May 7, 2009
GAO Testifies on Hedge Funds
The GAO released testimony it presented before the Senate Subcommittee on Capital Markets on Hedge Funds: Overview of Regulatory Oversight, Counterparty Risks, and Investment Challenges GAO-09-677T, May 07, 2009. This testimony discusses:
(1) federal regulators’ oversight of hedge fund-related activities; (2) potential benefits, risks, and challenges pension plans face in investing in hedge funds; (3) the measures investors, creditors, and counterparties have taken to impose market discipline on hedge funds; and (4) the potential for systemic risk from hedge fund related activities. To do this work we relied upon our issued reports and updated data where possible.
SEC's Enforcement Director Testifies Before Senate Banking Subcommittee
Robert Khuzami, the SEC's Director, Division of Enforcement made his first appearance before the U.S. Senate Banking, Housing, and Urban Affairs Subcommittee on Securities, Insurance, and Investment and presented Testimony Concerning Strengthening the SEC's Vital Enforcement Responsibilities. He stated that:
In your letter inviting me to appear, you asked me to provide my views on: (1) the extent to which the resource shortages and enforcement policies of the SEC in recent years have hampered aggressive enforcement of securities laws; (2) what changes are needed to ensure that the SEC does not once again fall behind on its enforcement responsibilities; and (3) what changes Congress should consider to ensure adequate resources and authority for the SEC to fulfill its vital enforcement role.
In his testimony, Mr. Khuzami addressed the GAO's recent report Securities and Exchange Commission: Greater Attention Needed to Enhance Communication and Utilization of Resources in the Division of Enforcement (GAO-09-358) and stated that he fully concurred with the GAO's recommendations. He stated that he would use additional resources in the following ways:
Administrative and paralegal support: The Division's lawyers and accountants spend too much time doing document or organizational tasks that are better handled by para-professional personnel. This includes document collection, organization, uploading and indexing, as well as tasks related to the collection and distribution of disgorgement and penalties. It would be much more efficient, and free-up much more time for high-value investigative tasks, if these efforts were transferred to administrative and support staff.
Information technology support: The SEC is working on a number of technology initiatives designed to bolster its ability to detect, investigate, and prosecute wrongdoing. These initiatives include a review of how the SEC handles tips, complaints, and referrals; the improvement and expansion of the Division's document management, reporting and case management capabilities; and the improvement of the SEC's ability to identify, track, and analyze data to identify risks to investors better.
Trial lawyers: It is important that the Commission maximize the capacity and ability of its trial unit. Simply stated, we must convey to all defendants in SEC actions that not only do we assemble winning cases against them, but also we are prepared to go to trial and we will win. Only then can we expect to secure the type of settlements that both achieve justice for investors and save resources to be used in pursuing the next case. Without that credible threat, we are at a severe disadvantage. Our trial unit does an admirable job, but given the increased caseload, particularly the great increase in the number of emergency actions such as temporary restraining orders and asset freezes, it needs to grow.
Hiring a Chief Operating Officer/Business Manager: the Division lacks a business manager or COO who can manage administrative, information technology, project management, and human resource issues. Additional staffing in the Office of Collections and Distributions would be welcome, as our attorney-investigators spend a significant amount of time doing collection and distribution work — approving distribution plans and distribution service providers — when they could be investigating cases.
SEC Will Consider Custody-Related Issues under IA Act on May 14
SEC Open Meeting - Thursday, May 14, 2009 - 10:00 a.m.
The subject matter of the Open Meeting will be:
The Commission will consider custody-related matters, including whether to propose amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940 and related forms and rules. The proposed amendments would enhance the protections provided advisory clients when they entrust their funds and securities to an investment adviser. If adopted, the amendments would require investment advisers having custody of client funds and securities to obtain a surprise examination by an independent public accountant, and, unless the client assets are maintained with an independent custodian, obtain a review of custodial controls from an independent public accountant.
Results of Stress Tests
Here are the results of the stress tests: The Supervisory Capital Assessment Program:Overview of Results.
SEC's 2010 Budget Request Emphasizes Enforcement Efforts
President Obama's 2010 budget would increase the SEC's funding by 6.8%, to $1.027 billion, and the CFTC's funding by 8.8%, to $161 million. WSJ, SEC, CFTC Would Get More Enforcement Resources. The SEC has posted on its website its FY 2010 Congressional Justification in Brief that provides detail on the budget request. The SEC identifies 63% of its budget to "enforce compliance with federal securities laws," 17% to "foster informed investment decision making," 9% to "promote healthy capital markets," and 11% to "maximize the use of SEC resources" (Chart 1).
FINRA Announces ARS Settlements with Four Firms
FINRA announced today that it has entered into final settlements with four additional firms to settle charges relating to the sale of Auction Rate Securities (ARS) that became illiquid when auctions froze in February 2008. To date, FINRA has concluded final settlements with nine firms, imposing a total of $2.6 million in fines and guaranteeing the return of more than $1.2 billion to investors. Investigations continue at a number of additional firms. The settlements announced today are with NatCity Investments, Inc. of Cleveland, which was fined $300,000; M&T Securities, Inc. of Buffalo, which was fined $200,000; Janney Montgomery Scott LLC of Philadelphia, which was fined $200,000 and M&I Financial Advisors, Inc. of Milwaukee, which was fined $150,000. All four firms agreed to initiate or complete offers to repurchase ARS sold to their customers where the auctions for the ARS had failed.
FINRA also announced that SunTrust Investment Services, Inc. and SunTrust Robinson Humphrey, Inc., both of Atlanta, determined not to finalize previously announced settlements in principle with FINRA. FINRA's investigation into both firms' ARS-related activities is continuing.
FINRA's investigation found that each firm sold ARS using advertising, marketing materials or other internal communications with its sales force that were not fair and balanced and therefore did not provide a sound basis for investors to evaluate the benefits and risks of purchasing ARS. In particular, the firms failed to adequately disclose to customers the potential for ARS auctions to fail and the consequences of such failures. FINRA's investigation also found evidence that each firm failed to establish and maintain a supervisory system reasonably designed to achieve compliance with the securities laws and FINRA rules with respect to the marketing and sale of ARS.
In the actions announced today, the firms agreed to a comprehensive settlement plan that has been applied in FINRA's previous ARS settlements. That plan includes several elements, including offers to repurchase at par ARS that were purchased by individual investors and some institutions between May 31, 2006, and Feb. 28, 2008. The firms have also agreed to make whole individual investors who sold ARS below par after Feb. 28, 2008. In addition to individual retail ARS investors, the buy-back offers include non-profit charitable organizations and religious corporations or entities, trusts, corporate trusts, corporations, pension plans, educational institutions, incorporated non-profit organizations, limited liability companies, limited partnerships, non-public companies, partnerships, personal holding companies and unincorporated associations that made individual ARS purchases and whose account value did not exceed $10 million.
Each firm is required to provide notice to its eligible customers promptly. Repurchases must begin no later than 30 days after the settlement is approved and must be completed no later than 60 days after settlement approval. Beginning no later than six months after settlement approval, each firm has also agreed to make its best efforts to provide liquidity to all other investors who purchased ARS during the same time period but who were not eligible for the initial repurchase.
FINRA noted that in the settlements announced today, each firm received credit for actions already taken to provide extraordinary remediation and other benefits to their ARS customers. Janney Montgomery Scott was credited for initiating its own offers in October 2008 to buy back frozen ARS from all customer accounts, irrespective of whether such ARS were purchased through the firm. Janney Montgomery Scott has already completed its repurchases. In addition, the firm was credited for extending cost-neutral loans to affected customers in March 2008, shortly after the ARS auctions failed. M&I Financial was credited for initiating its own offers in August 2008 to buy back ARS from those customers from whom it had not already repurchased ARS earlier in the year. M&I Financial has already completed its repurchases. M&T Securities was credited for initiating its own offers in December 2008 to buy back frozen ARS from customer accounts, without regard to when such ARS were purchased, and for providing cost-neutral lines of credit and demand notes through M&T Bank. NatCity was credited for having previously bought back ARS held by customers from whom it received complaints.
As part of the settlement plan, the firms also agreed to participate in a special FINRA-administered arbitration program to resolve investor claims for any consequential damages - that is, damages they may have suffered from their inability to access funds invested in ARS. Under this program, ARS investors may participate in an expedited arbitration paid for by the firm. The participating firm may not contest liability related to the illiquidity of the ARS holdings, nor to the ARS sales, including any claims of misrepresentations or omissions by the firm's sales agents. To speed the arbitration process under the special procedure, cases claiming consequential damages under $1 million will be decided by a single public (non-securities industry) arbitrator. In cases with consequential damage claims of $1 million or more, the parties can, by mutual agreement, expand the panel to include three public arbitrators. Additional information can be found at www.finra.org/ars.
In concluding these settlements, the firms neither admitted nor denied the charges, but consented to the entry of FINRA's findings.
After auctions for these securities began to fail in February 2008, FINRA released guidance for investors in the Investor Alert Auction Rate Securities: What Happens When Auctions Fail.
Investors can obtain more information about, and the disciplinary record of, any FINRA-registered broker or brokerage firm by using FINRA's BrokerCheck. FINRA makes BrokerCheck available at no charge. In 2008, members of the public used this service to conduct 11.6 million reviews of broker or firm records. Investors can access BrokerCheck at www.finra.org/brokercheck or by calling (800) 289-9999.
May 6, 2009
Treasury Will Release Banks' Stress Tests Thursday
The stress tests on the leading banks will be released Thursday May 7 at 5 p.m., although the press is reporting many of the results; see WSJ, Stress Tests Separate Strong Banks From Weak; NYTimes, Bank of America Needs $33.9 Billion, U.S. Says. Treasury has posted at its website an explanation of the tests -- Joint Statement by Secretary of the Treasury Timothy F. Geithner, Chairman of the Board of Governors of the Federal Reserve System Ben S. Bernanke, Chairman of the Federal Deposit Insurance Corporation Sheila Bair, and Comptroller of the Currency John C. Dugan; The Treasury Capital Assistance Program and the Supervisory Capital Assessment Program.
Paredes Speaks on Short Selling at Security Traders Association
SEC Commissioner Troy Paredes spoke on short sales on May 6 at the Security Traders Association 13th Annual Washington Conference.
GAO Releases Report on SEC's Enforcement Division and Corporate Penalties Policies
The GAO recently released a report entitled Greater Attention Needed to Enhance Communication and Utilization of Resources in the Division of Enforcement. As the report explains,
The Securities and Exchange Commission’s (SEC) Division of Enforcement (Enforcement) plays a key role in meeting the agency’s mission to protect investors and maintain fair and orderly markets. In recent years, Enforcement has brought cases yielding record civil penalties, but questions have been raised about its capacity to manage its resources and fulfill its law enforcement and investor protection responsibilities. GAO was asked to evaluate, among other issues, (1) SEC’s progress toward implementing GAO’s 2007 recommendations; (2) the extent to which Enforcement has an appropriate mix of resources dedicated to achieving its objectives; and (3) the adoption, implementation, and effects of recent penalty policies. GAO analyzed information on resources, enforcement actions, and penalties; and interviewed current and former SEC officials and staff, and others.
What GAO Recommends
GAO recommends the SEC Chairman (1) consider an alternative organizational structure for OCD; (2) further review the level and mix of resources dedicated to Enforcement, and assess the impact of the division’s internal case review process; (3) examine whether the 2006 corporate penalty policy is achieving its intended goals; and (4) take steps to ensure appropriate staff participation in policy development and review. SEC agreed with the recommendations.
Of particular interest, the report comments on two controversial policies of the Cox SEC: the factors to take into account in assessing corporate penalties and the requirement of prior Commission approval before staff initiated negotiations involving corporate penalties. As stated in the report:
Enforcement management, investigative attorneys, and others agreed that two recent corporate penalty polices—on factors for imposing penalties, and Commission pre-approval of a settlement range—have delayed cases and produced fewer, smaller penalties. GAO also identified other concerns, including the perception that SEC had “retreated” on penalties, and made it more difficult for investigative staff to obtain “formal orders of investigation,” which allow issuance of subpoenas for testimony and records. Our review also showed that in adopting and implementing the penalty policies, the Commission did not act in concert with agency strategic goals calling for broad communication with, and involvement of, the staff. In particular, Enforcement had limited input into the policies the division would be responsible for implementing. As a result, Enforcement attorneys reported frustration and uncertainty in application of the penalty policies.
The Gossip about Madoff
The June issue of Vanity Fair has an interview with Bernie Madoff's longtime secretary, detailing unflattering personal details about the Ponzi schemer. The magazine's website has a preview. Bernie Madoff's Secretary Spills His Secrets.
May 5, 2009
SEC Holds Round Table on Short-Selling
Today is the SEC's Roundtable on Short Selling. Here are Chairman Mary L. Schapiro's written comments.
SEC Charges The Reserve Primary Fund with Fraud
On May 5, 2009, the SEC filed a civil action in the United States District Court for the Southern District of New York charging the entities and individuals who operate The Reserve Primary Fund, including the Reserve Management Company, Inc. (RMCI), its Chairman, Bruce Bent Sr., its Vice Chairman and President, Bruce Bent II, and Resrv Partners, Inc., with fraud for failing to provide key material facts to investors and trustees about the fund's vulnerability as Lehman Brothers Holdings, Inc. sought bankruptcy protection. The Reserve Primary Fund "broke the buck" on Sept. 16, 2008, when its net asset value fell below $1.00 per share. In bringing the enforcement action, the SEC also seeks to expedite the distribution of the fund's remaining assets to investors.
According to the complaint, defendants failed to provide key material information to the Primary Fund's investors, board of trustees, and ratings agencies after Lehman Brothers filed for bankruptcy protection on September 15. The fund, which held $785 million in Lehman-issued securities, became illiquid on that day when the fund was unable to meet investor requests for redemptions. According to the SEC's complaint, the defendants misrepresented that RMCI would provide the credit support necessary to protect the $1 net asset value of the Primary Fund when, in fact, RMCI had no such intention.
The SEC also alleges that RMCI significantly understated the volume of redemption requests received by the fund and failed to provide the trustees with accurate information concerning the value of Lehman securities. Because of these misrepresentations and omissions, the fund was unable to strike a meaningful hourly net asset value as required by the fund's prospectus.
The complaint alleges that RMCI, Resrv Partners and Bruce Bent II violated Section 17(a) of the Securities Act of 1933 (Securities Act) and Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5 thereunder and that RMCI directly violated and Bruce Bent Sr. and Bruce Bent II directly violated and aided and abetted violations of Sections 206(1), (2) and (4) of the Investment Advisers Act and Rule 206(4)-8 thereunder. The complaint further alleges violations by Bruce Bent Sr. and Bruce Bent II of Section 10(b) and Rule 10b-5 thereunder as aiders and abettors and control persons.
The complaint names the Reserve Primary Fund as a relief defendant and seeks an order pursuant to Section 25(c) of the Investment Company Act and Section 21(d)(5) of the Exchange Act compelling a pro rata distribution of remaining fund assets which would release a significant amount of money that is currently being withheld from investors pending the outcome of numerous lawsuits against the fund, the trustees and other officers and directors of the Reserve entities.
The SEC's complaint seeks a final judgment permanently enjoining the defendants from future violations of the federal securities laws and ordering them to pay civil penalties and disgorgement of ill-gotten gains plus prejudgment interest.
SEC Charges Attorneys with Running a "Rule 144 Legal Opinion Mill"
The SEC filed a complaint in the United States District Court for the Northern District of Georgia against Albert J. Rasch, Jr. ("Rasch") and Sandra B. Masino ("Masino") of Costa Mesa, California, Kathleen R. Novinger ("Novinger") of Cypress, California, and 144 Opinions, Inc. ("144 Opinions") a California corporation formerly headquartered in Newport Beach, California. The complaint alleges that Rasch was the sole partner and owner of the Law Firm of Albert J. Rasch and Associates, Novinger was the sole associate at Rasch and Associates, and Masino was the sole owner and employee of 144 Opinions.
The complaint alleges that during 2007, the defendants collectively operated a legal "opinion mill," which issued fraudulent legal opinions used by promoters in a pump-and-dump scheme, and others, to sell securities in violation of the registration provisions of the federal securities laws. Masino and 144 Opinions drafted and Rasch or Novinger executed, at least 24 legal opinion letters concerning the removal of restrictive legends on certificates representing over 22 million shares of Mobile Ready Entertainment Corp. ("Mobile Ready"). The defendants cited to non-existent documents and misrepresented critical facts in executing the 24 legal opinions. The complaint alleges that the false and misleading statements drafted by Masino and 144 Opinions and thereafter executed by Rasch and Novinger fraudulently induced the transfer agent for Mobile Ready to remove the restrictive legends and permit the illegal sale of over 22 million shares of Mobile Ready in violation of the registration provision of the federal securities laws.
The Complaint alleges that the defendants have violated the registration and antifraud provisions of the federal securities laws, Sections 5(a), 5(c) and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission's complaint also seeks (i) permanent injunctions against future violations; (ii) disgorgement of ill-gotten gains plus prejudgment interest from Rasch and Masino; (iii) imposition of civil penalties as to Rasch, Novinger and Masino; and (iv) an order permanently prohibiting defendants from participating in any offering of penny stock.
SEC Brings Insider Trading Charges Involving CDSs
The SEC filed a civil action in the United States District Court for the Southern District of New York on May 5, 2009, alleging that Renato Negrin, a former portfolio manager at hedge fund investment adviser Millennium Partners, L.P., and Jon-Paul Rorech, a salesman at Deutsche Bank Securities Inc., engaged in insider trading in the credit default swaps of VNU N.V., an international holding company that owns Nielsen Media and other media businesses. According to the Commission's complaint, Rorech learned information from Deutsche Bank investment bankers about a change to the proposed VNU bond offering that was expected to increase the price of the CDS on VNU bonds. Deutsche Bank was the lead underwriter for a proposed bond offering by VNU. According to the complaint, Rorech illegally tipped Negrin about the contemplated change to the bond structure, and Negrin then purchased CDS on VNU for a Millennium hedge fund. When news of the restructured bond offering became public in late July 2006, the price of VNU CDS substantially increased, and Negrin closed Millennium's VNU CDS position at a profit of approximately $1.2 million.
The Commission's complaint charges violations of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. The Commission's complaint seeks a final judgment permanently enjoining Rorech and Negrin from future violations of the federal securities laws, ordering them to pay financial penalties and to disgorge ill-gotten gains with prejudgment interest.
The Commission's investigation is ongoing.
FINRA Bars Former Citigroup Broker for Defrauding Nun
FINRA announced today that it barred broker William Joseph Boyle from the securities industry for wrongfully converting and using funds from customer accounts and for failing to cooperate with FINRA investigators. Boyle's misconduct occurred both while he was working for Legg Mason Wood Walker, which was acquired by Citigroup in 2006, and at Citigroup.
FINRA found that Boyle deceived a 64-year-old nun into giving him two separate checks totaling approximately $531,000, which she believed would be deposited into accounts for her benefit. Instead, Boyle deposited one check into his personal joint bank account and the second into a mutual fund account held in his name. Boyle similarly persuaded a retired couple and an elderly widow to give him additional checks totaling approximately $80,000 — which he again deposited into his own accounts, using the funds for his own benefit.
FINRA received information regarding Boyle's misconduct in November 2007. At about that time, Boyle refunded $50,000 to the retired couple. Of the approximately $531,000 that Boyle received from the nun, he refunded approximately $39,000. Legg Mason reimbursed the nun for the remainder of the money that Boyle had misappropriated and Citigroup reimbursed $30,000 to the elderly widow.
In settling this matter Boyle neither admitted nor denied the charges, but consented to the entry of FINRA's findings
May 4, 2009
Senior Investment Protection Act Introduced in Senate
There was recently introduced in the Senate the Senior Investment Protection Act of 2009 (S. 906) that would provide grants to states to establish programs to combat misleading and fraudulent marketing techinques aimed at senior investors, including the use of phony "senior specialist" certifications.
Schapiro Addresses Mutual Fund Directors
SEC Chair Mary Schapiro gave an Address at the Mutual Fund Directors Forum Ninth Annual Policy Conference: Critical Issues for Investment Company Directors, on May 4, 2009. Among the topics covered was target date mutual funds:
However, target date funds have produced some troubling investment results. The average loss in 2008 among 31 funds with a 2010 retirement date was almost 25 percent. In addition, varying strategies among these funds produced widely varying results. Returns of 2010 target date funds ranged from minus 3.6% to minus 41 percent.
One explanation put forward for these outcomes is that many target date funds underlying retirement plans actually establish their "glide paths" based on the assumption that investors will continue to maintain their investments, and partially live off the proceeds, for a number of years following retirement. If that is the case, it must be plainly disclosed to investors. A target date fund underlying a college investment or so-called 529 plan, on the other hand, would need to more closely track its target date since it is far more likely that investors would need access to their investment at or near the fund's target date.
I can assure you that SEC staff is closely reviewing target date funds' disclosure about their glide paths and asset allocations. The staff also is examining whether the same target date funds underlie both retirement and college savings plans. The staff has been working closely with the Department of Labor in light of target date funds' prevalence in participant-directed retirement funds. This important issue has also been an area of focus for Chairman Kohl and the Senate Special Committee on Aging.
She also addressed short sales, proxy access, money market funds, and rule 12b-1 fees.
May 3, 2009
Spindler on IPO Underpricing
IPO Underpricing and Disclosure, by James C. Spindler, University of Southern California Law School, was recently posted on SSRN. Here is the abstract:
Using a unique data set, I find that U.S. IPO prospectus disclosure dramatically affects the degree of first day underpricing of the new issue, consistent with theories of underpricing as caused by informational asymmetry. In particular, a 1 standard deviation increase in positive prospectus disclosure is associated with almost a third reduction in first day underpricing. Further, this may derive from disclosure-related litigation risk: an increase in negative prospectus disclosure is associated with an increase in subsequent IPO-related lawsuits, which suggests that less positive (or more negative) disclosure is a reaction to litigation risk.
Karmel on Voting Power
Voting Power Without Responsibility or Risk - How Should Proxy Reform Address the Decoupling of Economic and Voting Rights?, by Roberta S. Karmel, Brooklyn Law School, was recently posted on SSRN. Here is the abstract:
The regulation of proxy voting resides at an uncomfortable intersection between federal and state law. Although state law controls the holding of annual meetings to elect directors and the corporate governance aspects of proxy voting, the federal securities laws control the solicitation of proxies. Since at least 1977 shareholder activists have been trying to persuade the Securities and Exchange Committee (“SEC”) to revise the proxy solicitation disseminated by a public corporation to allow competing shareholder nominees to be included in opposition to the board of directors’ nominees. Although the SEC has proposed rules to this effect, such rules have not yet been adopted. An SEC rule permitting some shareholder access to management’s proxy is probably inevitable during the administration of Mary Schapiro as SEC Chair. If a shareholder access rule goes forward, one of the issues the SEC will have to address is which shareholders should be granted such access.
The growth of derivatives and various trading strategies by some investors have led to a decoupling of economic and voting rights in public corporations, permitting proxy voting by shareholders with little or no economic interest in the shares they vote. Such voting is referred to as “empty voting.” If the SEC engages in proxy reform to allow competing director nominees to appear on the same ballot, the problems of empty voting in a proxy contest are likely to be exacerbated unless the SEC addresses this issue. But the question of whether economic rights need to be aligned with voting rights in order for voting rights to be valid, would appear to be a state law, rather than a federal law, issue. Further, a recent Delaware Supreme Court case suggests that the Delaware courts are prepared to referee the skirmishes between institutional shareholders and corporate boards with regard to shareholder nominations, and recently enacted legislation in Delaware likewise would deal with shareholder proposals to amend by-laws to allow for shareholder nominees in a company proxy. Therefore, even if the SEC has authority with regard to granting some shareholders access to a company’s proxy, there is a policy question as to whether such regulation of corporate internal affairs is wise.