SEC Enforcement News: Insider Trading and Internal Controls

• Posted on: Sep 5 2018

During the last week in August, the Securities and Exchange Commission (“SEC” or “Commission”) filed a number of actions and administrative proceedings involving, among other things, insider trading and the use of financial models and controls. Today’s installment of SEC Enforcement News looks at two of the actions/proceedings filed by the Commission: one involving insider trading allegations against former Cleveland Browns linebacker, Mychal Kendricks (“Kendricks”), and the other involving Moody’s Investors Service, Inc. for failing to implement proper controls over a) certain financial models operated by an affiliate, and b) the use of its rating symbols.

SEC v. Kendricks

On August 29, 2018, the Commission announced (here) that it had filed a complaint against Kendricks for insider trading. According to the SEC, Kendricks and Damilare Sonoiki (“Sonoiki”), a Harvard-educated former investment banker who recently served as a staff writer for the ABC television show “Black-ish”, purchased securities in companies that were soon to be acquired and then sold those positions after the deals were publicly announced.

The SEC alleged that after meeting at a party, Kendricks began receiving illegal tips from Sonoiki, a former analyst at an investment bank (later disclosed to be Goldman Sachs) who had access to confidential, non-public information about upcoming corporate mergers and acquisitions. Kendricks allegedly made $1.2 million in illegal profits by purchasing securities in companies that were about to be acquired and then selling those positions after the deals were publicly announced, in one instance generating a nearly 400 percent return on his investment in just two weeks.

According to the SEC, Kendricks purchased call options in four companies that were planning to merge with another company: Compuware Corporation (“Compuware”), Move, Inc. (“Move”), Sapient Corporation (“Sapien”), and Oplink Communications, Inc. (Oplink”). When each company announced a merger or acquisition, the value of Kendricks’s options increased significantly.  For example, Kendricks purchased approximately $60,000 in Compuware call option contracts. After Compuware announced that it was being acquired by the private-equity firm, Thoma Bravo LLC in a going-private transaction, Kendricks sold those same option contracts for approximately $138,000, which was a 130% increase from the purchase price.  With respect to Move, Kendricks purchased approximately $71,000 in call options and sold those same contracts for approximately $350,000, which constituted a 393% increase from the purchase price, after it announced that News Corp. was acquiring it in an all cash tender offer. For Sapient, Kendricks purchased approximately $146,000 in call option contracts and sold them for approximately $635,000, which was a 335% increase from the purchase price, after it announced that it was being acquired by the French advertising firm Publicis Groupe PLC in a cash tender offer.  Finally, Kendricks purchased Oplink call option contracts for approximately $446,000 and sold them for approximately $798,000, which was a 79% increase from the purchase price, after it announced that it was being acquired by a subsidiary of Koch Industries, Inc. in a cash tender offer.

According to the SEC, Kendricks made a profit of approximately $78,000 from his Compuware investments, approximately $279,000 from his Move investments, approximately $489,000 from his Sapient investments, and approximately $352,000 from his Oplink investments, for a total of approximately $1.2 million.

The scheme ended in 2015, when Sonoiki left Goldman Sachs to work on “Black-ish.”

According to the SEC’s complaint (here), Kendricks rewarded Sonoiki for his tips and other assistance, which included setting up an online brokerage account that both men could access, by providing cash kickbacks, free NFL tickets, and an evening on the set of a pop star’s music video in which Kendricks made a cameo appearance.

“As alleged in our complaint, Kendricks paid cash and shared celebrity perks for illegal tips that enabled him to trade and profit on confidential information that the rest of the investing public didn’t have,” said Stephanie Avakian, Co-Director of the SEC Enforcement Division.

Kendricks and Sonoiki are alleged to have facilitated the trading through coded text messages and FaceTime conversations.

“Kendricks and Sonoiki allegedly tried to evade detection by using a variety of communication methods to hide their misconduct, but we were able to use methodical investigative work to piece together a trail of evidence and expose their insider trading scheme,” said Joseph G. Sansone, Chief of the SEC Enforcement Division’s Market Abuse Unit.

In a statement, Kendricks admitted wrongdoing, said he fully cooperated with investigators and promised to repay the funds that he illegally gained.

I apologize. Four years ago, I participated in insider trading, and I deeply regret it. I invested money with a former friend of mine who I thought I could trust and who I greatly admired. His background as a Harvard graduate and an employee of Goldman Sachs gave me a false sense of confidence. To that point, I had worked my tail off since I was 5 years old to become the football player that I am today. I was drawn in by the allure of being more than just a football player. While I didn’t fully understand all of the details of the illegal trades, I knew it was wrong, and I wholeheartedly regret my actions.

Since the beginning of the investigation, I have fully cooperated with all of the authorities and will continue to do so. I accept full responsibility for my actions. Although I did not take any of the profits for myself, I am committed to repaying all of the funds gained illegally and accept the consequences of my actions.

The SEC filed its complaint in the United States District Court for the Eastern District of Pennsylvania (Civil Action No. 18-cv-03695). The complaint charges Kendricks and Sonoiki with two counts of securities fraud and is seeking the return of their ill-gotten trading profits plus interest and penalties.

Also, on August 29, the U.S. Attorney’s Office for the Eastern District of Pennsylvania announced parallel criminal charges against Kendricks and Sonoiki. (Here.)

If convicted, each defendant faces a maximum possible sentence of 25 years’ imprisonment, a three-year period of supervised release, $5,250,000 fine, and a $200 special assessment. Forfeiture of all proceeds from the offenses also may be ordered.

In the Matter of Moody’s Investors Service, Inc.

On August 28, 2018, the SEC announced (here) that Moody’s Investors Service Inc. (“Moody’s”), one of the nation’s largest credit ratings agencies, agreed to pay a total of $16.25 million in penalties to settle charges involving internal control failures and failing to clearly define and consistently apply credit rating symbols. (Adm. Proc. File No. 3-18688 (August 28, 2018).) According to the SEC, this was “the first time the SEC has filed an enforcement action involving rating symbol deficiencies.”

Moody’s agreed to pay $15 million to settle charges of internal controls failures involving models it used in rating U.S. residential mortgage-backed securities (“RMBS”) and will retain an independent consultant to assess and improve its internal controls. Moody’s separately agreed to pay $1.25 million and to review its policies, procedures, and internal controls regarding rating symbols. Moody’s did not admit or deny the SEC’s charges.

According to the SEC’s order in the internal controls proceeding (here), Moody’s failed to establish and document an effective internal control structure as to models that Moody’s had outsourced from a corporate affiliate (Moody’s Analytics) and used in rating RMBS from 2010 through 2013. Moreover, Moody’s failed to maintain and enforce existing internal controls that should have been applied to the models. Ultimately, Moody’s corrected more than 650 RMBS ratings with a notional value exceeding $49 billion, due, in part, to errors in the models. Also, in 54 instances, Moody’s failed to document its rationale for issuing final RMBS ratings that deviated materially from model-implied ratings.

“Rating agencies play a critical role in our capital markets and need to have effective controls over their rating processes,” said Antonia Chion, Associate Director of the SEC’s Division of Enforcement. “As our order notes, the SEC put Moody’s on notice about its internal controls obligations yet it did not develop an effective process to ensure the accuracy of the models it relied upon when rating residential mortgage-backed securities.”

In the SEC’s order relating to rating symbols (here), the Commission found that Moody’s assigned ratings to securities known as combo notes in a manner that was inconsistent with other types of securities that used the same rating symbols. These securities had a total notional value of about $2 billion.

“Investors expect and the law requires that symbols used by rating agencies be clearly defined and consistently applied,” said Reid Muoio, Deputy Chief of the Enforcement Division’s Complex Financial Instruments Unit. “Today’s proceeding is the SEC’s first enforcing the Universal Ratings Symbol requirement and we will continue to pursue failures that render rating symbols unclear or inconsistent.”

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