Securities Law Blog

The collapse of Bernard Madoff’s estimated $65 billion dollar Ponzi scheme in 2008, was the precursor to the “Year of the Ponzi” in 2009. Defrauded investors saw an estimated $16.5 billion dollars disappear as more than 150 pyramid schemes unraveled, according to the Associated Press analysis of scams in all fifty states. Madoff’s very public decline brought a heightened public awareness and increased scrutiny to Ponzi schemes. But he wasn’t the only securities fraudster who made headlines.

Following the breakdown of Ponzi schemes nationwide, there was a drastic increase in federal securities fraud investigations opened in 2009. The FBI alone increased its securities fraud investigations by 1,750 from 2008. The Securities and Exchange Commission (SEC)’s Ponzi scheme investigations now make up 21 percent of the SEC’s enforcement workload. The Commodity Futures Trading Commission more than doubled its amount of civil actions in Ponzi cases this past year.

In its continuing effort to avoid being burned by another major Ponzi scheme, the SEC is developing new investigative units to improve its enforcement. A major focus will be to encourage companies and individuals to cooperate more closely in providing information, and to better analyze tips and complaints the SEC receives. The cooperation efforts will include similar incentives that have been used by the Justice Department in its criminal investigations. Included in these incentives will be written cooperation agreements under which SEC attorneys recommend leniency for parties providing information in their proposals to the SEC commissioners.

With the surge of federal fraud investigations in 2009 and those that date back to the credit crisis in 2007, an increase in federal prosecutions of financial crimes is expected to follow in 2010.

Two of Bernard Madoff’s victims sued the U.S. Securities Exchange Commission last week for failing to uncover Madoff’s $65 billion Ponzi scheme. The lawsuit was filed by Phyllis Molchatsky, a disabled retiree and single mother who lost $1.7 million, and Steven Schneider, a doctor who lost almost $753,000. The SEC earlier denied the investors’ administrative claims, clearing the way for them to file today’s suit under the Federal Tort Claims Act. The government’s “sovereign immunity” from lawsuits should be waived under a law that permits cases against the U.S. if its workers were negligent, according to the complaint filed in Manhattan federal court seeking the return of $2.4 million. Through a “pattern of incompetence,”the SEC missed at least six opportunities to uncover Madoff’s fraud even after receiving detailed tips from an expert explaining how Madoff’s high returns and mysterious investment strategy were proof of the world’s biggest Ponzi scheme, according to the complaint. “Had the SEC carried out its functions with even a minimum of reasonable due care, many, if not most, of Madoff’s victims would have been spared the financial ruin they face today,” the two New York investors said in their 63-page complaint. “Plaintiffs relied on the SEC to protect them and, instead, time after time, the SEC’s agents looked the other way, allowing an obvious danger to grow exponentially, until massive injuries to the plaintiffs and other Madoff investors became inevitable,” according to the complaint.

The SEC, already faulted by Congress for missing the scheme, has been busy trying to restore faith in its abilities after an internal report released last month outlined its failures in the Madoff matter. According to a draft five-year strategic plan released Oct. 8, the agency will seek to improve training and tackle “structural issues” that hurt communication in its Office of Compliance Inspections and Examinations. The plan followed SEC Inspector General, H. David Kotz’s Sept. 29 report that said the agency missed at least six opportunities to spot Madoff’s fraud because it assigned inexperienced employees to inquiries and failed to pursue leads. The SEC’s own investigators said the agency was unwise when choosing cases and that it rewards its workers based on “quantity” rather than “quality.”

Madoff, 71, is serving a 150-year sentence for running the fraud. His family members and his biggest investors have been sued for as much as $15 billion by the bankruptcy liquidator for New York-based Bernard L. Madoff Investment Securities LLC.

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.”

Massachusetts Secretary of the Commonwealth William Galvin confirmed last week that the Securities Division has opened a probe of State Street its funds. In a story appearing April 30, 2009 in Investment News, it was reported that the fund is among several fixed-income strategies managed by State Street’s investment unit, State Street Global Advisors, to lose substantial amounts of money because of exposure to the subprime mortgage market. In an interview, Secretary Galvin is looking at whether State Street made “ representations that were either flat-out untrue or potentially deceptive” to conservative investors.

According to published reports, pension funds and other institutional investors initially invested in the State Street Limited Duration Bond Fund as an “enhanced cash fund,” with the idea to generate better returns than ultra-safe, conservative money market funds with just slightly more risk. Investors now say the Limited Duration Bond Fund took on large positions of high-risk mortgage-related assets, a move that ultimately proved devastating for investors.

More than a year ago, several lawsuits were filed against State Street over charges the firm misrepresented the risks of various bond funds, including the Limited Duration Fund. A State Street spokeswoman declined to comment to the Wall Street Journal regarding the investigation.

A top aide to disgraced money manager Bernard Madoff had employees generate trading tickets, thought to be fake, in order to dupe investors into thinking their returns were legitimate, the Wall Street Journal reported Monday.

According to Journal reporter Amir Efrati, Annette Bongiorno directed two assistants to research daily stock prices, at times dating back several months, and to use the information to produce trading tickets that would reflect the returns that Madoff had become famous for.

"This is how it was done – there were all these thousands and thousands of trade confirmations purporting to sort of signify that there were trades that occurred and we know now that, obviously, there weren't trades at least for 13 years and probably a lot longer than that – maybe decades," Efrati told CBS News.

Irving Picard, the court-appointed trustee charged with sorting out the Madoff mess, indicated last month that there was "no evidence to indicate securities were purchased for customer accounts."

Madoff is scheduled to appear in federal court Thursday and is expected to plead guilty to charges that range from securities fraud to money laundering, reports the Journal. U.S. District Judge Denny Chin invited victims of Madoff's alleged $50 billion ponzi scheme to the hearing – the very same people who got bogus client statements in the mail each month.

"For the most part, the people who got these statements had no reason to believe anything was wrong," said Efrati. "They showed these statements to their accountants, their accountants signed off on them."

But looking back at the paper trail, Efrati said that it was possible to detect that something was amiss.

"They say that the statements didn't make sense at the time and that you could, by scrutinizing client statements that were going out every month, deduce that something was wrong."

The two assistants, Semone Anderson and Winnie Jackson, offered information on the alleged fake tickets to the U.S. attorney's office in what is called a proffer agreement, which protect informants from having their statements used against them as long as they are truthful, reports the Journal.