S.E.C. v. Papa

• Decision Date: 06 February 2009
• Docket Number: No. 08-1172.,08-1172.
• Citation: 555 F.3d 31
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff, Appellant, v. Virginia A. PAPA, Kevin F. Crain, and Sandra G. Childs, Defendants, Appellees.
• Court: U.S. Court of Appeals — First Circuit

555 F.3d 31

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, Appellant, v. Virginia A. PAPA, Kevin F. Crain, and Sandra G. Childs, Defendants, Appellees.

No. 08-1172.

United States Court of Appeals, First Circuit.

Heard October 6, 2008.

Decided February 6, 2009.

Tracey A. Hardin, Senior Counsel, Securities and Exchange Commission, with whom Brian G. Cartwright, General Counsel, Andrew N. Vollmer, Deputy General Counsel, Jacob H. Stillman, Solicitor, and Katharine B. Gresham, Assistant General Counsel, were on brief, for appellant.

Anthony Mirenda, with whom Robert E. Toone, Jennifer A. Cardello, Jennifer S. Behr and Foley Hoag LLP were on brief, for appellee Kevin F. Crane.

Anthony Mirenda, for appellees Virginia A. Papa and Sandra G. Childs.

Kelley A. Jordan-Price, Michael J. Connolly, Laura B. Angelini and Hinckley, Allen & Snyder LLP on brief, for appellee Virginia A. Papa.

John A. Sten, Jason C. Moreau and Greenberg Traurig, LLP on brief, for appellee Sandra G. Childs.

Before BOUDIN, STAHL and HOWARD, Circuit Judges.

BOUDIN, Circuit Judge.

This is an appeal by the Securities and Exchange Commission ("SEC") from a judgment of the district court dismissing with prejudice a civil complaint against three individuals charging them with violations of the securities laws. On the grant of a motion to dismiss, well-pleaded facts in the complaint are taken as true, Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 127 S.Ct. 2499, 2509, 168 L.Ed.2d 179 (2007), so our description of events is largely drawn from the complaint.

Putnam is a well-known money management firm. One of its entities, Putnam Fiduciary Trust Company ("PFTC"), acts as an administrator of employee-defined contribution plans and Putnam mutual funds. Cardinal Health, Inc., a PFTC client who utilized PFTC to run its employee-defined contribution plans, decided to merge with Allegiance Health, and in late 2000 the two companies arranged to combine their defined contribution plans, creating a trust with PFTC as the trustee and investment manager.

In this role, PFTC was responsible for investing the merged plan's assets, making payments on its behalf, and carrying out investment instructions. On January 2, 2001, the assets of the Cardinal and Allegiance plans were combined into a single new combined account; this was done by selling the assets of the old Cardinal and Allegiance accounts and transferring the proceeds from those sales to the new combined account. PFTC had been directed to invest the combined assets in several mutual funds as soon as possible.

In fact, PFTC did not make the investments until January 3, 2001, causing the combined plan to miss a sharp upswing in the markets. Had the same funds been invested on January 2, the value of the holdings of the combined plan would have been almost $4 million greater. Told on January 3 that the investments had been made (but not told of the one-day delay), a Cardinal employee rejoiced, saying that "[t]he market is up and we look great being invested on the upswing."

PFTC officials took a set of steps designed to offset much of the "loss" to the combined account resulting from the delay and to conceal the misadventure and its repair. These activities gave rise to the present law suit. According to the SEC's complaint, at least six employees of PFTC were in some measure responsible:

Karnig Durgarian, Jr., the highest ranking executive of PFTC and of various Putnam mutual funds, in several of which the combined plan assets were invested on January 3;

Virginia A. Papa and Donald McCracken, two senior officers of PFTC who reported directly to Durgarian;

Kevin Crain and Sandra Childs, both unit heads reporting to Papa; and

Ronald B. Hogan, an officer in Childs' unit who reported to her.

According to the SEC, Crain, Childs, Hogan and perhaps others met on January 3 or 4, 2001, and agreed that the combined plan should be protected from losses resulting from the one-day delay. On January 4 or 5, Hogan began to work out possible transactions to achieve this end. On or about January 5, all six defendants met and Hogan described a plan to cover the loss by using "as-of" transactions— backdated purchases or sales of securities that use the price from an earlier day rather than the price current on the date the transaction occurred.

Such as-of trades can dilute the value of other shares in a mutual fund, but (we are told) they are not necessarily illegal and are used to correct trading errors. However, to prevent harm to its mutual fund shareholders from dilution that may be caused by as-of trades, PFTC had an internal policy, known as the penny-per-share policy, requiring the party responsible for the error necessitating the as-of trade to compensate mutual fund shareholders for any dilution of value beyond a penny per share.

Each participant in the January 5, 2001, meeting, the SEC asserts, knew that the transactions would harm the other mutual fund investors and that the harm would exceed a penny per share. Nevertheless, says the SEC, "[a]fter discussion, Defendants agreed to execute Hogan's plan." Durgarian said that Cardinal should not be informed about the delay in making the original investments and that PFTC would not bear the cost of the shortfall.

Hogan thereafter executed several transactions involving Putnam funds. The first, which serves as an example, involved reversing on the books some January 2, 2001, sales by Cardinal (made in liquidating its old account) and restating the sales as occurring on January 3, crediting the new combined account with the higher value that those shares had on the later date. This generated $450,000 for the combined plan at the expense of the Putnam funds' shareholders.

This first set of transactions were followed by two more transactions, differently designed but also at the expense of other Putnam funds' shareholders. The result was to offset about $3 million of the $4 million loss. The remaining $1 million in loss, which was due to delayed investment in the Franklin Small Cap Fund—a non-Putnam mutual fund—went uncompensated. Hogan and Durgarian both contacted Franklin and attempted to persuade it to execute similar as-of trades, but Franklin refused.

At a later meeting or meetings attended by all six of the officials identified above, Durgarian told McCracken to use various accounting adjustments so as to increase recorded expenses for certain of the adversely affected Putnam funds. The purpose was to mask the apparent effect of the as-of transactions. The adjustments were designed to appear on the books at the same time as the as-of trades themselves.

On January 18, 2002, and February 7, 2003, PFTC's outside auditor conducted audits of PFTC's internal controls in the defined contribution plan servicing unit for the years 2001 and 2002. As part of the audit, certain senior managers were required to sign statements (the "audit letters") stating that they were "unaware of any uncorrected errors, frauds or illegal acts attributable to" PFTC that had affected its clients. Crain, Childs and Papa all signed these statements for both audits.

These events came to light in early 2004 when Crain, having been fired by PFTC for other reasons, told PFTC's internal auditor that the January 5, 2001, events had the "fingerprints" of "financial fraud." Ultimately PFTC terminated Durgarian, Papa and Hogan and converted McCracken's 2002 resignation into a termination for cause. PFTC made compensatory payments to the affected Putnam mutual funds and to others who had redeemed shares or withdrawn from the Putnam funds or combined plan.

On December 30, 2005, the SEC filed a civil complaint in the district court alleging that all six of the PFTC officers had violated section 17(a) of the Securities Act, 15 U.S.C. § 77q(a) (2006), section 10(b) of the Exchange Act, id. § 78j, and its implementing regulation, Rule 10b-5, 17 C.F.R. § 240.10b-5 (2008), and that each had aided and abetted PFTC's uncharged primary violations of section 10(b) and Rule 10b-5, thus violating section 20(e) of the Exchange Act, 15 U.S.C. § 78t(e).

Section 10(b) of the Exchange Act, which is central to this case, makes it unlawful "[t]o use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate." Id. § 78j. Rule 10b-5 identifies false, misleading or incomplete statements as violations and proscribes the use of devices, schemes or artifices to defraud. 17 C.F.R. § 240.10b-5.

On motions by the defendants to dismiss for failure to state a claim, the district court denied the motions as to Durgarian, McCracken, and Hogan in light of their actions in ordering or carrying out the pertinent transactions. SEC v. Durgarian, 477 F.Supp.2d 342, 350, 353-54 (D.Mass.2007). By contrast, the district court found that none of the counts stated a claim against Papa, Crain, and Childs, id. at 360, and entered final judgment in favor of each, Fed.R.Civ.P. 54(b), permitting an immediate separate appeal by the SEC, Fed. R.App. P. 4(a).

The district court, in dismissing claims against the appellees as primary violators, stressed that Papa, Crain, and Childs were not charged with ordering or executing any of the wrongful transactions in January 2001; the complaint merely asserted in general terms that they had "agreed" on January 5, 2001, to the overall plan. This, the district court said, was insufficient to make them "substantial" participants in a potentially wrongful scheme directed by Durgarian and carried out by Hogan and McCracken.

The appellees' signing of the audit letters over a year after the transactions (and then again a year after that) were affirmative acts but, as to them, the district court said:

[T]he alleged false [audit letters] bearing their signatures are too attenuated to link them to the fraudulent...