2010 Mid Year Securities Enforcement Update

July 12, 2010

I.  Overview of the First Half of 2010

Nearly a year and a half ago, Mary Schapiro took over as Chairman of the SEC with a promise to reinvigorate the Enforcement Division.  Shortly thereafter, Robert Khuzami, the Director of the Division of Enforcement, announced a series of initiatives with the goal of making the Enforcement Division more effective.  The first six months of this year have seen those initiatives take shape with a reorganization of the Enforcement Division into specialized units and the formal announcement of a cooperation initiative for individuals. 

But of greater significance is the extent to which the Enforcement Division is filing cases against major financial institutions and senior executives — and without negotiating settlements in advance of filing and without the "muscle" of parallel criminal cases.  This is a trend that we noted in last year’s Mid-Year Review, and it continues this year.  Overall, this Commission is marked by a willingness to take on risk in litigation, particularly in cases related to the financial crisis and to extend jurisdiction and remedies.  The last six months have also seen some significant victories and some notable losses in the SEC’s litigation efforts.  Nevertheless, we expect the SEC to continue to pursue an aggressive strategy of filing cases against prominent defendants to demonstrate its vigor in investor protection.  Highlights of the past six months include:

• Several major cases related to subprime loans and the financial crisis;
• Aggressive application of the Sarbanes Oxley "clawback" remedy;
• A victory in asserting jurisdiction over credit default swaps (while losing on the merits of an insider trading claim);
• Large dollar insider trading cases, some involving institutional investors; and
• Launch of the Division of Enforcement’s cooperation initiative and internal reorganization.

A.  Enforcement Initiatives Move from Theory to Practice

Last year Mr. Khuzami announced several initiatives he intended to revitalize the Enforcement Division.  This year, those concepts became concrete.

1.  The Cooperation Initiative Promulgated

Motivating individuals to cooperate in SEC investigations has long been an elusive goal for the Enforcement Division.  In January, Mr. Khuzami announced the Division’s new initiative to incentivize individuals to cooperate, which is codified in a new section in the Enforcement Manual entitled "Fostering Cooperation."  The initiative provides guidance for evaluating an individual’s cooperation and authorizes new cooperation tools the staff and cooperators may use to document the cooperation relationship.  The new tools include:

• Cooperation agreements;
• Deferred prosecution agreements;
• Non-prosecution agreements;
• Expedited immunity requests to the Department of Justice;
• Proffer agreements; and
• Oral assurances against recommending an enforcement action.

In sum, the new cooperation tools provide a more formalized process by which individuals may cooperate with an SEC investigation in return for credit in the form of reduced or no charges or sanctions. 

One of the open questions in this initiative is the extent to which the SEC intends to publicize the existence of individual cooperators in any particular case.  We understand that the Enforcement Division has several cooperators currently in the program.  However, to date the SEC has not publicly identified any individuals as cooperators.  Thus, in the absence of a public record, it remains difficult for a would-be cooperator to weigh the costs and benefits of cooperating.

For a more detailed discussion of the new cooperation initiative and its implications, see our alert, "SEC’s Initiative to Foster Cooperation — Perspective and Analysis." 

2.  Specialized Units Take Shape

Last year, Mr. Khuzami also announced his intention to reorganize a portion of the Enforcement Division staff into specialized units to focus on particular subsets of issues within the securities industry: 

• Asset Management — focuses on investigations of investment advisers, hedge funds, mutual funds and private equity funds.
• Market Abuse — focuses on investigations of potential large-scale market abuses and complex manipulation schemes by institutional traders and market professionals.
• Structured and New Products — focuses on investigations of complex derivatives and financial products, including credit default swaps, collateralized debt obligations and securitized products.
• Foreign Corrupt Practices — focuses on investigations of potential violations of the FCPA.
• Municipal Securities and Public Pensions — focuses on the municipal securities market and public pension funds.

In January of this year, Mr. Khuzami announced the appointment of the leadership of the new specialized units.  Over the ensuing several months the staff for each of the units was selected and the units became operational.  In the future, look for these units to seek to make cases in their respective areas of specialization.  For example, one newly appointed unit chief announced his desire to "strategically initiate risk-based investigations" — alternatively referred to as industry-wide sweeps — in an effort to follow up on suspicions raised through the media, academics and tips and complaints.  These investigations can often result in requests for substantial data from numerous participants in a particular market or segment for the purpose of reviewing a specific industry practice. 

B.  Statistics and Trends

For the last three years we have been tracking certain metrics of enforcement activity and have identified noteworthy trends that have emerged.  First, during the first six months of 2010, the SEC filed 118 civil injunctive actions in federal court.  This is down significantly from the same period in 2009, when the SEC filed 167 civil actions, but consistent with the number of actions filed in 2008.   

Figure 1 – January to June Injunctive Actions Filed

Similarly, in looking at the number of defendants charged, in the first six months of 2010, the SEC charged 333 defendants, down from 527 during the same period in 2009, but still slightly higher than the 317 defendants charged during the same period in 2008.   

Figure 2 – January to June Number of Defendants Charged

A continued trend of actions filed without settlements at the time of filing suggests that the SEC continues to be willing to litigate cases when it cannot achieve the result it seeks in settlement.  Last year we noted a significant decline in the percentage of defendants settled at the time of filing.  That trend continues this year.  In the first six months of 2010, 21% of defendants’ charges were settled at the time of filing.  This is slightly higher than the percentage in 2009 of 19%, but more significantly, continues to be markedly lower than the percentage in 2008 of 31%.   

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

 C.  Significant Cases[1]

Since becoming Division Director, Mr. Khuzami has often stated that he seeks to measure the performance of the Division less through traditional quantitative metrics and more through qualitative measures, such as the programmatic importance of enforcement actions.  Thus, even though the number of cases may be down from last year, the SEC has focused resources on investigating, filing and ultimately litigating, significant cases against major financial institutions and senior executives, particularly in areas related to the financial crisis.  We highlight certain significant cases below and discuss them in more detail in subsequent sections of this Review.

1.  Financial Crisis

Not surprisingly, the SEC continues to make cases related to the financial crisis a top priority.  As Mr. Khuzami said in February when announcing one recent case, "Investigating potential securities law violations arising out of the credit crisis remains a high priority for the SEC Enforcement Division."[2]  The greatest attention by far has been devoted to the SEC’s case against Goldman Sachs, concerning the structuring and marketing of a collateralized debt obligation ("CDO").  That case has received extensive media coverage, and thus it is worth noting the other cases that have marked the SEC’s continued focus in this area:

• A settled action against State Street Bank and Trust Company for allegedly misstating the extent to which its Limited Duration Bond Fund had become concentrated in subprime investments, while allegedly providing more complete information on the fund’s subprime concentration to certain clients of the Bank’s internal advisory groups.
• An unsettled action against Morgan Keegan & Company and Morgan Asset Management and two employees, alleging that the respondents made unsupported price adjustments to securities backed by subprime mortgages in fund portfolios causing the NAV of the funds to be misstated.
• An unsettled action against an investment adviser, ICP Asset Management, and its principal, alleging mismanagement of several CDOs for which ICP acted as collateral manager. 
• An unsettled action against mortgage lender Taylor, Bean & Whitaker Mortgage Corp. ("TBW") and its former Chairman alleging that TBW submitted false information concerning mortgages and mortgage-backed securities to Colonial Bank to maintain a line of credit, thus causing the Bank’s parent company to misstate its assets.  The SEC also alleges that TBW misrepresented its ability to deliver a capital infusion to the Bank, thus causing the Bank to misstate its eligibility for TARP funds.

Finally, the SEC and Bank of America received court approval of a renegotiated settlement calling for a penalty of $150 million, up from the $33 million settlement that Judge Rakoff rejected several months earlier.  The settlement — and the court’s analysis — highlight the SEC’s continuing struggle with the issue of when to assess penalties against public companies for alleged disclosure violations and the tension between seeking to compensate former shareholders at the expense of current shareholders.

2.  Insider trading

The SEC’s emphasis on insider trading and hedge funds continues with a case involving another high profile hedge fund.  After a lengthy and highly publicized investigation, in May the SEC filed a settled insider trading case against Pequot Capital Management and its CEO, Arthur Samberg, for trading in Microsoft stock in 2001, resulting in a settlement including $28 million in disgorgement, interest and penalties. 

It is not often that insider trading cases are tried to judgment and the SEC’s litigation record in such cases is mixed.  The last six months provided just such an example.  We have previously written about SEC v. Rorech, the first case in which the SEC alleged insider trading in credit default swaps.  In April, the case went to trial and in June the court issued its decision.  The court ruled in favor of the SEC on the jurisdictional issue, holding that the credit default swaps at issue in that case were subject to section 10(b) as "securities-based swap agreement[s]" under the Gramm-Leach-Bliley Act.  However, on the ultimate issue of liability, the court ruled in favor of the defendants, finding that the SEC had failed to prove any element of an insider trading violation. 

3.  Accounting Fraud — Clawback of Executive Compensation

We have previously discussed the SEC’s use of section 304 of the Sarbanes-Oxley Act in SEC v. Jenkins to seek clawback of compensation from executives not accused of any wrongdoing, but who receive incentive-based compensation during a financial period that is subsequently restated due to misconduct.  There have been two significant recent developments in this area.

First, in the Jenkins case, the district court denied a motion to dismiss by Jenkins, agreeing with the SEC’s interpretation that section 304 does not require misconduct by the defendant and that misconduct by the company is sufficient.  The court relied on the plain language of the statute and its legislative history.  The court deferred to another day the question of what the appropriate measure of the clawback should be.

Second, a week earlier, in an action concerning accounting issues at Diebold, Inc., the SEC brought a settled "no fault" SOX 304 action against the company’s former CEO.  In the settlement, the former CEO agreed to reimburse the company $470,016 in bonuses, 30,000 shares and options for 85,000 shares of stock. 

With these cases, it is clear that the SEC will continue to push this remedy against CEOs and CFOs of companies who, despite the absence of misconduct on their part, are at the helm of a company during a financial reporting period that is subsequently restated due to the misconduct of others at the company.

D.  What to Look for in the Second Half of 2010

The SEC’s focus on investigations related to the financial crisis will continue and thus we expect to see additional cases being filed in this area.  In addition, previously filed cases in this area will work their way through litigation and approach trial or result in settlements. 

Now that the reorganization of the Enforcement Division is complete, look for the specialized units to take investigative initiatives in an effort to demonstrate that specialization also yields results.  And now that the cooperation initiative is underway, look for the SEC to take a step to demonstrate publicly that the program is motivating individuals to cooperate and that such cooperation is helping them make cases.

Finally, the United States Congress is close to passing the most sweeping overhaul of financial regulation since the Great Depression.  With it will come significant changes for the SEC by broadening the scope of its oversight to previously unregulated entities and financial instruments.  With this increased authority will come an increased budget, staffing and resources.  The increased enforcement activity we have observed in the last year may pale in comparison to what the next several years hold. 

II.  Insider Trading

A.  Extending Jurisdiction to Derivatives

A major focus of current SEC matters has been insider trading in derivatives.  In SEC v. Rorech, the SEC for the first time sought to apply insider trading law to credit default swaps ("CDSs").[3]  As we discussed in the 2009 Year-End Review of SEC Enforcement, the SEC filed a complaint in 2009 against Jon Paul Rorech, a bond salesperson at an investment bank, and Renato Negrin, a portfolio manager for a hedge fund, alleging that they engaged in insider trading of CDSs related to VNU N.V., a Dutch media conglomerate.

In August 2009, the court deferred to trial a decision on whether the CDSs at issue were securities within the meaning of section 10(b), holding that "the scope of the material terms of the CDS contracts and whether they were actually based on securities are questions of fact that cannot be resolved" on a motion to dismiss.[4]  Following a three-week bench trial earlier this year, the court held that the CDS contracts are securities subject to section 10(b), but found that the SEC had failed to prove that the defendants had committed insider trading.[5]

The court held that the CDSs were subject to section 10(b) as "securities-based swap agreements" under the Gramm-Leach-Bliley Act.  The defendants had argued that, while the CDSs at issue may have been related to the price, yield, value, or volatility of the underlying VNU bonds, the price of the CDSs was not "based on" those characteristics of the bonds, which they argued should be interpreted to require a direct or exclusive dependence.  The court rejected this interpretation, noting that it "would allow traders to escape the ambit of section 10(b) and Rule 10b-5 through clever drafting.  Under the defendants’ view, as long as CDSs’ material terms did not make actual reference to the price or value of securities, the CDSs would not be ‘security-based,’ no matter how closely tied to securities their material terms actually were."[6]  While recognizing the possibility that not all CDSs are "based on" securities, the court stated that "the jurisdictional issue in this case is whether the material terms of the particular VNU CDSs purchased by Mr. Negrin were based on the price, yield, value, or volatility of securities," a condition it found met in this case.[7]  Further influencing the court’s decision was the legislative history of the Commodity Futures Modernization Act of 2000, which suggested that Congress intended that "the SEC’s traditional anti-fraud and insider trading enforcement authority appl[y] to novel financial instruments."[8] 

On the ultimate merits of the litigation, the court ruled against the SEC in a decision that is a notable example of the challenges the SEC faces in proving insider trading through circumstantial evidence.  The court found that the SEC failed to prove any of the elements of insider trading: that Mr. Rorech received or shared with Mr. Negrin any confidential information concerning the investment bank’s recommendation regarding the VNU CDSs; that any of the information conveyed was material, since Mr. Rorech’s knowledge at the time of the alleged tip was not sufficiently different from information already in the market; that Mr. Rorech breached a duty owed to the investment bank; or that Mr. Rorech had the requisite scienter to be held liable for insider trading.  The SEC relied on evidence of a telephone call between the defendants followed by a cell phone call between them, allegedly to avoid the investment bank’s audiotape system, and then a trade by Mr. Negrin.  The court found that such evidence was insufficient to prove the elements of insider trading.  Id. pp. 36-41.    

B.  Hedge Funds and Other Financial Professionals Under Scrutiny

The Rorech case is also notable because of the SEC’s focus on potential insider trading by hedge funds.  Other cases demonstrated that continued scrutiny. 

In May, the SEC filed charges — and reached settlement — in  SEC v. Pequot[9], a long-running insider trading investigation stemming from alleged misconduct in 2001.  Pequot Capital, once among the world’s largest hedge funds, and its founder, Arthur Samberg, agreed to pay $28 million to settle the SEC’s allegations that they traded in Microsoft shares on the basis of inside information acquired from David Zilkha, a then-Microsoft employee who had accepted an employment offer from Pequot.  The settlement, including $28 million in disgorgement and penalties, is one of the largest insider trading settlements to date.

Settlement was reached after a protracted investigation, which the SEC initiated in 2004, and temporarily closed in 2006 without filing charges.  In 2006, the case also drew Congressional scrutiny when a former SEC attorney accused the SEC of mishandling the investigation; the United States Senate held hearings on the matter, culminating in a report that was critical of the SEC.  In January 2009, the investigation was reopened when Zilkha’s ex-wife furnished the SEC with copies of allegedly incriminating e-mails that were located on Zilkha’s hard drive, and which he had allegedly failed to produce during the first phase of the investigation.  This discovery also led the SEC to initiate administrative proceedings under the Investment Advisers Act against Zilkha for insider trading, seeking a cease-and-desist order and civil money penalties.[10]   

The SEC has also continued to expand its allegations in SEC v. Galleon.[11]  As we reported in our 2009 Year-End Review, last year the SEC and DOJ filed charges against Galleon Management, its founder Raj Rajaratnam, and several others for their alleged insider trading.[12]  In January of this year, the SEC filed a second amended complaint, adding additional charges and details based on information that came to light in the related criminal proceedings.[13]  The amended complaint now alleges approximately $45 million in profits.  The case has also received significant attention because of the use of wiretaps in the parallel criminal investigation.  This aspect of the case has sparked substantial motion practice over the use of wiretaps in insider trading investigations and the production of the results to the SEC in the civil litigation.  For a more detailed discussion of these issues, see the section below on Litigation Developments.

In a novel twist on insider trading, the SEC charged a secretary to a Walt Disney Company executive and her boyfriend who allegedly conspired to sell the company’s earnings information to hedge funds before the information became public.[14]  According to the complaint, the boyfriend allegedly sent anonymous e-mails to over thirty hedge funds and other investment companies offering to sell the information.  FBI agents posing as traders subsequently met with the boyfriend and provided $15,000 in exchange for nonpublic information on the company’s earnings.  Shortly thereafter, the defendants were arrested.  Notably, some of the hedge funds whom the boyfriend solicited alerted the SEC, which commenced an investigation.

In SEC v. Poteroba[15], the SEC filed a complaint against an investment banker who allegedly misappropriated inside information from his employer and leaked it to his friend (also a securities industry professional), who in turn tipped another friend.  The defendants, all Russian citizens, were accused of illegally trading ahead of at least 11 deals from 2005 to 2009, netting approximately $1 million in illicit gains.  According to the SEC, the defendants used coded e-mail messages to convey inside information, referring to securities using terms like "frequent flyer miles" and "potatoes."  The SEC’s complaint is similar to, but slightly more expansive than, the criminal complaint, which estimates the total profits at $870,000. 

C.  Misappropriation Cases

The misappropriation theory of liability continues as a core premise of insider trading liability.  In February the SEC obtained summary judgment against a husband and wife accused of insider trading in SEC v. Suman.[16]  The husband, an IT specialist at MDS, a scientific equipment manufacturer, allegedly had access to confidential information about the company’s merger negotiations with Molecular Devices Corp., a biotech company.  According to the SEC, the husband tipped his wife, and the pair traded on the basis of the information, profiting by more than $1 million.  In granting summary judgment, the court drew an adverse inference from the defendants’ assertion of the Fifth Amendment, as well as the husband’s deletion of information from his computer, and the defendants’ refusal to comply with discovery orders.  The court found no genuine issue of material fact regarding the husband’s possession of material nonpublic information and breach of a duty owed to his employer.  Similarly, the court held that the wife knew of the breach, drawing an adverse inference from a lengthy phone call between the defendants the night they purchased Molecular stock. 

In the last few months, the SEC has also filed settled insider trading charges in other misappropriation cases, including SEC v. Foley[17], involving an employee benefits specialist at an accounting firm who allegedly obtained material non-public information about three firm clients and tipped two others, and SEC v. MacDonald[18], in which the defendant allegedly misappropriated inside information from his wife, traded for his account and that of a friend, and tipped others.[19] 

III.  Financial Reporting Cases

In the first half of 2010 the SEC continued to aggressively apply the "clawback" provision of section 304 of the Sarbanes-Oxley Act of 2002.  Cases relating to the subprime mortgage crisis remain a priority for the SEC, as do cases against professionals.  The SEC also brought another enforcement action under Regulation FD, just as it did in the latter half of 2009. 

A.  Use of SOX 304 "Clawback" Provision

Section 304 of the Sarbanes-Oxley Act ("SOX 304") provides that if an issuer "is required to prepare an accounting restatement due to material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws," the CEO and CFO must reimburse the issuer for any bonus or other incentive-based or equity-based compensation received, and any profits from the sale of securities of the issuer during the 12-month period following the original financial report.[20]

In June 2010, the SEC filed an enforcement action against Walden O’Dell, the former CEO of Diebold, Inc., under SOX 304, seeking to "claw back" certain compensation he received while Diebold allegedly was engaging in a fraudulent accounting scheme designed to inflate its earnings.[21]  In its complaint against O’Dell, the SEC does not allege that O’Dell committed any violation of the securities laws, but instead simply alleges that Diebold was required to restate its annual financial statements as a result of misconduct.  Pursuant to a settlement, O’Dell agreed to reimburse the company $470,016 in cash bonuses, 30,000 shares of Diebold stock, and stock options for 85,000 shares of Diebold stock.  In connection with the action against O’Dell, the SEC also filed enforcement actions against Diebold and three former financial executives for allegedly inflating Diebold’s earnings.  The three individuals are litigating their matters.[22]  Two of the three defendants served as chief financial officer during the years that were restated.  The SEC is seeking a clawback remedy and other relief from them.

The case against O’Dell marks the second civil suit the SEC has filed under SOX 304 seeking to "claw back" compensation from an executive who has not been accused of any securities law violation.[23]  The first case applying the SOX 304 "clawback" provision to an uncharged executive was brought in July 2009 when the SEC sought a court order requiring Maynard Jenkins, former CEO of CSK Auto Corp., to reimburse the company more than $4 million in bonuses and stock sale profits in the period following the filing of annual financial statements that were ultimately restated.  In June 2010, the district court in Arizona denied Jenkins’s motion to dismiss the SEC’s complaint for failure to state a claim, holding that the statute requires only misconduct by the issuer, not personal misconduct by the executive.  Prior to these two cases, SOX 304 had only been invoked against executives who had been charged with wrongdoing.  For a more detailed discussion of the legal and policy implications of this case, see our article entitled "Using SOX ‘Clawback’ Against Uncharged Execs?"

B.  Subprime & Financial Crisis Related Cases

In June, the SEC charged Lee Farkas, former chairman and majority owner of Taylor, Bean & Whitaker Mortgage Corp. ("TBW"), a major mortgage lender, with securities fraud and attempting to defraud the U.S. Treasury’s Troubled Asset Relief Program through false representations.[24]  The SEC’s complaint alleges that from 2002 to 2009, when TBW declared bankruptcy, Farkas arranged for the sale of more than $500 million in fake residential mortgage loans and $1 billion in severely impaired residential mortgage loans and securities from TBW to Colonial Bank.  The complaint further alleges that Farkas’ fraud caused the loans and securities to be falsely recorded as high-quality, liquid assets in the fillings made with the SEC by Colonial BancGroup, Inc., the publicly traded parent of Colonial Bank.

The SEC’s complaint also alleges that beginning in 2009, Farkas represented to Colonial BancGroup, Inc. and to the public that TBW had obtained commitments for a $300 million equity infusion, which would qualify Colonial Bank for approximately $550 million in TARP funds.  The SEC alleges that the press releases regarding this capital commitment were fabricated and no equity investment existed.

This case is also noteworthy for the remedies it seeks against Farkas.  In addition to seeking the traditional remedies of an injunction, disgorgement, penalties and an officer and director bar, the SEC has also requested an equitable order pursuant to section 21(d)(5) of the Securities Exchange Act prohibiting Farkas from serving in a senior management or control position at any mortgage-related company or other financial institution and from holding any position involving financial reporting or disclosure at a public company.  This demand reflects an effort to obtain broader remedies using existing statutory authority and invoking the broad equitable jurisdiction of the courts. 

C.  Regulation FD Cases

In March 2010, the SEC brought an action against Presstek, Inc. and Edward Marino, its former CEO, for alleged violations of Regulation FD and section 13(a) of the Securities Exchange Act.[25]  Regulation FD requires public companies to disclose material non-public information regarding the issuer at the same time that it is disclosed to selected investors.  The complaint alleges that Marino selectively disclosed to a managing partner of a registered investment adviser material non-public information regarding Presstek’s poor financial performance without simultaneously disclosing such information to the public.  Marino continues to litigate the action.

Presstek consented to a settlement including an injunction and a $400,000 penalty.  The Litigation Release relating to the action states that the SEC "took into account certain remedial measures taken by Presstek, including revising its corporate communications policies and corporate governance principles, replacing its management team and appointing new independent board members, and creating a whistleblower’s hotline."[26]

The SEC’s action as to Presstek, along with SEC v. Black,[27] filed in late 2009,  indicate a renewed focus by the enforcement staff on Regulation FD since the Commission’s defeat in SEC v. Siebel Systems, Inc. in 2005.[28]

D.  Auditor Cases

In March 2010, the SEC instituted administrative proceedings under Rule 102(e) against two accountants who allegedly engaged in improper professional conduct while conducting audits of the 2004 financial statements for AA Capital Partners, Inc., an investment adviser registered with the SEC, and one of its affiliated private equity funds.[29]  According to the SEC’s order instituting proceedings, in the course of the audit the accountants allegedly learned that AA Capital’s president, director and co-owner had borrowed $1.92 million in client funds allegedly to pay a personal tax liability arising from his ownership interest in the private equity funds.  In reality, this "tax loan" was allegedly meant to conceal the president’s ongoing misappropriation of client funds for personal use.  Instead of properly evaluating the "tax loan" as a related party transaction, the Enforcement Division alleges that the accountants relied solely on unconfirmed information from AA Capital’s CFO.  The Enforcement Division alleges that the accountants cause their audit firm to issue unqualified audit reports despite the fact that the purported "tax loan" was not adequately disclosed in conformity with GAAP and the audits were not conducted in accordance with GAAS.  Neither respondent settled the case and it was sent to an administrative law judge for a hearing.

This matter is also unusual in that most Rule 102(e) proceedings concern financial statements of public companies, rather than of investment advisers or affiliated private funds.  The order does not specify what opinions were filed with the Commission or clearly state how the respondents were practicing before the Commission as required by the Rule.

IV.  Broker-Dealer Cases

In the first half of 2010, the SEC’s enforcement actions against broker-dealers continued to focus on issues related to the financial crisis, market operations, and sales practices (particularly those related to sales involving senior citizens).

A.  Financial Crisis

In January, the Commission instituted settled administrative proceedings against Mortgages Ltd. Securities, LLC ("MLS"), a registered broker-dealer located in Phoenix, Arizona.[30]  MLS purportedly raised $741 million from approximately 2,700 investors nationwide through the offer and sale of securities issued by Mortgages Ltd. ("MLtd."), an Arizona-based private lender.  MLtd. securitized and sold high interest, short-term loans to real estate developers through private placement offerings made through MLS.  MLS allegedly misrepresented the quality of those loans, stating, for example, that MLtd. had never failed to pay back principal in its 40+ year history.  In a settlement, the Commission revoked the registration of respondent MLS as a broker or dealer, but waived payment of disgorgement and prejudgment interest based upon MLS’s financial condition. 

In 2007, the SEC and DOJ brought parallel civil and criminal charges against two former brokers, Julian Tzolov and Eric Butler, alleging fraud in the sale to customers of auction rate securities collateralized by subprime mortgages.  In 2009, Tzolov pleaded guilty and testified against Butler in a criminal trial that resulted in a guilty verdict against Butler.  In January of this year, Butler was sentenced to five years imprisonment.  Butler is appealing his conviction.  Tzolov’s sentencing is expected later this year. 

B.  Short Selling Abuses

We noted in our last report that the SEC filed its first ever set of enforcement actions alleging violations of Regulation SHO, the rule to prevent abusive "naked" short selling in August 2009.[31]  Regulation SHO requires broker-dealers to locate a source of borrowable shares prior to selling short, and to deliver securities sold short by a specified date.  In May, the Commission instituted settled administrative proceedings against a broker-dealer alleging failure to deliver certain positions as required by Regulation SHO, even though the broker-dealer had previously implemented procedures designed to ensure compliance with the regulation. 

C.  Pay to Play

In March, the Commission instituted administrative proceedings against Southwest Securities, Inc., a broker-dealer and municipal securities dealer.[32]  A senior vice president of Southwest made political contributions to an incumbent for office with influence over the municipal securities business in Massachusetts, and Southwest engaged in municipal securities business with issuers associated with the incumbent within two years of the contributions.  The proceedings against Southwest are settled, but those against the senior vice president continue. 

In February, the Commission instituted settled proceedings against Granite Financial Group, which provides securities brokerage services to several investment advisers to hedge funds.[33]  The SEC’s order alleged that Granite paid personal expenses of two employees of a hedge fund adviser in exchange for directing trades through Granite.  As part of the settlement, Granite agreed to retain, and adopt the recommendations of, an independent compliance consultant.  

D.  Sales Practices

SEC Chairman Mary Schapiro has referred to frauds against senior citizens as "particularly pernicious."[34]  Accordingly, SEC enforcement actions have continued to focus on misconduct against elderly customers by brokers, including: a broker-dealer that sold unsuitable variable annuities to senior citizens who had been solicited through free-lunch seminars;[35] a broker who engaged in churning and charged excessive and undisclosed mark-ups in accounts of the Sisters of Charity congregation of elderly nuns;[36] and a broker who solicited elderly investors to invest in unregistered "convertible debentures," misrepresenting that funds were guaranteed and would be used to develop real estate.[37]  In a criminal case, a broker pleaded guilty to criminal charges for causing elderly clients to invest in fictitious "federal housing certificates" and then misappropriating the clients’ funds for personal use.[38]

The SEC also took action against several managers who failed to supervise brokers engaged in various misconduct, including: selling unsuitable private placements to elderly customers, unauthorized trading and churning;[39] unauthorized trading, unsuitable recommendations, and churning the accounts of two municipal entity customers;[40] and transferring funds from an elderly customer’s account to the broker’s personal bank account.[41] 

E.  Registration

Finally, the Commission instituted settled administrative proceedings against a firm for operating as an unregistered broker.[42]  The firm solicited day traders to open accounts in exchange for access to trading programs to place and route orders to the market electronically, as well as research and analytical software, training, technical support and administrative services.  Because the firm received transaction-based compensation for its services, the Commission found that it operated as an unregistered broker. 

V.  Investment Adviser Cases

A.  Cases Related to the Financial Crisis

The SEC charged an investment adviser, ICP Asset Management, and its principal, acting as a collateral manager for collateralized debt obligations ("CDOs").[43]  According to the complaint, the investment adviser caused the CDOs to engage in trades without required approval from the CDOs.  The SEC also alleges that the adviser conducted those trades at inflated prices in order avoid realizing losses by the adviser’s clients and increase fees earned from management of the CDOs.  The SEC continues to conduct other investigations relating to the creation, sale and managements of CDOs and to make these issues a high priority.

The SEC instituted administrative proceedings against Morgan Keegan & Company and Morgan Asset Management and two employees alleging that the respondents provided inaccurate net asset values ("NAVs") for funds based on subprime mortgages.[44]  According to the order instituting proceedings, the portfolio manager instructed the adviser’s fund accounting department to make price adjustments that increased the values of certain portfolio securities and ignored lower values quoted by various dealers.  In addition, the adviser’s accounting manager allegedly failed to validate the accuracy of the funds’ NAVs.  As a result, the NAVs of the funds were allegedly inflated.

The SEC instituted a settled action against State Street Bank and Trust Company for allegedly misstating the extent to which its Limited Duration Bond Fund had become concentrated in subprime investments, while allegedly providing more complete information on the fund’s subprime concentration to certain clients of the Bank’s internal advisory groups.[45]  Pursuant to the settlement, State Street agreed to pay $8.3 million in disgorgement, $50 million in penalties and $255 million in additional payments to investors in the fund.

B.  Short Selling Ahead of Secondary Offerings

The SEC instituted its first enforcement actions for violations of the amended Rule 105 of Regulation M.[46]  The SEC amended Rule 105 effective October 2007 to prohibit participation in a secondary offering of securities by any person who sold short that security during the five-day restricted period preceding pricing of the offering.  The amendments eliminated any requirement that the trader use the offered shares to cover a short position created during the restricted period.[47]  In this settled action, the SEC alleged that two investment advisers sold short stock in two companies during the restricted period preceding secondary offerings by those companies and then purchased stock in those secondary offerings.  In one case, the investment adviser allegedly used two accounts, one of which contained only funds from the adviser’s principals, in an effort to take advantage of an exception in Rule 105 for separate accounts.  However, the SEC found that the "close collaboration" between the accounts precluded reliance on that exemption. 

C.  Theft

Last year, we noted that the SEC filed several cases alleging Ponzi schemes in the wake of the Madoff case and increased investor redemption demands.  This trend continues with more cases alleging Ponzi schemes and other misappropriation of investor funds.  One notable case was filed against Kenneth Ira Starr.  The SEC accused Starr of transferring money from his clients’ accounts for his own personal use.[48]  Allegedly, Starr and his companies violated several rules governing custody of client assets, by failing to hire an accountant to perform annual examinations of client assets and holding some client assets in an office safe.  Furthermore, according to the SEC, on separate occasions, Starr and his companies transferred millions of dollars from client accounts.  When certain clients learned of the transfers, Starr allegedly reimbursed them by using funds from other clients.

VI.  Litigation Developments

We have discussed above two of the most significant litigation developments in the last six months — the interpretation of the SOX 304 clawback provision in SEC v. Jenkins and the application of insider trading law to CDSs in SEC v. Rorech (accompanied by the SEC’s ultimate loss on the elements of insider trading).  We discuss below other significant litigation developments in the first half of this year.

A.  The Scope of Primary Liability

In our 2009 Mid-Year Review, we noted the decision by the U.S. Court of Appeals for the First Circuit in SEC v. Tambone, which concluded that the underwriter-defendants’ use of prospectuses they did not author amounted to "implied statements of their own regarding the accuracy and completeness of [the] prospectuses,"[49] subjecting them to Rule 10b-5(b) liability.  The court reconsidered the appeal en banc and upheld the district court’s dismissal of the SEC’s complaint, reversing the panel’s earlier decision.[50]  In deciding whether persons who did not author allegedly misleading words but nevertheless used or disseminated those words could be subject to primary liability for "mak[ing] any untrue statement of material fact," the court noted that its decision turned on the meaning of the word "make."  It rejected the SEC’s "expansive interpretation" of the word:

It is inconsistent with the text of the rule and with the ordinary meanings of the phrase "to make a statement," inconsistent with the structure of the rule and relevant statutes, and in considerable tension with Supreme Court precedent.[51]

The court also reasoned that by interpreting the plain language of the statute as a clear line between primary and secondary liability, its ruling was also more "faithful" to Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).

B.  Statute of Limitations

Perhaps it is no surprise that the SEC continues to struggle with litigating cases based on old conduct.  But the decision in SEC v. Kearns indicates that the passage of time alone is not conclusive on the issue of whether the statute of limitations has run. [52]  Assuming that the five-year limitations period in 28 U.S.C. § 2462 applied, the court found that the limitations period was "equitably tolled until the date of discovery, so long as the SEC pursued its claim with due diligence."[53]  The U.S. District Court for the District of New Jersey followed the Seventh and Ninth circuits in adopting this "discovery rule."

While the Kearns decision avoided the question of whether 28 U.S.C. § 2462 applied to the SEC’s claims, SEC v. Quinlan and SEC v. Gabelli addressed it squarely.  In SEC v. Quinlan, the SEC sought only equitable remedies in the form of injunctive relief and an officer/director bar.[54]  The Sixth Circuit noted that the district court found that the equitable claims sought were remedial in nature and agreed that the requested relief was therefore not a "penalty" subject to the five-year limitations period.  And in SEC v. Gabelli, the court held that the SEC’s request for civil penalties was subject to the five-year limitations period but that its request for permanent injunctive relief and disgorgement of ill-gotten gains were not.[55] 

C.  Wiretaps and Parallel Investigations

The Galleon case marks the first time investigators pursued and obtained wiretap evidence in an insider trading case, and whether that wiretap evidence may properly be disclosed to the SEC is an emerging issue now before the Second Circuit.[56]  Though the DOJ and SEC investigated the trading conspiracy "jointly," the DOJ did not disclose the wiretap evidence to the SEC.  But, of course, the DOJ disclosed the evidence to defendants once the indictments were returned, and the SEC thereafter propounded discovery requests calling for defendants’ production of the recordings.  Defendants objected, citing 18 U.S.C. §§ 2510-2522 (or "Title III" of the Omnibus Crime Control and Safe Streets Act of 1968), and argued that federal law prohibited them from disclosing recordings obtained by the government.  The district court, finding the issue to be a "relatively simple one," held that Title III permitted disclosure of wiretap evidence by the recipient if not by the government directly.[57]  The court also suggested any contrary ruling might very well result in absurdity:

[T]he notion that only one party to a litigation should have access to some of the most important non-privileged evidence bearing directly on the case runs counter to basic principles of civil discovery in an adversary system and therefore should not readily be inferred, at least not when the party otherwise left in ignorance is a government agency charged with civilly enforcing the very same provisions that are the subject of the parallel criminal cases arising from the same transactions.[58]

The defendants appealed to the Second Circuit, and, in the meantime, the district court’s order has been stayed.  The appeal has been briefed but and argued, but not yet decided.

Meanwhile, in the Galleon criminal case, the defendants have challenged the use of wiretaps to investigate securities fraud.  The defendants moved to suppress the wiretap evidence, arguing that Title III does not authorize the government to use wiretapping for insider trading cases, and that the government had failed to establish probable cause and the necessity of resorting to wiretapping.  The court is expected to hear argument on the suppression motions in July.  In March, Judge Rakoff adjourned the civil trial (which had been set for August 2010) to February 2011 when the court of appeals indicated that resolution of the appeal in the civil case could be affected by the outcome of the suppression hearing in the criminal case.  The criminal trial is set for October 2010. 

D.  Collateral Estoppel

Generally, if a defendant is convicted, the SEC seeks judgment on the basis of res judicata or collateral estoppel.  But such a result may not be automatic.  In  SEC v. Nacchio[59], the defendant had been convicted in 2006 of 19 counts of insider trading.  The SEC subsequently moved for partial summary judgment in the civil case on collateral estoppel grounds, arguing that it was based on the same allegations as the criminal case.  However, the district court in Colorado denied the SEC’s motion, concluding that the SEC had failed to show that the factual issues in the civil case were "identical to those previously litigated [in the criminal case]."[60]

E.  Sharing of Information Among Agencies

An interesting decision from the Tenth Circuit made clear that documents disclosed to the SEC may not be shared with other government agencies where such disclosure is not specifically permitted by the terms of a governing protective order.[61]  The SEC filed suit against an investment firm for securities fraud, and it sought discovery from one of the victim investors.  Documents produced by the investor mysteriously made their way into the hands of the IRS, and the court granted the investor’s request that the documents be returned.  The appellate court found that the investor provided the confidential material in reliance on the terms of the protective order that material not be disclosed to government agencies not specifically enumerated therein. 

F.  The Court’s Equitable Powers in SEC Receivership Cases

The Second Circuit joined the Sixth and Ninth Circuits in permitting district courts to issue anti-litigation injunctions as part of their "broad equitable powers in the context of an SEC receivership."  In SEC v. Byers, the SEC alleged a massive Ponzi scheme spanning the United States, Africa and the Middle East that allegedly bilked victims out of approximately $255 million in investments.[62]  The court appointed a receiver and entered a Receiver Order, which included an anti-litigation provision that, in relevant part, prevented creditors from filing any bankruptcy petition.[63]  Committees of various creditors sought to modify the order, particularly to remove the prohibition against filing litigation or bankruptcy petitions.  The district court denied the request, and the Second Circuit upheld the denial.  Finding that there was "no question that district courts may appoint receivers as part of their broad powers to remedy violations of federal securities laws," the appellate court held that the anti-litigation injunction was simply one tool, perhaps to be used sparingly, available to the court to further the goals of the receivership.[64] 

Similarly, in SEC v. Vescor Capital Corp., the Tenth Circuit reaffirmed the district court’s broad equitable powers in receivership proceedings.[65]  The appellate court upheld the district court’s denial of a motion by defendant’s creditors to lift a stay of proceedings and permit foreclosure and state court tort actions.  The court noted, as did the Second Circuit in Byers, that the district court’s powers in an equity receivership are both broad in scope and entitled to considerable discretion.[66]