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SEC cases vs. companies: lessons from the litigators

The way to think about SEC cases brought against companies and management is simple: The SEC hates liars. This proposition should not be startling. What is interesting is the wide variety of packages in which untruths arise, some sufficiently subtle as to be cautionary for in-house counsel.

We start with the SEC’s May 2010 action in New York’s Eastern District against Sponge Tech Delivery Systems, Inc., its CEO and another senior executive.
In a “pump-and-dump” scheme, defendants sold an aggregate of 2.5 billion shares through affiliates in unregistered transactions after “flooding the market with the false information to fraudulently inflate the stock price.”

Having issued false press releases and SEC filings, the company allegedly obstructed the SEC’s investigation by producing sales documents for “make believe customers.”
Not surprisingly, the SECs civil action was accompanied by simultaneous criminal action by the U.S. attorney.

What makes this seemingly mundane (although audacious) case interesting is the allegation that two former company attorneys rendered baseless opinion letters. “Defendants . . . [attorneys] knowingly, or recklessly or negligently, made false or misleading statements in their attorney opinion letters to Sponge Tech’s transfer agents who then improperly removed the restrictive legends from Sponge Tech shares. This allowed. . .[certain shareholders] to distribute the shares illegally in the public market in unregistered transactions.”

Counsel preparing or reviewing “free up letters” would do well to read the allegations in this SEC complaint.

Seemingly, counsel knew or was reckless in not knowing that facts recited to support removal of the legend under Staff Legal Bulletin No. 4 did not apply; counsel issued 92 Rule 144 attorney opinion letters during a four-month period, unrestricting 922 million shares, based upon passage of the six-month holding period.
It is alleged that counsel knew, or was reckless in not knowing, that for 98 percent of these shares no six-month period had passed.

Gatekeepers on the hook

At a time when the SEC has renewed efforts to charge “gatekeepers” with liability for securities law violations, what level of diligence should in-house counsel apply in unlegending shares?

And, without being prissy about it, one might ask what level of inquiry notice arises when millions of shares are being sold through an Internet enterprise designated “nohypenobull.com.”

In June, the SEC filed a complaint against Diebold, Inc., and three executives for “a fraudulent accounting scheme to inflate the company’s earnings.”

The gravaman of the complaint is that financial management received “flash reports,” tracking earnings against analyst forecasts, and issued internal documents listing fraudulent devices designed to speed revenue recordation (accounting practices prevalent several years ago, now less prevalent given SOX: CEO and CFO certifications and Section 404 financial controls). Diebold agreed to pay a $25 million penalty.

The commission also filed a Sarbanes-Oxley action against Diebold’s former CEO, seeking a claw-back of compensation paid during these fraudulent accounting schemes (even though the CEO was not implicated in the frauds themselves; a result wholly consistent with Section 304 of SOX, which adopts “the buck stops here” approach to claw-backs without necessity of proof of personal wrong-doing). The CEO agreed to reimburse cash, stock and stock option compensation due to restatement of financials for several years.

The SEC accusations read like an historical summary of practices that tightened accounting standards were designed to prevent: recognizing “bill and hold” sales, recognizing lease revenue notwithstanding side deals to buy back equipment, manipulating reserves and accruals, capitalizing expenses that should be charged to earnings, and writing up the value of used inventory.

Strategies after Diebold

What should a company do in light of the Diebold complaint?

Normal diligence by the audit committee and the operation of SOX long ago should have eliminated these crude accounting twists. Perhaps a distribution of a copy of the complaint — available on the SEC homepage — to the audit committee, the CEO and the CFO?
In June, the SEC also brought action in the Southern District of California against Elizabeth Dragon, senior vice president of R&D of Sequenom, Inc., for lying during three public events where she made presentations to analyst and investors.

Dragon claimed almost 100 percent accuracy in the company’s tests for Down Syndrome in fetuses. The company thereafter announced that such data was inaccurate, whereupon the company’s stock fell 75 percent.

It is alleged that Dragon purposely falsified the number of samples, lied about test results, claimed the results were unambiguous, and claimed that the tests were “blinded.”
Dragon consented to a permanent injunction from future violations of Section 10b of the ’34 Act and to a bar from serving as officer or director of a public company; the court reserved the amount of financial penalty for later determination.

While the Dragon contentions are particularly egregious, amounting to purposeful fraud, the case highlights the necessity of extreme accuracy in reporting publicly on the efficacy, performance and value of any company product or service.

It should be noted that the SEC complaint sounded under Section 10(b) of the Exchange Act, alleging materially untrue statements “in connection with the purchase or sale of a security,” although no purchase or sale of any security by the company, Dragon or any other party is recited in the complaint.

This complaint carries forward the well-established principle that the SEC can itself bring actions under Section 10b for fraudulent statements directed to the marketplace at large, without alleging the sale of any specific securities.


The SEC also is focusing on misuse of material inside information in public trading. In May,
the SEC charged an employee of Walt Disney Co. with a blatant effort to sell upcoming earnings information to hedge funds. The funds contacted the SEC, and an FBI sting operation caught the employee delivering pre-release earnings information to an undercover operative.

Pleading a violation of Section 10(b) of the Exchange Act, the SEC established a compelling prima facie case against the employee (who, among other things, sent a series of astoundingly candid and venal e-mails to undercover agents — “I don’t think we will get caught if we stay discreet and careful. You can count on my discretion as I am counting on yours”).

The case is suggestive for counsel: How do you prevent such abuse? As part of normal diligence and the enforcement of an ERM program, any company should restrict access to material information to the smallest possible number of most trusted individuals.
But at bottom line, how do you ever know? Seemingly in Disney, the defendant had continuing access to information (“I will keep you informed of any unanticipated event, I keep my ears wide open here;” “I am not a fed, … I work for Disney, that is all I can tell you”).

An examination of the security measures for earnings announcements, SEC filings, press releases and the like seems fundamental, and yet here is one of America’s “name” public companies being compromised, saved only by the comical ineptitude of the perpetrator.
Witness the SEC charges against the New York hedge fund Galleon Management and its billionaire owner.

Companies are constantly being queried by investors, hedge funds and others for information that can inform trading activities. The line between permissible commentary upon publicly available information and the disclosure of material inside information (in violation of Regulation FD) is a constant issue.

In Galleon, the SEC and the DOJ charged a group of people, including executives at IBM, Intel and two IP associates in the New York offices of Ropes & Gray, with misappropriating (by disclosure) material non-public information.

The SEC alleged that Galleon’s CEO had contacted friends and business contacts to obtain tipped confidential information about earnings and takeover activities. Although Galleon’s CEO has denied allegations, it has been reported that more than half of the charged defendants, including one of the Ropes associates, already has admitted to wrongdoing.
Interestingly, although in SEC cases I have seen many discussions of improvident e-mails, in Galleon the federal government had wire-tapped more than 2,400 telephone conversations in building its case, using a method of proof generally reserved for drug and organized crime cases. This activity measures the importance the SEC ascribes to tipping, as it tries to reestablish confidence in the marketplace.

Must inside counsel worry not only about security of undisclosed material information within the walls of its own company, but also the security of that information as possessed by its law firm and outside advisors?

The answer is affirmative, but as a practical matter what does one do? Ask counsel, consultants, accountants and investment bankers to grant assurance that, in fact, they will make sure that their employees don’t tip? Certainly an interesting diligence and ERM approach.

Perhaps all that can be helpful is heightened education of directors, management and employees that, as a practical matter, they can’t talk to anybody outside their company or their service firm about anything, unless that conversation is supervised through identified monitors.

Reading SEC enforcement actions with respect to misrepresentations and tipping demonstrates the context in which these issues arise. An appreciation of these practicalities should serve to make us all more aware.

I suggest next weekend perhaps take home a few SEC complaints and court opinions, kick back with a summer cocktail, and read on. You will be the better for it.

Stephen M. Honig in a partner in the Boston office of Duane Morris.

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