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Lori A. Martin
© Copyright 2017. All rights reserved. This outline or portions thereof may be used in other materials published by the authors.
Ms. Martin is a partner in the Securities and Litigation and Controversy Departments of Wilmer Hale Cutler Pickering Hale and Dorr, LLP, resident in the Firm’s New York Office. Before joining WilmerHale, Ms. Martin was First Vice President and Assistant General Counsel of Merrill Lynch Investment Managers, L.P. (“MLIM”), the former asset management arm of Merrill Lynch, where she oversaw the litigation and regulatory practice of MLIM.
If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.
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In its 2016 fiscal year, the Securities and Exchange Commission brought 868 enforcement actions and obtained judgments and orders requiring payment of approximately $4 billion in civil penalties and disgorgement. See Press Release, SEC Announces Enforcement Results for FY 2016, available at https://www.sec.gov/news/pressrelease/2016-212.html.
The SEC’s 2016 enforcement actions include a number of first-of-their-kind cases, including an action against “a private equity adviser for acting as an unregistered broker.” Id. Among other enforcement initiatives, the SEC continued to focus on gatekeepers such as accountants, attorneys and compliance professionals, holding them accountable for failing to uncover misconduct by investment advisers and investment companies, as well as for failures to comply with professional standards. Id.
The SEC’s Office of the Whistleblower received nearly 4,200 tips. 2016 Annual Report to Congress on the Dodd-Frank Whistleblower Program, at 23, available at https://www.sec.gov/whistleblower/reportspubs/annual-reports/owb-annual-report-2016.pdf. It awarded a total of approximately $57 million to 13 whistleblowers in 2016.
SEC Chair Mary Jo White discussed the SEC’s new enforcement model. Chair White emphasized the “need to be trial-ready,” which accompanies the SEC’s “new ‘investigate to litigate’ philosophy.” Chair White identified strong remedies, individual liability, and the use of data analytics and whistleblowers as keys to continued success in protecting investors. Chair White addressed the need for strong enforcement of the securities laws as a deterrent to future violations, stating that the SEC will “increasingly focus attention on areas and cases that have a strong and immediate impact on problematic industry norms and practices.” See Speeches, Remarks at the New York University School of Law Program on Corporate Compliance and Enforcement, available at http://www.sec.gov/news/speech/chair-white-speech-new-york-university-111816.html (Nov. 18, 2016).
The SEC’s 2016 enforcement actions against investment advisers, investment companies and gatekeepers for funds included first-of-their-kind cases with important lessons for investment managers and funds. The high profile cases in the investment management industry include enforcement actions against:
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In December 2016, the Supreme Court issued an important decision involving the requirements for tippee/tipper liability established by Dirks v. SEC, 463 U.S. 646 (1983). The Supreme Court held that a personal benefit includes a tipper’s benefit from “making a gift of confidential information to a trading relative,” and resolved a split between the Second and Ninth Circuits as to what constitutes a personal benefit. Salman v. United States, 580 U.S.___(2016).
On September 1, 2011, Bassam Yocoub Salman was indicted on five counts involving insider trading. Salman received insider tips from his future brother-in-law, Maher Kara, who worked at Citigroup and shared information about upcoming mergers and acquisitions with his older broker, Mounir Kara. Mounir Kara traded on the tips from his older brother, Maher Kara, and shared the tips with Salman. Salman reaped nearly $1 million in profits from trading on the tips.
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At Salman’s trial, the court applied the Dirks liability standard, which held that an insider could not provide an outsider with information for “an improper purpose of exploiting the information for their personal gain.” “[T]he test is whether the insider personally will benefit, directly or indirectly, from his disclosure.” In Dirks, the Supreme Court defined benefit to include “a pecuniary gain or a reputational benefit that will translate into future earnings.” Salman appealed the verdict, arguing that the Ninth Circuit should apply the Second Circuit’s personal benefit standard as articulated by U.S. v. Newman, which held that a tippee can only be liable for insider trading if he has knowledge that the corporate insider (the tipper) obtained a personal benefit, and that the government may not “prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature.” 773 F.3d 438 (2d Cir. 2014).
The Supreme Court overruled Newman to the extent it required a tipper to receive a pecuniary benefit, or its equivalent, to be found to have breached the tippers fiduciary duty when tipping a friend or family member. The Court upheld the Ninth Circuit’s decision, finding that “Dirks … easily resolves the narrow issue presented here,” and explained “that when a tipper gives inside information to “a trading relative or friend,” a jury can infer that the tipper meant to provide the equivalent of a cash gift.” The Court added that Salman acquired Maher’s duty of trust and confidence to Citigroup when he received confidential information with the “full knowledge that it had been improperly disclosed.”
What examination and enforcement activity should advisers and funds anticipate in 2017? As was the case in 2016, the SEC “will further enhance its ability to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” U.S. Securities and Exchange Commission, Fiscal Year 2016 Agency Financial Report (“2016 Annual Report”), at 30, available at https://www.sec.gov/about/secpar/secafr2016.pdf.
The Office of Compliance Inspections and Examinations (OCIE) and the Division of Enforcement will continue to focus on “current and emerging high priority areas, and on leveraging cutting-edge technology and analytics.” To facilitate that, the SEC will prioritize its ability to analyze large volumes of data, to prosecute market structure cases, and to enhance its capacity to investigate financial reporting and accounting fraud. OCIE plans to invest in its technology
and data analysis tools to “promote efficiencies and expand the breath of examinations.” 2016 Annual Report, at 31-32.
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OCIE seeks to examine additional investment advisers who have never been examined. OCIE will also continue to encourage improvements in compliance programs throughout the industry. U.S. Securities and Exchange Commission, Fiscal Year 2017 Congressional Budget Justification (“2017 Budget”), at 64-66, available at https://www.sec.gov/about/reports/secfy17congbudgjust.pdf.
The SEC intends to develop rules encouraging more robust risk management practices for investment funds and investment advisers. In maintaining its focus on investment advisers, Enforcement will continue to work proactively to detect “issues concerning valuation, performance, fees and expenses, compensation, advertising, governance, portfolio management, and compliance policies and controls.” OCIE will maintain its interest in “protecting investors’ retirement accounts” by examining advisers’ sales and marketing practices. 2016 Annual Report, at 30-32.
|II. Statutory Basis of SEC Enforcement Proceedings Against Investment Advisers|
|III. State Enforcement Authority|
The federal securities laws include a number of savings clauses expressly preserving state authority to pursue fraud actions against securities law violators. The savings clauses recognize concurrent state jurisdiction to investigate and prosecute violations of state corporate and securities laws in conjunction with their federal counterparts. These federal savings clauses are discussed below, as well as the state blue sky and related statutes that have been the subject of significant state enforcement actions against mutual fund advisers and distributors.
The Dodd-Frank Act has resulted in over 2,000 SEC registered investment advisers shifting from federal to state registration, and state enforcement activity relating to investment advisers has already increased. The North American Securities Administrators Association (NASAA) in October 2012 reported that enforcement actions involving investment advisers almost doubled to approximately 400 in 2011, representing 15% of all state securities enforcement actions. See Enforcement Report Details Investor Protection Role of State Securities Regulators (Oct. 2012), available at http://www.nasaa.org/16832/enforcement-report-details-investor-protection-role-of-state-securities-regulators/.
Enforcement activity by state regulators is likely to increase over time. NASAA now estimates that there are 17,000 investment advisers registered with state securities regulators, as compared to 10,500 investment advisers registered with the SEC. North American Securities Administrators 2012/2013 Report at 25, available at http://www.nasaa.org/wp-content/uploads/2011/08/NASAA-2012-2013-Report.pdf.
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The New York Martin Act, N.Y. Gen. Bus. Law. Art. 23-A, § 352 et seq., authorizes the New York Attorney General (“NYAG”) to investigate any “fraudulent practice” in connection with “the issuance, exchange, purchase, sale, promotion, negotiation, advertisement, investment advice or distribution within or from [New York] state.” Id. at § 352-51.
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In 2003, the State of California amended its Government code to grant the CA Attorney General substantially similar authority to that enjoyed by the NYAG under the Martin Act. CA Gov’t Code §§ 1258-1259. The law grants the California Attorney General broad investigatory and subpoena power, and the power to pursue actions for disgorgement, restitution and injunctive relief for violations of the state’s securities laws. Id.
Massachusetts state law authorizes the Secretary of the Commonwealth to “make such public or private investigations within or outside of the commonwealth as he deems necessary to determine whether any person has violated or is about to violate any provision [of the Massachusetts Securities Act].” Mass. Gen. Laws Ch. 110A § 407. The Secretary’s investigatory authority includes the authority to compel testimony and document production and to issue subpoenas. Id. The Secretary may also issue cease and desist orders, impose administrative fines, and seek disgorgement and accounting. Id. at § 407A.
In Colorado, the Attorney General has interpreted the authority to investigate and prosecute deceptive trade practices under the Colorado Consumer Protection Act as including the authority to investigate and prosecute mutual fund trading improprieties. See Assurance of Discontinuance between the Attorney General of the State of Colorado and Janus Capital Corp. (Aug. 10, 2004) (citing CO Rev. Stat. §§ 6-1-105), available at www.ago.state.co.us/pr/081804pr.pdf.
|IV. Federal Enforcement Proceedings Against Advisers and Funds|
This Section discusses historical enforcement themes in actions concerning the investment advisory and mutual fund industry. At core, these actions typically involve a misstatement by an adviser or a failure to disclose conflicts, sometimes without an intention to deceive. Many cases also involve a breach of fiduciary duty by the adviser such that investors were not treated fairly, or a breach of the adviser’s duty of care in handling investor assets.
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Investment advisers have an obligation to treat their clients fairly, including in the allocation of investment opportunities. The SEC has brought enforcement actions against advisers that breached this duty by, e.g., holding an investment in a suspense account and allocating it after its profitability has been determined. The statutory basis for these actions frequently includes Section 17(a) of the Securities Act and Section 206 of the Investment Advisers Act.
The SEC has instituted enforcement proceedings against investment advisers that usurped investment opportunities belonging to a mutual fund.
During the technology boom of the 1990s, mutual funds that purchased IPOs reported extraordinary returns. The SEC initiated enforcement proceedings against advisers of several funds for allegedly failing to disclose that their record returns were attributable to the unprecedented success of initial public offerings.
More recently, the SEC has brought a number of actions involving fund investments in mortgage-related securities. Many of these actions have focused on disclosures of risks, and terms of collateralized debt obligations (CDO) and other complex structured
products. See U.S. Securities and Exchange Commission 2012 Fiscal Year Agency Financial Report at 125, available at www.sec.gov/about/secpar/secafr2012/pdf#2012review. See also SEC Enforcement Actions Addressing Misconduct That Led to or Arose From the Financial Crisis, available at http://www.sec.gov/spotlight/enf-actions-fc.shtml.
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Section 205 of the Investment Advisers Act generally prohibits investment advisers from charging fees based on capital gains or appreciation of a client’s assets. 15 U.S.C. §80b-5(a). Section 205(b)(2), however, permits investment advisers to enter into advisory contracts providing for performance-based compensation if the fee increases or decreases proportionately with an adviser’s investment performance, as measured against an appropriate index of securities prices over the same period of time. 15 U.S.C. § 80b-5(b)(2).
Wrap fee programs allow advisers to provide services for one “wrapped” fee that is not based on the number of transactions in a client’s account. Rule 204-3(f) of the Investment Advisers Act requires that the sponsor of a wrap fee program to prepare a “wrap fee brochure” that explains the adviser’s “wrap fee” program and its sponsor, and requires the sponsor to provide the brochure to wrap fee program clients.
Rule 2a-4 of the Investment Company Act provides that where a portfolio security is not regularly quoted on a public market, an adviser may price the security at “fair value as determined in good faith by the board of directors of the registered company” in calculating the NAV of the fund. 17 C.F.R. §170.0-2a-4. The SEC has
initiated enforcement actions against advisers that allegedly failed to adopt or apply a process to ensure that portfolio holdings were priced in good faith. The actions are premised on the allegation that mispriced securities resulted in the sale of funds at a price other than the true “current net asset value” of their underlying securities, in violation of Rule 22c-1 of the Investment Company Act.
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Mispricing of securities has been a traditional area of enforcement focus and mispricing of mortgage-related securities is currently drawing particular regulatory scrutiny as part of the financial crisis enforcement actions.
The federal securities laws impose affirmative duties on registered companies to supervise their employees in a manner reasonably calculated to prevent violations of the federal securities laws. See
15 U.S.C. § 78o(b)(4)(E) (authorizing enforcement actions under the Exchange Act against broker-dealers who fail to reasonably supervise their employees with a view towards preventing violations of federal securities laws); 15 U.S.C. §80b-3(e)(6) (authorizing enforcement actions under the Investment Advisers Act for failure to supervise employees in a manner reasonably designed to prevent violations of the federal securities laws). These provisions also authorize the SEC to initiate enforcement actions against companies and individual employees with supervisory authority who fail to fulfill their responsibility to adequately monitor employee conduct.
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Section 19(a) and Rule 19a-1 of the Investment Company Act require that dividend payments from mutual funds disclose the source of the payments to shareholders (“19(a) notices”). The purpose of the requirement is to ensure that investors are informed as to whether payments derive from fund income or a return of shareholder capital. The SEC has initiated enforcement actions against advisers or their affiliates for failure to enclose 19(a) notices with dividend payments.
The purchase or sale of securities on the basis of material, non-public information when the trader has a duty not to trade violates Section 10 of the Exchange Act and Rule 10b-5. Chiarella v. United States, 445 U.S. 222 (1980). The SEC has broad authority to police insider trading violations, and enforcement in this area has been of particular interest to Congress. Section 21A of the Exchange Act, for example, explicitly authorizes the SEC to seek increased penalties for insider trading violations. 15 U.S.C. § 78u-1. Advisers charged with trading portfolio securities must adhere to relevant insider trading prohibitions.
Insider trading has consistently been an enforcement priority of the SEC, and general examples of insider trading are addressed below. Two aspects of insider trader – insider trading by hedge funds and insider trading related to the use of expert networks, continue to be current priorities for the SEC. The Enforcement Division brought 58 insider trading cases in fiscal year 2013, comparable to the number of actions it brought in fiscal year 2012. These cases involved financial professionals, hedge fund managers, corporate insiders, attorneys, and government employees who unlawfully traded on material non-public information. See SEC 2013 Annual Report at 134-37, available at http://www.sec.gov/about/secpar/secafr2013.pdf#appendix.
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Section 206 of the Investment Advisers Act requires investment advisers to use care in responding to client requests for information.
An adviser’s acceptance of gifts or gratuities from broker-dealers or other affiliated personnel raises the possibility that the benefits conveyed may impair the adviser’s fiduciary obligations to place investor-client interests above his own. Gratuities from a broker to an adviser potentially may influence the adviser’s decision regarding where to direct brokerage execution. FINRA Rule 3220 expressly prohibits brokers from providing customers with gifts or gratuities worth more than $100.
Conflicts of interest and affiliated transactions have been the subject of on-going focus by the SEC, and this section addresses general examples of actions brought by the Commission.
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Rule 105 of Regulation M, “Short Selling in Connection with a Public Offering,” prohibits covering a short sale position with securities obtained in a public offering if the short sale occurred within the Rule 105 Restricted Period, which is the shorter of (1) five business days before the pricing and ending with the pricing; or (2) the period between the filing of a registration statement and the pricing. 17 C.F.R. § 242.105(a)(1).
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Investment Advisers Act Rule 204A-1 requires all investment advisers registered or required to be registered under section 203 of the Act to adopt a Code of Ethics to establish a standard of business conduct required of supervised persons and reflecting the adviser’s fiduciary obligations and those of its supervised persons. The Rule further requires that supervised persons execute a written acknowledgement of receipt of the firm’s Code of Ethics, and that the adviser retain the acknowledgements in accordance with the books and records requirements of Rule 204-2.
In In the Matter of Consulting Services Group and Joe D. Meals, Investment Advisers Act Rel. No. 2669 (Oct. 4, 2007), the compliance officer for an investment adviser allegedly prepared written acknowledgements for supervised persons and instructed them to backdate the acknowledgement forms to a period before they had received the firm’s Code of Ethics. The SEC charged the investment adviser with willful violations of Section 204 and Rule 204-1 of the Investment Advisers Act, failure to adopt a timely Code of Ethics in accordance with Rule 204A-1, and failure to maintain accurate written acknowledgements by all supervised persons of their receipt of a Code of Ethics compliant with Rule 204A-1. Additionally, the investment adviser allegedly purchased a pre-packaged policies and procedures manual from a compliance-outsourcing firm. The manual was designed for investment advisers offering discretionary money management services to clients and not for advisers that served institutional or pension clients. Because they were not tailored to the investment adviser’s business, and did not address, for example, the conflict of interest between the investment adviser and its wholly owned broker-dealer, the SEC alleged that they were not “reasonably designed to prevent violations” of the Advisers Act. The adviser consented to a censure, cease and desist order and a civil penalty in the amount of $20,000. The compliance officer also consented to a bar from association with a broker, dealer or adviser in any compliance capacity.
In general, prior to the Dodd-Frank Act amendments to the Investment Advisers Act, effective in July 2011, investment advisers with at least $30 million of assets under management were required to register with the SEC, subject to certain exemptions, including an
exemption for private advisers. Advisers with less than $25 million of assets were subject to state regulation and were prohibited from registering with the SEC unless they qualify for an exemption from the prohibition. Advisers with assets between $25 million and $30 million could elect to register with either the SEC or the states.
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Under the Investment Advisers Act, as amended by the Dodd-Frank Act and regulations adopted thereunder, the registration framework is more complicated. Generally speaking, advisers with less than $25 million of assets remain subject to state regulation and prohibited from registering with the SEC unless they qualify for an exemption from the prohibition. Advisers with less than $100 million of assets, subject to state registration and examination, are prohibited from registering with the SEC unless they qualify for an exemption from the prohibition. Advisers with at least $100 million are required to register with the SEC, subject to exemptions as amended by the Dodd-Frank Act. The Dodd-Frank Act eliminated the private adviser registration exemption, but created new exemptions, including exemptions for venture capital fund advisers and for private fund advisers with less than $150 million of assets under management.
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Pursuant to Section 13(f) of the Securities Exchange Act, institutional investment managers that exercise investment discretion of over $100 million or more in Section 13(f) securities must file a Form 13F report of holdings by the end of the calendar quarter. The Form requires institutional investors to report the issuer name of all Section 13(f) securities (in alphabetical order), a description of the class of security listed (e.g., common stock, put/call option, class A shares, convertible debenture), the number of shares owned, and the fair market value of the securities listed, as of the end of the calendar quarter. The Official List of Section 13(f) Securities is available at http://www.sec.gov/divisions/investment/13flists.htm.
The SEC has also brought enforcement actions against “portfolio pumping” – manipulation of the price of portfolio holdings near reporting periods in order to boost fund performance.
Auction rate securities (“ARS”) are long-term bonds or preferred shares whose rates reset periodically through an auction process. The instruments derived their liquidity from market demand. Typically, in auctions where there was insufficient demand, the broker-dealer who underwrote or marketed the instrument would submit support bids to assure the auction’s clearance. However, in late 2007 through early 2008, growing investor liquidity concerns and struggles at monoline insurers (who insured the credit quality of bonds backing ARS), diminished demand for the instruments, forcing auction dealer firms, the balance sheets for which were already under stress due to the mounting credit crisis, to submit more support bids and take more ARS into inventory than they could sustain. In February 2008, firms ceased supporting auctions, triggering widespread auction failure and effectively freezing the auction rate market.
The SEC, FINRA and state regulators extensively investigated the broker-dealer activities concerning ARS. They have brought numerous actions, generally alleging broker-dealer misrepresentations in connection with ARS sales and marketing. In particular, regulators have alleged that firms were aware of increased liquidity risks associated with ARS shortly before the market collapsed, but continued to market the instruments as safe, liquid cash and money market alternative investments. Numerous auction dealers settled with regulators, generally consenting to permanent injunctions and undertakings that included, among other things, the purchase of ARS at par from retail customers. See SEC Finalizes ARS Settlements with Citigroup
and UBS, Providing Nearly $30 Billion in Liquidity to Investors, Rel. No. 2008-290 (Dec. 11, 2008); Bank of America Agrees in Principle to ARS Settlement, Rel. No. 2008-247 (Oct. 8, 2008); Press Release, Attorney General Cuomo Announces Settlements With Bank of America and Royal Bank of Canada to Recover Billions for Investors in Auction-Rate Securities (Oct. 8, 2008) and Attorney General Cuomo Announces Auction Rate Securities Settlement with Oppenheimer & Co. Inc. (Feb. 24, 2010); Press Release, FINRA Announces Agreements in Principle with Five Firms to Settle Auction Rate Securities Violations (Sept. 18, 2008).
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Although the enforcement settlements did not generally require any undertakings with respect to ARS issuers, dealers and the SEC Division of Investment Management encouraged closed-end funds that issued ARS to redeem or restructure those issues to restore liquidity. See Linda Chatman Thomsen, Testimony Concerning the SEC’s Recent Actions With Respect to Auction Rate Securities, before the Committee on Financial Services, U.S. House of Representatives (Sept. 18, 2008).
In SEC v. Berliner, CA 08-CV-3859 (S.D.N.Y. Apr. 24, 2008), the SEC alleged that Paul Berliner disseminated a false rumor designed to depress the stock price of a publicly traded company. Berliner allegedly sent instant messages to numerous individuals, including traders at brokerage firms and hedge funds, reporting that Alliance Data Systems Corp. (“ADS”) was convening an emergency board meeting to consider a revised proposal from the Blackstone Group to acquire ADS for significantly less than the per-share priced announced in a definitive agreement entered into six months prior. The SEC asserted that as the rumor spread across Wall Street and was picked up by various news sources, the price of ADS plummeted, dropping from $77 per share to an intraday low of $63.65 – a 17% decline – and that Berliner allegedly profited from the decline by short selling ADS stock and covering those sales as the stock price fell. The SEC asserted that Berliner’s alleged manipulation of ADS stock price and related trading violated Section 17(a) of the Securities Act and Sections 9(a)(4) and 10(b) of the Exchange Act and rule 10b-5 thereunder. Without admitting or denying the SEC’s allegations, Berliner consented to a permanent injunction, disgorgement of $26,129 in trading profits and a $130,000 civil penalty. A subsequent order based on the same conduct barred Berliner from association with any broker or dealer. In the Matter of Paul S. Berliner, Securities Exchange Act Rel. No. 57774 (May 5, 2008).
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The SEC’s continued on focus on gatekeepers for failing to uphold their responsibilities under the securities laws has included cases against the directors of funds, which are responsible for oversight of mutual funds and include, as well, direct responsibility for valuation of portfolio securities. The gatekeeper focus has also resulted in actions against advisers, for deception of the Board in connection with the 15(c) advisory contract review.
The Enforcement Division has also brought actions relating to compliance programs and appropriate responses to examination deficiencies. See Press Release, SEC Penalizes Investment Advisers for Compliance Failures (Nov. 28, 2011), available at http://www.sec.gov/news/press/2011/2011-248.htm. The following actions are illustrative of actions involving compliance programs or involving compliance officers. The SEC announced settlements of three administrative proceedings relating to compliance program failures in November 2011.
In November 2013, the SEC announced its first deferred prosecution agreement with an individual. In connection with an investigation, the SEC announced that Scott Herckis, a fund administrator of a hedge fund, had assisted the SEC staff in its pursuit of an action against a hedge fund manager that “stole investor assets” and overstated fund performance. Herckis allegedly aided and abetted the violation. He computed the performance of the fund’s assets and facilitated transfers of fund assets to the general partner of the fund, in breach of the partnership agreement. The terms of the deferred prosecution agreement preclude Herckis from service as a fund administrator for five years and further preclude association with a registered investment adviser, broker-dealer or registered investment company. The agreement further required disgorgement of $50,000, representing Herckis’ compensation as administrator. The deferred
prosecution agreement is available at http://www.sec.gov/news/press/2013/2013-241-dpa.pdf.
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The Enforcement Division’s Asset Management Unit, in cooperation with the Division of Risk, Strategy and Financial Innovation and OCIE, announced an aberrational performance inquiry. The initiative uses risk analytics to identify funds with returns that exceed their peer group. The initiative is designed to “identify and charge advisory firms and individuals with misconduct including improper use of fund assets, fraudulent valuations, and misrepresentation of fund returns.” SEC 2012 Annual Report at 3; see also SEC Press Releases 2012-209 (Oct. 17, 2012) and 2011-252 (Dec.11, 2011), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171485332#.Usb78_3ZQ8M and http://www.sec.gov/news/press/2011/2011-252.htm.
The SEC’s 2013 Annual Report emphasizes that the prosecution of Frauds/Ponzi schemes continues to be an enforcement priority. SEC 2013 Annual Report at 142-144, available at http://www.sec.gov/about/secpar/secafr2013.pdf#appendix. Cases illustrative of the federal regulators’ actions related to offering frauds/Ponzi schemes are described below:
In 2010, the SEC Enforcement Division announced the launch of a mutual fund fee initiative in its Asset Management Unit. The initiative has led to several actions regarding fee disclosures.
In In the Matter of Anthony Fields, CPA, Investment Advisers Act Rel. No. 3348 (Jan. 4, 2012), the SEC instituted cease and desist proceedings alleging that Fields, his registered investment adviser and his unregistered broker-dealer used LinkedIn and other social media to make fraudulent offers of fictitious securities, reported false information on the adviser’s Form ADV, did not maintain required books and records, did not implement an adequate compliance program and published misleading information on their websites. The action highlights the SEC’s focus on the risks of social media. The SEC issued risk and investor alerts on social media in connection with this proceeding. See SEC Press Release 2012-3, available at www.sec.gov/news/press2012/2012-3.htm.
In In the Matter of Keiko Kawamura, Securities Act of 1933 Rel. No. 9622 (Aug.5, 2014), the SEC and an unregistered investment adviser entered into a consent order based on the adviser’s use of her website and social media accounts to further two fraudulent investment schemes. In the first scheme, the adviser purportedly managed a
“hedge fund” where she would pool investor funds and take 20% of any profits gained. The adviser solicited clients touting her extensive experience managing millions of dollars. In fact, she had placed only a few trades using her boyfriend’s account of less than $10,000. She misappropriated most of the funds she received for vacations and living expenses. Using social media, the adviser posted screenshots of unusually successful trades suggesting she was making excellent returns. She also falsified tax records for the investors showing that the funds were invested when they had already been misappropriated.
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The second scheme centered around the adviser’s website www.kawamurafinancial.com. She promoted the website through social media and charged between $94.95 and $174.95 for investment advice. She again inflated her status in the industry and made false claims about her returns, bragging she had an 800% YTD return when she had already lost the money. She offered access to a blocked Twitter account so paying investors could access her tips real-time. The SEC settled with the adviser and ordered her to cease and desist from violating Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5, and Sections 206(1), 206(2) and 206(4) of the Advisers Act and Rule 206(4)-8. The adviser was barred from associating with any investment organization and ordered to pay $275,117.78 in disgorgement and prejudgment interest of $14,644.41. She was also fined $50,000.
In setting forth its examination priorities for 2013, the SEC announced the IA-IC Program’s focus on “distribution-in-guise.” Advisers and funds make a wide variety of payments to distributors and intermediaries, and the SEC determined to examine whether those payments comply with applicable regulations, including SEC Rule 12b-1. The rule permits a fund to pay service fees – such as revenue sharing, sub-TA, shareholder servicing and conference support – out of fund assets without any plan authorizing their payment.
Distribution fees, on the other hand, may be paid out of fund assets only if the fund has adopted a plan authorizing the payments. Distribution fees may include marketing and advertising costs. The SEC is concerned that advisers may disguise distribution fees as service fees and thereby pay them out of fund assets without the imprimatur of a 12b-1 authorizing plan.
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In In the Matter of KBR, Inc., No. 3-16466 (SEC Apr. 1, 2015), available at www.sec.gov/litigation/admin/2015/34-74619.pdf, the SEC issued in a settled administrative proceeding a cease and desist order directing that the respondent cease violating Commission Rule 21F-17(a). That rule prohibits “tak[ing] any action to impede an individual from communicating directly with the Commission staff about a possible securities law violation, including enforcing, or threatening to enforce, a confidentiality agreement . . . with respect to such communications.” The rule was adopted pursuant to authority granted by the Dodd-Frank Act, which became effective in August 2011. At issue in KBR was a form confidentiality statement used by the company when conducting internal investigations of alleged misconduct reported by company employees. The confidentiality agreement had been used long before the passage of Dodd-Frank and Ruel 21F-17. The confidentiality statement required individuals interviewed during an internal investigation to agree to “protect the integrity of the
review” and “prohibited” the employee from “discussing any particulars regarding this interview and the subject matter discussed during the interview, without the prior authorization of the Law Department.” Although the Commission was not aware of any instance in which the confidentiality statement prevented any employee from reporting a possible securities law violation to the SEC, or any instance in which KBR sought to enforce the confidentiality statement so as to prevent an employee from reporting an alleged securities law violation to the SEC, the Commission believed that the confidentiality statement alone constituted a violation of Rule 21F-17(a). The Commission concluded that the “language found in the form confidentiality statement impedes such communications by prohibiting employees from discussing the substance of their interview without clearance from KBR’s law department under penalty of disciplinary action including termination of employment.”
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|V. The Mutual Fund Market Timing, Late Trading and Compensation Scandals|
In September 2003, NYAG Spitzer initiated an action against Canary Capital Partners, a hedge fund, for engaging in market timing and late trading of leading mutual fund families. State of New York v. Canary Capital Partners, LLC, Index No. 402830/2003 (N.Y. Co. Sup. Ct. Sept. 3, 2003). The Complaint averred that the mutual fund advisers consented to or had been complicit in the practices. The same day it filed the Canary Complaint and, simultaneously announced a settlement of the action, the NYAG issued a press release stating that he had “obtained evidence of widespread illegal trading schemes that potentially cost mutual fund shareholders billions of dollars annually.” Press Release, State Investigation Reveals Mutual Fund Fraud (Sept. 3, 2003), available at http://www.oag.state.ny.us/press/2003/sep/sep03a_03.html. The allegations triggered a spate of federal and state regulatory into the mutual fund industry, culminating in a series of state and federal enforcement actions.
Late trading refers to the practice of placing orders to buy or redeem mutual fund shares after the mutual fund has calculated its NAV for the next day (which is typically at the close of trading at 4:00 pm Eastern Standard Time), but receiving the price based on the prior day’s NAV. Late trading enables the trader to profit from market events that occur after 4:00 pm, but that are not reflected in
that day’s NAV. The late trader obtains an advantage at the expense of other mutual fund shareholders when he learns of market moving information and is able to purchase or redeem mutual fund shares at prices set before the information is reflected in the mutual fund share price. Investment Company Act Rule 22c-1(a) (the “forward pricing rule”) expressly prohibits late trading by requiring registered investment companies and affiliates authorized to consummate transactions on their behalf to sell and redeem mutual fund shares at a price based on the fund’s NAV “next computed after receipt of a tender of such security for redemption or of an order to purchase or sell such security.” 17 C.F.R. § 270.22c-1 (emphasis supplied).
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Late traders allegedly obtained the capacity to execute mutual fund transactions from investment advisers and affiliated brokers in a number of ways, sometimes with the assistance of a mutual fund trading intermediaries. For example, mutual funds expect that large investors, like retirement plans, require several hours after the deadline to process orders submitted by plan participants, and therefore accept batch orders for processing after the deadline based on assurances that the orders were placed before the deadline. Some traders obtained late-trading capacity by persuading intermediaries to include their post-4:00 pm trades with these batched orders. Alternatively, late traders submitted “proposed” trades to fund brokers or distributors before the 4:00 pm deadline, when they would be time-stamped, and then “confirmed” the trades after the deadline had passed. Traders declined to confirm unprofitable trades, and unconfirmed trades were not cleared. Some distributors and brokers also allegedly accommodated late traders by installing electronic processing platforms that enabled traders to enter orders directly for clearing and to bypass distributor operations and compliance.
Nothing in either the Investment Company Act or the Investment Advisers Act expressly prohibited the practice of market timing, which generally refers to short term trading that exploits mutual fund pricing procedures. Because advisers generally price portfolio holdings in open-end funds only once a day, and because the value of the securities those shares represent fluctuates continuously, share values potentially may diverge from the market value of their underlying assets. This occurs, for example, with funds based on international holdings because of time zone differences. For example, when a fund with international holdings prices shares at 4:00 pm using the closing price of the securities on a foreign exchange, the value assigned will not reflect events that occurred between the closing of the foreign exchange and 4:00 pm. Market timers engage in short-term trading to take advantage of the profit potential created when a disparity exists between a funds’ NAV and the current market value of its portfolio holdings.
Regulators contend that market timing increases the cost of administering the fund and harms other fund shareholders by forcing the manager to keep cash available to meet liquidity needs created by frequent redemptions. Regulators also have asserted that the profits that market timers realize by selling shares may dilute the value of the shares held by long-term investors.
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Enforcement actions against investment advisers for permitting market timing have proceeded on theories of breach of fiduciary duty and inadequate disclosure. Many funds included disclosures in their prospectuses and other offering documents that they discouraged or prohibited market timing. Regulators contend that if a fund prospectus disclosed that it disfavored market timing, but, in practice, the fund’s adviser permitted or failed to prevent favored individuals or companies from engaging in such trading, the adviser violated securities laws prohibiting materially misleading disclosures in connection with a securities offering. The non-disclosure of conflicts of interest arising out of arrangements between advisers and market timers may also breach an adviser’s fiduciary duties to fund shareholders.
Additionally, several advisers allegedly permitted market timing in exchange for long-term investments in other fee-generating vehicles managed by the adviser, sometimes called “sticky assets.”
The focus of mutual fund investigations extended beyond market timing and late trading and into compensation arrangements between funds and broker-dealers that distributed their funds. In particular, regulators challenged (a) directed brokerage; (b) revenue sharing arrangements; (c) soft dollar transactions, and the potential conflicts of interest such payments created for investment advisers.
|VI. State Response to Credit and Liquidity Crisis|
State regulators have responded to the credit and liquidity crisis and its corresponding impact on the fund industry through increased enforcement measures. At times, state activity has complemented federal enforcement activity. At other times, states have initiated independent proceedings.
In Oregon v. Oppenheimer Funds, Inc., No. 09C14018 (Ore. Cir. Ct. Apr. 13, 2009), the Oregon Attorney General asserted state securities claims against Oppenheimer Funds in connection with losses in the 529 College Savings Plan resulting from investments in high risk
instruments. The Attorney General alleged that OppenheimerFunds misrepresented investments as conservative when it was investing in speculative, “hedge-fund like” instruments. State of Oregon v. Oppenheimerfunds, Inc., No. 09C14018 (Marion Co. Apr. 13, 2009).
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The California Attorney General sued a prominent custodian bank, alleging that custodian bank misappropriated millions of dollars from CalPERS and CalSTRS, the state’s largest pension funds, by charging an undisclosed mark-up for the costs of foreign currency trades. The People of the State of California v. State Street Corporation, No. 34-2008-00008457-CU-MC-GDS (Super. Ct. Co. of Sacramento, Oct. 20, 2009).
|VII. Limits of State Regulatory Authority|
Congress enacted NSMIA, in part, to eliminate duplicative and contradictory regulatory standards and to designate “the Federal Government . . . [as] the exclusive regulator of national offerings of securities.” H.R. Rep. 104-622, 104th Cong., 2nd Sess. 1996 at 16. The legislative history of NSMIA discusses state remedial authority insofar as relates to prospectus disclosures for covered securities: NSMIA “precludes State regulators from, among other things, citing a State law against fraud or deceit or regarding broker-dealer sales practices as its justification for prohibiting the circulation of a prospectus or other offering document . . . The Committee intends to eliminate States’ authority to require or otherwise impose conditions on the disclosure of any information for covered securities.” H.R. Rep. 104-864, 104th Cong., 2nd Sess. 1996 at 40.
Litigants have challenged the remedial authority of state regulators. See generally, Lori A. Martin and Cristina Alger, State Regulators and the Mutual Fund Industry, 39 The Review of Securities and Commodities Regulation 219, 228-232 (Nov. 15, 2006). In particular, they have claimed that states lack the authority to compel reduction in advisory fees and that NSMIA preempts state authority to compel prospectus revisions.
The NYAG’s template market timing settlement required advisory fee reductions. The advisory fee reductions were typically imposed in addition to substantial monetary fines and penalties. One adviser challenged New York’s remedial authority to regulate or set
an adviser’s fees as allegedly preempted by Section 36(b) of the Investment Company Act. J. & W. Seligman & Co., Inc. v. Spitzer, No. 05 Civ. 7781 (S.D.N.Y. Sept. 6, 2005).
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Section 36(b) of the Investment Company Act provides an express right of action to challenge mutual fund advisory fees. In relevant part, Section 36(b) states, “[a]n action may be brought under this subsection by the Commission, or by a security holder of such registered investment company on behalf of such company, against such investment adviser, or any affiliated person … for breach of fiduciary duty in respect of such compensation.” 15 U.S.C. § 80a-36(b). Seligman contended that the creation of express rights of action – one by the SEC and the other by a mutual fund investor – impliedly preempts all other actions, including state regulatory challenges to advisory fees.
Seligman further argued that imposing fee reductions awards windfall recovery to future investors. According to the Seligman Complaint, any investors harmed by the adviser’s market timing conduct were past investors, not future ones. Fee reductions, however, would benefit uninjured, future investors, thus presenting an inappropriate remedial measure for market timing.
The district court declined to enjoin an investigation by the NYAG challenging Seligman’s mutual fund advisory fees and the information provided to the funds’ board of directors in connection with the advisory agreement renewals. Without deciding the preemption question, the district court refused to enjoin the NYAG’s investigation on the grounds that NSMIA preserves state enforcement authority. J. & W. Seligman & Co. Inc. v. Spitzer, No. 05 Civ. 7781 (KMW), 2007 U.S. Dist. LEXIS 71881 (Sept. 27, 2007). On March 13, 2009, without admitting or denying the allegations, Seligman agreed to pay $11.3 million to four mutual funds that were allegedly adversely affected by its adviser fee arrangements.
Although the scope of state regulatory authority at issue in the Seligman case was an issue of first impression, the preemptive effect of Section 36(b) as against state common law claims has been adjudicated in private litigation. In Green v. Fund Asset Mgmt., 245 F.3d 214 (3d Cir. 2001), the U.S. Court of Appeals for the Third Circuit held that nothing in the legislative history of Section 36(b) indicated Congressional intent to displace actions under state law, and that the maintenance of a suit at state law would not impede the accomplishment of the Act’s objectives.
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In 2010, the Supreme Court addressed Section 36(b) in Jones v. Harris, 130 S. Ct. 1418 (2010). The Court endorsed the 25-year-old Gartenberg factors for evaluating the legal obligations of investment company boards and investment advisers in the negotiation of investment advisory agreements for funds registered under the Investment Company Act. Liability under Section 36(b) requires that “an investment adviser must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s length bargaining.” Importantly, the Court emphasized that “the standard for fiduciary breach under §36(b) does not call for judicial second-guessing of informed board decisions” and that courts should not “engage in a precise calculation of fees representative of arm’s-length bargaining.” The Supreme Court left open a few important issues, including the relevance of institutional separate account fees, relevance of fees for comparable mutual funds managed by competitors and the relevance of alleged process-based failures during the negotiation of investment advisory agreements.
In light of Jones v. Harris, the Supreme Court remanded another excessive fee case, Gallus v. Ameriprise Financial, 561 F.3d 816 (8th Cir. 2009). In that case, the plaintiff argued that the adviser breached its fiduciary duty to mutual fund investors by charging an advisory fee that exceeded the advisory fee for institutional separate accounts. The plaintiff also challenged the truthfulness and completeness of the competitive fee information and alleged that the adviser had misled the independent trustees. The district court concluded that institutional separate account fees were not a valid comparison because the nature and quality of services provided to the two sets of clients were dramatically different and ultimately dismissed the action. The Eighth Circuit reversed, noting that the district court had erred “in rejecting a comparison between the fees charged to [the adviser’s] institutional clients and its mutual fund clients.” The Eighth Circuit also noted that “[u]nscrupulous behavior with respect to either can constitute a breach of fiduciary duty.” Upon remand, the district court reinstated summary judgment; the plaintiffs again appealed and on March 30, 2012 the Eighth Circuit affirmed.
There have been several challenges to state authority to compel revisions of mutual fund prospectus disclosures.
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