Today, the Federal Securities Litigation Blog continues its with its larger-than-usual blog entry examining the Top 10 securities litigation stories that were the most intriguing in 2011. As mentioned yesterday, like any sort of Top 10 list, not everyone will agree. Other bloggers will have their own lists with different stories. But on a personal basis, these stories that fascinated me – like a good book, I look forward to the next "chapter" in these stories in 2012.

Here’s a quick headline look at the Top 5:

5. The SEC’s Inspector General Reports on the Conduct of the Commission Staff.

4. Insider Trading at Galleon Management: Record-Setting Results.

3. The New Whistleblower Rules: Do I Tell Management Before I Tell The SEC?

2. The Lindsey Manufacturing Saga: The Verdict DOJ was "Fiercely Committed" to Obtaining is Vacated.

1. The Citigroup Case: Judge Rakoff’s Decision and the Potential Impact on How SEC Cases Proceed.

These five stories are discussed in greater detail after the jump.

The stories selected as numbers 6 through 10 are available here.

As they used to say on Casey Kasem’s American Top 40, "the Countdown now continues with Number Five …"

5. The SEC’s Inspector General Reports on the Conduct of the Commission Staff.

If you listen to Congressional testimony of people like former SEC Chairman Harvey Pitt, you would have to conclude that SEC Inspector General David Kotz is the most unpopular employee walking the halls at the SEC. Mr. Pitt denounced the Inspector General, saying that he "seemingly operates on the assumption that he can effectively terrorize innocent employees under the guise of upholding the law." Why does Mr. Kotz trigger such a vitriolic response? The Inspector General issued a series of reports this fall that examined the way the Commission handled certain issues, finding certain errors and suggesting reforms.

In one of the most talked about reports, released on September 20, 2011 and discussed here, the Inspector General found that David Becker, the former General Counsel and Senior Policy Director of the Commission, "participated personally and substantially in particular matters in which he had a personal financial interest by virtue of his inheritance of the proceeds of his mother’s estate’s Madoff account and that the matters on which he advised could have directly impacted his financial position." According to the Inspector General:

• upon the death of Mr. Becker’s mother in 2004, an account at Bernard L. Madoff Investment Securities LLC was transferred to her estate and liquidated for approximately $2 million and the Trustee administering the Madoff liquidation filed a clawback suit against Mr. Becker and his brothers (who were the executors and beneficiaries of the estate) in February 2011, alleging that approximately $1.5 million of the $2 million constituted "fictitious profits" and should be returned to the fund of customer property for distribution to other Madoff customers;

• while Mr. Becker was at the SEC, he was aware that the Trustee might commence such a lawsuit, but "played a significant and leading role in the determination of what recommendation the staff would make to the Commission regarding the position the SEC would advocate as to the determination of a customer’s net equity," which would be used to determine the amount of funds that the Trustee would seek to clawback in the Liquidation;

• seven SEC officials including Chairman Mary Schapiro and now General Counsel Mark Cahn were informed of the existence of this account, yet "none of these individuals recognized a conflict or took any action to suggest that [Mr.] Becker consider recusing himself from the Madoff Liquidation;" and

• Mr. Becker "provided comments on a proposed amendment to [the Securities Investor Protection Act of 1970] that would have severely curtailed the Trustee’s power to bring clawback suits against individuals like him in the Madoff Liquidation."

As discussed here, Congress held a hearing to look into the matter, hearing testimony from Inspector General Kotz, Mr. Becker and SEC Chairman Mary Schapiro. Mr. Becker emphasized that he sought and followed the advice of the SEC Ethics office (a fact acknowledged by the Inspector General’s Report) and "was advised that [he] had no conflict of interest in providing legal advice to the SEC about the interpretation of the legal standard in the Securities Investment Protection Act … that governed the net equity claims of holders of [Madoff] securities accounts."

The Inspector General referred the results of the investigation to the Public Integrity Section of the Criminal Division of the United States Department of Justice, who, as discussed here, elected not to prosecute Mr. Becker.

Other issues which the Inspector General considered this fall included:

• the SEC’s policy of destroying documents gathered in pre-investigation inquiries known as Matters Under Inquiry ("MUI") (as mentioned in No. 7 of our Top 10 list yesterday and also further discussed here) (the Inspector General found that in some cases, documents that should have been preserved were destroyed); and

• the SEC’s investigation of Mark Cuban, which resulted in a finding that there was not "sufficient evidence to substantiate any allegations of misconduct" by the Division of Enforcement (as discussed here).

Perhaps one of the more intriguing elements of the Inspector General’s work in 2011 was that, in some circumstances, the individuals responding to his inquiries responded in such a way that one suspects defendants in SEC investigations might respond. For example, Mr. Becker acknowledged that he was "aware of the possibility" that the Trustee might sue him and his brothers, but said he "was confident that the Trustee would never find it necessary to sue me. If it turned out that there were indeed fictitious profits in my mother’s account, all the Trustee had to do was notify me and explain his calculations, and I would return any excess funds in my possession." One wonders how the Commission would respond if an individual under investigation made a similar statement. As for Mr. Becker, the Trustee did find it necessary to sue him and the parties were still in litigation as of November 2011.

4. Insider Trading at Galleon Management: Record-Setting Results.

When Raj Rajaratnam and others involved in the Galleon Management LLC circle were arrested and charged in October 2009, many pointed out that the authorities’ use of wire taps as a new development in these types of cases. Well, that development yielded results in 2011 as a parade of guilty pleas and guilty verdicts commenced. Mr. Rajaratnam, the central figure in the cases, was sentenced to 11 years in October 2011 in prison, the longest to date for anyone involved in the group.

As discussed here, on May 11, 2011, a federal Jury in New York convicted Mr. Rajaratnam of five counts of conspiracy to commit securities fraud and nine counts of securities fraud, stemming from what prosecutors called "his involvement in the largest hedge fund insider trading scheme in history." Prosecutors argued that Mr. Rajaratnam received non-public, material insider information through overlapping conspiracies from insiders and others at hedge funds, public companies, and investor relations firms, and then executed trades in the stock of public companies, including Goldman Sachs, Clearwire, Akamai, AMD, Intel, Polycom, and PeopleSupport. The evidence in the eight-week trial included numerous recordings of wiretapped phone calls between Mr. Rajaratnam and co-conspirators (many of whom pled guilty). Mr. Rajaratnam claimed that he pieced together information from a variety of sources to reach a decision on investing.

On June 13, 2011, one of his co-conspirators, Zvi Goffer and two other Wall Street professionals, were found guilty on Monday of conspiracy and securities fraud charges (as discussed here). Prosecutors argued that Mr. Goffer, his brother, Emanuel, and a third defendant, Michael Kimelman, conspired with attorneys Arthur Cutillo and Brien Santarlas, (formerly of the Ropes & Gray law firm) and others. Specifically, Mr. Goffer, nicknamed "Octopussy" due to the number of connections he had, and others paid the attorneys for inside information regarding mergers and acquisitions of public companies represented by the law firm.

On September 21, 2011, Mr. Goffer was sentenced to ten years in prison. With respect to Mr. Goffer, U.S. Attorney Preet Bharara said that his "sentence is a fitting conclusion to yet another sordid chapter in the illegal insider trading conspiracies that have become so alarmingly pervasive."

On October 13, 2011, Mr. Rajaratnam received his 11-year sentence. The sentence, despite its length, fell short of what was sought by the prosecution, who had argued that Mr. Rajaratnam should be given a sentence "within the applicable Guidelines range of 235 to 293 months" (in other words between approximately 19 to 24 years). Mr. Rajaratnam argued that such a sentence was "grotesquely severe," and pointed out that the average sentence imposed in 2010 for violent crimes were far less – the average sentence for manslaughter was 73 months, for example. Media coverage of the sentencing hearing revealed that Judge Holwell said Mr. Rajaratnam’s ill health (advanced diabetes and the likely need for a kidney transplant) justified some leniency in sentencing. Less than a month later, Judge Jed Rakoff entered a $92 million civil judgment against Mr. Rajaratnnam in the SEC’s civil case against him. Mr. Rajaratnam was also named as a defendant in the SEC’s suit against Rajat Gupta, bringing new insider trading charges against him (as discussed here).

The lengthy sentences in the criminal cases are not a surprise to those who have considered the issue – but remain an ominous warning sign. In October, 2011, as discussed here, a Wall Street Journal article presented data showing an increase in the length of sentences in insider trading cases over the last eighteen years. The article reviewed the data from sentences in 108 insider trading cases from the Eastern District and Southern District of New York since 1993. From 1993 to 2000, no defendant received a sentence of longer than two years in prison, a trend which ended in 2000 when a six-year sentence was given. From 2000 to 2006, the sentences remained brief (less than three and one-half years, with one exception). But from 2006 to the present, the Journal identified nine defendants who were sentenced five years or more in prison. Moreover, in 2011 alone, 14 defendants were sentenced to jail terms in the Eastern and Southern Districts.

3. The New Whistleblower Rules: Do I Tell Management Before I Tell The SEC?

As discussed here, on May 25, 2011, the SEC adopted final rules to implement Section 922 of the Dodd-Frank Act regarding securities whistleblower incentives and protection. The most hotly debated issue at that point was whether whistleblowers should be required to raise their issues with their corporate employer before reporting to the SEC or whether they could report directly (by-passing the corporation). In the final rules, the Commission elected to not require whistleblowers to report to their employer first, but created a number of incentives for them to do so.

According to Chairman Mary Schapiro, the Commission’s final rules "[struck] the correct balance – a balance between encouraging whistleblowers to pursue the route of internal compliance when appropriate – while providing them the option of heading directly to the SEC." She highlighted three elements of the final rules which address this issue:

• expanding the length of time by which a whistleblower must report to the SEC (after reporting to the corporation internally) from 90 to 120 days;

• providing that, when determining the amount of the award, the Commission will consider how much a whistleblower has participated in or interfered with the internal compliance process; and

• giving credit to a whistleblower who reports to the corporation internally when the company passes the information along to the Commission, even if the whistleblower does not.

The Commission established an Office of the Whistleblower, headed by Sean McKessy, to work with whistleblowers, handle their tips and complaint, and help the Commission determine the awards for each whistleblower. That Office announced the launch of its new website (discussed here), which "include[d] information on eligibility requirements, directions on how to submit a tip or complaint, instructions on how to apply for an award, and answers to frequently asked questions."

The new website yielded 334 whistleblower tips between August 12 and September 30, 2011. As discussed here, the Office of the Whistleblower’s Annual Report revealed that the most common complaint categories were market manipulation (16.2%), corporate disclosures and financial statements (15.3%), and offering fraud (15.6%). The Report also provided information regarding the geographic origins of the tips, with California having over 30, New York having over 20 and Florida and Texas both having over 15 (with no other state having more than 10). There were 32 tips from overseas, including 10 from China and 9 from the United Kingdom.

As the 2012 continues, we will learn more about the impact of the new rules and the Office’s work.

2. The Lindsey Manufacturing Saga: The Verdict DOJ was "Fiercely Committed" to Obtaining is Vacated.

On May 10, 2011, when a federal jury convicted Lindsey Manufacturing Company (a privately-held company), its President Keith Lindsey, its Vice President Steve Lee and an intermediary, Angela Aguilar, in an FCPA case, Assistant Attorney General Lenny Breuer, called the verdicts "an important milestone," and said "we are fiercely committed to bringing to justice all the players in these bribery schemes." In a little over six months, the words "fiercely committed" took on a whole new meaning and the case unraveled when Judge A. Howard Matz found that the Government conducted a "… notably over-zealous investigation … that was so flawed that the Government’s lawyers tried to prevent inquiry into it." The Court held that "the multiple acts of misconduct … undoubtedly affected the verdicts and thus substantially prejudiced" the Defendants, necessitating the remarkable decision – made with what the Court called "deep regret" – to vacate the convictions and dismiss the Superseding Indictment.

The May 2011 conviction (discussed here) was based on payments to employees of the Comisión Federal de Electricidad ("CFE"), an electric utility company owned by the government of Mexico, which were made in exchange for the CFE to award contracts to Lindsey Manufacturing. After hearing evidence for five weeks, the jury took one day to find the company, President Lindsey and Vice President Lee guilty on all counts (one count of conspiracy to violate the FCPA and five counts of actually violating the Act). Ms. Aguilar, the intermediary, was found guilty of a single count of conspiracy to commit money laundering.

As discussed here, in the immediate aftermath of the verdict, Jan Handzlik of Greenberg Trauig, counsel to Lindsey Manufacturing and Mr. Lindsey, vowed to continue fighting the charges, including "pursu[ing] our motion to dismiss the indictment on grounds of prosecutorial misconduct." That motion (filed on May 9 – before the verdict) accused the Government of presenting the Grand Jury with "knowingly false and misleading representations on critical matters" and omitting the "disclosure of material facts" during the testimony of an FBI Special Agent. The defendants further accused the Government of covering up this testimony by refusing to produce the complete Grand Jury transcript of the agent’s testimony until ordered by the Court in the middle of the trial. The Government filed its Opposition on June 6, 2011.

As discussed here, at a June 27, 2011 hearing, Judge Matz learned that certain grand jury transcripts which he previously ordered to be disclosed had not been turned over to the defendants. The Court then ordered the Government to turn over the missing transcripts by 9:00 a.m. the following morning and ordered further briefing. On July 25, 2011, the defendants filed a supplemental brief (discussed here), stating that the Government’s "investigation and prosecution of this case were permeated with instances of purposeful, prejudicial government misconduct. The government’s misconduct was patent and pervasive, designed to win the case, not do justice." The Government filed a responsive brief on September 5, 2011. The Court also issued an order vacating the scheduled sentencing hearing for the company and Messrs. Lindsey and Lee, which had been set for September 16, 2011.

On December 1, 2011, Judge A. Howard Matz entered an order granting the motion to dismiss. The Court’s decision was based, in part, on: the untruthful testimony of an FBI agent to the grand jury; the provision of false information in applications for search and seizure warrants; the improper review of e-mail communications between a defendant and her lawyer; the failure to comply with discovery obligations and other court rulings; and misrepresentations to the Court. The Court noted that there were other examples of wrongful conduct that may not have directly prejudiced Lindsey Manufacturing and Messrs. Lindsey and Lee, but reflected "just how far the Government was willing to go" in the case. The Court found that these acts "substantially prejudiced" the defendants, and that it was appropriate to dismiss the Superseding Indictment and vacate the convictions as both a deterrent and to release the defendants "from further anguish and uncertainty." The Government immediately appealed Judge Matz’s ruling.

Judge Matz described the parties as having engaged in "almost non-stop, often acrimonious motion practice" prior to the trial. He also described the individuals as having been " put through a severe ordeal." He described the "immense" financial costs and "the emotional drubbing" to the individuals, and that the very survival of the "small, once highly-respected enterprise [Lindsey Manufacturing] has been placed in jeopardy."

Few expect the events of this case to be repeated, but the case is a stark reminder of how aggressively these issues will be fought by the government and defendants alike, and the impact of those actions.

Finally, the most intriguing matter in securities litigation in 2011 was:

1. The Citigroup Case: Judge Rakoff’s Decision and the Potential Impact on How SEC Cases Proceed.

For decades, when the SEC has settled a matter against a defendant, it has allowed the defendant to do so without admitting or denying any wrongdoing. So, in October 2011, when the Commission settled a case with Citigroup Global Markets, Inc., it did so under its usual practice – Citigroup Global Markets was not required to admit or deny the allegations in the Complaint. While the Commission viewed the matter one way, Judge Jed Rakoff viewed it another and refused to approve the settlement. Now, the Second Circuit will have an opportunity to review the matter and a Congressional Committee has decided to hold hearings on the issue.

In short, the Citigroup case began a chain of events, which may (or may not) result in a significant change in the way the SEC handles its settlements. Looking back a mere ten and a half weeks ago …

On October 19, 2011, the SEC and Citigroup Global Markets agreed to a settlement under the usual neither-admit-nor-deny standard in which the defendant agreed to pay $285 million (consisting of $160 million in disgorgement, $30 million in prejudgment interest and a $95 million civil penalty).

When the parties requested that Judge Rakoff approve the settlement, he asked them to answer a series of questions about it (including "[w]hy should the Court impose a judgment in a case in which the SEC alleges a serious securities fraud but the defendant neither admits nor denies wrongdoing?"), in an effort to "ascertain whether the proposed judgment is fair, reasonable, adequate, and in the public interest."

The SEC responded on November 7, 2011 by saying that the use of such consent judgments "has been long endorsed by the Supreme Court" and "criticism of consent decrees for not including … an admission is ‘unjustified.’" The SEC traced the history of its policy, emphasizing the desire to "preclude denials both in the consent decree itself and elsewhere." The Commission argued that, based on the fact that Citigroup does not deny the allegations in the Complaint, the "approach has clearly succeeded in clearly conveying that the conduct alleged did in fact occur." The SEC also argued that the Court was not entitled to consider some of the questions it had raised.

On November 28, 2011, Judge Rakoff issued a blistering ruling in which he rejected the proposed settlement with Citigroup as "neither fair, nor reasonable, nor adequate, nor in the public interest." He also accused the SEC of searching for "a quick headline," stated that they had argued the wrong legal standard, and criticized the long-standing policy of accepting settlements without an admission of liability as "hallowed by history, but not by reason." He also said that the Commission’s request that the Court assert its authority without knowing the facts was "worse than mindless, it [was] inherently dangerous."

The SEC fired back with its own statement that afternoon, asserting that Judge Rakoff "ignore[d] decades of established practice throughout federal agencies and decisions of the federal courts," but on the same day wrote to Congress to seek stricter penalties (which was another issue raised by Judge Rakoff).

On December 15, 2011, the SEC appealed the matter to the Second Circuit and the following day moved to stay the litigation before Judge Rakoff, arguing, among other things, that Judge Rakoff’s Opinion and Order ran afoul of "the strong deference afforded to federal agencies presenting proposed consent judgments for approval."

On December 27, 2011, Judge Rakoff denied the Motion to Stay. The SEC then filed an emergency motion with the Second Circuit seeking a stay. On December 28, 2011, the Second Circuit ruled that the SEC’s emergency motion would be submitted to that Court’s motions panel on January 17, 2012," and that "[i]n the interim, proceedings in the District Court are stayed until a ruling by the motions panel."

Meanwhile, on December 16, 2011, the House Committee on Financial Services announced that it would hold hearings on the neither-admit-nor-deny practice. Congressman Spencer Bachus, the Chairman of the Committee, said "[t]he SEC’s practice of using ‘no-contest settlements’ has raised concerns about accountability and transparency."

To summarize, the Commission argued that its decision to settle under its usual practice should be approved under "the well-established and oft-approved practice of federal agencies entering into consent judgments providing for injunctive relief in which defendants do not admit to the allegations in the complaint."

Judge Rakoff ruled that he did not care if the cases had been settled that way for years, it did not make it right (which sounds like a variation of what my father called the "if-all-your-friends-jumped-off-a-bridge-would-you-do-it-too?" argument). Judge Rakoff ruled that "when a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance."

Both arguments have their merits. Sit down and sort out the possibilities and it is very likely that your head will start to ache. The Second Circuit could agree with the SEC and reverse Judge Rakoff and return everything back to the way it was. But, what if the appellate court does not do so? The Second Circuit could agree with Judge Rakoff and say, don’t ask for an injunction without getting an admission. The parties in the dozens of SEC cases that are settled each year would face a slew of new questions …

• What will defendants do? Will they tell the Commission: "I cannot settle with you and admit wrongdoing because every plaintiff’s class action lawyer from Philadelphia to San Diego will be waiting outside the Courthouse with a summons for me"? On the other hand, can they afford to go to trial with the SEC?

• What then will Commission do? If the Court won’t accept a settlement without an admission and defendants cannot afford to make such an admission, will the SEC be forced to litigate many more cases? Chairman Mary Schapiro has already told Congress that under existing budget constraints, the Commission is stretched awfully thin. Alternatively, will the SEC begin using Administrative Proceedings to resolve matters and avoid the federal court system and the Judge Rakoffs of the world?

• Will Congress weigh in and address the issue? It seems unlikely, but the very prospect of the SEC defending the practice and others attacking it in a Capitol Hill hearing room will only heat up the debate further.

It is possible that in the next twelve months, Judge Rakoff’s ruling could be a distant footnote and settlements with the SEC could continue as usual. On the other hand, it could result in a significant shift in the way the SEC, defendants and the Courts look at settlements going forward. That alone made the case, the ruling and its aftermath, the story to watch as the calendar page turns.


As 2011 comes to a close and the new year beckons, on behalf of Porter Wright and the Federal Securities Law Blog, we want to wish all of you who read our blog a happy, healthy and prosperous 2012.