THIS WEEK IN SECURITIES LITIGATION (April 23, 2010)
This week, the trial of the SEC’s CDS insider trading case continued in New York. The Commission brought its most significant enforcement action in years, SEC v. Goldman Sachs. Many viewed the case as an indication that the SEC’s enforcement program is on the mend. Others claimed the suit, approved by a 3-2 vote of the Commissioners, was politically timed to help the Administration move its financial reform legislation through Congress. As the controversy over the suit continues, the SEC dismissed its most significant charges against David Stockman and the other defendants in a financial fraud case to obtain a settlement. The jury returned not guilty verdicts on sixteen of twenty counts in the criminal option backdating case against the former president of KB Home. Charles Schwab agreed to pay $200 million to settle a class action arising out the management of one of its bond funds.
SEC v. Goldman Sachs
SEC v. Goldman Sachs & Co., Case No. 3229 (S.D.N.Y. Filed Apr. 16, 2010) focuses on events at the core of the market crisis. The complaint, discussed here, is straightforward despite the complex transactions on which it is built. Wall Street hedge fund Paulson & Co. believed the sub-prime residential real estate market was about to collapse according to the SEC. The firm came to Goldman looking to create an investment opportunity and profit from its belief. Some investment firms refused to consider the proposal. Goldman did not.
The investment bank had other clients such as IKB, a commercial bank headquartered in Düsseldorf, Germany, who held the opposite view of Paulson. Goldman knew that the bank and others who agreed with its market assessment would only purchase shares in an investment fund tied to the sub-prime market if there was an independent portfolio selection agent. Accordingly, ACA was recruited by Goldman to fill that role. The fund – called ABACUS – was constructed in 2007 using synthetic collateralized debt obligations tied to the sub-prime residential mortgages. The securities selected were the lowest investment grade. Paulson influenced the selection of the securities in the fund, rejecting some that were higher quality, according to the complaint.
The materials provided to potential ABACUS investors contained information regarding its construction, investments and risks. The role of Paulson & Co. was not mentioned.
Paulson essentially shorted the fund. IKB and others purchased shares in ABACUS, taking a long position. Ultimately the sub-prime residential real estate market collapsed. ABACUS shareholders suffered huge losses. ACA suffered losses. Paulson & Co. made huge profits.
The SEC’s complaint alleges fraud based on the failure to disclose the role of Paulson & Co. The complaint suggests that investors were not told that the role of ACA as portfolio selection agent had been undermined if not completely compromised. It goes on to imply that the fund was essentially a rigged sham, crafted to fail for the benefit of Paulson, a fact investors were not told. This constitutes securities fraud. The case is in litigation.
Now the Financial Services Authority, Britain’s financial regulator, has opened an investigation into Goldman Sachs. The FSA has commenced a formal enforcement investigation into the allegations in the SEC’s case. The regulator plans to coordinate closely with the Commission.
SEC enforcement actions
Investment fund fraud: SEC v. Onyx Capital Advisors, LLC, (E.D. MI. Filed Apr. 22, 2010) is an action against Roy Dixon, Jr., his fund, Onyx Capital, and his friend Michael Farr. The complaint claims that Mr. Dixon, with substantial assistance from Mr. Farr, defrauded three Detroit area public pension funds that invested $23.8 million in the Onyx fund. Mr. Dixon and his fund are alleged to have misappropriated over $3.11 million from the fund. Mr. Farr, through three controlled businesses, received about 80% of the money invested through Onyx fund and diverted it to personal use. The case is in litigation.
Financial fraud: SEC v. Collins & Aikman, Civil action No. 07-CV-2419 (S.D.N.Y. Filed March 27, 2007) is a financial fraud case against former OMB director David Stockman and others. The complaint, discussed here, alleged that Mr. Stockman, the former CEO and Chairman of the company, and other senior company officials and board members, engaged in multiple fraudulent schemes and made materially false and misleading statement about the financial condition of the company and its operating results. These actions were alleged to have violated Securities Act Section 17(a) and Exchange Act Sections 10(b), 13(a), 13(b)(2)(A) and 13(b)(2)(B) and the pertinent rules thereunder.
In the settlement, the Commission dropped most of the significant claims. Mr. Stockman, Michael Stepp, the former CFO and Vice Chairman of the Board, and David Cosgrove, the former controller, consented to the entry of a permanent injunction prohibiting future violations of Securities Act Sections 17(a)(2) and (3)and the reporting, recordkeeping, internal controls and the making false statements to auditors sections of the Exchange Act. The injunctions against Messrs. Stockman and Stepp also include the SOX provisions regarding CEO and CFO certifications. In addition, Mr. Stockman agreed to pay approximately $4.2 million in disgorgement and about $2.3 million in prejudgment interest along with $400,000 in civil penalties. The obligation to pay disgorgement is offset by up to $4.4 million paid to settle parallel civil actions. Messrs. Stepp and McCallum each agreed to pay a $75,000 civil penalty while Mr. Cosgrove will pay a $40,000 penalty.
Paul Barnada, the former vice president and director of purchasing for a division, consented to the entry of a permanent injunction prohibiting future violations of the reporting, record keeping, internal controls and making false statements to auditors provisions of the Exchange Act and the payment of a $20,000 penalty.
Insider trading: SEC v. Galleon Management, LP, Civil Action No. 09-CV-8811 (S.D.N.Y.) is the Commission’s action arising out of the insider trading claims brought against Galleon and its founder, discussed here. Traders at the Schottenfeld Group had allegedly been furnished with inside information use to trade in the firm’s accounts. Previously, the SEC announced a tentative settlement with Schottenfeld Group which had been submitted to Judge Rakoff for consideration as discussed here. After initially raising questions regarding the proposed settlement, the court approved it this week.
Criminal cases
Option backdating: U.S. v. Karatz, Case No. 09-203 (C.D. Cal.) is the option backdating case against Bruce Karatz, former Chief Executive Officer of KB Home, discussed here. The jury returned not guilty verdicts on sixteen of twenty counts in the case against Mr. Karatz. The not guilty verdicts were on counts which include mail and wire fraud, securities fraud and filing false proxy statements. The acquittals came on all charges based on option backdating claims. The convictions were on two counts of mail fraud and two counts of making a false statement. The case is based on claims of fraudulent stock option practices alleged to have been used to improperly increase the compensation of Mr. Karatz. A parallel SEC case was settled. SEC v. Karatz, Civil Action No. CV 09-06012 (C.D. Cal. Sept. 15, 2008).
Financial fraud: U.S. v. Marsh (E.D.N.Y.) is a case against the president of financial advisory firm Gryphon Holdings Inc., Kenneth Marsh, and four employees, Baldwin Anderson, Robert Budion, Jeanne Lada and James Levier as discussed here. According to the court papers, since at least January 2007, the defendants defrauded investors of more than $17.5 million paid for fees and investment advisory services. In 2009, for example, the firm obtained $9.6 million from investors and $3 million more in the first two months of 2010 based on misrepresentations. The misrepresentations included claims about the expertise of two traders who were in fact fictitious, quotes in marketing materials attributed to George Soros which were false and claims about offices here and abroad which did not exist. Nevertheless, investors paid fees ranging from $99 to $250,000 to access the firm’s investment advisory services. Following the firm’s advice caused investors to lose even more money. The defendants were arrested this week.
The SEC filed a parallel suit which adds two defendants. SEC v. Gryphon Holdings, Inc., Case No. CV 10-1742 (E.D.N.Y. Filed April 20, 2010). The Commission obtained a temporary freeze order over the assets of the company. See also Litig. Rel. 21494 (Apr. 20, 2010).
Insider trading: U.S. v. Tang, Case No. 10-80 (N.D. Cal.) is a criminal insider trading action brought against King Chuen Tang, the former CFO of a private equity fund. Mr. Tang is alleged to have received inside information from his brother-in-law who was at the time head of finance for a venture capital firm. This week, Mr. Tang pleaded guilty to one count of conspiracy and one count of insider trading. He is reportedly cooperating with prosecutors. Mr. Tang has also been named as a defendant in a parallel SEC action, discussed here.
Financial fund fraud: U.S. v. Altadonna, Case No. 10-cr-00075 (W.D.N.Y.) is a case against Lorenzo Altadonna who was employed as a representative of M-One Services, a company associated with Watermark Financial Services Group, Inc. Mr. Altadonna solicited funds from people who thought they were investing in real estate. In fact, as he began to realize by late 2007 or early 2008, but refrained from confirming, he was raising money for a $6 million Ponzi scheme at Watermark. Mr. Altadonna pleaded guilty to securities fraud. In the plea agreement, the government and the defendant agreed to a two and one half year prison term, a fine between $5,000 and $50,000 and two to three years of supervised release and $1.9 million in restitution.
Private actions
Mortgage backed securities: In re: Charles Schwab Corp. Sec. Litig., Case No. 08-cv-01510 (N.D. Cal.) is an action against Charles Schwab Corp. which alleged that the firm violated the Investment Company Act and made false representations regarding its YieldPlus fund. The complaint claimed that firm violated the Investment Company Act by abruptly changing the terms of the fund’s policy in 2006 without a shareholder vote. That change eased the fund’s 25% limit on investments in uninsured mortgaged back securities. At times, as much as 100% of the funds assets were put in those securities. When the market collapsed in 2008 the fund value dropped significantly, Plaintiffs also claimed there were misrepresentations in the prospectus. A tentative settlement was reached under which Schwab will pay $200 million to the investor class.
Option backdating: In re Staples Inc. Shareholder Derivative Litig., Case No. 2611- VCL (Ch. Ct. Del.) is a derivative suit against executives of Staples, Inc. The complaint is based on the alleged back dating of 7.5 million options between 1994 and 2003. The options were priced in violation of company policy and the applicable regulations according to the complaint. Under the terms of a settlement, submitted for court approval, the carrier for the company will pay $7.25 million to the company which agreed to re-price nearly $1 million in outstanding vested and unexercised stock option grants held largely by senior executives. The company also agreed to adopt certain corporate governance provisions. The proposed settlement caps attorney fees at $2.5 million and the incentive award to the lead plaintiff at $5,000.