by T. GormanPosted on Posted in SECActions

This week the SEC continued its renewed emphasis on insider trading cases by filing four new actions.

In SEC v. Keeney, Case No. 1:07CV0103 (D.C.C.), a former consultant to Frederick’s of Hollywood, Inc, a privately held company, was charged with trading in the securities of Movie Star, Inc. prior to the announcement of a merger between the two companies.  According to the complaint, Mr. Keeney served as a board consultant and participated in the merger negotiations.  During one period, he made over a dozen purchases of Movie Star, acquiring 157,000 shares which were sold after the announcement.  The cases was settled with a consent decree, the entry of a statutory injunction, and an order directing Mr. Keeney to disgorge his profits of $77,540.50, pay prejudgment interest and pay a penalty equal to his trading gains.  The SEC’s Litigation Release is available here.  

In SEC v. Gad, Civil Action No. 07-cv-8385 (S.D.N.Y. Filed Sept. 27, 2007), the Commission brought an action against Nathan Rosenblatt, a board and audit committee member of NBTY, Inc. and his friend, Morris Gad.  According to the SEC’s complaint, Mr. Rosenblatt learned at a board meeting that NBTY’s earnings would fall substantially short of projections.  Subsequently, he informed Mr. Gad, who sold the stock short, purchased put contracts and sold call contracts through the custodial accounts of his children.  After the announcement by the company, Mr. Gad liquidated his position, making about $900,000.  This case is in litigation and the Commission’s Litigation Release can be viewed here.  This is one of a number of insider trading cases brought against market professionals this year.

In SEC v. Smith, Civil Action No. 07-CV-8394 (S.D.N.Y. Filed Sept. 27, 2007), the Commission brought an insider trading action against a father and son, both of whom are securities professionals.  The SEC alleged in its complaint that the son, a former investment banker with Banc of America Securities, obtained inside information about three companies, which he gave his father.  The father, an employee of Broadband Capital, was furnished inside information by his son about three deals.  The father traded while in possession of the information and prior to the public announcements.  To settle the action, each defendant consented to the entry of a permanent statutory injunction, an order holding each jointly and severally liable for disgorgement in the amount of $204,476 plus prejudgment.  The father also agreed to a two-time penalty, while the son agreed to pay a penalty equal to the amount of the disgorgement.  The Litigation Release from the SEC appears here.  

The complaint in SEC v. Hershey, Civil Action No. 3:07-cv-409 (W.D.N.C. Sept. 27, 2007) alleged that Mr. Hershey was tipped by his friend Brian Paquette, then a Lending Tree VP, about the takeover of Lending Tree by U.S. Interactive.  Mr. Hershey then traded while in possession of the inside information and also tipped three of this friends, who also traded.  Mr. Hershey consented to the entry of a statutory injunction enjoining him from future violation of the securities laws and the entry of an order requiring the payment of disgorgement of over $14,000 in trading profits, prejudgment interest, and a civil penalty of over $88,000, an amount equal to his trading profits and those of his tippees.  The Commission’s Litigation Release may be viewed here.  Earlier this year the SEC lost an insider trading case based on this transaction, when the District Court in Colorado dismissed insider trading charges against a Fidelity National director who traded after learning about the proposed transaction.  Fidelity owned a stake in Lending Tree at the time.  The court held there was no duty of confidentiality.  That case, SEC. v. Talbot, was discussed in this blog on February 23, 2007 (here).  

These actions are just the latest in a series of insider trading cases that the SEC has brought this year.  As reported earlier, the SEC has undertaken a series of initiatives in this area including new agreements with other regulators, a Wall Street sweep and sending questionnaires to hedge funds.  The new focus seems to be yielding results if the number of cases filed is any measure.  At the same time, while three of the four cases filed this week are settled, many of the most significant inside trading cases filed this year are being litigated.  It remains to be seen if the SEC can prevail in those actions. 

The SEC also continued its renewed emphasis on Foreign Corrupt Practices Act cases.  In SEC v. Chandramowli Srinivasan, Civil Action No. 1:07-cv-01699 (D.D.C. Filed Sept. 25, 2007) the Commission filed a settled civil injunctive action against the former president of A.T. Kearney India, a subsidiary of EDS at the time.  According to the complaint, defendant paid at least $720,000 in illicit payments to senior employees of India state-owned enterprises to retain business.  To resolve the action, defendant consented to the entry of a statutory injunction and an order requiring him to pay a $70,000 penalty.  In a related administrative proceeding, EDS consented to the entry of a cease-and-desist order relating to records violations and an order requiring the payment of over $358,000 in disgorgement, along with prejudgment interest.  The proceeding was based on allegations that EDS failed to disclose the cost of certain derivatives, failed to disclose an extraordinary transaction that represented a significant part of its revenue, and maintained inaccurate books and records.  The Commission’s Litigation Release is here.  

Finally, the SEC brought another accounting fraud case against a quasi government corporation claiming that it improperly smoothed earnings.  This time the company was Freddie Mac.  In SEC v. Federal Home Loan Mortgage Corp., Case No. 07-CV-1728 (D.D.C. Filed Sept. 27, 2007) the Commission filed a settled civil injunction action against Freddie Mac and four of its former executives.  The complaint alleged that from 2000 to 2002 the company improperly smoothed its earning trends by misreporting net income.  The improper actions resulted from a corporate culture which placed great emphasis on steady earnings, rather than compliance.  To settle the case, the company agreed to the entry of a statutory injunction and the payment of a $50 million civil penalty.  Each of the officers also consented to the entry of statutory injunctions and the payment of civil penalties.  This latest case appears in the SEC’s Litigation Release here.  Earlier this year the SEC settled an accounting fraud case with Federal National Mortgage which paid a $400 million penalty. (discussed here and here).    

by T. GormanPosted on Posted in SECActions

Materialization is another theory used to plead and prove loss causation. This theory is used “where the alleged misstatement conceals a condition or event which then occurs and causes the plaintiff’s loss, it is the materialization of the unclosed condition or event that causes the loss.” Glover v. Deluca, 2006 WL 2850448 (W.D. Pa. Sept. 29, 3006). As the Glover court explained, the key to this theory is that the risk is first concealed and then later that specific risk materializes. Under this theory, the securities law plaintiff “must provide proof that the market recognized a relationship between the event disclosed and the fraud.” In re Williams Securities Litig., 2007 WL 2007987 (N.D. Okla. July 6, 2007). If the truth gradually leaks out and the effects of the relevant truth – the facts which expose the fraud – cannot be differentiated from bad news unrelated to the fraud, the theory fails.

The key to materialization is that the concealed condition appears. In that instance, corrective disclosure is not required. In Teamsters Local 445 v. Bombardier, 2005 WL 218919 (S.D.N.Y. Sept. 6, 2006) for example, plaintiffs alleged that defendants made misrepresentations and omissions regarding the integrity of underwriting standards used in securitizing interests in a pool of mortgages. Subsequently, a high delinquency rate caused the price to drop. Judge Schendlin held that the plaintiffs correctly pled loss causation. A corrective disclosure was not required because the facts materialized.

Similarly, where a concealed scheme was revealed, the court held that loss causation was properly pled. In In re Parmalat Sec. Lit., 376 F. Supp. 2d 472, 510 (S.D. N.Y. 2005), defendants engaged in sham transactions to aid a defendant company in concealing its true financial condition. The scheme utilized worthless invoices to conceal the fact that the defendant could not pay its debts. Ultimately, the company could not pay its debts. Judge Kaplan held that loss causation was sufficiently pled.

In contrast, in In re Initial IPO Sec. Litig., 2005 WL 1162445 (S.D.N.Y. May 6, 2005), Judge Schendlin concluded that loss causation had not been properly pled. There, plaintiffs alleged that defendants engaged in a scheme to discount earnings estimates so that the companies could beat the estimates. As a result of the scheme, the share price became inflated. Plaintiffs claimed the truth materialized when the companies failed to meet earnings and the financial statements were published. The court rejected the claim: “The fact that an event – in this case a failure to meet earnings forecasts or a statement foreshadowing such a failure – disabused the market of the belief does not mean that the event disclosed the alleged scheme to the market.”

Next: How much truth and the impact of bad news.