Cady Bar the Door | SEC Enforcement Defense Attorney

SEC Going after Lawyers

By David Smyth on May 16th, 2012 Posted in Microcap Fraud

Over the last year, SEC Enforcement Director Rob Khuzami has made no secret of his disdain for defense counsel who engage in “questionable tactics” to gain advantage for their clients involved in SEC investigations. He made a speech last June in which he cited a number of examples of those tactics. They included:

Multiple representations of witnesses with what appear to be adverse interests;
Multiple witnesses represented by the same counsel who all adopt the same implausible explanation of events;
Witnesses who answer “I don’t recall” dozens and dozens of times in testimony, sometimes hundreds of times, including in response to questions about basic and uncontroverted facts documented in their own writings;
Counsel signaling to clients during testimony; and
Questionable tactics in document productions and internal investigations.

He also noted one hilarious episode in which a witness in investigative testimony – looking for a toe-tapping signal his lawyer had been warned against during a break – “extended [his foot] so far [under the table] that he was almost doing a split.”

The Wall Street Journal picked up the tune in an article on May 1, highlighting comments by the SEC’s Structured and New Products Unit chief Ken Lench, who said he had seen “some factual situations where [he] seriously question[ed] whether the advice that was given was done in good faith.”

Though the conduct is different from that described in Khuzami’s speech, the SEC quickly made good on its word, and sued three attorneys at the end of April and start of this month. All of the cases were filed in federal courts in Florida, and all three involved issuing shares of microcap companies’ stock. These sorts of cases have been mainstays in the SEC’s Enforcement Division for a long time, but they have typically named only the issuers and their officers as defendants. These three recent cases are different. In all three, the companies purported to convert their debt into “free trading” stock held by the companies’ affiliates. To accomplish this conversion, the companies’ transfer agents required legal opinion letters from attorneys attesting to the propriety of issuing share certificates without restrictive legends. (Many microcap, or penny stock, companies do not record shares electronically and actually still use share certificates.) The SEC alleges that the opinion letters written in these cases had no legal basis, and has charged the attorneys themselves with violating Section 5 of the Securities Act. Briefly, Section 5 prohibits using interstate commerce to sell a security unless a registration statement or exemption covering it is in effect.

It is a fairly bold position to take, though it’s not like the SEC has never considered the possibility before. In 2008, it settled charges with attorney Ken Christison for being a cause of a number of Section 5 violations for writing just the sort of legal opinion letters that are at issue in the current cases. In the new cases, though, the attorneys are being charged with direct violations of Section 5, and in one of the cases with an additional count of aiding and abetting Section 5 violations. It is an interesting way to get at gatekeepers who are ethically obliged to give good-faith advice about the law. Without their legal opinion letters, many of the shares in these tiny companies will never be issued. I wonder, though, if the staff filing the two cases alleging only direct violations will regret not including an aiding-and-abetting count as well. If the attorneys themselves did not own the securities, could they sell them? We might soon learn the answer if the defendants move to dismiss on that basis.

SEC and DOJ Issue First FCPA Declination Opinions

By David Smyth on May 9th, 2012 Posted in FCPA

Some in the FCPA commentariat have long said that the Justice Department and SEC should publicly issue declination opinions when the agencies decide not to pursue a matter. We already see the factual scenarios that lead those agencies to file charges, in the form of the complaints and indictments themselves. Many have argued that declination opinions would be a very useful window into the factual scenarios that do not rise to that level.

They won’t call it this officially, but on April 25^th, the SEC and DOJ sort of issued their first FCPA declination opinions. The opinions came in the form of a case where former Morgan Stanley managing director Garth Peterson was charged with FCPA violations and investment adviser fraud, but Morgan Stanley itself conspicuously escaped sanction.

Facts of the Garth Peterson Matter

As a Morgan Stanley managing director and the head of the bank’s Shanghai office, Peterson’s job was to evaluate, negotiate, acquire, manage, and sell real estate investments on behalf of Morgan Stanley’s advisers and funds. As such, he owed a fiduciary duty to Morgan Stanley and to the funds’ clients. By the time he was terminated in 2008, he had worked on at least 28 deals in China. Many of those deals involved Yongye Enterprise (Group) Co. Ltd., a real estate development arm of the Luwan District Government in Shanghai. Peterson’s misrepresentations about some of those deals form the core of the SEC’s complaint.

Investment Adviser Fraud Violations

In one such deal, called Project Cavity, a Morgan Stanley real estate fund known as MSREF IV bought one tower of a two-tower apartment building in Shanghai. As Peterson negotiated Project Cavity, he secretly planned, along with Yongye’s chairman and a Canadian attorney, to buy an interest from MSREF IV after that fund bought the tower. The three used a British Virgin Islands entity called Asiasphere Holdings to purchase and hold their interest in the tower. And because of his relationship with the Yongye chairman, Peterson was able to negotiate both sides of the transaction, in breach of the fiduciary duty he owed to MSREF IV. Peterson repeatedly misled Morgan Stanley about his and Asiasphere’s interests in the tower. He told his superiors that Asiasphere was in fact a Yongye subsidiary, not a separate entity owned by Yongye’s chairman and Peterson himself. “Just to be clear,” he said in an email to several Morgan Stanley employees, “[the Yongye chairman] will not ‘acquire another 4.5% of shares’ from [Morgan Stanley]. It’s Yong Ye. . . .”

FCPA Violations

In another deal, Morgan Stanley negotiated at least five separate Chinese real estate investments involving Yongye and its chairman. To incentivize the chairman to help Morgan Stanley win this business, Peterson invited him to invest personally with the bank and its funds in these five pending investments at a discount. Specifically, he gave the chairman a “3-2-1” deal. Under its terms, Morgan Stanley would sell the Yongye chairman a 3% interest in each deal he brought to Morgan Stanley for the cost of 2%, allowing him to keep the remaining 1% as a “finder’s fee.” Peterson also promised to pay an added return on any completed purchase he called a “promote,” to incentivize the official to help make any acquired investments profitable. Peterson told supervisors about the 3-2-1 arrangement in April 2006. But before the Yongye chair had been paid anything, a Morgan Stanley compliance officer warned him of the bribery implications of paying the official personally for help obtaining business. One of Peterson’s supervisors then told him to abandon the 3-2-1 deal entirely. He didn’t.

Law Enforcement’s View of Morgan Stanley

Morgan Stanley voluntarily reported these violations after they came to its attention, and the government, it seems, could not have been happier. The SEC devoted almost two pages of its complaint to describing Morgan Stanley’s extensive FCPA compliance program and internal controls. In it we learn that Peterson received training on anti-corruption policies seven times between 2002 and 2008. He was reminded 35 times about those policies, and had written materials in his office to back up those reminders. For its part, the Justice Department included an entire paragraph in its press release to Morgan Stanley’s compliance efforts. It notes, among other things, that the bank’s compliance personnel regularly monitored transactions, randomly audited particular employees, transactions, and business units, and tested to identify illicit payments.

The quotes from the various law enforcement personnel are also telling for the degree to which they shower praise on Morgan Stanley and blame on Peterson:

Criminal Division Chief Lanny Breuer: “As a managing director for Morgan Stanley, he had an obligation to adhere to the company’s internal controls; instead, he lied and cheated his way to personal profit.”
U.S. Attorney for the E.D.N.Y. Loretta Lynch: “This defendant used a web of deceit to thwart Morgan Stanley’s efforts to maintain adequate controls designed to prevent corruption. Despite years of training, he circumvented those controls for personal enrichment.”
SEC Enforcement Director Rob Khuzami: “This case illustrates the SEC’s commitment to holding individuals accountable for FCPA violations, particularly employees who intentionally circumvent their company’s internal controls.”
SEC FCPA Unit Chief Kara Brockmeyer: “As a rogue employee who took advantage of his firm and its investment advisory clients, Peterson orchestrated a scheme to illegally win business while lining his own pockets and those of an influential Chinese official.”

If these officials are speaking code, it’s pretty easy to crack. They are saying about as plainly as they can that if a company does what it can to prevent FCPA violations from taking place, an employee who ignores those internal controls and lies about his actions will not render the compliance efforts a nullity.

Declination Opinions in the Future?

This does not have to be a one-off event. Occasionally companies walk in the door of the SEC and the Justice Department to report FCPA violations that are not enough to merit prosecution. Believe it or not, it happens. Neither agency has felt comfortable enough to issue opinions describing the facts and why filed charges were not merited. There are legitimate reasons not to. The SEC and DOJ would not want corporations to infer a “floor” below which law enforcement would not deign to prosecute. If companies pay foreign government officials to obtain business, at whatever level, the government would generally like them to fear being punished for doing that. Companies who do escape charges also would want to avoid any public record that could lead to their identification and the private lawsuits that could follow. It is also no small matter for the enforcement staff to change procedures in a way to allow for public declination opinions. The bureaucratic issues involved in doing that are quite difficult, involve memos and meetings and persuasion on top of whatever one’s day job entails.

Still, it can be done. The Justice Department already has an opinion release procedure – not so different from SEC no-action letters – by which companies can seek assurance that their business plans will not trigger an FCPA charge. The program is not hugely prolific; it typically results in two or three opinions each year. But it does add to the mosaic of information available to companies as they plan their global business activities. Declination opinions by both agencies could do the same thing, and could give concrete examples of voluntary self-reports leading to good results – at a time when some question the value of self-reporting at all. Too much money is at stake in the form of penalties, internal investigation expenses, and other costs to ignore this option. The Morgan Stanley matter may indicate the SEC and DOJ could be going in that direction.

Khuzami Touts SEC’s Focus on Compliance

By David Smyth on May 3rd, 2012 Posted in Compliance, Insider Trading, Investment Advisers, Non-scienter-based Violations

The SEC’s Enforcement Director, Rob Khuzami, gave an interview to Thomson Reuters last week that you should read. These things are always edited, so it’s hard to know in what order he spoke, but as it is written he gets the interview off to an interesting start. He does not crow about any particularly “big” cases, though there have been a number in his tenure as director. See here, here, and here, for example. What he does is talk up a genre of cases where the SEC has gone after registered entities for securities compliance issues.

We have charged firms for having compliance failures even where there were no underlying violations. We want to send a message that businesses have to have controls in place in order to prevent fraud. Preventing wrongdoing in the first place is much better than after-the-fact enforcement, which more often than not is not going to fully compensate investors for the harm they have suffered.

I think this is fairly significant. The SEC has a lot of front-line investigative staff, and it’s hard to stand out in the crowd. One way to get noticed is to lead the charge on some of the larger cases like the ones I noted above. But there aren’t so many of those. Most of the cases the SEC brings don’t have the same PR impact that those do.

Still, the compliance-based cases the SEC has done in the last year are quite meaningful in their own way. They require real expertise to get into the weeds of statutes that aren’t as frequently handled by the Enforcement Division. These cases also have the potential to get out in front of smaller problems before they become bigger ones. In the last year, the SEC has brought cases addressing the safe handling of nonpublic information at investment advisers (Buckingham Capital) and broker-dealers (Janney Montgomery Scott), investment adviser supervision (at AXA Advisors), and trading huddles at Goldman Sachs. If these cases prevent larger issues down the road, they will be well worth the effort.

To have Khuzami talking up these cases publicly is a signal to the SEC staff, and real encouragement to pursue them more vigorously. We might be seeing more in the future.

Friday Weekly Roundup

By David Smyth on April 27th, 2012 Posted in Uncategorized

Taking it from the top:

Last Friday, the SEC sued two twin brothers from the U.K. with creating and promoting a fake “stock picking robot” that purportedly identified penny stocks set to double in price. “Instead, the brothers were merely touting stocks they were being paid separately to promote,” the SEC said in a press release. Clusterstock probably had the funniest headline about the case. Actually, that honor may go to Dealbreaker.
On Monday, the SEC continued its growing line of pay-to-play cases involving public pension funds when it charged the former CEO of CalPERS and his close personal friend with scheming to defraud an investment firm into paying $20 million in fees to the friend’s placement agent firms. Interestingly, the case was brought by the Los Angeles Regional Office, and does not appear to have involved the SEC’s Municipal Securities and Public Pensions Unit.
Monday also brought a case against SinoTech Energy, a China-based oil field services company and two of its senior officers for a scheme mislead investors about the value of its assets and its use of $120 million in IPO proceeds. The SEC also charged the company’s chairman for a separate $40 million theft from the company.
Wednesday saw a significant FCPA and investment adviser fraud case against a former Morgan Stanley executive, who settled the matter. The executive, Garth Peterson, also pled guilty to criminal charges in the Eastern District of New York. It seems like we can hardly have an FCPA case these days without it being part of some sort of “sweep”, and this one appears to be part of the government’s sweep of the financial services industry. More cases like it may be coming down the pike.
In other FCPA news, the internet almost blew up this week after Saturday’s publication of a New York Times story about Wal-Mart’s FCPA issues in Mexico. This story will be evolving for a long time to come, and may derail efforts to amend the statute, at least in the near term.

Happy April 27th!

Friday Weekly Roundup

By David Smyth on April 20th, 2012 Posted in SEC Litigation

I’d like to try a weekly post with short bits recapping what I think are the most interesting stories or cases from the past week. We’ll see how it works, but for this week:

Matt Solomon, an AUSA in the District of Columbia, was recently named Deputy Chief Litigation Counsel in the SEC’s trial unit. Solomon appears not to have done much securities work, but does have a lot of trial experience in fraud, money laundering, and bribery matters, which will put him in good stead for his new job. Chief Litigation Counsel Matt Martens has been shouldering the leadership role in the trial unit alone since Mark Adler left for the PCAOB in December 2010, so I imagine he welcomes the help.
Short-selling Australian hedge fund manager John Hempton makes interesting points about discovering fraud and why it is against his own interests to tip the SEC and other regulators to the subjects of his trades. Briefly, he doesn’t want to tip regulators to frauds in the making because (1) he can profit from them if they are allowed to go on until his short positions are covered, and (2) he does not want to alert the SEC to odd but honest activity in the small number of cases where he’s wrong about the fraud. The piece is actually pretty complimentary about the recent work of Mary Schapiro’s SEC.
Where are the Congressional hearings on the SEC’s neither-admit-nor-deny policy? Some in Congress made a lot of noise about this last December. Have they lost steam and moved on to other things?
On Monday, the SEC charged an online brokerage and a clearing agency specializing in options and futures with participating in an abusive naked short selling scheme. Here is how short selling works, as John Hempton explained to his son in the piece linked above: “I borrow a share from a broker. I sell it in the market. If the stock goes down I get to buy it back for less than I sold it. I repay the loan by returning the share and I keep the profit. I explained it does not work so well when the stock goes up.” All of this is perfectly legal, but to be so, Regulation SHO requires the trader has to do two things: (1) locate actual shares to borrow, and (2) deliver the borrowed shares to the counterparty three days after the trade is completed (aka T + 3, in trading parlance). If no delivery is made by that time, the trader must purchase or borrow the securities to close out the failure-to-deliver position by no later than the beginning of regular trading hours on the next day (T+4). The Enforcement Division’s Market Abuse unit alleged that Chicago-based optionsXpress failed to satisfy its close-out obligations under Reg. SHO by repeatedly engaging in a series of sham “reset” transactions designed to give the illusion that the firm had purchased securities of like kind an quantity. According to the SEC, the firm and customer Jonathan I. Feldman engaged in these sham reset transactions in a number of securities, resulting in continuous failures to deliver. As we’ll see below, the SEC was not through with optionsXpress for the week.
Also on Monday, the Southern District of Florida entered a judgment enforcing an SEC administrative order suspending William J. Reilly, a New York attorney residing in Boca Raton, Florida, from appearing or practicing as an attorney before the SEC. In October 2009, Reilly was suspended for three years under Rule 102(e) of the Commission’s Rules of Practice for his participation in a penny stock scheme. In July 2011, though, a legal opinion letter authored by Reilly appeared as an exhibit in a registration statement on Form S-8. Someone at the SEC noticed, and the Enforcement Division sought to enforce the order in December 2011.
On Thursday, the SEC sued optionsXpress again in an administrative proceeding again, this time for continuing trading operations after delisting from the Chicago Board Options Exchange and deregistering from the SEC, apparently to avoid an audit, according to the SEC’s press release.
Finally, credit rating agency Egan-Jones announced that the SEC had voted to take enforcement action against it for allegedly material misstatements made in a regulatory application in 2008. The agency appears to be taking a combative stance toward the action. Because it is an administrative proceeding, any contested hearing will happen quickly. It will not drag on with much discovery like a case in federal court would.

That’s all for today. Have a good weekend.

SEC and N.C. Securities Division Join Forces on Alleged Ponzi Scheme

By David Smyth on April 18th, 2012 Posted in Broker-Dealers

As you probably know by now, Ponzi schemes, once rarely touched by the SEC’s Enforcement Division, have become fairly commonplace. It now appears that the SEC and the North Carolina Securities Division have teamed up in addressing one, or at least have taken parallel paths in doing so. In the SEC’s complaint, filed on April 12^th, Ephren Taylor and his City Capital Corporation are accused of running a scheme that targeted “socially conscious” investors from church congregations and raised $11 million. The North Carolina state regulators issued a final administrative cease-and-desist order against Taylor and City Capital Corp., among others, on March 29^th. The order, which was unchallenged, permanently enjoins the respondents from selling unregistered securities, acting as unregistered broker-dealers, and committing securities fraud.

The case is interesting to me for two reasons. First, the SEC doesn’t actually team up with state regulators on particular matters that often. Unlike with the situation with the Department of Justice, when the reasons for pursuing parallel civil and criminal actions will be more obvious, it is more likely for either the SEC or a state regulator to bring a civil case, and not both. Of course, it is impossible to tell how much the SEC and the N.C. Securities Division cooperated in this case, and perhaps they didn’t cooperate at all.

Second, the SEC’s matter has the usual securities fraud charges under Section 10(b) of the Exchange Act and Section 17(a) of the Securities Act. But the complaint also includes charges under Section 15(a) of the Exchange Act. That provision requires that anyone acting as a securities broker to be registered as such. Proving a violation of Section 15(a) does not require evidence of scienter or any intent to defraud at all. But once a defendant has been found to have acted as an unregistered securities broker, trouble follows if the defendant has also been charged with securities fraud. As Judge Rakoff said in SEC v. Platinum Inv. Corp., 2006 WL 2707319, at *3 (S.D.N.Y. 2006):

A broker . . . has a duty to investigate the truth of the representations he makes to clients, because, by virtue of his title, clients are entitled to presume that the representations made were the result of reasonable investigation. Hanly v. SEC, 415 F.2d 589, 596 (2d Cir.1969). Thus, when recommending specific securities, a broker has a duty to do some independent investigation and cannot rely solely on the materials submitted by the issuer or given to him by his employer. SEC v. Hasho, 784 F.Supp. 1059, 1107 (S.D.N.Y. 1992). The amount of independent investigation required varies with the circumstances, but the duty to investigate is greater whenever the legitimacy of an investment is in some way questionable. SEC v. Milan Capital Group, Inc., 2000 WL 1682761, at *5 (S.D.N.Y. Nov.9, 2000). Moreover, “[s]ecurities issued by smaller companies of recent origin obviously require more thorough investigation.” Hanly, 415 F.2d at 597. Where circumstances “raise enough questions,” “a person’s failure to investigate before recommending that investment [may be considered] reckless.” Milan Capital Group, 2000 WL 1682761, at *5 (citing various examples).

The effect is to take red flags about an investment that might not have reached the level of severe recklessness and to catapult any lingering concerns well past that threshold. Not only should those red flags have been worrisome, the defendant now is retrospectively saddled with a duty to have figured out what was going on. In this kind of Ponzi scheme case, the Section 15(a) charge thus has power that goes far beyond the technical-sounding, registration-based claim that lies on the surface. It can go a long way toward making the fraud charges much more likely to stick.

SEC’s Individual Cooperation Program Gets off the Ground

By David Smyth on April 15th, 2012 Posted in Accounting Fraud, Cooperation

At times, the SEC staff is confronted with investigations in which an individual seems likely to have quite a bit of information about the investigation’s core matters but little or no responsibility for any misconduct. Not so long ago, when trying to collect information from those people, the staff really had only one option: subpoena their testimony. While the staff might have wanted to explain that a particular witness had nothing to fear, that an investigation was quite unlikely to result in any liability, they had no authority to do so. What if new information came in – however remote the chances – and cast a new light on the witness’s conduct? In that case, the staff would be left holding the bag, and held responsible for any promises not to bring action against the witness. No Commission policy existed to protect the staff’s decision to hold back against certain witnesses, and gather information and cooperation with the promise of preferential treatment as compared to more culpable actors.

This, of course, was not the situation with criminal prosecutors. So when former AUSA Rob Khuzami joined the SEC in March 2009, one of his priorities was to establish a program that would allow just this sort of cooperation. Less than a year later, the Commission unveiled a policy statement outlining circumstances in which individuals could cooperate with SEC investigations and receive credit for their cooperation. The statement laid out four factors the SEC would consider in assessing how much credit should be given to cooperating individuals: (1) the assistance provided by the individual; (2) the importance of the underlying matter; (3) the societal interest in holding the individual accountable; and (4) the individual’s profile, including his or her history of lawfulness and acceptance of responsibility for any prior misconduct.

Unfortunately, the ensuing two years have not provided many opportunities for the program to be put into effect. But March brought two matters in which the SEC announced credit that had been granted to individuals in exchange for cooperating with investigations.

AXA Rosenberg

The first, announced on March 19^th, related to a settled enforcement action brought in February 2011 against AXA Rosenberg. In that matter, the SEC found that the Orinda, Calif.-based institutional money manager, specializing in quantitative investment strategies, concealed a material error in the computer code of the model it used to manage client assets. The error affected over 600 client portfolios and caused roughly $217 million in losses. Over a year later, the Enforcement Division announced credit given to a “senior executive” who had given substantial assistance to the staff’s investigation. Khuzami made a separate public statement to highlight the significance of the matter. Going through the four factors laid out in 2010, the SEC said:

The senior executive was the first to offer cooperation in the AXA Rosenberg matter, gave high-quality assistance, and did so without conditions. His help allowed the staff to conserve resources that would have been spent to dig up his information by other means;
This was the first enforcement action ever arising from errors in a quantitative investment model, and it fully addressed the harm caused by the misconduct. All losses were returned to investors, and a significant penalty was imposed in addition;
The executive had played a limited role in events surrounding concealment of the coding error, and he advocated that the CEO be informed of it. Interest in holding the executive accountable for any misconduct was therefore minimal; and
The executive had no disciplinary or regulatory history, and is no longer associated with any regulated entity. He is in fact retired from the investment advisory industry, and is not in a position to commit future violations of the securities laws.

This last factor has led some thoughtful lawyers at Gibson Dunn to suggest that the announcement may not mean very much. After all, in some ways this is the easy case to give credit. If the executive is retired anyway, what is the risk in letting him go without any charges? It is true that the Enforcement Division will not necessarily consider itself bound by these facts, but I think the publicity given to the matter is significant and offers at least a partial roadmap for how future cooperators might best position themselves for credit from the SEC.

United Commercial Bank / John Cinderey

The second case received far less hoopla, and was first publicly noticed by Bruce Carton at Securities Docket, as far as I can tell. It was part of a financial crisis-related accounting matter filed first in October 2011 against executives of San Francisco-based United Commercial Bank. On March 27, the SEC brought a settled action against John Cinderey, a former executive vice president who, acting at the direction of his superiors, misled the outside auditors evaluating financial statements of the bank. The complaint alleges that Cinderey altered memos prepared for the auditors and circumvented accounting controls and policies that required the bank to accurately assess the risks associated with loans. Cinderey agreed to settle the charges and accepted a permanent injunction against violating provisions of the securities laws regarding record-keeping, misleading outside auditors, and internal controls. He did not have to pay a civil penalty, partially in acknowledgement of a $40,000 penalty he paid in a related FDIC matter, but also because of “his substantial assistance in the investigation and the fact that he has entered into [a] cooperation agreement to assist in an ongoing related enforcement action.”

So the individual cooperation program is up and running. Companies facing SEC investigations should consider that the SEC now has two functioning programs designed to elicit information from individuals that might lead to enforcement actions. The whistleblower program is authorized to pay 10-30% of a judgment the SEC collects in an enforcement to informants who bring the staff original information leading to that judgment. Under the individual cooperation program, the SEC can avoid limit claims against an individual or avoid charges entirely if some liability might otherwise lie. People who qualify for one likely would not qualify for the other, but two angles for reporting information to the staff exist that did not two years ago. It’s almost enough for companies to beef up their compliance regimes and avoid having issues to report in the first place.

SEC Charges Thornburg Mortgage Executives with Financial Fraud

By David Smyth on March 30th, 2012 Posted in Accounting Fraud, Auditors, Financial Fraud, SEC Litigation

Perhaps the SEC, at least for the time being, is finding its groove with respect to financial fraud matters. For the second time in a two-month span, the Commission has brought a case for fraudulent disclosures regarding the health of a residential loan portfolio. In January, the SEC filed suit against Florida-based BankAtlantic and its CEO, discussed here. On March 13, the SEC charged three executives of Thornburg Mortgage Inc. – once the nation’s second largest independent mortgage company after Countrywide – with misrepresenting the company’s financial health in the wake of the recent credit crisis. Thornburg declared bankruptcy in 2009 and was not named as a defendant. But CEO Larry Goldstone, CFO Clarence Simmons, and chief accounting officer Jane Starrett were named. As always with litigated matters on Cady Bar the Door, the facts that follow come from the SEC’s complaint, have not been proven, and may not be true.

Background

As a real estate investment trust, Thornburg was unable to retain most of its earnings because it was required to pay them out as dividends. So, to finance its mortgage business, Thornburg needed constant access to financing, which included money borrowed from various lenders under reverse repurchase (or, “repo”) agreements. These repo agreements typically consisted of a sale of adjustable-rate mortgage (“ARM”) securities to a lender at an agreed price in return for Thornburg’s agreement to repurchase the same securities in the future at a higher price. The repo agreements required Thornburg to maintain a degree of liquidity and subjected the company to margin calls if the value of its securities serving as collateral fell below designated thresholds.

Trouble Hits in August 2007 and Doesn’t Let Up

In August 2007, Thornburg ran into some financial difficulty. Though the company received margin calls from its lenders in the normal course of its business due to fluctuations in the value of its ARM securities, that month the margin calls reached unprecedented levels. In response to roughly $2 billion in margin calls, Thornburg sold nearly $22 billion of its mortgage-backed securities at an estimated loss of $1.1 billion and decided to forego a common stock dividend for the third quarter. Margin call issues continued in the fourth quarter of 2007, and Thornburg paid approximately $360 million in margin calls in the last two months of the year.

Thornburg’s financial condition and liquidity worsened in January and February 2008 as a result of ongoing turmoil in the financial and mortgage markets. The company met about $650 million in newly issued margin calls from its lenders. As a result of its severely compromised liquidity, Thornbug was not in a position to timely meet the $300 million in margin calls it received in the last two weeks of February 2008, just before filing its 2007 10-K. The company was consequently in violation of its lending agreements with at least three lenders. Unwilling to disclose these late payments or the severity of the company’s liquidity crisis, Goldstone, Simmons, and Starrett scrambled to satisfy all outstanding margin calls before filing Thornburg’s 10-K at the end of February, according to the complaint. One of its strategies allegedly was to sell the interest-only portions of its securitized ARM loans (“I/O strip transactions”) to generate sufficient cash to meet its margin calls during the last week of February. These sales were significant because they further depleted Thornburg’s liquidity to meet margin calls and called into question the company’s ability to hold its ARM securities to maturity.

The company’s plan allegedly then became this: file the 10-K as early as possible on the morning of February 28, be able to say in that document that the company had “successfully” met all of its margin calls as of that moment, and hope for the best. It didn’t work out. The 10-K was filed at 4 a.m., and additional margin calls flooded in from Thornburg’s lenders two hours later. The company’s available liquidity was exhausted by 7:30 a.m. Two business days later, Thornburg filed an 8-K announcing that it had incurred an additional $270 million in margin calls, and that it did not have sufficient liquidity to satisfy the substantial majority of them. Another 8-K followed on March 5, disclosing that a lender issuing a notice of default was exercising its rights to the securities serving as collateral under its repo agreement due to Thornburg’s failure to meet its $28 million margin call. The company filed yet another 8-K on March 7, stating that it had incurred over $1.77 billion in margin calls since the first of the year, and that it did not have enough cash to cover $610 million of those. And Thornburg would also be restating its 2007 financials to recognize an impairment charge of $427 million in unrealized losses associated with its ARM securities.

Audit Issues

In connection with Thornburg’s 2007 year-end audit, the company was required to analyze whether it had the intent and ability to hold its ARM securities to maturity or until their value recovered in the market. If Thornburg truly planned to hold the securities to maturity, any losses associated with them were deemed to be temporary and only needed to be reflected on the company’s balance sheet. If Thornburg could not hold them to maturity, the losses were deemed to be other than temporary, and Statement of Financial Accounting Standards No. 115 required the losses to be reflected in the company’s income statement as well. This analysis is called an other-than-temporary impairment (or, OTTI) analysis.

The SEC charges that Thornburg’s executives failed to consider all of the critical information in connection with their OTTI analysis of the company’s ARM securities and misrepresented or concealed this from Thornburg’s outside auditor. When the outside audit manager specifically asked about any contractual breaches or noncompliance issues, the defendants failed to disclose Thornburg’s violation of its lending agreements. In sum, the executives knew, or were reckless in not knowing, that the losses associated with the company’s ARM securities were other than temporary, but told its outside auditor and public investors otherwise.

Claims

The SEC charged all of the defendants with (1) violations of Sections 10(b), 13(b)(2), and 13(b)(5) of the Exchange Act, (2) aiding and abetting Thornburg’s violations of Section 10(b) and 13(a) of the Exchange Act, and Rules 12b-20 and 13a-1 thereunder, (3) violations of Section 17(a) of the Securities Act, and (4) violations of Rule 13b2-2 under the Exchange Act. The complaint also charges Goldstone and Simmons with control person liability under Section 20(a) of the Exchange Act for Thornburg’s violations of Sections 10(b), 13(a), and 13(b)(2) of that Act.

Interesting Facets of the Case

A number of features about this case leap out at me. First, the 10-K as Thornburg filed it at 4:00 a.m. on February 28, 2008, was in large measure technically true. The company had met all of its margin calls. It appears that the defendants knew that disaster was right around the corner – and it was – but as of the filing of the 10-K, the statements about Thornburg having met its margin calls were true. In the press release, Don Hoerl of the SEC’s Denver Regional Office calls the 10-K “disingenuous” because it is hard to say flatly that it was false. To be fair, the complaint also alleges that the 10-K’s statement that Thornburg had not sold any assets to meet margin calls was not true without further statements making the I/O strip transactions clear.

Second, any misrepresentations in the 10-K were essentially corrected by March 7, 2008, the date of the last of the follow-on 8-Ks. That is an extremely compressed time period, much more so than the two quarters of alleged misstatements in the recent BankAtlantic case. But misrepresentations are misrepresentations, and the SEC is not tolerating them here.

Finally, the SEC has likely charged the Goldstone and Simmons alternatively as control persons because of lingering concerns from last summer’s Janus Capital Group decision from the Supreme Court. Rather than worry about amending the complaint if the district court ultimately decides that those two did not “make” the statements attributable to the company in the 10-K, the Commission has gone ahead and foreclosed the possibility of dismissal on that basis by naming them as control persons. It is probably a smart move. Again, the facts of this case have not yet been proven, and may not be true, but it will be interesting to see what happens as it progresses.

SEC Files Rare Subpoena Enforcement Action against Wells Fargo

By David Smyth on March 24th, 2012 Posted in SEC Litigation, Structured and New Products

Though it hardly seems this way from the outside, the SEC’s enforcement staff is in a somewhat difficult position in its investigations. The staff issues voluntary requests or administrative subpoenas to entities with potentially responsive documents, and then it waits. If a company doesn’t respond quickly, or at all, what is the SEC going to do? Sue? Remember that in the investigative stage no judge is in place to hear a motion to compel, as there would be with a publicly filed action in federal court.

But, yes, maybe the SEC will sue. If the circumstances are extreme enough, the SEC will file a subpoena enforcement action to seek to compel production of documents sought in the subpoena. As it did yesterday in this matter against Wells Fargo in the Northern District of California. The facts that follow assume that the facts in the SEC’s application are true, though they may not be.

Underlying Investigation

In the underlying investigation, the staff is investigating whether Wells Fargo made material misrepresentations or omissions in connection with a series of offerings of residential mortgage-backed securities. For each of the offerings, Wells Fargo engaged an investment bank to serve as the underwriter and perform due diligence on the quality of the loans. This due diligence included evaluating a sample of the loan pool to ensure that the sampled loan complied with the bank’s loan origination standards. If loans did not meet those standards, the bank removed them from the loan pool. Based on the information currently available to the Commission, though, it does not appear that Wells Fargo took any steps to address similar deficiencies in the remainder of the loans being securitized and sold to investors.

The Subpoenas

The SEC’s staff received a formal order of investigation in November 2010 and sent the first of six subpoenas to Wells Fargo on September 30, 2011. The first requested, among other things, all loan underwriting guidelines associated with the RMBS offerings. In response, Wells Fargo produced some documents with the representation that the documents “may be responsive to or may contain information responsive to” this request. After reviewing the documents, the SEC found that the production actually failed to include any but a few sets of what appeared to be summary versions of underwriting guidelines. In a meeting in January 2012, the Commission’s staff reiterated the need to produce all of the outstanding responsive documents, and specifically identified the guidelines as missing ones. A similar reminder followed in February, but the bank never produced the guidelines.

The other subpoenas followed a similar pattern. In November 2011, the SEC asked for documents relating to the RMBS prospectuses. Wells Fargo did not produce them, but on February 14, the bank said it would do so by “next week.” To date, it has not produced any. In December 2011, the SEC asked for draft RMBS prospectuses. The bank produced some, but not all, and said it expected to complete its production by March 7. It didn’t. Three other subpoenas went much the same way.

Wells Notice

On February 24, the SEC staff notified Wells Fargo that it was “considering recommending” that the Commission bring an enforcement action against the bank. To be clear, this “Wells notice” (no relation) related to the underlying RMBS investigation itself, not the subpoena enforcement action. Wells Fargo’s counsel took the Wells notice as reason to abandon any efforts to produce documents in response to the subpoenas.

SEC’s Argument

The Commission’s argument for production is pretty simple, and cites three factors it must meet: (1) whether it has authority to investigate; (2) whether procedural requirements have been followed; and (3) whether the evidence is relevant and material to the investigation. Application at 9 (citing EEOC v. Karuk Tribe Housing Auth., 260 F.3d 1071 (9th Cir. 2001)). The SEC obviously argues that it has met the three requirements. It argues further that the investigation continues regardless of the Wells notice and that the notice is no justification to ignore outstanding subpoenas.

Procedural Posture and Lessons from the Case

To press its case, the SEC filed an application for an order compelling compliance with its subpoenas, not a complaint. The Commission spends a page in the application justifying this summary procedure. It is wise to seek the most efficient remedy it can, because there is substantial risk in its position. Subpoena enforcement actions require a lot of time and effort, and the potential payoff is unclear. It could take a long time for the court to make a ruling on the SEC’s application. Further, if the court simply writes to hold Wells Fargo to account for its deficient document production, without further sanctions for delay, the message to defendants will be that resisting production could be a useful exercise. Merely getting the documents due under the subpoena would be useful, but still a tough pill to swallow for the Commission given the substantial costs in pressing this interlocutory matter.

SEC and CFTC Whistleblower Chiefs Speak

By David Smyth on March 22nd, 2012 Posted in Whistleblowers

Sean McKessy and Vince Martinez, the respective chiefs of the whistleblower offices for the SEC and CFTC, spoke last week on a webinar hosted by Securities Docket, and made a number of salient points about their programs. You can listen to the 70-minute webinar here. Some of the more interesting issues (to me) follow:

Internal Reporting

Much ado was made after the Dodd-Frank Act was passed in 2010 and these two agencies had to write rules implementing the whistleblower provisions of the statute. Many publicly traded companies pushed to require insider whistleblowers to report potential violations to internal compliance departments before bringing them to the attention of government agencies.

McKessy noted that the SEC’s rules were crafted to encourage, but not require, internal reporting, and that he hoped corporate compliance officers felt empowered by rules that would hold companies’ feet to the fire. That is to say, he hopes compliance staff will be able to use the rules to impress the importance of robust compliance programs on corporate management. If those programs are not funded and staffed adequately to make internal reporting an attractive and unthreatening option for employees, other, less appealing options are available. Employees can simply go to the government instead.

For the CFTC’s part, Martinez pointed to rules that allow his agency to strike a balance between encouraging internal reporting and allowing whistleblowers to make the government their first stop in flagging violations of the law. Specifically, assisting an internal investigation can be a factor increasing a whistleblower’s award, 17 C.F.R. § 165.9(b)(4), while undermining the integrity of internal compliance and reporting systems can be a factor in decreasing such an award, 17 C.F.R. § 165.9(c)(3).

Self-Reporting

Current rules for both agencies allow a whistleblower to report a potential violation internally and maintain her place “in line” for 120 days for award purposes, even if a second whistleblower goes directly to the SEC or CFTC with the same information in the intervening period. McKessy made the point several times that this 120-period was not a de facto deadline for companies to initiate and complete internal investigations and report the results to the government. At the same time, he acknowledged that it would be naïve to think that companies should not consider the 120-deadline at all. For companies that think it is likely that internal tips have also been communicated to the government, perhaps an interim update to let regulators know the situation is under control could be a good idea.

Martinez said the situation was quite similar for the CFTC. He added that the most significant threat to cooperation credit was the prospect that a company could sit on an allegation without making a materiality determination and decide not to report to the government at all.

McKessy also repeated an observation he had made last month at the SEC Speaks conference in Washington: the vast majority of insider whistleblowers have reported their tips to internal compliance departments before reporting to the SEC. He could think of only “less than a handful” of instances in which a whistleblower had disregarded his company’s internal reporting mechanisms and gone to the SEC directly. The threat obviously remains, but I think this anecdotal evidence is fairly significant given the corporate protests of rules that did not require internal reporting – and worries that those rules would strongly discourage internal reporting at all.

Professional Whistleblowers

Martinez and McKessy both said that external whistleblowers are encouraged by rule and policy. That is, people making original observations from the outside of corporations or doing original, independent analysis are free to make submissions to either agency and can earn whistleblower awards for doing so. It is possible that such whistleblowers could connect dots in a way that the enforcement staffs have not yet been able to do. Harry Markopolos, of Bernard Madoff fame, is perhaps the most celebrated example of this type. Martinez hopes those whistleblowers will become a very prominent part of the CFTC’s program.

I’ll close by adding that the webcast series on Securities Docket is really quite extraordinary. It now includes about 75 seminars on a wide variety of topics relevant to securities enforcement and litigation. The panelists are always excellent, the programs are completely free, and they can be viewed at any time. If you haven’t listened to these, I encourage you to check them out.