S.E.C. v. Pinez, Civil Action No. 97-10353-PBS.

989 F.Supp. 325

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, v. Emanuel PINEZ, Defendant, and Lehman Brothers, Inc., Relief Defendant.

Civil Action No. 97-10353-PBS.

United States District Court, D. Massachusetts.

December 16, 1997.

COPYRIGHT MATERIAL OMITTED

Jeffrey W. Kobrick, Stuart P. Feldman, Carlos Costa-Rodrigues, Linda Bridgeman, John M. D'Amico, Juan Macel Marcelino, Grant David Ward, U.S. Securities & Exchange Commission, Boston, MA, for Securities and Exchange Commission.

Francis J. DiMento, DiMento & Sullivan, Boston, MA, for P.G. Technologies.

John C. Bartenstein, Robert K. Gad, Mark Szpak, Ropes & Gray, Boston, MA, for Lehman Brothers.

John J. Falvey, Jr., Assistant U.S. Attorney, Boston, MA, for United States of America.

James B. Adelman, Choate, Hall & Stewart, Boston, MA, for Paine Webber, Inc.

Glen DeValerio, Berman, DeValerio & Pease, Boston, MA, for Centennial Technologies, Inc., Special Committee of the Board of Directors.

Robert L. Ullman, Nutter, McClennen & Fish, Boston, MA, for Nutter, McClennen & Fish.

Vincent M. Amoroso, Robert A. McCall, Peabody & Arnold, Boston, MA, Sarah R. Wolff, Sachnoff & Weaver, Chicago, IL, for Greg Goldsmith, Craig Anderson, Robert Wasserman, Timothy Werner, Lakota Trading.

Glen DeValerio, Norman Berman, Matthew Miller, Berman, DeValerio & Pease, Boston, MA, for Investors in Centennial Technologies, Inc.

Dennis M. Kelleher, Thomas J. Dougherty, Skadden, Arps, Slate, Meagher & Flom, Boston, MA, for Coopers & Lybrand, Partnership.

Marilyn D. Stempler, Andrew P. Strehle, Andrew Strehle, Brown, Rudnick, Freed & Gesmer, Boston, MA, for Felix, Inc.

MEMORANDUM AND ORDER

SARIS, District Judge.

I. INTRODUCTION

This action arises out of the alleged illegal insider trading practices of the former Chairman and Chief Executive Officer of Centennial Technologies, Inc. ("Centennial"), Emanuel Pinez ("Pinez"). On February 14, 1997, the Securities and Exchange Commission ("SEC") filed a complaint against Pinez alleging that he traded in options on the common stock of Centennial while in possession of material, nonpublic information regarding Centennial's true financial condition in violation of section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b), Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder, and section 17(a) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77q(a). The SEC's complaint, and its accompanying ex parte motion for a temporary restraining order, requested that Pinez be restrained from committing further acts of securities fraud, and that any and all assets that are "in the name of, in the custody of, held for the benefit of, or subject to the control of" Pinez be frozen to prevent dissipation. In a written order dated February 14, 1997, this Court temporarily restrained the allegedly fraudulent business practices of defendant Pinez¹ and his agents, and froze the assets in several accounts alleged to be under defendant Pinez's direct or indirect control.²

The SEC now seeks to transform its temporary restraining order freezing Pinez's assets into a preliminary injunction against Pinez and all persons and institutions holding assets under the control of or for the benefit of the defendant. One such financial institution, the brokerage firm of Lehman Brothers, Inc. ("Lehman"), objects to a preliminary injunction as it would apply to it, arguing that Lehman has an immediate and unconditional entitlement to the proceeds of the liquidated option securities that it held in Pinez's margin account.³

After hearing, the Court ALLOWS the SEC's motion for a preliminary injunction freezing Pinez's assets, including the $4.69 million held in the Lehman escrow account.

II. FACTUAL BACKGROUND

The SEC has presented the following evidence:

A. Centennial — A Star Performance

From 1989 until 1997, Pinez was the Chairman, Chief Executive Officer ("CEO"), and Secretary of Centennial Technologies, Inc., which is a publicly-traded corporation in Billerica, Massachusetts that manufactures parts for computer systems and owns stock in several other computer manufacturing companies. During 1996, Centennial's stock, which was registered with the SEC and traded on the New York Stock Exchange ("NYSE"), increased in price by nearly 451% and was determined to be the best performing issue on the NYSE. As the chief executive, Pinez owned approximately 25% of Centennial's common stock.

In February of 1996, Pinez opened a private client services account with Lehman, a corporation that provides financial and brokerage services. In opening the account, Pinez entered into a "Client Agreement," granting Lehman a security interest in the assets held in his account. That fall, Pinez executed the "Margin Account Agreement" portion of the Client Agreement which made him eligible to engage in margin transactions and to borrow money from Lehman secured against the assets in the account. At the time the margin account was established, the assets that Pinez surrendered as collateral consisted mainly of shares of Centennial stock. Pinez borrowed substantial amounts of money from Lehman secured against these shares, which were valued at approximately $55-$58 per share at the end of December of 1996. At that time, Lehman estimates that these shares had a value of more than $14 million.

B. A Falling Star

By January 31, 1997, the market value of Centennial stock had declined to approximately $23.75 per share. Having just released a public statement reporting substantial earnings for the second quarter of the 1997 fiscal year,⁴ Centennial's Board of Directors ("Board") began to question the company's revenue recognition and inventory valuation for the second quarter of 1997. On January 31, 1997 the SEC initiated an investigation of Centennial and requested Mr. Pinez's trading records from Lehman. On that date, Lehman knew that the SEC had launched an investigation of Centennial because the SEC requested trading records from Lehman in a letter.

At a meeting on February 4, which Pinez attended, a corporate officer informed the Board that Coopers & Lybrand, Centennial's public accountant, was concerned about Centennial's accounts in regard to a specific client and had asked to meet with the company's Audit Committee to discuss the matter. During a conversation immediately following the meeting, it was clearly stated that Centennial directors and officers should not trade Centennial securities while the matters were being investigated.

On February 5, 1997, amidst allegations from Centennial employees about the misstated measure of the company's inventory, the Board appointed a committee of four directors to examine the accuracy of Centennial's reported earnings and financial statements and Pinez's credentials. On February 6, 1997, Pinez was advised that he may be asked to resign as CEO. On Friday, February 7, the Board directed Centennial's Chief Financial Officer ("CFO"), James Murphy, to personally conduct a physical audit of the corporation's merchandise.

C. Margin Indebtedness

By January 30, 1997, Pinez's margin indebtedness to Lehman was approximately $5.5 million — and the debt grew larger as the value of the Centennial stock that Pinez had pledged to secure the loan declined. According to Julianne Call, the operations manager of Lehman's Boston office, Lehman was watching the account intensely throughout January to make sure Lehman was not going too far out on a limb as the price dropped from $58 to $40 to $35 a share. By January 30, it had declined to $30 a share.

On February 7, as the Board began investigating the possibility of material misrepresentations in Centennial's earnings reports, Pinez contacted Franklin Pierce, his account representative at Lehman, and requested that Lehman execute a "zero-cost collar" transaction at market to hedge against any further downward movement of the Centennial stock in his margin account. Pierce understood Pinez's request, which was made at approximately 1:00 PM on Friday, February 7, to mean that Pinez wanted to purchase a substantial number of "put" option contracts, which are options to sell stock at a set price, using money that was generated by selling "call" option contracts, which are options to buy stock at a set price. With put options, Pinez could sell his Centennial stock at a predetermined price regardless of its market value; thus, purchasing puts would shield Pinez from further losses due to Centennial's declining market price. Moreover, because the proceeds from selling calls would offset the cost of purchasing the puts, Pinez could get this protection against the continued downfall at no extra cost to him.

To effectuate such a "zero-cost collar" by the end of that business day, as Pinez had specifically requested, Pierce and his supervisor, Julianne Call, calculated that Lehman would need to trade approximately 6000 options contracts before 4:00 PM. Per firm policy, Pierce and Call consulted with Lehman officials in New York and requested authorization before agreeing to undertake this sizeable transaction.⁵

Once Lehman authorities had cleared the transaction and Pinez had given a firm order to purchase the puts and sell the calls, Pierce contacted Lehman's floor trader at the Chicago Board Options Exchange ("CBOE"), Don Klein, who commenced making "combo trades"⁶ with Centennial options traders ("market makers"⁷). By the close of trading on that Friday, February 7, Klein, on behalf of Pinez, had purchased 2,700 puts and sold 2,700 calls — affecting nearly 540,000 shares of underlying Centennial stock. The options, which expired on the third Friday in March, had an exercise price ("strike price") of $20 per share for the calls and either $20 or $17.50 per share for the puts. The market price of Centennial stock at the close of trading on Friday, February 7 was $18 per share. According to the SEC, these trades constituted more than 75 percent of the total volume...