Martha Stewart’s sale of ImClone Systems stock has spawned a cottage industry of cases beyond the criminal prosecution (and now appeal), including the SEC’s civil action alleging insider trading and a shareholder lawsuit against her company, Martha Stewart Living Omnimedia, alleging violations of Rule 10b-5 for failing to make proper disclosure about her legal situation. The attorneys for the securities class action plaintiffs, the well-known Milberg Weiss firm, sought to discover otherwise privileged communications with Wachtell Lipton, the company’s counsel during the period of the SEC/U.S. Attorney investigation into her stock sales in 2002. An article in the New York Times (Feb. 8 here) discusses a ruling by U.S. District Judge John Sprizzo permitting discovery of the communications by the company with Wachtell Lipton but not Stewart’s communications with her own lawyers. The ruling appears to follow the shareholder exception to the privilege, which in limited circumstances allows shareholders to gain access to communications with the company’s lawyers if there is "good cause" (see the venerable decision in Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970)). Certainly, Stewart’s communications with her personal attorney would not be subject to that exception, which is limited to corporate counsel. An interesting question, which is not clear from the article but hinted at, is whether Wachtell Lipton represented both the company and Stewart personally during the government’s investigation. If the firm represented Stewart personally, that could create a potential conflict for the firm and, more importantly, a very sticky situation for analyzing whether her communications with corporate counsel were in her personal or corporate capacity. The usual rule is that communications by a corporate officer are made on behalf of the company and only protected by the organization’s attorney-client privilege, but personal representation of the officer changes the analysis. (ph)
Category: Securities
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The SEC has raised the maximum Civil Monetary Penalty it can impose for violations of various provisions of the federal securities laws (including the Sarbanes-Oxley Act), as detailed in a final rule adopted by the Commission that becomes effective on Feb. 14 — Happy Valentine’s Day! (Rule available here). The changes range from $5,000 to $50,000, depending on the particular provision and type of defendant (individual, corporation, broker-dealer, etc.) that permits the Commission to seek a CMP. While the increases are not particularly significant, and many cases involving CMPs are for less than the statutory maximum, the change will likely affect the calculus for settlement negotiations because the SEC’s starting point on an acceptable penalty most likely will be raised. (ph)
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The Irish drug company Elan Corporation, plc, settled SEC civil charges that it made materially false statements regarding its operations in 2000 and 2001. The three primary disclosure violations involved statements about income and gains that failed to note their non-recurring nature, the failure to disclose that $490 million of transactions involved round-trip payments for which there was no real economic gain with partners in a joint venture, and a sale of securities with an affiliated party for which the company did not disclose the relationship. The SEC Litigation Release discussed the effect of the company’s disclosure violations:
Elan represented in its public statements that it was generating record amounts of revenue, net income and operating cash flow from drug sales and licensing activities. Elan also claimed that it was making significant progress towards achieving its goal of transforming itself into a fully integrated pharmaceutical company and generating $5 billion of annual revenue by 2005. The complaint alleges that these statements were materially misleading because Elan failed to disclose, or inadequately disclosed, certain transactions that were critical to Elan’s perceived success. As a result, investors were led to believe that Elan had achieved record results through improvements in the company’s business, when in fact it had not.
Elan agreed to pay $1 in disgorgement — it is not clear what the basis for that remedy is, and it is an amount much lower than usually seen in SEC enforcement actions involving disgorgement — and a $15 million civil penalty (now that’s more like it). (ph)
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The SEC and the U.S. Attorney’s Office for the Central District of California (Los Angeles) announced on Feb. 7 the filing of criminal and civil charges against Courtney D. Smith, an investment advisor who wrote the well-known market newsletter Wall Street Winners (company website here). According to the Litigation Release issued by the SEC, Smith received approximately $1.1 million in cash and stock that was funneled through his girlfriend’s small vitamin exporting company to tout the shares of GenesisIntermedia, Inc. (GENI), a now defunct public company:
The Commission alleges that Smith assisted GENI’s Chief Executive Officer and his accomplice (a Saudi Arabian national reputed to be an international arms dealer and financier) in a fraudulent stock manipulation and lending scheme that occurred between September 1999 and September 2001. According to the complaint, GENI’s CEO secretly paid Smith approximately $1.1 million in cash and GENI stock to tout GENI shares on television. Smith’s public statements, many of which were false or misleading, artificially inflated the price of GENI shares and facilitated the misappropriation of approximately $130 million by GENI’s CEO and his accomplice.
The SEC’s complaint is here, and a copy of the criminal filing will be posted when it is available. (ph)
UPDATE: A press release issued by the U.S. Attorney’s Office describes the criminal charges: "The indictment charges Smith with conspiring with a high-ranking officer and substantial shareholder of GENI to violate the securities laws through his paid promotion of the stock. Smith is also charged with eight substantive counts of violating federal securities laws for failing to disclose the payments he received for promoting GENI on television. If he is convicted of the nine counts in the indictment, Smith faces a maximum possible sentence of 45 years in federal prison."
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The government set the stage for introducing the audiotapes made by Bill Owens, HealthSouth’s former CFO, who wore a wire for two days immediately before the FBI executed a search warrant at the company as part of its accounting fraud investigation. The defense has raised questions regarding the veracity of the tapes and problems regarding the government’s handling of them. At the trial today, prosecutors called an FBI evidence technician, who testified she made an "honest mistake" when she put the incorrect date on the evidence log for the tapes. The defense has sought to exclude the tapes from being introduced at trial, a position U.S. District Judge Karon Bowdre rejected before trial (see earlier post here) but did give the defense the opportunity to raise admissibility questions at trial. The government appears to be laying the foundation for admission of the tapes through Owens. Interestingly, while the defense has sought to exclude them, counsel has also said they are exculpatory of Scrushy and show that it was Owens who was the perpetrator of the fraud. No harm in having a fall-back position, in case the tapes come in. An AP story discussing the testimony at Scrushy’s trial is here.
This type of evidence is uncommon in white collar cases, but not unique — recall the prosecution of senior Rite Aid executives involved a cooperating witness who wore a wire to meetings with other defendants. The recordings in that case were challenged as being made in violation of Pennsylvania Rules of Professional Conduct 4.2 and 8.4 because it was an unauthorized contact with a represented person and involved dishonest conduct by the federal prosecutor, U.S. v. Grass, 239 F.Supp.2d 535 (M.D. Pa. 2003), arguments the district court rejected in refusing to suppress the tapes. (ph)
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The government witness testifying on Jan. 31 in the trial of Richard Scrushy was Harvey Kelly, who worked for PriceWaterhouseCoopers as an accountant in its investigation of the accounting fraud at HealthSouth. Kelly testified that he did not come across any documents (memoranda, e-mails, etc.) specifically linking Scrushy to the overstatements of revenue and income at the company, although he also noted that he was not looking for any when he conducted the internal investigation of the accounting issues. The testimony is consistent with the defense theory that financial officers of the company were responsible for the fraudulent accounting, although it does not undermine the government’s position that Scrushy urged those same officers to do whatever was necessary to make the numbers Wall Street wanted to see. It is likely the government will soon call Bill Owens, a former CFO and senior officer at the company, to testify about Scrushy’s involvement in the misconduct; his testimony is expected to be quite lengthy, with the cross-examination very contentious with regard to the recordings he made prior to the government’s search of HealthSouth’s offices. An AP story (here) discusses Kelly’s testimony.
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The government’s prosecution of four former executives of Charter Communications, Inc., the large cable TV company, ended when the fourth defendant, former CFO Kent Kalkwarf, agreed to enter a guilty plea. According to the press release issued by the U.S Attorney’s Office for the Eastern District of Missouri (St. Louis):
In an effort to generate approximately 15 to 20 million dollars in additional revenue needed to meet these cash flow projections, Charter solicited advertising business from some of Charter’s largest suppliers, including their suppliers of set-top boxes. Kalkwarf and others offered Charter funds to these suppliers so that they could then use those same funds to purchase advertising from Charter at no cost to the suppliers, and these suppliers agreed to return that money to Charter by buying advertising in an equal dollar amount. Charter paid $20 more than necessary for each set-top box, but then received that same $20 back as advertising revenue, creating nothing but a "wash transaction."
Another example of the effect of the enormous pressure on corporate executives to churn out numbers (here, cash flow) to meet Wall Street’s expectations, the same show being played out in the WorldCom and HealthSouth prosecutions. (ph)
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The U.S. Attorney’s Office for the Central District of California (Los Angeles) announced yet another revenue recognition accounting fraud involving an internet company, this time L90, Inc., an internet advertising company. According to the press release, Keith Kaplan, a former vice president and head of sales for the company
conspired with two other former L90 executives to inflate the company’s earnings so that it would meet Wall Street analysts expectations. Those other two executives – John C. Bohan, L90’s former CEO, president, and board member; and Lucrezia Bickerton, L90’s former vice president of finance – have already pleaded guilty to criminal charges. At the time of the alleged offenses, L90 was based in Santa Monica and Marina del Rey, and its stock was traded on the Nasdaq National Market System. L90 is now known as MaxWorldwide, Inc. In the final quarter of 2000, Kaplan and his co-conspirators were concerned that L90’s total revenues for the quarter would not meet analysts’ projections, according to the indictment. In order to make up the anticipated revenue shortfall, Kaplan and his co-conspirators allegedly developed several schemes to fraudulently inflate L90’s revenue numbers.
The pressure to commit accounting tricks in response to the bursting of the internet bubble in 2000 continues to hit home. (ph)
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A report in the Wall Street Journal (Jan. 28) discusses heavy purchases of Gillette February call options right before the close of trading on Jan. 27, after which word began to leak out about the acquisition of Gillette by Procter & Gamble. Buying a call option, especially one set to expire in less than a month at a price well above the underlying stock’s current market price, is a particularly bullish bet — and often a signal of insider trading. According to the Journal report:
The heaviest trading was in Gillette’s short-term February options, and 4,224 February 45 calls changed hands Thursday. Each of these calls gives the right, until mid-February, to buy 100 shares of stock at $45 apiece, and were valued at between $75 and $135 Thursday. By Friday, after the deal with P&G made headlines, Gillette shares gained $5.44 to $51.13. Each February 45 call is now worth between $610 and $630 Friday morning — a nearly sixfold increase in less than 24 hours. Altogether, there were 6,525 Gillette February 45 calls currently outstanding.
My quick estimate, based on purchasing 4,000 calls at the highest price and selling at the lowest identified price, is that the transactions could yield a one-day profit of $1.9 million, and the actual profit is likely much higher, although the trades may have been conducted by more than one person or group. That kind of gain gets the attention of the SEC in a hurry, and we can expect to see the first cases filed in the next week or so, especially if any of the trading were conducted through an off-shore account that sought to liquidate its position. The Commission routinely files for a TRO to have the accounts frozen pending its investigation, and the courts (usually the Southern District of New York) just as routinely grant the temporary freeze orders. Moreover, when this type of brazen trading takes place, the U.S. Attorney’s Office will not be far behind. (ph)
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The testimony of David Myers, former WorldCom controller, continued on Friday (Jan. 28) in the government’s effort to link Bernie Ebbers to the company’s accounting fraud. An AP story recounts the following part of the testimony:
[Myers] remembers Ebbers saying that if the stock slid below the mid-teens, "My margin calls are called and everything I’ve worked for since I’ve joined WorldCom will basically be wiped out. "At the same meeting, without specifically referring to accounting tricks, he said Ebbers said "while the company was in extraordinary times, extraordinary things had to be done." In addition, Myers said Sullivan told him twice in 2001 that Ebbers understood, as Myers put it, "the magnitude of what we were doing on the revenue side and the line-cost side." The testimony appeared to be the most damaging yet against Ebbers, whose lawyers claim Ebbers left accounting matters to Sullivan and that Sullivan masterminded the fraud.
It is hard to draw much of a conclusion from the testimony because the cross-examination has not yet begun. (ph)
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