Chief Compliance Officer and Vice President for Compliance, involving violations of Regulation SHO’s close-out requirements.[94] The Commission alleged that optionsXpress permitted its customers to maintain naked short positions after T+3 by pairing purported close-out purchases with sales of deep in-the-money call options, which the purchasers regularly exercised that same day. The Commission has disapproved of this practice in the past. The individuals caused the violation, the Commission alleged, because they were aware of the Commission’s prior guidance, yet continued to permit customers (who directed their own accounts) to cover their short positions by selling the call options. For these violations, the respondents consented to cease and desist orders.

          B.   Financial Crisis

In February, the SEC brought an unsettled action in federal court against four investment bankers and traders at Credit Suisse and Credit Suisse Securities.[95] The SEC’s complaint alleged that the defendants engaged in a scheme to overstate the prices of over $3 billion of subprime bonds owned by Credit Suisse to avoid millions of dollars in losses and secure each defendant’s multi-million-dollar bonus. According to the SEC, much of the evidence against the defendants came from recorded conversations.

And in February and March, the SEC saw two favorable rulings against Stanley Brooks of broker-dealer Brookstreet.[96] The SEC charged Brooks and Brookstreet with fraud for systematically selling risky mortgage-backed securities to customers with conservative investment goals, such as seniors and retirees. The federal court granted the Commission’s motion for summary judgment in February, finding that Brooks violated Section 10(b) and Rule 10b-5 of the Exchange Act. In March, the federal court entered judgment and ordered Brooks to pay a $10 million civil penalty and $110,713.31 in disgorgement.

          C.   Sales Practices, Preferential Treatment and Fraud

In January, the SEC affirmed a FINRA enforcement action imposing a 10-day suspension and a $10,000 fine against Dante DiFrancesco, a registered representative associated with Bank of America Investment Services.[97] FINRA alleged that DiFrancesco violated NASD Rule 2110–requiring "high standards of commercial honor and just and equitable principals of trade"–when he disclosed client account information to his future employer. The Commission’s opinion noted that the conduct was self-interested and intentional, but noted that DiFrancesco had admitted his conduct and was forthcoming to FINRA investigators.

In February, the SEC affirmed in part a FINRA disciplinary proceeding against John and Kathleen Mullins. FINRA alleged that the Mullins’s breached their fiduciary duties to a customer, an elderly widow, by misappropriating her property, accepting a loan from the customer without proper documentation, and making various misstatements to their broker-dealer employer regarding their relationships with the customer. John Mullins was barred from associating with a FINRA member. The Commission affirmed the majority of Kathleen Mullins’s penalty (a six-month suspension), but reduced her fine by $5,000 after determining that one of the alleged false statements was true.[98]

In March, a federal district court ordered James Konaxis, a former registered representative at broker-dealer Sentinel Securities, to disgorge more than $483,000 in commissions earned by defrauding a September 11, 2001 widow.[99] The SEC’s complaint alleged that Konaxis excessively traded the widow’s account in order to increase commissions and caused the account to lose over half its value. Konaxis had previously consented to an antifraud injunction and an associational bar in a related administrative proceeding; the district court’s order resolved a dispute regarding disgorgement.

In May, the SEC brought unsettled charges against Arnet Waters in federal court. The SEC alleged that Waters, who ran a broker-dealer and an investment adviser, misappropriated $780,000 that he raised from eight investors, including a church, and concealed his theft through misrepresentations to investors, FINRA, and the Commission. The court granted the SEC’s request to freeze Waters’s assets and entered a consensual preliminary injunction against violation of the securities laws.[100]

And recently, on June 11, a federal district court assessed penalties in connection with a Ponzi scheme run by Jeffrey Mowen with the assistance of former licensed broker-dealers. The SEC alleged that, as the former broker-dealers assisted Mowen raise $41 million from over 150 investors, they did not conduct sufficient due diligence that would have uncovered that Mowen was a convicted felon and securities law recidivist, and that Mowen was operating a Ponzi scheme.[101] The court ordered all defendants to disgorge gains and pay civil penalties.[102]

          D.   Manipulation

In February, a federal court entered a final judgment against Marc Riviello, a registered representative at a broker-dealer.[103] The SEC’s complaint alleged that Riviello and other individuals agreed to sell large blocks of shares in penny stocks through nominee accounts and then sell the shares to unsuspecting investors following the issuance of false or misleading press releases. Riviello was allegedly essential to that scheme because he used his position at the broker-dealer to open the nominee accounts and execute sell orders. Riviello consented to the final judgment that permanently enjoined him from violations of the securities laws and, in a related administrative action, agreed to an associational bar.[104] Riviello pleaded guilty to related money laundering conspiracy charges and was sentenced to eight months’ imprisonment and ordered to pay $107,000 in forfeiture.

          E.   Municipal Securities

The SEC continued its enforcement efforts against perceived bid-rigging in the municipal securities markets. In late December of last year, the SEC brought a settled action in which it alleged that GE Capital obtained information regarding competitors’ bids, which enabled it either to raise a losing bid to a winning bid, or to lower a winning bid to lower its costs.[105] Without admitting or denying the allegations, GE Capital agreed to pay approximately $25 million in disgorgement and penalties, in addition to approximately $43.35 million already paid to other agencies in related actions. The federal court approved the settlement and entered judgment in January.[106]

The SEC also brought a settled administrative proceeding against UBS Financial Services Inc. of Puerto Rico ("UBS PR") in May. The SEC alleged that UBS PR made misrepresentations to retail customers in Puerto Rico regarding the liquidity of certain non-exchange traded closed-end funds which were primarily invested in municipal bonds. Without admitting or denying the allegations, UBS PR agreed to an undertaking regarding its consumer-protection policies; was censured; and agreed to pay a $14 million civil penalty, $11.5 million in disgorgement, and $1.1 million in prejudgment interest, all of which would create a fair fund.[107]

          F.   Regulatory Initiatives

In May, the SEC renewed its efforts to revise regulations first proposed five years ago on issues such as net capital,[108] customer protection,[109] books and records,[110] and notification rules for broker-dealers.[111] The Commission reopened the comment period without revising the proposed release; comments were due June 8.[112] The proposed rule would require broker-dealers to treat the accounts they carry for domestic and foreign broker-dealers in the same manner as they treat other "customer" accounts under Rule 15c3-3. Currently, broker-dealers do not include these accounts in their customer reserve calculations even though other broker-dealers may share pro rata in the customer reserve should the broker-dealer liquidate; the new rule would "correct the gap."[113] The proposed rule also would limit a broker-dealer’s freedom to choose where to keep its customer reserve account. Broker-dealers would no longer be able to count any money kept at an affiliated bank towards its customer reserves and would also face limitations on the amount of cash they could maintain at any one unaffiliated bank.[114] The proposal would, however, limit regulatory burdens somewhat by allowing broker-dealers to keep in the customer reserve account money-market funds that meet certain criteria (under current rules, such accounts can contain only cash or U.S. Treasury securities).[115] Several other areas were covered: a new requirement to acquire securities from short sales among the broker-dealer’s customers;[116] a new rule preventing broker-dealers from investing customers’ free credit balances in instruments other than money-market accounts or insured bank deposits without a specific customer instruction;[117] new rules involving repurchase transactions that would set the broker-dealer as a default "principal" in the transaction and require reports to the SEC if total outstanding repurchase agreements exceed 2,500% of tentative net capital.[118] The SEC received 20 comments[119] and has not yet issued a final rule.

Later that month, the SEC and the U.S. Commodity Futures Trading Commission ("CFTC") jointly issued final rules regarding the definition of "swap dealer" and "security-based swap dealer." Under both definitions, a market participant is a "dealer" if he or she (1) holds himself or herself out as a dealer; (2) makes a market in either product; (3) regularly enters into swaps or security-based swaps with counterparties as an ordinary course of business for his or her own account; or (4) engages in any activity causing himself or herself to be commonly known in the trade as a dealer,[120] but excludes participants for whom such activity is not part of a regular business, akin to the "dealer exemption" under the Exchange Act.[121] The release frequently relied upon the so-called "dealer-trader distinction" as a factor to consider in assessing whether or not one is a "dealer": (1) providing liquidity; (2) advising counterparties; (3) having regular clientele; (4) acting in a market maker capacity; and (5) helping to set prices.[122] The release also included several registration exclusions, the most prominent of which is the de minimis exception. This exception relies exclusively upon the notional value of a participant’s swaps transactions–the Commissions rejected alternative measures–and defined the exceptions as follows: $3 billion for swaps,[123] $150 million for security-based swaps,[124] and $25 million for swap transactions with certain "special entities."[125] These provisions and others take effect July 23, 2012.[126]

V.   Public Company Accounting and Financial Reporting

          A.   U.S.-traded Chinese Companies

The SEC and the Public Company Accounting Oversight Board ("PCAOB") have increasingly focused on alleged accounting fraud involving foreign private issuers, particularly companies based in the People’s Republic of China ("PRC"). Several U.S.-listed, China-based issuers were accused of fraud and accounting irregularities during the past year, which has led to heightened concerns, billions in investor losses, and a flood of auditor resignations at the end of the audit season. As of June, 67 auditors resigned from China-based issuers and 126 issuers were either delisted or no longer filing reports with the SEC.[127] In response, U.S. accounting enforcement regulators have intensified efforts to oversee activities in China and filed charges against issuers and their executives.[128]

                 1.   Auditing Firm Oversight

Although U.S. regulators continue to explore diplomatic solutions with China in hopes of obtaining cooperative agreements similar to those with other foreign oversight authorities, they report that Chinese regulators continue to forbid cooperation with SEC investigations and PCAOB inspections, citing state-secrecy laws.[129] Chinese regulators have also issued rules requiring gradual shifts in control of the Big Four member audit firms located in China to local Chinese partners.[130] As U.S. regulators attempt to resolve the impasse over access to work papers of China-based audit firms diplomatically, the SEC and PCAOB have instituted proceedings against PCAOB-registered foreign audit firms to gain access to audit materials.

In May, the SEC instituted administrative proceedings against Deloitte Touche Tohmatsu CPA Ltd. ("D&T Shanghai"), an audit firm based in mainland China, seeking to obtain audit work papers relating to a China-based company involvement in an SEC investigation.[131] The order instituting proceedings alleges that the SEC "sought to obtain the relevant audit work papers through international sharing mechanisms, yet these efforts have been unsuccessful."[132] The SEC’s administrative order follows litigation filed last year by the SEC to enforce a subpoena seeking documents from D&T Shanghai related to a different audit client.[133] The subpoena litigation is pending in the U.S. District Court for the District of Columbia.

In a somewhat related matter, the PCAOB settled disciplinary orders against New York accounting firm Brock, Schechter & Polakoff and James R. Waggoner, its former Director of Accounting & Auditing, in connection with their representation of companies in China and Taiwan.[134] The Board alleged that the firm and Waggoner accepted the engagements but did not have experience auditing foreign issuers and companies and did not understand or have the ability to communicate in Chinese. The PCAOB censured the firm and Waggoner, revoked the firm’s registration, and imposed a $20,000 penalty, and barred Waggoner from associating with a PCAOB-registered accounting firm for three years.

                 2.   Fraud Allegations Against Issuers and Executives

To address alleged fraud involving Chinese issuers, the SEC has also filed actions against several Chinese companies and their executives for alleged accounting irregularities. For example, the SEC filed a complaint in February against Puda Coal Inc.’s Chairman Ming Zhao and former CEO Liping Zhu for allegedly transferring the company’s revenue-producing asset to Zhao.[135] The complaint alleges that the transactions rendered the value of the company to a shell. In addition, Deputy Director Canellos stated that Zhao and Zhu were alleged to have engaged in forging documents and "brazen obstruction" of the SEC’s enforcement investigation.[136]

In another case involving an alleged theft of assets, the SEC charged SinoTech Energy Limited ("Sino-Tech"), a China-based oil field services company, and its CEO and former CFO with fraudulently overstating its primary operating assets and misrepresenting how it used IPO proceeds.[137] The SEC also charged SinoTech’s Chairman Qinzeng Liu with siphoning $40 million from the company’s bank account.

In still another case, the SEC alleged that China Natural Gas Inc. and its chairman and former CEO Qinan Ji defrauded investors and failed to disclose loans benefiting Ji’s son and nephew.[138]

The SEC also filed complaints against China-based companies and associated persons for alleged market manipulation and insider trading. In April, the SEC obtained a court-ordered freeze of assets in connection with alleged insider trading in Zhongpin Inc., a pork processor based in China but traded in the United States.[139] The freeze applied to six Chinese citizens and an entity in the British Virgin Islands that purchased $20 million in Zhongpin securities before a public announcement.

The SEC alleged that AutoChina International Limited ("AutoChina") and 11 of its investors engaged in a market manipulation scheme to boost its trading volume.[140] The individuals charged included several relatives of AutoChina’s Chairman and Chief Executive Officer, who owned more than 57% of the company. The individuals allegedly engaged in matched orders and wash trades to increase trading volume and improve the company’s ability to get a stock-backed loan.

          B.   Financial Crisis Related Cases

During the first few months of 2012, the SEC brought several cases against mortgage companies, banks, and their executives for allegedly fraudulent accounting practices during the financial crisis of 2007-2009.

The SEC filed charges in March against senior executives of Thornburg Mortgage, Inc. ("Thornburg"), once the second largest independent mortgage company in the United States.[141] The complaint alleged that CEO Larry Goldstone, CFO Clarence Simmons, and Chief Accounting Officer Jane Starrett misled investors and Thornburg’s outside auditor by concealing substantial margin calls. In particular, the SEC alleged that the executives purposely failed to disclose the margin calls to its auditor and signed a management representation letter that Thornburg was currently in compliance with its material contractual agreements, despite receiving a notice of default from a major lender. Allegedly, Thornburg paid its then-outstanding margin calls just before filing its 2007 annual report, but hours later received a new wave of margin calls exceeding its liquidity.

In April, the SEC charged Anthony J. Nocella and J. Russell McCann, Franklin Bank Corp.’s former CEO and CFO, with allegations of hiding mortgage loan delinquencies and inflating income and earnings in the third and fourth quarters of 2007.[142] The SEC alleged that Nocella and McCann engaged in a fraudulent accounting scheme to transform non-performing loans into performing loans simply by "wav[ing] a magic wand." Franklin Bank Corp. declared bankruptcy in 2008. In addition to other relief, the SEC seeks a clawback of Nocella’s and McCann’s bonuses pursuant to Sarbanes-Oxley Section 304.

The SEC also filed charges against bank holding company BankAtlantic Bancorp, Inc. ("BankAtlantic") and its CEO and Chairman Alan Levan for allegedly misleading investors about mortgage loan portfolios in 2007.[143] According to the SEC’s allegations, BankAtlantic and Levan failed to disclose negative information about the loans and did not properly classify loans "held for sale" and write them down to the lower of cost or fair value.

          C.   Actions Seeking SOX 304 Civil Money Penalties from CEOs and CFOs

Continuing the SEC’s use of its executive compensation clawback authority under Sarbanes-Oxley Section 304, the SEC filed an action to recover bonus compensation and stock sale profits from the former CEO and CFO of ArthroCare Corporation, a surgical products manufacturer.[144] The complaint makes no allegations of misconduct by the executives and is, instead, premised on a restatement of misconduct by two former ArthroCare Corporation executives who were the subject of a separate lawsuit filed in July 2011 that alleged that they fraudulently overstated the company’s revenues and earnings.

In March, Judge Rudolph T. Randa of the District Court for the Eastern District of Wisconsin approved the SEC’s settlement with Koss Corporation ("Koss Corp.") and its CEO and former CFO Michael J. Koss.[145] The charges against Koss Corp. stemmed from a former executive’s embezzlement and accounting fraud, which resulted in materially inaccurate financial statements. As discussed in Gibson Dunn’s 2011 Year-End Securities Enforcement Update ("2011 Year-End Update"),[146] Judge Randa had expressed concerns about the proposed settlement and asked the SEC to provide additional information. Koss agreed to a permanent injunction and reimbursement of his incentive bonuses. After the SEC responded to Judge Randa’s concerns, he concluded that the "injunctions are sufficiently specific" and "the proposed final judgments are fair, reasonable, adequate, and in the public interest."

The SEC settled actions with Symmetry Medical, Inc. ("Symmetry"), a medical device and aerospace product manufacturer, the company’s former CEO and CFO, four senior executives at Symmetry’s British subsidiary, and two employees who worked for the subsidiary’s outside auditors.[147] Symmetry restated its 2005, 2006, and first and second quarter 2007 financial statements because of material overstatements of the subsidiary’s revenues and assets, understatements of its expenses, and falsifications of books and records. The company agreed to a cease and desist order against future financial reporting, books-and-records, and internal controls violations. Symmetry’s former CEO and CFO agreed to reimburse the company for bonus compensation and stock profits. Fred Hite, the former CFO, also agreed to a $25,000 penalty for failing to provide an internal audit status report to the company’s audit committee. The audit partner and senior manager on the audits of Symmetry’s British subsidiary, both formerly of Ernst & Young’s U.K. member firm, agreed to two-year suspensions to settle related SEC charges brought against them. The SEC alleged that these individuals, both citizens of the U.K., failed to properly audit the subsidiary’s accounts receivable balances and inventory.

          D.   Other Notable Financial Reporting Cases

The PCAOB announced settled disciplinary orders in February censuring Ernst & Young LLP ("E&Y") and imposing sanctions on four of its partners who allegedly failed to properly evaluate the sales returns reserve of Medicis Pharmaceutical Corporation ("Medicis").[148] The PCAOB alleged that the sales returns reserve estimate, and consequently the company’s overall reported revenue, was misstated because Medicis improperly estimated its returns reserve based on replacement cost rather than gross sales price. The PCAOB imposed a $2 million penalty against E&Y. The PCAOB also imposed the following penalties against the E&Y partners: a $50,000 penalty and bar with right to reapply in two years with respect to the supervisory partner for the 2003, 2004, 2005, and 2007 audits; a $25,000 penalty and bar with right to reapply in one year with respect to the independent review partner; a $25,000 penalty and censure with respect to a second partner and supervisory partner for the 2006 audit; and a censure as to the second partner for the 2007 audit.

A former audit partner at BDO USA LLP pleaded guilty in January to charges that he lied to SEC enforcement staff during an investigation.[149] Bryan N. Polozola was the subject of a 2005 NASD (now FINRA) proceeding involving allegations that he took funds from a former employer for personal use. Polozola neither admitted nor denied the NASD allegations, but resolved the proceeding by agreeing to repay the funds to his former employer and a bar from associating with any NASD member firm. In 2011, the SEC questioned Polozola in connection with an investigation into an investment adviser that managed hedge funds he audited. SEC enforcement attorneys questioned Polozola about the NASD bar and he said that he was not aware that the funds at issue in the NASD investigation were repaid, despite having directed the payment. Polozola pleaded guilty to a charge that he made a false statement and was sentenced to 24 months of probation, 200 hours of community service, and a $100 fine.[150] He was also suspended from appearing or practicing before the SEC.

In June, the SEC suspended H. Clayton Peterson from appearing or practicing before the SEC following his guilty plea to insider trading charges last year.[151] As discussed in the 2011 Year-End Update, the SEC alleged that Peterson, chairman of Mariner Energy Inc.’s ("Mariner") audit committee, provided his son with confidential information about Mariner’s acquisition of Apache Corporation. Peterson was formerly Regional Managing Partner at Arthur Andersen.

Gibson Dunn is one of the nation’s leading law firms in representing companies and individuals who face enforcement investigations by the Securities and Exchange Commission, the Department of Justice, the Commodities Futures Trading Commission, the New York and other state attorneys general and regulators, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange, and federal and state banking regulators.

Our Securities Enforcement Group offers broad and deep experience. Our partners include the former Director of the SEC’s prestigious New York Regional Office, a former Associate Director of the SEC’s Division of Enforcement, the former Director of the FINRA Department of Enforcement, the former United States Attorney for the Central District of California, and former Assistant United States Attorneys from federal prosecutor’s offices in New York, Los Angeles, and Washington, D.C.

Securities enforcement investigations are often one aspect of a problem facing our clients. Our securities enforcement lawyers work closely with lawyers from our Securities Regulation and Corporate Governance Group to provide expertise regarding parallel corporate governance, securities regulation, and securities trading issues, our Securities Litigation Group, and our White Collar Defense Group.

Gibson, Dunn & Crutcher’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you work or any of the following:

New York
Mark K. Schonfeld (212-351-2433, [email protected])
Joel M. Cohen (212-351-2664, [email protected])
Lee G. Dunst (212-351-3824, [email protected])
Barry R. Goldsmith (212-351-2440, [email protected])
George A. Schieren (212-351-4050, [email protected])
Alexander H. Southwell (212-351-3981, [email protected])
Jim Walden (212-351-2300, [email protected])
Lawrence J. Zweifach (212-351-2625, [email protected])

© 2012 Gibson, Dunn & Crutcher LLP

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