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SEC ENFORCEMENT TRENDS 2011

Thomas O. GormanDorsey & Whitney LLP

Washington, D.C. www.secactions.com

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INDEX

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . 4

Market reform . . . . . . . . . . . . . . . . . . . . . . .. 6

Reorganization . . . . . . . . . . . . . . . . . . . . . . 8

Close cooperation . . . . . . . . . . . . . . . . . . . 10

The reach of enforcement . . . . . . . . . . . . 15

The SEC in court . . . . . . . . . . . . . . . . . . . . 18

Significant market crisis cases . . . . . . . . . . 25

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INDEX

Insider trading . . . . . . . . . . .. . . . . . . . . . . . 35

FCPA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Financial fraud . . . . . . . . . . . . . . . . . . . . . . 63

Analysis and conclusions . . . . . . . . . . . . . . 77

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INTRODUCTION

• In the wake of the market crisis the SEC has struggled to overcome scandal and regain its once sterling reputation

• Over the past two years new Commissioners and new senior staff have worked diligently to rejuvenate and reinvigorate the once proud agency

• The enforcement division for example has undergone what is claimed to be the largest reorganization in its history

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INTRODUCTION

• To examine the results of those efforts and evaluate the future direction of SEC enforcement – points will be considered:

– Market reform – Reorganization – Close cooperation – The reach of enforcement – The SEC in court – Significant market crisis cases– Focus on insider trading – The new era of FCPA enforcement– Financial fraud cases – Analysis and conclusions

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MARKET REFORM

• Dodd Frank augmented the authority of SEC enforcement in a number of provisions including:

– Enhanced antifraud authority under Exchange Act Sections 9, 10(1) and 15

– An expansion of the extraterritorial jurisdiction of the antifraud provisions

– Extending aiding and abetting authority to include the Securities Act, the Investment Company Act and the Investment Advisers Act

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MARKET REFORM

• Dodd Frank (cont’d)– Clarifying the SEC’s authority over formerly associated persons

of regulated entities

– Imposing joint and several liability on control persons in SEC actions

– Authorizing nationwide service of subpoenas in SEC district court cases

– Authorizing the SEC to impose collateral bars, and

– Expanding the Commission’s authority to impose penalties to all cease and desist proceedings

– Expanded whistleblower program

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REORGANIZATION

• The division of enforcement has undergone what is perhaps the most significant reorganization in its history

– The management structure was flattened, eliminating the branch chief position

– Specialty groups were created

• Asset management

• Market abuse

• Structured and new products

• FCPA

• Municipal securities and public pensions

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REORGANIZATION

• New initiatives (cont’d)– Cooperation

• New initiatives for individuals

• Use of non-prosecution and deferred prosecution agreements

• Carters, Inc. is the first corporate cooperation agreement. The underlying fraud is similar to Seaboard

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CLOSE COOPERATION

• AG Eric Holder, in recent remarks stressed that the government will use the “full range of parallel criminal and civil enforcement resources to combat financial fraud”

• There is a growing trend of closer cooperation between the SEC, DOJ and other agencies

• Traditionally the SEC did formal referrals under the statutes

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CLOSE COOPERATION

• Joint working task forces have accelerated the trend– 2002 post Enron the Financial Fraud Task Force was formed

– 2009 by executive order a new and expanded task force was created

– Virginia Task Force – USAOEVA, SEC and Virginia State regulators – focus on financial fraud

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CLOSE COOPERATION

• Now referrals are much more likely to be informal. See generally SEC Enforcement Manual, Section 5.2.1

• The result has been the increased criminalization of securities enforcement

• This has resulted in a blurring of the line between civil and criminal enforcement

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CLOSE COOPERATION

• This trend can provide efficiencies for the government and the defense

• It also has pitfalls: – U.S. v. Samueli, Case No. 10-500024 (C.D. Ca.)

– U.S. v. Stockman; SEC v. Collins & Aikman, Civil Action No. 07-CV-24019 (S.D.N.Y. Filed March 27, 2007)

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CLOSE COOPERATION

• Pitfalls (cont’d)– Consider the comments of Chief Judge Kozinski of the Ninth Circuit in a

recent concurring opinion reversing a financial fraud case for lack of evidence:

“this case has consumed an inordinate amount of taxpayer resources, and has no doubt devastated the defendant’s personal and professional life. The defendant’s former employer also paid a price, footing a multimillion dollar bill for the defense. And, in the end, the government couldn’t prove that the defendant engaged in any criminal conduct . . . This is not the way criminal law is supposed to work. Civil law often covers conduct that falls in a gray area of arguable legality. But criminal law should clear separate conduct that is criminal from conduct that is legal . . .this is not only because of the dire consequences of conviction . . But also because criminal law represents the community’s sense of the type of behavior that merits the moral condemnation of society. . . When prosecutors have to stretch the law or the evidence to secure a conviction as they did here, it can hardly be said that such moral judgment is warranted.” U.S. v. Goyal, No. 08-1436 (9th Cir. 2010) (concurring).

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THE REACH OF ENFORCEMENT

• Traditionally SEC enforcement has had a transnational reach where there was significant conduct or effects in the U.S.

• In Morrison v. National Australia Bank Ltd., 130 S.Ct. 2869 (2010) the Court held that Exchange Act Section 10(b) has no extraterritorial reach. The statute is limited to either actions on a U.S. securities exchange or those involving the purchase or sale in this country

• Since this holding is based on the text of the statute it applies to private suits and those brought by the SEC

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THE REACH OF ENFORCEMENT

• The SEC has essentially acknowledged the impact of Morrison. Report of Investigation, Moody’s Investor Services, Inc., Exchange Act Release No. 62802 (Aug. 31, 2010)

– Declined to bring an enforcement action in a case where much of the conduct occurred in Europe but there were filings with the SEC filings

– The Commission noted there were questions as to its jurisdiction

– The Report cautioned that recent legislation would permit the SEC to bring an enforcement action in the future

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THE REACH OF ENFORCEMENT

• Dodd-Frank extends the jurisdiction of the antifraud provisions as to the SEC and DOJ to include conduct within the U.S. that constitutes “significant steps in furtherance of the violation” even where the securities transaction is not in the U.S. and involves only foreign investors.

• Questions remain however. The Section amends the jurisdictional provisions of the various securities laws. Morrison held that the statutes already provided for jurisdiction. However Section 10(b) did not afford a cause of action the Court held.

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THE SEC IN COURT

• Most SEC enforcement actions are settled. Few corporations are willing to litigate with a government agency. For many individuals the cost is prohibitive.

• Prevailing at trial is a key component of the SEC enforcement program.

• In recent cases however the SEC has had at best mixed results.

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THE SEC IN COURT

• Wins in court– SEC v. Jasper, Case No CV 08-6122 (N.D. Cal.). The SEC

prevailed at trial in an option backdating case against Carl Jasper, former CFO of Maxim Integrated Products. The company and its CEO previously settled.

– SEC v. Huff, Civil Action No. 08-06315 (S.D. Fla.) is a financial fraud action in which the SEC prevailed after a seven day bench trial against W. Anthony Huff. The case was based on a scheme to inflate revenue by recording a bogus $47 million letter of credit.

– SEC v. U.S. Pension Trust Corp., Civil Action No. 07-22570 (S.D. Fla.) is a case in which the SEC prevailed after a five day bench trial against the company and its affiliates. The case centered on claims that investors in the fund were mislead about the nature of the investment and the commissions which ran as high as 85%.

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THE SEC IN COURT

• Losses in court– SEC v. Rorech, Civil Action No. 09 Civ. 4329 (S.D.N.Y.) is

perhaps the most high profile loss.

• The case was the first insider trading case based on CDS.

• The SEC prevailed on a jurisdictional challenge but lost on the merits following a bench trial.

• The court concluded that the SEC had presented evidence of suspicious circumstances but failed to prove illegal tipping between the two defendants.

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THE SEC IN COURT

• Losses in court (cont’d)– SEC v. Obus, Case No. 1:06-cv-3150 (S.D.N.Y.0 is an insider

trading case which centered on the acquisition of SunSource by Allied Capital Corp. in 2001.

• The SEC claimed that a member of the deal team tipped his friend who then tipped defendant Obus who traded and made a profit of $1.34 million

• The court found no violation of duty by the deal team member because there was no confidentiality agreement and he had not been made a temporary insider. With no breach of duty there was no deception

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THE SEC IN COURT• Losses in court (cont’d)

– SEC v. Zachariah, Case No. 08-60698 (S.D.Fla.) is an insider trading case against a corporate director in which the court found for the defendant after a bench trial.

• The case centered on trading by the director and others he was alleged to have tipped on two deals, one of which involved the company for which he served as a director.

• The SEC proof was circumstantial and relied on inferring proof of inside information in each deal. The court rejected the SEC’s proposed inferences.

– SEC v. Shanahan, Case No. 4:07-cv-1262 (E.D. Mo.) is an option backdating case against a corporate director who was a member of the compensation committee.

• The SEC claimed the defendant violated the proxy provisions and aided and abetted false filings.

• Previously the company settled similar claims and the company CEO who was the defendant’s father was convicted on criminal charges based on the same scheme.

• Here the court concluded the SEC failed to establish the applicable standards as to what a member of the board and compensation committee had a duty to undertake with respect to the proxy filings.

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THE SEC IN COURT

• Mixed results – SEC v. Berlacher, Civil Action No. 0-3-800 (E.D. Pa.) is a case in

which the court rejected the key claims against a hedge fund operator.

• The action centered on a series of PIPE offerings in which the defendant learned about the deal and then took positions in the market in advance of the filing of the resale registration statement.

• The Court rejected claims based on the registration provisions and insider trading finding as to the latter that there was insufficient proof of an agreement.

• The defendant was found liable for making a false statement as to his market position on one deal.

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THE SEC IN COURT

• Mixed results (cont’d)– SEC v. Delphi Corp., Civil Action No 2:06-cv-14891 (E.D. Mich.)

is an action tried against the former CEO and former Chief Accounting officers of the company on financial fraud claims.

• The complaint centered on multiple schemes to boost revenue.

• The jury found in favor of the former CEO on the only fraud claim against him but found him liable for lying to the auditors and aiding and abetting books and records violations.

• The jury found the former CEO not liable on one fraud charge but liable on others.

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SIGNIFICANT MARKET CRISIS CASES

• The SEC has been conducting dozens of market crisis investigations

• Yet few significant cases have been brought

• The cases brought to date fall into four groups showing mixed results:

– Major Wall Street players

– Lenders

– New Jersey and

– Others

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SIGNIFICANT MARKET CRISIS CASES

• Major Wall Street players – SEC v. Goldman Sachs, Case No. 3229 (S.D.N.Y. Filed April 16,

2010) is an action centered squarely on the market crisis.

• It is based on the construction of an entity called ABACUS using collateralized debt obligations tied to the subprime real estate market.

• According to the complaint it was constructed at the request of Paulson & Co. so the fund could bet against the subprime market. Paulson influenced the construction, an undisclosed fact. The bank and one of its employees were named as defendants.

• Goldman settled, consenting to the entry of a permanent injunction based on Securities Act Section 17(a) and paying a fine of $535 million, a record for an investment bank.

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SIGNIFICANT MARKET CRISIS CASES

• Major players (cont’d)– SEC v. Citigroup, Inc., Civil Action No. 1:10-CV-01277 (D.D.C. July

29, 2010). The complaint alleges violations of Securities Act Section 17(a)(2) and Exchange Act Section 13(a).

• It alleges that as the market crisis unfolded the bank falsely disclosed its exposure to the subprime market as $13 billion when in fact it was $56 billion. Two portfolios were not included despite the fact that two senior executives were repeatedly informed about them.

• The bank settled consenting to the entry of an injunction based on the sections cited in the complaint, instituting certain procedures and paying a penalty of $75 million. The district court judge at first questioned the settlement and then reluctantly agreed to acquiesce to the Commission.

• A related administrative proceeding was brought against the two officers. In the Matter of Gary L. Crittenden, Adm. Proc. File No. 3-13985 9filed July 29, 2010). The officers settled consenting to a cease and desist order based on Exchange Act Section 13(a) and agreeing to pay penalties of $100,000 and $80,000.

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SIGNIFICANT MARKET CRISIS CASES

• Major players (cont’d) – SEC v. Bank of America, Case No. 09-5829 (S.D.N.Y.) is an action

alleging violations of the proxy provisions by the bank in the acquisition by Merrill Lynch.

• The complaint alleged that although the boards of both entities agreed to a bonus pool for Merrill executives of up to $5.6 billion the disclose materials omitted this fact and suggested otherwise.

• The action was eventually settled with a consent decree, a $150 million fine and new procedures.

• The settlement was questioned and heavily criticized by the court. The court considered the initially proposed $30 million fine inadequate and questioned not naming the officers.

– The New York AG brought a parallel action against the bank and two senior officers. State of New York v. Bank of America (S.Ct. N.Y. Filed Feb. 4, 2010). The case is in litigation.

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SIGNIFICANT MARKET CRISIS CASES

• Lenders – The two most significant cases involving lenders were brought

against the officers of Countrywide Financial and New Century Financial, once the number one and three subprime lenders. Two significant market crisis cases that settled last year are SEC v. Mozilo, Case No. CV 09-03994 (C.D.Cal. Filed June 4, 2009) and SEC v. Morrice, Civil Action No. CV 09-01426 (C.D. Cal. Filed Dec. 7, 2009).

• The former is against the officers of the number one sub-prime lender, Countrywide Financial, while the latter names as defendants the senior officers of New Century Financial, the number three sub-prime lender.

• Each case essentially centered on fraud claims based on the failure of the defendants to disclose the true financial condition of the company as the sub-prime lending market tumbled down.

• Mozilo also contained claims that Angelo Mozilo, the company chairman, engaged in insider trading as his company spiraled to a crash while Morrice includes additional financial fraud claims.

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SIGNIFICANT MARKET CRISIS CASES• Mozilo & Morrice (cont’d)

– On the eve of trial the Commission secured what the headlines claim are significant settlements to resolve Mozilo.

– Each defendant consented to the entry of an injunction and to pay disgorgement, prejudgment interest and a civil penalty.

– Mr. Mozilo and former COO David Sambol agreed to injunctions based on the antifraud and reporting provisions while former CFO Eric Sieracki consented to the entry of an order based on Securities Act Sections 17(a)(2) and (3).

– In addition to consenting to the entry of a permanent officer and director bar, Mr. Mozilo agreed to pay a total of $67.5 million, including $45 million in disgorgement and interest and a penalty of $22.5 million.

– Mr. Sambol, who agreed to the entry of a three year officer/director bar, will pay disgorgement and interest of $5 million and a civil penalty of $520,000.

– In his settlement Mr. Sieracki agreed to pay a penalty of $130,000 and to the entry of a Rule 102(e) order barring him from practicing before the Commission as an accountant for one year.

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SIGNIFICANT MARKET CRISIS CASES

• Morrice (cont’d)– The Commission also fully resolved Morrice. Brad Morrice, the former CEO and

co-founder, Patti Dodge, the former CFO and David Kenneally, the former controller settled with the SEC.

– Mr. Morrice and Ms. Dodge each consented to the entry of an injunction prohibiting future violations of Securities Act Actions 17(a) and Exchange Act Sections 10(b) and 13(b)(5) as well as from aiding and abetting violations of Section 13(a).

– Mr. Kenneally agreed to the entry of a similar injunction although it did not include Section 17(a). Each defendant agreed to the entry of an officer/director bar with a right to re-apply after five years.

– In addition, Mr. Morrice will pay disgorgement $464, 364 along with prejudgment interest and a penalty of $250,000. Ms. Dodge will pay disgorgement of $379,808 along with prejudgment interest and a penalty of $100,000 while Mr. Kenneally will pay disgorgement of $126,676 along with prejudgment interest.

– See also SEC v. State Street Bank and Trust Co., Case No. 1:10-CV-10172 (D. Mass. Filed Feb. 4, 2010); In the Matter of State Street Bank and Trust Co., Adm. Proc. File No. 3-13776 (Filed Feb. 4, 2010)(settled actions relating to misleading statements made to investors in a bond fund as the market unraveled).

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SIGNIFICANT MARKET CRISIS CASES

• SEC v. Perry, Case No. CV 11-01309 (C.D. Cal. Filed Feb. 11, 2011); SEC v. Abernathy, Civil Action No. CV 11-01308 (C.D. Cal. Filed Feb. 11, 2011) are based on the failure of IndyMac. .

– Perry, which names as defendants the former CEO and CFO, focuses on the impact of events on the capital of the bank, its efforts to bolster it through stock sales and the failure to update filings and offering documents which contained a mixture of statements which were dated and vague, boiler plate statements about the use of funds. None of this accurately and specifically disclosed the declining regulatory capital position of the bank or that the stock sale proceeds were intended to bolster it.

– Abernathy, which also names a former CFO as a defendant, stems from the same basic allegations. The action centers more however on the negligent failure of another former CFO to ensure that updated information about difficulties with the consumer loan origination documents were included in current filings rather than boiler plate. Investors were thus not told about seriously flawed loan documents which portended problems with the loans.

– Perry includes allegations of scienter based fraud and is in litigation. – Abernathy settled with a consent to a permanent injunction prohibiting future violations of

Securities Act Sections 17(a)(2) and (3), the payment of disgorgement and prejudgment interest and a civil penalty. In addition, Mr. Abernathy agreed to the entry of an order barring him from practicing before the Commission as an accountant with a right to reapply in two year.

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SIGNIFICANT MARKET CRISIS CASES • In the Matter of State of New Jersey, Adm. Proc. File No. 3-14009

(Aug. 18, 2010). The Order claimed that the state violated Securities Act Sections 17(a)(2) and (3) in connection with the sale of municipal bonds from August 2001 through April 2007.

– Essentially the State is alleged to have made it appear as a result of certain legislative action that two large pension funds discussed in the offering materials were funded when in fact they were not. When the state became aware of the underfunding it failed to take any steps to correct the situation.

– Until 2007 and 2008 when disclosure counsel was retained, the state did not have any written policies and procedures regarding the review or updating of bond offering documents. By the time the proceeding was filed policies had been adopted and a committee created to oversee the entire disclosure process.

– The case was resolved with the entry of a cease and desist order. The proceeding has particular significance in view of the effects of the market crisis and con-going financial difficulties of many states and municipalities.

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SIGNIFICANT MARKET CRISIS CASES• Two other market crisis cases brought last year which are in litigation are

SEC v. ICP Asset Management LLC, Civil Action No. 10-cv-4791 (S.D.N.Y. Filed June 21, 2010) and SEC v. Farkas, Civil Action No. 1:10 cv 667 (E.D. Va. Filed June 16, 2010).

– ICP is an action against a registered investment adviser and its related entities. The complaint centers on transactions involving four multi-billion dollar collateralized debt obligations in which ICP Asset Management and the other defendants are alleged to have repeatedly defrauded certain clients in certain transactions. The case is in litigation.

– Farkas is a fraud action against Lee Farkas, the former chairman of mortgage lender Taylor, Bean & Whitaker.

• Prior to its collapse, Taylor Bean was the largest non-depository mortgage lender in the country. When the lender began having liquidity problems as early as 2002,

• Mr. Farkas is alleged to have shuffled funds among various accounts and engaged in other fraudulent conduct including using sham transactions to conceal the true nature of the company.

• Mr. Farkas was recently convicted in the parallel criminal case. U.S. v. Farkas (E.D. Va. Filed June 16, 2010). The Commission’s case is pending.

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INSIDER TRADING

• Insider trading has long been an enforcement priority. – In recent years however it has become a focal point not just for

the SEC but also the Department of Justice and, in particular, the U.S. Attorney’s Office for the Southern District of New York.

– Working under the auspices of the President’s Executive Order creating a broad financial fraud task force, the SEC and the New York USAO have developed a close working relationship.

– Together they have adopted an aggressive stance which may rewrite the definition of insider trading.

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INSIDER TRADING

• Blue collar tactics– U.S. v. Rajaratnam, Case No. 09 mg 2307 (S.D.N.Y.); U.S. v. Chiesi,

Case No. 09 Mg 2307 (S.D.N.Y.); SEC v. Galleon Management, L.P. Civil Action No. 09-CV-8811 (S.D.N.Y. filed Oct. 16, 2009).

• The Galleon cases, which began with criminal and civil charges against hedge fund mogul Raj Rajarantnam, New Castle Funds LLC trader Danielle Chriesi, and others, were the first insider trading cases to make wholesale use of what many consider to be blue collar tactics.

• The cases are built in large measure on the repeated use of wire taps, wired informants and similar techniques. While law enforcement has long utilized these tactics in organized crime and drug prosecutions, the use in white collar cases has been limited.

• The charges in the two cases are predicated on overlapping insider trading schemes involving trading in multiple securities. Those include shares of Polycom, Hilton, Google, AMD and Clearwire. The information supposedly came from multiple sources including insiders at the company.

• The Rajarantanam jury is currently deliberating.

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INSIDER TRADING

• Blue collar tactics (cont’d) – U.S. v. Goffer, Case No. 9 Mg. 2438 (S.D.N.Y.); SEC v. Cutillo,

Civil Action No. 09-09208 (S.D.N.Y. filed July 2, 2009). Shortly after the Galleon cases were brought, another insider trading ring was uncovered.

• This one centered on information flow from the law firm of Ropes and Gray. Firm lawyer Arthur Cutillo and another attorney, Jason Goldfarb, were at the center of the ring which included a number of hedge fund traders.

• Following these indictments more charges were brought. To date fourteen have pleaded guilty. Nine civil settlements have been executed. Ms. Chiesi and each of the defendants charged with her has pleaded guilty. The central figure of the cases, Raja Rajaratnam, is scheduled for trial shortly.

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INSIDER TRADING

• Blue collar tactics (cont’d) – Expert network cases: The Manhattan U.S. Attorney’s Office and the SEC

recently unveiled the so-called “expert network” investigation. This inquiry, built on the same blue collar tactics, focuses on information flow from expert networks that grew up in the wake of SEC Reg. FD. That regulation was intended to level the playing field for the dissemination of corporate inside information.

– Shortly after the raids, the first cases were brought by the U.S. Attorney. U.S. v. Shimoon, Case No 10 Mg 2923 (S.D.N.Y.) named four individuals as defendants. One was previously employed by expert network Primary Global Management while three were corporate consultants.

• The case focused solely on information flow – the charges are conspiracy and wire fraud, not insider trading. The SEC did not initially file an enforcement action. After more criminal charges were filed which include insider trading, the agency brought an insider trading enforcement action. SEC v. Longoria, Civil Action No. 11-CF-07530 (S.D.N.Y.). The government has stated the investigation is in its early stages.

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INSIDER TRADING

• Aggressive tactics – The SEC has been very aggressive in many insider trading cases. In

some instances the agency has brought insider trading charges based on little more than the trading data.

– SEC v. One or More Unknown Purchasers of Martek Biosciences Corporation, Case No. 10 Civ. 9527 (S.D.N.Y. Filed Dec. 22, 2010)

• The case was filed just days after the event in order to freeze trading profits of persons as yet to be identified. It is based on the take over by Royal DSM N.V., a Dutch company, of Maryland based Martek Biosciences Corporation. It was announced on December 21, 2010.

• Just days before the announcement 2,616 Marteck call options were purchased through an account at UBS. The purchases represented over 90% of the volume for the transaction days. When the deal was announced the share price increased by 36% giving the account an unrealized profit of $1.2 million. The Commission filed its complaint alleging violations of the antifraud provisions on December 23 and obtained a freeze order.

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INSIDER TRADING

• Aggressive tactics (cont’d)– SEC v. One or More Unknown Purchasers of Options of InterMune,

Inc., Case No. 10-Civ. 9560 (Filed Dec. 23, 2010) • It centers on an announcement from the European Union’s Committee for

Medicinal Products for Human Use regarding a drug of InterMune, Inc., a biotechnology company based in Brisbane, California.

• When the Committee announced it would recommend the drug for approval on December 17, 2010, the share price for the company increased about 144%.

• Just days before the announcement 400 call options were cleared through UBS Securities LLC. On one day the purchases represented 100% of the volume while on another they were 57%. A few days later 237 option contracts cleared through Barclays Capital, New York. The unrealized profits for the two accounts are $912,000.

• Again the Commission quickly filed a complaint and obtained a freeze order.

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INSIDER TRADING

• Aggressive tactics (cont.)– SEC v. Di Nardo, Civil Action No. 08-cv-6609 (S.D.N.Y. filed July

25, 2008) is an insider trading action filed against unknown purchasers of DRS Technologies securities where in discovery the identity of the trader was determined. The trader settled last year.

– SEC v. Condroyer, Case No. 1:09-cv-3600 (N.D. GA. Filed Dec. 22, 2009) is an insider trading case against two French nationals residing in Belgium who traded just before a take over announcement. The SEC obtained a freeze order despite the fact that there is no evidence in the complaint alleging a source of inside information or any connection between the individuals.

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INSIDER TRADING• Pushing the edge

– In some cases the SEC pushes the edge of what is insider trading– In SEC v. Steffes, Case No. 1:10-cv-06266 (N.D. Ill. Filed Sept. 30, 2010) the case

is based on the trading of family and friends. The group is alleged to have made about $1.6 million in trading profits.

• Gary Griffiths and Cilff Steffes, who are related, both work for Florida East coast Railway, LLC. On May 8, 2007 it was announced that Fortress Investments Group LLC would take over the company. The transaction traces to a determination of the board in December 2006 to solicit bids for the company. Over a period of time bidders toured the properties.

• Gary and Cliff are alleged to have had inside information which is the predicate for the trading.

• According to the SEC’s complaint Gary, a vice president and chief mechanical officer who reported to the COO, had inside information because:

1) In early March before the deal the CFO asked him to prepare a comprehensive list of company equipment;2) he was aware of a number of unusual people touring the property and he “believed” they were investment bankers for a

possible sale;3) employees asked him if the company was up for sale and they would lose their job; and 4) he arranged a monitored rail trip for the Fortress executives in a special rail car reserved for visitors. Cliff observed similar

events. 5) One defendant settled with the Commission. The others are litigating the case.

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INSIDER TRADING

• The Commission cases can also be divided into the following categories

– market and other professionals

– Corporate executives and

– family and friends

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INSIDER TRADING

• Market and other professionals – SEC v. Poteroba, (S.D.N.Y.) Filed March 25, 2010 and U.S. v.

Poteroba (S.D.N.Y. Filed March 25, 2010). The defendants are Igor Poteroba, a managing director at UBS Securities in their Healthcare Group, and Alexander Koval, previously employed at Citigroup Asset management, and Alexander Vorobiev. • Each defendant is a Russian National. • The criminal and civil cases are based on essentially the same scheme. • The criminal information, alleging one count of conspiracy and three counts

of securities fraud, claims that Mr. Poteroba tipped defendant Koval about six different companies over a four year period beginning in 2005. The trading generated about $870,000 in illegal profits.

• The SEC complaint, alleging violations of Exchange Act Sections 10(b) and 14(e), centers on the same conduct but adds five additional deals. Both cases are in litigation.

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INSIDER TRADING • Market and other professionals (cont’d)

– SEC v. Garcia, Civil Action No. 10 C 5268 (N.D. Ill filed Aug. 20, 2010). The defendants are Juan Jose Fernandez Garcia, the head of European equity derivatives at Banco Santander, S.A. and Luis martin Caro Sanchez. Both are residents of Madrid, Spain.

• The case centers on the unsolicited bid for Potash Corporation of Saskatchewan by BHP Billiton Plc announced on August 17, 2010. The announcement of the deal was followed by a share price increase of 27%. Banco Santandar was an adviser to Potrash.

• Prior to the bid Mr. Garcia purchased 282 Potash call options for $13,669. After the announcement they were sold at a profit of $576,033. Mr. Sanchez purchased 331 call options in Potash in mid-August at a cost of $496,953.33. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e). Mr. Garcia recently settled consenting to an injunction, paying disgorgement and a small fine. .

• See also In the Matter of David W. Baldt, Adm. Proc. File No. 3-13887 (Filed May 11, 2010). Here a portfolio manager for bond funds learned of large redemptions and is alleged to have suggested to family members that they liquidate their holdings); SEC v. Marquardt, Civil Action No. 10-10073 (D. Mass. Jan. 20, 2010)(settled action against fund administrative officer who learned that certain actions would result in a reduction of NAV after which he and his family redeemed their holdings.

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INSIDER TRADING • Market and other professionals (cont’d)

– SEC v. Flanagan, Civil Action No. 10-CV-4885 (N.D. Ill. Filed Aug. 4, 2010) is an action against Thomas P. Flanagan, former Vice Chairman of Deloitt, resident in its Chicago office and his son Patrick, the COO of a private company.

• According to the complaint, between 2005 and 2009 Mr. Flanagan traded on inside information nine times, making 71 trades through multiple accounts. The information concerned audit clients of the firm. Overall Mr. Flanagan made profits of about $430,000. The complaint also claims that Mr. Flanagan in some instances tipped his son who traded, making profits of about $57,000.

• The action was resolve with each defendant consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act sections 10(b) and 14(e). Each defendant also agreed to disgorge their trading profits and pay prejudgment interest along with a civil penalty equal to the trading profits.

• In addition, Mr. Flanagan consented to the entry of an order denying him the right to appear and practice before the Commission as an account in a separate administrative proceeding. Lit. Rel. 21612 (Aug. 4, 2010).

• See also SEC v Gansman, Civil Action No. 089-CV - 4918 (S.D.N.Y. Filed May 18, 2008). This is a settled insider trading case against attorney James Gansman who was employed in the transaction advisory group of Ernst & Young an is alleged to have repeatedly tipped his friend and former stock broker Donna Murdoch.

• SEC v. Foley, Civil Action No. 1:00-CV-00300 (D.D.C. Filed Feb. 25, 2010) is a settled case in which Mr. Foley obtained inside information from his employment at Deloitte and tipped two others.

47

INSIDER TRADING

• Corporate executives – SEC v. Horn, Civil Action No 1:10-CV-00955 (N.D. Ill. Feb. 16, 2010) is a case

where the executive traded for his own account. Defendant Gerald Horn was the medical director for one of the facilities of LCA Visions, Inc.

• According to the complaint, from December 2005 through August 2006, the defendant made six separate trades while in possession of inside information. The information came from reviewing internal reports about the number of eye surgeries done. From this data Mr. Horn estimated revenue. By trading in LCA options the defendant made profits of $869,629. The case is in litigation. Lit. Rel. No. 2114 (Feb. 16, 2010).

– SEC v. Wagner, Case No. 1:10-cv-10031 (D. Mass. Filed Jan. 11, 2010). The defendant, Brooke D. Wagner, is the former VP of Corporate communications of Indevus Pharmaceuticals, Inc.

• According to the SEC Mr. Wagner learned that the FDA had expressed concerns about the side effects of a drug for which the company was seeking approval. Prior to the public announcement about the FDA letter, the defendant sold his shares and later sold short. The share price fell about 69% following the announcement.

• To settle the case Mr. Wagner consented to the entry of a permanent injunction prohibiting future violations of the antifraud provisions of the federal securities laws. He also agreed to pay disgorgement of about $64,000 along with prejudgment interest and a civil penalty equal to the amount of the disgorgement. Lit. rel. No. 21370 (Jan. 11, 2010)

48

INSIDER TRADING

• Corporate executives (cont’d)– SEC v. Lyva, Civil Action No. 09 CV 1565 (S.D. Cal.) is a settled

action against the former director of strategic marketing analysis for Qualcomm who traded in call options before the announcement that the company had obtained a significant litigation settlement.

– SEC v. Navarro, Civil Action No. 4:10-CV-189 (N.D. Okla. Filed march 31, 2010) is a settled action against a crude oil purchasing manager who liquidated his holdings after learning of unannounced cash flow difficulties.

– SEC v. Fogel, Case No. 1:10-CV-10097 (D. Mass. Jan. 22, 2010) is a settled case against former vice president who traded prior to an acquisition by his company.

49

INSIDER TRADING

• Corporate executives (cont’d) – SEC v. Self, Civil Action No. 10-cv-430 (E.D. Pa. Filed Sept. 1, 2010) James

Self, executive director at Merck & Co., tipped his friend, Stephen Goldfield, an unemployed former hedge fund manager according to the complaint.

• Prior to the acquisition in April 2007 of AstraZeneca by Medimmune, Inc., Mr. Self and others were solicited by investment bankers representing Medimune about a possible acquisition. Mr. Self was on the team which reviewed the material non-public information about the deal.

• By March 2007 Mr. Self furnished his friend with information on the subject. Mr. Goldfield purchased Medimmune options and, following the deal announcement, made profits of $13.9 million.

• The case settled with each defendant consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act section 10(b). Mr. Self also agreed to pay a civil penalty of $50,000 based on his financial condition. Mr. Goldfield agreed to disgorge the trading profits along with prejudgment interest. All but $600,000 of that amount was waived based on his financial condition. Lit. Rel. No. 21638 (Sept. 1, 2010);

– SEC v. Berrettini, Civil Action No. 10-CV-01614 (N.D. Ill. Mar. 31, 2010) is an action against former director of real estate for Philips Electronics who tipped his friend about a take over by his company.

50

INSIDER TRADING • Family and friends

– SEC v. McClellan, Case No. CV 10 5412 (N.D. Cal. Filed Nov. 30, 2010) is an action against two couples who are alleged to have formed an international insider trading ring.

• Arnold McCelland and his wife Annabel reside in San Francisco. Mrs. McCelland’s sister and her husband, James and Miranda Sanders, reside in London. According to the complaint, Arnold McCelland, is a mergers and acquisition tax partner at Deloitte. He misappropriated inside information on six deals over a two year period beginning in 2006.

• Both couples used the information to trade. In addition, Mr. Sanders, in some instances, furnished the information to customers at the brokerage where he worked.

• The FSA in London has filed charges against the Sanders in the U.K. as well as customers of the brokerage. Mrs. McCelland has also been indicted on obstruction of justice charges in connection with the SEC investigation. The cases are in litigation.

– SEC v. Cohen, Case No. 10 CV 2514 (S.D. Cal. Filed Dec. 8, 2010) is a case centered on an insider trading ring involving two brothers, a fraternity brother and an uncle where the source of the information is alleged to have been the employment of one brother.

– SEC v. Temple, Case No. 10-cv-1058 (D. Del. Filed Dec. 7, 2010) is an action involving two brothers-in-law where one is alleged to have misappropriated the inside information from the law firm where he worked.

51

INSIDER TRADING

• Family and friends (cont.)– SEC v. McDonald, Case No. 3:10cv151 (D. Conn. Filed Feb. 2,

2010) is an action against Bruce Macdonald. • His wife is a corporate secretary and vice president of human resources

of Mamry Corporation. The company put itself up for sale.

• Mrs. Macdonald, who was involved in the process, periodically discussed it with her husband who later purchased shares and tipped friends.

• Overall Mr. Macdonald had gains in one account of $890 and $25,509 in another. His friends had profits of about $20,000.

• To resole the case Mr. Macdonald, and the friend he tipped, consented to the entry of permanent injunctions prohibiting future violations of the antifraud provisions of the Exchange Act. Each man also agreed to the entry of an order requiring him to disgorge the trading profits along with prejudgment interest and to pay a penalty equal to the trading profits. Lit. rel. No. 21404 (Feb. 2, 2010).

52

INSIDER TRADING

• Reg FD– SEC v. Office Depot, Inc., Civil Acton No 9:10-cv-81239 (S.D. Fla. Filed Oct. 21,

2010); In the Matter of Stephen Odland, Adm. Proc. File No. 3-14095 (Filed Oct 21, 2010); In the Matter of Patricia McKay, Adm. Proc. File No. 3-14096 ( Filed Oct. 21, 2010).

• The cases center on a series of talking points used by the director of investor relations in would not make guidance. The CEO and CFO worked out a series of talking points for the IR director to deliver in a meeting. Those talking points did not reference material non-public information. Rather, they focused on publicly available information regarding the difficulty of making guidance. Following the talk, a number of analysts lowered guidance.

• The company settled the Reg FD charge as part of an overall global settlement of other filing violations. The two individuals also settled. Each consented to the entry of a cease and desist order based on Exchange Act Action 13(a) and Reg FD. Each also undertook to pay a civil penalty of $50,000.

– See also SEC v. Presstek, Inc. Civil Action No 10-1058 (E.D.NY. Filed March 9, 2010) which is a settled action against manufacturer and its former audit committee chairman who, after learning of performance difficulties in some segments discussed the matter with an investment adviser.

53

FCPA

• Record setting payments – The hallmark of corporate FCPA settlements is the spiraling cost of

settlement. That cost begins with what is paid to the enforcers. The current top ten largest settlements as compiled by the FCPA blog are:

• Siemens in 2009 at $800 million in 2008• KBR in 2009 at $579 million;• BAE in 2010 at $400 million;• Snamprogetti Netherlands B.V. in 2010 at $365 million;• Technip S.A. in 2010 at $338 million;• JGC Construction in 2011 at $218.8 million; • Daimler AG in 2010 at $185 million;• Alcatel-Lucent in 2010 at $137 million; and• Panalpina in 2010 at $81.8 million. • Johnson & Johnson in April 2011 a $70 million

54

FCPA

• Record setting payments (cont’d) – Eight of the largest amounts paid to settle FCPA charges are from

settlements in 2010 and early 2011. • The unmistakable nature of this trend is emphasized by the fact that the composition

of the top ten list has changed twice in the first few months of 2011. • To be sure these cases are frequently based on what DOJ and the SEC has

characterized as pervasive patterns of misconduct and/or multiple violations over a period of years.

• Siemens (here) and Diamler, for example, involved pervasive patterns of multiple violations – essentially corporate cultures which utilized bribes as a business tool according to prosecutors.

• KBR, Tehnicup, Snamprogetti and JGC were involved in the years long TSKJ conspiracy to secure contracts through bribery.

• At the same time not all of the cases in the top ten rise to the level of Siemens or the TSKJ conspiracy. Johnson and Johnson for example (here) is based on a much more limited fact pattern had extensive FCPA procedures which helped root out conduct that was limited to a few subsidiaries.

55

FCPA• Selected cases

– Mergers: SEC v. Alliance One International, Inc., Civil Action no. 01:10-cv-01319 (D.D.C. filed Aug. 6, 2010) Alliance One was formed from a merger of Diamon, Inc. and Standard in May 2005.

• Between 2000 and 2004 Diamon, in conjunction with Universal Corporation, paid about $800,000 in bribes to the Thailand Tobacco Monopoly to secure about $11.5 million in sales contracts for certain Universal subsidiaries. During the same period Dimon and Standard paid bribes to government officials of the Thailand Tobacco Monopoly totaling $1.2 million to obtain about $18.3 million in sales contracts.

• In addition, from 1996 through 2004 a subsidiary of Dimon paid about $3 million in bribes to officials of the Kyrgyzstan government to purchase tobacco. Diamon also made improper payments to tax officials in Greece and Indonesia and paid for inappropriate gifts, travel and entertainment to officials in the Asian Region, including China and Thailand. None of these payments were properly recorded.

• Alliance settled with the SEC by consenting to the entry of a permanent injunction prohibiting future violations of the anti-bribery and books and records and internal control provisions of the FCPA. Alliance also agreed to pay disgorgement of $10 million and to retain an independent monitor.

• The company settled with DOJ, entering into a non-prosecution agreement and agreeing to pay a $9.45 million criminal fine.

• See also SEC v. Universal Corporation, Inc., Civil Action no. 1:10-cv-01318 (D.D.C. Filed Aug. 6, 2010)(FCPA case based on substantially the same conduct and settled on similar terms).

56

FCPA

• Selected cases – mergers (cont’d)– SEC v. General Electric Company, Case No. 1:10-CV-01258 (D.D.C.

filed July 27, 2010).The company was named as a defendant along with two subsidiaries.

• The complaint centers on violations by two GE subsidiaries and two companies which GE acquired after the alleged violations. According to the complaint, from 2000 to 2003 two GE subsidiaries made about $2.04 million in kickback payments in the form of computer equipment, medical supplies and services to the Iraqi Health Ministry as part of the U.N. program.

• The kickbacks were made through agents in the form of “after sales service fees” on the sale of products to Iraq. Similarly, the two companies which later became GE subsidiaries paid about $1.55 million in cash kickback payments to Iraqi under the U.N. program.

• To settle the action with the SEC, each of the three defendants consented to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B). GE also agreed to disgorge $18,397,949 in wrongful profits, pay prejudgment interest and a civil penalty of $1 million. The settlement reflects the cooperation of the defendants according to the SEC.

57

FCPA• Grease payments

– Facilitation or grease payments are not bribes. Under the Act payment to an official to expedite the completion of what are otherwise ministerial duties is not a violation of the anti-bribery provisions.

– The question of grease payments was involved in In the matter of NATCO Group, In., Adm. Proc. File No. 3-13742 (filed Jan. 11, 2010); SEC v. NATCO Group, Inc., Civil Action No. 4:10-CV-98 (S.D. Tex. Filed Jan. 11, 2010).

• These cases focus on Huston based NATCO and its subsidiary TEST Automation & Controls which has an office in Kazakhstan. TEST won a contract in Kazakhstan.

• The subsidiary hired local Kazakh workers and expatriates. During an audit of TEST in 2007 Kazakh Immigration prosecutors claimed that the expatriate workers did not have proper documentation and threatened to impose fines and either jail or deport the workers if the company did not pay the fines.

• Accordingly, TEST reimbursed two payments but did not properly record them. In addition, a TEST consultant who did not have the proper license, but had close ties to the Ministry of Labor, requested cash to facilitate obtaining a visa. The consultant provided the company with bogus invoices for the necessary amount of money. Those invoices were necessary under local law to withdraw the sum from the bank. Later they were reimbursed by TEST despite knowledge of their true purpose.

• The company settled with the SEC, consenting to the entry of a cease and desist order based on FCPA books and records and internal control charges and the payment of a $65,000 penalty

58

FCPA• Gifts, travel and entertainment

– There is no guidance in the statute regarding gifts. In contrast, the 1988 amendments to Act added an affirmative defense for reasonable and bona fide expenditures for travel and lodging expenses directly related to promotions and demonstrations for products and the execution or performance of a contract.

– A criminal case brought last year centered on a gift of two snowmobiles. In U.S. v. Mercator Corp., (S.D.N.Y. Filed Aug 6, 2010) the defendant merchant bank pleaded guilty to one count of making corrupt payments in violation of the FCPA.

• The bank acted as an adviser to the government of Kazakhstan in connection with the sale of part of the oil and gas wealth of the country. It was dependent on the good will of three senior government officials. Those officials had the ability to influence whether Mercator obtained and retained lucrative business and would be paid. To maintain its lucrative contracts, in November 1999 Mercator purchased two snowmobiles and shipped them to Kazakhstan for deliver to one of the officials.

59

FCPA• Gifts, travel and entertainment (cont’d)

– SEC v. UTStarcom, Inc., Case No. CV-09-6094 (N.D. Cal. Filed Dec. 31, 2009) involved the payment of travel and entertainment expenses.

• Here the SEC claimed that the telecommunications company paid about $7 million for 225 foreign trips by employees of a Chinese state owned company. While the trips, made between 2002 and 2007, were to be for training, the Commission claimed that in fact they were largely entertainment.

• The complaint also alleged that there were expenditures for executive training programs in the U.S. and field trips to nearby tourist destinations. In addition, the company provided $10,000 in French wine and $13,000 in other entertainment expenditures to employees of a government owned telecommunications customer in Thailand. In Mongolia, $1.5 million was paid to an agent for a so-called “license fee” when in fact the actual fee was only $50,000 and the balance was used to make improper payments to a government official.

• To settle with the SEC the company consented to the entry of a permanent injunction prohibiting future violations of the anti-bribery, books and records and internal control provisions of the FCPA. The company also agreed to pay a $1.5 million penalty. The criminal investigation was resolved with an agreement to pay a $1.5 million criminal fine. DOJ noted that the resolution of the case reflected the cooperation and remedial efforts of the company including self-reporting.

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FCPA

• Individuals – A key focus of the new era of FCPA enforcement is a focus on

individuals. Perhaps the most significant indication of this focus is the nineteen indictments brought against twenty-one individuals in January 2010 from the largest FCPA sting operation in history. See, e.g., U.S. v. Goncalves, Case No. CR-09-335 (D.D.C. unsealed Dec. 19, 2009)(and related cases).

• The indictments center on a sting operation in which an undercover FBI agent, posing as a sales agent, met with executives of various companies in the defense supply business. The executives were told that the defense minister for an African country was prepared to spend $15 million to outfit the country’s presidential guard.

• The so-called agent then told the executives that a 20% “commission” was required. Half of the commission would go to the agent and half to the minister. To participate, the executive would then agree to create two price quotes for the equipment. One quote did not have the commission while the other included it. These cases are currently proceeding to trial.

61

FCPA

• Individuals (cont’d)– U.S. v. Warwick (E.D. Va.) is an action in which John Warwick pleaded guilty to

one count of conspiring to make payments in violation of the FCPA. • The case centered on efforts to secure a maritime contract from certain Panamanian government

officials for Ports Engineering Consultants Corporation. Mr. Warwick admitted that from 1997 through July 2003 he and others made corrupt payments of more than $200,000 to the former administrator and deputy administrator of the Panama maritime Authority and to a former high ranking elected official of the Panama government.

– SEC v. Elkin, Civil Action No. 1:10-cv-0061 (DD.C. Filed April 28, 2010) is a settled FCPA action against individuals formerly employed by Dimon, Inc. discussed above. The defendants are Bobby Elkin, Jr., former country manager for Kyrgystan, Baxter Myers, former Regional finance Director, Thomas Reynolds, former corporate controller and Tommy Williams, a former Senior vice President of Sales.

• Each defendant settled the action by consenting to the entry of a permanent injunction prohibiting future violations of the anti-bribery and books and records and internal control provisions of the Exchange Act. Defendants Myers and Reynolds also agreed to pay civil penalties of $40,000 each. See also U.S. v. Elkin, Case No. 4;10 CR 00015 (W.D. Va. Filed Aug. 3, 2010)(Mr. Elkin pleaded guilty to a one count information alleging conspiracy to violate the FCPA).

62

FCPA• Individuals (cont’d)

– SEC v. Summers, Civil Action No. 4:10-cv-02286 (S.D. Tex. filed Aug. 5, 2010) is a settled FCPA action against Joe Summers, the former country manager for Venezuela for Pride International. From 2003 through 2005 Mr. Summers, according to the complaint, authorized the payment of $384,000 to third parties with the understanding the money was going to state officials to help obtain three oil drilling contracts. Mr. Summers settled the action by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 30A and 13(b)(5). He also agreed to pay a civil penalty of $25,000. See also Lit. Rel. 21617.

– SEC v. Turner, Civil Action No. 1:10-cv-01309 (D.D.C. Filed Aug. 5, 2010) is a settled FCPA action against two former Innospec, Inc. executives, David Turner and Ousama Naaman. The action centers on payments initially made under the U.N. Oil For Food Program which continued after it ended. Corrupt payments were made in connection with the sale of the chemical Tetra. Between 2000 and 2008 about $6.3 million in bribes were paid while another $2.8 million were promised to secure about $176 million in contracts. The case was settled with the consent by each defendant to the entry of a permanent injunction prohibiting future violations of the anti-bribery and books and records and internal control provisions of the FCPA. In addition, Mr. Naaman agreed to disgorge over $810,000 and pay prejudgment interest along with a penalty of $438,000 which will be satisfied by payment of a criminal fine in a related action previously brought by DOJ. See also Lit. Rel. 21615 (Aug. 5, 2010).

– The focus on individuals also means that more cases are going to trial. In 2009 for example, three criminal FCPA cases were tried to verdict. DOJ prevailed in all three cases. Currently thirty-five individuals are awaiting trial on FCPA charges. Overall, the New Era of FCPA enforcement is reflected in the increasing cost of corporate settlements, increasing prosecutions against individuals and the increasing number of FCPA cases going to trial.

63

FINANCIAL FRAUD

• Financial fraud has long been a staple of SEC enforcement. While the Commission continues to concentrate enforcement resources in this area there are indications of an altered focus. In part that may stem from the market crisis from which some of these cases were developed. In part it may be a product of the overall enforcement environment.

• To examine these trends three points will be considered: 1) The line between civil and criminal cases; 2) the liability of directors and officers; and 3) selected financial fraud cases.

64

FINANCIAL FRAUD

• The line between criminal and civil cases– As in other areas under the federal securities laws, the division between

criminal and civil violations of the law is supposed to be governed by the willfulness standard written into the statutes by congress when they were first passed. In practice the line has all but vanished in the view of many commentators. Court decisions defining criminal “willful” to include “willful blindness” and “conscious avoidance” and civil “scienter’ to encompass “reckless disregard” blur the division to the point of being virtually a distinction without a difference as discussed in an earlier part of this series.

– In the context of these court decisions the dividing line between criminal and civil financial fraud becomes a function of prosecutorial discretion. This is typically measures in terms of the egregiousness of the underlying conduct. For example, the collapse of mortgage lender Taylor, Bean & Whitaker and bullet proof vest manufacturer DHB Industries, Inc. resulted in SEC enforcement actions as well as criminal prosecutions against former offers of each company. By virtually any definition the conduct in each case was egregious.

65

FINANCIAL FRAUD

• Line between criminal and civil (cont’d)– SEC v. Farkas, Civil Action No. 1:10 cv 667 (E.D. Va. Filed June 16,

2010); U.S. v. Farkas, 10-cr-00206 (E.D. Va. Filed June 16, 2010)• The criminal charges against Lee Farkas center on the collapse of the company

he founded and ran, Taylor Bean, and its affiliate, the Colonial Bank. • The sixteen count indictment alleges a $1.9 billion scheme which contributed to

the collapse of both companies and involved an attempt to defraud the Troubled Asset Relief Program.

• In one part of the fraudulent scheme Mr. Farkas is alleged to have shuffled money between Taylor Bean and the lender to conceal huge cash shortages.

• Another facet of the scheme involved the alleged misappropriation of hundreds of millions of dollars from a related loan facility and misrepresentations to the government in an effort to secure TARP funds.

• Mr. Farkas was recently convicted. Six others previously employed at the company or bank have pleaded guilty. The SEC’s case is pending.

66

FINANCIAL FRAUD

• The line between criminal and civil (cont’d)– SEC v. DBH Industries, Inc., Civil Action No. 0:11-cv-60431 (S.D.

Fla. Filed Feb. 28, 2011); SEC v. Brooks, Civil Action No. 07-61526 (S.D. Fla. Filed Oct 25, 2007); SEC v. Schlegel & Hatfield, Civil Action No. 06-61251 (S.D. Fla. Filed Aug. 17, 2006); U.S. v. Brooks (E.D.N.Y).

• The conduct underlying the collapse of DHB Industries, and which is at the center of the SEC’s actions as well as the criminal prosecutions, is similar in character.

• In those cases former company CEO David Brooks and his lieutenants have been charged with essentially looting the company and using millions of dollars for their personal benefit.

• Mr. Brooks, along with former COO Sandra Hatfield have been convicted of criminal securities charges following a jury trial. The SEC’s action is pending.

67

FINANCIAL FRAUD

• The line between criminal and civil (cont’d)– See also SEC v. Collins, Case No. 07 cv 11343 (S.D.N.Y. Filed

Dec. 18, 2007) (financial fraud action settled following criminal conviction of the former Mayer Brown attorney who participated in accounting fraud which lead to the financial collapse of Refco).

– SEC v. General Re Corporation, Case No. 10 CV 458 (S.D.N.Y. Filed Jan. 20, 2010) (settled financial fraud action which is one of a series of civil and criminal cases based on two fraudulent financial schemes).

– Cf. SEC v. Styam Computer Services Ltd., Case No. 1:11-cv-00672 (D.D.C. filed April 5, 2011) (settled financial fraud action which alleged that a group of officers fabricated documents to falsify revenues over a period of years; a parallel criminal case is pending in India where the company is based).

68

FINANCIAL FRAUD

• The line between criminal and civil (cont’d)– The Commission’s civil financial fraud actions are also typically based on allegations of intentional wrong

doing.

– SEC v. Diebold, Inc. Civil Action No. 1:10-CV 00908 (D.D.C. Filed June 2, 2010) is a settled financial fraud action which alleged that over a five year period the manufacturer of automated teller machines improperly inflated revenue on certain transactions by recognizing revenue on lease transactions that were subject to buy back agreements, contrary to GAAP. The company is also alleged to have manipulated its reserved and improperly capitalized expenses. As a result Diebold was required to restate its financial statements. The complaint alleged violations of the antifraud and books and records provisions. The settlement was based on a consent to an injunction based on those provisions and the payment of a civil penalty.

– SEC v. Gupta, Civil Action No. 8:10-cv-00100 (D. Neb. Filed March 15, 2010). is one of a series of financial fraud actions centered on alleged violations of the antifraud, proxy and reporting provisions by Vinod Gupta, the founder, and former chairman of infoUSA Inc. The case focused on claims that over a four year period Mr. Gupta received about $9.5 million in unauthorized and undisclosed compensation. In addition the company, and another Mr. Gupta controlled, engaged in millions of dollars of undisclosed related party transactions. The case was settled with a consent to the entry of a permanent injunction prohibiting future violations of the antifraud, proxy and reporting provisions along with the payment of disgorgement and a civil penalty.

– While neither Diebold nor Gupta involves the kind of misconduct in the Taylor Bean or DBH Industries cases, both center on years long intentional misconduct. The difference is one of degree.

69

FINANCIAL FRAUD

• The line between criminal and civil (cont’d)– In some instances what appears to be blatant financial fraud turns out to be

much less. This is precisely what happened in SEC v. Collins & Aikman, Civil Action No. 07-CV-2419 (S.D.N.Y. Filed Mar. 27, 2007).

• There the SEC brought a financial fraud action against former OMB director and former CEO and Chairman of the company David Stockman as well as the company and other senior officials and board members. At the same time criminal charges were brought against Mr. Stockman.

• All of the claims centered on a claimed financial fraud which supposedly involved multiple fraudulent schemes. In January 2009 the U.S. Attorney voluntarily dismissed its case.

• The SEC however continued to litigate its action for over a year before dropping all of the intentional fraud claims against and settling for negligence based injunctions under Securities Act Sections 17(a)(2) & (3).

• While Mr. Stockman did agree to pay disgorgement, prejudgment interest and a civil penalty most of the sum was offset by payments made to settle parallel class actions. If the settlement is little more than a face saving effort by the agency, as it appears, it raises significant questions about prosecutorial discretion.

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FINANCIAL FRAUD

• Officers and directors– Financial fraud actions are typically brought against the company and in many

instances the officers alleged to have been involved. Comparatively few actions are brought against individuals for their role as a corporate director.

– SEC v. Krantz, Civil Action No. 0:11-cv-60432 (S.D. Fla. Filed Feb. 28, 2011) is however an action brought against the outside directors of DBH Industries, Inc.

• The complaint is based on what is claimed to be egregious conduct. Although each defendant was an outside director, the SEC claims that the independence of each was compromised by their personal relationships to the now convicted former CEO of the company, David Brooks.

• The complaint goes on to detail a series of blatant red flags presented to the board regarding the looting of the company by Mr. Brooks. These included concerns expressed by the auditors, a material weakness letter, and other indications of the fraud. In each instance the directors failed to take any meaningful action according to the complaint. The complaint alleges violations of the antifraud and reporting provisions of the federal securities laws.

• The case is in litigation.

71

FINANCIAL FRAUD

• Officers and directors (cont’d)– More typical is the complaint in SEC v. Conaway, Case No. 05 cv 40263

(E.D. Mich. Filed Aug. 23, 2005) which is a financial fraud action against the former CEO of Kmart Corporation in which the SEC obtained certain ancillary relief last year after prevailing at trial in 2009.

• The civil fraud clams against Mr. Conaway centered on a scheme to cover up deteriorating financial conditions at the company which stemmed in part from a massive inventory overbuy paid for on credit. At the time the company was suffering from liquidity problems.

• Despite the scheme, which included effectively borrowing millions of dollars from vendors by initiating a program of delayed payments and false statements in SEC filings about the liquidity of the company, Kmart eventually collapsed in bankruptcy.

• A jury found the defendant liable for violations of Exchange Act Sections 10(b) among other things. See also SEC v. Morrice, Civil Action No. CV 09-01426 (C.D. Cal. Filed Dec. 7, 2009) (fraud action against the former senior officers of subprime lender New Century Financial settled in February 2011 in part by consents to injunctions based on the antifraud provisions as discussed earlier in this series).

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FINANCIAL FRAUD • Officers and directors

– In other financial fraud actions the complaint alleges what is, or at least appears to be, intentional conduct. The resolution of the case however is based on negligence rather than scienter based fraud injunctions.

– SEC v. Dell, Inc. Civil Action No 1;10 cv 01245 (D.D.C. Filed July 22, 1010) is an action against the company and its founder, Chairman and CEO Michael Dell

• The company l had picture perfect results for years, according to the complaint, meeting street expectations quarter after quarter and year after year. The company told investors and the markets this came from superior products and management. In fact from 2003 through 2007 a large portion of the company’s revenues came not from what the markets were told but from what they were not told – payments from chip maker Intel not to use the product of a competitor

• Likewise, when the payments were curtailed in 2007 investors were told that the sharp drop in income resulted from other causes, not a cut in Intel payments

• To resolve this case the company, Mr. Dell and other officers consented to the entry of a permanent injunction based in part on negligent fraud under Securities Act Section 17(a)(2)&(3). Penalties were of course paid and those who were accountants were suspended from practice before the Commission. See also SEV v. Imhoff, Case No. 1:10 – cv -01464 (D.D.C. Filed Aug. 2, 2010)(settled financial fraud actions against additional two additional Dell officers on similar terms).

– See also SEC v. Abernathy, Civil Action No. CV 11-01308 (C.D. Cal. Filed Feb. Filed Feb. 11, 2011) (financial fraud action settled based on negligent fraud where action arose out of failure of lender IndyMac; the action was against the former CFO who failed to update boiler plate disclosures about loan portfolio to show serious loan origination difficulties as market crisis unfolded); but see SEC v. Perry, Case No. CV 11-01309 (C.D. Cal. Filed Feb. 11, 2011) (scienter based fraud action against two other IndyMac officers which is in litigation).

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FINANCIAL FRAUD

• Officers and directors – SEC v. Citigroup Inc. Civil Action No. 1:10-cv-01277 (D.D.C. July 29, 2010);

In the Matter of Gary L. Crittenden, Adm. Proc. File No. 3-13985 (Filed July 29, 2010).

• These actions center on a claim that the bank misrepresented its exposure to the sub-prime market as the market crisis was unfolding. Citi told investors that its exposure was about $13 billion when in fact it was about $56 billion.

• The bank failed to disclosure two groups of sub-prime loans valued at $43 billion. Repeated false disclosures were made despite the fact that the two officers named in the administrative proceeding were repeatedly informed about the true facts.

• All of the settlements were based on Securities Act Sections 17(a)(2) & (3) . The settlements included penalties.

• When presented with the settlement papers in Citigroup, the court initially refused to execute the consent decrees.

• Following a hearing the Judge ultimately, but reluctantly, deferred to the Commission. It was perhaps the mismatch between the allegations of what appeared to be intentional misconduct with the resolution of the actions that triggered the court’s reluctance.

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FINANCIAL FRAUD• Other selected cases: Related part transactions

– SEC v. Escala Group, Inc., Case No. 09 CV 2646 (S.D.N.Y. March 23, 2009) is a settled action against the former chairman of Escala, an international company in the collectables business. The case centered on a series of related party transactions made by defendant Gregory Manning. Those transactions were disclosed as being at arms length and were used to improperly boost the value of the company just before a merger. Mr. Manning settled by consenting to an injunction based on the Exchange Act antifraud and books and records and internal control provisions and an officer director bar for ten years. He also agreed to pay disgorgement, prejudgment interest and a penalty.

– SEC v. Priddy, Civil Action No. 1:10-cv-00739 (D.Md. filed Mar. 25, 2010) is a settled action against Richard Priddy, the former CEO and President of TVI Corporation, Charles Sample, the former EVP of the company and their personal accountant J. Michael Broullire. The case alleged that Messrs. Priddy and Sample sold product to the company through undisclosed related party transactions which netted them significant profits. In another facet of the fraud Mr. Priddy increased the compensation of Mr. Sample which was then paid back to him in undisclosed kickbacks. Messrs. Priddy and Sample settled, consenting to the entry of permanent injunctions prohibiting future violations of Exchange Act Sections 10(b) and 14(a) and from aiding and abetting violations of Section 13(a). Mr. Brullire consented to the entry of a similar injunction based only on Sections 10(b) and 13(a). A related criminal case is pending.

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FINANCIAL FRAUD

• Other selected cases: Revenue recognition– SEC v. International Commercial Television, Inc., Case No. 3:10-cv-05555 (W.D. Wash.

Filed Aug. 9, 2010) is a settled action against the company centered on premature revenue recognition. International Commercial Television is alleged to have recognized revenue on sales of its primary product made through Home shopping Network prior to the actual sale. It also carried receivables on its books from the claimed sale of product prior to the actual sale and improperly recognized revenue on sales with a right of return. The company settled, consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Sections 13(a), 13(b)(2)(A) and 13(b)(2)(B). See also SEC v. Redekopp, Case No. 3:10-cv-05557 (W.D. Wash. Filed Aug. 9, 2010) (pending action against the former CFO of the company); In the Matter of Dohan + Company CPAs, Adm. Proc File No. 3-13997 (Aug. 9,2010)(pending proceeding against outside auditors, founding partner, engagement partner and audit manager).

– SEC v. Lapine, Case No. 10 Civ. 1842 (N.D. Ca. Filed Sept. 27, 2001) is a settled action against Jay Lapine, former General Counsel to HBOC and, after its merger with McKesson to the HBOC division of McKesson HBOC. The complaint claimed that after learning the company was improperly falsifying its books by inflating revenue he participated in the scheme rather than halting it. The case was settled with the consent to the entry of a permanent injunction based on the antifraud and reporting provisions, a five year officer/director bar and the payment of a $60,000 fine.

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FINANCIAL FRAUD

• Other selected cases: Clawback – The SEC has brought actions under the clawback provision of

the Sarbanes-Oxley Act against officers who fail to repay certain incentive compensation when there is a restatement of the company financial statements. SEC v. Jenkins, Case No. CV 09-01510 (D. Ariz. Filed July 22, 2009); SEC v. O’Del, Civil Action No 1:10-CV-00909 (D.D.C. Filed June 2, 2010).

– Section 304 applies regardless of whether the executive was involved in the underlying conduct according to the Commission. That view has been upheld by the Second Circuit. Cohen v. Viray, Case No. 3860-cv (2nd Cir. Sept. 30, 2010).

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ANALYSIS & CONCLUSIONS

• In the wake of the market crisis and huge scandals SEC Enforcement has reorganized and streamlined its operations to become more aggressive

• At the same time the SEC now has new and enhanced authority

• There is also an increasingly close working arrangement with DOJ and other regulators

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ANALYSIS AND CONCLUSIONS

• While enforcement is taking aggressive positions, its track record in court is at best mixed

• Similarly despite expending significant resources on market crisis investigations the results are at best modest

• In insider trading however the SEC is being very aggressive and in some cases appears to be redefining what is insider trading

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ANALYSIS AND CONCLUSIONS

• In FCPA cases the SEC is working closely with DOJ and continues to be aggressive

• Financial fraud actions have been a traditional focus for the SEC. Here the agency appears to be creating a new kind of “failure to monitor” claim. The SEC can also be expected to become more aggressive in this area through the task force