Kathrein on Investor Fraud

It's Time To Reinstate Aiding and Abetting Liability Against Those Who Help Securities Fraud

Now is the time, if ever, for Congress to pass legislation that would reinstate aiding and abetting liability for accountants, lawyers, and others who help corporate executives commit securities fraud that harm investors. The public is outraged from watching all those who assisted in the market meltdown walk away with their huge bonuses.

Senator Arlen Specter, introduced Senate Bill 1551 on July 30, 2009, seeking to do just that. The Bill called the"Liability for Aiding and Abetting Securities Violations Act of 2009," is currently co-sponsored by Edward Kaufman [D-DE], John Reed [D-RI] and Sheldon Whitehouse [D-RI]. The Bill seeks to amend the SEC Act of 1934 subject to liability in a private civil action any person that knowingly or recklessly provides substantial assistance to another person (aids and abets) in violation of that act. The Senator's goal is to restore the ability to sue third parties in securities fraud lawsuits as freely as you could before the U.S. Supreme Court's ruling in Stoneridge v. Scientific Atlanta (Supreme Court docket).

The main provision of the Bill states:

For purposes of any private civil action implied under this title, any person that knowingly or recklessly provides substantial assistance to another person in violation of this title, or of any rule or regulation issued under this title, shall be deemed to be in violation of this title to the same extent as the person to whom such assistance is provided.’.

Senator Spector"s floor speech follows: 

 Mr. President. I have sought recognition to urge support for the legislation I just introduced, the Liability for Aiding and Abetting Securities Violations Act of 2009. My legislation would overturn two errant decisions of the Supreme Court--Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 1994, and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 522 U.S. 148, 2008, by amending the Securities Exchange Act of 1934 to authorize a private right of action for aiding-and-abetting liability.

 Act's main anti-fraud provision, §10(b), makes it "unlawful for any person, directly or indirectly," to commit acts of fraud "in connection with the purchase or sale of any security." Nearly fifty years ago the Court implied a private right of action under §10(b). The result was that investors could recover financial losses caused by violations of 10(b) and the companion regulation issued by the SEC commonly known as "Rule 10b-5."

Until Central Bank, every circuit of the Federal Court of Appeals had concluded that §10(b)'s private right of action allowed recovery not only against the person who directly undertook a fraudulent act--the so-called primary violator--but also anyone who aided and abetted him. A five-Justice majority in Central Bank, intent on narrowing §10(b)'s scope, held that its private right of action extended only to primary violators.

When Congress debated the legislation that became the Private Securities Litigation Reform Act of 1995, PSLRA, then-SEC chairman Arthur Levitt and others urged Congress to overturn Central Bank. Congress declined to do so. The PSLRA authorized only the Securities and Exchange Commission, SEC, to bring aiding-and- abetting enforcement litigation.

It is time for us to revisit that judgment. The massive frauds involving Enron, Refco, Tyco, Worldcom, and countless other lesser-known companies during the last decade have taught us that a stock issuer's auditors, bankers, business affiliates, and lawyers--sometimes called "secondary actors"--all too often actively participate in and enable the issuer's fraud. Federal Judge Gerald Lynch recently observed in a decision calling on Congress to reexamine Central Bank that secondary actors are sometimes "deeply and indispensably implicated in wrongful conduct." In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d. 304, 318 n.15, S.D.N.Y. 2009. Professor John Coffee of Columbia Law School, a renowned expert on the regulation of the securities markets, has even laid much of the blame for the major corporate frauds of this [sic].

The immunity from suit that Central Bank confers on secondary actors has removed much-needed incentives for them to avoid complicity in and even help prevent securities fraud, and all too often left the victims of fraud uncompensated for their losses. Enforcement actions by the SEC have proved to be no substitute for suits by private plaintiffs. The SEC's litigating resources are too limited for the SEC to bring suit except in a small number of cases, and even when the SEC does bring suit, it cannot recover damages for the victims of fraud.

Last year's decision in Stoneridge made matters still worse for defrauded investors. Central Bank had at least held open the possibility that secondary actors who themselves undertake fraudulent activities prescribed by §10(b) could be "held liable as ..... primary violator[s]." Stoneridge has largely foreclosed that possibility. A divided Court held that §10(b)'s private right of action did not "reach" two vendors of a cable company that entered into sham transactions with the company knowing that it would publicly report the transactions in order to inflate its stock price. The Court conceded that the suppliers engaged in fraudulent conduct prescribed by §10(b), but held that they were not liable in a private action because only the issuer, not they, communicated the transaction to the public. That remarkable conclusion put the Court at odds with even the Republican Chairman of the SEC.

My legislative response would take the limited, but important, step amending of the Exchange Act to authorize a private right of action under §10(b) (and other, less commonly invoked, provisions of the Act) against a secondary actor who provides "substantial assistance" to a person who violates §10(b). Any suit brought under my proposed amendment would, of course, be subject to the heightened pleading standards, discovery-stay procedures, and other defendant-protective features of the PSLRA.

On Thursday, September 17, the Senate Judiciary Committee, Subcommittee on Crime and Drugs held a hearing consider the Bill, entitled  "Evaluating S. 1551: The Liability for Aiding and Abetting Securities Violations Act of 2009." S. 1551.  Sen. Arlen Specter's chaired the hearing. The witnesses were John C. Coffee, Columbia University School of Law; Patrick J Szymanski, General Counsel, Change to Win (a group of labor unions); Tanya Solov, Director, Illinois Securities Department, of behalf of the North American Securities Administrators Association; Robert J. Giuffra, Jr., a partner in Sullivan & Cromwell LLP, NYC; and Adam C. Pritchard, University of Michigan Law School. Coffee, Szymanski and Solov testified in favor of the Bill. Their can be found here:

John Coffee

Patrick Szymanski

Tanya Solov

 

Messrs. Giuffa and Pritchard both testified against the Bill, asking for lesser enforcement of the securities laws, and arguing that private law suits cost millions to those who are sued (forgetting about the billions lost in the recent market crash), and pointing to the evil plaintiffs lawyers who actually make money enforcing these laws ( while conveniently ignoring the millions made by the attorenys now shielded from liability when they help their clients commit fraud). Rather, they prefer that the inept SEC retain sole jurisdiction to go after aiders and abettors. Professor Pritchard wants to do away with actual damages and substitute only the amounts gained by the wrongdoers...effectively making damages so small that no attorney could afford to bring a case. Their testimony can be found here:

Robert Giuffra

Adam Pritchard

 

Senator Patrick Leahy's statement in favor of the Bill can be found here:

 

The Honorable Patrick Leahy

 

 

 

A Fraudster's Mia Culpa: Marc S. Dreier---I Just Wanted Respect

        If you have seen my posts on Madoff, you can tell that I am curious about the criminal mind. With normal securities fraud I have always subscribed to the thought that people simply get caught up in little lies, which get bigger, and then out of control. It mostly happens as a series of events, gets covered up, until bad economic situations cause the fraud to be revealed. But rarely have I seen the two lives these people live as we have seen with such highly regarded individuals as Madoff, and now Marc Drier.

        In a recent letter, Dreier wrote to convince the Judge who is going to sentence him, we see another amazing sad story of refusing to fail at all costs...and perhaps a true lack of self esteem. While Madoff never appeared to lack self-esteem, he did grow up on the wrong side of the tracks...so to speak...for the social circles he wanted to accept him so badly. Dreier just outright confesses to this desire. His letter is reprinted below in its near entirety. If you are unfamiliar with the crime...just read on. Dreier lays it our for you. Read it for what it reveals...and skip the excuses:

Marc S. Dreier

c/o Law Offices of Gerald Shargel

570 Lexington Ave., 45 th Fl.

New York, NY 10022

 

July 7, 2009

 

Dear Judge Rakoff,

 

Please consider this letter in connection with my sentencing on July 13, 2009.

 

I know of course that no words can diminish the harm I have caused to so many people. Those who were victimized by my bogus loans lost millions of dollars. Clients of my law firm lost escrow funds they entrusted to me. The attorneys and staff at my firm who put their faith in me lost their jobs. My friends and colleagues have been tainted by their association with me. And the families of all these people have no doubt shared in the suffering — as has my own family. My children have lost the father they knew, as well as their good name and the  happiness they deserve. I have betrayed the people I care about most, and I suffer every day from the shame and self-loathing and regret with which I will always have to live.

 

My crimes are inexcusable. I expect and deserve a significant prison sentence.

 

Nevertheless, I am writing to give some context to what I did — certainly not to minimize my crimes but to try to explain how a person with my background and advantages came to do the unconscionable. Perhaps in learning how I made these terrible decisions which have ruined my life, others may avoid such mistakes. I have requested that my attorneys file this as an open letter, available in the public record, in the hope that it may do some good as a warning to others not to follow in my path.

 

I was raised in New York by a loving family. in a comfortable home. I always succeeded

in school. I attended Yale College and Harvard Law School. After law school I spent 20 years in several prominent law firms, first as an associate, then as a partner. I performed well, but I was achieving less satisfaction and recognition than I expected. Colleagues of mine and certainly clients of mine were doing much better financially and seemingly enjoying more status. By my mid-forties I felt crushed by a sense of underachievement.

 

So I started my own firm in 1996. My intention was to try to attract lawyers who, like myself, were dissatisfied with large firms and were looking for a more gratifying way to have a sophisticated practice. I had virtually no cash and very few clients. but I was able to grow the firm modestly over the next few years by investing my life in it.

 

I had planned poorly. however, for the expenses. I couldn't get bank loans without better credit or collateral, so I was funding the firm partially with advances from some clients but primarily through "factors" who charged exorbitant fees and interest and were highly intrusive in monitoring the firm's accounts. By 2001 I was deeply in debt.

 

In January 2002, my wife sued for divorce. I had been married for 15 years. We have two children. We entered into a settlement agreement under which I took on financial obligations to her and our children which were actually far more than I could afford. I believed that my fledgling law firm could not survive a contested divorce.

 

All of this left me feeling overwhelmed — by my debt, by a disappointing career, by a failed marriage. And so, incomprehensibly, in 2002 I started stealing. First, I invaded some settlement proceeds due a client. Then I arranged a few bogus investments with some individuals. And soon I stumbled upon the brazen idea of arranging fictitious loans from hedge funds, ostensibly to my principal client (the real estate developer referenced in the Indictment), and diverting the loan proceeds to myself.

 

As I sit here today, I can't remember or imagine why I didn't stop myself. It all seems so obviously deplorable now. I recall only that I was desperate for some measure of the success that I felt had eluded me. I felt that my law firm was my last chance to make a mark for myself, and I was fearful of seeing it fail. I know of course that this amounted to nothing more than self pity, but this was my state of mind when I became a criminal. I gave in to being overwhelmed by the anxieties of life that we are all expected to cope with every day, and most people do, but I just could not manage to do so. I had no one close to me with whom I could talk. I had isolated myself, both personally and professionally. I lost my perspective and my moral grounding, and really, in a sense, I just lost my mind.

 

At the beginning, I spent most of the money on growing the law firm. Much of the money also went to servicing the "debt" itself. But, as time went on, I was more and more self-indulgent.I bought extravagant things — a beach house, an apartment, a boat, expensive art. Obviously, other men suffer through divorce and "mid-life crisis" and manage not to steal. And, other people grow their business without resorting to crime. I just wasn't in control of myself.

 

It is hard to explain how my crimes in 2002 reached the level that they did by 2008. Certainly I never intended when this began to steal on the scale I eventually did. I took the first money thinking that I could and would repay it shortly with revenue derived from the law firm. Soon, however, I exhausted the money, and it was evident not only that I would be unable to repay the initial "loans" but that I would need more. I had stepped in a quicksand of spending. By 2008 I had hired over 250 lawyers and opened additional offices in Los Angeles. Pittsburgh and Connecticut. The expenses were more and more uncontrollable, and the "loans" became more and more expensive. As the credit markets worsened, hedge funds were demanding much higher interest rates and, in many cases. substantial discounts to principal. In some cases, when I desperately needed new money to pay back loans becoming due, I was selling loans for 60-65 cents on the dollar, meaning that I was paying back far more principal than the hedge funds were actually paying me, which obviously was dramatically deepening the hole I was in.

 

In this way, without ever actually planning to. I found myself running a massive Ponzi scheme with no apparent way out. No doubt as is typical in Penn schemes, there was always the unrealistic expectation, or at least the hope, that I could use the "borrowed" money to eventually make it all work out. Obviously, and predictably, I was unable to do so.

 

When I was no longer able to pay off old "loans" to the real estate developer by creating

new ones, I placed a few other fictitious loans, in much the same manner, by using instead as the purported borrower a Toronto pension fund that I had once represented. Finally, when there were no loans I could invent, I began to pull money again from a few of the firm's escrow accounts, knowing of course that it was terribly wrong but still thinking that I could somehow restore the funds in short order. Typically, I did restore this money, but in early December 2008 I was unable to restore about $40 million to one such client account as the due date for its disposition was nearing. As a result, I engaged in the most desperate and irrational act yet - impersonating an attorney from the pension fund in Toronto in order to "close" a loan from a hedge fund which would have given me the funds to return the escrow money. I knew very well that this time I would most likely be caught. I was caught, and that escrow money was not restored.

 

In some sense, being caught was a relief. I had been living a self-inflicted nightmare,

scrambling every day to sustain the charade. I had three "full time" jobs: First, I was managing a large active law firm, with all the daily challenges that come with such responsibility. Second, I was head of the firm's litigation department, with a very heavy active practice and caseload of my own. Finally, I was managing a huge portfolio of fraudulent loans, which required me to constantly prepare and update bogus financial statements and loan documents, field inquiries from lenders and prospective lenders, arrange payments of principal and interest on existing loans, obtain new loans as old ones matured, and do all that was necessary to keep the scam a secret. At the same time, I was trying to spend as much time as possible caring for my son, who lived with me full-time, and my daughter, who lived about half the time with each parent. It was all I could do to get through each day, and each day it got harder. It was a frantic life which I had created for myself, and it left me exhausted and impaired.

 

Your Honor has rightfully observed that as a lawyer I have dishonored the legal profession, and I am very painfully ashamed of that. My whole ambition in life was to be a lawyer who would distinguish himself and honor the profession. Over the course of 33 years of practice, I represented many clients well and devotedly. I made my work as a lawyer the center of my life.

 

Obviously, I then strayed very far from those goals. I lost myself to my ambition and

sacrificed everything else.

Recently, I have had the opportunity to read the letters sent to the Court by the victims of

my offense. I am shamed by these letters. During the time I was committing my fraud. I tried to convince myself that I was hurting only "institutions' . and not "individuals - (as if that were less contemptible), because I was borrowing almost entirely from hedge funds. I knew of course then and I know now that this was all nonsense - my fraud devastated "real people" in a very real way. The letters from these individual victims show their suffering first-hand. I will only add that I believed these individuals would not be harmed. because I always made certain that there were sufficient funds still available to repay them when their money came due. At the time of my arrest, there were in fact sufficient funds in the firm's account (over $10 million) to repay all f these individuals. After my arrest, while I was jailed in Toronto, I instructed the controller of the firm to transfer $10 million to a separate non-law firm account, believing that by doing so I could shield the money owed to these individuals from any competing claims until I returned to New York. As I understand it now, however, several individuals remain unpaid in the wake of the firm's collapse, and these individuals who trusted the firm I controlled have been terribly harmed. I never intended for them to lose their money, but obviously I am responsible for even he unintended consequences of my wrongdoing.

 

Since my arrest, I have done whatever little I can to start to make amends for my crimes.

From the outset I acknowledged my guilt. I never considered putting my victims through the burden of a trial. I have also cooperated fully with the Receiver and Trustees appointed by the ourt. In numerous meetings and discussions I have tried to help them identify and recover funds and other assets to start to compensate those who are owed money.

 

More than that, I can only explain to the people I betrayed how I came to make these mistakes and express my profound remorse. In the brief time I may have to speak at my sentencing, I hope to express my remorse to those I have hurt. Perhaps at least they will feel some degree of my shame, which I will have to live with for the rest of my life.

 

For rne, the punishment that I receive from this Court will only be part of my sentence. I have already been disgraced beyond anything I could ever have imagined. Despite whatever good I once accomplished in my life, and what I had hoped to accomplish, I will always be remembered as a thief. I have lost all my friends. I have lost my law firm, my law license and all that I ever owned. 1 have seen my family suffer the unimaginable. I have lost my past and y future. I have lost everything a man can lose. And now I will lose my freedom as well, and rightly so.

 

All that I have left in my life is the prospect of still sharing in my children's lives, both while I am in prison and, I pray, for some time thereafter. My son is 19; my (laughter is 17. We are very close. I have devastated their lives, and unfortunately nothing I do now can diminish that. I can only try to be there for them to whatever extent I can.

 

I don't know what gives some men the strength of character to lead virtuous lives for all of their lives, and what causes others, such as myself, to lose their way. There is no excuse

whatsoever for what I have done. I have explained it the best I can. 1 will try to learn from this, and hopefully others will as well.

 

Respectfully yours.

Marc S. Dreier

Fixing the Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform

Fixing the Financial Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform  I waited for March 26, 2009, in great anticipation that we might see meaningful change in protecting investors. I pray that my retirement years are not stolen from me as they have been from those who we represent - those who trusted Charles Schwab, OppenheimerFunds, MassMutual and Madoff. However, March 26 came and went with little recognition of why and how this happened by those our new President entrusted to help steer these changes. Both Timothy Geithner (Secretary of Treasury) and Mary L. Schapiro (SEC Chair) testified today on improving our financial regulatory system. Geithner spoke to Barney Frank and his House Committee on Financial Services, and Schapiro spoke to Christopher Dodd's Senate Committee on Banking, Housing and Urban Affairs. Geithner's testimony can be found here, and Schapiro's here.

Before I start in on my criticism, let me say that I understand that both Geithner and Schapiro are long time industry/regulatory insiders. Change comes slow to those who have been part of the system and failed to step forward early. Certainly, it is better to talk about "failures" than to admit that they were asleep at the switch. It is better to talk in the abstract with little criticism that might incite a lynch mob.

Reading both testimonies, I am dumbfounded at how little attention is paid to the mutual fund industry that took investors' money and started pouring it into any asset available regardless of its objectives.

Geithner gives a strong statement recognizing the need for investor protection:

"[W]eaknesses in our consumer and investor protections harm individuals, undermine trust in our financial system, and can contribute to systemic crises that shake the very foundations of our financial system."

 Hear hear! Geithner then swiftly moves on to talk about mortgage lending, not investor protection. Try to sort out the following statement:

"Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system."

It's almost like the financial services industry wrote his words: "Tim, throw in words that make it look like 'things' caused us to commit fraud, and then put the blame on the 'many Americans with obligations they did not understand...'"

Let's pretend our mess was caused by poor consumers who did not know what they were buying, instead of the greed; greed of financiers who "created" packages of garbage loans, and dumped them on retirees for huge fees, profits and commissions. This slight of hand makes my blood boil.

Geithner completely leaves out the crimes of our mutual fund industry. Instead, he focuses on Money Market Funds that broke the buck. Big deal. This cost the American people a tad of what was lost in mutual funds by companies that sold "conservative," "stable" investments to retirees following the models that touted moving to bonds in your retirement years to preserve capital and earn income. The Reserves money market fund, when all is said and done, lost about three percent. Oppenheimer's Champion Income Fund lost 79 percent. Schwab's Ultra Short Term Bond Fund lost more than 50 percent.

Schapiro jumps on the fraud bandwagon too. She deplores penny stock frauds and insider selling, she touts the SEC's recent (mostly pre-Schapiro) enforcement activity, but she appears oblivious to reality, and the following statement is laughable:

"Our capital requirements go a long way to ensuring that customer funds entrusted with a broker-dealer are safe in the event the broker-dealer gets in financial trouble. Again, our focus is not to insulate broker-dealers from competition and the risks of failure, but to protect investors in the event that failures do occur. We conduct examinations of these firms to assess their compliance with laws and regulations. And when we find violations or deficiencies, we direct that corrective action be taken."

Think Bernie Madoff Investment Service (a broker dealer regulated by the SEC). Ahhhhh! Capital requirements? Protect? Examinations? Compliance? Of course note the disclaimer; "And WHEN we find..."

Schapiro does however have a solution for making sure Madoff's don't occur:

"I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets. The list of certifying firms would be publicly available on the SEC's Web site so that investors can check on their own financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide both investors and regulators with information to then evaluate the auditors."

"As part of this effort, I expect to come to you in the near term with a request for authority to compensate whistleblowers who bring us well-documented evidence of fraudulent activity."

 Ok. Let me get this straight...

1. Madoff would be required to sign a certification - big help.
2. The auditors name would be public - oh, this helped the Oppenheimer Tremont Rye fund investors who received audit reports from KPMG and Ernst & Young who believe that they are isolated from liability because they can rely on certifications by Madoff's audit or shoeshine man.
3. The SEC could now pay whistleblowers who present "well documented evidence...because when Madoff's whistleblower Harry Markopolos came to the SEC for free the SEC could not believe that anyone would blow the whistle for free!

As for mutual funds: NADA, Nothing, Zip! Certainly, Schapiro recognizes the importance of mutual funds:

"Ultimately, capital comes from investors - people who invest directly in companies; people who invest in financial institutions that lend capital; people who invest in mutual funds and other pooled vehicles that in turn invest in America's businesses; people who buy municipal securities to help fund the operations of state and local governments; and people who look to the capital markets to save, put away money for their kids' education, and prepare for retirement. Markets that attract this capital are critical to America's economic future."

But Schaprio talks only about the past enforcement efforts and current regulations. As for future change, she talks only about money market funds. She apparently does not recognize that current regulations do not work for mutual funds.

The Courts have recently thrown out the private rights of action under the Investment Company  Act, which regulates the fund industry. Because of the structure of the funds, purported independent trustees ( who often sit on the boards of 10, 20 and even 40 funds offered by the same investment adviser), and trust agreements, even state law claims are impossible to bring. That leaves the paltry resources of the SEC to enforce those laws for an industry with more than $9 trillion in assets.

Mutual Funds are sold primairly over the phone or with glossy web pages and/or brochures containing smiley faces, impressive graphics and a sales pitch. To the extent that disclosures can be found, they  are impossible to read, dispursed in a staggering array of documents with indecipherable names, never actually delivered until after the purchase, and even then rarely. The funds' advisers retain near unlimited power to change their focus overnight...if it brings in more profits. The industry is driven by a need to do what it takes to attract capital, not the interests of the investor.

Neither Geithner nor Schapiro seem to recognize these issues, nor seem to care.

Dear, dear. The more things change the more they stay the same.

Famous Madoff Qoutes: "I Suppose You Could Program a Computer To Violate A Regulation, But We Haven't Gotten There Yet"

 

Famous Madoff Quotes: "I Suppose You Could Program a Computer To Violate A Regulation, But We Haven't Gotten There Yet", 60 million people retire next ten years? "Good Luck " and "I'm very close to the Regulators...my niece married one."

And More

 

As we proceed to work our way through the Madoff litigation, we tend to focus on those cases where we believe we can best find a source of recovery for our clients. To date that has been principally the Tremont Rye Funds which were controlled by Oppenheimer and Massachusetts Mutual, audited by two of  the Big Four accounting firms, KPMG and Ernst & Young, and supposedly had a custodial bank, Bank of New York Mellon. We have focused also on the feeder funds to the Tremont Rye Funds, such as Spectrum, Future Select, Austin and Meridian. Others crop up every day. Nevertheless, these stories, at this point, are rather dry and our minds still drift over to how  Madoff pulled this off. A video of Bernie Madoff discussing his business has surfaced on the internet, and helps lead us there.

 

When I watched this video of Bernie Madoff ( and his computer guru, Josh Stampfli) participating in a round table discussion, on the future of the stock market, I expected to find a hint of irrationality or slick behavior. The link to the video, audio and transcripts can be found here. Instead we hear a very rational human being, thoughtfully discussing fraud, human behavior and profits. Download Madoff TranscriptBut we also see tremendous irony in Bernie's statements. I highly recommend anyone impacted by this scandal to watch, especially around the the 43 minute mark. An index to Bernie's more ironic statements are as follows:

 

At minute 26 Bernie Madoff states:

 

"Now, no one is going to run a benefit for Wall Street, so whenever I go down to Washington and meet with the SEC and complain to them that the industry is either over-regulated or the burdens are too great, they all start to roll their eyes, just like all of our children do whenever we talk about the good old days."

 

At minute 28 Bernie Madoff states:

 

Today, basically the big money on Wall Street is made by taking risks. Firms were driven into that business, including us, because you couldn’t make money charging commissions, primarily because the rates were lowered and because of the regulatory infrastructure you had to have dealing with clients.

 

At minute 30 Bernie says:

 

"There are so-called Chinese Walls that are required to be established at every brokerage firm. They’re called Information Barriers—a term most people would understand—to sort of wall off a brokerage firm from taking advantage of information that he has as to what clients are basically going to trade or not going to trade. There are separate divisions within the firms and it is very carefully enforced and surveilled. It doesn’t mean there are not abuses, for sure, but by and large in today’s regulatory environment, it’s virtually impossible to violate rules. This is something that the public really doesn’t understand. If you read things in the newspaper and you see somebody violate a rule, you say well, they’re always doing this. But it’s impossible for a violation to go undetected, certainly not for a considerable period of time.  And when you consider the volumes of trading, the trillions of dollars of trading that go on today in Wall Street—I mean, our firm, for example, we trade an excess of $1 trillion dollars a year and that’s one firm—and you look at what we would consider to be the infractions, they’re relatively small, primarily because of all the regulation. Most firms do try to comply with that."

 

At minute 43 Bernie states:

 

So we determined that the best thing for us to do was basically to take the human being out of the equation. That had two advantages in our industry. Number one, when you take the human being out of the equation, you solve your regulatory problems because the nature of any human being, certainly anyone on Wall Street, is the better deal you give the customer, the worse deal it is for you. You’re on the other side of the transaction. It’s like going into any store—the store sells you a television at a higher price, they’re going to make more money. They sell you the lower price, their profit goes down accordingly. As honest as you try and get people to be, there’s this normal, natural pole that you have to deal with. By taking the human being out of the equation to a great extent and turning it over to a computer to make your decision—I guess you could also program the computer to violate the regulations, but we haven’t gotten there yet.

 

At minute 69 Bernie states:

 

"The future is silence. I don’t see a lot changing in the marketplaces. It’s hard to of course say that because everything always changes, but I cannot imagine what else we’d do, from an automation standpoint..."

 

At minute 71 Bernie's states:

 

"You know, this is a psychoanalytical group, I guess, right?... I’m sort of curious—maybe because no one got a chance to ask any questions about it yet—what are human beings contributing to the marketplace?  Is there any change in their actions?

At minute 111: Bernie states:

 

"This is SEC’s concern today because they call us all the time and ask us: should we be concerned about the fact that certain firms have left certain areas of the industry and are not serving the public, or not serving even other parts of the industry itself? The answer is it’s too late, because you’ve done it. So there’s always this friction that goes on between the regulation side of the industry and the practitioners that say okay, where do you draw the line? I’m very close with the regulators so I’m not trying to say that what they do is bad. As a matter of fact, my niece just married one.  (Speaker:  My condolences) (Speaker; Did the SEC approve?) Madoff:  He’s an attorney. (Speaker:  Okay.)

Madoff:  The issue is, the way they tend to look at the industry if you’re making a profit there’s something wrong, even though intellectually they know that shouldn’t be.

 

At minute 118, Bernie states:

 

"You know, my theory—and I’ve always said this even though we were one of the ones that started all this automated algorithmic trading—was that I never wanted to get into a cockpit of a plane and see there wasn’t a pilot sitting there...But more importantly, in our firm—and I don’t know that we’re unique, but I know there are other firms that do not operate this way—we  have a group of traders that are watching the systems work and the results of the systems to make sure that from their sense of trading things look right. With all due respect to Josh and a lot of other people that we have with similar backgrounds, programmers—not that he’s a programmer—but people of his ilk can tend to believe too much in the math and in the model. They fall in love with it sometimes. Not so much Josh, which is why he’s with us, but we have a lot of people like Josh that we employ and deal with. They’re different. The thing that separates somebody that is a good algorithmic trader from somebody that is dangerous is somebody that just always believes the machine is right. There are people like that. It goes back to what Bob said about the joke of the dog. It’s supposed to make sure that nobody touches the machine. You always want to have the human factor involved in the process because that makes it better. At least that’s been our experience.

 

And most disturbing at minute 125:

 

Audience:  "My question is a little basic. It’s open for the whole audience. How do you feel that the baby-boomers retiring, starting this year, will affect the future of the stock market, considering there were probably about 60 million people who are going to retire in the next ten years?"

 

Madoff:  "Good luck."

What is the take from this...its hard to tell. Here we have a man who created the NASDAQ, and took the human element out of the trading, and yet clearly likes to spend time with people. Maybe he was bored and needed the human touch. By playing the big man on campus, and spreading largess, he was the center of attention. As he states in minute 69...."The reason why is it’s quiet. When you went up to our firm you said, “Well, I’m surprised at how quiet it is.” I find it difficult to get used to that because I’m used to a lot of noise and screaming."

 

Clearly worst punishment for Bernie Madoff will be silence.

 

Bernie Madoff...We Trusted You So Long

One of the best movies of the year is a french movie, starring Kristen Scott Thomas, entitled, "I Loved You So Long." It is a sad and tragic movie, about a love so deep for a child...and how that love, and the mother's assisting her son die peacefully from cancer, haunts her upon her release from prison. Why it reminds me of Bernard L. Madoff is hard to say...but clearly their are parallels. The investors who have approached us have told us of decades old trust...a love so long...and now they are facing a death of their own...and they too are haunted, and some may be for the rest of their lives. And of course there is prison....

Often times securities fraud class actions felt like aiding a gambler who got cheated at the pool table. No tears were felt, but their were rules to be enforced and money returned. Today....it is not the same...in the Madoff matter and others. Today those who fled the tough and tumble of the public markets, and sought safety and security...investing in money market funds, cash, and trusted advisors, are telling us of having lost their entire savings and in too many cases, the funds needed to pay their medical bills and retirement. It is hard not to want to cry.

One of our clients had invested with a partnership pool almost 40 years ago, and that is where his money stayed and grew. Today he got the call where the caller revealed the "worst nightmare" ...all of the money had been invested with Madoff. 75% or his retirement gone! Shock does not describe his feelings...if any are left.

The SEC has now shut down Madoff's operations, including Bernard L Maddoff Investment Securities LLC, or BMIS. The freeze order can be found here. The SEC's complaint used to obtain the order can be found here.

But who else was involved, and where will investors be able to seek recovery?

Our investigation...in its early stages...leads use to believe that many were involved...and many knew or suspected. The investors we know invested in partnerships who invested with partnerships... who invested with Bernie M. And Bernie M. and some of the General Partners of these partnerships seem to have close relationships. We are trying to learn more about those partnerships and relationships...many of the partnerships seem to have less of a real presence than the 3 auditors of Bernie M's fund. At least they had a 12 by 18 foot office and showed up for 15 minutes a day in their tie dye T-shirts. We know that there was a group of funds or partnerships funneling money to Bernie M. But the pciture needs paint.

You can help us with our investigation. Help us define the web that allowed this Ponzi scheme to hurt so many. A description of our investigation is available here.

Is Cadence's Restatement Likely the Result of Fraud?

Meaningful Disclosure.

Is Cadence's Restatement Likely the Result of Fraud? Posted by Reed Kathrein 11/04/08 1:38 AM On October 15, 2008, Cadence (NASDAQ: CDNS) of San Jose, California, was supposed to announce its third quarter results for 2008. Instead it announced the resignation, "by mutual agreement" of its CEO, Mike Fister and four other executives: Kevin Bushby, executive vice president, worldwide sales operations; James S. Miller Jr., executive vice president of products and technologies; William Porter, executive vice president and chief administrative officer; and R.L. Smith McKeithen, executive vice president, corporate affairs. Porter had also served as CFO between 1999 and April 2008. Then on October 23, 2008, Cadence announced that it has improperly recognized $24 million in revenue in the first quarter, which should have been recognized over the duration of the contracts beginning in the second quarter. While a restatement of $24 million is only about 10 percent of the revenue, the impact on the income/loss would have been tremendous, as the first quarter was already a loss of $27 million. Hence, if the executives were scrambling to close the gap on the loss, a little revenue recognition shenanigans might have helped:

PERIOD ENDING			28-Jun-08	29-Mar-08	29-Dec-07	29-Sep-07
Total Revene			329,478	287,189	457,943	400,924
Cost of Revenue			59,670	51,734	56,150	52,404
Gross Profit			269,808	235,455	401,793	348,520
	Operating Expenses
	Research Development		120,087	125,356	297,611	125,391
	Selling General and Admin		124,870	130,742	(13,942)	137,910
	Non Recurring		(355)	600	(102)	(4,388)
	Others		5,820	5,760	5,760	4,739
	Total Operating Expenses		250,422	262,458	289,327	263,652
Operating Income or Loss			19,386	(27,003)	112,466	84,868

Even then, however, the stock took a hit over the next two quarters. Results:

But often a good indicator of fraud is insider selling. However, insider sales have been very small over the last year, though James Miller, one of the executives who resigned, sold about $120,000 in September and an executive who did not resign, sold about $631,000 in February. Much more was sold in the last two quarters of 2007, before the revenue recognition problems, but it is always possible that the executives foresaw the upcoming income declines and sold before they needed to play revenue games.

Of course another incentive could be the need to raise cash for acquisitions such as the failed attempt to acquire Mentor Graphics announced in May 2008.

We will keep monitoring this story, and if you have any information, let us know. See our post on Meaningfuldisclosure.com.

It's Now Time to Resurrect Our Investor Protection Laws

The National Association of Securities and Consumer Law Attorneys has long fought for the protection of investor rights. But back in 1994, Christopher Cox, our current SEC chairman....the chairman under whose watch this current financial fraud crisis occurred, helped lead the charge to make it nearly impossible to bring a suit against big corporatations who were committing securities fraud. That law was innocently called the Private Securities Litigation Reform Act, or PSLRA.

Again,  in 1998, Mr. Cox was part to the Congress who struck down state laws protecting investors with the passage of the the Securities Litigation Uniform Standards Act, or SLUSA.

One needs ask whether the current crisis is based on lax standards permitting fraud, misrepresentations and omissions to go unanswered as a result of these laws. Like the bust of the dot.com bubble a few years earlier (and the failures of Enron, Worldcom and Tyco ) which Wikepedia ( http://en.wikipedia.org/wiki/Dot-com_bubble  ) defines as having been caused by a "canonical "dot-com" company's business model [which] relied on harnessing network effects by operating at a sustained net loss to build market share (or mind share)," the investment banks, General Electrics, etc. all relied on a similarly "comical" business model of lending (at unrealistic rates, or with cheap introductory rates) at a net loss to build assets whidh they could then sell or pawn off on cash rich investors. As with the dot.com's the "motto "get big fast" reflected this strategy." And also like the dot.coms, where "companies relied on venture capital and especially initial public offerings of stock to pay their expenses," and the "novelty of these stocks, combined with the difficulty of valuing the companies, sent many stocks to dizzying heights and made the initial controllers of the company wildly rich on paper, ' in the investment banks and other asset lenders relied on the Schwabs and Ameritrades, to funnel investor's hard earned cash into novel derivatives (mortgage backed securities and asset-back securities) which were impossible to value, and whose credit risk was unsupported.

Everyone recognizes the need to regulate such out-of-control activity. A need to go back to the days of accountablity. But we cannot do this with big corporations being protected from decieving the public and immune from lawsuit. NASCAT has a recommendation. In a press release dated September 22, 2008, NASCAT states:

“During the past two years, even while Wall Street firms were handing out tens of billions of dollars in bonuses to executives, many of these same firms had misrepresented the value of mortgage backed securities (MBS) and collateralized debt obligations (CDOs) held on their own books and sold to other investors.  At the same time, the actual subprime mortgage loan originators misrepresented the strength and integrity of their lending policies and procedures.  On Friday, Federal Reserve Chairman Bernanke said our problem stems from what in fact were ‘lax underwriting practices’ that were not truthfully disclosed.  Had these corporations been honest about their practices and the true value of, and risks inherent, in these securities, the current crisis may never have developed as it did.

“These practices were not victimless excesses stemming from market exuberance. The calculated wrongdoing of many financial executives has now placed the hard won savings and retirements of the majority of Americans at risk.  At risk are the pensions covering many of NASCAT’s clients including public school teachers, firemen, policemen, union workers and the individual retirement accounts and plans of tens of millions of more Americans. 

“Recognizing this wrongdoing for what it was, state attorneys general, our frequent allies in the fight to uphold investor protection and recover fraud losses, had begun in 2003 to investigate the abusive and misleading practices of subprime mortgage lenders that they believed violated state laws.  Had the efforts of state attorneys general not been halted by the Bush Administration’s federal preemption of the authority of state consumer protection law and law enforcement officers, the subprime mortgage based crisis now upon us might well have been averted.  Certainly, there would be far fewer ‘bad’ sub-prime mortgages sold by loan originators to packagers and marketers of mortgage-backed securities that taxpayers are now being asked to buy.

“Given these facts, as Congress weighs the proposal to federalize vast parts of our financial system and give the executive branch unbridled authority over our markets, law makers should be mindful of the hard-taught lessons of post-Depression American history.  In addition to this bailout plan, the next Administration and Congress will be considering regulatory reforms to ensure such a crisis is not repeated.  As Congress moves forward on all fronts, NASCAT urges it and the next Administration to consider these lessons of experience:
 
-- The authority of federal and state regulators and state attorneys general should neither be diminished nor curbed by any new actions by the legislative or executive branches of our federal government in its effort to address this financial crisis in our capital markets.

-- As we face and work through a financial crisis of unknown magnitude, the SEC should halt its reckless push to shift America’s corporate accounting system from our proven U.S. rule-based Generally Accepted Accounting Standards and regulatory oversight to the more lax and less regulated International Accounting Reporting Standards.  This is no time to endanger investor protection by giving corporate and financial institutions  greater latitude in reporting their financial results. 

-- Investor civil actions remain, in the Securities and Exchange Commission’s traditional words, ‘a necessary supplement to the Commission's efforts.’ In addition to helping police securities markets, private law suits provide the primary method for defrauded investors to recover their losses. It would be a tragic error to further dilute the rights of private investors to take actions against those who perpetrate fraud and abuse.

-- The shields against corporate and financial institution accountability erected by the Supreme Court that protect from liability those who knowingly aid and abet securities fraud and otherwise knowingly engage in schemes to defraud and mislead investors should be removed by Congress.  There is little doubt that these shields against liability helped embolden corporate and financial players to engage in massive wrongdoing and take trillion dollar risks at the expense of investors, homeowners and, now, taxpayers.”

I would add to this list, to reform the PSLRA by dropping the pleading standard that requires evidence to be pled when it is secretly held by the corporation, bringing back aiding and abetting liability, creating private rights of action to sue mutual fund investment advisors under the provisions of the Investment Company Act of 1940, adding a private cause of action against conspirators, and eliminating SLUSA preemption of state law claims which touch upon fraud or misrepresentation....just as a start.

Cornerstone's 2007 Securities Settlement Analysis

Kevin LaCroix's The D & O Diary Blog reports that Cornerstone Research released its review and analysis of 2007 securities class action settlements:

Cornerstone’s press release emphasizes that the aggregate dollar value of all settlements was down 60% compared to 2006, but the full report emphasizes that, when the four largest settlements are removed from the analysis, the aggregate value of all settlements in 2007 exceeded all prior years except the unprecedented year of 2006.

Of interest here is the question of Professor Grundfest concerning the uptick of activity now underway as a result of the "subprime crisis" and whether that will mean more and larger settlements 3-5 years from now. I certainly agree that there is a crisis for investors, and agree that there will be a flury of settlements from these suits which began to be filed last summer. As I lectured at the PLI Institute in September, the demise of securities fraud class actions was nothing more than a temporary lull waiting for the next new financial bubble to crash. All you need to do is follow the money. In the 80's it went into the Savings and Loans, in the 90's into High Tech and in the first decade of the 2000s it flowed into mortgages.

I predict that when this mess is sorted out, we will see that the unsuspecting small investor has been left holding the bag by mutual fund managers chasing yields.

For more on Kevin's analysis of the Cornerstone report, go to his blog.  Links to the report are also there.

Stoneridge - A Walk for Corporate Fraudsters?

Will 2007 be the year  known as the year the corporate fraudsters were given a "walk" by the Supreme Court? Right now the fraudsters have been pitched four ball, and it certainly looks like a walk for the fraudsters:

1. Ball One: In Bell Atlantic Corp. v. Twombly,127 S. Ct. 1955 (May 21, 2007), the Supreme Court tossed  the long standing pleading standard in  corporate conspiracy cases, requiring injured parties to plead enough facts " to raise a reasonable expectation that discovery will reveal evidence of illegal agreement,” noting that "discovery can be expensive;"
2. Ball Two: In Credit Suisse Securities v. Billing, 127 S. Ct. 2383 (June 18, 2007), the Court tossed a private antitrust suit alleging anticompetitive activities by underwriters in the issuance of initial public offerings, stating in the most conclusory and broadly speculative terms, that "the threat of antitrust lawsuits, through error and disincentive, could seriously alter underwriter conduct in undesirable ways" and was, in essence, preempted by the securities laws;
3. Ball Three: In Tellabs, Inc. v. Makor Issues & Rights, Ltd , 127 S. Ct. 2499, 2007 WL 1773208 (June 21, 2007), tossed the notion that at the pleading stage, before any discovery had begun, that the injured securities purchaser was entitled to all inferences being drawn in the plaintiffs favor. Instead,  “to curb perceived abuses of the § 10(b) private action—‘nuisance filings, targeting of deep-pocket defendants, vexatious discovery requests and manipulation by class action lawyers’” a "complaint will survive...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;” and
4. BALL FOUR....WALK: The U.S. Supreme Court decision today in Stoneridge Investment Partners v. Scientific-Atlanta, where, by a vote of 5-3, the Court tossed wide of home plate, any notion that "scheme liability" exists in the context of private causes of actions under the securities laws because investors cannot be said to rely on fraudulent schemes they do not know exist. This leaves sole enforcement and recovery in the hands of that same under-funded, under-manned, out-gunned, SEC that now has to handle all those antitrust issues( See Ball Three ), at least until a new Congress and a new President, untethered to Corporate Lobbyists, come to the rescue, and rectify this unintelligible and illogical mess. Of course I would not be so critical if this were anything other than a policy decision devoid of fact.

In throwing ball four, and hence a walk to corporate conspirators committing deceptive acts, the Court reasoned that even though the act may be deceptive, and intentionally so, the Court will not allow a presumption that investors rely upon a third party's actions or statements. Justice Kennedy wrote:

Though §10(b) is “not ‘limited to preserving the integrity of the securities markets,’” Bankers Life, 404 U. S., at 12, it does not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way.

To do so might sweep all conspiring suppliers and customers out of the game of accountability for the huge damage they contribute too. The Court, in outright protectionism of Corporate Fraud, rejected the irrefutable fact and logic that:

in an efficient market investors rely not only upon the public statements relating to a security but also upon the transactions those statements reflect. Were the Court to adopt petitioner’s concept of reliance—i.e., that in an efficient market investors rely not only upon the public statements relating to a security but also upon the transactions those statements reflect—the implied cause of action would reach the whole marketplace in which the issuing company does business.

Whew!!!! I didn't know that deception was such a part of our society that we needed to protect fraud conspirators from their own wrongdoing. Rather, the Court decided, as a matter of unsupported fact and law that these conspiring vendors:

had no duty to disclose; and their deceptive acts were not communicated to the public.  [please ignore the inflated revenues] No member of the investing public had knowledge, either actual or presumed, of [the two companies’] deceptive acts during the relevant times. [as long as the deceptive act is hidden the fraudsters can't be held liable] [Stoneridge], as a result, cannot show reliance upon any of [the companies’] actions except in an indirect chain that we find too remote for liability. [and what is the factual basis of this finding?]

So, even though the vendors knew their deceptive billings would inflate Stoneridge's revenues, and that there was no other purpose for the deception, since the public only relied on the false aggregate revenue numbers and not the vendors bills themselves, the Court finds as a matter of law and fact that there can be no reliance???? What happened to the requirement of evidentiary proof and the jury system?

Ohhh, yes, I remember now what the Court said about that. If we hold corporate conspirators liable:

[o]verseas firms with no other exposure to our securities laws could be deterred from doing business here. 

No, we would not want that. We need foreign corporate conspirators to keep our economy running!!!!

Even more confusing is the Court's implication that state law remedies are sufficient:

“Were the implied cause of action to be extended to the practices described here, however, there would be a risk that the federal power would be used to invite litigation beyond the immediate sphere of securities litigation and in areas already governed by functioning and effective state-law guarantees.”

What state law guarantees is the Court talking about?  Has the Supreme Court forgotten about the Securities Litigation Uniform Standards Act of 1998 that preempts class actions that allege fraud under state law "in connection with the purchase or sale" of securities?

Today's ruling will be followed soon by the Ernon case against the investment banking firms who helped Enron create the fraudulent financial vehicles that dupped investors to buy Enron stock— California Regents v. Merrill Lynch, et al. (06-1341) ("Enron").

Can the Court find a difference where the wrongdoer is not a supplier or a customer? Can it be said that investors do not rely on fraudulent transactions with customers but do rely on fraudulent transactions with those more closely engaged in keeping the issuer involved in the securities market, such as lawyers, auditors, bankers and underwriters?

Letting a customer off the hook, when the customer actually bought the goods is one thing, but letting off the lawyers, auditors, bankers and underwriters off the hook when they actually got paid to help commit the fraud, is another. No one will riot over the first. The second will rally a lot of troops as we sit in the middle of this subprime mortgage meltdown.

There is a hint that the Court is not dull and could pick off one or two of these corporate conspirators who take too big of  a lead-off.

First, the Court notes, in talking about these supplier/customer defendants, that their actions were "beyond the securities markets—the realm of financing business – to purchase and supply contracts – the realm of ordinary business." Clearly a distinction would be drawn against the investment bankers in Enron.

Second, the Court states that:

It was Charter, not respondents, that misled its auditor and filed fraudulent financial statements; nothing respondents did made it necessary or inevitable for Charter to record the transactions as it did.

***

Here respondents were acting in concert with Charter in the ordinary course as suppliers and, as matters then evolved in the not so ordinary course, as customers. Unconventional as the arrangement was, it took place in the marketplace for goods and services, not in the investment sphere. Charter was free to do as it chose in preparing its books, conferring with its auditor, and preparing and then issuing its financial statements. In these circumstances the investors cannot be said to have relied upon any of respondents’ deceptive acts in the decision to purchase or sell securities; and as the requisite reliance cannot be shown, respondents have no liability to petitioner under the implied right of action.

It may be arguable, in Enron, that the investment bankers misled or acted with the auditors, or did take action that that "made it necessary or inevitable for [Enron] to record the transactions the way it did." Or the Court may see what they did in Enron as being in the "investment sphere," which it was.

Finally, in another good omen for investors, the Supreme Court rejected, out right,  the oft repeated contention that one must make a deceptive statement to be liable under §10(b):

The Court of Appeals concluded petitioner had not alleged that respondents engaged in a deceptive act within the reach of the §10(b) private right of action, noting that only misstatements, omissions by one who has a duty to disclose, and manipulative trading practices (where “manipulative” is a term of art, see, e.g., Santa Fe Industries, Inc. v. Green, 430 U. S. 462, 476– 477 (1977)) are deceptive within the meaning of the rule.443 F. 3d, at 992. If this conclusion were read to suggest there must be a specific oral or written statement before there could be liability under §10(b) or Rule 10b–5, it would be erroneous. Conduct itself can be deceptive, as respondents concede. In this case, moreover, respondents’ course of conduct included both oral and written statements, such as the backdated contracts agreed to by Charter and respondents.

So the game is not over. Traditional suppliers and customers of goods are safe on base and off. The bankers, the lawyers, the accountants, and the underwriters better keep tight on base....at least until the next pitch....

For more see Jay Brown's weblog.

Supreme Court Oral Argument Transcript

Should Institutions Jump on the VeriFone Bandwagon?

     Many Public Pension Plans are heavily invested in VeriFone Holdings Inc. (NYSE:PAY) and have, most likely, suffered substantial losses as a result of the December 3, 2007 meltdown of the stock.

      We have been investigating this case and have found the facts to be compelling. On December 3, 2007, VeriFone announced that it would restate its financials at least as far back as the quarter ending January 2007. This restatement wiped out four-fifths (80%) of its pretax profits for the first nine months of 2007.

     Clearly, a restatement alone is not fraud. But, in this case, at least three facts compel us to believe that the restatement is not innocent.  

     First, the insider sales in the month of November were huge. The CEO dumped almost 400,000 shares (about 25% or his family trust holdings)for $18.5 million during the month , with 43,000 shares sold just a week before VeriFone’s stock collapsed $23.20, or 48.3%, to $24.83. Over the course of the year the CEO dumped $76,057,159 shares and purchased none. In November, the CFO exercised options for and sold all of his 18000 shares of Verifone stock. For his sales in the month of November he received $802,814, and for the entire year in question he received $7,246,260 for his sales and made no purchases. Even more compelling is the fact that the insiders have been selling shares almost without exception during the entire period at question.The insiders have been dumping their stock for the past 7 ½ quarters, with no purchases since the beginning of the restated periods. While it is widely reported that these sales were pursuant to a 10b5-1 sales plan, both the plan of the CEO and CFO were reported by them to have been adopted on December 10, 2006 at the inception of the accounting irregularities.

    Second, the purported accounting errors which are being blamed for the restatement involve the valuation of “in-transit inventory”:

On December 2, 2007, following a review by and on the recommendation of management, the Company concluded that its unaudited interim consolidated financial statements for the three months ended January 31, 2007, the three and six months ended April 30, 2007 and the three and nine months ended July 31, 2007 should no longer be relied upon, principally due to errors in accounting related to the valuation of in-transit inventory and allocation of manufacturing and distribution overhead to inventory, each of which affects the Company’s reported costs of net revenues.

     Inventory is one of those items that a company can easily play with, to boost profits for a quarter or two or, in this case, at three. W. Stephen Albrecht, PhD., of Brigham Young University, has written for the AICPA’s Antifraud and Corporate Responsibility Center:

Inventory frauds have been such a significant problem historically that a few years ago the Wall Street Journal featured a front-page article titled "Inventory Chicanery Tempts More Firms, Fools More Auditors."….

See Albrecht, Identifying Fraudulent Financial Transactions, American Institute of Certified Public Accountants, 2005. http://antifraud.aicpa.org/Resources/Auditors/Tools+and+Aids/Fraudulent+Financial+Transactions.htm?PrinterFriendly=true

Dr. Albrecht has identified at least 15 fraud schemes that can be used to overstate Inventory and/or understate Cost of Goods Sold, all of which have the effect of increasing net income in the current period. This in turn leads to a huge problem for management that does not exist with other financial manipulations¬¬¬---it must be repeated more intensely in the next period to cover it up:

With revenue-related frauds, reported revenues are overstated in the current period and accounts receivable are overstated on the balance sheet. However, there is no compounding effect in the subsequent period. With inventory frauds, however, the "overstated ending inventory" of one period becomes the "overstated beginning inventory" of the next period and causes net income to be understated in the second period. Thus, if a dishonest management wanted to continue the fraud into a second period (most frauds are multiple-period frauds), they would have to perpetrate a fraud of an equivalent magnitude just to offset the overstated beginning inventory, and then commit an additional fraud if they again wanted to overstate inventory to increase net income. The result is larger misstatements and a fraud that is much easier to detect.

Fortunately, most financial statement frauds are perpetrated out of desperation, and dishonest management worries only about how income can be overstated in the current period with no thought of the problems they create for themselves in subsequent periods.

    This is the very pattern we see in VeriFone’s restatement. As reported by VeriFone in it’s 8-K filed on December 3, 2007:

[T]he Company’s management currently anticipates that the restatement will result in reductions to previously reported inventories of approximately $7.7 million, $16.5 million and $30.2 million as of January 31, 2007, April 30, 2007 and July 31, 2007, respectively, and reductions to previously reported pre-tax income of approximately $8.9 million, $7.0 million and $13.8 million for the three month periods ended January 31, 2007, April 30, 2007 and July 31, 2007, respectively.

Based on this compounding pattern and Dr. Stephens observations, the inventory overstatements appear intentional.

     Third, the size of the restatement is huge when one considers it has all but wiped out the profits, and conveniently is accountable for 80% or the Company’s profits. Moreover, in the Company’s 8-K of December 3, 2007, it states that it has not finished it’s investigation and has cautioned that more is yet to come.

     In VeriFone’s defense, the SEC has not yet started an investigation, Goldman Sachs is blaming it on “friction” with the Lipman acquisition (but the Company is not) and others are blaming VeriFone’s major customers which may have held tons of VeriFone inventory. The Company, itself, has claimed that the overstatement is the result of double entries in VeriFone’s inventory accounting system. According to one unverified press report which comports with at least one analyst report (we wonder where the 8-K is of this filing or why the conference does not seem to have complied with Reg FD and was made public----do you hear me SEC?):

During a conference call with analysts Monday afternoon, Bergeron explained the company's accounting system was not set up to automatically input the value of inventory moving between VeriFone locations in Singapore; Sacramento, Calif.; and Tel Aviv, Israel, Card Technology’s sister publication CardLine reported. Bergeron told analysts that because the in-transit shipments were not automatically applied to the accounting system, someone had to manually input the numbers. Bergeron said that procedure was correct and required. The error surfaced when someone incorrectly determined that direct shipments also had to be entered manually, he said. The double entry was not found until work began on VeriFone's annual audit. "In short, these errors were characterized by double-booking of overhead in Sacramento," Bergeron said. "We are confident that we have isolated the problems in our systems and in our accounting. We are also confident that this issue did not exist before fiscal year 2007."

Card Technology.com, December 5, 2007. http://www.cardtechnology.com/article.html?id=20071205VUXI34XB.

     Whether there is truly a fraud here will be developed by investigations still in process. But, as the class action lawsuits have been filed and the days are counting down to the last day for an institutional investor to decide whether to take the lead the prosecution of the litigation on behalf of all purchasers of VeriFone stock, is coming up, you do not have the luxury of waiting to see how the facts develop.