The SEC Files One Insider Trading Case And Settles Another

The SEC continues to focus on insider trading. On Monday, a new case was filed against three individuals, while it settled another which has been in litigation since 2005.

First, the SEC filed an insider trading case against Dr. Zachariah P. Zachariah, Dr. Mammen P. Zachariah and Dr. Sheldon Nassberg. According to the complaint, shortly after Dr. Z. P. Zachariah became a director of IVAX, a Florida pharmaceutical company, he learned from the Chairman and former CEO that the company had entered into a tentative agreement with Teva Pharmaceuticals Limited to be acquired. Almost immediately after Z. P. Zachariah received the telephone call from the Chairman, he initiated a series of trades in the stock of the company despite the fact that there was a trading black out period in effect. Later, Z. P. Zachariah tipped his brother, M. P. Zachariah, who also traded. In total, Z. P. Zachariah purchased 35,000 shares of IVAX stock at a cost of $730,000. His brother purchased 2,000 shares at a cost of about $46,000. After the announcement, each defendant sold his shares. Z. P. Zachariah made a profit of about 20% or about $150,000, while his brother, who purchased the day before the announcement, made a profit of about 10% or $4,600.

The complaint claims that, previously Dr. Z. P. Zachariah either traded on or misappropriated inside information about the acquisition of Correctional Services Corporation by GEO Group, Inc. According to the complaint, Z. P. Zachariah purchased about $200,000 of Correctional Services stock during the time the take over was being negotiated. During that period, the complaint claims he had multiple potential sources of inside information: his companies were a consultant to GEO; he was a long time personal friend of GEO’s chairman and chief executive officer; and his son Zachariah P. Zachariah, Jr. (known as Reggie) worked as a financial analyst in GEO’s mergers and acquisitions group and worked extensively on the deal. According to the complaint, Z. P. Zachariah either acquired the inside information or misappropriated it from one of these sources and traded while in possession of it. He also passed the information to his brother Mammen and a friend, Dr. Sheldon Nassberg. In total, the three men purchased more that $390,000 of Correctional stock.

None of the defendants settled. This case is in litigation. SEC v. Zachariah, Civil Action No. 08-60698 (S.D. Fl. May 12, 2008). The Commission’s Litigation Release on the matter is here.

Second, the SEC settled an insider trading case based on the 2004 takeover of Charter One Financial, Inc., by Citizens Bank. SEC v. Tom, Civil Action No. 05-CV-11966 (D. Mass. Filed Sept. 29, 2005). The SEC’s complaint was brought against Global Time Capital Management, LLC, an investment adviser, its portfolio manager and principal, Michael Tom, former Citizens employee Shengnan Wang and her husband Hai Liu and Michael Tom’s brother, David Tom. The U.S. Attorney’s Office filed related criminal charges against Shengnan and her husband.

According to the complaint, Shengnan Wang learned of the potential takeover transaction during final due diligence and tipped her husband, who in turn told Mr. Tom, a former Citizen’s employee who was then running a hedge fund in which her husband had invested. Subsequently, defendant Tom purchased Charter One call options for his personal account and that of the hedge fund. Mr. Tom also purchased Charter One stock in a joint account he managed for his wife and in-laws. Collectively, his trading yielded $743,505 in profits following the announcement. Mr. Tom and Hai Liu also tipped their brothers, David Tom and Zheng Liu, respectively. Both brothers traded in Charter One.

On Monday, the Commission announced that Michael Tom and Global Time Capital Management settled the action by consenting to the entry of statutory injunctions prohibiting future violations of Section 10(b) and Rule 10b-5. In addition, Mr. Tom also agreed to pay disgorgement of over $543,000 plus prejudgment interest of over $107,000 and a civil penalty of $150,000. Global Time Capital agreed to pay a penalty of about $39,000 and relief defendant GTC Growth Fund agreed to pay over $189,000 in disgorgement and prejudgment interest of bout $23,000.

Previously, in June 2006, Shengnan Wang, her husband Hai Liu and his brother Zheng Liu settled. Each defendant consented to the entry of statutory injunctions and the payment of disgorgement, prejudgment interest and civil penalties.

Option Backdating: A Flawed SEC Complaint Raises Questions About the Enforcement Program And Its Direction

Last week, the court granted in part a motion to dismiss portions of the claims brought against Lisa Berry, former General Counsel of Juniper Networks, Inc. and KLA-Tencor. The motion was based on the statute of limitations and the failure to plead fraud with particularity as required by Federal Civil Rule 9(b). SEC v. Berry, Civil Action No. C-07-04431 slip op. (N.D. Cal. May 7, 2008).

The Commission filed a complaint against Ms. Berry based on option backdating claims for the time period 1997-2002. That complaint alleged that Ms. Berry routinely used hindsight to identify dates with historically low stock prices, facilitating the backdating of option grants by KLA’s stock option committee. After moving to Juniper, Ms. Berry established a similar backdating process at that company, creating minutes of fictitious stock option committee meetings to document false grant dates. This resulted in materially false disclosures and overstated net income at KLA and Juniper. The complaint alleges violations of Sections 10(b) and 17(a), as well as the books and records and proxy provisions. It seeks a permanent injunction, disgorgement of ill-gotten gains, monetary penalties and an officer director bar.

Ms. Berry’s motion to dismiss was granted in part and denied in part. First, Ms. Berry sought dismissal based on the statute of limitations. In this regard, the Court noted that under 28 U.S.C. § 2462, there is a five year statute limitations. This applies to any relief that is a penalty but not to the equitable relief. The request for a penalty is barred. In contrast, a request for disgorgement is not a penalty. Since the SEC argues that the statute is subject to equitable tolling, the court granted an opportunity to amend the complaint.

Second, the court held that under Section 9(b) the SEC must plead fraud with particularity. While this does not apply to allegations regarding state of mind, it does apply to other facts relating to the fraud. The court ruled that the SEC failed to meet this standard for most of the allegations in the complaint:

The SEC’s entire complaint against Ms. Berry regarding KLA focuses on her role in backdating stock options to employees. The complaint makes cursory references to option grants to executives, and at one point uses a discussion regarding executive stock options grants to suggest Ms. Berry possessed scienter. But, at no point does the SEC clearly allege with particularity that KLA backdated stock options to executives. Absent such an allegation, there is no basis for concluding that the discussion regarding executive stock option grants in the proxy statements was false. On the contrary, the option discussion in the proxy statements could be true. To recap, Ms. Berry has carried her burden of demonstrating the SEC has failed to allege with particularity any securities fraud based on misstatements, other than the SEC’s allegations arising from Ms. Berry signing KLA’s two Form S-8. With respect to the Forms S-8, the SEC’s allegations are sufficient.

Slip Op. May 5, 2008.

This is not the first time the SEC has filed a case based on years-old conduct or that part of its claims have been held time barred. Undoubtedly it is not the first time that it has failed to meet the pleading standards. But, it should be the last. There is no excuse for the SEC to file cases based on conduct which on its face appears to be time barred without at least pleading facts sufficient to establish tolling. Likewise, there is no excuse for the SEC to file a complaint which lacks specificity, particularly in view of the Commission’s vast investigative powers. Bringing enforcement actions is not a game where one hopes to slide by. Bringing enforcement actions is a deadly serious business which scars those named as defendants for life, whether the SEC ultimately prevails in the litigation or not. Regardless of whether the SEC prevails in this case, more is required of a good prosecutor than filing actions which are time barred on their face and lack the basic facts. It is time to conduct a complete review of enforcement policies and procedures to re-energize the program.