Matthew Martoma was convicted of insider trading by a Manhattan jury. That jury found him guilty of one count of conspiracy and two counts of securities fraud. The convictions continues the unbroken string of victories in criminal insider trading cases arising out of i investigations by the Manhattan U.S. Attorney’s Office into hedge funds. Over the last four years that Office has secured 79 convictions or guilty pleas in insider trading cases.
In contrast, the SEC continues to have difficulty in the courtroom. A jury rejected all of its insider trading claims in one high profile, aggressive insider trading case. A jury also rejected most of the regulator’s claims in a financial fraud action. Since late December 2013 – a period of less than two months – the Commission has lost either all or the majority of claims tried in court in five separate cases.
Outside the courtroom the Commission focused on its microcap fraud initiative. Trading suspensions were issued under an initiative called “Operation Sell-Expel” for 255 issuers, a program which resembles the typical Section 12j proceedings that are periodically brought to delist delinquent filers. The agency also brought twenty stop order proceedings centered on registration statements which failed to disclose that the sole officer of the firm was a securities law recidivist. In addition, the SEC also brought two actions based on parking violations, two involving short selling, one alleging the misappropriation of millions of investor dollars and another centered on a claimed investment fund fraud.
Trading suspension: The Commission announced Operation Shell-Expel, a program targeted at microcap shells. In connection with the announcement the agency suspended trading in the shares of 255 issuers. See, e.g., In the Matter Able Energy, Inc., SEA Release No. 71465 (Feb. 3, 2014).
Remarks: Commissioner Luis Aguilar addressed The American Retirement Initiative’s Winter 2014 Summit, delivering remarks titled Protecting the Financial Future of Seniors and Retirees, Washington, D.C. (Feb. 4, 2014). His remarks reviewed select enforcement actions, elder abuse, the priorities for the national exam program and reporting elder financial abuse (here).
Testimony: Acting Chairman Mark P. Wetjen testified before the Senate Committee on Banking, Housing & Urban Affairs, Washington, D.C. (Feb. 6, 2014). His testimony discussed the Volcker Rule, the implementation stage of Dodd-Frank, international coordination and agency resources (here).
Testimony: Acting Chairman Mark Wetjen testified before the House Committee on Financial Services, Washington, D.C. (Feb. 5, 2014). The testimony reviewed the progress of the agency on financial reform, the coordination of regulators on the Volcker Rule, differences between the final and draft provision and the needs of the agency for funding to monitor compliance (here).
SEC Enforcement – Litigated actions
Financial fraud: SEC v. Life Partners Holdings, Inc., Civil Action No. 1-12-cv-00033 (W.D. Tx. Verdict Feb. 3, 2014) is a financial fraud action against the firm and its chairman and CEO, Brian Pardo, along with president and general counsel, Scott Peden, among others. The complaint alleged that the defendants misled shareholders by failing to disclose that the company was systematically and materially underestimating the life expectancy estimates it used to price transactions. Most of the revenue of the company is derived from brokering life settlements which involve the sale of fractional interests of life insurance policies whose value is keyed to the insured’s life expectancy. For this purpose the company used life expectancy estimates provided by a doctor with no actuarial training or prior experience in this area, according to the complaint. No meaningful due diligence was conducted to determine if the doctor’s methodology and qualifications were appropriate.
The complaint claimed the two officers were aware that the estimates were systematically and materially short. Nevertheless, between February 2007 and January 2009 Messrs. Pardo and Peden sold, respectively, about $11.5 million and $300,000 of Life Partners common stock while in the possession of inside information. The Commission also claimed that from fiscal year 2007 through the third quarter of fiscal 2011 the company prematurely recognized revenue and understated impairment expense related to its investment in life settlements. Violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(a) and 13(b)(5) and Securities Act Section 17(a) were alleged. The complaint also demanded the repayment of certain stock sales profits and bonuses under SOX.
Following trial the jury found against the Commission on most claims. Specifically, on the nine claims presented the jury found against the SEC on six and for the agency on three. The claims were: 1) Securities fraud under Exchange Act Section 10(b) against the three defendants tied to the risks and trends of the business model: Verdict for the defendants; 2) Insider trading: For the defendants; 3) Securities fraud under Securities Act Section 17(a) for not disclosing the firm revenue recognition policy: For the SEC against all defendants; 4) Section 13(a) and Rules 12b-20, 13a-1 and 13a-13 against the company (and aiding and abetting violations by the individuals) for false filings: For the SEC and against all defendants; 5) Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B) as to the company (and aiding and abetting as to each individual defendant) for failing to maintain an adequate system of internal controls: Against the SEC; 6) Exchange Act Section 13(b)(5) as to the two individual defendants for falsifying the books or circumventing internal controls: Against the SEC; 7) Exchange Act Rule 13b2-1 as to the two individual defendants for falsifying the books: Against the SEC; 8) Exchange Act Rule 13b-2 against each individual defendant for making a false statement to an auditor: Against the SEC. 9) Exchange Act Rule 13a-14 against Mr. Pardo for certifying a report of the firm filed with the Commission that contained a misrepresentation or omission. The jury found in favor of the Commission on this claim.
Insider trading: SEC v. Steffes, Case No. 1:10-cv-06266 (N.D. Ill. Verdict Jan. 27, 2014) is an action that focuses on trading by a group of family members and their friends. The defendants included: Rex C. Steffes, Cliff Steffes, Rex R. Steffes, Bret W. Steffes, Robert J. Steffes and W. Gary Griffiths. Defendant Gary Griffiths is married to the sister of his high school class mate and longtime friend Rex C. Steffes. Rex C. Steffes has three sons who were defendants: Cliff, Bret and Rex R. His brother is defendant Robert J. Steffes who settled before trial.
The case centered on the acquisition of Florida East Coast Railway, LLC by Fortress Investment Group LLC, announced on May 8, 2007. Defendants Gary Griffiths and Cliff Steffes were employed by the railroad during the period of the transaction. Gary and Cliff, according to the complaint, obtained inside information and then tipped the other defendants. Collectively, the trades generated about $1.6 million in profits.
The SEC claimed that each man acquired inside information through his position with the firm and a series of events. Gary Griffiths was a vice president and chief mechanical officer employed at the headquarters in Jacksonville. He reported to the COO. Cliff Steffes was a trainman at the Bowden Rail Yard in Jacksonville. He obtained his position with the assistance of his uncle, Gary Griffiths.
Each man saw, heard or speculated about certain events, according to the SEC. For Gary those were: In early March the CFO asked him to prepare a comprehensive list of equipment owned by the company; he became aware that there was an unusual number of yard tours (potential bidders toured);“he believed” the yard tours were provided to investment bankers for a possible sale; employees asked him if the company was being sold and they would lose their jobs; and he arranged and monitored a rail trip from the Bowden to the Hialeah Yard for Fortress executives in a special rail car reserved for visitors. For Cliff Steffes those were: There was an unusual number of yard tours involving people dressed in business attire; many employees who had not personally witnessed the tours became aware of them; shortly before the tours began a number of employees expressed concern about the company being sold and a loss of jobs; and the Fortress executives toured the Bowden yard where Cliff Steffes worked. The Commission’s complaint alleged violations of Exchange Act Section 10(b).
SEC Enforcement – Filed and Settled Actions
Statistics: This week the Commission filed or announced the filing of 4 civil injunctive, DPAs, NPAs or reports and 22 administrative proceedings (excluding follow-on and Section 12(j) proceedings).
Investment fund fraud: SEC v. Zada, Civil Action No. 2:10-cv-14498 (E.D. Mich.) is a previously filed case against Joseph Zada and Zada Enterprises, LLC. The action centered on a fraudulent investment scheme through which the defendants raised at least $27.5 million from 60 investors between January 2006 and August 2009. Investors were solicited to purchase promissory notes with varying rates of interest. They were told their funds would be in oil related investments and that Mr. Zada had significant contacts in the industry and the Middle East. In fact the defendants were conducting a Ponzi scheme. On January 31, 2014 the Court entered final judgments of permanent injunction against each defendant prohibiting future violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Section 10(b). In addition, the court found the defendants liable, jointly and severally, for disgorgement of $56,571,243, prejudgment interest and imposed a civil penalty against Mr. Zada in the amount of the disgorgement. Previously, the Court had granted the SEC’s motion for summary judgment. A parallel criminal case was brought against Mr. Zada. See Lit. Rel. No. 22919 (Feb. 5, 2014).
Parking: In the Matter of Thomas C. Gonnella, Adm. Proc. File No. 3-15737 (Feb. 4, 2014) and In the Matter of Ryan C. King,Adm. Proc. File No. 3-15736 (Feb. 4, 2014) are proceedings naming as Respondents two traders at different firms. The Orders focus on the period September 2008 through the end of 2011. During that period Mr. King of firm B agreed with Mr. Gonnella of firm A to temporarily hold certain securities which would later be repurchased by his friend. The purpose of the transactions was to evade certain restrictions at firm A regarding the age of inventory. Ensuring compliance with those restrictions helped earn additional compensation for Mr. Gonnella but resulted in a loss for his firm. The round trip transactions involved ten securities, nine of which were immediately repurchased. The tenth was later repurchased at a loss. Mr. Gonnella then took steps to cover the loss with other transactions. The Orders allege violations of Securities Act Sections 17(a)(1) and (3) and Exchange Act Section 10(b). Mr. King cooperated with the Commission. He resolved the proceeding against him, consenting to the entry of a cease and desist order based on the Sections cited in the Order. He also agreed to pay disgorgement of $22,606.80 along with prejudgment interest and to the entry of an order barring him from the securities business or from participating in any penny stock offering with a right to apply for re-entry after three years. The Commission took into account his cooperation. The proceedings will be set for hearing.
Stop orders: See, e.g., In the Matter of the Registration Statement of Yuma Resources Inc., Adm. Proc. File No. 3-15734 (Feb. 3, 2014) is a series of twenty proceedings. Each proceeding is essentially the same. Each registration statement sought to register the shares of an insider; each claimed that the issuer is engaged in “exploration for certain metals and other minerals;” the management consists of “one person;” and each Registration Statement includes false statements, failing to disclose the fact that the firm’s executive officer and controlling director was charged with fraud in SEC v. Golden Apple Oil and Gas, Inc., et al., Civil Action No. 09-Civ-7580 (S.D.N.Y.) and has been barred from appearing before the Commission in In the Matter of John Briner, Exchange Act Release No. 63371 (Nov. 24, 2010). In each instance the issuer sought to withdraw its registration statement when informed that it should cooperate with a staff examination. That action “constitutes a failure to cooperate with, refusal to permit, and obstruction” of the examination by each issuer, according to the Order. The cases are pending.
Short selling: SEC v. Revelation Capital Management Ltd., Civil Action No. 14-cv-0645 (S.D.N.Y. Filed Jan. 31, 2014) is an action against the investment adviser and its principal, Christopher P.C. Kuchanny. It alleges violations of Rule 105 of Regulation M which prohibits short selling during a designed period prior to a secondary offering. Here the complaint alleges that defendants violated the Rule in connection with the Central Fund of Canada Limited’s November 2009 offering. The shares of Central Fund were sold during the restricted period and then securities were purchased in the offering, yielding defendants profits of $1,368,243. The action is pending. See Lit. Rel. 22915 (Feb. 3, 2014).
Short selling: In the Matter of Gonul Colak, Adm. Proc. File No. 3-15712 (Jan. 31, 2014) is a proceeding against two university professors, Milen Kostov and Gonul Colak. The two men executed a short selling trading scheme in which one established an account and took a synthetic long position created from puts and calls with the same strike price and expiration. A synthetic short position would also be created using calls and puts with the same strike price and expiration. That position used deep-in-the money call options.
Then the other would establish an account at a different firm. Deep-in-the-money call options would be purchased by placing and pricing the buy orders so that they matched the sell orders from the first account. In the second, they then exercised the deep-in-the-money call options. The shares would be sold immediately into the market. Typically the exercise of the options resulted in the call options being assigned at the end of the day to the other account which held a large part of the open interest. In the final part of the scheme Respondents did not purchase the shares as required by the notice. Rather, they entered into a “reset” trade under which the account with the notice purchased the stock and, at the same time, wrote deep-in-the-money call options for the same number of shares. This created the illusion of cover in accord with the notice while in actuality leaving the short position open and uncovered – that is, naked. The strategy, which would be repeated, was implemented for stocks that were hard to borrow. This made the cost of the options higher in relation to the price for others where the shares were more readily available. While typically the price of the put and call options would be in parity, that frequently does not occur with the hard to borrow securities because of the price premium. This disparity permitted Respondents to generate trading profits. By not delivering shares sold Respondents profited at the expense of purchasers of the shares. The “[f]ailure to deliver can have a negative effect on shareholders, potentially depriving them of the benefits of ownership . . .” according to the Order. Those losses were roughly equivalent to the profits Respondents were able to make on the transactions. This strategy was executed using twenty different stocks beginning in mid-2010 and continuing until early 2012. It generated profits of about $420,000 which Respondents shared. The Order alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b).
To resolve the proceeding each Respondent consented to the entry of a cease and desist order based on the Sections cited in the Order. In addition, Mr. Colak agreed to pay disgorgement of $285,600 along with prejudgment interest and a civil penalty of $150,000. Mr. Kostov agreed to pay disgorgement of $134,000, prejudgment interest and a civil penalty of $70,000.
Investment fund fraud: SEC v. Zenger, Civil Action No. 2:14-cv-00065 (D. Utah Filed Jan. 31, 2014) is an action against Michael Zenger. It alleges that since June 2013 Mr. Zenger has raised at least $200,000 from two friends for the purpose of trading futures, commodities and government securities. About half of the funds were invested. Mr. Zenger misappropriated the other half, according to the complaint. That complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). The Commission obtained a freeze order. The case is pending. See Lit. rel. No. 22916 (Feb. 4, 2014).
Misappropriation: SEC v. Penn, Civil Action No. 1:140cv-00581 (S.D.N.Y. Filed Jan. 30, 2014) is an action against Lawrence Penn, Michael St. Altura Ewers, Camelot Acquisitions Secondary Opportunities Management, LLC (or CASO Management), a registered investment adviser controlled by Mr. Penn and Camelot Group International, LLC, controlled by Mr. Penn and SSecurion LLC, an entity controlled by Mr. Ewers. The action centers on a scheme implemented by Messrs. Penn and Ewers beginning in early 2010 and continuing through mid-fall 2013 under which about $9.3 million was taken from CASO Management under the guise of due diligent fees for services by Ssecurion. In fact, according to the complaint, few if any services were provided. Rather, the funds were kicked back to entities controlled by Mr. Penn and then used to pay a variety of expenses including for office space and to secure other business. In an effort to avoid detection, documents were falsified and furnished to the auditors. The complaint alleges violations of Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2), 204 and 207. It also contains a claim for unjust enrichment. A freeze order was obtained in the action which is in litigation.
Fraudulent pricing: U.S. v. Leszczynski, No. 1:12-cr-00923 (S.D.N.Y.) is an action against Mark Leszczynski and Benjamin Chouchane in which Mr. Leszezynski previously pleaded guilty to charges of securities fraud and wire fraud. The charges arose from a scheme that took place beginning in 2005 and which continued through the end of 2008. During that period Mr. Leszczynski and his confederates were employed at a broker-dealer in New York City. When executing transactions for firm clients they falsified the prices in such a manner as to generate additional revenue for the firm at the expense of the clients. This netted them large bonuses. This week Mr. Leszcynski was sentenced to serve eighteen months in prison followed by two years of supervised release. He was also ordered to forfeit $1.5 million.
Agreement: FINRA and BATS Global Markets entered into an agreement under which the regulator will conduct cross-market surveillance to four BATS’ exchanges. Now FINRA will conduct surveillance for nearly 100% of U.S. equity trading.
AML: The regulator imposed a record $8 million fine on Brown Brothers Harriman & Co. for substantial anti-money laundering violations. Specifically, beginning in 2009 and continuing until mid-2013, the firm executed or delivered transactions involving at least six billion shares of penny stocks, in many instances on behalf of undisclosed customers of foreign banks, and without having basic information such as the beneficial owner. The firm also could not determine in many instances if the shares were registered and failed to file suspicious activity reports. FINRA thus concluded that the firm lacked adequate AML procedures. The global AML Compliance Officer, Harold Crawford, was also fined $25,000 and suspended for one month.
Confirmations: The Australian Securities and Investment Commission imposed a fine of $15,000 on Pershing Securities Australia Pty Ltd. for failing to provide transaction confirmations to certain customers, contrary to the pertinent rules. The failure took place from August 2010 to June 2012. The beach was brought to the attention of the firm by a third party. The firm then self-reported.
Insider dealing: Simon Chui Wing Nin, formerly an assistant director of finance at CITIC Pacific Limited, pleaded guilty to two counts of insider dealing in the shares of his firm. In 2008 he learned through his work that the firm had suffered certain significant mark-to-market losses. Prior to the public announcement of the losses, he sold 81,000 shares of CITIC stock. Following the announcement the share price dropped 60%. Mr. Chui was sentenced to serve nine months in prison and to pay a fine of $623,000. He was also directed to pay the cost of the investigation and will be disqualified from being a director of a company in Hong Kong for three years.
The Financial Conduct Authority fined State Street UK £22.9 million for charging certain clients unauthorized fees. Specifically, the firm provided a service as part of a program to clients in support of structural changes in their asset portfolios. The program was intended to manage risk and increase returns. From mid-2010 to September 2011 the firm charged six clients a total of $20,169,603 in unauthorized fees under the program. The practice was discovered when a client complained to the staff.