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

Read More

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.

Read More

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

Read More

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.

Read More

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

Read More

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

Read More

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

Read More