Securities Industry Commentator by Bill Singer Esq

The SEC Is Asked to Go Back To The Future to Rewrite History (BrokeAndBroker.com Blog)

SEC Charges The Kraft Heinz Company and Two Former Executives for Engaging in Years-Long Accounting Scheme / Company Will Pay $62 Million to Settle Charges Related to Inflated Cost Savings that Caused it to Restate Several Years of Financial Reporting (SEC Release)

Statement Regarding Information Bundling and Corporate Penalties by SEC Commissioner Caroline A. Crenshaw

SEC Charges Public Company and Former Executives with Insider Trading, Internal Accounting Control Violations, and Misleading an Auditor (SEC Release)

Former South Bay Executive Found Guilty of Federal Criminal Charges for Insider Trading and Securities Fraud Scheme (DOJ Release)

Co-Founder Of Investment Fund Sentenced To 4 Years In Prison For Defrauding Investors Of Over $25 Million / Jason Rhodes Served as Chief Investment Officer and Chief Risk Officer While Defrauding Investors (DOJ Release)

SEC Files Subpoena Enforcement Action Against Penny Stock Promoter (SEC Release)

SEC Charges Seven Individuals in Orange County-Based Offering Frauds (SEC Release)

SEC Obtains Final Judgment Against Investment Adviser Charged with Defrauding Advisory Clients (SEC Release)

SEC Obtains Emergency Relief, Charges Couple Who Operated $18 Million Ponzi scheme (SEC Release) 

Vanguard Prevails Over Customer in FINRA Arbitration Dispute Over Moderna Shares

In the Matter of the Arbitration Between Mark D. Mills, Claimant, v. Vanguard Marketing Corporation, Respondent (FINRA Arbitration Award)

FINRA Fines and Suspends Rep Over False Attestations Involving an Elderly Widow's Beneficiary Designation (BrokeAndBroker.com Blog)

UPDATE: If You Didn't Know But Now Do. If You Hadn't Told FINRA But Did. If You Ask For A Stay But the SEC Doesn't. (BrokeAndBroker.com Blog)

[F]rom the last quarter of 2015 to the end of 2018, Kraft engaged in various types of accounting misconduct, including recognizing unearned discounts from suppliers and maintaining false and misleading supplier contracts, which improperly reduced the company's cost of goods sold and allegedly achieved "cost savings." Kraft, in turn, touted these purported savings to the market, which were widely covered by financial analysts. The accounting improprieties resulted in Kraft reporting inflated adjusted "EBITDA," a key earnings performance metric for investors. In June 2019, after the SEC investigation commenced, Kraft restated its financials, correcting a total of $208 million in improperly-recognized cost savings arising out of nearly 300 transactions.

. . .

As alleged in the SEC's order and in its complaint against Hofmann, Kraft failed to design and maintain effective internal accounting controls for its procurement division. As a result, finance and gatekeeping personnel repeatedly overlooked indications that expenses were being improperly accounted for. In addition, Pelleissone was presented with numerous warning signs that expenses were being managed through manipulated agreements with Kraft's suppliers, but rather than addressing these risks, he pressured the procurement division to deliver unrealistic savings targets. Hofmann approved several improper supplier contracts used to further the misconduct despite numerous warning signs that procurement division employees were circumventing internal controls, and certified the accuracy and completeness of the procurement division's financial statements when the misconduct was occurring. As a member of Kraft's disclosure committee, Pelleissone then improperly approved the company's financial statements.

. . .

The SEC's order finds that Kraft violated the negligence-based anti-fraud, reporting, books and records, and internal accounting controls provisions of the federal securities laws. The order also finds that Pelleissone violated the negligence-based anti-fraud, books and records, and internal accounting controls provisions of the federal securities laws and additionally, failed to provide Kraft's accountants with accurate information and caused Kraft's reporting, books and records, and internal accounting controls violations. The SEC's complaint against Hofmann alleges that he violated the negligence-based anti-fraud provisions, failed to provide accurate information to accountants, and violated the books and records and internal accounting controls provisions of the federal securities laws.

In March of this year, I gave a speech to the Council of Institutional Investors suggesting that the SEC should reconsider its approach to assessing penalties against corporate wrongdoers.[1]  Rather than calibrating penalties to actual misconduct, some Commissioners have viewed corporate benefits as a limiting constraint on penalty amounts.[2]  This approach posits that any penalty that exceeds the easily quantifiable benefits resulting directly from a securities law violation unfairly burdens the corporation's shareholders.  As I explained in March, this approach is flawed.

Corporate benefits are notoriously difficult to quantify.  If we limit penalties to only those benefits that are easy to count, we will invariably undercount, leaving the corporation in a potentially better economic position for having committed the violation.  That is precisely the wrong outcome to advance our goals of punishing misconduct and delivering effective specific and general deterrents.  Paying a penalty cannot be just a cost of doing business.

And the imprecision of measuring corporate benefits is not just a result of complexity.  Corporate defendants strategically release bad news in ways that dampen or obscure the market's reaction.  The resulting change in stock price therefore may not be an effective way to measure corporate benefits.  Today's enforcement action against The Kraft Heinz Company ("Kraft") highlights this problem.  In my view here's why penalties should not be constrained by a mechanistic approach to corporate benefit:

Kraft first announced the SEC's investigation to the public on February 21, 2019, at the same time that it announced a dividend cut and a $15.4 billion write down of goodwill in certain reporting units and intangible assets.  Kraft also stated that it recorded only a $25 million increase in cost of products sold in connection with its response to the SEC's investigation.  The company further stated that it did not expect the matters under investigation to be "material to its current period or any prior period financial statements."   Its stock price fell following this announcement.  But, Kraft's release of all this negative information at the same time obfuscated what portion of the stock drop resulted from news related to its potential SEC violations versus the other significant issues. 

Later, on May 6, 2019, Kraft announced that it planned to restate its financials for fiscal periods 2016, 2017 and the first three quarters of 2018, as it was nearing completion of an internal investigation into its procurement division.  According to Kraft's press releases, the company now believed that the misstatements were not "quantitatively material" and that "[t]he findings from the investigation did not identify any misconduct by any member of the senior management team."  Then, on June 7, 2019, Kraft filed an annual report containing the restated financial results, with the errors totaling $208 million, not just $25 million, and reiterated that it did not identify any misconduct by any members of senior management.  But I note we announced a settlement with a former Chief Operating Officer of Kraft for negligent misrepresentations and accounting violations.  Corporate claims of lack of senior management involvement or materiality could also dampen the stock price reaction to negative news and affect a corporate benefit analysis. 

We did not charge Kraft based on these statements, but these facts present a useful opportunity to highlight a practice that is far from unique.  Academic research describes releasing confounding news along with bad news as "information bundling."  A recent analysis determined that it results in dramatically fewer successful recoveries by private securities litigants who, unlike the SEC, must prove that corporate stock price losses were directly attributable to the specific bad news.[3]  In this study researchers also concluded that information bundling resulted on average in $21.17 to $23.45 million lower recoveries for shareholders.[4]

In considering the appropriate penalty to impose in actions brought by the SEC, I am concerned about corporate issuers benefitting from information bundling.  To the extent corporations thereby make it more difficult to measure corporate benefit, that merely reinforces my inclination in setting penalties to focus more heavily on other factors, such as punishing misconduct and effectively deterring future violations.

According to the SEC's complaint, filed in the United States District Court for the District of Arizona, Cavco, at Stegmayer's direction, used material, non-public information obtained through merger discussions with another public company, Skyline Corp., to trade in Skyline securities. Ultimately, Skyline announced a merger with a different company, which increased Skyline's stock price by 48% and resulted in alleged gains for Cavco of approximately $260,000. Additionally, the complaint alleges that after Cavco received an SEC subpoena concerning the Skyline trading, Stegmayer sold over 11,000 Cavco shares that he personally owned. After news of the SEC investigation and the Skyline trading came out, Cavco's share price decreased by 23%. The complaint alleges that by selling stock in advance of this news, Stegmayer avoided losses of over $880,000.

In addition, the SEC's complaint alleges that Cavco failed to devise a system of internal accounting controls sufficient to provide reasonable assurance that its securities trading would be executed in accordance with its board's authorization, its corporate investment policy, and its securities trading policy, and that Stegmayer and Urness aided and abetted that failure. The complaint further alleges that Stegmayer circumvented and/or failed to implement the few controls that were in place by causing Cavco to trade in shares of Skyline and of other companies that Cavco was interested in acquiring, all without board knowledge. The SEC also alleges that Urness circumvented and/or failed to implement Cavco's investment policy by setting up a system to fund the trades without informing the board or ensuring the trades complied with that policy. The complaint further alleges that Stegmayer and Urness knowingly misled Cavco's auditors with respect to the Skyline trading and an ongoing Financial Industry Regulatory Authority (FINRA) investigation into those trades.

The SEC's complaint alleges that Cavco violated Sections 10(b) and 13(b)(2)(B) of the Securities and Exchange Act of 1934 ("Exchange Act") and Rule 10b-5 thereunder; that Stegmayer violated Section 17(a) of the Securities Act of 1933 ("Securities Act"), Sections 10(b) and 13(b)(5) of the Exchange Act, and Rules 10b-5 and 13b2-2(a) thereunder and aided and abetted Cavco's violation of Section 13(b)(2)(B) of the Exchange Act; and that Urness violated Section 13(b)(5) of the Exchange Act and Rule 13b2-2(a) thereunder and aided and abetted Cavco's violation of Section 13(b)(2)(B) of the Exchange Act. Without admitting or denying the allegations, Stegmayer consented to the entry of judgment, subject to court approval, that permanently enjoins him from violating the charged provisions, bars him from serving as an officer or director of a public company for 5 years, and orders him to pay a civil penalty of $1.48 million.

The Commission also announced insider trading charges against Robert Scott Parkhurst, an Indiana resident and former national sales manager at Skyline. According to the SEC's complaint, filed in the United States District Court for the Northern District of Indiana, Parkhurst obtained material, non-public information about Skyline's merger discussions through his role as national sales manager at Skyline. The SEC alleges that Parkhurst traded on the basis of that material, non-public information and also tipped his father and son. After the merger news was publicly released, Parkhurst had gains of approximately $4,893, and his father and son of $6,210. Without admitting or denying the allegations, Parkhurst consented to the entry of judgment, subject to court approval, that permanently enjoins him from violating the antifraud provisions of Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5 thereunder and orders him to pay a civil penalty of $15,995.

[L]oman was a vice president of finance and the corporate controller for OSI Systems Inc., a publicly traded security, health care and electronics manufacturing company, from 2006 until 2018. In these roles, Loman had advance knowledge of OSI's revenue and earnings and, as corporate controller, was responsible for compiling and internally reporting the company's confidential financial results.

In December 2015, Loman received confidential information that OSI was financially underperforming and would fall far short of their earnings and revenue forecast for its second quarter of its fiscal year 2016. Acting on this information in December 2015, Loman purchased a series of options contracts with the intent of profiting when OSI's stock price fell.

On January 27, 2016, OSI announced its disappointing second-quarter earnings, and lowered its sales and earnings guidance for the remainder of its fiscal year. On the day of this announcement, OSI shares plunged approximately 30 percent in value from their previous closing day price. As a result, Loman gained approximately $355,000 in illegal profits from this scheme.

In March 2016, Loman misused nonpublic information by purchasing stock of American Science & Engineering Inc., a Billerica, Massachusetts-based manufacturer of security screening equipment that OSI had targeted for acquisition. Once OSI publicly announced in June 2016 its agreement to acquire AS&E, Loman immediately sold his shares in AS&E and made approximately $120,000 in illegal gains. In September 2016, OSI formally acquired AS&E for approximately $270 million.

Loman made a total of approximately $475,000 in illicit gains through this scheme.

Beginning in at least 2013 and through in or about December 2016, RHODES, together with his co-conspirators, solicited investments in Sentinel by falsely representing to investors that their funds would be used for legitimate, specified, investment purposes, namely purchasing securities.  In fact, RHODES failed to invest the investor monies as promised, but rather diverted investor funds to his own personal use and the personal use of his co-conspirators and, in a Ponzi-like manner, used them to make repayments to other investors who were demanding their money.  Among other things, RHODES diverted investor funds to a trucking business operated by RHODES and his wife; used them to pay more than $1 million to settle an unrelated civil lawsuit filed against RHODES and one of his co-conspirators; and expended them on other, personal expenses including a resort stay in Dubai and a luxury time-share vacation club.  Through this scheme, RHODES and his co-conspirators defrauded over 25 investors out of more than $25 million.

Among other fraudulent acts, RHODES and a co-conspirator falsified an account statement for an investor ("Investor-1") to conceal the fact that RHODES and his co-conspirators had misappropriated most of the $4.2 million Investor-1 had invested in Sentinel.  After Investor-1 discovered the fraudulent nature of the account statement, RHODES, working with others, obtained funds from yet another investor ("Investor-2") in order to make payments to Investor-1.  RHODES and his co-conspirators then, on multiple occasions, created fraudulent reports for Investor-2, falsely reflecting that Investor-2's funds were invested with portfolio managers in Sentinel's brokerage accounts and were earning returns.  In truth and in fact, and as RHODES well knew, Investor-2's funds had been almost entirely misappropriated upon their receipt to repay Investor-1 and were not being managed by portfolio managers on Sentinel's platform.  

[R]ecidivist Michael P. Owens set up and controlled a boiler room that raised approximately $67 million from investors in Elite between 2014 and summer 2018. The complaint alleges that Owens operated the boiler room with the knowledge of Elite's executive officers, Dustin B. Tillman and Zeeshawn S. Zia, and assistance from his associates, Dawson L. Davenport (also a recidivist) and Andrea J. Lindstrom. The SEC alleges that Elite paid undisclosed commissions of about 15% per investment to unregistered salespeople, failed to properly disclose to investors that approximately 30% of offering proceeds were used to pay offering costs, and that Owens, Davenport, Lindstrom, Tillman, and Zia took steps to conceal these omissions. The SEC's complaint also alleges that Davenport, Lindstrom, Tillman, and Zia made misrepresentations to Elite investors regarding the status of an acquisition and the status of Elite's financial audit, and that Owens acted as an unregistered broker.

The complaint also alleges that Owens' company, RMMH, LLC, conducted a separate unregistered and unauthorized offering of Elite common stock in 2017. According to the SEC, RMMH sold Elite shares it owned to about 20 investors, raising approximately $2 million, but Owens and his affiliates concealed the offering from Tillman and Zia. In order to provide purchasers in the RMMH offering with their stock certificates, defendants Owens, Davenport, Lindstrom, Robert Gunton, and Julie Yale schemed to generate Elite stock certificates and use the signature stamps of Tillman and Zia without their authorization.

1. The evidence, and in particular the recording of the subject call, are consistent with

Respondent's position. While it is unfortunate that Claimant did not either complete the

transaction he wanted, or ask Respondent to do so, that was due to no fault of Respondent. Respondent's employee who took Claimant's call was clear and professional. Claimant did not request that Respondent's employee do anything that he didn't do, even when asked if there was anything else he could do for him. Respondent's employee did not represent that he had confirmed Claimant had completed the order. There is no evidence of breach of any duty by Respondent.

• Securities Industry Commentator
• Bill Singer