Securities Law - Should Congress Enact Legislation Allowing Those Who Aid And Abet Securities Law Violations To Be Held Liable?

A recent survey was distributed by Opinion Research Corporation to determine if investors in securities markets should have additional rights. About 1,000 people responded. Seventy-four percent (74%) stated that there should be additional rights to seek redress for losses as a result of corporate wrongdoing. Ninety percent (90%) believe that those who participate in financial fraud such as knowingly engaging in sham transactions should be held accountable to investors.

The President of the National Association Of Shareholder And Consumer Attorneys, Ira Schochet, in a press release stated, “America must understand that Congress and the Administration must substantially increase accountability in our financial markets in order to protect investors and reduce the likelihood of systemic crisis.” Schochet, a partner in the New York law firm of Labaton Sucharow, is an experienced securities class action lawyer. Schochet also stated that the survey results show an overwhelming support for Congress to restore liability for those who aid and abet securities fraud and for those who manipulate public disclosures. Schochet said that Congress can accomplish these goals in part by reversing the principles set forth in Stoneridge Investment Partners, LLC v. Scientific-Atlantic, Inc., 522 U.S. 148 (2008) and Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) In Stoneridge, the U.S. Supreme Court held that those who aid and abet securities fraud are not liable. In that case, customers and suppliers of a cable company helped Stoneridge inflate its revenue by engaging in sham transactions to mislead the issuers’ auditors. The U.S. Supreme Court held that because the customers and suppliers owed no duty to the investors, they were not primarily liable for the fraud.
In Central Bank the U.S. Supreme Court held that the delay in updating an old land appraisal until after a closing was aiding and abetting unlawful conduct but did not give rise to primary liability under Section 10(b)(5). Specifically, the Court stated at p. 179: “[f]rom the fact that Congress did not attach private aiding and abetting liability to any of the express causes of action in the securities Acts, we can infer that Congress likely would not have attached aiding and abetting liability to § 10(b) had it provided a private § 10(b) cause of action.”

Senator Arlen Specter recently introduced legislation to give litigants a cause of action against aiders and abettors of securities fraud. Senator Specter recommended that the Securities Exchange Act of 1934 be amended to provide for private civil actions. Specter also stated that fraud involving companies such as Enron, Refco, Tyco and Worldcom have shown that secondary actors such as lendors, bankers, business affiliates and lawyers actively participate on occasion in actions that enable securities fraud. He went on to make reference to a decision by United States District Court Judge, Gerald Lynch in In re Refco Inc. Sec. Litig., SD NY No. 1-05-CV-08628 (March 2009) in which Judge Lynch suggested Congress reexamine the aiding an abetting issue. The Refco case involved a securities class action against Chicago law firm Mayer Brown LLP over its alleged role in the Refco fraud. The claims against Mayer Brown were dismissed.

Judge Lynch stated that:
“While the impulse to protect professionals and other marginal actors who may too easily be drawn into securities litigation may well be sound, a bright line between principals and accomplices may not be appropriate....There are accomplices and there are accomplices … some civil accomplices are deeply and indispensably implicated in wrongful conduct.”

The U.S. Better Business Bureau quickly issued a statement opposing the proposed legislation. Doubtless the proposed legislation will be opposed by the Republican members of the senate.

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Securities Law - SEC Appeals Adverse Mark Cuban Ruling

Earlier this year, see below entry of September 18, 2009, the Northern District of Texas dismissed the SEC’s complaint, alleging insider trading, against Mark Cuban the colorful owner of the Dallas Mavericks basketball team. The undersigned respectfully disagrees with the ruling of the District Court, as does the SEC.

Mamma.com, a public company decided to have a public offering of common stock. A few days before the public announcement, the CEO decided to call Mark Cuban, a 6% stockholder of Mamma.com to determine if he wished to buy stock in the offering. Before telling Cuban, the CEO asked Cuban to keep the information confidential and Cuban agreed. When Cuban learned from the CEO of the common stock offering, he said he was not in favor of the offering because it would dilute current stockholders and said “Well, now I’m screwed. I can’t sell.” A couple of days later Cuban sold his entire 6% holding of common stock. By selling, Cuban avoided a loss of Seven Hundred Fifty Thousand Dollars ($750,000.00). Cuban did not inform Mamma.com that he was going to sell his stock.

The SEC filed a civil law enforcement action charging Cuban with claims under Section 21(d), 21(e) and 27 of the Securities Exchange Act of 1934. Cuban filed a motion to dismiss on the grounds that he did not agree he would not sell.

The District Court granted the motion to dismiss and the SEC appealed to the Fifth Circuit. The SEC argues in its brief on appeal that Cuban misused confidential information in a breach of a duty established by the United States Supreme Court in U.S. v. O’Hagan, 521 U.S. 642 (1997), which adopted the misappropriation theory of insider trading. Under that theory a person commits fraud “in connection with a securities transaction, and thereby violates Section 10(b) and Rule 10(b)(5), when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.” p. 652. Following that decision, the SEC issued Rule 10(b)5-2(b)(1), which in part states that a duty of trust and confidence exits when “a person agrees to maintain confidentiality of information.” Cuban had argued that the SEC did not allege in its complaint that he agreed not to trade.

In its brief, the SEC also argues that the District Court failed to give proper deference to Commission Rule 10(b)5-2(b)(1). which provides that an agreement to maintain information in confidence gives rise to a duty that makes trading on confidential information without disclosure deceptive. The SEC stated because that interpretation of Section 10(b) is reasonable the Rule is entitled to Chevron deference. Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984) which held that courts must defer to the Commission’s interpretation of Section 10(b) if Congress has not “unambiguously forbidden [the interpretation] and it is *** based on a permissible construction of the statute.”
The SEC also argued that the District Court’s interpretation is incorrect even apart from Rule 10(b)5-2(b)(1). According to the SEC, trading on material non-public information after agreeing to maintain it in confidence is deceptive under the general terms of Section 10(b) and Rule 10(b)(5).

In the writer’s opinion, if the case were to be decided by the Second Circuit Court Of Appeals, it would be reversed. To the writer, the issue is simple. Cuban’s first reaction was correct. “Well now I’m screwed. I can’t sell.” The information belonged to the Company. The CEO called Cuban for a proper corporate purpose to sell stock to Cuban. The Company did not intend to give the information to Cuban. Cuban knew no gift was intended. Yet, he took the information for personal profit. That opportunity was not given to the stockholders holding the other 94% of the Company.

The Fifth Circuit however has few Securities cases and the SEC could lose.

The SEC has submitted a well-written brief. The authors of the brief are David M. Becker, General Counsel, Mark D. Chan, Deputy General Counsel, Jacob H. Stillman, Solicitor, Randall W. Quinn, Assistant General Counsel and Michael L. Post, Senior Litigation Counsel.

Cuban is represented by Lyle A. Roberts, Dewey & LeBoeuf, L.L.P.

Edward X. Clinton, Sr.
Copyright 2010

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Contract Law - The Duty of Good Faith Does Not Apply To The Bank's Decision To Call A Loan

In Reger Development, LLC v. National City Bank, No. 09-2821, the Seventh Circuit affirmed the dismissal of the Borrower's complaint against its Lender.

Reger Development alleged that it was an Illinois limited liability company involved in the development of real estate. On June 25, 2007, Reger's Principal, Kevin Reger, met with National City and executed loan documents for a revolving line of credit in the amount of $750,000. The terms of the note allowed National City to demand payment at will. Reger Development made all interest payments that were due and owing.

On August 18, 2008, National City asked Reger to pay down $125,000 towards the principal of the line of credit, which Reger did the next business day.

On September 9, 2008, National City requested that Reger "term out" $300,000 of the Note by having one of Kevin Reger's other businessess agree to take out a three-year loan in that amount secured by a second mortgage on some real estate. National City also notified Reger that it would be reducing the amount of available credit on the line of credit to between $400,000 and $500,000.

According to the complaint, Kevin Reger expressed surprise at these developments and asked if the bank would "call the line of credit if Reger Development did not agree to the requests." Opinion at 5.

Reger Development then filed a complaint alleging that (a) National City breached the contract; and (b) National City engaged in a fraudulent scheme to deceive "people into taking out loans by concealing the fact that the principal could be called on demand." Opinion at 5. Reger Development initially filed the case in the State Court, but it was removed to the Northern District of Illinois by National City.

The district court dismissed the Complaint for failure to state a cause of action.

Under Illinois law a plaintiff alleging a breach of contract must allege four elements: "(1) the existence of a valid and enforceable contract; (2) substantial performance by the plaintiff; (3) a breach by the defendant; and (4) resultant damages." Opinion at 7 (quoting W.W. Vincent & Co. v. First Colony Life Ins. Co., 814 N.E.2d 960, 967 (Ill. App. Ct. 2004). As the Court noted, "during our review we do not look at any one contract provision in isolation; instead, we read the document as a whole." Opinion at 8.

Reger Development argued that Illinois law holds that "a covenant of fair dealing and good faith is implied into every contract absent express disawoval." Opinion at 8, citing Foster Enterprises, Inc. v. Germania Federal Savings and Loan, 421 N.E.2d 1375, 1380 (Ill. App. 1981).

According to the Seventh Circuit, Reger Development's claim had a fatal flaw, namely "the duty to act in good faith does not apply to lenders seeking payment on demand notes." Opinion at 8 (citing N.W.I. Int'l, Inc. v. Edgewood Bank, 684 N.E.2d 401, 409 (Ill. App. Ct. 1997).

Thus, Reger Development could not claim that National City acted in bad faith in calling the loan. "Viewed as a whote in the light most favorable to the nonmoving party, the Note before us is plainly a demand instrument entitling National City to collect its loan whenever it wants." Thus, the demand for repayment was not a breach of contract and Reger Development could not allege a breach of contract by National City.

Comment: in the author's experience it is almost impossible to challenge bank forms and demand notes. This case illustrates that principal. Those who sign such documents need to read them and understand them.

Edward X. Clinton, Jr.
Copyright 2010

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Securities Law - Self Incrimination In SEC Investigation

The Fifth Amendment to the U.S. Constitution provides that no person shall be compelled in any criminal case to be a witness against himself. The privilege applies to both criminal and civil cases. (McCarthy v. Arndstein, 266 U.S. 34). The only limitation on this right is that the person claiming the privilege must have reasonable cause to believe that she or he could incur a prosecution or conviction from a response. The Courts have also stated that there can be no adverse inference when the privilege is asserted in a criminal case.

In a civil case, however, there can be significant risks. A 1976 U.S. Supreme Court case (Baxter v. Palmigiano, 425 U.S. 308) held that a prisoner could assert the privilege at a disciplinary hearing, but prison officials could draw an adverse inference. The proceeding was considered civil but could lead to criminal action. The claim was that the prisoner was attempting to encourage other prisoners to disobey prison rules which could lead to a riot.

The Securities and Exchange Commission began to claim that an adverse inference can be made against individuals who claim the privilege. The SEC has a manual for staff use that provides during an investigation the Commission can assert that an adverse inference can be drawn against an individual who asserts the Fifth Amendment privilege.

In a SEC investigation the Commission will inform those about to be interrogated that they do not have to answer questions based on their Constitutional right under the Fifth Amendment. But, the Commission staff does not inform those persons that an adverse inference can be made if the person is to be interrogated claims the privilege. Although the SEC investigation is not criminal in nature, the results can be serious. The SEC investigation could, after a hearing, lead to a civil monetary penalty or an order barring the person from employment in the securities industry
Further, proposed witnesses are not informed that information obtained can be sent to other governmental agencies that administer criminal statues.

Can the government insist that a corporate employer not pay legal fees for employees until there is cooperation with the government? U.S. v. Stein v. Jones, 541 F.3d 130 answers this question in the negative. In Stein, a U.S. Attorney distributed a memorandum which stated:…whether the corporation appears to be protecting its culpable employees and agents and a corporation’s promise of support to culpable employees and agents, either through the advancing of attorneys fees, through retaining the employees without sanction for their misconduct, or through providing information to the employees about the government’s investigation pursuant to a joint defense agreement, may be considered by the prosecutor in weighing the extent and value of a corporation’s cooperation.

The Second Circuit in the Stein case dismissed indictments against thirteen (13) individuals because those individuals had a Sixth Amendment right to counsel and the action of the employer interfered with the right to counsel protected by the Sixth Amendment. The Stein Court did not consider the Fifth Amendment question.
Individuals faced with the prospect of testifying in a SEC investigation have to carefully consider their options, if he or she cooperates in the hope or expectation that the government agency will accept cooperation and not pursue them further. Even if that occurs and sanctions are not imposed in that investigation, is that the end of the story? If the information is passed on to others such as the U.S. Attorney, a prosecution could result if the conduct violates other laws.

In short, a person called upon to testify in an agency investigation should seek experienced counsel to help guide them through the treacherous path.

Edward X. Clinton, Sr.
Copyright 2010

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Securities Law - College Fund Losses In Bright Start Plan

Do not assume that just because you invested in what you consider a conservative college fund for the education of your children that your investment is safe.

Lisa Madigan, the Illinois Attorney General, was a leader in obtaining a 77.2 Million dollar settlement from Oppenheimer Fund due to Oppenheimer’s alleged mismanagement of a fund with Illinois 529 College Savings Program. Lisa Madigan, the Illinois Attorney General, and the State Treasurer, Alexi Giannoulias, reached a settlement with Oppenheimer resolving an investigation into the firm’s mismanagement of the “Core Plus Fixed Income Strategy” fund. Illinois began to investigate Oppenheimer’s investment strategy after Core Plus lost about 38% of its value in the year 2008. The settlement means a recovery of about 50 cents on each dollar lost. Core Plus investors who incurred losses between January 1, 2008 and January 25, 2009 are eligible to participate in the recovery.

On December 22, 2009, Lisa Madigan stated “As a result of this agreement, Illinois families who invested in the funds will be able to recover substantial losses in their college savings account in a timely manner while avoiding the uncertainty of delay that would accompany lengthy and expensive litigation.” Five other states are negotiating settlement agreements with Oppenheimer. Those settlements so far range between 67 million and 20 million.

The Core Plus program was marketed as a conservative investment option for families with children near college age. However, suspicions emerged when Core Plus suffered losses of about 40% compared to the Bond Index used to benchmark the fund. The Bond Index showed gains of more than 5%.

Oppenheimer acknowledged the Illinois settlement but admitted no wrongdoing. It stated “Oppenheimer funds agreed to the settlement to resolve the investigation that commenced after the severe market volatility that impacted all investments in 2008, to enable the company to move ahead with its mission to provide high quality investment management services.” High quality management services! Why did they settle for $164 Million?

Investigators determined that Core Plus actually contained serious and risky investments and was leveraged by Oppenheimer’s management team. The risks were never disclosed to Illinois officials. Not surprising, the Investment Team at Oppenheimer responsible for the Core Plus strategy is no longer with Oppenheimer. Core Plus has been liquidated and replaced with alternate fixed-income investment options.
The lesson - monitor investment results frequently. Don’t wait for Lisa Madigan to bail you out.

Edward X. Clinton, Sr.
Copyright 2009

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Securities Law - Accounting and Legal Malpractice Claims

True Value, as a public company, is required to file its financial statements with the SEC pursuant to the Exchange Act. According to the SEC, there were accounting errors in the financial statements of True Value of about One Hundred Thirty Million Dollars ($130,000,000) and that for the year 1999 such loss was to be recognized. Accordingly, such statements had to be recast. Undoubtedly, the True Value stock which is publicly traded, took a hit when the news became public. That was only the start of True Value’s problems.

Management of True Value decided to pursue a remedy against its former accountants, Ernst & Young and decided that it would interview two law firms to sue Ernst & Young. The Firm of Goldberg, Kohn, Bell, Black, Rosenbloom & Moritz, Ltd. made the successful presentation to True Value and was selected. The Goldberg Firm filed an arbitration claim against Ernst & Young. The Ernst & Young Engagement Agreement with True Value required arbitration.

After four years and expenses of approximately twelve million dollars ($12,000,000) an arbitration panel ruled against True Value and ordered that True Value pay the fees and costs incurred by Ernst & Young. The panel found that True Value, through the Goldberg Firm’s actions, had exhibited “bad faith” because it failed to consider the extent of the audit work done by Ernst & Young and pressing its lawsuit on several issues where it had no chance of success. True Value opposed an Eighteen Million Dollars ($18,000,000) fee demand by Ernst & Young and ended up by paying about Eleven Million Dollars ($11,000,000) to Ernst & Young and new counsel. True Value then in December 2009 sued the Goldberg Firm in the Circuit Court of Cook County for legal
malpractice.

According to the Complaint, among other things, the Goldberg Firm advised True Value to sue its former auditors for accounting malpractice and, also, that the Goldberg Firm failed to analyze the merits of the claim and did not obtain at an early point an accounting expert.

Also True Value alleged that the Goldberg Firm failed to advise True Value that if it did not prevail in the case, it could be liable for the costs and fees to defend the accounting malpractice case. It alleged that the Goldberg Firm failed to inform True Value at an early stage that the malpractice claim would have to be arbitrated in accordance with the engagement letter and that the arbitration panel likely would consist of auditors.

The current lawsuit against the Goldberg Law Firm seeks to impose the costs incurred by Ernst & Young on the Goldberg Firm and seeks approximately Twenty Million Dollars ($20,000,000) in damages. Also, Goldberg, according to the Complaint gave negligent Securities Law advice, contributing to the above damages for which Goldberg was charged about One Million Dollars. True Value also seeks a recovery of that expense.
What started as an almost routine need to restate earnings ended up in a protracted arbitration by True Value against its former accountants and, now, in furtherance of the fiasco, True Value sues its former lawyers for legal malpractice.

Edward X. Clinton, Sr.
Copyright 2010

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Business Law - Why Incorporate?

Every now and then someone asks us why they should incorporate their business. After all, they say, why not just continue in business and use Schedule C of the IRS 1040 form to pay taxes on the business. Moreover, to incorporate invariably costs money - fees are paid to the Secretary of State (at least for an Illinois corporation) and annual fees are paid thereafter. There is also a modest legal fee as well.

Incorporation, however, is an absolute must for every business.

First, in most cases incorporation prevents a creditor from seeking to hold the owner of the business personally liable. If you are in business without a corporation, and something goes wrong, the creditor can seek to collect from your personally. This is the primary reason for the use of corporations. It is the oldest (several hundred years in the United Kingdom) and best form of "asset protection."

Second, incorporation separates the business from the owner's personal life. Your personal finances do not get mixed in with the business finances. This is an advantage.

Third, corporations provide additional flexibility and greater control. The owner may decide to reward an employee or business partner with a portion of the stock. With a corporation, provided that these decisions are properly documented, the owner may retain control by keeping the majority of the stock of the business. On the other hand, if the owner is in business without a corporation and then adds a "partner," a court may find that the owner has given away 1/2 of the business to this "partner." Worse still, both of the partners may be held personally liable for a debt of the business.

Recently we have seen advertisements on television for do-it-yourself corporations. Not surprisingly, we recommend against the do-it-yourself approach. The main reason why it is not a good idea for a nonlawyer to establish a corporation is that the nonlawyer may make a small technical mistake - which then voids the corporation. We have reviewed many do-it-yourself attempts that did not successfully form and maintain the corporation and were simply a waste of the owner's money. The Courts rarely give partial credit for a bungled attempt at incorporation.

If you have incorporated on your own, without legal advice, we recommend that you show your papers to a lawyer to obtain a professional opinion.

Edward X. Clinton, Jr.
Copyright 2010

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