Time is Money: Second Circuit Vacates SEC’s $38 Million Fine Against Hedge Fund Pentagon Capital Management

On August 8, 2013, the Second Circuit vacated the SEC’s $38 million fine against hedge fund Pentagon Capital Management PLC, holding that the Supreme Court’s decision in Gabelli v. SEC required the case to be remanded for recalculation of the civil penalty. This case is one of several SEC enforcement actions affected by the Gabelli ruling since the Court issued its decision less than six months ago. The Second Circuit’s decision highlights the limiting effect Gabelli will have on civil remedies available to the SEC for securities law violations that occurred more than five years before the agency initiated its enforcement action.

In Gabelli, the Court held that the five-year statute of limitations for filing civil enforcement actions seeking penalties for fraud begins to run from the date of the alleged violation, not when the SEC discovers, or reasonably should have discovered, the violation. Citing Gabelli, the Second Circuit in SEC v. Pentagram Capital Management PLC found that any profits Pentagon earned more than five years before the SEC filed its suit could not be included in the penalty. The parties agreed that remand on the issue was required.

The SEC alleged that Pentagon and its owner, Lewis Chester, committed securities fraud under Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 by engaging in late trading of mutual funds. Late trading involves placing and executing orders as if they occurred at or before the time the mutual fund price was determined. Such trading allows the purchaser to profit from information released after the mutual fund price is fixed each day, but before it can be adjusted the following day. The SEC alleged that Pentagon engaged in late trading through its broker dealer, Trautman Wasserman & Co., from February 2001 through September 2003. Read More

The Honeymoon is Over: Post-DOMA, Same-Sex Couples Now Spouses For Purposes of the Securities and Exchange Act Rules

The Supreme Court in U.S. v. Windsor held that the federal Defense of Marriage Act’s (DOMA) section defining marriage as between a man and woman is unconstitutional because it violates the Fifth Amendment’s equal protection clause. Under Section 3 of DOMA a person could only be considered a spouse under federal law if they were married to a person of the opposite sex.

The term “spouse” appears several times in the Securities and Exchange Act Rules. Exchange Act Rule 10b5-2 provides a non-exclusive definition of circumstances in which a person has a duty of trust or confidence for purposes of the misappropriation theory of insider trading. The misappropriation theory expands the traditional view of insider trading to cases where a person misappropriates confidential information in breach of a duty owed to the source of the information.

Subsection (b)(3) of Rule 10b5-2 enumerates circumstances where this duty is presumed to exist and includes circumstances when “a person receives or obtains material nonpublic information from his or her spouse[.]” Because Rule 10b5-2’s enumerated list is non-exclusive it’s possible a duty of trust and confidence could be found between domestic partners regardless of the Windsor ruling. However, the expanded definition of spouse post-Windsor shifts the burden, creating a rebuttable presumption that such a duty exists between same-sex couples in states where they are legally married for the purposes of the misappropriation theory of insider trading.

There are other instances where the term spouse may be significant under the securities laws, including beneficial reporting requirements for Section 16 insiders and Audit Committee independence rules.

 

Broker-Dealers: The New Frontier for SEC Enforcement

In a split vote last week, the SEC adopted new rules designed to increase protections for customers who invest money and securities with broker-dealers. Recent rulemaking and statements made by the SEC have highlighted the fact that broker-dealer regulation is becoming a growing area of SEC interest. In connection with last Wednesday’s vote, SEC Chair Mary Jo White stated that “[i]nvestors need to feel confident that their money is safe when it’s being held by their broker-dealers… [and] these rules will strengthen the audit requirements for broker-dealers and enhance [the SEC’s] oversight of the way they maintain custody over their customer’s needs.”

The new rules amend the broker-dealer reporting and notification rules codified in Section 17 and Rules 17a-5 and 17a-11 of the Exchange Act. Currently, a broker-dealer is required to file an annual report with the SEC and the SRO designated to examine that broker-dealer. The report must contain audited financial statements conducted by an independent public accountant registered with the PCAOB. Under the new requirements, a broker must file a quarterly report telling the SEC whether and how it maintains control over its client’s funds. The new rules also require that the broker-dealer let the SEC review the work-papers of the accountant, if requested. Read More

The SEC Says Cities (and City Officials!) Must Obey Securities Laws, Too

Yesterday the SEC filed an Order Instituting Cease and Desist Proceedings against the City of Harrisburg, Pennsylvania for violations of Rule 10b-5. The City consented to entry of a Cease and Desist Order. The SEC also issued a Report of Investigation under Section 21(a) discussing “Potential Liability of Public Officials With Regard to Disclosure Obligations in the Secondary Market.”

The headline message from this proceeding is that the SEC found that the City had violated the securities laws through public statements made by public officials, as well as budget documents released during a certain time period, which allegedly failed to disclose material information about the City’s dire financial condition (primarily related to its obligations on certain waste-to-energy project bonds which the City had guaranteed). The reason these statements were deemed so significant is that during this period the City had fallen far behind in releasing its Comprehensive Annual Financial Reports (“CAFRs”), so that investors had no other available current financial information. The SEC used this proceeding and its Report of Investigation to re-emphasize the statements made in its 1994 Interpretive Guidance on the obligations of participants in the municipal securities markets, and its 1996 Report following the bankruptcy of Orange County, California, that statements made by public officials which might be “reasonably expected to reach investors and the trading markets” can be subject to antifraud rules, even when such statements are not part of a specific securities offering. Read More

SEC: Facebook Friends Can Benefit

The SEC issued a release today confirming that companies can use social media outlets like Facebook, Twitter, and LinkedIn to announce information in compliance with Regulation FD (“Reg FD”) so long as investors have been alerted in advance about which social media will be used to send the information.

The SEC’s release grows out of an inquiry involving the CEO of a major Internet television network. The CEO posted on his Facebook page that his company’s online viewing had exceeded a key milestone for the first time. His Facebook statement was not accompanied or preceded by any company press release or 8-K. The stock jumped substantially, and the SEC came knocking.

The SEC’s release confirms that companies are permitted to announce material news through social media, provided investors know when and where to expect it. In response to the SEC’s latest release on Reg FD, we expect that public companies will update their social media protocols and, as appropriate, integrate investor relations communications more closely with links to sites like Facebook, Twitter and LinkedIn.

Inside Out: NASDAQ Proposes Rule to Require Internal Auditing

The NASDAQ Stock Market recently submitted a proposed rule change that would require all companies listed on the NASDAQ to maintain an internal audit function. The function would “provide management and the audit committee with ongoing assessments of the Company’s risk management processes and system of internal control.” In addition, the company’s audit committee would be required to meet periodically with the internal auditors and oversee the internal audit function. If implemented, the rule would require companies listed prior to June 30, 2013 to establish the internal audit function by December 31, 2013. Companies listed after June 30, 2013 would have to establish the function prior to listing.

The purpose of the proposed rule is to ensure that listed companies have a mechanism to regularly review and assess their internal controls and ensure management and audit committees receive information about risk management. The NASDAQ also believes the internal audit function will assist companies in complying with Rules 13a-15 and 15d-15, which require management to evaluate a company’s internal controls on a quarterly basis.

Despite the rule’s requirement of an internal audit function, the proposed language permits companies “to outsource this function to a third party service provider other than its independent auditor.” So, while the rule permits the internal audit work to be done by an outside third party, the company cannot engage the same auditing firm as both its internal and external auditor. In other words, the company needs both an independent outside auditor that cannot act as the inside auditor and an inside auditor that can be an outside auditor as long as it’s not the independent outside auditor.

Although most companies listed on the NASDAQ already have an internal audit function, the proposed rule would bring the NASDAQ into alignment with the New York Stock Exchange, which already requires its listed companies to have an internal audit function. See NYSE Listed Company Manual Section 303A.07(c).

The deadline for comments on the proposed rule is March 29, 2013.

Can We Be Classmates?

On September 6, the Second Circuit expanded class standing in a mortgage-backed securities class action suit for alleged misrepresentations in a shelf registration statement. NECA-IBEW Health & Welfare Fund v. Goldman Sachs & Co., No. 11-2763 (2d Cir. Sept. 6, 2012). The plaintiff, an investment fund, sued Goldman Sachs & Co. (“Goldman”) and GS Mortgage Securities Corp. (“GS”) alleging violations of Sections 11, 12(a)(2), and 15 of the Securities Act of 1933 on behalf of a putative class of persons who acquired mortgage-backed certificates underwritten by Goldman and issued by GS. The plaintiff alleged that a single shelf registration statement connected with 17 separate offerings sold by 17 separate trusts contained false and misleading statements concerning underwriting guidelines, property appraisals, and risks and that these alleged misstatements were repeated in prospectus supplements.

The lower court had granted the defendants’ motion to dismiss, holding that the plaintiff—who had purchased securities from only two of the seventeen trusts—lacked standing to bring claims on behalf of purchasers of securities of the other fifteen trusts.

The Second Circuit disagreed that the plaintiff lacked class standing. Although the plaintiff had individual standing only as to the securities it purchased from the two trusts, the court held that the analysis for class standing is different. According to the court, to assert class standing, a plaintiff has to allege (1) that he personally suffered an injury due to the defendant’s illegal conduct and (2) that the defendant’s conduct implicates the “same set of concerns” as the conduct that caused injury to other members of the putative class. Read More

Second Circuit Revives Securities Fraud Class Action, Finding Economic Loss Where Stock Price Rebounds Soon After Fraud Is Disclosed

Imagine a plaintiff who buys stock in a company that subsequently discloses a misstatement in its financial statements that existed at the time plaintiff invested.  The stock price drops upon the initial disclosure, and then rebounds back above the purchase price. Can that plaintiff plead economic loss, as is required under Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005)? According to the Second Circuit, the answer is yes. Read More

In Auditor Suit, Second Circuit Says Quantity Does Not Always Mean Quality

The U.S. Court of Appeals for the Second Circuit has revived a federal securities class action against Grant Thornton LLP regarding its unqualified 1999 audit opinion indicating that Winstar Communications Inc.’s 1999 financial statements was in conformity with generally accepted accounting principles. The Second Circuit’s opinion is notable because it finds that, despite an apparently thorough audit (in terms of hours spent and documents reviewed) a fact finder could still find enough evidence of a conscious disregard of signs of fraud to support an inference of recklessness. In other words, even where an auditor does a significant amount of work on an audit, such work will not necessarily immunize the auditor from securities claims. Read More

Madoff Fund Investors’ Exchange Act Claims Bite the Morrison Dust

Courts have been making slow but steady progress in testing the limits of the 2010 Supreme Court case Morrison v. Nat’l Australian Bank Ltd., 130 S.Ct. 2869 (2010). In Morrison, the Court held the federal securities laws apply only to purchases or sales made “in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.” Id. at 2888. The Second Circuit has held that the “purchase and sale” of a security occurs when “irrevocable liability” occurs and the parties are bound to the transaction. Absolute Activist Value Master Fund v. Ficeto, 677 F.3d 60 (2d Cir. 2012) Read More