Securities Law Blog

I have always been a strong believer that Boards need to tread lightly in matters of investments—there are potential fiduciary duty breaches everywhere. Were the investments prudent? Were they held too long? Were they sold do early? Did you take enough risk? Did you take too little risk? A recent NY Times article detailed a new study that examines Madoff fraud losses and suggests that a bigger Board may help prevent account losses.

As reported in last Sunday’s New York Times, the SEC was allegedly chasing “small fish” while the Madoff White Shark was swimming up and down the east coast eating everything in his path. As reported by Joe Nocera:

Talking Business
Chasing Small Fry, S.E.C. Let Madoff Get Away
By JOE NOCERA

Three months ago, in a courtroom in Bridgeport, Conn., a 72-year-old former Morgan Stanley broker named Richard A. Kwak was cleared of any involvement in a small-time stock manipulation scheme.
The Boston office of the Securities and Exchange Commission began the investigation around 2001. Three years later, formal charges were brought against Mr. Kwak and seven others. By the time the case went to trial, in 2007, only three defendants were left; the others had settled with the S.E.C.
In that 2007 trial, Mr. Kwak and another defendant, Stephen J. Wilson, were cleared of one charge, with a hung jury on the remaining charges. (The third defendant, who foolishly acted as his own lawyer, was found liable and fined $10,000.)

The S.E.C. retried Mr. Wilson in 2008. He was cleared. Finally, in March 2009, the S.E.C. retried Mr. Kwak, with the same result. The jury took less than four hours to exonerate him.
Mr. Kwak’s life is now in tatters. He is around $1 million in debt and suffers from emotional problems. He has struggled to stay out of bankruptcy. Although he is still a broker — he certainly can’t afford to retire — he long ago lost his job with Morgan Stanley, where he had spent several decades without so much as a hint of impropriety. Needless to say, his business is a small fraction of what it once was.

“It pretty well wiped me out,” he said a few days ago. He is extremely bitter. The same is true of Mr. Wilson, who is also deeply in debt and struggling to reclaim his life.

I bring all this up because this Monday, Bernard L. Madoff, a contender for the title of greatest financial criminal in history, will be sentenced for the Ponzi scheme he ran for years. Mr. Madoff ruined lives, destroyed philanthropies and cost his investors billions of dollars — yet the S.E.C. was nowhere to be found, despite the repeated entreaties of a whistle-blower, Harry Markopolos.

Indeed, it was the agency’s Boston office — the same one that so relentlessly pursued Mr. Kwak — that Mr. Markopolos first approached about Mr. Madoff, whom he strongly suspected of financial chicanery. In 2000, 2001 and 2005, he peppered investigators with evidence that, while circumstantial, was far more compelling than anything the S.E.C. ever had on Mr. Kwak. In 2005, the Boston office finally referred the Madoff matter to the S.E.C.’s New York office, which did nothing.

After Mr. Madoff’s crimes were exposed, there was an outcry over the failure of the S.E.C. to uncover the Madoff scandal. What in the world was it doing all that time? Now we know the answer. Among other things, it was prosecuting two men who, in all likelihood, did nothing wrong.

When you talk to lawyers who defend people in trouble with the S.E.C., they tend to make several broad complaints. The first is that the agency spends too much time going after small fry like Mr. Kwak. “It happens more times than you can possibly imagine,” said Steven N. Fuller, one of the lawyers in the case.

This is an allegation the S.E.C. fiercely denies: “I have been at the agency for over 10 years, and I haven’t seen any evidence of that,” said Sylvester Fontes, who prosecuted Mr. Kwak.
But even the new S.E.C. enforcement chief, Robert Khuzami, acknowledges that the agency has for too long judged itself primarily on “quantitative metrics” — that is, the number of actions it brings and cases it settles — something he hopes to change. John A. Sten, a former S.E.C. lawyer who was Mr. Kwak’s lawyer during the second trial, said, “As an investigator, you are pressured to generate ‘stats.’ ” Clearly, it is far easier for the S.E.C. to add scalps by going after little guys, who will often agree to a settlement and a fine even when they are innocent. They either run out of money, or lose the will to keep fighting, or both.

A second issue is that the S.E.C. has a very difficult time shutting a case down once the commissioners have agreed to pursue it. Even if the facts start to look shaky, the internal dynamics of the agency push its lawyers to either settle or go to trial, but never to abandon it. “The staff has a real problem persuading the commission to cut off a case once it has begun,” Mr. Sten said.
Now that it has new leadership, the enforcement division is undergoing “a self-assessment of our management structure, process and operations,” Mr. Khuzami told me. He wants to make sure the agency puts a premium on cases that grew out of the financial crisis — such as the fraud and insider trading charges the S.E.C. recently brought against Angelo R. Mozilo, the former chief executive of Countrywide Financial.

But when I brought up the Kwak case, Mr. Khuzami cautioned me against “drawing any inference about how we handle all our cases from a single case.” I suppose he’s right about that. Still, even as a narrow window into the culture of the S.E.C., it is hard not to see the Kwak case as an example of misspent resources and misplaced priorities. It boggles the mind to think that the S.E.C. spent eight years pursuing this case while taking a pass on Mr. Madoff.

Of course, no stock manipulator should get a pass, no matter how small a fish. But in this case, even though five defendants settled with the agency and one was found liable, it is far from certain that a manipulation scheme even existed, much less that it involved Mr. Kwak and Mr. Wilson.

The supposed ringleader was a former Prudential broker named Chauncey D. Steele, who, everyone agrees, was enamored with Competitive Technologies, an over-the-counter stock with the symbol CTT. The company marketed university patents, and made money by taking a cut from licensing deals it negotiated.

In truth, the company has never amounted to much, but it’s always had fans like Mr. Steele, who think every new patent it acquires will be the road to riches. Mr. Kwak and Mr. Wilson were also fans of the stock, and they recommended it to clients and chatted about it incessantly with their fellow CTT aficionados. “These guys spent a tremendous amount of their time doing nothing else but talking about the company,” said Mr. Fuller.

To the government, all those phone calls — Mr. Steele called the others literally thousands of times over a three-year period — meant that the men were conspiring to drive up the stock. The S.E.C. claimed that the men were buying CTT in concert, especially at the end of the day, so the stock would end up on an uptick.

But the only evidence they had were those phone records, which didn’t tell the investigators anything about what the men actually said to one another. Mr. Wilson told me that many of the calls he got from Mr. Steele went straight into voice mail; he stopped taking them because Mr. Steele was driving him crazy. Mr. Kwak told me that although he spoke to Mr. Steele frequently, the conversations were always about the company, not about manipulating the stock.

Nor did the allegation that they were acting in concert hold up; the trading records showed occasional coincidental trades, but nothing that would suggest a systematic attempt to manipulate the market. Indeed, for people who were supposedly manipulating the stock, they lost their shirts because they never sold any shares, not even when it topped $17 a share during the Internet bubble. (It closed on Friday at $1.72.)

So why did five of the defendants settle with the government? None of them are allowed to contest the government’s allegations — that’s part of any S.E.C. settlement — but I came away convinced that they settled because they could no longer stand up to the pressure of an S.E.C. enforcement action. Only Mr. Steele was hit with a major fine, $150,000. Another man, Frank R. McPike, the former chief executive of Competitive Technologies, had insurance to cover his fine, but only if he settled “without admitting or denying the charges,” as the S.E.C. boilerplate reads. If he went to trial and lost, he would have to pay out of his own pocket. (Mr. McPike was ensnared because he was in charge of the company’s stock buyback program, which the government claimed was part of the scheme.)

Mr. Kwak and Mr. Wilson, however, refused to settle. Even though fighting to the bitter end had ruinous financial consequences, they couldn’t bear the thought of admitting to something they didn’t do. “For Richard Kwak, this was a matter of honor,” said Elliott Dudnick, who is one of his brokerage clients and testified on his behalf at the first trial.

Mr. Kwak, a former Marine, agreed. “The day they told me I was charged, I told them I would fight them until the day I died,” he said. “I would never be involved in timing a trade. I have always followed the rules.”

Even though his wife and sons begged him to settle, he wouldn’t. He couldn’t.
So long as the case was going on, Mr. Kwak held himself together, but these last few months have been difficult. Several people who know him told me that he has shown symptoms of post-traumatic stress disorder.

There is one thing he did, though, early this year. He made tapes of the hearings in which the S.E.C. was excoriated by Congress for failing to uncover Mr. Madoff’s Ponzi scheme. “I’ve kept them,” he said. I asked him why.

“They chose me instead of Bernie Madoff.”

Victims of Madoff Seek Claims Overhaul

By Diana B. Henriques. The New York Times. June 7, 2009

In a step that would substantially increase the price tag for Bernard L. Madoff’s long-running Ponzi scheme, lawyers for a group of his victims are asking a federal bankruptcy judge to reject the way their losses in the fraud are being calculated.

J. B. Reed for The New York Times

Irving Picard is overseeing claims for the Securities Investor Protection Corporation.

The customers say that, by law, they should be given credit for the full value of the securities shown on the last account statements they received before Mr. Madoff’s arrest in mid-December, even though they were bogus and none of the trades were ever made. According to court filings, those account balances add up to more than $64 billion.

After months of private negotiations and Internet arguments, lawyers for these customers formally put the issue before the federal bankruptcy court in New York in a lawsuit filed late Friday evening, less than a month before the deadline for filing claims for compensation.

The approach they seek would produce a significantly higher tally of cash losses than the formula being used by the court-appointed trustee overseeing the claims process for the Securities Investor Protection Corporation, a government-chartered agency financed by the brokerage industry.

The trustee, Irving H. Picard, is calculating investor losses as the difference between the total amount a customer paid into the scheme and the total amount withdrawn before it collapsed.

Customers who qualify are eligible for up to $500,000 in immediate compensation from SIPC. Those whose eligible losses exceed that amount would divide up the assets recovered by the trustee.

Thousands of long-term investors, including elderly people who lived for decades on withdrawals from their Madoff accounts, do not qualify for SIPC payments because they withdrew considerably more over time than they originally entrusted to Mr. Madoff, Barry Lax, a lawyer for the plaintiffs, said.
Some of them desperately need the money they would receive from SIPC if the final account balances were taken into consideration, Mr. Lax said.

“We are talking about some of the saddest cases imaginable,” he said. “These are people in their 70s and 80s who cannot work and have no possible source of income to replace the money” lost in the fraud.
He added: “Under the trustee’s approach, thousands of people will not get a dime. That doesn’t seem fair to me — it leaves out the people most affected by the fraud.”

David J. Sheehan of Baker Hostetler, a lawyer for Mr. Picard, declined to comment on the litigation.

The outcome of the dispute will be important for SIPC and the brokerage firms that pay into its compensation fund. So far, with more than 8,800 claims filed, most investors with valid claims have qualified for the full $500,000 payment. If all the claims follow that pattern, the expense to SIPC for Madoff claims could approach $4.4 billion — a sum the taxpayers would have to cover if SIPC could not.
The claims calculation issue has been simmering for months, as customers’ lawyers met with officials at the Securities and Exchange Commission, which has jurisdiction over SIPC, and with lawyers for Mr. Picard. But its resolution has become more urgent with the approach of the July 2 deadline for filing SIPC claims.

Even if the courts overrule Mr. Picard’s approach, victims who did not file a claim before that deadline will not be eligible for compensation, Mr. Lax said.

“Many thousands of victims have not bothered to file a claim, assuming it would be rejected,” he said. Therefore, the class-action case filed by his firm, Lax & Neville, also asks the court to rule that any victims affected by the lawsuit would automatically be deemed to have filed a claim before the deadline.
The essence of a Ponzi scheme is that the money one investor takes out, if it exceeds the cash that investor puts in, actually comes from another investor’s pocket, not from any legitimate source. As long as more cash was coming in than was being withdrawn, Mr. Madoff used money from new investors to cover withdrawals by other investors.

When the cash to cover withdrawal demands ran out, he confessed to his sons that his money management operation was a fraud and was arrested. After pleading guilty to federal fraud and money-laundering charges in March, he was jailed to await sentencing, scheduled for this month.

To complicate the question of calculating losses, the trustee has asserted in litigation that Mr. Madoff gave some investors credit for higher rates of return than other investors received — meaning they could withdraw more money from the scheme than others.

The account balances that Mr. Lax’s clients want to use as the basis for their losses also reflect Mr. Madoff’s sleight of hand, because the value of the stocks or Treasury securitiesshown on them increased according to his whim. A customer who was favored with a higher rate of return wound up with a larger fictional balance than a customer who put in and took out the same amount of cash but was not favored.
In a recent interview, Mr. Picard argued that recognizing these fraudulent transactions as the basis for actual cash losses would be to “allow the thief to pick the winners and losers.”

The Securities and Exchange Commission today instituted an enforcement action against a Poughkeepsie, N.Y.-based firm and several representatives and supervisors for their alleged roles in fraudulent and unsuitable sales of variable annuities to senior citizens who were lured through free-lunch seminars at restaurants in south Florida.

The SEC's Division of Enforcement alleges that Prime Capital Services (PCS) and its parent company recruited elderly investors to attend the seminars, after which the seniors were encouraged to schedule private appointments with PCS representatives who then induced them to buy variable annuities. The sales pitches allegedly concealed high costs, lock-in periods, and other material information. While the firm and its representatives earned millions of dollars in sales commissions, the Division alleges that many of the variable annuities were unsuitable investments for the customers due to their age, liquidity, and investment objectives.

The Securities and Exchange Commission charged a money manager yesterday who lives in Wayland, Mass., for conducting a multi-million dollar Ponzi scheme in which he promised investors lofty returns as high as 20 percent but instead often stole their money for his personal use.

The SEC alleges that Michael C. Regan and his firm, Regan & Company, fraudulently obtained at least $15.9 million from dozens of investors nationwide by selling securities in his now defunct River Stream Fund. Regan provided fake account statements and tax forms to investors showing artificially inflated account balances and concealing that he did no securities trading at all for several years and suffered substantial losses on investments that he did make. Regan falsely claimed that he earned an MBA from a major New York university and promoted a phony track record of successful securities trading and investment expertise. Regan is not registered as an investment adviser with the SEC or any other securities regulator.

“Regan lured investors, including family and friends, by touting his investment prowess,” said James Clarkson, Acting Director of the SEC’s New York Regional Office. “He routinely fabricated investment returns to make it appear that he was a successful money manager when in fact he was stealing investor money to pay his own expenses.”

The SEC’s complaint, filed in the U.S. District Court for the Southern District of New York, alleges that Regan misrepresented to investors that because of his trading expertise and successful investment track record, they could expect annual returns averaging 20 percent with minimal risk to their principal. He promised investors that their money would be pooled into a “fund” that he would invest on their behalf in securities using a conservative, low-risk trading strategy that he claimed was based upon “short-term price trends.”

The SEC alleges that Regan actually used less than half of the funds entrusted to him for trading purposes. Instead of protecting the investors’ principal and delivering the promised returns, Regan misappropriated millions of dollars in investor funds to satisfy withdrawal requests from some investors. He used at least $2.4 million for his personal expenses, including support payments to various family members.

The SEC’s complaint charges Regan and Regan & Co. with violating Section 17(a) of the Securities Act of 1933, Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, and Sections 206(1), 206(2), 206(4) and Rule 206(4)-8 of the Investment Advisers Act of 1940. The complaint seeks permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest, and financial penalties against both Regan and Regan & Co.

Separately, the U.S. Attorney’s Office for the Eastern District of New York (USAO) today announced criminal charges against Regan for the same misconduct alleged in the SEC’s complaint.