THE SECURITIES REPORTER - Fried Frank

Volume 11, Issue 1 Spring 2006

THE SECURITIES REPORTER™

The Newsletter of the ABA Section of Business Law Committee on Federal Regulation of Securities

Dixie L. Johnson – Chair Volume 11, Issue 1 Michael Hyatte– Editor Spring 2006

FROM THE CHAIR by

Dixie L. Johnson [email protected]

I am pleased to introduce our new editor of THE SECURITIES REPORTER, Michael Hyatte of Sidley Austin LLP. Michael’s extensive experience in the SEC's Division of Corporation Finance, including more than ten years in its Office of Chief Counsel and five years in its Office of International Corporate Finance, are sure to serve him well as he manages the REPORTER’s publication. I would like to thank Catherine Dixon, P. J. Himelfarb and Theresa Hyatte of Weil Gotshal & Manges LLP for editing the REPORTER for so many years. Ladies, you not only kept the publication going, which was a feat in and of itself, but you also exponentially improved it. Thank you for your extensive contributions to the publication and to the Committee on Federal Regulation of Securities.

When I first began writing this column, I had recently returned from our spring meeting in Tampa, Florida. Whether you attended or not, you may be interested in reading Former SEC Director of the Division of Corporation Finance Alan Beller’s keynote speech, which is included in this edition of the REPORTER. Also inside, in addition to a wonderful collection of articles and the latest update on recent events, are Jack Bostelman’s notes of the Dialogue with the new SEC Director of Corporation Finance, John White, and Deputy Director Martin Dunn.

Since we are publishing the REPORTER after the meeting this time (my fault, not Michael’s – he was ready), I can also report that I was honored as this year’s recipient of the Jean Allard Glass Cutter Award. This lovely award is presented by the ABA Section of Business Law to one woman each year who has cut through the proverbial glass ceiling to “attain high accomplishment” in the Section. The thought of being named this year’s “glass cutter” has deeply moved me, and has prompted me to reflect on the many people whose unwavering support and encouragement provided the glass cutting opportunity. This is my last “substantive” From the Chair column, because this column for the August edition will focus on succession in subcommittee and committee leadership, and my tenure as Chair ends after the Annual Meeting. So I am seizing the

moment to share some of these memories with you. If you are new to the Committee, I hope these words inspire you to find ways to get involved. If you have been involved for some time, I hope you will be inspired by these examples to help someone else along the way.

I was not one of those lawyers who instinctively knew how to get involved in bar activities, or why getting involved would be valuable. My first permanent job as a lawyer is the one I still hold: this fall, I will have practiced as a lawyer at Fried, Frank, Harris, Shriver & Jacobson LLP for twenty years. Early in my years as an associate, Harvey Pitt, then a partner at my firm, asked me to help organize and complete a report of an ABA task force exploring the SEC’s settlement process. He also asked me to prepare the initial draft of a comment letter the ABA would file on pending legislation that ultimately became the Securities Enforcement Remedies Act of 1990. Both the task force report and the comment letter were later published, and when Harvey could not appear on an ABA panel regarding the Act, he asked me to take his place. The other panelists welcomed me, and Kathleen Warwick urged me to participate actively on the panel because she knew I understood the new law and had valuable things to say.

Harvey ultimately assigned many ABA-related projects to me, as well as many client-related projects. He also made sure I attended the ABA meetings regularly, even when we were busy on other work. He introduced me to his friends and encouraged me to take on projects on my own. He taught me the value of interacting with regulators outside the context of any particular client matter. He also taught me the professional obligation of sharing important practice-related information and insight with other members of the practicing bar. By the time he left the firm to become Chairman of the Securities and Exchange Commission in 2001, I was experienced at creating my own ABA projects based on what I thought might be valuable to attorneys who practiced in my field. But without Harvey’s, and my law firm’s, consistent support of ABA activities as an important vehicle for developing as a lawyer and contributing to the profession, I probably would not have fully appreciated the ABA’s value or pursued its opportunities.

Even those who had no control over my law firm assignment process found ways to encourage me toward, and through, that glass ceiling. Through the

Page 2 Volume 11, Issue 1 Spring 2006

years, Jim Cheek, John Olson, John Liftin, Dick Phillips, and so many other Committee and Section leaders took the time to notice the projects on which I was working and to find other opportunities for me, from becoming founding editor of THE SECURITIES REPORTER to serving as Co-Chair of the Subcommittee on Civil Litigation and Enforcement Matters. Stan Keller then chaired the Fed Reg Committee through its busiest four years. We commented on and organized numerous programs to address the flurry of rule proposals brainstormed under Harvey Pitt’s and Alan Beller’s leadership, as well as those required by the Sarbanes Oxley Act. Together, we launched even more projects, including gathering and providing informal feedback to the SEC staff tasked with evaluating the performance of the various divisions. Ultimately, Stan handed the reins of the Committee over to me.

I list these things not to suggest that they are required, or even desirable. But if you are interested in getting more involved, these examples may inspire you to envision a project you believe would be valuable to other attorneys who practice in your field, and then pursue that project through the relevant subcommittee or task force toward a goal of

publishing a final product. I also know that, as practicing lawyers face more pressures to bill hours and develop clients, mentoring time can suffer. If you are involved in an ABA project already, please consider how you might include a younger colleague in that project and encourage her or him to attend an ABA meeting with you. It can make such a difference.

Thank you to all those I have mentioned and to the myriad family members, colleagues and friends who also have been so supportive over the years. And thanks to you, fellow Fed Reg Committee members, for continuing to support our activities during my tenure. It’s been a great ride!

Dixie L. Johnson, Chair

THE SECURITIES REPORTER can be accessed on-line at http://www.abanet.org/buslaw/committees/CL410000pub/newsletter.shtml. If you have any questions, please send an E-mail to [email protected].

Volume 11, Issue 1 Page 40 Spring 2006

HIGHLIGHTS OF JUDICIAL DECISIONS AND ADMINISTRATIVE

ACTIONS REGARDING THE FEDERAL SECURITIES LAWS AND

STATE LAW, SPRING 2006 BY DIXIE L. JOHNSON, TONY REGENSTREIF, KIM

CAIN, MIKAL SHAIKH, BRIAN THAVARAJAH *

Federal News Accounting • In the Matter of Clyde Bailey, P.C., and

Clyde Bailey CPA, (November 22, 2005); In the In the Matter of Kenny H. Lee CPA Group, Inc., and Kwang Ho Lee, CPA (November 22, 2005). The Public Company Accounting Oversight Board (“PCAOB”) announced disciplinary proceedings against two registered accounting firms - Clyde Bailey P.C. and Kenny H. Lee CPA Group Inc. - and the sole shareholder of each firm. Under Section 105 of the Sarbanes-Oxley Act, the PCAOB may investigate and discipline public accounting firms for violating the Act, PCAOB rules, or audit-related securities laws. With respect to Clyde Bailey PC, the PCAOB found a failure to perform audits in compliance with PCAOB accounting standards in a number of areas, such as the valuation of option rights and securities. For Kenny H. Lee CPA Group Inc., the PCAOB found numerous violations of its accounting standards, including improper auditing of deferred taxes. Without admitting or denying the findings, each firm agreed to revocation of its registration and a bar from acting as an associated person for a registered accounting firm.

• In re Merck & Co. Inc. Secs. Litig., No. 04-

3298 (3rd Cir. Dec. 15, 2005). The U.S. Court of Appeals for the Third Circuit affirmed a district court’s dismissal of claims brought by a class of Merck stockholders for securities violations under Section 10(b) of the Securities Exchange

* Ms. Johnson is a partner and Mr. Regenstreif, Ms.

Cain, Mr. Shaikh, and Mr. Thavarajah are associates in the Washington, D.C. office of Fried, Frank, Harris, Shriver & Jacobson LLP.

Act of 1934 and Section 11 of the Securities Act of 1933. Merck had planned an IPO to spin off its subsidiary, Medco. Merck first announced the spin off in a January 2002 press release, in which Merck’s CEO announced that Merck and Medco would “pursue independent strategies for success.” Merck filed an S-1 with the SEC on April 17, 2002, that disclosed that Medco, as a pharmacy benefits manager, had recognized co-payments that went directly to the pharmacy, not Medco. Merck interpreted accounting standards to allow for this recognition. In the S-1, however, Merck did not disclose the total amount of co-payments recognized. The SEC did not approve this S-1, but eventually approved an S-1 Merck filed on July 9. Soon thereafter, the market forced Merck to lower Medco’s offering price, and eventually Merck decided to abandon the IPO entirely. The class plaintiffs alleged that Merck’s April 17 misstatements of the revenue recognition policy were material, as Merck’s stock price dropped based on a Wall Street Journal article about the co-payment scheme published two months later. The court found that materiality is determined based on the effect of the statement immediately after it is made. Because there was no drop in stock price in the period immediately following the April 17 statement, the statement was not material. Finding no Section 10(b) or Section 11 violations, the court also dismissed plaintiff’s claim for control-person liability.

• Pew v. Cardarelli, No. 05-1990-cv (2d. Cir.

Jan. 24, 2006). The Second Circuit affirmed dismissal of a class action suit by investors against Donald Cardarelli and Peter O’Neill, former officers of Agway Inc. The complaint alleged that the defendants had fraudulently induced the plaintiffs to invest in Agway money market certificates by failing to disclose that: 1) the only substantial source of assets to repay maturing certificates was the cash obtained by selling new certificates; 2) Agway’s most valuable assets had already been pledged as security for senior debt or were otherwise not available to repay the certificates; and 3) the certificates were worth only a fraction of what was paid by plaintiffs. The court


found, however, that Agway public filings including numerous cautionary statements regarding: the risk of defaulting on the Certificate debt; the subsidiary nature of that debt; Agway’s resort to increasingly bleak credit arrangements; loss of core business assets and operations; and the consequences of a potential bankruptcy. Given these warnings, the court found that no reasonable investor could have been misled. The court also noted that even if the plaintiffs had relied on any alleged misstatements, their claims were time-barred.

• Qwest Communication Agrees to Settle

Class Action Alleging Accounting Improprieties (Nov. 1, 2005). Qwest Communications International Inc. has agreed to pay $400 million to settle a putative class action arising out of the company’s recognition of revenue from exchanges of network capacity with other telecommunications providers. Pending court approval, Qwest will be required to pay the settlement in three installments to those who purchased Qwest securities between May 24, 1999 and July 28, 2002. Qwest will pay $100 million within 30 days of the court’s preliminary approval of the settlement, another $100 million within 30 days of the court’s final approval, and the remaining $200 million by Jan. 15, 2007. The proposed settlement will resolve all claims in the lawsuit except for those filed against Joseph P. Nacchio, Qwest’s former CEO, and Robert S. Woodruff, the company’s former CFO. In 2004, Qwest settled charges of accounting fraud with the SEC for $250 million.

• SEC v. American International Group,

Inc., Case No. 06 CV 1000 (S.D.N.Y. Feb. 9, 2006). Without admitting or denying the allegations, American International Group, Inc. (“AIG”) settled securities fraud charges with the SEC related to allegations that AIG materially misstated its financial results through sham transactions and entities created for the purpose of misleading the investing public. AIG consented to the entry of a court order requiring that AIG pay a civil penalty of $100 million and disgorge ill-gotten gains of $700 million. The order also enjoins AIG from violating the

antifraud, books and records, internal controls, and periodic reporting provisions of the federal securities laws. AIG has also agreed to certain undertakings including, among other things, (i) appointing a new Chief Executive Officer and Chief Financial Officer; (ii) putting forth a statement committing it to achieving transparency through effective corporate governance, high ethical standards, and financial reporting integrity; (iii) establishing a Regulatory, Compliance and Legal Committee to provide oversight of AIG’s compliance with applicable laws and regulations; and (iv) enhancing its “Code of Conduct” for employees and mandating that all employees complete special formal ethics training. The SEC alleged that, among other false transactions, in December 2000 and March 2001, AIG entered into two sham reinsurance transactions with General Re Corporation (“Gen Re”) that had no economic substance but were designed to allow AIG to improperly add a total of $500 million in false loss reserves to its balance sheet in the fourth quarter of 2000 and the first quarter of 2001. In addition, the SEC alleged that in 2000, AIG engaged in a transaction with Capco Reinsurance Company, Ltd. (“Capco”) to conceal approximately $200 million in underwriting losses in its general insurance business by improperly converting them to capital (or investment) losses to make those losses less embarrassing to AIG. AIG’s internal investigation eventually led to a restatement of its accounting for approximately 66 transactions or items. The SEC stated that the settlement took into consideration AIG’s cooperation during the investigation, which included: (i) promptly providing information regarding any relevant facts and documents uncovered in its internal review; (ii) regularly updating the SEC Staff on the status of the internal review; and (iii) sending a clear message to employees that they should cooperate in the investigation by terminating those employees, including members of AIG’s former senior management, who chose not to cooperate in the staff’s investigation. The settlement with the SEC was part of a series of settlements announced the same day with the New York Attorney General, the New


York Insurance Department, and the United States Department of Justice. These settlements additionally require AIG to pay $375 million to AIG policyholders; $344 million to states harmed by AIG’s practices involving underreporting for workers’ compensation funds; and, fines of $100 million to New York and $25 million to the Department of Justice.

• SEC v. Fuks, 05-Civ. 2668, (S.D.N.Y. Nov.

3, 2005). Zvi Fuks and Sabina Ben-Yehuda agreed, without admitting or denying the allegations, to settle charges with the SEC that they violated Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The SEC alleged that, on December 27, 2001, Sam Waksal, the former CEO of ImClone, informed Ben-Yehuda, an employee of an investment vehicle created by Waksal, that the Food and Drug Administration (“FDA”) decided not to approve an ImClone drug, Erbitux, for public use. Later that same day, the SEC claims that Ben-Yehuda passed this information on to Fuks, a member of ImClone’s Scientific Advisory Board. Both defendants sold ImClone stock on December 27, 2001; Fuks sold shares worth $5 million and Ben-Yehuda sold $73,000 worth. The day after their sales, ImClone announced the FDA’s rejection of Erbitux and shares in the company subsequently fell by 16% by the end of the trading day. Fuks agreed to disgorge $1,214,239 with interest of $230,615, a $1,214,239 civil fine, and a permanent injunction from violating insider trading laws. Ben-Yehuda agreed to disgorge $50,958 with $9,678 in interest, a $50,958 civil fine, and a permanent injunction from insider trading.

• United States v. Causey, No. CR-H-04-25 (S.D. Texas, Dec. 28, 2005). Pursuant to a plea deal, former Enron Corp. Chief Accounting Officer Richard A. Causey has pleaded guilty to one count of securities fraud. He will serve seven years in prison and forfeit $1.25 million in criminal proceeds. His prison term could be reduced to five years if he fully cooperates with the Enron Task Force’s investigation of Enron’s demise. Causey admitted to conspiring with

Enron’s senior management to make false and misleading statements in Enron’s Form 10-K and Form 10-Q reports, as well as other misleading statements about Enron’s financial condition that he knew to be inaccurate. Causey’s plea agreement comes three weeks before he was to be tried with co-defendants Kenneth Lay, former Enron chairman, and Jeffrey Skilling, former chief executive officer. Prosecutors expect that Causey will provide valuable information for their case against Lay and Skilling.

• United States v. Olis, 5th Cir., No. 04-20322 (5th Cir. Oct. 31, 2005). The U.S. Court of Appeals for the Fifth Circuit reversed the sentence imposed by the district court against James Olis, a former senior director of tax planning and vice president of finance at Dynegy. Although the Fifth Circuit affirmed the fraud and conspiracy convictions against Olis for his involvement in a plan to disguise a loan received by Dynegy as revenue, the court characterized the sentence, which included 292 months in prison and a $25,000 fine, as “extraordinarily high.” In overturning the sentence, the Fifth Circuit explained that much of the losses incurred by Dynegy’s shareholders occurred before the accounting improprieties were revealed and, thus, could not be attributed to Olis’s conduct. The court criticized the district court’s complete reliance on expert testimony to justify attributing all of the $105 million loss incurred by University of California Retirement System (UCRS), a shareholder of Dynegy, to the scheme in which Olis participated. In addition, the Fifth Circuit highlighted the district court’s refusal to consider a report that reflected other potential causes for the decline in Dynegy’s stock price. The Fifth Circuit remanded the case for resentencing.

• United States v. Olis, No. 03-217 (S.D. Texas Jan. 5, 2006). The U.S. District Court for the Southern District of Texas sentenced Gene Shannon Foster, former Dynegy Inc. vice president of tax and Helen Sharkey, former Dynegy Inc. accountant, for their involvement in a complex 2002 gas trading and financial deal known as “Project Alpha.” “Project Alpha” was a scheme to


show certain loans as cash flow instead of debt on financial statements. Fifty victims were affected by this scheme, and one shareholder suffered a $105 million loss. Both Foster and Sharkey had pleaded guilty to conspiracy to commit securities fraud. Foster will serve fifteen months in prison, followed by three years’ probation. He will also pay a $1,000 fine. Sharkey will serve a 30-day sentence. In exchange for their reduced sentences, Foster and Sharkey agreed to provide information to prosecutors in the government’s case against Jamie Olis, Dynegy’s former vice president of finance and senior director of tax planning/international tax.

• United States v. Sebastian, CR 04-128-PA (C.D. Cal. Dec. 5, 2005). The U.S. District Court for the Central District of California sentenced the former chief financial officer of L90 Inc., an Internet advertising firm now called MaxWorldwide Inc., to a 18-month prison term for securities fraud conspiracy. Thomas A. Sebastian admitted to participating in a conspiracy to generate fraudulent revenues for the company. Sebastian assisted the company’s subsidiary to swap checks with other Internet companies for bartered advertising, and then reported those amounts as revenue without indicating that they were bartered transactions. L90 also used a sham third party in the transactions in an effort to mask the true nature of the barter transactions from auditors and the public. Lastly, Sebastian signed L90’s 10-K and 10-Q that contained false and misleading financial information. The court declined to sentence Sebastian to the 21-month prison term advocated by the prosecution, citing his “exemplary life” prior to this crime and his history of active volunteerism.

Antifraud • Fadem v. Ford Motor Co., No. 05-0856 (2d

Cir. Dec. 7, 2005). The U.S. Court of Appeals for the Second Circuit affirmed the district court’s dismissal of securities fraud claims filed by shareholders alleging that Ford Motor Co. and its officers materially misstated its multimillion-dollar losses in future and forward contracts for palladium. According to the district court, Ford entered

into contracts to purchase palladium. Shortly after these contracts were ratified, the price of palladium fell by more than 50%, and Ford’s new catalyst design technology decreased the company’s need for palladium. As a result, Ford was forced write off $963 million, which the company disclosed in its Form 10-K. The shareholders alleged that Ford and its officers made various misstatements and material omissions regarding the palladium deals. The Second Circuit, in an unpublished summary order dismissing the complaint, found that the shareholders had not pleaded with particularity that Ford made any material misrepresentation or omission with scienter.

• In re Hypercom Corp. Secs. Litig., No. CV-05-0455-PHX-NVW (D. Ariz. Jan. 24, 2006). A class action securities fraud suit against Hypercom Corp. alleging violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder was dismissed with leave to amend by the U.S. District Court for the District of Arizona for failing to adequately plead scienter. The complaint alleged that in February 2005, Hypercom announced that it would restate its financial statements for the first three quarters of 2004 because several thousand leases had been misclassified as sales-type leases rather than operating leases. The misclassification caused $3.2 million in revenue and $2.1 million in net income to be prematurely recognized. In March 2005, Hypercom announced that the misclassification was the result of a material weakness in its internal controls over financial reporting. The press release also noted that the company’s independent auditors would be issuing an adverse opinion with regard to Hypercom’s internal controls over financial reporting. Hypercom’s stock price declined by 18.25% following the March press release. In dismissing the complaint, the court noted that the plaintiffs did not allege facts sufficient to establish a strong inference of scienter.

• Kennedy v. Trustmark National Bank, No. 3:05cv220-RS (N.D. Fla. Jan. 17, 2006). The U.S. District Court for the Northern


District of Florida dismissed a complaint by a plaintiff who alleged that his employer, Fisher-Brown Inc. had violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 12(a)(2) and 15 of the Securities Act of 1933 by conspiring to defraud him of approximately $750,000. Thomas Kennedy was a vice president of Fisher-Brown and owned Fisher-Brown common stock that he had received as compensation. A stock purchase agreement that Kennedy had entered into required that Kennedy sell the stock back to Fisher-Brown for fair market value if he ever ceased to be an employee. When Kennedy was terminated from Fisher-Brown he sold his stock back to the company under the stock purchase agreement for $1500 per share. According to the complaint, however, $1500 was not the fair market value of the shares, because only ten months later, Trustmark National Bank paid $4000 per share for all of Fisher-Brown’s stock. The complaint alleged that $1500 was the book value of the shares rather than the fair value in violation of the purchase agreement, and that Fisher-Brown had conspired to defraud him of that difference in value. The court dismissed the Securities Act claims on the basis that only purchasers have standing to sue under the Securities Act, and that Kennedy had sold rather than purchased securities. The Rule 10b-5 claims were dismissed because the complaint failed to state with particularity facts giving rise to a strong inference that the defendants acted with severe recklessness in making a misstatement or omission.

• In re MarketXT Inc., SEC, Admin. Proc. File No. 3-11813 (Dec. 22, 2005). An administrative law judge held that an electronic trading market program operated by MarketXT and its chief technology officer, Irfan Amanat, did not violated antifraud provisions of the federal securities laws. The alleged scheme involved the use of wash trades and matched orders aimed at capturing market-data rebates from Nasdaq. Under the rebate program, NASD members who exceeded a certain number of trades received a transaction credit. The SEC had alleged that the trading program was a

manipulative device that was used to qualify MarketXT for a tape revenue rebate, in violation of Section 10(b) under the Securities and Exchange Act of 1934 and Rule 10b-5. The judge found no evidence that Amanat’s rebate trading program was designed with the intent to manipulate the price of funds. The judge also noted several errors made by the SEC Division of Enforcement’s expert, who could not read computer code and applied incorrect trade standards in his analysis of MarketXT data. The judge dropped all charges against Amanat. MarketXT had previously settled with the SEC.

• Makor Issues & Rights Ltd. v. Tellabs Inc., No. 04-1687 (7th Cir. Jan. 25, 2006). The U.S. Court of Appeals for the Seventh Circuit reinstated several claims of a class action lawsuit that had been dismissed by a lower court under the heightened pleading standards of the Private Securities Litigation Reform Act (“PLSRA”). The Seventh Circuit said that this case represented its “first opportunity to address” the new PLSRA pleading standards. The complaint alleged that Tellabs Inc., its CEO Richard Notebaert, and its chairman and former CEO Richard Birck had, among other things, violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder by overstating demand for the company’s current generation product, and misstating the availability of the company’s next-generation product. The complaint also alleged that the defendants made misstatements and exaggerations regarding the company’s financial condition in the fourth quarter of 2000. The court addressed each of the alleged misstatements, and dismissed some of them as simple puffery. The court noted, however, that several alleged statements “went well beyond puffery,” such as statements by management that the current-generation product was continuing to maintain its growth rate, when in fact product sales were declining. The plaintiff’s allegations that Tellabs engaged in channel stuffing were also held to be sufficient to withstand the heightened pleading requirements. Further, the generalized cautionary statements in regarding the company’s problems with its


products were not particularized enough to fall under the PLSRA’s safe harbor provision. In reinstating some of the plaintiff’s claims, the court noted that the scienter standard was unchanged by the PLSRA pleading requirements, and that it remained “an extreme departure from the standards of ordinary care.” In deciding whether the scienter pleading standards have been met, the Seventh Circuit held that “the best approach is for courts to examine all of the allegations in the complaint and then decide whether collectively they establish” a strong inference of scienter. Finally, the court refused to apply a “group pleading” standard of scienter, and held that the plaintiff is required to individually create the “strong inference” of scienter for each defendant.

• In re Polymedica Corp. Secs. Litig., No. 05-1220 (1st Cir. Dec. 13, 2005). The U.S. Court of Appeals for the First Circuit, in a case of first impression, adopted the prevailing view’s definition of an efficient market in the context of establishing the fraud-on-the-market presumption of reliance. Plaintiff Thomas Thuma, a purchaser of stock in PolyMedia Corp., alleged that PolyMedia Corp. issued false and misleading statements regarding sales and revenue that artificially inflated the stock price. When news of these misleading statements spread, PolyMedia’s stock price decreased by 80 percent. Thuma moved for class certification under the fraud-on-the-market theory, and its rebuttable presumption that plaintiffs relied on the “integrity of the marketplace” which contained that misstatement, rather than showing direct individualized reliance on PolyMedia’s misstatements. However, in order for a plaintiff to rely on the “integrity of the marketplace,” the market must be shown to be “efficient.” The court adopted the prevailing view among the circuits of an efficient market as “one in which the market price of the stock fully reflects all publicly available information.” This differed from the district court’s view of the efficient market as one in which “market professionals generally consider most publicly announced material statements about companies, thereby affecting stock

market prices.” The First Circuit added “by ‘fully reflect,’ we mean that market price responds so quickly to new information that ordinary investors cannot make trading profits on the basis of such information.” As for the evidence needed to invoke the presumption of reliance at the class-certification stage, Thuma would need only to show the basic facts, which could be rebutted at trial. In a companion opinion decided the same day (In re Xcelera.com Securities Litigation, No. 05-1221 (1st Cir. December 22, 2005), the court reiterated its definition of an efficient market and rejected defendant’s argument requiring that the market price perfectly and accurately reflect publicly available information.

• SEC v. Johnson, Civ. Act. No. 03-0177 (S.D.N.Y., Nov. 11, 2005). In the U.S. District Court for the Southern District of New York, a jury found Paul Johnson, a research analyst formerly associated with Robertson Stephens Inc., liable for committing securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission alleged that, in 1999 and 2002, Johnson failed to disclose, in research reports and media releases, his financial interest in pending mergers involving companies he covered. In addition, in 2001, Johnson allegedly issued a false buy recommendation for stock in Corvis Corp., when in fact he expressed different private opinions and was selling stock in the company. The SEC has indicated that it will request relief consisting of a permanent injunction, disgorgement, and a civil fine against Johnson.

• SEC v. Mutual Benefits Corp., No. 04-60573, Civ-Moreno (S.D. Fla. Dec. 1, 2005). Three former principals of Mutual Benefits Corp., without admitting or denying the charges, have agreed to pay $25 million to settle charges brought by the Securities and Exchange Commission that they defrauded investors. The settlement is pending court approval, and the SEC will continue its action against three other defendants. According to the SEC’s complaint, settlement defendants Joel Steinger, Leslie Steinger, and Peter


Lombardi defrauded over 31,000 investors through the fraudulent sale of over $1 billion in viatical settlements. Viatical settlements involve the sale of a terminally ill policyholder’s life insurance benefits at a discounted price. The defendants failed to disclose to investors that 1) investors’ returns relied on life expectancy estimates that were determined by Joel Steinger, as opposed to an independent doctor, 2) funds from new investors were used to pay older policies, and 3) the Steingers exercised control over the company and had a disciplinary history. As part of the settlement, the defendants have agreed to an injunction against future violations of securities laws. Additionally, Joel and Leslie Steinger will each pay $9 million in disgorgement and prejudgment interest and $500,000 in civil fines, and Lombardi will disgorge $5.8 million and pay a $120,000 fine.

• Yung v. Lee, No. 04-3139-cv(L) (2d Cir.

Dec. 13, 2005). The U.S. Court of Appeals for the Second Circuit held that Section 12(a)(2) of the 1933 Securities Act, which prohibits selling securities by means of a prospectus containing materially untrue or omitted statements, does not apply in any private sale of securities, whether primary or secondary. In this case, the plaintiffs were shown and relied on a prospectus and other publicly filed company documents in its decision to purchase Integrated Transportation Network Group Inc. securities. Plaintiffs later discovered that these documents contained false and misleading information about the company. The Second Circuit expanded the reasoning in Gustafson [Gustafson v. Alloyd Co., 513 U.S. 561 (1995)], which held that plaintiffs purchasing securities in a private secondary sale did not fall under the protection of Section 12(a)(2) because the term “prospectus” refers to a document describing a public offering, not a private sale contract. Because there is no obligation to distribute a prospectus in a private sale of securities, Section 12(a)(2) liability does not attach to such transactions. The Second Circuit joined the First, Fifth, and Tenth Circuits in deciding that Gustafson applies to not only private secondary sales but all

private securities offerings. Plaintiffs tried to argue that regardless of whether it was a private sale, the defendants used the prospectus, containing misleading information, in their marketing of the securities for private sale, and thus should be liable under Section 12(a)(2). The court disagreed, however, stating that the defendants were not obligated to disseminate the prospectus, and that the subscription and letter agreements used in the sale clearly stated that the securities “were not offered . . . by means of publicly disseminated advertisements or sales literature.”

Arbitration • Peebles v. Merrill Lynch, Pierce, Fenner &

Smith Inc., No. 04-16304 (11th Cir. Dec. 12, 2005). The U.S. Court of Appeals for the Eleventh Circuit, deciding a case of first impression, held that the amount in controversy requirement is met for diversity jurisdiction purposes where a party moves to vacate a zero dollar arbitration judgment and seeks a new arbitration hearing for an amount exceeding $75,000. Don Peebles, a real estate developer in Florida, enlisted the assistance of a Merrill broker to invest in low-risk funds. Peebles then became interested in high-risk tech stocks, and lost more than $1 million. Peebles attributed this loss to Merrill Lynch’s knowingly misleading favorable research about issuers, and brought an NASD arbitration proceeding against Merrill alleging securities violations and requesting a $2 million award. The arbitration panel issued a zero dollar arbitration award, and Peebles sought to vacate the award and requested a new arbitration hearing in state court. Merrill Lynch moved to remove the case to federal district court, and Peebles objected on the ground that the case did not meet the amount in controversy requirement for subject matter jurisdiction based on diversity. The district court found, and the appeals court affirmed, that because Peebles requested a new hearing and a $2 million award in addition to his request to vacate the zero dollar award, the amount in controversy requirement was met.


Attorneys • In re Brown, SEC, Admin. Proc. File No.

3-9354 (Dec. 1, 2005). The Securities and Exchange Commission granted lawyer James P. Brown’s application for reinstatement to practice law before the Commission. In 1997, the SEC brought an action against Brown, a former in-house general counsel and senior-vice president of Policy Management System Corp. (“PMSC”), charging that as a control person Brown was liable for PMSC’s failure to maintain accurate records and adequate internal accounting controls, which led to materially misstated financial statements. Brown was also charged with providing inaccurate information to auditors. Brown settled the lawsuit with the SEC without admitting or denying wrongdoing, and agreed to be enjoined from future securities law violations. Brown also consented to an order barring him from SEC practice, with the right to reapply after five years. The SEC granted Brown’s application for reinstatement to practice law before the Commission, citing personal affidavits attesting that Brown had complied with the settlement by not practicing law before the Commission, had not been subject to any other disciplinary action since the settlement, and had paid a $20,000 civil penalty in connection with the settlement.

Broker-Dealers • Bernstein & Co. Settles With NASD Over

Research Conflict of Interest (Feb. 8, 2006). Without admitting or denying the allegations, Bernstein & Co. and its research analyst Charles B. Hintz have agreed to pay fines of $550,000 for violating NASD conflict of interest rules, the largest fines ever imposed by the NASD for violations of those rules. In late 2004, Hintz personally owned substantial amounts of stock of Lehman Brothers and stock options of Morgan Stanley that he wished to sell. At the time Hintz had issued favorable ratings for both companies. NASD conflict of interest rules prohibit a firm from trading contrary to the analyst’s recommendation, however, and Bernstein had been denied an exemption from the rules. Bernstein therefore created a plan to sell the stock and options without violating NASD rules by

purporting to end coverage of Lehman and Morgan Stanley, selling the stock and options, and then resuming coverage of the two companies. The plan was vetted by the legal and compliance departments of Bernstein and found to be within NASD rules. On December 23, 2004 Hintz issued “final” reports on Lehman and Morgan Stanley, but indicated that coverage would resume in February 2005. The NASD believed that Hintz’s January 2005 sales of stock and options violated the conflict of interest rules because the termination of coverage was not “bona fide” because the firm intended to resume coverage after the sale.

• SEC v. Calugar, CV-S-03-1600 (D. Nev. Jan. 10, 2006). Former president of Security Brokerage Inc. (“SBI”), Daniel Calugar, settled charges with the SEC without admitting or denying allegations of improper late trading and market timing. According to the SEC, after the market closed at 4 p.m., Calugar would transmit trades to his own account through SBI. SBI would then manipulate reports to show that the trading actually occurred at 3:59 pm. Calugar also engaged in market timing of mutual funds despite knowledge that such timing was prohibited by the funds. As part of the settlement, Calugar will disgorge $103 million in illegal profits and will pay a $50 million fine. He is permanently barred from association with broker-dealers, and he and SBI, now out-of-business, are enjoined from future securities laws violations. The settlement remains subject to court approval.

• Hedge Fund Manager Mangan Settles Charges With NASD Related To Deceptive PIPE Transaction (Dec. 20, 2005). Hedge fund manager and former registered broker John F. Mangan Jr. settled charges of deceptively purchasing shares in a PIPE (Private Investment in a Public Equity) transaction, short selling the shares, and profiting from the sale without authorization from his brokerage firm, Friedman, Billings, Ramsey & Co. (“FBR”). Under the terms of the settlement, Mangan will pay a $125,000 fine and is permanently barred from association with any NASD-registered firm. According to the NASD, Mangan learned of


the confidential PIPE offering of Compudyne through FBR, Compudyne’s placement agent. Mangan obtained copies of the Private Placement Memo and other documents that FBR’s brokers were using to solicit potential investors in the PIPE. Mangan asked senior FBR officials whether he could invest in the PIPE through one of his hedge funds. The FBR official stated that Mangan could not buy shares in the Compudyne PIPE due to his association with FBR. Despite this prohibition, Mangan invested in the PIPE using his hedge fund partner’s investment adviser, HLM Securities LLC. Mangan received a broker commission from FBR for HLM’s investment in the PIPE. Mangan’s partner signed the Purchase Agreement for the securities, but Mangan provided all the funds necessary to buy the shares and the two agreed to share equally in the PIPE’s profits. Mangan did not disclose this arrangement to FBR. Mangan also allegedly caused HLM to use the shares from the PIPE to cover its naked short position in Compudyne. Mangan received $87,000 in profits from the transaction.

• Merrill Lynch Settles over Research Conflicts (Feb. 17, 2006). Merrill Lynch & Co. announced that it has agreed in principle to settle 23 class action lawsuits, which were brought over Merrill Lynch’s allegedly false and misleading research reports. Merrill Lynch brokers including Henry Blodget were alleged to have issued artificially favorable research reports on several Internet stocks in order to solicit or maintain investment-banking services with the firms. As part of the settlement, Merrill Lynch will agree to pay $164 million. Merrill Lynch, along with 9 other firms, had previously entered into a settlement with regulators for a total of $1.4 billion regarding allegedly false and misleading research reports. According to Merrill Lynch, only two class action suits against the company relating to its research coverage of Internet stocks remain pending.

• Trumball Investments Ltd. v. Wachovia Bank NA, No. 05-1536 (4th Cir. Feb. 3, 2006). The U.S. Court of Appeals for the Fourth Circuit held that Wachovia bank was

not liable to its client for failing to execute an oral instruction because the account was a discretionary investment account. The discretionary investment account agreement stated that Wachovia “shall in its discretion, follow and rely on any instruction” given by the client’s agent. On April 4, 2000, the client’s agent gave an oral instruction to a bank employee that all securities in the accounts be liquidated, and that all proceeds be invested in U.S. Treasury issues. Wachovia did not execute the instruction, and account lost $1,626,889 in value. The plaintiff alleged that Wachovia breached the account agreement, and was liable to the plaintiff for the loss in the account’s value. The court found that the term “‘[s]hall in its discretion’ has an entirely different meaning than ‘shall’ standing alone” and that “[a]ny other interpretation would treat ‘in its discretion’ as mere surplusage, which the courts are disinclined to do.” Because the court found that the word “shall” did not transform the discretionary account into a nondiscretionary account, Wachovia did not breach the agreement by failing to execute the oral instruction.

• NASD Sanctions Four Firms for Bond

Markups and Markdowns (Oct. 31, 2005). Without admitting or denying the allegations, four firms - SG Americas Securities LLC, RBC Capital Markets Corp., RBC Dain Rauscher Inc., and DebtTraders Inc. – agreed to settle charges with the NASD that they utilized excessive markups or markdowns in executing bond trades. The NASD’s policy states that markups and markdowns, the amount added to or subtracted from the price of the security by a dealer, generally should not exceed 5%, a threshold that all four firms exceeded for multiple trades. The settlement also resolved claims that SG Americas Securities LLC, RBC Dain Rauscher Inc., and DebtTraders Inc. violated books and records provisions by failing to report transaction information for the bond trades on the NASD’s Trade Reporting and Compliance Engine (TRACE), where firms must report price and volume data for all corporate bond transactions. The four firms agreed to pay a total of $7.85 million in fines, and SG Americas Securities, RBC Capital Markets,


and RBC Dain Rauscher also agreed to revise their written supervisory procedures for high yield bond transactions.

Crime • United States v. Adelson, No. 05-Cr-0325

(S.D.N.Y. Feb. 17 2006). A jury convicted Richard P. Adelson, the former president and CEO of Impath Inc., of conspiracy, securities fraud, and making false statements in connection with a fraudulent accounting scheme. Impath was alleged to have fraudulently overstated revenue by over $60 million between 2000 and 2002. While six defendants were indicted by the Department of Justice for their roles in the fraud, Adelson was the only defendant not to plead guilty to the charges.

• United States v. Forbes, No. 3:02-cr-00264 (D. Conn., Feb. 9, 2006). A mistrial was declared in the criminal fraud trial of Walter Forbes, the former Chairman of Cendant Corp., when jurors failed to reach agreement after nearly a month of deliberation. Forbes’s previous trial for the same charges in January 2005 also ended in a mistrial. Forbes’s indictment alleges that while at CUC International, the predecessor of Cendant, he supervised an accounting scheme to inflate CUC income and artificially maintain the stock price. Forbes was charged with conspiracy, mail fraud, wire fraud, making false statements to the SEC and insider trading. E. Kirk Shelton, the former Vice Chairman of Cendant, also allegedly participated in the scheme, and he was convicted in January 2005. Shelton was sentenced to 10 years in prison and ordered to pay restitution of $3.275 billion.

• United States v. Herwitz, No. 05-0901 (NGG) (E.D.N.Y. Dec. 19, 2005); SEC v. Herwitz, 05-CV 10622 (LAP) (S.D.N.Y. Dec. 19, 2005). Gary D. Herwitz, a former accounting firm president, pleaded guilty to trading in Sirius Satellite Radio Inc. stock after having received confidential information that Sirius was in negotiations with Howard Stern. Herwitz also settled a similar charge with the SEC without admitting or denying the allegations. Herwitz learned in confidence from Stern’s longtime personal accountant that Stern was

in negotiations with the satellite radio channel. Despite the accountant’s warnings that this was confidential, nonpublic information, Herwitz purchased and later sold Sirius shares for a profit. Herwitz faces a maximum federal prison sentence of 20 years and a $5 million fine in the criminal action. Under the terms of the SEC settlement, Herwitz will pay $18,163 in disgorgement and $34,000 in civil penalties.

• United States v. Rigas, S2-02-CR.1236 (S.D.N.Y. Nov. 23, 2005). Michael Rigas, the former chief operating officer of Adelphia Communications Corp. and the son of company founder John Rigas, plead guilty to making a false entry on a Form 13D filing with the SEC. The prosecution alleged that Michael Rigas falsely stated that he conducted a reasonable inquiry with respect to the source of funds used to purchase company shares in a 1999 private placement. Rigas faces up to three years in prison for this offense; sentencing is schedule for March 3, 2006. In July 2004, a jury acquitted Rigas on counts of conspiracy and wire fraud and failed to reach a verdict on securities fraud and bank fraud charges.

• United States v. Schultz, 8:02-CR-111-EAK-MAP-ALL (M.D. Fla. Dec. 15, 2005). Jurors in the U.S. District Court for the Middle District of Florida found Gregory G. Schultz, a Florida attorney, guilty of securities fraud and other crimes in connection with a Ponzi scheme in which the attorney divested $18 million from 300 unwitting investors. Under the scheme, Schultz marketed promissory notes, participation agreements, and stock certificates under fictitious names to investors in Florida and 21 other states. Schultz was found guilty of securities fraud, sale of unregistered securities, mail fraud, money laundering, and conspiracy.

• United States v. Stringer, CR 03-432-HA (D. Ore. Jan. 9, 2006). The U.S. District Court for the District of Oregon dismissed criminal charges against three former executives of FLIR Systems Inc. related to their alleged roles in a fraudulent revenue recognition scheme. The court held that the US Attorney’s Office (“USAO”) violated


defendants’ Fifth Amendment due process and self-incrimination rights when it gathered information for a criminal prosecution through the SEC instead of conducting its own investigation. The court dismissed the indictment, instead of suppressing the testimony given in the SEC investigation, because the government “engaged in deceit and trickery to keep the criminal investigation concealed” that was “grossly shocking and so outrageous as to violate the universal sense of justice.” The court found that the USAO did not conduct its own parallel investigation even though it had consistently held the position that criminal prosecution was warranted. The court explained that the government was concerned that the presence of a criminal investigation would halt successful discovery by the SEC, witnesses would be less cooperative and more likely to invoke their constitutional rights, and that the rules of criminal discovery would be invoked. However, the court noted that the USAO was actively involved in the SEC investigation: meeting regularly, receiving documents, requesting interviews be conducted in Oregon to establish jurisdiction, advising what information was needed for a successful criminal prosecution, specifically instructing on how best to conduct interviews to gather evidence for false statement cases, intentionally hiding its presence from FLIR’s attorneys, and repeatedly planning with the SEC as to when it would be best to surface and conduct an overt criminal investigation. The court also found that the SEC’s standard warnings to the defendants contained in Form 1662 did not sufficiently alert them to the possibility of criminal exposure in light of the active role the USAO in the SEC’s investigation.

• United States v. Weisberg, No. 05-CR-81 (D. Colo. Dec. 28, 2005). The U.S. District Court for the District of Colorado accepted a guilty plea to charges of wire fraud from Marc B. Weisberg, a former Qwest Communications International, Inc. executive. According to the indictment, Weisberg secretly took advantage of investment opportunities that were directed to Qwest for his own personal gain, reaping

over $2.9 million in proceeds as a result. Under the plea agreement, which the court will review at a March 3 sentencing hearing, Weisberg will cooperate with prosecutors investigating other officers of Qwest. Weisberg faces a two-year probation term, 60 days’ home detention, and a $250,000 fine. He has also agreed not to hold any position in a public company for two years.

• United States v. Wenger, No. 04-4022, (10th Cir. Oct. 26, 2005). In upholding the conviction of Jerome Wenger, the U.S. Court of Appeals for the Tenth Circuit affirmed the district court’s rejection of constitutional challenges to Section 17(b) of the Securities Act of 1933, which requires those who receive compensation for publicizing a security to disclose the compensation and the amount of the compensation. Jerome Wenger, a radio host of a program called “The Next SuperStock” and the publisher of a newsletter of the same name, was convicted under Section 17(b) of promoting stock in companies on his program without informing listeners that he had received compensation from those companies. Wenger contended that Section 17(b) violates the First Amendment, however, the Tenth Circuit, applying the standard of review for commercial speech restrictions, held that the required disclosures under the provision are sufficiently tailored to the government’s interest in preventing consumers from being misled. In addition, the Tenth Circuit rejected an argument that Section 17(b) is void for vagueness, explaining that the provision required clear action from Wenger: disclosure of the compensation and the amount received. The court also affirmed a conviction under Section 10(b) of the Securities Exchange Act of 1934 stemming from Wenger’s failure to disclose his financial arrangements with companies he was promoting to readers of his newsletter.

• United States v. Yuen, CR 05-918-JFW (C.D. Cal. Jan. 23, 2006). The U.S. District Court for the Central District of California rejected a plea agreement between the Justice Department and Henry Yuen, the former chief executive officer of Gemstar-


TV Guide International Inc. The court stated that the plea, in which Yuen received a recommendation from the U.S. Attorney’s Office that he be sentenced to two years probation, including six months home detention, donate $1 million to charity, and pay an additional fine of $250,000, failed to reflect the seriousness of the offense. Yuen had agreed to plead guilty to a felony charge of obstructing the SEC investigation into alleged accounting irregularities that led Gemstar to overstate its revenues by $248 million from 1999 to 2002. Yuen had admitted in the plea agreement to deleting e-mails and Gemstar documents that an SEC subpoena required him to produce and to installing a computer program called “Eraser 2003” on his Gemstar office computer.

Financial Fraud • Financial Acquisition Partners LP v.

Blackwell, No. 04-11300 (5th Cir. Feb. 14, 2006). The U.S. Court of Appeals for the Fifth Circuit dismissed without leave to amend a class action complaint against the former officials and auditor of Amresco, Inc., holding that the pleading standards under the Private Litigation Securities Reform Act were not met. The complaint alleged that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder by making false and misleading public statements about Amresco’s financial condition. The defendants were alleged to have knowingly or recklessly made misleading statements at a May 2001 meeting by stating that Amresco would obtain certain new funding, and that only the terms of that funding were still an issue. In dismissing this allegation, the court noted that the complaint failed to identify which defendant made the statement. Further, the court held that that the plaintiffs could not have relied on any statements made at that meeting because none of the plaintiffs actually attended it. The court also dismissed claims that the defendants overstated the value of certain assets in the company’s Form 10-K on the basis that the complaint failed to “plead facts supporting an allegation that any Defendant knew the value of Amresco’s assets was overstated, or that it was fraudulent in using its discount rate or

credit-loss assumption.” For similar reasons, the court dismissed the plaintiffs’ claim that the defendants failed to adequately disclose a substantial executive compensation plan.

• In re LeCrone, SEC, Admin. Proc. File No. 3-12134 (Dec. 22, 2005). Kenneth R. LeCrone, without admitting or denying the allegations, settled charges with the SEC that LeCrone willfully aided and abetted fraud in his role as accountant for Sport-Haley, Inc. According to the SEC, LeCrone caused Sport-Haley to file materially false and misleading quarterly and annual reports with the SEC, materially misrepresenting Sport-Haley’s income, work-in-process inventory, period costs, and discontinued headwear operations. According to the SEC, LeCrone’s recklessness led to improper accounting and reporting practices. As part of the settlement, LeCrone is barred from practicing before the SEC as an accountant for at least two years.

• SEC v. Snyder, Civil Action No. 03 CV 4658 (S.D. Texas Feb. 1, 2006). The former chief accounting officer of Waste Management Inc., Bruce E. Snyder Jr. was found by a jury to have violated the antifraud provisions of the securities laws for failing to make required disclosures in the company’s Form 10-Q and for insider trading. The SEC alleged that Waste Management’s Q1 1999 Form 10-Q was prepared, reviewed and signed by Snyder, that the form was materially false or misleading because it failed to disclose that the company’s reported income included millions of dollars of non-recurring income items, and that Snyder knew or was reckless in not knowing of that the Form 10-Q was false or misleading. The SEC further alleged that Snyder traded Waste Management securities on May 17, 1999 knowing that Waste Management’s reported income was false or misleading, and thus that he traded while in possession of material non-public information. According to the SEC complaint, Snyder sold Waste Management stock again on June 19, 1999, when he knew the material non-public information that Waste Management’s


internal earnings projections fell far short of previous earnings guidance.

• SEC v. Yuen, No. CV 03-4376 (C.D. Cal. Feb. 7, 2006). Without admitting or denying the allegations, the former CFO of Gemstar-TV Guide International Inc. Elsie M. Leung agreed to pay $1.4 million to settle charges brought by the SEC. The SEC alleged that Leung and Henry Yuen, Gemstar’s former chairman and CEO, participated in an accounting scheme to inflate Gemstar’s revenues by at least $248 million dollars. As part of the settlement, Leung also agreed to be barred from serving as an officer or director of a public company, to be barred from appearing or practicing before the Commission as an accountant, and to be permanently enjoined from future violations of the federal securities laws.

Insider Trading • SEC v. Agarwala, Civ. Act. No. 06 CV

0352J (S.D. Cal. Feb. 16, 2006). The SEC settled insider-trading claims against Dr. Sanjiv S. Agarwala, an associate professor of medicine and associate medical director of the melanoma program at the University of Pittsburgh Medical Center. The SEC alleged that Agarwala had acted a researcher on the clinical trials of the cancer drug Ceplene produced by Maxim Pharmaceuticals. According to the complaint, Agarwala learned material non-public information about the drug during the course of the clinical trials, and he used that information to buy and sell the securities of Maxim before public announcement of the information was released. The information included the positive and negative results of the clinical trials, and FDA approval of the drug. As a result, Agarwala allegedly made trading profits and avoided losses of $14,784. Under the terms of the settlement, in which Agarwala neither admits nor denies the allegations, Agarwala agreed to disgorge his profits, pay $398 in prejudgment interest, and pay $29,568 in civil penalties. Agarwala is also permanently enjoined from future violations of the securities laws.

• SEC v. Bucknum, No. 06-10065 PBS (D.

Mass. Jan. 12, 2006). Thomas J. Bucknum,

former general counsel of Biogen Idec Inc., settled, without admitting or denying, insider trading charges with the SEC. Bucknum consented to the entry of a final judgment permanently enjoining him from committing future violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Bucknum also agreed to pay disgorgement in the amount of $1,938,465, pre-judgment interest thereon in the amount of $102,005, and a civil penalty of $969,232. Bucknum will also be prohibited from acting as an officer or director of any publicly-traded company for a period of five years. The SEC alleged that on the morning of February 18, 2005, Bucknum told his broker that he wanted to exercise options to purchase 89,700 shares of Biogen stock and sell those shares, which the broker understood Bucknum wanted to sell at a price of $68 per share or better. According to the SEC, Bucknum’s broker therefore proceeded to contact Biogen, pursuant to the company’s policies, for the necessary clearance before making the trade. Bucknum attended a meeting later that day at which he learned material, non-public information that a patient participating in a clinical trial of Biogen’s multiple sclerosis drug, Tysabri, had been diagnosed with progressive multifocal leukoencephalopathy (“PML”), a rare and often-fatal brain disease, and that another patient participating in a Tysabri clinical trial had an unconfirmed PML diagnosis. The SEC claimed that at approximately 1:30 p.m., Bucknum had a second conversation with his broker’s associate during which Bucknum instructed the associate to proceed with the sale of his 89,700 shares at the market price, which was then around $67 per share. On February 28, 2005, Biogen and its development partner announced that they were suspending the marketing of Tysabri because of the confirmed and unconfirmed PML diagnoses. Biogen’s stock price declined $28.63, or more than 42%. The SEC argued that Bucknum reaped a substantial profit by selling shares of Biogen stock before the stock price fell.


• SEC v. Champe, Case No. 1:05CV02445 (D.D.C. Dec. 22, 2005). Without admitting or denying any wrongdoing, Gregory N. Champe, an executive of Martek Biosciences Corp., settled insider-trading charges with the SEC. According to the SEC, Champe traded on his company’s stock one day before a negative earnings announcement, which caused the stock to decline by 46 percent. Champe, in trading the stock, avoided a loss of $71,552. Champe agreed to an injunction from future securities law violations, and disgorged $54,825 in unlawful profits.

• SEC v. Day, No. 06-CV-10202-RWZ (D. Mass. Feb. 2, 2006). The SEC has settled claims with William A. Day that he misused inside information regarding the takeover of Oratec Interventions, Inc. by Smith & Nephew plc. The SEC alleged that Day wrote an anonymous post on an Internet message board revealing details of the takeover agreement approximately 24 hours before the agreement was publicly announced on February 14, 2002. The alleged message read “Be my valentine by: auntbetty1234 Happy Valentine’s Day to my Nephew Smithmie [sic]. He’ll be 12 ½ on thursday [sic]. When I take him shopping, he just wants to buy-out everything in the store. He’s so cute and much smarter than most. Love, Aunt Betty.” The takeover agreement was in the form of a tender offer from Nephew & Smith for the outstanding shares of Oratec at an offer price of $12.50 per share. Day himself was alleged to have purchased 12,000 shares of Oratec from February 12 - February 13, and sold them on February 14 after the takeover announcement was released. Without admitting or denying the allegations, Day agreed to pay $94,464.49 in disgorgement, pre-judgment interest, and civil penalties, and consented to be barred from future violations of the securities laws.

• SEC v. Jeong, Civil Action No. CV 06-0256 DSF (C.D. Cal. Jan. 18, 2006). Without admitting or denying the allegations, Deog Kyoon Jeong, a co-founder and paid consultant to Silicon Image, Inc., settled insider trading charges with the SEC related to the sale of Silicon

Image shares. The SEC alleged that Jeong sold 40,000 shares of Silicon Image within hours of learning that the company’s audit committee had launched an internal investigation into revenue recognition issues. According to the SEC, a week after Jeong’s sale, Silicon Image announced that because of the audit committee’s recently launched internal investigation it would not file its Form 10-Q for the third quarter of 2003 in a timely manner. The price of Silicon Image stock fell 28% and the SEC alleged that Jeong avoided losses of $56,000 by selling his shares of Silicon Image in advance of the announcement. Jeong consented to the entry of a final judgment that permanently enjoins him from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The final judgment also requires Jeong to pay a $56,000 civil penalty and to disgorge $56,000 in illegal trading profits and $6,363.10 in prejudgment interest thereon.

• SEC v. Menezes, Civil Action No. 06 CV 0701 (S.D.N.Y. Jan. 31, 2006). The SEC reached a settlement with Victor J. Menezes, a former senior officer of Citigroup, over allegations that Menezes engaged in insider trading in March of 2002. The SEC alleged that Menezes exercised Citigroup stock options and sold most of the resulting shares on March 28, 2002, at a time when he was in possession of the material, non-public information that Citigroup would report hundreds of millions of dollars in losses related to the company’s Argentine operations, and that Citigroup would miss consensus estimates. When the company announced its reduced earnings on April 15, 2002, the stock price was $4.07 lower than when Menezes sold his stock. As a result, the SEC alleged that Menezes avoided substantial losses. In the settlement, Menezes neither admits nor denies the allegations, is permanently enjoined from violating Section 17(a) of the Securities Act of 1933, and is required to pay $2.68 million in disgorgement, prejudgment interest, and civil penalties.

• SEC v. Svoboda, No. 00 Civ. 8557 (MBM) (S.D.N.Y. Jan. 3, 2006). The U.S. District


Court for the Southern District of New York granted the SEC summary judgment and found that Richard A. Svoboda, a former NationsBank N.A. credit policy officer, and Michael A. Robles, Svoboda’s alleged tippee, engaged in insider trading involving information about the bank’s clients in violation of Section 17(a) of the Securities Act of 1933 and Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 and Rules 10b-5 and 14e-3 thereunder. The court permanently enjoined both defendants from violating the antifraud provisions of the federal securities laws and ordered Svoboda to disgorge $219,100 in ill-gotten insider trading gains plus prejudgment interest of $186,911.11 and Robles to disgorge $1,039,252.80 in ill-gotten insider trading gains plus prejudgment interest of $757,821.53. Under the court’s order, Svoboda is jointly and severally liable for Robles’ disgorgement and prejudgment interest. The court also imposed civil money penalties of $150,000 on Svoboda and $250,000 on Robles. The court found that in late 1994 or early 1995, Svoboda and Robles agreed that Svoboda would give Robles inside information regarding NationsBank clients, including information about prospective acquisitions or negative earnings developments. Robles would then execute all of the securities trades and split the illegal profits evenly with Svoboda. Robles traded in the securities of over 20 different issuers based on inside information. Svoboda also secretly executed several trades using confidential inside information for his own profit. The court declined to impose the civil penalties requested by the SEC, the maximum civil penalty of more than $3 million apiece, given the defendants’ financial situations, other assessed sums, and previously concluded criminal proceedings.

• SEC v. Talbot, No. 04-04556 MMM (PLAx) (C.D. Cal. Feb. 14, 2006). An insider trading lawsuit by the SEC against J. Thomas Talbot, a former director of Fidelity National Financial Inc. was dismissed by the U.S. District Court for the Central District of California. The complaint alleged that on April 22, 2003 Talbot learned from Fidelity’s CEO in a board meeting that

LendingTree, Inc. would be acquired for a substantial premium. At the time, Fidelity held a large stake in LendingTree. Despite being warned not to trade on the information, the SEC alleged that Talbot bought 10,000 shares of LendingTree shortly thereafter. Talbot allegedly then sold the stock once the acquisition on LendingTree was announced, netting a profit of $67,800. In dismissing the case, the Court held that the SEC failed to show that Fidelity, and derivatively its directors, owed any duty of confidentiality to LendingTree when it received the information regarding the acquisition. Therefore, the court held that Talbot could not have breached any duty of confidentiality to LendingTree by trading on that information.

Internal Controls • In re Cummins Inc., SEC Admin. Proc.

File No. 3-12173 (Feb. 7, 2006). Without admitting or denying the charges, Cummins Inc. reached a settlement with the SEC over alleged books and records and reporting violations under Sections 13(a), 13(b)(2)(A), and 13(b)(2)(B) of the Securities Exchange Act of 1934 and Rules 12b-20, 13a-1, and 13a-13 thereunder. The SEC did not allege that any of Cummins’ violations involved scienter. Rather, the SEC alleged that Cummins violated the securities laws by failing to reconcile accounts payable and other balance sheet accounts at two manufacturing locations. Because of the failure, the Cummins was forced to restate its financial results for the 2000 to 2002 financial years. The SEC also alleged that Cummins failed to maintain a system of internal controls that were adequate “to provide reasonable assurances that its transactions were recorded as necessary to permit the preparation of its financial statements in conformity with generally accepted accounting principles.” As part of the settlement, Cummins was ordered to cease and desist from future violations of the books and records and reporting rules. The SEC noted that it took into consideration the cooperation and remedial acts of Cummins in determining the terms of the settlement.


Jurisdiction and Procedure • Belizan v. Hershon, No. 04-7187 (D.C. Cir.

Jan. 17, 2006). The U.S. Court of Appeals for the District of Columbia Circuit held that the Private Securities Litigation Reform Act of 1995 (“PSLRA”) does not mandate that a dismissal be made with prejudice for failure to meet pleading requirements. Plaintiffs alleged that they purchased debt securities from InterBank Funding Corp. (“IBF”) as part of a Ponzi scheme where proceeds from successive securities offerings were used to make interest payments to those who had invested in prior offerings. During the relevant period, Radin Glass & Co. served as IBF’s independent auditor and CIBC World Markets Corp. sold IBF’s debt securities to investors. The complaint alleged that: (1) Radin and CIBC had disseminated materially false and misleading information about IBF’s funds in violation of Section 10(b) of the Securities Exchange Act of 1934;. (2) Radin violated Section 11 of the Securities Act of 1933 by attesting that IBF’s financial statements, which were allegedly materially false and misleading, complied with generally accepted accounting principles; and (3) CIBC had violated the prospectus delivery requirements of Section 12(a)(1) and (2) of the Securities Act when it sold IBF’s securities to investors. The court noted that although the PSLRA provides that “‘[d]ismissal for failure to meet pleading requirements’ is appropriate, 15 U.S.C. § 78u-4(b)(3)(A), the Act does not say whether such dismissal should be with or without prejudice” and that the text of the PSLRA does not provide language that supersedes the ordinary application of Rule 15(a). As a result, the court stated that the general standard for dismissing a complaint with prejudice held in which dismissal with prejudice is warranted only when a trial court determines that the allegation of other facts consistent with the challenged pleading could not possibly cure the deficiency. See Firestone v. Firestone, 76 F.3d 1205, 1209 (D.C. Cir. 1996).

• Carnero v. Boston Scientific Corp., No. 04-1801 (1st Cir. Jan. 5, 2006). The U.S. Court of Appeals for the First Circuit denied Argentinean national Ruben Carnero

whistleblower protection under the Sarbanes-Oxley Act (“the Act”) when he was terminated by Boston Scientific Argentina, a Brazilian subsidiary of Boston Scientific Corp. (“BSC”), a U.S. company. Carnero claimed he was terminated when he disclosed that the company’s Argentinean and Brazilian officials were engaged in fraudulent accounting schemes. Carnero sued the company in Argentina seeking termination benefits, and filed a complaint against BSC with the Department of Labor (“DOL”) under Section 806 of the Act. The DOL determined that employees of U.S. companies working outside of the U.S. were not covered under the whistleblower protections of Sarbanes-Oxley. Carnero appealed to the U.S. District Court for the District of Massachusetts, which upheld the DOL’s decision. Carnero argued on appeal to the First Circuit that the whistleblower protection should extend to employees outside of the U.S., to prevent U.S. companies from shielding themselves, through their foreign operations, from the investor protection of Sarbanes-Oxley. The First Circuit noted that while Carnero’s arguments had merit, there is a presumption that U.S. laws do not have extraterritorial application absent a clear indication from Congress that they do. The court held that because Congress has indicated the extraterritorial application of other provisions of the Act, the absence of such intent in this provision of the Act indicates that Congress did not intend for it to have extraterritorial application.

• Miles v. H-Quotient Inc., No. 05-289 (U.S.

Nov. 7, 2005). The Supreme Court denied a petition for certiorari filed by defendant Timothy Miles seeking review of the U.S. Court of Appeals for the Fourth Circuit’s dismissal of his appeal of a district court’s ruling that it lacked subject-matter jurisdiction under the 1998 Securities Litigation Uniform Standards Act (“SLUSA”). Congress enacted SLUSA to prevent litigants from bringing actions in state court to avoid the pleading requirements of the 1995 Private Securities Litigation Reform Act. SLUSA allows a defendant to remove a state law class action, in which the plaintiffs allege


misrepresentations in connection with a purchase or sale in a covered security, to federal court and to seek dismissal of such an action. In the present case, plaintiff H-Quotient Inc. brought suit in Virginia state court against Miles for allegedly defamatory statements posted on his web site and in press releases. Miles removed the case to federal district court and sought dismissal, but the district court remanded the case to state court due to a lack of subject-matter jurisdiction. In reaching this conclusion, the district court explained that SLUSA did not apply because that statute only addresses suits in which damages are sought on behalf of more than 50 persons whose claims involve common issues of law and fact; while in the present matter, only H-Quotient sought damages against Miles.

Mutual Funds • In re American Express Financial Corp.,

SEC, Admin. Proc. File No. 3-12114 (Dec. 1, 2005); In re American Express Financial Advisors Inc., SEC, Admin. Proc. File No. 3-12115 (Dec. 1, 2005). Without admitting or denying liability, Ameriprise Financial Inc. (“AFI”), an investment adviser, and Ameriprise Financial Services Inc. (“AFSI”), a broker-dealer, settled charges with the SEC. The SEC alleged that AFI permitted certain shareholders to engage in market timing of mutual funds advised by AFI, even after the funds prospectus disclosures expressly prohibited the practice. AFI agreed to pay $15 million in disgorgement and civil penalties. In addition, AFI settled similar charges with the Minnesota Division of Securities, resulting in an additional $2 million civil penalty. With regard to AFSI, the Commission alleged that the entity failed to disclose the receipt of revenue-sharing payments and directed brokerage commissions from certain mutual fund families in exchange for benefits, such as reduced transaction charges and exclusive shelf space for selling their funds. AFSI agreed to pay a total of $30 million to settle the SEC charges and an additional $12.3 million to settle similar allegations made by the NASD.

• Chase Investment Services Settles Charges With NASD Over Failure Of Adequate Controls, Pays $290K (Dec. 12, 2005). The NASD has settled its case against Chase Investment Services of Chicago for $290,000. The NASD alleged that Chase failed to enforce mutual fund trading limits to prevent market timing by a hedge fund client as a result of Chase’s inadequate supervision policies and procedures. Upon receiving notice of trading restrictions from 19 mutual funds that prohibited the hedge fund from future trading in the fund, Chase did not implement adequate procedures to ensure these restrictions were enforced. It further allowed the hedge fund to set up new accounts in an effort to evade the trading restrictions. As a result, the hedge fund earned additional profits at the expense of other fund shareholders. In the settlement, Chase did not admit or deny the charges, but agreed to pay a fine and restitution to the disadvantaged mutual funds.

• In re Federated Investment Management Co., SEC, Admin. Proc. File No. 3-12111 (Nov. 28, 2005). Three affiliates of Federated Investors Inc., a mutual fund manager, agreed, without admitting or denying the allegations, to settle charges with the SEC that they engaged in market timing and late trading. The SEC alleged that Federated’s affiliates entered into undisclosed arrangements that allowed three investors to engage in market timing of Federated mutual funds. In addition, the SEC alleged that Federated’s trade processing system allowed employees to process trades after 4:00 PM at the current day’s net asset value. Federated agreed to pay $72 million in fines and to reduce management fees over the next five years by $20 million. Federated’s settlement with the SEC also resolved an investigation into the same conduct by the New York Attorney General’s Office.

• SEC v. JB Oxford Holdings Inc., Civil Action No. CV 04-7084 PA (VBKx), (C.D. Cal. Jan. 18, 2006); In the Matter of JB Oxford Holdings Inc., SEC, Admin. Proc. File No. 3-12148 (Jan. 18, 2006). Without admitting or denying the allegations, JB Oxford Holdings Inc. (“JBOH”), its wholly-


owned broker-dealer subsidiary National Clearing Corporation (“NCC”), James G. Lewis, who was chief executive officer and president of NCC and president and member of the board of JBOH, Kraig L. Kibble, who served as director of operations for NCC, and James Y. Lin, formerly vice president of correspondent services at NCC, settled charges with the SEC that NCC facilitated several customers late trading and deceptive market timing in mutual fund shares. The SEC charged that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and that NCC with violating Rule 22c-1 under the Investment Company Act of 1940, which prohibits the purchase or sale of mutual fund shares except at a price based on the current net asset value of such shares that is next calculated after receipt of a buy or sell order. The SEC alleged that NCC personnel negotiated, drafted, and executed an agreement that allowed NCC’s institutional customers to confirm, cancel, or revise mutual fund trades facilitated by NCC after 4:00 p.m. Eastern time, when the relevant funds calculated their net asset value. Additionally, the SEC claimed that NCC engaged in practices that circumvented the restrictions that the mutual funds had placed on certain accounts as a result of market timing activities, and utilized various methods to conceal certain market timing activities. JBOH agreed to cease and desist from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and to refrain from having a controlling interest in, or operating, a firm engaged in the broker-dealer clearing business for a period of five years. NCC agreed to disgorge more than $1 million in ill-gotten gains, and to pay a civil penalty of $1 million. Lewis agreed to pay a $200,000 penalty, to be barred from serving as an officer or director of a public company for five years, and to the issuance of an SEC order barring him from association with any broker or dealer for at least five years. Kibble agreed to pay a $50,000 penalty and to the issuance of an SEC order barring him from association with any broker or dealer for at least four years. Lin agreed to pay a $35,000 penalty and to an order barring him

from association with any broker or dealer for three years.

• Merrill, Wells, And Linsco Settle With NASD Over Suitability and Supervisory Rule Violations (Dec. 19, 2005). Merrill Lynch, Pierce, Fenner & Smith, Wells Fargo Investments, and Linsco/Private Ledger Corp. settled charges brought by the NASD that they violated suitability and supervisory rules in recommending mutual fund shares to customers. The investment firms have agreed to pay a total of $19.4 million in fines. According to the NASD, the three firms’ brokers sold Class B and Class C mutual fund shares to customers without informing the customers that purchasing Class A shares would be more beneficial to their portfolios from an expense perspective. Under NASD rules, brokers must consider various factors, such as a customer’s anticipated holding period and the costs associated with the share class before recommending a particular share class to the customer. The NASD alleged that the firms failed to suitably advise their customers as to the Class A shares. As part of the settlement, the firms have agreed to a remediation plan for their customers under which the customer would be allowed to convert their shares to a more beneficial mutual fund share class.

• In re Millennium Partners L.P., SEC, Admin. Proc. File No. 3-12116 (Dec. 1, 2005). Without admitting or denying the charges, Millennium Partners, a hedge fund, and associated individuals - including Millennium founder Israel Englander, COO Terence Feeney, and General Counsel Fred Stone – agreed to settle charges, with the SEC and the New York Attorney General’s Office, that they took steps to conceal market timing in violation of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission alleged that, from 1999 through 2003, Millennium engaged in market timing, through rapid purchases and sales of mutual funds, and tried to disguise this from the mutual funds through a number of methods, such as using over 100 legal entities to execute the transactions, using brokers with


multiple registration numbers, and breaking large transactions into several smaller ones. Under the terms of the settlement, Millennium agreed to disgorge over $140 million and to implement certain corporate governance undertakings. With regard to the individual respondents, each of the three agreed to pay a civil penalty: Englander will pay $30 million, Feeney will pay a $2 million fine, and Stone will pay a $25,000 penalty.

• In re Morgan Keegan & Co. Inc., SEC Admin. Proc. File No. 3-12177 (Feb. 8, 2006). The SEC entered into a settlement with brokerage firm Morgan Keegan & Co. Inc., resolving administrative charges that the firm willfully violated Rule 22c-1(a) under the Investment Company Act of 1940 by permitting a client hedge-fund adviser to engage in late trading of mutual fund shares. The SEC alleged that because of a series of miscommunications, a Morgan Keegan broker mistakenly told the client hedge fund adviser that it could submit orders for mutual fund shares as late as 4:30 p.m. CT and still receive the day’s NAV. Morgan Keegan executed approximately 90 late trades on behalf of that client. Under the terms of the settlement, Morgan Keegan neither admits nor denies the charges, and will pay $558,806.99 in disgorgement, prejudgment interest, and civil penalties.

• The Rockies Fund Inc. v. SEC, No. 04-1255 (D.C. Cir. Nov. 15, 2005). The U.S. Court of Appeals for the District of Columbia Circuit partially vacated a SEC order due to a lack of substantial evidence to support the SEC’s finding of stock manipulation in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The SEC’s charges of stock manipulation arose out of the private placement of shares of Premier Concepts Inc., an endeavor began by petitioners John Power and Stephen Calandrella, in 1994. In this private placement, Ranald Butchard, a friend of the petitioners, acquired 200,000 shares pursuant to Regulation S, a provision governing sales outside the United States. When Butchard decided to sell these shares, he received advice from counsel that, under

Regulation S, he must resell them publicly. Subsequently, Power and Calandrella arranged for purchasers of Butchard’s stock; these transactions were found to be matched orders, those made with knowledge of a reciprocal order of the same amount at the same time. In addition, Power purchased shares of Premier in the private placement, and later engaged in wash sales, transactions that do not alter beneficial ownership, by selling Premier stock to entities he controlled and to his brother. Power stated that he entered into these transactions to receive de facto short-term loans from brokers, as a result of policies similar to those used for margin accounts, and to generate cash for himself or his brother. The D.C. Circuit explained that, even though Butchard’s sales were matched orders and Power’s transactions were wash sales, the SEC had failed to meet its burden with regard to the scienter requirement. The court explained that the mere existence of wash sales and match orders does not satisfy the SEC’s burden of proving a manipulative intent, especially when alternative motivations for the transaction exist. The D.C. Circuit did not reach the issue of whether a stock manipulation violation under Section 10(b) requires specific intent or just extreme recklessness, as the court found that the SEC could satisfy neither standard.

• Stegall v. Ladner, No. 05-10062-DPW (D. Mass. Oct. 14, 2005). The U.S. District Court for the District of Massachusetts dismissed claims brought, under Sections 36(a) and (b) of the Investment Company Act of 1940, by a mutual fund investor against fund directors and investment advisers. The plaintiff alleged that the directors and investment advisers breached a fiduciary duty by failing to participate in class action suits against companies whose stock the funds owned. With regard to Section 36(a), which creates a cause of action against affiliates of investment companies based on a breach of fiduciary duty, the district court held that this section created no private right of action, as evidenced by the express reference to SEC enforcement of the provision and the presence of an express private right created


in Section 36(b). The court also found no violation of Section 36(b), which imposes a fiduciary duty on investment advisers to not charge excessive fees, as the plaintiff failed to show a sufficient nexus between the decision not to participate in the class actions and the compensation received by the investment advisers.

• UBS to Pay $49.5 Million to Resolve NYSE, New Jersey Market-Timing Allegations (Jan. 12, 2006). UBS Financial Services, Inc. agreed, without admitting or denying the charges, to be censured and fined a total of $49.5 million by New York Stock Exchange Regulation (“NYSER”) and the New Jersey Bureau of Securities for failure to supervise market-timing activities engaged in by brokers, failure to establish appropriate procedures for supervision and control, and failure to maintain adequate books and records. NYSER alleged that beginning in January 2000 and continuing through December 2002, brokers in at least seven UBS branch offices used trading practices to conceal their identities, and those of their customers, mostly hedge funds, to enable them to trade in mutual funds that sought to limit or curtail their market-timing. NYSER claimed that these trading practices included the use of multiple branch wire code prefixes, multiple broker identification numbers, multiple customer accounts, and the splitting of one trade into numerous smaller ones to avoid detection by mutual funds, known as “under the radar” trading. According to NYSER, UBS received more than 1,000 market-timing- related complaints from mutual funds, but did not have any policies or procedures in place that would have required individuals receiving such notices to alert the Compliance Department or escalate them to appropriate supervisors. In addition, from April through October 2001, UBS became aware, in some instances, that certain brokers were engaged in market-timing practices, but did not put in place reasonable procedures to ensure that it complied with these specific complaints. NYSER alleged that UBS also failed to maintain records of certain trades placed by the brokers and intra-firm e-mail prior to August 2001, which disadvantaged UBS’s

ability to supervise the activity, as well as the subsequent regulatory investigation. UBS agreed to retain an outside law firm to review the its procedures relating to relating to supervision and the maintenance of books and records, and to have that report submitted to NYSER and its Board of Directors.

• In re Veras Capital Master Fund, SEC,

Admin. Proc. File No. 3-12133 (December 22, 2005); In re Veras Investment Partners LLC, DFTC, Docket No. 06-01 (December 22, 2005). Two hedge funds, their investment adviser, and two senior executives, without admitting or denying the allegations, settled charges brought by the SEC, the CFTC and the New York Attorney General’s office for market timing and late-trading in mutual funds. According to the SEC, Veras sought to evade mutual fund market timing restrictions that limited the frequency of trades by using newly created legal entities to open multiple accounts at various brokerage firms. Through multiple accounts, Veras was able to trade with smaller amounts in an effort to conceal its true identity. Veras also engaged in late trading. In the SEC and criminal actions, the defendants will pay approximately $35,000,000 in disgorgement, prejudgment interest, and restitution. The two senior executives additionally will each pay a $75,000 civil penalty and will be barred from the investment advisory industry for at least 18 months. In the CFTC case, the defendants have agreed to be held jointly and severally liable for a $500,000 civil penalty, with a similar 18-month industry bar for the two senior executives.

NASD • NASD v. SEC, No. 04-1145 (D.C. Cir. Dec.

13, 2005). The U.S. Court of Appeals for the District of Columbia found that the NASD lacked standing to challenge a Securities and Exchange Commission judgment dismissing an NASD disciplinary action. The NASD argued that it was a “person aggrieved by a final order of the Commission” under section 25(a) of the Securities Exchange Act of 1934, entitling the NASD to judicial review. The D.C. Circuit agreed with the Commission’s


argument, however, that the NASD is not a “person aggrieved” under section 25(a) when it is acting in its adjudicatory capacity. The court noted that this was the first time the NASD, in its 70-year history as a first-level adjudicator, had appealed to the courts to reverse an SEC order overturning an NASD decision. The court declined to address whether the NASD could ever be a “person aggrieved” under the statute, stating, “We leave for another day the question of whether the NASD can be a ‘person aggrieved’ in its capacity as a professional association with a cognizable stake in a SEC decision overruling a NASD disciplinary decision.” The court characterized the NASD as a “disgruntled first-level tribunal, complaining because it has been reversed by a higher tribunal.”

New York Stock Exchange • NYSE Fines 18 Firms for Failure to

Comply with “Blue Sheet” Requirements (Jan. 31, 2006). The NYSE announced that 18 firms would be fined between $150,000 and $500,000 each for a total of $5.85 million for failing to comply with NYSE “blue sheet” reporting requirements. “Blue sheets” contain information about trades executed by member firms, such as the identity of the account holder and the type of transaction. The NYSE allegations, which the member firms neither admitted nor denied, claimed that the settling firms failed to respond accurately to mandatory regulatory requests for the “blue sheets.” As part of the settlement, the firms agreed to establish and maintain systems and procedures to comply with the “blue sheet” reporting requirements, and agreed to the imposition of a censure. The settling firms were: Calyon Securities (USA) Inc., Merrill Lynch, Pierce, Fenner & Smith Inc., Neuberger Berman LLC, NF Clearing Inc. f/k/a Fiserv Securities, Inc., UBS Securities LLC, Wachovia Capital Markets LLC, Charles Schwab & Co. Inc., National Financial Services LLC, Pershing LLC, Piper Jaffray & Co., Southwest Securities, Inc., Credit Suisse First Boston, E*Trade Clearing LLC, Goldman, Sachs & Co., LaBranche Financial Services Inc., Lazard Capital Markets LLC, Lehman Brothers Inc., Preferred Trade Inc., Sanford C.

Bernstein & Co. LLC, and SunGard Global Execution Services LLC. Disciplinary action has also begun against Wedbush Morgan Securities Inc. and Schon-EX LLC in connection with “blue sheet” reporting violations.

Officers and Directors • In re Goodfellow, SEC, Admin. Proc. File

No. 3-12117 (Dec. 1, 2005). In the first enforcement action brought under Section 13(k) of the Securities Exchange Act of 1934, a provision added by the Sarbanes-Oxley Act to prohibit publicly-traded companies from making personal loans to executives, Peter Goodfellow, the former CEO of Stelmar Shipping Ltd. (“Stelmar”), and Stamatis Molaris, the company’s former CFO, agreed, without admitting or denying wrongdoing, to settle charges with the SEC. The SEC alleged that, in violation of Section 13(k), Goodfellow authorized an interest-free $125,000 loan from the company to Molaris, and Molaris authorized an interest-free loan to Goodfellow for $169,400. In their defense, the respondents claimed that they believed the payments to be “advances” that were not governed by Section 13(k); however, the SEC explained that the provision draws no distinction between loans and advances. Prior to their resignation from the company, Stelmar imposed a $50,000 fine on Goodfellow and a $30,000 fine on Molaris. Each individual agreed to an order to cease and desist from future securities law violations.

Remedies • Weinraub v. Glen Rauch Securities Inc., 05

Civ. 4072 (SAS) (S.D.N.Y. Dec. 9, 2005). The U.S. District Court for the Southern District of New York dismissed the frivolous claims of an angry investor against a brokerage, and imposed Rule 11 sanctions against his attorney. Under the sanctions, the attorney must pay the brokerage and other defendants’ attorney’s fees, totaling $40,000, unless he can show that the sanctions are an “unreasonable burden.” The plaintiff, investor Mark Weinraub, first brought an NASD arbitration proceeding against defendant Glen Rauch Securities, Inc. alleging breach of fiduciary duty and negligence for allowing Weinraub to maintain an “unreasonably risky margin


position” in his margin account. The NASD found against Weinraub, and Glen Rauch was awarded damages for outstanding debt in Weinraub’s margin account. A New York state court confirmed the award, and Weinraub was unsuccessful in appealing the confirmation order. Weinraub then filed this suit in federal court against the brokerage, the NASD arbitrators, and several other defendants for alleging violations of securities laws, breach of fiduciary duty, civil rights violations, breach of contract, defamation, and conspiracy. The court dismissed the complaint as “woefully deficient”: it was barred by res judicata, time-barred under the statute of limitations, did not comply with the 1995 Private Securities Litigation Reform Act pleading requirements and failed to allege any violations against one of the defendants. Having dismissed all federal claims in the complaint, the court determined that it did not have jurisdiction over the case. The court further found that Rule 11 had been violated, and ordered Weinraub and his attorney, who is also his brother, to demonstrate to the court why it should not impose sanctions on the attorney.

SEC Enforcement • SEC Drops Charges In Revenue

Recognition Scheme (Dec. 20, 2005). The Securities and Exchange Commission dismissed charges, a month before trial, against four former executives of TenFold Corp, a software development company. The executives had been charged with misstating or omitting material information about the company’s operations and earnings while benefiting from illegal profits from the sale of TenFold stock. TenFold settled the charges against it when they were brought in 2002, but litigation was still pending for the four executives. A SEC spokesman stated that the dropped charges were due to newly discovered evidence that was previously withheld as privileged.

• SEC v. KPMG LLP, Civil Action No. 03 CV 0671 (S.D.N.Y. Feb. 22, 2006). The SEC settled charges against four individual KPMG auditors, the last remaining KPMG defendants in connection with a fraudulent $1.2 billion earnings manipulation scheme

by Xerox Corp. Under the settlement, the defendants neither admit nor deny the allegations. Two of the settling defendants agreed to pay $150,000, which are the largest civil penalties ever imposed by the SEC against individual auditors, while a third defendant agreed to pay $100,000. The complaint alleged that the auditors were each involved in the audits when Xerox employed fraudulent “topside adjustments” in order to meet Wall Street earnings expectations. These “topside adjustments” included, among other things, improper adjustment of the allocations of revenues that Xerox received from leases of Xerox office equipment. While the scheme was occurring, KPMG allegedly issued unqualified audit reports that Xerox’s financial statements were in compliance with GAAP. The SEC alleged that these audit reports were materially false and misleading, and that by issuing the reports, the defendants aided and abetted Xerox’s fraud. Three of the four settling audit partners were alleged to have: permitted Xerox to use certain topside accounting adjustments that they knew or should have known violated GAAP; failed to test or require Xerox to test the assumptions used to justify the adjustment; and failed to exercise the professional care and skepticism required by GAAS. Each was permanently enjoined from violating certain provisions of the securities laws, and was suspended from practicing before the Commission as an accountant. The fourth settling audit partner allegedly failed to exercise professional care and skepticism in his role as concurring audit partner by failing to address the numerous problems with Xerox’s 2000 audit while conducting an “in depth review” of the audit. He agreed to a censure under the SEC’s Rules of Practice, but was not required to pay a civil penalty.

• SEC v. McAfee Inc., Civil Action No. 06-009 (PJH) (N.D. Cal. Jan. 4, 2006); In re Applix Inc., SEC, Admin. Proc. File No. 3-12138 (Jan. 4, 2006). The SEC will determine the appropriateness of a corporate penalty based on two considerations: whether the corporation benefited as a result of the violation and whether the penalty will


further harm the injured shareholders. In addition, the SEC highlighted seven additional factors that should be considered: “1) The need to deter the particular type of offense; 2) The extent of the injury to innocent parties; 3) Whether complicity in the violation is widespread throughout the corporation; 4) The level of intent on the part of the perpetrators; 5) The degree of difficulty in detecting the particular type of offense; 6) The presence or lack of remedial steps by the corporation; and 7) The extent of cooperation with the SEC and other law enforcement agencies.” The SEC compared the McAfee and Applix cases, and explained that despite similar accounting fraud charges, McAfee was assessed a $50 million penalty while Applix settled without a penalty imposed. The SEC stated that the reasons for the difference in penalties were: (1) McAfee benefited from its fraudulent accounting scheme, while Applix did not; (2) McAfee is a “financially strong” company, and a financial penalty would unlikely cause hardship to its shareholders, whereas a financial penalty for Applix, a much smaller company, would devastate shareholders; (3) the monetary penalty could be distributed effectively to shareholders who were adversely affected by the McAfee’s conduct, whereas in Applix this would be “impractical;” and (4) the conduct in McAfee was pervasive, while the deceptive conduct in Applix was more limited.

Short Sales • SEC v. Compania Internacional

Financiera S.A., No. 05-CV-10634 (LAK) (S.D.N.Y. Dec. 19, 2005). In what will be the largest settlement in an SEC enforcement action involving a violation of Rule 105 of Regulation M, Compania Internacional, a European investment vehicle, will pay $6.3 million in disgorgement and civil penalties to the SEC for alleged violations of Rule 105 and Section 10(a) of the Securities Exchange Act of 1934 short-sale restrictions. According to the SEC, Compania sold short during the restricted period set by Rule 105, and then used securities it bought from underwriters of IPOs to cover its shares. Under this short

selling scheme, Compania made over $4.7 million in profits.

Short Swing Profits • Allaire Corp. v. Okumus, Docket No. 04-

2149-cv (2d. Cir. Jan. 5, 2006). The U.S. Court of Appeals for the Second Circuit ruled in a case of first impression that the expiration of a short call option is not a purchase, and thus does not expose the insider/writer to Section 16(b) liability if the insider/writer wrote another call option within six months of that expiration. Section 16(b) of the Securities Exchange Act of 1934 prohibits statutory insiders from reaping any profits from their “short-swing” trades in equity securities of the corporation. A “short-swing” occurs when a sale and purchase of an equity security is made within six months of each other. Allaire alleged that Okumus wrote a set of call options on Allaire stock on November 17, 2000, the call options expired unexercised a month later, and in January 2001 Okumus wrote a second set of call options in violation of Section 16(b). The court disagreed, noting that the purpose of the statute is to “hold[] traders liable only for those transactions in which they can exploit their inside information for their own profit.” The court continued “when the option is written by the insider (and not canceled), leaving the insider with no control over whether or not it will be exercised, his or her inside information, at least in the usual case, cannot be employed for his or her personal profit.” Thus, the court upheld the district court’s conclusion that the expiration of a call option is not a “purchase” under Section 16(b).

• Litzler v. CC Investments LDC, No. 02 Civ. 6313 (AKH) (S.D.N.Y. Jan. 24, 2006). The District Court for the Southern District of New York held that three institutional investors did not constitute a group for purposes of the short-swing profits rules under Section 16(b) of the Securities Exchange Act of 1934. To raise additional capital, Data Race Inc. had sought to find investors for a private placement of its convertible preferred stock, and eventually identified and began due diligence with three potential institutional investors. Data


Race requested that a single attorney be used as the principal draftperson for all of the three firms. While the three potential investor firms agreed and used a single attorney to negotiate with Data Race, they each otherwise acted independently in deciding to invest in the issuer, taking advice from counsel, and conducting due diligence. Data Race and the three firms entered a purchase agreement for the convertible preferred stock on November 7, 1997, and conversion of the stock occurred in 1998. In June 2002, Data Race filed for bankruptcy, and in August 2002, a Data Race shareholder filed this suit to recover the short-profits realized by the three firms on conversion of the preferred stock. In September 2002, the bankruptcy trustee of Data Race was substituted as the plaintiff. The complaint alleged that because the investors had negotiated through a single attorney, the firms acted with others as a group under Section 13(d)(3) of the Exchange Act, and should be considered a group for purposes of the short-swing profits forfeiture rule of Section 16(b). Because the firms collectively, but not individually, owned more than 10% of Data Race, if treated as a group the firms would be liable to Data Race for the profits made upon conversion of the stock. The court found no evidence that Data Race ever considered the three firms as a group, and that the plaintiff had showed nothing more than the use of a single lead draftsman, at the behest of Data Race. Therefore the court granted the defendant’s motion for summary judgment.

Stock Markets • PTR Inc. v. SEC, 3d Cir., No. 04-4451

(Nov. 9, 2005). The U.S. Court of Appeals for the Third Circuit upheld disciplinary sanctions on a Philadelphia Stock Exchange member firm, PTR, Inc., and its executive vice president, Dennis McBride, for violating exchange rules by misrepresenting trading orders from broker-dealers as orders from public customers. McBride admitted during a disciplinary hearing of the Exchange’s Business Conduct Committee (“BCC”) that he misrepresented eighty-six trade orders from broker-dealers as orders from public customers, without making a reasonable effort to verify whether customer

was a public customer. Although McBride argued that these mistakes were inadvertent, and that he was not aware at the time that he was obligated to comply with the rule, McBride admitted that he had on a previous occasion settled with the Exchange and paid a fine for violating the rule. Finding that McBride had violated the rule, the BCC censured PTR and McBride, imposed an $86,000 fine, and suspended McBride from association with the Exchange for one week. McBride sought review of this decision by the Board of Governors, who affirmed the fine but increased the suspension term to three months. The SEC affirmed the decision of the Board. Rejecting McBride’s argument that the increased suspension term without notice or hearing violated the procedural provisions of the Exchange rules and the Securities Exchange Act, the Third Circuit held that the provisions of the rule clearly authorized the Board to increase the sanction in its discretion. The court further noted that PTR and McBride were given notice of the charges and a full hearing before the BCC, and notice through the clear language of the rule that sanctions could be increased upon Board review. The court determined that the Board did not abuse its discretion in increasing the sanctions, as McBride’s repeated disregarded for the Exchange’s rules warranted heavy sanctions to deter future improper conduct.

• In re NYSE Specialists Secs. Litig., 03 Civ. 8264 (RWS) (S.D.N.Y. Dec. 12, 2005). The U.S. District Court for the Southern District of New York upheld the NYSE’s immunity, dismissing charges against the NYSE related to the alleged misconduct of seven of its specialist firms. The complaint, brought by a class of public investor plaintiffs who bought and sold shares listed on the NYSE, alleged that specialists benefited through improper trading practices at the expense of their customers, in violation of Sections 10(b) and 20(a) of the 1934 Securities Exchange Act and state law fiduciary duties. The NYSE was charged with failing to properly exercise its regulatory authority. The NYSE argued that it was immune from these charges under the doctrine of absolute immunity. The court, citing the Second Circuit’s reasoning in the D’Alessio opinion


[D’Alessio v. New York Stock Exchange, 258 F.3d 93 (2d Cir. 2001)], found that the NYSE is immune from suit when it is acting in its quasi-governmental capacity. The court further explained that as a self-regulating organization, the NYSE acted much like the SEC in interpreting securities laws and monitoring compliance among its members. As such, the court reasoned, the NYSE enjoyed the same absolute immunity as the SEC when performing such quasi-governmental functions. Because the alleged misconduct in this case fell within the NYSE’s quasi-governmental functions, the NYSE enjoyed immunity from these claims and the court dismissed the charges.

State News • Abrams Centre National Bank v. Farmer,

Fuqua & Huff P.C., No. 08-05-00140-CV (Tex. Ct. App. Oct. 27, 2005). A Texas appeals court affirmed a grant of summary judgment for defendant Farmer, Fuqua & Huff P.C. (Farmer) with respect to a claim of negligent misrepresentation in connection with Farmer’s audit of ESS College of Business Inc. (“ESS”). Farmer provided ESS with audits for the fiscal years of 1998 through 2001 to send to Chase Bank of Texas (“Chase”) in connection with providing ESS with a line of credit. In addition to sending copies of Farmer’s audits to Chase, ESS also sent them to Abrams Centre National Bank (“Abrams”), from whom ESS took additional lines of credit, without notifying Farmer. When ESS defaulted on its loans, Abrams brought suit against Farmer for negligent misrepresentation of ESS’s financial state in the audits. The appellate court rejected this claim, explaining that Farmer did not owe Abrams a fiduciary duty because Farmer never was aware that Abrams would receive the audits and, thus, never intended that Abrams would rely on them.

• Citigroup Violates R.I. Securities Act For Failure to Supervise, Pays $1 Million Penalty (Dec. 21, 2005). Citigroup Global Markets Inc. settled charges that it violated the Rhode Island Securities Act when it failed to properly supervise two sales representatives who engaged in unethical conduct in the sale of securities. Over a

three- to four-year period, the sales representatives targeted elderly clients and sold them unsuitable investments, engaged in unauthorized trading and misappropriated client funds. As part of the settlement, Citigroup will pay a $1 million fine, investigate the unsuitable sales and report its findings to the state, and hire a consultant to review the business practices of its Rhode Island offices.

• Red Coat Capital Management LLC v. CIBC World Markets Corp., No. B173444 (Cal. Ct. App. Oct. 18, 2005). In a case governed by New York state law, the California Court of Appeals affirmed the trial court’s dismissal of a series of state-law claims, including fraud and breach of the implied covenant of good faith, against defendant CIBC World Market Corp. (“CIBC”) arising out of a referral agreement with plaintiff Red Coat Capital Management (“Red Coat”). The written referral agreement provided that CIBC, an investment bank, would refer potential investors to Red Coat, a hedge fund, in exchange for a percentage of the resulting fees collected by Red Coat. In 2001, due to concerns over the high percentage of funds invested by Red Coat in two small companies, CIBC sent a letter to its investors informing them of the termination of the referral agreement and how to terminate any investments in Red Coat. A month after termination of the referral agreement, Red Coat brought suit against CIBC alleging, among other things, that CIBC had breached an oral promise to refer $500 million worth in business. In dismissing Red Coat’s lawsuit, the court of appeals explained that any oral promises made by CIBC would be barred under the parol evidence rule because the parties’ written referral agreement qualified as a full integration.

• Spitzer v. McLeod, No. 403855/02 (N.Y. Sup. Ct. Feb. 9, 2006). A New York Supreme Court judge found that Clark E. McLeod, former CEO of telecommunications company McLeodUSA Inc., violated New York law by failing to disclose his receipt of stock in lucrative initial public offerings (“IPOs”) as part of a


“stock spinning scheme” operated by Salomon Smith Barney (“SSB”). The State alleged that SSB sought to ensure that McLeod and other executives would continue to retain it for their companies’ investment banking needs by diverting large quantities of IPO stock into accounts maintained for the executives by SSB. The complaint further alleged that SSB touted these IPOs to drive up the price of the stock, which allowed McLeod and other executives to sell the stock at inflated prices and yield huge personal profits. According to the court, the State asserted that McLeod caused McLeodUSA to retain SSB as its investment bank and pay $77.3 million in fees between June 1996 and January 2001. In return for this business, the State claimed that from September 1997 to September 2000, SSB allegedly allocated shares of IPOs to McLeod 32 times, from which McLeod realized $9,430,901 in profit. Additionally, the State alleged that Jack Grubman, then a SSB analyst, touted McLeodUSA’s stock after attending a company board meeting in 2001, after which McLeod sold 2.2 million shares of his personal McLeodUSA stock for a profit of approximately $99 million. The court held that McLeod violated New York’s Martin Act when he failed to disclose his receipt of IPO shares from SSB because the non-disclosure was both material and fraudulent for Martin Act purposes. The court reasoned that the receipt of the IPO shares was material information because it was reasonable for an investor “who knows that a director/officer has entered into a remunerative relationship with one of the corporation’s banks or clients to infer that that director/officer has abandoned or at least compromised his position of trust.” The court added that the non-disclosure was fraudulent because the purchasing public tended to be deceived or misled as to the totality of the reasons underlying the decision to retain SSB and relay on its advice.

• Tucker v. Scrushy, CV 02-5212 (Ala. Cir. Ct. Jan. 3, 2006). The Alabama Circuit Court will require Richard Scrushy, former HealthSouth Corp. Chairman and Chief Executive Officer to return $48 million in bonuses he received based on fraudulently

inflated company revenues. While Scrushy was absolved of any criminal wrongdoing, the court ordered him to repay his bonuses under an unjust enrichment theory. The court noted that Scrushy’s bonus was tied to the financial performance of the corporation. Bonuses paid out to Scrushy were based on fraudulent financial statements that were inflated by hundreds of millions of dollars. Based on the actual financial performance of the corporation, under the bonus scheme Scrushy should not have received any bonuses in the first place. The unjust enrichment standard requires a false statement, inducement, reliance, and injury. The court, in applying this unjust enrichment theory, followed Delaware precedent in another case against Scrushy. In the Delaware case, the court found that Scrushy was unjustly enriched when he repaid a company loan using artificially inflated shares of HealthSouth stock. The Alabama court noted that in both cases, Scrushy, as CEO of HealthSouth, benefited from fraudulent financial statements at the expense of HealthSouth.

Documents

THE SECURITIES REPORTER - Fried Frank