2013 Mid-Year Securities Enforcement Update

July 15, 2013

I.    Overview of the First Half of 2013

The first six months of 2013 represented a time of transition for the SEC’s enforcement program, with a new Chairman and new Co-Directors for the Division of Enforcement at the helm.  It is too soon to predict exactly how they may reshape the program – in contrast with this period four years ago, when Chairman Mary Schapiro and Enforcement Director Robert Khuzami assumed their positions in the wake of Madoff and the financial crisis and with a mandate for major reform, the new team is moving more incrementally.  However, there can be little doubt that, when it comes to enforcement, the new leadership will be striking an aggressive tone.  For the first time in the Commission’s history, the Chairman and the Enforcement Division leadership are all former criminal prosecutors.  As Chair Mary Jo White recently emphasized:  "The SEC is a law-enforcement agency.  You have to be tough.  You have to try to send as strong a message as you can, across as broad a swath of the market as you regulate."[1] 

White and Co-Directors of Enforcement Andrew Ceresney and George Canellos have already begun to signal some notable changes.  They have announced a decision to revisit the agency’s long-standing (and, recently, much-maligned) policy of allowing defendants to settle enforcement actions without admitting wrongdoing, proclaiming that in at least certain egregious cases admissions would be required.  They have signaled that they would once again focus on potential accounting fraud by public companies (an area which has seen a steep decline in recent years), recently announcing the formation of a new task force.  White’s budget priorities highlight continued scrutiny of investment advisers, particularly hedge funds and private equity managers registered with the Commission in the wake of Dodd-Frank.  Meanwhile, the barrage of high profile insider trading cases continues unabated.

            A.    The Changing of the Guard

Mary Jo White was sworn in as the 31st Chairman of the SEC on April 10, 2013.  In contrast to her predecessor, Mary Schapiro, a career regulator at the SEC and FINRA, Chair White comes to the SEC with a prosecutorial background.  White spent nearly a decade as the U.S. Attorney for the Southern District of New York under Presidents Clinton and George W. Bush, where she was responsible for, among other things, prosecuting terrorists and organized crime figures.  And while this might suggest an aggressive enforcement bent, she spent her time before and after two separate tours at the U.S. Attorney’s Office as a lawyer with a large New York law firm, where she earned a solid reputation as a prominent member of the white collar defense bar.  As a result of this varied history, Chair White’s confirmation hearings saw her shoring up both sides of her resume, assuring investor advocates that she could comfortably return to her prosecutorial roots while promising conservative congressmen that she would make SEC rulemaking – particularly the loosening of capital-raising restrictions pursuant to 2012’s JOBS Act – a top priority.

Notably, rather than confirm her for the full four-year term to which she had been nominated by President Obama, the Senate elected to confirm her instead only for the remaining 14 months of Schapiro’s term.  And while she enjoyed nearly unanimous support, and a reappointment in 2014 seems likely, the Senate’s move does suggest that her early months will be closely watched in Washington, both by those supportive of and wary of a more aggressive SEC.

Chair White’s new Enforcement leadership team also hails from a prosecutorial background.  Breaking from precedent, White appointed two Co-Directors for the Division of Enforcement, though this may be more of a transitional move than a long-term structural change.  New appointee Andrew Ceresney previously served as an Assistant U.S. Attorney under White, and then became her partner in private practice where they worked closely together on securities and white collar matters.  Also named as Co-Director was George Canellos, another former Assistant U.S. Attorney under White, who joined the SEC in 2009 as Director of the New York Regional Office and was appointed Deputy Director of Enforcement by Robert Khuzami in 2012.  With both White and Ceresney new to the agency, Canellos provides some consistency from the Khuzami years.  Canellos played a significant role in many of the major reforms initiated by Khuzami, including the creation of specialized units and the rolling out of cooperation tools comparable to those used by criminal prosecutors.  Like Khuzami, Canellos has shown himself to be a strong supporter of aggressive Enforcement actions, tempered by a cautious approach to more novel theories and wary of overreaching in the face of significant litigation risks in close cases.  Whether Ceresney will follow a similar course remains to be seen.

            B.    "Neither Admit Nor Deny" and the Continuing Scrutiny of Settlements

In her first bold enforcement policy pronouncement, Chair White stated at a June 18 conference that the SEC would break from its long-standing practice of allowing defendants to settle SEC cases without admitting or denying the allegations, and, at least in select cases, require party admissions as a condition of settlement.[2]  Though it is unclear how far reaching this change will be, an internal email sent from Ceresney and Canellos to the Enforcement Division staff stated admissions might be required in cases of "egregious intentional misconduct," where the conduct harmed large numbers of investors, or where the defendant had obstructed the investigation.[3]

The change comes in response to the controversy that the SEC’s settlement approach has generated in some courts and, more recently, in Congress.  In February 2013, the Second Circuit Court of Appeals heard arguments in the Citigroup case, where District Court Judge Jed Rakoff had rejected the SEC’s $285 million settlement with Citigroup because, in the absence of an admission, the allegations were "unsupported by any proven or acknowledged facts."[4]  The Second Circuit granted an emergency stay of the case pending appeal, using language indicating the panel was dubious of Judge Rakoff’s position, but as of June 2013 the Court had yet to issue a decision.[5]

While Citigroup has been pending, a growing number of district courts have followed suit in criticizing or outright rejecting SEC settlements.  In connection with the SEC’s proposed settlement with a hedge fund manager in an insider trading case, Judge Rakoff’s colleague in the Southern District of New York, Judge Victor Marrero, was highly critical of the non-admission settlement approach; the court tentatively approved the settlement, but expressly conditioned approval on the outcome of the Citigroup appeal.[6]  Going even farther, Colorado District Court Judge John Kane rejected the SEC’s settlements with two purported Ponzi scheme operators, ruling, "I refuse to approve penalties against a defendant who remains defiantly mute as to the veracity of the allegations against him.  A defendant’s options in this regard are binary:  He may admit the allegation or he may go to trial."[7]

The cudgel has also been taken up by Senator Elizabeth Warren.  Following a February hearing at which she grilled then-Chair Walter (as well as Ben Bernanke and Eric Holder) on why they do not take more cases to trial, Senator Warren sent a letter asking the SEC for "any internal research or analysis on trade-offs to the public between settling an enforcement action without admission of guilt and going forward with litigation as necessary to obtain such admission."[8]  On June 10, Chair White responded with a compelling defense of the neither-admit-nor-deny settlement approach,[9] yet just one week later she announced the SEC’s change in policy.

Even beyond the issue of admissions, some district courts are closely scrutinizing SEC settlements (though this continues to be the exception, not the rule).  For example, last year Judge Richard Leon of the District of Columbia stalled a proposed $13 million FCPA settlement between the SEC and Tyco International.  Several months later, on June 17, Judge Leon finally approved the settlement after additional hearings at which the Court apparently became satisfied with the company’s improved compliance efforts and management changes.[10]  Meanwhile, a second FCPA settlement delayed by Judge Leon around the same time (involving IBM) remains unresolved.

The SEC’s change in policy, as well as continued judicial scrutiny of its settlements, is likely to have several important repercussions.  First and foremost, an admission of liability has serious collateral consequences in any related private action, or even an action brought by another state or federal regulator.  Given the potential exposure, individual and corporate defendants faced with a demand that they admit wrongdoing as a term of the settlement are more likely to take their chances in court, leading to significantly higher litigation expenses and stretching the SEC’s already limited enforcement resources.  Second, as more courts scrutinize SEC settlements, the SEC is likely to file more actions as administrative cease-and-desist proceedings – not just in settled actions, but in litigated cases (in the event that a settlement may be reached before the hearing).  Now that Sarbanes-Oxley and Dodd-Frank have allowed the SEC to obtain substantially the same remedies in a cease-and-desist proceeding as it can in court, such as monetary penalties and officer and director bars, the SEC may avail itself to this venue far more frequently.  As administrative proceedings provide far fewer rights to the parties (i.e. no jury trial, limited or no discovery), such a trend could similarly have significant impact on those actors facing SEC enforcement actions.

            C.    Enforcement Priorities: Reading the Tea Leaves

It is too soon to predict the extent to which White and Ceresney will reshape the Enforcement program, either structurally or in terms of case priorities.  However, one change they have signaled is a renewed focus on public company accounting and reporting fraud.  Historically a major subject matter area for the SEC, typically constituting 25% or more of annual Enforcement actions filed by the agency, the number of financial fraud cases has been at least halved in the past few years, representing around 11% of the Enforcement docket.[11]  Some of this decline may reflect lasting change in corporate governance and accounting and auditing practices in the wake of Sarbanes-Oxley, with public companies beefing up their internal controls systems and auditors exerting greater pressure on management.  But some of this trend may also be cyclical, driven by the economic slowdown’s reduced pressure on earnings as well as the Enforcement Division’s greater allocation of resources to financial crisis-related investigations and hot-button  issues like insider trading.

A May 2013 Wall Street Journal article reports that the SEC under White is again focusing greater attention on public company reporting.  Among other things, the agency is said to be developing computer programs to help sift through SEC filings for signs of irregularities, including both quantitative financial anomalies and suspicious word choice in management discussion and analysis.[12]  And at the beginning of July, the SEC announced the formation of a "Financial Reporting and Audit Task Force," under the leadership of a Regional Director, to proactively identify potential financial frauds using, among other things, quantitative analytics.[13]  While the move does not include the massive organizational restructuring and dedication of resources that accompanied the roll-out of specialized units back in 2010, it at least signals a public commitment by the agency and the Enforcement Division to step up its scrutiny of public companies.

It is unclear how fruitful a proactive approach to opening investigations based on mere red flags would be in the long run; traditionally, most SEC financial fraud cases are triggered by some sort of corporate crisis – a surprising earnings miss, a whistleblower complaint, the discovery of side letters that defeat revenue recognition – often self-reported by the company to the regulators.  However, even if a data (and linguistics) based approach to identifying accounting improprieties turns up few actual frauds warranting enforcement actions, at minimum pursuing these initiatives could generate inquiries from the Enforcement staff and trigger multiple internal investigations at company expense.        

Beyond financial fraud, the new administration has signaled its continuing emphasis on managers of hedge funds and private equity funds, and investment advisers generally.  At the same time the proportion of financial reporting cases brought by Enforcement was cut in half, the number of investment adviser actions essentially doubled, now representing about a quarter of annual SEC enforcement actions.[14]  And the number and complexity of such cases is likely to increase, as the influx of large hedge fund and private equity managers recently registered with the SEC under Dodd-Frank is subjected to exams by the SEC’s Office of Compliance Inspections and Examinations (OCIE).  In late 2012 and early 2013, OCIE began rolling out its new "Presence Exam" initiative, under which examiners are conducting relatively narrow, risk-focused exams of a large number of new registrants.  Given the fact that many of these advisers have not previously been subject to regulatory oversight, they confront a heightened risk of compliance deficiencies finding their way into enforcement referrals.

Perhaps most indicative of the Commission’s keen focus on advisers is the Chair’s Fiscal 2014 Budget Request.  In her Congressional testimony in support of the budget proposal, White called beefing up the investment adviser exam program one of her top priorities.  She sought funding to hire 250 additional investment adviser examiners.  Coupled with an additional 75 new examiners for broker-dealers and other regulated entities, this would represent a 33% increase in OCIE’s manpower.  In contrast, the 2014 budget proposal seeks a less than 10% increase in enforcement staffing, and about a 15% increase in SEC staffing overall.[15]  And while Congressional frugality in the age of sequestration makes it unlikely that such an ambitious budget increase will be fully granted, there can be little doubt where the SEC’s new leadership is training its focus.

Finally, two additional subject matter areas warrant particular attention.  The first, insider trading, is hardly new.  The steady flow of large insider trading schemes implicating public company insiders, expert networks, and hedge fund professionals in the wake of the government’s investigation of Raj Rajaratnam and Galleon Management have not slowed; the first half of 2013 showed a continuing stream of large, high profile actions brought by both the SEC and the U.S. Department of Justice. 

The other noteworthy area of SEC interest is municipal securities.  In April 2013, Commissioner Luis Aguilar stated at a roundtable on retail investors that "a greater focus on th[e municipal securities] market is needed in order to protect investors."[16]  The Commission’s municipal securities enforcement unit has been functioning for several years.  This spring, its investigations led to charges against the state of Illinois as well as against cities in California, Pennsylvania and Florida alleging that the municipal bond offering statements for those entities failed to disclose material information. 

            D.    Other Significant Trends

                        1.    Keeping Up With the Supremes

For the third time in three years, the U.S. Supreme Court has handed down a decision with significant consequences for SEC enforcement.  In February 2013, the Supreme Court answered the important question: when does the five-year statute of limitations for monetary penalties begin to run? In Gabelli v. Securities and Exchange Commission, the Commission had argued that the limitations period should not begin to run until it discovers the defendant’s alleged fraud.  The Supreme Court disagreed and held that the five-year period begins to accrue at the time of the defendant’s fraud, without regard to when the Commission learned of the misconduct.[17]  However, the Supreme Court left open the possibility that the doctrines of fraudulent concealment or equitable tolling might toll the statute of limitations in appropriate cases.

In the first decision to apply Gabelli, Judge Scheindlin in the Southern District of New York granted partial summary judgment to defendants based on their statute of limitations defense.[18]  Although the SEC argued that the defendants’ fraudulent concealment warranted equitable tolling of the statute of limitations, Judge Scheindlin ruled that the fraudulent concealment exception only applies in narrow circumstances (which the SEC had failed to demonstrate), such as when a defendant promises not to plead the statute of limitations or engages in the spoliation of evidence.[19]  This strict interpretation of the exceptions not reached by the Court’s opinion in in Gabelli suggests that the SEC will have limited ability to rely on such arguments to toll the statute of limitations in future enforcement actions.

The practical effect of these decisions on Commission investigations may be significant. SEC staff may choose to rush to complete investigations in order to file a complaint before the limitation period has run.  Alternatively, the staff may seek tolling agreements in more cases, putting companies and individuals in the difficult position of deciding whether to give the agency more time to investigate or standing on their statutory right to repose. Anecdotally, in the wake of Gabelli, we have observed the staff increasingly request tolling agreements in investigations at much earlier stages of investigations than had previously been typical.

In addition, the lower courts continue to grapple with the reach of the Supreme Court’s 2011 Janus decision on who could be regarded as a "maker" of a statement for purposes of liability under Rule 10b-5.[20]  Joseph Brenner, Chief Counsel of the Division of Enforcement, commented that the effect of Janus on enforcement actions was "modest" due to the Commission’s ability to bring claims for secondary liability.[21]  Additionally, in 2013, the Commission has been successful in defeating Janus-based defenses in court.  For example, the Northern District of Illinois disagreed with defendants’ argument that they could not be susceptible to an SEC fraud action for a misstatement made in their attorneys’ opinion letter.[22]  In that same case, the Court concluded that Janus did not bar the SEC’s claims under Section 17(a).

Finally, courts continue to sort out the effects of the Supreme Court’s 2010 Morrison decision, which limited the international reach of Section 10(b) of the Exchange Act to (1) transactions in securities listed on U.S. exchanges and (2) domestic transactions in other securities.[23]  While Dodd-Frank limited the effect of Morrison on the SEC’s enforcement powers by effectively eliminating the decision’s reach over enforcement actions and restoring the "conduct and effects" test used in many circuits prior to Morrison,[24] courts have had to parse the Morrison decision’s effect on the SEC’s enforcement powers over conduct that occurred prior to Dodd-Frank’s enactment in 2010.

Generally, courts have treated a securities transaction as domestic where title passes or irrevocable liability is incurred in the United States.[25]  Recently, the Southern District of New York faced the situation where an offer to sell securities was made domestically but the sale was consummated abroad.  The court held that Section 17(a) of the Securities Act could still be charged after Morrison, and allowed the SEC to take the 17(a) claim to trial.[26]

In a second case, the court confronted an international securities offering with an unusual procedural posture.  The SEC’s civil case had been stayed pending completion of a parallel criminal case.  The SEC moved for collateral estoppel based on the defendants’ criminal convictions.  However, the court found the defendants were not collaterally estopped from defending themselves on the question of whether the fraud was within the territorial jurisdiction of the U.S. securities laws because this question was not decided in the criminal case, which had been decided prior to Morrison.[27]

                        2.    Cooperation

The SEC has continued to make gradual progress in rolling out its cooperation initiative. In May 2013, the Commission announced a non-prosecution agreement with Ralph Lauren Corporation in an FCPA investigation alleging improper payments from a subsidiary to government officials in Argentina.  Ralph Lauren paid a $882,000 penalty but was not charged by the SEC.  The SEC’s press release highlighted aspects of the company’s cooperation, including promptly reporting the findings of its internal investigation to the SEC, translating documents for the staff, summarizing witness interviews, and making overseas witnesses available for interviews in the US.[28]  The SEC also announced in connection with a February 2013 action against two individuals alleged to have defrauded seniors out of millions in a charity scam that it had entered into a cooperation agreement with the company’s in-house counsel, who agreed to be suspended from appearing before the SEC as an attorney and to allow the court to make a later determination as to whether financial penalties are appropriate.[29]

                        3.    Whistleblowers

On June 12, 2013, the Commission announced a second case in which it had approved whistleblower awards under Dodd-Frank.  The matter involved a hedge fund offering fraud in which the principals were previously sued (and the CEO has been sentenced to 40 months in prison). The government has not yet recovered any funds from the defendants; however, the SEC ordered that three whistleblowers who notified the SEC about this fraud will be permitted to share 15% of any ultimately recovery.  A fourth application for an award was denied because the information provided did not lead to or significantly contribute to the enforcement action.[30]

While the small number of awards to date, both in fairly straightforward offering fraud cases, have led to some question whether the program would be successful in ferreting out more complex corporate fraud, the SEC has suggested it has a growing pipeline of large awards on the way.  In May 2013, an Associate Director in the Division of Enforcement noted at a conference that the whistleblower program was likely to produce "incredibly impactful cases" with "some extremely significant whistleblower awards."  He cautioned that the public should not rush to judgment about the program, because the proof will take five to ten years to develop; however, "the question on whether it turbocharges the enforcement program or makes the program more successful [ ] is undeniable because of the type of information we are receiving and how we are using it in some of our investigations."[31]

II.    Public Company Accounting and Reporting

            A.    U.S.-traded Chinese Companies

The SEC has continued its ongoing initiative against foreign-based issuers trading in US markets, particularly China-based companies.  Most recently, in June, the SEC filed a litigated case against China MediaExpress and its Chairman and CEO Zhen Cheng for materially overstating cash balances in its SEC filings and in press releases.[32]  Among other things, the SEC alleged that the company had reported $57 million in cash at a time when it had less than $150,000 on hand.  The SEC also alleged that defendants made material misrepresentations relating to the nature of the company’s business relationships with two other multi-national corporations.  The SEC’s press release announced that the case originated out of the SEC’s Cross-Border Working Group which has to date been able to "file fraud cases against more than 65 foreign issuers or executives and deregister the securities of more than 50 companies." 

One of the larger issues in these cases is the ability of US regulators to obtain foreign workpapers.  In May, the Public Company Accounting Oversight Board ("PCAOB") announced that it had entered into a Memorandum of Understanding on Enforcement Cooperation with the China Securities Regulatory Commission ("CSRC") and the Ministry of Finance.[33]  The MOU "establishes a cooperative framework between the parties for the production and exchange of audit documents relevant to investigations in both countries respective jurisdictions" and, to that end, "provides a mechanism for the parties to request and receive from each other assistance in obtaining documents and information in furtherance of their investigative duties." 

Meanwhile, the administrative proceedings initiated by the SEC last December against Chinese firms associated with the five major global accounting networks for their failure to turn over audit workpapers related to various China-based companies under investigation by the SEC remains pending.[34]  A hearing was held recently, with an initial decision by the administrative law judge expected by October 2013.

            B.    Auditor Independence

The SEC has continued its enforcement of the auditor independence rules.  In June, the SEC brought a settled proceeding against accounting firm Rosenberg Rich Baker Berman & Co. and one of its partners, Brian Zucker.[35]  The SEC alleged, among other things, that Zucker was performing Financial and Operations Principal ("FINOP") services for a broker-dealer client while his firm was serving as the independent auditor.   As part of the settlement, Zucker was suspended from practicing as an accountant before the SEC for a period of at least one year, and the firm was required to pay disgorgement of $12,000 and a civil monetary penalty in the amount of $25,000.

            C.    Regulation FD and Social Media

In April, the SEC took the opportunity to clarify its stance on the dissemination of material non-public information through social media.  In July 2012, Netflix, Inc. CEO Reed Hastings announced on his personal Facebook page that Netflix had streamed 1 billion hours of content in the prior month.  The post was not accompanied by a press release, a post on Netflix’s own website or a Form 8-K.  The SEC investigated the propriety of this disclosure and, in the course of its investigation, concluded that there was uncertainty in the market as to how Regulation FD and the SEC’s 2008 Guidance on electronic disclosure apply to disclosures made by issuers through social media channels.  To address this uncertainty, on April 2, 2013, the SEC issued a Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 regarding Netflix and Hastings.[36]  The SEC, while not pursuing an enforcement action in the matter, confirmed that issuer communications through social media channels require Regulation FD analysis and are governed by the SEC’s 2008 Guidance.  The SEC concluded that public companies could use social media and other emerging communications channels to announce important information as long as investors have been alerted as to which social media will be used to disseminate such information.  The SEC added that, in most cases, disclosure of material information on the personal social media site of an individual corporate officer, without advance notice that the site would be used for this purpose, is unlikely to satisfy Regulation FD’s requirement that the communication "provide broad, non-exclusionary distribution of the information to the public." 

            D.    Oversight of "Going-Private" Transactions

This year, the Commission also made clear that it is maintaining oversight of the representations made by companies in "going-private" transactions.  On June 13, 2013, the SEC initiated settled cease-and-desist proceedings against Revlon Inc.[37]  The Commission alleged that Revlon, in the course of it pursuing a "going-private" transaction, violated Section 13(e) of the Exchange Act and Rule 13e-3 thereunder by failing to disclose to its minority shareholders an opinion from a third-party financial adviser who found that the terms of Revlon’s proposed ‘going-private’ transaction did not provide for adequate consideration within the meaning of ERISA to participants in Revlon’s 401(k) plan.  According to the SEC, the failure to disclose this opinion to Revlon’s minority shareholders rendered the disclosures Revlon made to the minority shareholders materially misleading.  To settle the proceedings, Revlon agreed to pay a civil money penalty in the amount of $850,000. 

III.    Insider Trading Developments

            A.    Expert Networks and Hedge Funds

The SEC continues to focus substantial resources on insider trading investigations and actions, initiating several new enforcement actions and settlements over the past six months.  Unsurprisingly, the SEC’s post-Galleon assault on expert networks and hedge funds has continued to churn new cases and settlements.  These include:

• Dosti and Whittier Trust Co.:  The SEC filed a settled insider trading case against a wealth management company and a former fund manager who were involved in an insider trading scheme involving securities of multiple public companies. The charges are the agency’s latest in its ongoing investigation into expert networks and hedge fund trading.[38]
• Rajaratnam:  The SEC charged Rajarengan "Rengan" Rajaratnam for his role in the massive insider trading scheme spearheaded by his older brother Raj Rajaratnam and hedge fund advisory firm Galleon Management. Rengan Rajaratnam allegedly reaped more than $3 million in illicit gains.[39]
• Sigma Capital Management:  The SEC charged this New York-based hedge fund advisory firm with insider trading based on nonpublic information allegedly obtained through one of its analysts regarding the quarterly earnings of two companies. The firm agreed to pay nearly $14 million to settle the charges.[40]  A separate litigated action against Sigma’s portfolio manager (along with a parallel criminal action) was filed shortly thereafter.[41]
• Nguyen et al.:  The SEC charged a former employee of a California-based medical device manufacturer with illegally tipping confidential financial data to her brother, who illegally traded in the company’s stock and passed the information on to his hedge fund clients, enabling them to do the same.[42]

The SEC also announced that Judge Rakoff approved a $1.8 million settlement between the SEC and hedge fund manager Douglas F. Whitman and his firm Whitman Capital, LLC in one of the many cases that arose from the SEC’s investigation of widespread insider trading perpetrated by Galleon’s Raj Rajaratnam and other hedge fund managers.[43]  In addition, the SEC obtained the final settlement in the "Golden Goose" Wall Street insider trading case, nearly five years after charges were first filed,[44] and settled the charges brought against Level Global Investors LP in January 2012.[45]

            B.    Insider Trading and Auditors

In April, the SEC and the U.S. Attorney’s Office for the Central District of California announced insider trading charges against Scott London, a former partner at a Big Four accounting firm.  From October 2010 through April 2012, London allegedly tipped a friend with material, non-public information that London obtained from several of the firm’s present and former audit clients.  The friend was able to trade on the information regarding these companies’ earnings announcements, releases of financial results, and impending mergers, allegedly making more than $1.2 million in illicit profits.  Both later entered guilty pleas and await sentencing.

            C.    Emergency Actions, Cross-Border Cooperation, and Foreign
                   Enforcement Efforts

The SEC is currently pursuing two new cases in which it successfully initiated emergency proceedings to freeze assets immediately after suspicious trading.  The SEC obtained these asset freezes notwithstanding the fact that it did not yet have evidence that the trader had material nonpublic information.  Indeed, the SEC did not even know the traders’ identities in one case.[46]  The success of this strategy was recently confirmed in a case in which the SEC announced settled charges against an alleged tipper.[47]  That case began as an emergency action in 2010 against the overseas trader, similarly without allegations about the source of the inside information; during the course of the subsequent litigation, the SEC was able to identify the source as a former officer of a California-based pharmaceutical company.  The ongoing investigation involved several overseas regulators, including the Swiss Financial Market Supervisory Authority, the Cyprus Securities and Exchange Commission, and the British Virgin Islands Financial Services Commission.

Cross-border cooperation was also highlighted in a recent action where the SEC filed settled insider trading charges against Richard Bruce Moore, a Toronto-based investment banker who agreed to pay more than $340,000 to settle the charges that he traded on inside information that he obtained through his job of pitching investment ideas to the Canada Pension Plan Investment Board (CPPIB).[48]  The SEC acknowledged the assistance of the Ontario Securities Commission—which filed and settled its own illegal insider trading charges against Moore in April 2013.[49]  The U.K.’s Financial Conduct Authority (the predecessor to the FSA) is also aggressively pursuing insider trading enforcement efforts; it has already secured two convictions for insider trading in 2013, and is currently prosecuting an additional seven individuals.[50]

            D.    Traditional Insider Trading

Sometimes lost in the shuffle of more high profile cases, the SEC continues to pursue more traditional insider trading cases alleging trading or tipping ahead of merger announcements, as well as cases alleging misappropriation of confidential information by family members. 

                        1.    Mergers and Acquisitions

The SEC filed multiple actions alleging trading ahead of merger or acquisition announcements, simultaneously settling all but two cases.  In perhaps the largest case filed so far this year, the SEC filed charges against Matthew Teeple, a California-based hedge fund analyst, who was allegedly tipped by his friend, the CEO of a technology company, about the upcoming acquisition of the company for $3 billion.[51]  Teeple then caused his employer, a hedge fund advisory firm, to purchase shares in his friend’s company in the days before the acquisition announcement, allowing the firm to reap millions of dollars in profits after the announcement.  Teeple also allegedly passed the information to another friend.  The U.S. Attorney’s Office for the Southern District of New York is pursuing criminal charges against all three defendants in the $29 million trading scheme.[52]

In another action with a string of tippees and a parallel criminal proceeding, the SEC charged Kevin L. Dowd, a financial adviser based in Boca Raton, Florida, with tipping inside information about the upcoming acquisition of a pharmaceutical company in exchange for a $35,000 cashier’s check and a jet-ski dock.[53]  Dowd allegedly learned about the acquisition from a supervisor at the brokerage firm where he worked; the supervisor had learned about it from a customer who sat on the company’s board of directors.  Dowd then tipped his friend, a penny stock promoter, who bought stock in the company on the last trading day before the acquisition was announced.  The trader-tippee in turn tipped another person who bought call options in the company’s stock.  The group collectively reaped $708,327 in profits in two trading days.  The U.S. Attorney’s Office for the District of New Jersey announced criminal charges against Dowd on the same day the SEC filed its complaint.[54]

Settled cases in the M&A context include charges against company executives, board members, and even information technology professionals.  In one of the more unique fact patterns in the first half of 2013, the SEC charged Mark Begelman for trading on confidential information obtained through membership in World Presidents’ Organization ("WPO"), a global group of business leaders and executives with a written policy to keep information learned from other WPO members confidential.[55]  In violation of that policy, Begelman allegedly purchased stock in a company whose high-ranking executive was a fellow WPO member and told Begelman, in confidence, of his company’s plans to merge with another company.  Begelman allegedly profited from the 46% jump in stock price upon the merger’s announcement. 

Settling for six-figure dollar amounts and five-year officer and director bars, two public company vice presidents were charged with trading ahead of acquisition announcements learned through the course of their employment – one involving Del Monte Foods Company’s acquisition by an investor group,[56] and the other involving International Paper Company’s tender offer of Temple-Inland, Inc.[57]  The SEC also charged a long-time director who purchased stock and call options in the company on whose board he sat, having learned from his board membership that the company would be acquired.[58]  The SEC also filed a settled action against two information technology specialists at an Oregon-based health insurance company, one of whom, in resolving a technology issue with the CEO’s email account, allegedly read confidential documents about the company’s plans to merge with a competitor, and then tipped his boss, both of whom traded the next day in their company’s stock.[59]

                        2.    Family Relationships

Family members continue to serve as sources of material non-public information for traders and tippees in misappropriation cases.  In February, the SEC filed settled charges against James Balchan for trading ahead of the acquisition of National Semiconductor after he allegedly misappropriated confidential information from his wife, a partner at a law firm that was consulted on issues related to the acquisition.[60]  After Balchan’s wife told him that a social event they planned to attend with the company’s general counsel had been canceled because the general counsel was busy working on an impending merger, Balchan bought shares in the company, in violation of the duty of trust and confidence owed to his wife, who in turn owed such a duty to her law firm and its clients.   

In May, the SEC brought settled charges against the brother of a director, his friend, and his sister-in-law for insider trading in the securities of the company on whose board the brother sat.[61]  While working at his brother’s investment advisory firm, John Stilwell allegedly misappropriated confidential information from his brother, a physician on the board of American Physicians Capital, Inc., ("ACAP"), about the anticipated acquisition of ACAP by another insurance company.  Stilwell then tipped the non-public information to his friend and his sister-in-law, each of whom traded and tipped another person who purchased ACAP shares.   

The SEC also charged a pair of brothers in the eighth insider trading case related to Sanofi-Aventis’ announcement of its intent to make a tender offer for pharmaceutical company Chattem back in late 2009.[62]  The first brother allegedly learned of the tender offer during a confidential conversation with his brother-in-law, a Chattem executive at the time who was also a friend from business school, who asked that the conversation be kept confidential, to which the brother agreed.  The next day, he called his brother and told him about the confidential deal, and his brother purchased shares of Chattem a few days later. 

IV.    Investment Adviser Developments

            A.    Valuation

There were several enforcement developments involving asset valuation, long a high priority item for the SEC’s examination program and Asset Management Unit.  In March, the SEC instituted a settled action against the advisers to a fund of private equity funds, alleging that they improperly valued the fund’s largest holding at a markup to the estimate of the underlying holding’s manager.[63]  The SEC further contended that the advisers lacked policies reasonably designed to ensure that valuations were determined in a manner consistent with representations to investors.

In June, the SEC settled an action it had filed last December against the former independent directors of mutual funds managed by Morgan Asset Management.[64]  As we reported in the 2012 Year End Update, the SEC’s somewhat novel case alleged that the directors had delegated responsibility for valuing securities without readily available market quotations to a valuation committee without providing meaningful guidance on how fair valuation determinations should be made.[65]  The directors consented to an order that they cease and desist from causing the funds’ violations of Rule 38a-1 of the Investment Company Act, which requires funds to "adopt and implement written policies and procedures."  Notably, the SEC dropped two additional charges, and did not impose penalties or any other relief.

            B.    Custody Rule and Other Compliance Violations

In April, the SEC instituted settled administrative proceedings against Vector Wealth Management, LLC for custody rule and other compliance violations.[66]  According to the SEC’s order, a clerical employee of Vector had forged checks to misappropriate $33,147 of dividends owed to four advisory clients participating in two pooled-investment vehicles.  Although Vector possessed custody of the pooled-investment vehicles, it did not arrange to deliver to clients quarterly account statements or audited annual financial statements, nor was it subject to an annual surprise examination.  The SEC further alleged that Vector lacked policies reasonably designed to prevent violations of the custody rule.  As part of the settlement, Vector agreed to a cease-and-desist order and to retain an independent compliance consultant.  The SEC declined to assess a penalty based on Vector’s cooperation with the SEC’s investigation.

In a related development, OCIE issued a Risk Alert regarding compliance with the Custody Rule on March 4.[67]  The Risk Alert described "significant deficiencies" concerning custody-related issues in roughly one-third of the firms examined in the National Exam Program.  The investment advisors’ deficiencies included failure to recognize possessing custody, failure to meet surprise-examination requirements and failure to satisfy qualified-custodian requirements.

In another action involving multiple compliance issues, the SEC instituted a settled administrative action against Foxhall Capital Management, Inc. and Chief Executive Officer, Chief Compliance Officer, and Co-Chief Information Officer Paul G. Dietrich on April 19.[68]  The SEC alleged, among other things, that Foxhall Capital did not maintain current information about client account balances, causing the adviser to place trades for which certain clients did not have sufficient funds, and then to improperly reallocate the shares to other investors.  Foxhall Capital agreed to several undertakings to settle the SEC’s charges, including agreeing to change Foxhall Capital’s primary custodian, upgrade its trading platform, and hire a compliance consultant and independent accountant.  Foxhall agreed to pay disgorgement and prejudgment interest of approximately $23,000 and a $100,000 civil penalty, and Dietrich agreed to pay a $25,000 civil penalty. 

The SEC also instituted settled administrative proceedings against IMC Asset Management, Inc. alleging that IMC’s compliance officer "performed virtually no compliance-related functions."[69]  As part of the settlement, IMC agreed to several undertakings, including retention of an outside compliance consultant and training for its chief compliance officer on the Adviser’s Act.

            C.    Financial Crisis Fall-Out

The SEC’s investment adviser docket continued to be heavily populated by cases at least peripherally related to the financial crisis.  For example, in April, the SEC instituted a settled administrative action against HarborLight Capital Management, LLC, an unregistered investment advisor, and Dean G. Tanella, its principal.[70]  According to the SEC, one of the funds of funds they managed, due to impaired assets, was unable to honor redemption requests.  Harborlight reacted to the liquidity shortfall by causing another fund the managed to invest in a new fund they had created, then using this new fund to pay outstanding redemption requests for the first fund.  At the same time, the SEC alleged, Harborlight raised money from investors for the new fund without disclosing that the money was being used to honor redemption requests from earlier investors.  The settled order included a twelve month suspension for Tanella, approximately $70,000 in disgorgement and interest, and a $200,000 civil money penalty.

In another case involving redemption-related issues, the SEC filed a litigated action against hedge fund managers David Bryson and Bart Gutekunst and their firm, New Stream Capital, LLC, as well as its former CFO, alleging that during the financial crisis in 2008, Bryson and Gutekunst revised the fund’s capital structure to benefit its largest investor.[71]  According to the SEC, the investor was given preferential treatment after it threatened to redeem its investment, while the defendants continued to raise $50 million in new investor funds without disclosing the structural change that subordinated the rights of new investors.  Related criminal charges were filed by the U.S. Attorney’s Office in Connecticut.

Finally, in February, the SEC filed a litigated action against ABS Manager, LLC and George Charles Cody Price, an investment manager who co-hosted a radio show in San Diego, alleging fraud in connection with the sale of funds invested in risky collateralized mortgage obligations (CMOs).[72]  The complaint alleges that Price deceived investors by stating that the investments would be secure even though the investments were in one of the riskiest traunches of CMOs on the market, and compounded his fraud by providing fake monthly statements that inflated the fund performance.

            D.    Cherry-Picking and Front-Running

The SEC also brought several cases involving purported self-dealing by investment advisers.  In May, the SEC filed a litigated court action against a Chicago-area father and son, Charles J. Dushek and Charles S. Dushek, and their investment advisory firm, Capital Management Associates, Inc.[73]  The SEC alleged that the Dusheks placed millions of dollars in securities trades without designating in advance whether they were trading in personal or CMA’s client funds.  The Dusheks would then "cherry pick" winning trades for their personal accounts and allocate losing trades into CMA’s clients’ accounts.  As a result, CMA allegedly misrepresented its proprietary trading activities to clients in brochures that were a part of its Form ADV.  According to the SEC, the cherry-picking scheme lasted from 2008 through 2012, the Dusheks made more than 13,500 purchases during that period, and these purchases totaled more than $350 million.   

In another case involving allegations of "cherry-picking," the SEC in January settled a case it had filed in August 2012 against MiddleCove Capital, LLC and Noah L. Myers, MiddleCove’s principal, chief investment officer, and sole owner.[74]  The case alleged that MiddleCove and Myers allocated trades that had appreciated to Myers’ personal and business accounts, but trades that depreciated to MiddleCove’s advisory clients’ accounts.  As part of the settlement, SEC revoked MiddleCove’s registration as an investment advisor, barred Myers from the industry, and ordered the respondents to pay nearly $800,000 in disgorgement and penalties.

Lastly, in May, the SEC charged Daniel Bergin, a senior equity trader at an asset management firm, with a fraudulent front running scheme.[75]  The SEC alleged that Bergin made over $500,000 by purchasing securities in his wife’s accounts before placing large trades on behalf of his firm’s clients.  The SEC also alleged that Bergin concealed his trading activity by failing to disclose his brokerage accounts to the firm, and that he attempted to hide his wife’s accounts from SEC examiners.  The SEC obtained a freeze of Bergin’s and his wife’s assets, and the case is litigating.

V.    Broker-Dealer Developments

            A.    Fraud and Unregistered Brokers

In the first half of 2013, the Commission continued its efforts to identify brokers defrauding investors.  In January, the Commission charged a former executive at Jeffries & Co. with defrauding investors as part of a scheme involving the sale of mortgage-backed securities.[76]  The Commission alleged that the executive lied to customers during the sales of mortgage-backed securities, either by inflating the original purchase price in order to re-sell the security at a higher price, or creating a fictional seller to increase the purchase price.  Other recent actions by the Commission include fraud charges against a New York brokerage firm and two brokers for allegedly using misleading sales tactics[77] and charges against two former brokers in Arizona who allegedly diverted at least $1.8 million of investor money for their personal use by soliciting investors for a tankless water heater project.[78] 

Recent actions against broker-dealers, however, targeted not only conduct by brokers which harmed investors, but also conduct by individual brokers which harmed their firms.  For example, in April, the Commission charged a rogue trader whose conduct caused the trader’s employer to cease operations.[79]  Upon receiving a customer order for the purchase of 1,625 shares of Apple stock, broker David Miller instead placed an order for 1.625 million shares, apparently planning to share in any profits or, if the stock price declined, to claim that the order was placed in error.  When Apple’s share price in fact fell, the firm was stuck with a $5.3 million loss, causing its available liquid assets to fall below the regulatory limits required of broker-dealers; the firm ceased operations shortly thereafter.  Miller agreed to a permanent industry bar and to pay a penalty to be set following sentencing in a related criminal proceeding.

In addition to these recently initiated actions against broker-dealers, the Commission has also seen recent court victories for its previously-filed actions.  In April, the United States District Court for the Southern District of New York granted summary judgment for the Commission against two broker-dealers who violated securities laws by misleading investors, misappropriating funds, and preparing false account statements.[80]  In this case, the broker-dealers "promised and otherwise encouraged clients to believe, that they could expect unreasonably large and rapid returns on their investments."  The broker-dealers lied about their educational and professional backgrounds, as well as the global reach of the company for which they solicited investors.  Similarly, in April, the United States Court of Appeals for the Sixth Circuit affirmed the district court’s imposition of a permanent bar against an individual charged with trading in unregistered securities.[81]

In the first half of 2013, in addition to targeting fraud perpetrated by brokers, the Commission has continued its efforts to target brokers who are not registered in accordance with securities laws.  In June, for example, the Commission filed a civil injunctive action in the United States District Court for the District of Nevada against Banc de Binary Ltd., a Cyprus-based company.[82]  The Commission alleged that the company was offering and selling binary options—securities in the form of options contracts whose payout depends on whether the value of the underlying assets increases or decreases—in the United States without registering the securities and without registering as a broker.  The company solicited customers in the United States through YouTube videos, spam e-mails, and other Internet-based advertising.  Further, the company interacted with investors by phone, e-mail, and instant messaging.  According to the Commission, the company’s solicitation efforts were particularly successful in attracting customers of modest means.

            B.    Other Broker-Dealer Enforcement Developments

In an administrative decision that found for the Enforcement Division, an administrative law judge issued an initial decision in June finding that broker optionsXpress, its former CFO, and a customer of the firm had violated Regulation SHO (as well as the antifraud provisions) and ordered them to disgorge $4.2 million and pay penalties of more than $4 million.[83]  The judge also permanently barred the former CFO from associating with a broker or investment adviser.  The case, which was filed in April 2012, involved allegations of naked short selling in the options of several companies between 2008 and 2010, where the respondents allegedly engaged in sham transactions to give the appearance that the firm had purchased securities allowing it to avoid its stock delivery obligations.

In another judicial proceeding, the United States Court of Appeals for the District of Columbia Circuit reaffirmed its prior guidance regarding the SEC’s review of agency disciplinary action.  In Saad v. SEC, the court held that the SEC abused its discretion when it upheld the lifetime ban imposed by the Financial Industry Regulatory Authority (FINRA) on John Saad, a securities broker.[84]  FINRA imposed the lifetime ban after a disciplinary hearing in which the panel determined that Saad filed false expense reports and misled investigators during the investigation.  This decision was affirmed by both FINRA’s National Adjudicatory Counsel and the SEC.  On appeal to the District of Columbia Circuit, Saad argued that the SEC abused its discretion by failing to consider mitigating factors when affirming the lifetime ban.  Ultimately, the court held that the SEC ignored several potentially mitigating factors.  Citing prior guidance on this issue, the court stated that the "SEC ‘must be particularly careful to address potentially mitigating factors’ before affirming a permanent bar."  Although the court took "no position on the proper outcome of this case," the court remanded the case for further consideration by the SEC.

Finally, continuing a trend that began with DirectEdge and has included the NYSE, the Commission brought settled actions in the past few months against NASDAQ and CBOE.

            C.    Regulatory Initiatives

In April, David W. Blass, Chief Counsel of the SEC’s Division of Trading and Markets, spoke before an investment-law group on the topic of private funds.[85]  He stated that the SEC was increasingly focused on private funds advisers (particularly those newly-registered under Dodd Frank and now subject to examinations) who may be improperly acting as unregistered brokers.  According to Blass, the SEC was considering two scenarios:  first, "a fund adviser that pays its personnel transaction-based compensation for selling interests in a fund or that has personnel whose only or primary functions are to sell interest in the fund"; and, second, "the private fund adviser, its personnel, or its affiliates receive transaction-based compensation for purported investment banking or other broker activities relating to one or more of the fund’s portfolio companies."  Blass’s speech went on to highlight some of the considerations that could lead to private fund advisers running afoul of the broker registration requirements.  He also noted a recent enforcement action, suggesting that the issue was likely to draw attention not just from OCIE examiners, but from the Enforcement Division as well.

VI.    Municipal Securities & Pension Developments

Although several SEC Commissioners have spoken publicly about the SEC’s focus on the municipal securities market, and the specialized Municipal Securities and Public Pensions Unit was formed in 2010, it was not until early 2013 that a dramatic upturn in the number of municipal securities enforcement actions became noticeable.  Over the past six months, the Enforcement Division brought high profile cases against several cities and a state. 

In March, the Commission charged the State of Illinois with fraud, alleging that the state offered and sold over $2.2 billion worth of municipal bonds from 2005 to 2009 without informing investors of the problems with its pension funding schedule.[86]  According to the SEC, Illinois failed to disclose that its statutory plan underfunded state pension obligations and increased the risk to its overall financial health.  The SEC also charged that the state misled investors about the effect of changes to its funding plan, and lacked mechanisms to ensure material information about its pension systems was accurately reflected in its bond disclosures.  The state settled to a cease-and-desist order and no penalties, with the SEC recognizing steps the state had taken since 2009 to remedy its pension disclosures.

In April, the Commission filed a complaint against the City of Victorville, California, its bond underwriter, and certain city officials, alleging that they inflated property valuations that secured a 2008 bond offering.[87]  The City, which controls the Airport Authority, issued bonds to finance various redevelopment projects, including four airplane hangars.  According to the SEC, the defendants used a $65 million valuation for the hangars even though the county assessor had valued them at less than half that amount.  The SEC also charged that the underwriter misappropriated $2.7 million in bond proceeds by taking unauthorized fees.  The matter was filed as a litigated action.    

In May, the Commission announced a settled cease-and-desist action against the City of South Miami, Florida.[88]  The city had borrowed $12 million in two bond offerings through the Florida Municipal Loan Council (FMLC) to develop a mixed-use retail property and parking structure.  According to the SEC, the city represented that the project was eligible for tax-exempt financing, but failed to disclose that it had jeopardized its tax-exempt status by restructuring the lease agreement with a for-profit developer.  The SEC alleged that subsequent city finance directors were not informed of the tax issue, and had no training or guidance on bond offering tax or disclosure issues.  The city ultimately had to enter a settlement with the IRS to avoid harming the bondholders.  As part of its settlement with the SEC, the city agreed to retain an independent consultant for three years to review the city’s bond policies and procedures.  

Also in May, in a somewhat novel case, the SEC filed a settled fraud action against the City of Harrisburg, Pennsylvania, alleging fraudulent misstatements and omissions by the City regarding the City’s financial condition, credit rating, and ability to repay certain bonds.[89]  This case is notable because it "marks the first time that the SEC has charged a municipality for misleading statements made outside of its securities disclosure statements."  Here, the misleading statements were conveyed through Harrisburg’s budget report, its annual and mid-year financial statements, and a State of the City address.  The case was announced in conjunction with an SEC report giving guidance on the obligations of public officials relating to their secondary market disclosures for municipal securities.[90]  The report cautioned that public officials "should consider adopting policies and procedures that are reasonably designed to result in accurate, timely, and complete public disclosures; identifying those persons involved in the disclosure process; evaluating other public disclosures that the municipal securities issuer has made, including financial information and other statements, prior to public dissemination; and assuring that responsible individuals receive adequate training about their obligations under the federal securities laws."

Finally, in a pair of pension-related cases, the SEC filed a settled action against the CEO of an investment advisory firm for lying to the California Public Employers’ Retirement System (CalPERS) about the firms’ purported assets under management;[91] and a settled action against the senior officers of another adviser for stealing over $3 million from a Detroit police and firefighter pension fund and using the money to purchase strip malls.[92]  

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