Securities Law - Illinois Securities Law

There has been much attention recently to the Securities Act of 1933 and the Securities Exchange Act of 1934. The actions and prosecution of Bernard Madoff increased interest.

The Illinois Securities Law (the “Act”) 815 ILCS 5, also merits attention because it is sometimes overlooked.

The Act is administered by the Secretary of State. It provides for remedies and attorneys’ fees for violations of the Act. Violations are set forth in Section 12 of the Act and remedies are described in Section 13. Section 13 also has to be followed carefully because it sets forth the procedures to pursue a remedy.
Section 12 provides generally that it is a violation of the Act to offer or sell a security except in accordance with the provisions of the Act. Violations include: (1) failure to deliver to a purchaser any security required to be registered without accompanying that security with a prospectus that meets the registration provisions; (2) failure to act as a dealer, sales person or investment advisor unless properly registered; (3) filing any document that is false or misleading, with respect to material fact, (4) engaging in any transaction which works or intends to work a fraud or deceit upon the purchaser or seller of a security; and (5) obtaining money through the sales of a security by means of an untrue statement of a material fact.
Section 13 of the Act provides that every sale in violation of the Act is voidable at the election of the purchaser. Persons who are liable are the insurer, controlling persons, underwriters, dealers or other persons who shall have participated or aided in the sale. Damages include the amount paid with interest from the date of payment. There must be a tender to the seller or tender to the Court of the securities sold. It the purchase prevails then the Court shall assess costs together with reasonable fees and expenses of the purchaser’s attorney.

There is a dual statute of limitations. First of all, a notice of election to rescind must be given within six months after the purchaser has knowledge that the sale is voidable. Notice is given served by registered or certified mail.

There is a three-year statue of limitations from the date of sale provided that if the person who brings the action knew or in the exercise of reasonable diligence should have known the violation. The three year period begins to run upon the earlier of (1) the date the person has actual knowledge, or (2) the date upon which the person bringing the action has notice of facts which in the exercise of reasonable diligence would lead to actual knowledge. The period is not extended in any event more than two years.

The Court also has the power on application by the Secretary of State when it learns that a person has engaged or is about to engaged in a violation to grant an injunction and if the proposed sale is determined to be unlawful the Court may assess costs against the defendant.

Therefore, although it is not widely understood, the Illinois Securities Law does provide several remedies including attorneys’ fees.

The Illinois Securities Law of 1953 was drafted by Samuel H. Young, former Republican Congressman for the Tenth Congressional District while he was acting as First Assistant Secretary of State. The Act of 1953 provided comprehensive investor protection including detailed provisions before securities could be offered or sold in Illinois.

During the reign of Jim Edgar as governor, the law was revised to remove many of the investor safeguards, particularly, in the area of the registration of securities. Mr. Young traveled to Springfield, Illinois at his own expense to testify before a House Committee to oppose the Edgar Amendments to the Illinois Securities Law. Unfortunately, he was not successful.

Edward X. Clinton, Sr.
Copyright 2010

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Securities Law - Section 10b-5 Insider Trading

Notwithstanding its incompetence in the handling of the Madoff Ponzi Scheme, the SEC can be thorough and aggressive, as indicated in the lawsuit filed by the SEC on March 11, 2010, SEC v. Berrettini and Pirtle, 1:10-cv-01614, in the U.S. District Court in the Northern District Court of Illinois.

In the Berrettini and Pirtle Complaint, the SEC charges both defendants with violations of Section 10b5. This Complaint also alleges that Pirtle, who tipped Berrettini, profited in the amount of $246,000.

Pirtle was an employee of a subsidiary of Royal Philips, a corporation organized in the Netherlands. Between 2001 and May 2006, Pirtle was employed as Director of Real Estate for Phillips Electronics North America, a wholly- owned subsidiary of Philips. Berrettini was a real estate broker with offices in Park Ridge, Illinois and a resident of Lake Forest, Illinois. The Complaint alleges, among other things, that Berrettini on 17 occasions transferred money to Pirtle which Pirtle described as loans, but according to the SEC they were kickbacks for confidential information furnished to Berrettini by Pirtle. The SEC Complaint gives several examples of the improper transfer of information to Berrettini by Pirtle in violation of his duties to his employer, Philips.

The Complaint alleges that Pirtle on several occasions misappropriated insider information from his employer Philips and provided it to Berrettini with the intent to enable Berrettini to trade on the information.

According to the Complaint, the improper activities started with an alleged joint venture between Berrettini and Royal. Eventually an agreement was reached to settle a dispute between Berrettini and Pirtle. Apparently that agreement was documented in a written agreement signed by Pirtle and Berrettini. Shortly after the agreement was signed, Berrettini bought a $36,000 car for Pirtle and sent him $15,000 allegedly for a gambling trip to Las Vegas.

According to the Complaint, Pirtle tipped Berrettini of three acquisitions of public companies. Berrettini in each case allegedly bought stock in advance of the public announcement of the acquisitions.

The SEC in its prayer for relief seeks a permanent injunction enjoining Pirtle and Berrettini from further violating Section 10(b) of the Exchange Act and Rule 10b-5 and to order the defendants Pirtle and Berrettini to pay to the Commission disgorgement of Berrettini’s ill-gotten gains from the alleged illegal trading, prejudgment interest and to order Pirtle and Berrettini to pay civil penalties pursuant to Section 21(A) of the Exchange Act in the amount of three times Berrettini’s ill-gotten gains resulting from the alleged illegal trading.

The Defendants have not as yet had the opportunity to respond to the Complaint by the SEC.

In conclusion, this is a thorough well-prepared Complaint by the local Branch office of the SEC in Chicago.

Special Note

The SEC alleges in the Complaint that its investigation is not complete.

Edward X. Clinton, Sr.
Copyright 2010

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Securities Law - Section 10b-5 and Investment Company Act

An important § 10b-5 case was decided by the Second Circuit on February 16, 2010. Operating Local 649 Annuity Trust Fund and certain individuals as class plaintiffs vs. Smith Barney, LLC et al., (Second Circuit, Docket No. 07-5125-cv). The main plaintiff, Local 649, purchased shares in 105 mutual funds sponsored and managed by affiliates of Citigroup. Plaintiffs claimed violations of § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 and breaches of fiduciary duty in violation of § 36(b) of the Investment Company Act of 1940. The affiliates of Citigroup included Smith Barney, Citigroup Global Markets (CGMI) and Citigroup Asset Management (CAM).
The main question was, did Smith Barney negotiate a contract for transfer services that saddled the Funds with excessive fees, a portion of which were for kickbacks to Smith Barney?

An outside contractor, First Data, had provided transfer agent services for the Funds. These services included calculating daily asset values, share prices and commissions, distributing proxies and certain accounting functions. CAM disclosed the total fees paid in Fund Prospectuses. At some point, it was decided to renegotiate the contract with First Data. CAM organized a new subsidiary CTB which contracted with the Funds to provide transfer agent services and then CTB contacted with First Data to provide most of the same services at a much lower rate. That negotiation resulted in a subcontract with First Data in a “side letter.” CTB charged the funds more in transfer agent fees than it paid First Data. It kept the money, which would later be argued belonged to the Funds.

The important aspects were concealed from the Funds’ Board of Directors. The Board was told that the goal of the new contract with CTB was to reduce fees and promote future growth.

CAM concealed its scheme from investors. The fees were disclosed in Funds prospectuses but CAM did not disclose that the transfer agent, CTB, would perform only minimal functions, but would pocket the difference between what it charged the Funds
and what it paid for its data.

A whistleblower reported to the SEC about CAM’s failure to disclose the arrangement to the Funds’ Board. Three months later CAM issued supplements to the Funds’ Prospectus disclosing the existence of the side letter and disclosing that CAM had not informed the Funds’ Board at the time of the transfer agent contract. The SEC investigated the violations of the Investment Company Act. According to the SEC the effect was to provide CTB with pre-tax revenues of approximately $100 million, offset by expenses of $10.5 million and to funnel to CAM $17 million in additional revenue. The SEC settled with Smith Barney and CTB who agreed to pay $200 million in fines and to disclose the process generated by the scheme. Various lawsuits were filed after the public disclosure of the SEC action and settlement. They were consolidated into the subject case. The District Court granted defendants’ motion to dismiss the Complaint, holding that the mischaracterization of the fees paid to CTB as transfer agent fees was not a false material representation under § 10(b).

The District Court also dismissed Local 649’s § 36(b) claims on the grounds that such a claim can only be brought derivatively. The Second Circuit said that the District Court dismissed Local 649 § 10(b) claims because it concluded that when an advisor discloses a total amount of fees paid by a fund for various services neither the fees allocation nor the transfer agent profit margin is material and that the amount of fees is relevant to the price of value and finding that an investor who knows the amount of fees the Funds pays can, when deciding to invest, compare the fees to those of its competitors. Because the total amount of fees was disclosed, plaintiffs were in possession of all material information and that “it is the amount of fees, not their allocation or a transfer agent’s transfer profit margin that is relevant to the price and value of the Funds.”

The Second Circuit pointed out that although a statement may be literally true, if susceptible to another interpretation by a reasonable investor, it may properly be considered a material misrepresentation. The determining factor is that for a fact to be considered material, there is substantial likelihood that a reasonable investor would consider it important in deciding whether to buy or sell shares.
Plaintiffs argued that the defendants’ misrepresented the services that CTB performed because investors were not told that CTB was limited to operating a small call center, that First Data would provide the majority of the services or that First Data would charge only a fraction the fees that would be drained from the Funds. Accordingly, the Court held that CAM’s misrepresentations were material and that a substantial likelihood existed that a reasonable investor would view them as significant alterations of the total mix of information available. The Court also stated that CAM acting through investment advisor Smith Barney owed a duty of uncompromising fidelity and undivided loyalty to the Funds’ shareholders. The Defendants had an obligation to negotiate the best possible arrangement for the funds. In addition, they were obligated to disclose candidly to shareholders the material features of the arrangements they crafted. The Defendants’ misrepresentations were material because there was a substantial likelihood that a reasonable investor would consider it important that its fiduciary was in essence receiving kickbacks.

The Court concluded that the dismissal by the District Court of Local 649’s Section 36(b) claim under the Investment Company Act was proper. Such a claim must be plead derivatively on behalf of the funds with damages going to the Funds rather than directly to the shareholders.

The dismissals of Local 649’s claims under 10(b) and Rule 10b-5 were vacated and remanded while the ruling by the District Court of Local 649’s claims under § 36(b) were affirmed.

Special Notes

1. There are clear similarities between the Local 629 case and Judge Easterbrook’s decision in Jones et al v Harris Associates, L.P., 527 F.3d 629 (May, 2008) described in the Clinton Firm Blog dated September 24, 2009. In the Jones case, Judge Easterbrook said courts should not second guess the setting of fees. The U.S. Supreme Court has granted certiorari in the Jones case. If the Supreme Court affirms the Jones case it, on application, may order a remand of the Second Circuit case for reconsideration of the Local 629 case.

2. It is also interesting that the SEC paid serious attention to the whistleblower in the Local 649 case, but failed in the Madoff case to follow up with careful analyses.

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Securities Law - Illinois Securities Law

Can holders of securities seek damages based on a claim that they retained a stock in a corporation based on a fraudulent financial report?

Murphy Finance Corp. was a consumer finance company engaged in the purchasing of individual installment sales contracts from automobile dealers. KPMG was the accounting firm that audited the Mercury reports. In 1997, Mercury publicly reported that the financial reports from 1993 to 1996 had been overstated due to accounting errors. The New York Stock Exchange suspended trading and the Mercury stock dropped from $14.87 to $2.12 per share.

Plaintiffs filed a class action against Mercury’s chief executive officers and directors and KPMG alleging negligence, breach of duty and common law fraud. Mercury was later dismissed and filed for bankruptcy protection. The trial court eventually dismissed plaintiff’s fourth amended complaint on the ground that plaintiff could not allege any damage that was approximately caused by KPMG’s misrepresentations.
The Appellate Court in the case of Dloogathi and others similarly situated v. KPMG, et al., No. 1-08-0168, decided December 16, 2009, stated initially that no court in Illinois had decided whether holders of securities even have a cognizable claim based on common law fraud.

The U.S. Supreme Court considered whether a private cause of action exists for holders alleging violations of SEC Rule 10b-5, where they have neither purchased nor sold any shares. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). The Supreme Court in Blue Chip refused to recognize such a claim. The Appellate Court stated that although Blue Chip Stamps concerns the viability of a holder claim for violations of federal law and not common law fraud, the United States Supreme Court’s reasoning for prohibiting such a cause of action is relevant to the present case. In Blue Chip Stamps the Supreme Court stated in part:

“The manner in which the defendant’s violation caused the plaintiff to fail to act could be as a result of the reading of a prospectus, as respondent claims here, but it could just as easily come as a result of a claimed reading of information contained in the financial pages of a local newspaper. Plaintiff’s proof would not be that he purchased or sold stock, a fact which would be capable of documentary verification in most situations, but instead that he decided not to purchase or sell stock. Plaintiff’s entire testimony could be dependent upon uncorroborated oral evidence of many of the crucial elements of his claim, and still be sufficient to go to the jury.

* * *

The very risk in permitting those in respondent’s position to sue under Rule 10b-5 is that the door will be open to recovery of substantial damages on the part of one who offers only his own testimony to prove that he ever consulted a prospectus of the issuer, that he paid any attention to it, or that the representations contained in it damaged him.” Blue Chip Stamps, 421 U.S. at 746 (1975)

The Appellate Court stated that they have found no case throughout the United States that directly supports a “holder” claim such as in the case of the plaintiffs, owners of Mercury Finance Stock.

The Appellate Court concluded that plaintiffs failed to adequately plead both reliance and damages and, therefore, failed to state a cause of action upon which relief could be granted. Thus, the principle decided in Blue Chips was upheld in Illinois.

One Justice concurred in part and dissented in part. Justice Murphy stated that he would hold that a “holder” cause of action exists in Illinois quoting § 525of the Restatement Of Torts that provides, “One who fraudulently makes a misrepresentation of fact, opinion, intention or law for the purpose of inducing another to act or to refrain from action in reliance upon it, is subject to liability to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation.” Judge Murphy did agree with the portion of the Appellate Court opinion that plaintiffs failed to plead reliance on the false statements.

The writer agrees with the majority opinion that plaintiff failed to state a claim upon which relief could be granted.

Edward X. Clinton, Sr.
Copyright 2010

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