People of the State of New York v. Bank of America Corp, Kenneth Lewis, & Joseph Price – Examining the Martin Act & Securities Enforcement in New York State (Part II)

Over the past ten years, the New York State Attorney General has utilized the Martin Act to pursue individuals and corporate entities for acts underlying notorious corporate fraud allegations, including the telecom bubble of the late 1990s, AIG’s accounting scandal of the mid-2000s, and Bernard Madoff’s Ponzi scheme. 

A. Martin Act Claims Arising Out of Stock Spinning In the Late 1990s

In 2006, the New York State Supreme Court decided State v. McLeod.  There, CEOs and executives of four major telecommunications companies – McLeodUSA Inc., WorldCom, Metromedia, and Qwest – were charged with civil fraud violations of the Martin Act.  Analyst Jack Grubman (“Grubman”) of Salomon Smith Barney (“Salomon”) allegedly touted the private companies’ expected earnings prior to their respective initial public offerings (“IPOs”).  The telecom executives held shares of those IPO stocks in private accounts managed by Salomon.  After Grubman had pumped up those shares’ prices, the executives were then able to reap “huge personal profit[s],” in a practice known as “stock spinning.”

The State alleged that the executives holding private accounts with Salomon knew about this scheme and knew that the IPO companies were not nearly as profitable as Salomon claimed.  The scheme allegedly was a quid-pro-quo wherein, through Grubman, Salomon was able to generate and retain investment banking fees from these companies. 

Before the 2006 Order, which only pertained to Clark McLeod, of McLeodUSA, the State settled with the Qwest and Metromedia defendants.  Notably, in April 2005, the charges against Bernie Ebbers of WorldCom were severed from this case after Ebbers was convicted in a federal criminal case for securities fraud. 

The State asserted three Martin Act claims against McLeod, and those claims utilized the Martin Act’s broad definition of fraud.  The State’s best evidence consisted of McLeod’s own deposition testimony; McLeod did not contest receipt of the “hot IPOs” or deny that he failed to disclose those tips to the board and shareholders of McLeodUSA. 

In an interesting twist, the State argued that the court ought to apply precedent from a 2004 Delaware decision holding that directors and officers of eBay, Inc. had violated Delaware law when they engaged in “stock spinning” with Goldman Sachs’s aid.  See In re eBay, Inc. S’holders Litig., No. C.A. 19988-NC, 2004 WL 253521 (Del. Ch. Feb. 11, 2004).  Instead, the court looked to federal law and the ’33 and ’34 Acts for guidance.  Ultimately finding that McLeod was liable under the three Martin Act claims, the court relied on a Seventh Circuit decision addressing comparable facts.  See Monetta Financial Services, Inc., v. U.S. Securities & Exchange Commission, 390 F.3d 292 (7th Cir. 2004).  The court reasoned that “because the Martin Act requires less stringent proof than the federal securities laws on which it is modeled,” a finding of liability for comparable violations of federal law necessarily counsels toward a finding of liability under the Martin Act.  Therefore, the Martin Act’s broad ascription to the meaning of fraud and “less stringent” burden of proof would find liability where a federal enforcement action might not.  Thus, the inverse proposition is that where a federal action does not find fraud under the ’33 Act or the ’34 Act, such a result would not preclude a finding of fraud under the Martin Act.

The court rejected McLeod’s argument that federal law preempted the Martin Act claims.  In particular, McLeod relied on a provision of the National Securities Market Improvement Act of 1996 that bars states from making rules that “impose special conditions” on SEC disclosure requirements.  This statute did not provide relief to McLeod because he failed to “identify any federal law, rule or regulation that govern[ed]” his disclosure requirements. 

B. Martin Act Claims Arising Out Of AIG In The Mid-2000s

In a suit similar to that against BofA, Lewis, and Price, filed in 2005, the New York State Attorney General sued AIG, former CEO Maurice “Hank” Greenberg, and former CFO Howard Smith.  The State alleged that AIG, Greenberg, and Smith violated the Martin Act and Section 63(12) for improperly manipulating AIG’s accounting statements to deceive the investing public.  In early 2006, the State settled with AIG for $800 million, but the suit proceeded against Greenberg and Smith.

With respect to Greenberg, the complaint alleged that he and other top managers were directly “involved in negotiating some of the fraudulent transactions,” including sham transactions to illegally improve insurance reserves.  The Attorney General filed an amended complaint against Greenberg and Smith in September of 2006, and that action is still pending.  Recently, in March 2010, the Attorney General deposed Greenberg.

C. Martin Act Claims Arising From Bernard Madoff’s Ponzi Scheme

In February 2010, the New York State Supreme Court decided People ex rel. Cuomo v. Merkin, No. 450879/09, 2010 WL 936208 (N.Y. Feb. 8, 2010).  J. Ezra Merkin (“Merkin”) was general partner and director of several hedge funds and investment management companies that held approximately $2.7 billion from nearly 300 investors.  Madoff managed approximately 20-30% of the assets in Merkin’s funds.  Merkin also managed a feeder fund that directed over $200 million to Madoff.  In total, Merkin collected annual fees of over $500 million by 2008.

Cuomo filed three Martin Act claims against Merkin, alleging misrepresentations and omissions because Merkin did not reveal to his investors that their funds had significant exposure to Madoff.  Again, the court noted that the Martin Act’s broad meaning of “fraud” and that Cuomo need not prove intent or reliance.  The court did confirm that fraud under the Martin Act requires materiality and applied the federal standard from TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976) (“[T]here must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.”).

In documents sent to investors, Merkin claimed to be involved with the day-to-day management of the funds, allegedly concealing the fact that he had abdicated his role so that Madoff could take near-total control of the funds.  The court upheld the claims for material misrepresentations and omissions.  The court also upheld claims that Merkin violated Executive Law § 63(12), which gives the Attorney General power to pursue persons who engaged in “repeated fraudulent or illegal acts” or “otherwise demonstrate[d] persistent fraud.”  As is the case with the Martin Act claims, Section 63(12) claims rely on a broad construction of “fraud” and need not allege reliance or loss causation.