On Friday, the SEC lost its first Section 5 claim relating to a PIPE offering when the court granted a defense motion to dismiss.  In SEC v. Mangan, Civil Action No. 3: 06-CV-531 (W.D.N.C. Filed December 28, 2006), the SEC filed a complaint against former Friedman, Billings, Ramsey & Co., Inc. registered representative John F. Mangan, Jr., alleging the sale of unregistered securities and insider trading.  Specifically, the SEC’s complaint alleged that Mr. Mangan sold CompuDyne Corporation shares short at the opening of the market at prices over $15 per share at a time when he knew that company would announce a PIPE offering later that morning.  Subsequently, the complaint claimed Mr. Mangan continued to sell CompuDyne shares short.  After the Commission approved the resale registration statement and the shares were issued at about $12 per share, Mr. Mangan closed his short position at a significant profit according to the SEC.  The complaint alleged that by placing his initial short sale order prior to the opening of the market on the day the PIPE was announced, Mr. Mangan engaged in insider trading and that he violated the registration provisions by later covering his positions with shares from the offering because he effectively sold them prior to the effective date of the registration statement.

After a hearing on a motion to dismiss the court dismissed the Section 5 claim, but allowed the insider trading claim to stand.  In dismissing the Section 5 claim the court noted: “And what we have here, it seems to me, is a post hoc ergo propter [sic] argument by the government that because the PIPE in fact was not registered and because the PIPE shares were later in fact used, he in effect sold the PIPE.  Well, maybe, but I don’t think he [defendant] did anything illegal.  In short, no sale of unregistered securities occurred as a matter of law.” 

This same unregistered sale theory has been used repeatedly over the last year by the SEC.  For example, at the time the action was brought against Mr. Mangan the SEC brought a similar action against Friedman Billings and its principal.  Both defendants in that action settled (see the December 20, 2006 Litigation Release here), as did another hedge fund trader in SEC v. Spiegel (the Commission’s January 4, 2007 Release is here).  However, the defendant in SEC v. Berlacher, filed in September (the Litigation release is hereelected to litigate.  The ruling in Mr. Mangan’s case may have an impact on this case as well as other which may be under investigation.

Although the Court denied Mr. Mangan’s motion to dismiss the insider trading claim, it expressed some doubt about the claim.  In ruling on this claim the court noted that “As to the insider trading, the issue is coalesced around whether the information concerning the PIPE was material.  There’s no doubt that as of the time Mr. Mangan directed and called at 7:40 a.m. [on the morning of the announcement], the information was not public.  He strenuously argues that the information could not have been material as a matter of law.  The basic thrust of his argument is that the announcement of the PIPE was basically a nonevent so far as the price of the stock was concerned, at least for most of the day that the PIPE was announced.  And intriguingly, even looking at the information from the SEC, although the stock dropped to $12.41 on the 15th, significantly prior to the closing of the PIPE it also went beck up well above that.  So the stock price movement is interesting to say the least.  The SEC argues otherwise and points to a sharp drop in price from closing to closing the day before [the announcement] compared to the day of the announcement.  I find that pretty misleading.  The major part of the price drop occurred from the 8 October closing to the 9 October opening.  The price actually increased after the PIPE was announced on that day. … Relying on the standard [of materiality] quoted earlier, it seems clear to this court that the complaint as to the 10b-5 and insider trading states a claim.  Concededly, it is a very close call.  I found the defense argument rather compelling and persuasive … .”

The court’s ruling on both counts is significant.  The Section 5 claim raised by the SEC in the context of a trading market raises clear questions as the court recognized, since the short position could be covered with open market purchases.  There are also materiality issues concerning the insider trading claim based on facts presented at the hearing which demonstrated that the market price of the shares was essentially unchanged shortly after the announcement of the PIPE offering. 

What is perhaps more important, however, are the comments by the court about the SEC’s case and presentation.  Clearly the court had little regard for the basis of the Section 5 claim and the manner in which the case was presented.  The court’s comment that the Section 5 claim is little more than hindsight raises significant issues about the claims the SEC is selecting to include in its enforcement actions.  More disturbing, however, is the court’s statement that an argument presented by the Commission was misleading.  Such conduct has no place in court, let alone in a presentation by a government prosecutor.  Unfortunately, this is not the first time a court has made such a comment.  We should not simply sit by and hope that it is the last, however.  Rather, this case again argues for a careful review and revision of enforcement policies and procedures.

There is more than a renewed emphasis on insider trading, if last week is any indicator. Insider trading is dominating the regulatory landscape, again suggesting that issuers and executives carefully review compliance procedures and trading programs and carefully consider the timing of securities transactions not made within the confines of a Rule 10b5-1 plan. Key events from last week support this thought.

DHB INDUSTRIES, INC. – The SEC and DOJ have brought insider trading charges against former top executives of this defense contractor. In SEC v. Brooks, Civil Action No. 07-61526 -CIV-Althonaga/Turnoff (S.D. Fla. Filed October 25, 2007), the Commission filed fraud charges against David H. Brooks, former DHB CEO and COB. The complaint alleges a pervasive accounting fraud between 2003 and 2005 and insider trading by Mr. Brooks. At the same time the SEC filed its complaint, the U.S. Attorney’s Office for the Eastern District of New York announced that it was filing criminal insider trading and securities fraud charges against Mr. Brooks, who was arrested in Florida on October 25. Previously, criminal securities charges had been brought against former DHB CFO Dawn Schlegel and former COO Sandra Hatfield. U.S. v. Hatfield, 06-CR-550 (E.D.N.Y.). A superseding indictment will be filed in that case including Mr. Brooks. The Commission’s Litigation release, which also summarizing the criminal action, can be viewed here.

SEC TEMPLATE – The SEC Office of Compliance and Exanimations announced that it is testing out a new template for its inspections which includes an insider trading component. Frequently, when the SEC conducts examinations, firms do not perform testing for potential insider trading problems. This new template will require the firms to focus on and assist the SEC staff in reviewing the issue.

This action follows a staff request in an August letter to hedge funds seeking selected information about persons who have access to inside information. The apparent purpose of this information request, which is raising privacy concerns among many, is to create some type of inside trader profile.

RULE 10b5-1 PLANS – The SEC enforcement staff has commented previously on the fact that it is reviewing Rule 10b5-1 plans to determine whether executives are using the plans in a manner which gives them some type of trading advantage in the markets – something that was not intended when the safe harbor was created. These comments come in the wake of an academic study suggesting that executives using the plans are achieving above market returns. That conclusion at least raises a question as to whether the plans are being properly used. No cases have been brought to date, although there have been media reports of SEC inquiries focused at least in part on the question such as those regarding the Countrywide investigation.

The word from the SEC staff, however, is “watch for something shortly” on this issue. This is the substance of a comment made by a senior enforcement staff official at the ABA National Institute on Securities Fraud which is concluding today in Washington, D.C.

FOREIGN MARKETS – The increasingly intensifying focus on insider trading is not just the U.S. Congress, SEC and DOJ. Rather, for months there have been reports of rampant insider trading around the globe. Last week was no exception. There were reports of insider trading investigations or actions not just in the U.S., but also Singapore, Belgium, France, South Africa and Canada. This continuous stream of reports is no doubt the cause of the increasing global and national efforts of the SEC and DOJ to detect and prosecute insider trading. In the weeks to come, expect to see this trend continue. Again, prudent issuers and executives should consider the clear warning.