Subject to Inquiry: White Collar, Congressional, SEC, Energy Enforcement & Other Government Inquiries

On December 20, the SEC announced that it had entered into a non-prosecution agreement with Carter’s Inc., allowing Carter’s to avoid prosecution in exchange for cooperation with a fraud investigation.  This is the first non-prosecution agreement issued by the SEC since its announcement in January 2010 of new measures designed to strengthen SEC enforcement by encouraging more cooperation from individuals and companies in the agency’s investigations and enforcement actions.

In a complaint filed December 20, the SEC alleges that Joseph M. Elles, an Executive VP of Sales at Carter from 2004 to 2009, fraudulently manipulated the dollar amount of discounts that Carter’s granted to its largest wholesale customer, and persuaded the company to defer the discounts to later reporting periods, leading to an understatement of Carter’s expenses and a material overstatement of its net income.  During that time, Elles allegedly realized gains from insider trading in shares of Carter’s common stock, resulting in a pre-tax profit of approximately $4.7 million.  The fraud was disclosed on October 27, 2009, leading to a 23.8% drop in the company’s share price.  

The non-prosecution agreement means that Carter’s will not be charged with violations of the federal securities laws related to Elles’ conduct.  In its press release, the SEC made the following observations:

• the alleged unlawful conduct was relatively isolated;
• Carter’s promptly self-reported the conduct to the SEC;
• Carter’s cooperation with the SEC was “exemplary and extensive,” and included a thorough, comprehensive internal investigation; and
• Carter’s took extensive and substantial remedial actions.

The agreement requires Carter’s to cooperate with the Commission during its investigation and subsequent proceedings, including utilizing its “best efforts” to secure the full cooperation of current and former employees, and that Carter’s provide full testimony, non-privileged documents, and other information.  Additionally, under the agreement Carter’s cannot deny the underlying conduct except in legal proceedings where the SEC is not a party. The agreement applies only to the SEC and not to other self-regulatory or governmental proceedings, although the SEC may use its discretion in forwarding a letter detailing the cooperation of the company. 

With this case, the SEC has provided a roadmap to using non-prosecution agreements in the future. Companies should take note.

Samantha E. Thompson authored this post.

In a detailed, 122-page opinion (pdf), U.S. District Court Judge John G. Koeltl systematically dismantled and dismissed the SEC’s first-ever credit default swap insider trading case.  In SEC  v. Jon-Paul Rorech and Renato Negrin (pdf), the SEC alleged that Deutsche Bank bond salesman, Jon-Paul Rorech, passed material, non-public information to a Millennium Partners hedge fund manager, Renato Negrin and that Negrin profitably traded credit default swaps (“CDS”) based upon that information.  The allegedly confidential information concerned a bond offering for two subsidiaries of a Dutch media holding company VNU N.V. being underwritten by Deutsche Bank.  The SEC complaint asserted that Rorech told Negrin that Deutsche Bank would “recommend” to VNU’s sponsors that the bonds be issued at the holding company level rather than the subsidiary level and that Rorech already had a commitment from a customer to buy $100 million of the holding company bonds when released.  The SEC claimed that Negrin, once armed with this information, purchased two VNU CDS contracts which he later sold after the formal announcement of the VNU bond offering at a profit of $1.2 million.    

Rorech was heralded as a groundbreaking test of the SEC’s resolve to leave no corner of the capital markets unregulated.  Involving sophisticated market participants trading in complex credit derivatives, the SEC’s litigation release announcing the action in May 2009 led with the headline “SEC Files First Credit Default Swap Insider Trading Case.”  The implication of this “first” of its kind was supposed to act as a message:  the SEC understands Wall Street’s sophisticated products and will prosecute wrongdoing involving them.  

The massive challenge facing the SEC in Rorech was whether it had jurisdiction to sue over misconduct involving credit default swaps.  This was a highly technical question of whether the CDS contracts at issue fell within the definition of a “securities-based swap agreement” under section 206B of the Gramm-Leach-Bliley Act.  The results of that analysis would in-turn have an impact on whether the CDS at issue could fall within Section 10(b) of the Securities Exchange Act as amended by the Commodity Futures Modernization Act.

According to Judge Koeltl, the threat actually facing the SEC’s case was not its subject matter jurisdiction, the reach of securities laws, or even the complexities of credit derivatives but rather old-fashioned sufficiency of the evidence.  After a three-week bench trial, the Court found that the SEC’s complaint was deficient with respect to every required element of an insider trading case as (1) the SEC failed to show any evidence that the underlying confidential information was true, let alone that Rorech could have possibly possessed it;  (2) no evidence was presented, even assuming the purportedly confidential information to be true, that the information would have been material to investors;  (3)  the evidence presented demonstrated that the allegedly “confidential” information may not have been confidential, as there was no requirement or expectation that the information would be kept confidential by any of the parties involved;  (4)  no evidence of “deceit” or unauthorized theft of information was presented as required in insider trading actions brought pursuant to the misappropriation theory; and (5) the SEC failed to show that Rorech had the necessary intent, or scienter, to be held liable for insider trading.

The Court also noted that the SEC was unable to offer “any” evidence of Rorech’s motive for violating the securities laws since nothing was presented regarding how sales of the bonds or CDS protection would impact his compensation. 

In the end, the “controversial” issue of whether the CDS contracts were subject to the antifraud provisions of the federal securities laws was a red herring.  The Court reached the conclusion that the derivatives at issue were “securities-based” and thus well within the jurisdiction of the SEC. 

There is no word yet on whether the SEC will appeal this decision 

Allison D. Charney contributed to this post.

There is good reason, beyond anger, voyeurism and schadenfreude, for Wall Street and “Main Street” to keep their eyes on the SEC enforcement action against investment banking firm Goldman Sachs & Co and one of its vice presidents, Fabrice Tourre. 

According to the SEC’s complaint (pdf), Goldman was paid by one of the world’s largest hedge funds, Paulson & Co., to structure a “synthetic” CDO comprised of residential mortgage backed securities – later called the ABACUS 2007-AC1.  Paulson played a vital role in choosing which securities would be part of the CDO.  Unbeknownst to investors, Paulson would later take short positions against the CDO it had helped design.  In other words, the SEC is accusing Goldman of structuring a synthetic CDO that would fail for the benefit of Paulson without disclosing that fact to investors. 

Although on its face, the complaint appears to be a straight-forward allegation of fraud, the regulatory implications of the SEC’s lawsuit are far from simple and potentially far-reaching for all players in the multi-trillion dollar derivative markets.  The derivatives market is, for lack of a better term of art, gargantuan.  It is, to paraphrase Willie Sutton, “where the money is” on Wall Street.  Derivatives are also credited with being one of the systemic risks that exacerbated the damage caused by the credit crisis.  By bringing the action against Goldman, the SEC will have to grapple with the notion that, by definition, “synthetic” CDOs are composed of long and short bets on the direction a real, or so-called “reference” security, is going to move.  If one party bets for a rise in value, there must be someone betting for a decline.  Goldman, in its response to the SEC’s complaint (pdf) has said that  “[a]s normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa.”

Congress is presently debating how to regulate derivatives as part of a new financial regulatory reform bill.  However, by filing the Goldman complaint, the SEC may effectively be taking on aspects of the derivatives industry prior to legislative action.  By choosing to litigate the issue of whether Goldman needed to inform the alleged victims – all sophisticated investors – that Paulson stood to benefit from the reference securities declining in value, the SEC may be after more than just whether Goldman defrauded some investors.  It may be tinkering with how derivative products, like synthetic CDOs, will need to be created, marketed and documented in the future.  For example, a significant issue at stake is whether a broker-dealer or market-intermediary such as Goldman has a duty to disclose who is on each side of a bet or which party initially wanted to place a specific wager on a particular security?  And if there is such a duty, is it material to investors who the short or long positions are held by?  These and many other critical questions concerning the legal obligations of players in the derivative markets will be at issue as this enforcement action unfolds.

Allison D. Charney contributed to this post.