DETECTING, INVESTIGATING & DOCUMENTING FRAUD PART ONE

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1 DETECTING, INVESTIGATING & DOCUMENTING FRAUD PART ONE PRESENTED BY Christopher P. Seefer

2 CHRISTOPHER P. SEEFER Mr. Christopher P. Seefer earned his Bachelor of Arts degree and his Master of Business Administration degree from the University of California, Berkeley. Mr. Seefer earned his Juris Doctor degree from the Golden Gate University School of Law in Mr. Seefer concentrates his practice in securities class action litigation, including cases against Verisign, UTStarcom, VeriFone, Nash Finch, NextCard, Terayon and America West. Mr. Seefer was a Fraud Investigator with the Office of Thrift Supervision, Department of the Treasury ( ) and a field examiner with the Office of Thrift Supervision ( ). Source:

3 OVERVIEW DISCOVERY: PRIVATE SECURITIES LITIGATION VS. REGULATORY INVESTIGATIONS ESSENTIALS STEPS TO INVESTIGATE CORPORATE FRAUD STRATEGIES TO SUCCESSFULLY PLEAD A FRAUD CASE PROVIDE CASE STUDIES TO ILLUSTRATE KEY COURSE CONCEPTS

4 DISCOVERY: PRIVATE SECURITIES LITIGATION VS. REGULATORY INVESTIGATIONS ACCESS TO PRIVATE CORPORATE DOCUMENTS, REPORTS & COMMUNICATIONS OFFICE OF THRIFT SUPERVISION, Department of the Treasury Responsible for chartering, supervising, and regulating all federally chartered and statechartered savings banks and savings and loans associations. Power to service subpoenas and subpoenas duces tecum - SUBPOENAS DUCES TECUM Court summons ordering the recipient to appear before the court and produce documents or other tangible evidence for use at a hearing or trial. ATTORNEYS AND LAW FIRMS HAVE NO SUBPOENA POWER FOR PRIVATE SECURITIES LITIGATION

5 CASE STUDY: CHARLES KEATING CHARLES KEATING In the 1980s, Keating s American Continental Corporation and the Lincoln Savings and Loan Association, and took advantage of loosened restrictions on banking investments by buying risky junk bonds and other investments. When Lincoln failed in 1989, it cost the federal government over $3 billion and about 23,000 customers were left with worthless bonds. In the early 1990s, Keating was convicted in both federal and state courts of many counts of fraud, racketeering, and conspiracy. He served four and a half years in prison before those convictions were overturned in In 1999, Keating entered a plea agreement and admitted to having committed four counts of wire and bankruptcy fraud by extracting nearly $1 million from American Continental Corp. while already anticipating ACC s collapse that happened just weeks later. In return for the plea deal, the federal prosecutors dropped all other charges against him and sentenced to time he already served. 1 1 Courtesy of Associated Press

6 CASE STUDY: MORTGAGE CRISIS HOW REGULATORS MISSED THE MORTGAGE CRISIS OVERLOOKED RISKY UNDERWRITING STANDARDS IGNORED THE UNSUSTAINABLE RISE IN HOUSING PRICES IGNORED REPORTS OF EGREGIOUS AND PREDATORY LENDING PRACTICES Source: The Credit Blog

7 CASE STUDY: MORTGAGE CRISIS COLLATERALIZED DEBT OBLIGATION BAD LOANS MIXED IN WITH GOOD LOANS HIGH DEBT TO INCOM RATIOS NON-OWNER OCCUIED ISSUES HIGH LOAN TO VALUE FHA LAWSUITS: REPRESENATIONS FRAUDENTLY MADE WARRANTIES FRAUDENTLY MADE FCIC INVESTIGATION: HIGH RISK LOANS HAD NO COMPENSATING FACTORS ON FILE Source: The Credit Blog

8 SEC RULE 10B-5 Rule 10b-5: Employment of Manipulative and Deceptive Practices: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or ( (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

9 SEC RULE 10B-5 ELEMENTS OF THE OFFENSE 1. MANIPULATION OR DECEPTION; 2. MATERIALITY; 3. "IN CONNECTION WITH" THE PURCHASE OR SALE OF SECURITIES 4. SCIENTER PRIVATE PLAINTIFFS HAVE THE ADDITIONAL BURDEN OF ESTABLISHING: - STANDING - PURCHASER/SELLER REQUIREMENT - RELIANCE - LOSS CAUSATION - DAMAGES

10 CASE STUDY: JANUS CAPITAL GROUP V. FIRST DERIVATIVE TRADERS 564 U.S., 131 S. CT. 2296, 180 L. ED. 2D 166 (JUNE 13, 2011) On June 13, 2011, the Supreme Court decided Janus Capital Group, Inc. v. First Derivative Traders, No , holding that Rule 10b-5 provides a private right of action for securities fraud only against the person or entity with ultimate authority over the alleged false statement in a prospectus, and thus a mutual fund manager who influenced the content in a prospectus could not be held liable under the rule. The Supreme Court observed in a timely statement as we roll toward a presidential election "[e]ven when a speechwriter drafts a speech, the content is entirely within the control of the person who delivers it. And it is the speaker who takes credit or blame for what is ultimately said S. Ct. at 2302.

11 CASE STUDY: MATRIXX INITIATIVES, INC. V. SIRACUSANO 563 U.S., 131 S. Ct. 1309, 179 L. Ed. 2d 398 (Mar. 22, 2011) The Supreme Court addressed whether reports of adverse events associated with a pharmaceutical product are material "absent a sufficient number of such reports to establish a statistically significant risk that the product is in fact causing the events. 1 The Supreme Court rejected the application of any bright-line rule, observing that statistical evidence may not always be available and that an absence of such data "does not mean that medical experts have no reliable basis for inferring a causal link between a drug and adverse events S. Ct. at Id. at 1319.

12 CASE STUDY: MORRISON V. NATIONAL AUSTRALIA BANK LTD. 130 S. Ct. 2869, 561 US, 177 L. Ed. 2d 535 (Supreme Court, 2010) The case concerned the 1998 purchase by National Australia Bank of a mortgage servicing company, HomeSide Lending, head-quartered in Florida. In July 2001, NAB announced a USD 450 million write-down in assets due to losses associated with HomeSide Lending; and a further USD 1.75 billion write-down in September of that year. The root cause of the writedown, was that the modelling done by HomeSide Lending to determine future revenues from mortgage fees was based on overly optimistic assumptions. The plaintiffs claimed that this was part of an intentional scheme to defraud committed by HomeSide's management. The decision was unanimous in favor of the defendants. The majority opinion, by Scalia, held that since the plain language of section 10(b) only applies to US securities, it should not be read to apply to non-us securities, despite long-standing precedent, originating in the 2nd Circuit, and since adopted by other circuits also, that 10(b) also applies to non-us securities

13 FRAUD IN THE MARKET THE DEFENDANT HAS TO MAKE A PUBLICLY FRAUDULENT STATEMENT EVERY INVESTOR COULD THEN SUE IF IT COULD BE SHOWN THAT THE STATEMENT AFFECTED THE MARKET AS A WHOLE BASIC INC. V. LEVINSON, 485 U.S. 224 (1988)

14 THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Safe Harbor for Forward-Looking Information Limitations on Joint and Several Liability Increased Pleading and Proof Requirements Limitation on Damages Class Action Procedural Reforms Enhanced Attorney Sanction Provisions RICO Amendment Eliminating Sanctions Claims Auditor Duty Regarding Financial Fraud Additional SEC Rulemaking Authority

15 STEPS FOR INVESTIGATING FRAUD 1. COLLECTION AND ORGANIZATION OF ALL PUBLIC INFORMATION - Quarterly reports, 10K, annual report, press releases, etc. 2. PREPARE A FINANCIAL TREND ANALYSIS - Analysis should be of the year of the class period and years before the class period - Compare officer salaries and bonuses 1. REVIEW DAILY STOCK PRICES CHANGES - Analysis should be for the year of and years before class period - What is the trading volume before and after major announcements? - How does the stock price compare to major indexes and its industry peers? 4. DETERMINE EXISTENCE OF OTHER PROCEEDINGS - Bankruptcy filings or pending regulatory investigations 5. CONSIDER MOTIVE - Insider selling, executive compensation structure, recent company acquisitions

16 HOW TO LIFT STAY OF DISCOVERY REQUESTS SHOULD BE PARTICULARIZED - Have clearly defined universe of documents PROVE THAT THE MAINTENANCE OF THE STAY WOULD PERMIT IMPERMISSIBLE RISK OF EVIDENCE DESTRUCTION STAY WOULD CAUSE UNDUE PREJUDICE IF THE COMPANY IS UNDER SEC INVESTIGATION - Request a motion in federal district court (with a particularized request) - Ask the SEC to hand over any documents that the defendant already has submitted

17 CASE STUDY: IN RE: VERIFONE HOLDINGS INC. SECURITIES LITIGATION VeriFone, a San Jose, California-based electronic payments company, facilitates secure transactions between consumers, merchants, and financial institutions. In November 2006, it acquired Lipman Electronic Engineering Ltd, an Israeli company, and began integrating its business with that of Lipman. In three consecutive quarters, VeriFone's preliminary internal reports accurately showed it had fallen short of its earnings and gross margins forecasts. What is alleged is that Douglas Bergeron (CEO) and the company's former chief financial officer supervised the accounting staff as they made manual multi dollar adjustments to ensure their quarterly results met expectations. Plaintiff s attorneys discovered that Verifone was under a SEC investigation and requested specific documents. After initially denying the request, the SEC relented after multiple requests from the plaintiff s attorneys. The case was dismissed in March of 2011 by a federal judge. In December of 2012, a federal appeals court revived the lawsuit and reversed the lower court s ruling.

18 PLEADING SCIENTER Federal Rules of Civil Procedure 9(B) - Requires specific on facts showing false statements to be found - Ernst & Ernst v. Hochfelder 1. Court held that scienter was necessary to prove fraud 2. Court did not provide guidance as to the level of culpability to meet substantive scienter requirement The Private Securities Litigation Reform Act (PSLRA) - Designed to weed out frivolous or very weak cases at an early stage - Burden of proof was on the plaintiff to prove defendant s state of mind - PSLRA 21(D)(b)(2) - Plaintiff must be particularized on why the defendant knew or were reckless on their not knowing that their statements were false - Collective analysis look at all the facts

19 CASE STUDY: TELLABS V. MAKOR ISSUES & RIGHTS 551 U.S. 308, (2007) The Court ruled a reasonable inference of scienter from assumed-true facts was insufficient and inconsistent with Congressional intent. Writing for the Court, Justice Ginsburg wrote that "to qualify as strong within the intendment of 21D(b)(2), we hold, an inference of scienter must be more than merely plausible or reasonable - it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent...the inference of scienter must be more than merely reasonable or permissible -it must be cogent and compelling, thus strong in light of other explanations. A complaint will survive, we hold, only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged. Tellabs increased the hurdle civil litigants must traverse in order to recover damages for securities fraud because it made it more difficult to demonstrate scienter (a necessary element of the claim). Instead of being able to reasonably deduce scienter from the alleged facts of the case, a claimant must also demonstrate that fraud is at least as likely as other, more-innocent explanations

20 PLEADING A FRAUD CASE WHEN SUBJECT TO A DISCOVERY STATE, HOW DO YOU PLEAD A FRAUD CASE? INSIDER SELLING - Is the selling dramatically out of line with prior trading practices? - Was the stock sale pursuant to a 10b5-1 trading plan? - Were the terms of the 10b5-1 plan modified? EXECUTIVE COMPENSATION - Correlation of stock price and stock options and cash bonuses - Was the stock sale pursuant to a 10b5-1 trading plan? EXECUTIVE TERMINATION - Timing of termination - What was the former executive s role and expertise? - Were the terms of the 10b5-1 plan modified? RESTATEMENTS AND GAAP VIOLATIONS - Dramatic overstatement of income can raise strong inference of scientor - Nature and number of GAAP violations - Length of restatement FIND FORMER EMPLOYEES - Ensure that the employees are credible and reliable - Determine their position and responsibilities - Conduct a thorough interview

21 CASE STUDY: IN RE: NORTHWEST PIPE COMPANY Thee Northwest Pipe Company and certain of its top officials were accused of violating of Sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b-5. The Complaint alleges that between April 23, 2008 and November 11, 2009 Northwest Pipe Company issued materially false and misleading statements regarding the company s business and financial results. Northwest Pipe was specifically accused of overstated their revenues and earnings by booking sales when steel supplies were bought rather when the final manufactured pipes were complete and orders were placed by their customers. As a direct result of the challenged statements, Northwest Pipe common stock traded between April 23, 2008 and November 11, 2009, at artificially inflated prices. In August of 2012, Northwest Pipe Company disclosed that it had agreed to pay $13.25 million to settle a pair of lawsuits brought by shareholders related to accounting errors that forced the company to restate several years of financial reports. The settlements are also detailed in the company's quarterly 10-Q filing with the Securities and Exchange Commission

22 CASE STUDY: IN RE: YAHOO A securities litigation class action suit against Yahoo! Inc. and three Yahoo executives, Carol Bartz, Jerry Yang, and Timothy Morse, (collectively "Defendants"), alleging Defendants made materially false and misleading statements regarding Yahoo's investment in Alipay, a Chinese company. The case was brought on behalf of all persons who purchased or otherwise acquired Yahoo stock between April 19, 2011 and July 29, Plaintiffs alleged Defendants violated the Securities Exchange Act of 1934 by making materially false and misleading statements about the Company's investment in Alibaba Group Holdings Limited ("Alibaba" or "Alibaba Group"). Defendants move to dismiss the complaint, arguing Plaintiffs failed to state a Section 10(b) claim because Defendants had no duty to disclose the allegedly omitted information and that Plaintiffs failed to plead a strong inference of scienter; and that the claim against Defendant Jerry Yang failed because he did not make any of the challenged class period statements. 1 Of note was that Carol Bartz, former CEO of Yahoo!, was fired from her position shortly after a 10Q report was published announcing the Alipay issue. In August 2012, District Judge Charles R. Breyer found Plaintiffs failed to state a Section 10(b) claim, consequently the Defendant s motion to dismiss was granted. 1