The SEC continued implementing Dodd-Frank this week. New rules were issued regarding hedge fund registration and exemptions.

SEC enforcement resolved two significant market crisis cases this week. In one the agency filed a settled action against J.P. Morgan Securities regarding the sale of interests in a synthetic CDO. In a related case against an individual at the CDO portfolio manager which is being litigated. In the other it resolved a proceeding involving Morgan Keegan centered on the pricing of fund shares linked to the subprime market as the market crisis evolved. The Commission also resolved three of its Galleon related insider trading cases and filed an action against the former CEO of Taylor Bean who was sentenced to prison in a related criminal case.

The first expert networking insider trading case to go to trial ended when a jury returned a verdict of guilty. This is the third high profile insider trading case in Manhattan to end with a conviction this year.

The Commission

The Commission adopted two sets of rules under Dodd-Frank this week.

  • One set defines “family officers” that are excluded from the Investment Advisers Act (here).
  • A second set implements the provisions which require certain hedge funds to register with the Commission (here).

SEC enforcement – case filings and settlements

Market crisis: In the Matter of Morgan Asset Management, Inc., Adm. Proc. File No. 3-14847 (June 22, 2011) is an action by the Commission in coordination with FINRA and a task force of state regulators from Alabama, Kentucky, Mississippi, Tennessee and South Carolina. The Respondents were Morgan Asset Management Inc., a registered investment adviser; Morgan Keegan & Co., Inc., a registered broker dealer; James Kelso, the senior portfolio manager for Morgan Asset; and Joseph Weller, Morgan Keegan’s Controller and the head of its Fund Accounting Department reported to him. The order alleged violations of Investment Company Act Section 34(b) and Advisers Act Sections 206(1), 206(2) and 206(4) and related rules. The funds involved held varying amounts of securities backed by subprime mortgages. As the market crisis unraveled in the first half of 2007 Respondents failed to follow the appropriate procedures for pricing these securities for which there was no readily available market. The proper fair value methods were not used. Arbitrary prices were used in some instances. Overall there was no basis for setting NAV. As a result NAV was fraudulently inflated.

To settle Morgan Keegan agreed to the entry of a censure. A cease and desist order was entered based on Section 34(b) of the Investment Company Act. The firm will jointly and severally, along with Morgan Asset, disgorge $20,500,000 along with prejudgment interest and pay a civil penalty of $75 million to the SEC. The firm agreed to implement a series of undertakings as part of the settlement. In addition, the firm is paying $100 million into a state fund for investors. Morgan Assets was also censured and a cease and desist order was entered based on Sections 206(1), (2) and (4) of the Advisers Act and Section 34(b) of the Investment Company Act. The firm also agreed to implement a series of undertakings.

Respondent Weller consented to the entry of a cease and desist order based on Rules 22c-1 and 38a-1 of the Investment Company Act. He was also suspended from association in a supervisory capacity in the industry and from participating in any penny stock offering for twelve months. In addition, he is denied the privilege of appearing and practicing before the Commission as an accountant with a right to reapply after two years. Mr. Weller also agreed to pay a civil penalty of $50,000. Respondent Kelsoe consented to the entry of a cease and desist order based on Sections 206(1), (2) and (4) of the Advisers Act and Section 34(b) of the Investment Company Act. He was also barred from the industry and from participating in any penny stock offering. Mr. Kelsoe will pay a civil penalty of $250,000 to the SEC and $500,000 in penalties overall. The disgorgement, prejudgment interest and penalties paid to the SEC will be paid into a Fair Fund for investors.

Market crisis: SEC v. J.P. Morgan Securities LLC, Civil Action No. 11-04206 (S.D.N.Y. Filed June 21, 2011); SEC v. Steffelin, Civil Action No. 11-04204 (S.D.N.Y. Filed June 21, 2011). These cases center on the marketing and sale of interest in a largely synthetic collateralized debt obligation or CDO called Squared CDO 2007-1. Built primarily out of credit default swaps, the CDO was tied to the subprime housing market. The portfolio manager was GSCP (NJ) L.P. or GSC, an investment advisory firm with experience in analyzing credit risk in CDOs. Defendant Edward Steffelin was a Managing Director at GSC and an unregistered investment adviser. He was in charge of the team designated to select the collateral for Squared. In early 2007 as the market was beginning to crumble J.P. Morgan Securities marketed notes in the $1.1 billion CDO squared. About $150 million of the mezzanine tranches of Squared’s notes were sold to a group of fifteen institutional investors which included a non-profit and an asset manager for a pension fund. The CDO related securities were selected and warehoused by J.P. Morgan Securities along with hedge fund Magnetar Capital LLC and Mr. Steffelin and his team. As the market began to unravel the investment firm closed the warehouse and needed to sell its contents to avoid a huge write down. By the time of the closing of Squared, the hedge fund had a $600 million short position and an $8.9 million equity. The marketing materials told investors that the securities were selected by GSC and failed to mention the hedge fund and its huge short position. Within months of the closing the CDO securities were defaulting. The Mezzanine investors lost most if not all of their investment. The complaint against the investment firm alleges violations of Securities Act Sections 17(a) & (b). The action against Mr. Steffelin alleges violations of Securities Act Sections 17(a)(2) & (3) and Advisers Act Section 206(2).

J.P. Morgan Securities settled with the SEC, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) & (3). The firm also agreed to pay $18.6 million in disgorgement, prejudgment interest and a $133 million penalty. $125,869,721 of the total paid will be returned to the mezzanine investors through a Fair Fund distribution. Part of the settlement calls for the investment firm to take certain remedial steps in its review and approval of offerings of certain mortgage securities. In addition, J.P. Morgan Securities voluntarily made payments totaling $56,761,214 to certain investors in a transaction known as Tahoma CDO. The action against Mr. Steffelin is in litigation.

Investment fund fraud: SEC v Ilovici, Civil Action No. 3:11-CV-00981 (D.Conn. Filed June 21, 2011) is an action against Florin Ilovici which alleges violations of Exchange Act Section 10(b). According to the complaint, Mr. Ilovici has, since 2007, obtained over $1 million from two elderly women who live alone and had health problems. While he promised to invest the money in fact he lost much of it in risky trading and diverted portions to his personal use. The court entered a freeze order. The case is pending.

Galleon insider trading cases:

  • SEC v. Galleon Management LP, Civil Action No. 09-CV-8811 (S.D.N.Y.); SEC v. Cutillo, Civil Action No. 09-CV-9208 (S.D.N.Y.); In the Matter of Gautham Shankar, Adm. Proc. File No. 3-14433. Gautham Shankar, a former proprietary trader at Schottenfeld Group LLC who was named as a defendant in the first two cases and as Respondent in the third based on his role in the Galleon insider trading cases. He has now settled each action with the Commission. The Galleon action alleged that Mr. Shankar was furnished with inside information about the takeover of Hilton Hotels, the quarterly earnings of Google and the acquisition of Kronos Inc. and traded. In Cutillo the complaint alleges that Mr. Shankar was furnished inside information about other takeovers which came ultimately from the law firm of Ropes and Gray. In Galleon Mr. Shankar consented to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). He also agreed to pay disgorgement of $34,462.35 along with prejudgment interest. In Cuttilo he consented to a similar injunction based only on Section 10(b). He also agreed to pay disgorgement of $111,521 along with prejudgment interest. The question of a penalty will be resolved at a later date by the court in each case. In the administrative proceeding Mr. Shankar agreed to the entry of an order barring him from the securities business and from participating in any penny stock offering. Previously, Mr. Shankar pleaded guilty to one count of securities fraud and one count of conspiracy to commit securities fraud in a related criminal case, U.S. v. Shankar, 09-CR-996 (S.D.N.Y.).
  • SEC v. Smith, Civil Action No. 1:11-cv-0535 (S.D.N.Y.) is an action against former Galleon portfolio manager Adam Smith. The complaint alleged that he traded on inside information regarding the acquisition of ATI Technologies by AMD which he obtained from an investment banker working on the deal. Mr. Smith resolved the case by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b) and agreeing to pay $140,706.25 in disgorgement and prejudgment interest. Based on an agreement to cooperate with the SEC he is not being assessed a civil penalty. In a related administrative proceeding he agreed to the entry of an order barring him from the securities business. Previously he pleaded guilty to conspiracy to commit securities fraud and securities fraud in a related criminal case. U.S. v. Smith, 1:11-cr-00079 (S.D.N.Y.). He is awaiting sentencing in that case.
  • SEC v. Feinblatt, Civil Action No. 11-CV-0170 (S.D.N.Y.) is an action against Robert Feinblatt, a co-founder and principal of Trivium Capital Management LLC, and firm analyst Jeffrey Yokuty for insider trading in the securities of Polycom, Hilton, Google and Kronos. The action against the firm was dismissed since it is winding down and agreed to cooperate with the SEC. The action also alleged that Polycom senior executive Sunil Bhalla and Shammara Hussain, an employee at investor relations consulting firm Market Street Partners that did work for Google, furnished inside information to the other three defendants who traded and made over $15 million dollars in profits. Ms. Hussain settled with the SEC, consenting to the entry of a permanent injunction prohibiting future violations of Securities Act Section 17(a) and Exchange Act Section 10(b). She also agreed to pay disgorgement of $21,619.80 along with prejudgment interest plus a civil penalty equal to the amount of the disgorgement.

Criminal cases

Insider trading: U.S. v. Jiau, 11-cr-00161 (S.D.N.Y.) is an action against former Primary Global Research LLC consultant Winifred. This is the first of the expert networking cases to proceed to trial. According to the indictment, from 2006 through 2008 Ms. Jiau obtained inside information and furnished it to hedge fund managers who were clients of Primary Global. During that period she passed inside information about the up coming earnings releases of NVIDIA Corporation and Marvell Technology Group, Ltd. to network clients. She was paid about $200,000. Samir Barai, the founder and manager of Barai Capital, and Noah Freeman, formerly a portfolio manager at SAC Capital, obtained earnings information about Marvel and NVIDIA from Ms. Jiau. Conversations with these two hedge fund managers were taped. During the conversations Ms. Jiau made it clear, for example, that the information about Marvel came from an employee of the company. Based on this information Mr. Barai’s fund traded, netting profits of about $820,000. A jury found Ms. Jiau guilty of conspiracy to commit securities and wire fraud and securities fraud. Sentencing is scheduled for September 21, 2011.

Fraud: U.S. v. Allen, 11 cr 00165 (E.D. Va.) is an action in which defendant Paul Allen, the former CEO of Taylor Bean & Whitaker, the collapsed financial company, pleaded guilty to one count of making a false statement and one count of conspiracy to commit bank and wire fraud. He was sentenced to 40 months in prison. In a related action the SEC filed a complaint against Mr. Allen. SEC v. Allen, 1:11-CV-00657 (E.D.Va. Filed June 17, 2011). The complaint alleges that Mr. Allen aided and abetted violations of Exchange Act Section 10(b) in connection with the fraud which lead to the demise of his firm. Mr. Allen resolved the matter by consenting to the entry of a permanent injunction prohibiting future violations of Section 10(b). The question of financial penalties is pending before the court.

Investment fund fraud: U.S. v. Barry (E.D.N.Y.) is a case in which Mr. Barry was found guilty following a jury trial on 34 counts of securities fraud and wire fraud. The charges centered on a Ponzi scheme he operated called the Leverage Group which promised people a safe investment and guaranteed return. In fact it was a fraud. The court sentenced him to 20 years in prison and ordered him to pay $24,146,540 in restitution.

PCAOB

The Board issued a concept release seeking comment on the Auditor’s Reporting Model. In the release the PCAOB lists four alternatives: 1) An auditor’s discussion and analysis; 2) Required and expanded use of emphasis paragraphs; 3) Auditor assurance on other information outside the financial statements; and 4) Clarification of language in the standard auditor’s report. The text of the release is here.

Court of appeals

Venue: U.S. v. Tzolov, Docket Nos. 10-562-cr; 10-754-cr (2nd Cir. Decided June 15, 2011) is an appeal by Eric Butler who was convicted of securities fraud and conspiracy to commit securities and wire fraud. The charges are based on the sale of certain auction rate securities. Specifically, Mr. Butler and his co-defendant Julian Tzolov were employed at Credit Suisse’s Corporate Investment Management Group, working out of its Manhattan offices. In many instances the two defendants were required to visit clients, traveling by plane from JFK airport on Long Island. The evidence at trial demonstrated that the two defendants made misrepresentations to clients over the phone from their offices regarding the ARS. In a number of instances where they were directed to purchase ARS backed by student loans which were 90% guaranteed by the government they purchased other auction rate securities. To conceal this fact, clients were furnished false statements. Mr. Tzolov pleaded guilty. Mr. Butler was convicted on both counts following a jury trial.

The Second Circuit reversed the conviction on securities fraud but not the conspiracy charge, concluding that the venue was improper. The Sixth Amendment to the Constitution and Fed. R. Crim. P. 18 require that a defendant be tried in the district where his crime was committed. If the statute does not specify how to determine where the crime was committed the locus delicti must be determined from the nature of the crime. Since venue is not an element of a crime the government has the burned of proving it by a perepondernace of the evidence. Here the government failed. Securities fraud has a specific venue provision which specifies that a criminal proceeding can be brought in the district wherein any act or transaction constituting the violation occurred. In this case the government argued that venue was proper in the Eastern District of New York based on the plane trips from JFK. Those trips were at best preparatory acts according to the Court. The center of the crime here was the misrepresentations made from Manhattan. The contrary is true for the conspiracy count however. Under that statute an overt act in the district is sufficient. The plane trips are sufficient for this purpose the court concluded.