This Week In Securities Litigation (Week ending May 9, 2014)
The Commission issued an order which stayed the small segment of its controversial conflict mineral rule which the Court of Appeals concluded violated the First Amendment. The order does not impact the bulk of the rule.
This week the SEC filed a number of civil injunctive enforcement actions. Those included: Three insider trading actions; a case against a hedge fund claiming the falsification of its investment returns; another custody rule case; an action centered on claims that two Chinese companies that went public through reverse mergers had their shares manipulated by the promoters; and another in a series of cases centered on a prime bank fraud involving a Swiss entity.
SEC
Rules: The Commission issued an order staying the effective date for compliance with a portion of Exchange Act Rule 13p-1 and Form SD — its conflict minerals rule — that would require statements by issuers the Court of Appeals concluded would violate the First Amendment.
Remarks: Commissioner Kara M. Stein addressed the Council of Institutional Investors, Washington, D.C. (May 8, 2014). Her remarks focused on current activities of the Commission regarding disclosure requirements, shareholder rights and the fairness of the markets (here).
Remarks: Andrew J. Bowden, Director, Office of Compliance, Inspection and Examinations, addressed the Private Fund Compliance Forum 2014, New York City (May 6, 2014). His remarks discussed OCIE and the presence exam initiative, trends in private equity, and select exam observations (here).
CFTC
Remarks: Commissioner Scott D. O’Malia addressed Derivatives 2014: A Market In Transaction – A TabbForum Event with remarks titled We Have the Power to Reverse the Negative Impacts of the Commission’s Rules on Market Structure, May 6, 2014 (here). His remarks focused on high frequency trading, cross border harmonization and unworkable rules impacting market structure.
SEC Enforcement – Filed and Settled Actions
Statistics: This week the Commission filed, or announced the filing of, 7 civil injunctive actions, DPAs, NPAs or reports and 0 administrative proceedings (excluding follow-on and Section 12(j) proceedings).
Insider trading: SEC v. Campani, Case No. 3:14-cv-02882 (D.N.J. Filed May 6, 2014); SEC v. Mullin, Case No. 3:14-cv-02883 (D.N.J. Filed May 6, 2014); SEC v. Posner, Case No. 3:14-cv-02884 (D.N.J. Filed May 6, 2014) are actions, respectively, against John Campani, John Mullin and Alan Posner. Each is alleged to have been provided material non-public information about the acquisition of Home Diagnostics Inc. by its former COB, George Holley in 2010. Each man traded. Each complaint alleges violations of Exchange Act Sections 10(b) and 14(e). Each defendant settled, consenting to the entry of a permanent injunction prohibiting future violations of the Sections cited in the complaint. In addition, Mr. Campani will pay disgorgement of $26,700, prejudgment interest and a civil penalty of $13, 350; Mr. Mullin will pay disgorgement of $10,450, prejudgment interest and a penalty of $5,225; and Mr. Posner will pay disgorgement of $67,910 plus prejudgment interest and a penalty of $33,955. See Lit. Rel. No. 22987 (May 7, 2014); see also SEC v. Holley, No. 3:11-cv-0025 (D.N.J.)(action against the former Chairman).
False returns: SEC v. Kalucha, Civil Action No. 14 cv 3247 (S.D.N.Y. Filed May 5, 2014) is an action against Vinceet Kalucha, the CIO of Aphelion Fund Management LLC, also a defendant and an investment adviser, and George Palathinkal, a general partner and CFO of the adviser. The Aphelion funds began trading in July 2013. From May 2013 to the present Messrs. Kalucha, Palathinkal and Aphelion Management raised nearly $8 million from 8 different investors for an investment into a separate account managed by Aphelion Management. The Aphelion funds used a proprietary investment model developed by Mr. Kalucha at an earlier fund. Despite poor results from the model in an earlier application, marketing materials for Aphelion touted the positive results of the model. The model also yielded poor results here. In September 2013 an Audit Firm completed a review of the investment performance for an Aphelion client which showed a negative return of 3.08% net of fees or negative 0.66% before fees. Mr. Kalucha altered the audit report so it reflected a positive 30% net of fees. The altered report was distributed to potential investors and incorporated into Aphelion Management’s marketing materials. Later Mr. Kalicha told the Audit Firm that he discontinued use of the altered report when the audit firm protested. The Audit Firm resigned. Subsequently, the defendants told investors that Aphelion Management was revising its reported historical performance statistics to reflect a more conservative approach. The actual reason was the repudiation of the altered report by the Audit Firm and its resignation which was not disclosed to investors. Messrs. Kalucha and Palathinkal are also alleged to have used investor funds raised for operating expenses for their personal use. The complaint alleges violations of Exchange Act Section 10(b), each subsection of Securities Act Section 17(a) and Advisers Act Sections 206(1), 206(2) and 206(4). The case is pending.
Subsequently, the SEC dismiss all charges against Mr. Palathinkal with prejudice and without cost.
Custody rule: SEC v. Cowgill, Case No. 2:14 CV 396 (S.D. Ohio Filed May 5, 2014) is an action against Professional Investment Management, Inc., and its principal, Douglas Cowgill. The firm provides third-party administration services and investment advisory services for about fifteen retirement plans with approximately 3,000 participants. It currently has about $120 million in assets under management. Since it holds client funds under the custody rule it must implement certain controls to protect those assets which include using a qualified custodian and clients, notice to clients and an annual surprise audit. From 2010 through 2013 the form regarding the surprise exam for Professional Investment was not filed with the Commission as required. At the end of September 2013 Mr. Cowgill dismissed this failure in a communication with the staff as an administrative oversight. He also noted that the firm was going to switch its registration to the State of Ohio. Later that day a form was filed to withdraw the firm’s registration with the Commission. It never registered with Ohio. An exam in November 2013 confirmed that the firm continued to have custody of client assets. Nevertheless, Professional Investment failed to arrange for clients who assets were being held to receive quarterly account statements from a qualified custodian. Mr. Cowgill, as CCO for the firm, also did not arrange for the annual surprise audits. An audit by the staff demonstrated that the month end balances were consistently overstated for Fund 12. Defendants then took steps to conceal the shortfall in the accounts. During the November exam, Mr. Cowgill made false entries in the accounts which were later reversed. In response to a subpoena issued in January 2014 he again provided the staff with false reports regarding the accounts. During his investigative testimony Mr. Cowgill did admit, however, that he had entered a fake trade in an effort to demonstrate to the staff that the balances for Fund 12 could be reconciled. Subsequent to his testimony, Mr. Cowgill made an additional attempt to conceal the shortfall. The Commission’s complaint alleges violations of Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2), 203(a) and 206(4). The action is pending. See Lit. Rel. No. 22985 (May 5, 2013).
Manipulation: SEC v. Kelley, Civil Action No. 2:14-cv-2827 (D. N.J. Filed May 5, 2014) is an action against Paul Kelly, George Tazbaz, Roger Lockhart and Robert Agiogians along with Shawn Becker. The claims center on an alleged manipulation of the securities of two Chinese firms Mr. Kelly and others took public through reverse mergers, China Auto Logistics, Inc. and Guavwei Recycling Corporation. Over a four year period beginning in 2008 Messrs. Kelly, Tazbaz, Lockhart and Agiogians are alleged to have engaged in similar schemes to manipulate the share price of each issuer and reap millions in profits. Generally for each company: the group entered into an agreement with management to take the firm public; specified that 30-40% of the stock would go to them; acquired a public shell; structured the transaction so they could control the float; and then sold the shares into the market through a series of controlled entities. When the stock began trading Messrs. Kelly, Tazbaz, Lockhart and Argriogianis, along with stock promoter Shawn Becker and others manipulated the trading and volume so that a listing on NASDAQ could be obtained. Ultimately the group sold its shares, reaping millions in profits. The complaint alleges violations of Securities Acts Sections 5(a), 5(c) and 17(a), Exchange Act Sections 9(a), a 10(b), 13(d), 15(a), 16(a) and Regulation M. Messrs. Kelley, Lockhart and Agriogianis settled with the Commission. Each consented to the entry of a permanent injunction based on the statutory Sections cited in the complaint except Exchange Act 15(a) as to Messrs. Lockhart and Agriogianis. The orders as to Messrs. Kelly and Lockhart also include Regulation M. Mr. Kelly agreed to pay$2,828,353.53 in disgorgement, prejudgment interest and a civil penalty equal to the amount of the disgorgement. Mr. Lockhart agreed to pay disgorgement of $1,819,211.77, prejudgment interest and a civil penalty of $1 million. The amount of disgorgement and civil penalties to be assessed against Mr. Agriogianis will be determined by the Court at a later date. Messrs. Lockhart and Agriogianis also agreed to penny stock bars. The litigation is continuing as to the other defendants. See Lit. Rel. No. 22986 (May 7, 2014).
Prime bank fraud: SEC v. Smith, Civil Action No. 1:14-cv-192 (D.N.H. May 2, 2014) is an action against attorney Allen Ross Smith. Mr. Smith is charged with having participated in a scheme orchestrated by Swiss-based Malom Group AG (“Make A Lot Of Money”) that centered on a prime bank fraud discussed here. The complaint alleges violations of Securities Act Sections 5 and 17(a) and Exchange Act Section 10(b). The case is pending. See Lit. Rel. No. 22984 (May 2, 2014).
Criminal actions
Investment fund fraud: U.S. v. Konior, No. 1:13-cr-00275 (S.D.N.Y. Filed April 15, 2013) is an action against Jason Konior, the founder and manager of a group of entities referred to as “Absolute.” Mr. Kondior raised and misappropriated about $2.9 million from hedge fund investors from late 2011 through May 2012. Those investors were promised that Absolute would match their investments for trading funds by up to nine times, all of which would be in accounts that would be traded. The hedge funds would be responsible for trading losses and profits would be shared with Absolute. In reality he misappropriated much of the money. Previously, Mr. Konior pleaded guilty to one count of wire fraud. He was sentenced to serve 46 months in prison followed by three years of supervised release. Mr. Konior was also ordered to forfeit $2.9 million and to pay a fine in that amount.
Investment fund fraud: U.S. v. Ekdeshman, No. 1:14-mj-00929 (S.D.N.Y. Filed May 1, 2014) is a case which charges Alex Ekdeshman, formerly the CEO of Paramount Management, LLC, with conducting a fraudulent trading scheme. Specifically, the court papers alleges that he raised over $1.5 million from over 100 investors based on claims that the money would be invested in forex transactions. Instead he misappropriated much of the investor money. Mr. Ekdeshman is charged with one count of commodities fraud, one count of wire fraud and one count of mail fraud. The case is pending.
FINRA
Supervision: The regulator fined Morgan Stanley Smith Barney LLC $5 million for supervisory failures related to 83 IPOs to retail customers from early February 2012 to May 1, 2013. Prior to the effective date of a registration statement a firm may solicit an “indication interest” which will only result in the purchase of shares if it is reconfirmed by the investor after the effective date. A firm can also solicit “conditional offers to buy” which may result in a binding transaction after the effective date of the registration statement if the investor does not act to revoke the conditional offer before the firm accepts it. Here the firm used the terms interchangeably and failed to have supervisory policies and procedures and training for its staff to distinguish between the two.
PCAOB
The Board announced settled disciplinary actions against two audit firms and four individuals in which all were censured:
Berman W. Martinez y Asociados and Berman W. Martinez, of Managua, Nicaragua. The firm’s registration was revoked and Mr. Martinez was barred. The firm performed few if any audit procedures before issuing opinions and had no training or experience in performing audits under PCAOB standards. The firm also failed to establish and implement quality control policies and procedures that were adequate.
Jeffrey & Company and Robert G. Jeffrey, Wayne, New Jersey. The firm’s registration was revoked. Mr. Jeffrey was barred with a right to file a petition for consent to associate with a registered firm after three years. The firm and Mr. Jeffrey were not independent with respect to two issuer clients because Mr. Jeffrey served as the lead audit partner for more than five consecutive years. For a third client they were not independent because Mr. Jeffrey had served as lead audit partner for that client within five years of previously serving for the maximum permitted period.
Paul W. Marchant, CPA, New Jersey. Mr. Marchant was barred. He may file a petition to associate with a registered firm after three years. Mr. Marchant, who was associated with the Jeffrey firm, failed to cooperate and violated the standards regarding audit documentation. He altered papers before submitting them and furnished false testimony during the investigation.
Henry Mendoza, CPA, San Clemente, California. Mr. Mendoza was barred with a right to file a petition to associate with a registered firm after five years. Mr. Mendoza failed to cooperate in a Board inspection and investigation. He also violated Board standards regarding audit documentation.
Circuit courts
Extraterritorial application: In European Community v. RJR Nabisco, Inc., 11-2475 (2nd Cir. Decided April 29, 2014) the Court clarified its earlier ruling in Norex Petroleum Ltd. v. Asccess Industries, Inc., 631 F. 3d 29 (2nd Cir. 2010) regarding the application of Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010) to RICO. The complaint claims that RJR directed, managed and controlled a global money-laundering scheme with organized crime groups in violation of RICO. The firm is claimed to have laundered money through New York based financial institutions and repatriated the profits of the scheme to the United States. The District Court dismissed the RICO claim, following Norex and Morrison. The Circuit reversed. In Norex the Court rejected a claim that RICO had extraterritorial reach simply because it involved an enterprise which is engaged in activities that affect “interstate or foreign commerce.” The Court also rejected claims of extraterritorial effect simply because some of the predicate acts for RICO are based on statutes which in and of themselves clearly have such effect. However, the District Court’s conclusion that Norex rejected extraterritorially in all of its applications . . “ is incorrect. Rather, the Court “conclude[d] that RICO applies extraterritorially if, and only if, liability or guilt could attach to extraterritorial conduct under the relevant RICO predicate. Thus, when a RICO claim depends on violations of a predicate statute that manifests an unmistakable congressional intent to apply extraterritorially, RICO will apply to extraterritorial conduct, too, but only to the extent that the predicate would.” This conclusion, the Court held, is compelled largely by the statutory language. RICO itself does not have language which compels the conclusion that it has extraterritorial effect. Yet Section 1961(1), which defines “racketeering activity” for purposes of RICO, incorporates by reference a number of federal criminal statutes. Some of those statutes by their terms can only apply to activities outside the U.S. Other statutes clearly apply to both domestic and extraterritorial conduct. “By incorporating these statutes into RICO as predicate racketeering acts, Congress has clearly communicated its intention that RICO apply to extraterritorial conduct to the extent that extraterritorial violations of those statutes serve as the basis for RICO liability.”
Hong Kong
Breach of duty: The Securities and Futures Commission obtained a court order against Wong Kwong Yu and his wife, respectively a former Chairman and director of GOME Electrical Appliances Holding Ltd. Under the order the two must repay the company $420 million and interest in connection with their breaches of directors’ duties in certain share repurchases with the company that took place in late January and early February 2008.