Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Thursday, November 5, 2009

Frank Asks SEC and CFTC for Input on Derivatives Legislation

House Financial Services Committee Chairman Barney Frank sent a letter to Commodity Futures Trading Commission Chairman Gary Gensler and Securities and Exchange Commission Chairman Mary Schapiro seeking their input on efforts to strengthen the derivatives legislation recently approved by the Committee.

November 5, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

Statement on Convergence of IASB and FASB

Not as interesting as insider trading, but the SEC Chair Mary Schapiro stated today that:

 "I am greatly encouraged by the commitment of the IASB and the FASB to provide greater transparency to the standard setting process and their convergence efforts. I believe that these efforts will result in improved financial information provided to investors."

As background, the SEC release explained that:

Today, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a statement reaffirming the Boards' commitment to improving International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles (U.S. GAAP). In the statement the IASB and the FASB described their plans to strengthen their efforts for completing the major projects in their Memorandum of Understanding (MoU) by 2011. The publication of this statement is intended to provide an understanding of the progress that is being made by the Boards on these projects and to address public concerns regarding the potential of the two Boards to reach different conclusions in the major projects in the MoU. The respective oversight bodies of the IASB and the FASB also issued a statement fully supporting the efforts of the IASB and the FASB in reaching improved and converged global accounting standards.

November 5, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)

NASAA Expresses Concern over Proposed Expansion of FINRA Authority over Investment Advisers

Earlier today I blogged on the proposed Investor Protection Act that the House Financial Services Committee passed earlier this week.  Here is NASAA's statement on the bill and, in particular, whether FINRA should regulate investment advisers:

NASAA appreciates the Committee’s efforts to strengthen investor protection. While we continue to have concerns over certain aspects of the Investor Protection Act that will not serve investors, we look forward to working with the Committee in its efforts to strengthen the financial services regulatory framework and provide the best possible protections for American investors.

State securities regulators also appreciate Chairman Frank's concern over the far-reaching consequences of an amendment introduced by Ranking Member Spencer Bachus to provide the SEC with the authority to empower FINRA to enforce the fiduciary duty provisions in the Investment Advisers Act against not only broker-dealer members but also any affiliated investment advisory firm or any associated person. The amendment would give FINRA sweeping rule-making authority without any meaningful analysis or study of its implications. NASAA remains opposed to any effort to expand the jurisdiction and authority of private, membership organizations into an area that is more appropriately the province of government.

November 5, 2009 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

Government Charges 14 Defendants with Insider Trading

The government's investigation into insider trading and hedge funds continues.  The government today charged 14 defendants with insider trading in complaints connected to the charges filed against hedge fund manager Raj Rajaratnam.  Defendants include money managers and an attorney at a firm that works on private equity deals. The U.S. attorney for S.D.N.Y., however, says it "would be a mistake" to think the investigation focuses solely on hedge funds.  Stay tuned for further developments.  NYTimes, 14 Charged With Insider Trading as Galleon Case Grows.

In addition, the SEC today announced additional charges in its insider trading enforcement action against billionaire Raj Rajaratnam and Galleon Management LP by charging 13 additional individuals and entities, including three hedge fund managers, three professional traders at New York-based Schottenfeld Group, and a senior executive at Atheros Communications, a California-based developer of networking technologies.

The SEC also charged a pair of lawyers for tipping inside information in exchange for kickbacks as well as six Wall Street traders and a proprietary trading firm involved in a $20 million insider trading scheme.

In the press conference announcing the charges, Robert Khuzami, Director, SEC Division of Enforcement, emphasized that the alleged conduct was bad behavior, perhaps in response to published comments about the so-called "gray area" involving use of confidential information:

The ethical and legal judgments of these defendants were flatly wrong.

They weren't close calls.
They weren't nuanced.
They weren't in gray areas.

November 5, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

Supreme Court Hears Oral Argument in Excessive Mutual Fund Fees Case

The U.S. Supreme Court heard oral argument Monday in Jones v. Harris Associates, a case that could impact the amount of managerial fees that millions of mutual fund investors pay fund advisers.  The Court must decide what standard governs whether advisors' fees are excessive under the Investment Company Act (ICA) of 1940. Congress amended the ICA in 1970 to create a fiduciary duty for investment advisers “with respect to the receipt of compensation for services.” 15 U.S.C. § 80a-36(b).  The 1970 amendment also granted a private right of action to fund holders to sue for breaches of this fiduciary duty. 

 In Jones, three Oakmark Funds shareholders brought suit against the fund’s adviser for charging double the amount of managerial fees that it charged institutional investors for purportedly similar services.  The district court granted the advisor’s motion for summary judgment, holding that the Second Circuit’s 1982 decision in Gartenberg v. Merrill Lynch Asset Management, 694 F.2d 923, recognized a breach of duty under the ICA only where an adviser charges fees that are “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.”  While affirming the result, a Seventh Circuit panel led by Chief Judge Easterbook criticized Gartenberg, finding that the decision ignored economic realities.  As long as funds fully disclose managerial fees, market forces should keep mutual fund costs down in the face of industry competition.  527 F.3d 627.  The Seventh Circuit denied rehearing en banc by a 5-5 vote, accompanied by a forceful dissent from Judge Posner assailing the panel decision.  537 F.3d 728.

 The Seventh Circuit decision may not survive review. The Court signaled little enthusiasm for Judge Easterbrook’s analysis at oral argument on Monday, and even the litigants abandoned the panel’s position to revisit different aspects of the Gartenberg test.  Chief Justice Roberts and Justice Scalia, however, touched on free market principles in questions to petitioner’s counsel.  Chief Justice Roberts noted that technological developments now allow investors easy access to information about management fees at the click of a button.   If investors find the fees excessive, they could move money to another fund in “thirty seconds.”  Justice Scalia added that any fund experiencing investor exodus would clearly see the problem and recalibrate its adviser's compensation.   

Most of the questioning revolved around different articulations of the Gartenberg test.  Justice Kennedy inquired whether the ICA’s fiduciary duty language comported with other fiduciary duties, such as those applied to corporate officers and boards of directors.  Petitioner’s counsel argued that Congress used fiduciary in a special sense to ensure the fairness of fees.  Counsel offered a two-pronged fairness test a la Gartenberg.  First, was there full disclosure and good faith negotiating between the mutual fund board (many of whose directors may have been appointed by the advisors) and the investment advisers?  Second, was the fee fair when compared to the same or similar services charged to an outsider in an arms-length transaction (in this case, an institutional investor)?

 Justice Breyer noted that the plain text of the Gartenberg test could be read different ways simply based on one’s tone of voice.  The Court spent a good portion of argument grappling over the proper metric to measure excessive fees.  Breyer posed that a workable standard may lie in petitioner’s argument that courts should evaluate what an adviser charges a mutual fund against its institutional clients. 

It is difficult to predict what direction the Court will take.  Without a clear majority in support of the Seventh Circuit market analysis decision, the Court may reverse the appellate panel and embellish the Gartenberg test to provide additional guidance to lower courts on how best to determine excessive managerial fees. (It should be noted that there is no reported case where fund holders have prevailed under the Gartenberg standard.)

(Aaron Bernay, Corporate Law Fellow and University of Cincinnati Law '10, prepared the above summary analysis of the Nov. 2 oral argument in Jones v. Harris Associates.)

November 5, 2009 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Value Line Settles SEC Charges of Bogus Brokerage Commissions

The SEC settled charges that New York City-based investment adviser Value Line Inc., its CEO, its former Chief Compliance Officer and its affiliated broker-dealer defrauded the Value Line family of mutual funds by charging over $24 million in bogus brokerage commissions on mutual fund trades funneled through Value Line's affiliated broker-dealer, Value Line Securities, Inc. (VLS).  Value Line, its CEO Jean Buttner, its former Chief Compliance Officer David Henigson, and VLS agreed to settle the SEC's charges by consenting, without admitting or denying the Commission's findings, to the entry of a cease-and-desist order that also requires total payments of nearly $45 million in monetary remedies, including civil penalties. The SEC's order also imposes industry and officer and director bars and other relief.

The SEC's order finds, among other things, that:

From 1986 to November 2004, Value Line, while serving as investment adviser to the Value Line funds, directed a portion of the funds' securities trades to VLS through its so-called "commission recapture program." Value Line arranged for one of three unaffiliated brokers to execute, clear and settle the Funds' trades at a discounted commission rate of $.02 to $.01 per share. Instead of passing this discount on to the funds, Value Line had the unaffiliated brokers bill the funds $.0488 per share and then "rebate" $.0288 to $.0388 per share to VLS. In total, VLS received over $24 million in bogus brokerage commissions from the funds pursuant to this scheme, as VLS did not perform any bona fide brokerage services for the funds on these trades.

Value Line falsely represented to the funds' Independent Directors/Trustees and shareholders that VLS provided bona fide brokerage services for the commissions it received and that VLS otherwise served the best interests of the funds and their shareholders.

Buttner directed the "commission recapture program" and monitored its profitability to VLS, and thus to Value Line, by receiving periodic updates from Henigson, who was responsible for implementing the scheme. Buttner and Henigson were involved in structuring and negotiating the recapture arrangement with the unaffiliated rebate brokers. Through Buttner and Henigson, Value Line also made materially misleading statements and omissions about VLS and the recapture program to the funds and their shareholders in presentations to the Independent Directors/Trustees and in public filings with the Commission.

November 5, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)

House Financial Services Committee Passes Investor Protection Legislation

The House Financial Services Committee voted (41-28) on Nov. 4 to recommend the Investor Protection Act of 2009(Download H.R.3817) that has a variety of measures intended to improve  investor protection and increase investor confidence. Here is the Committtee's Press Release.

The bill contains two provisions of particular interest to retail investors.

First, the Act requires the SEC to establish a uniform "fiduciary duty" for broker, dealers and investment advisers providing personalized investment advice to retail customers.  The proposed language does this in a somewhat convoluted manner.  Section 103 amends the Securities Exchange Act and requires the SEC to promulgate rules that the standard of conduct for these brokers and dealers shall be the same as the standard of conduct for investment advisers.  In turn, the Investment Advisers Act would be amended to require the SEC to promulgate rules to provide that the standards of conduct for all such brokers, dealers and investment advisers shall be "to act in the best interest of the customer" without regard to the financial or other interest of the advice provider.

The proposed legislation would also require the SEC to "harmonize," to the extent possible, enforcement and remedy regulations applicable to brokers, dealers and investment advisers.

Second, section 201 of the proposed legislation gives the SEC the authority to prohibit or limit agreements that require customers of brokers, dealers, and investment advisers to arbitrate disputes "arising under the Federal securities laws or the rules of an SRO" if the SEC finds that it would be in the public interest and for the protection of investors.  Notice that, under this language, agreements to arbitrate disputes arising under state law are not explicitly prohibited.  Since many customers' disputes are negligence or breach of fiduciary duty claims arising under state law (since federal securities fraud requires scienter and federal courts do not recognize a private claim under SRO rules), adoption of this legislation may revive the complications that existed pre-McMahon, where federal claims could be brought in court while state claims arising under the same facts would go to arbitration. 

The proposed legislation contains a number of other provisions of large and small import, including an increase in the agency's funding.  It is reported in the press that a bipartisan amendment was added to the bill, to exempt permanently businesses valued at $75 million or less from the SOX 404(b) attestation requirement.  The SEC had exempted these firms from the requirement, but the exemption is scheduled to expire in 2011.

November 5, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

Wednesday, November 4, 2009

Merge Healthcare and Two Former Officers Settle SEC Accounting Fraud Charges

The SEC settled charges that Milwaukee-based Merge Healthcare Incorporated and two former senior executives engaged in an accounting fraud that ultimately caused the company's stock price to drop by two-thirds during a seven-month period.  The SEC alleges that former CEO Richard Linden and former CFO Scott Veech engineered a process where Merge, which is a provider of medical imaging software, hardware and services, improperly recognized revenue from sales that had not been fully completed with delivery of the software products, features or enhancements promised to customers.

The SEC further alleges that Linden, with Veech's knowledge, interfered with the audit confirmation process by instructing Merge sales personnel to tell some of Merge's customers not to disclose side agreements to Merge's outside auditor. Also, Linden signed at least 16 and Veech signed at least 14 false and misleading management representation letters to Merge's outside auditor.

According to the SEC's complaint, filed in federal court in Milwaukee, Merge prematurely recognized revenue from 124 transactions between 2002 and 2005, many of which involved Merge's promises to customers of "hanging protocols" that provide radiologists with the ability to rearrange the sequence and orientation of images. The SEC alleges that these fraudulent accounting practices caused Merge to overstate its net revenue by approximately 26 percent and overstate its net income by approximately 230 percent in annual and quarterly reports from its first quarter of 2002 through its second quarter of 2005. The accounting fraud ultimately cost the company more than $500 million in market capitalization.

Merge, Linden, and Veech each agreed to settle the SEC's charges without admitting or denying the allegations against them.  Under the settlement, Linden will pay a total of $590,000 and Veech will pay a total of $280,000. Linden and Veech are permanently enjoined from committing future violations of the antifraud provisions of the federal securities laws, and are barred from serving as an officer and director of a public company for five years. Additionally, Veech consented to the entry of an administrative order that suspends him from appearing or practicing before the Commission as an accountant, with a right to reapply after three years. Merge is permanently enjoined from future violations of the internal controls, books and records, and reporting provisions of the federal securities laws.

November 4, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Three Former Symbol Technologies Settle Accounting Fraud Charges

On November 2, 2009, the United States District Court for the Eastern District of New York entered final consent judgments against three defendants in the pending enforcement action against former executives of Symbol Technologies, Inc. ("Symbol"). The Commission's complaint, filed on June 3, 2004, alleges that from 1998 until early 2003, the defendants engaged in a fraudulent scheme to inflate revenue, earnings and other measures of financial performance in order to create the false appearance that Symbol had met or exceeded its financial projections.

Kenneth Jaeggi, Symbol's Chief Financial Officer, consented to entry of a judgment that requires him to disgorge a total $3,091,539, consisting of $2,274,935 in ill-gotten gains he obtained as a result of the conduct alleged in the complaint and $816,604 in prejudgment interest, and to pay a civil penalty of $250,000. The complaint alleges that Jaeggi: (i) spearheaded what was known within Symbol as the "Tango sheet" process, through which baseless accounting entries were made in order to conform the company's raw quarterly results to management's projections; (ii) engaged in channel stuffing and other revenue recognition schemes; and (iii) manipulated restructuring charges, operations reserves and inventory levels to boost reported earnings.

Christopher DeSantis, Symbol's former Vice President of Sales Finance, consented to entry of a judgment that requires him to pay a civil penalty of $40,000 (plus $1 of disgorgement. The complaint alleges that DeSantis carried out aspects of the channel stuffing scheme and other fraudulent revenue recognition practices, as well as the manipulation of reported inventory levels and accounts receivable data to conceal the adverse side effects of the revenue recognition schemes.

James Heuschneider, Symbol's former Director of Customer Service, consented to entry of a judgment that requires him to pay a civil penalty of $35,000 and to disgorge $3,587, consisting of $2,280 in ill-gotten gains as a result of the conduct alleged in the Commission's complaint and $1,307 in prejudgment interest. The complaint alleges that Heuschneider engaged in improper practices to overstate the customer service department's revenue and earnings.

November 4, 2009 in SEC Action | Permalink | Comments (1) | TrackBack (0)

SEC Charges Two Former J.P. Morgan Securities Officers in Alabama Illegal Payments Scheme

The SEC filed fraud charges against Charles E. LeCroy and Douglas W. MacFaddin, two former directors of J.P. Morgan Securities Inc. in connection with an unlawful payment scheme which allowed J.P. Morgan Securities to obtain $5 billion in Jefferson County, Alabama municipal bond offerings and swap agreement transactions.  J.P. Morgan Securities settled SEC charges and will pay a penalty of $25 million, make a payment of $50 million to Jefferson County, and forfeit more than $647 million in claimed termination fees.

The SEC alleged that between October 2002 and November 2003, LeCroy and MacFaddin directed over $8 million in payments from J.P. Morgan Securities to close friends of Jefferson County commissioners (County commissioners) who either owned or worked at local broker-dealers. These broker-dealers had no official role and performed few, if any, services on the transactions. In connection with these payments, according to the SEC’s complaint, the County commissioners voted to select J.P. Morgan Securities as managing underwriter and swap provider for the largest municipal auction rate securities and swap agreement transactions in J.P. Morgan Securities’ history.

The SEC’s complaint charges LeCroy and MacFaddin with violations of Section 17(a) of the Securities Act of 1933, Sections 10(b) and 15B(c)(1) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder, and Municipal Securities Rulemaking Board Rules G-17 and G-20. The SEC’s complaint seeks judgments against each defendant providing for permanent injunctions and disgorgement with prejudgment interest.

In April 2008, the SEC filed a civil action in the U.S. District Court for the Northern District of Alabama against Birmingham, Alabama Mayor Larry Langford (the former president of the Jefferson County commission); William B. Blount, chairman of Blount Parrish & Co, Inc., a broker-dealer based in Montgomery, Alabama; and registered lobbyist Albert LaPierre. The SEC's complaint alleged that while Langford served as president of the County Commission, he accepted more than $156,000 in undisclosed cash and benefits over the course of two years from Blount in exchange for Blount Parrish participating in every Jefferson County municipal bond offering and security-based swap agreement transaction during 2003 and 2004. Securities and Exchange Commission v. Larry P. Langford, William B. Blount, Blount Parrish & Co., Inc., and Albert W. LaPierre, Case No. Case No. cv-08-B-0761-S (N.D. Ala., filed April 30, 2008). This case was the SEC’s first enforcement action involving security-based swap agreements.

On December 1, 2008, the United States Attorney for the Northern District of Alabama filed criminal charges against Langford, Blount and LaPierre. The 101-count indictment charged Langford, Blount, and LaPierre with, among other charges, conspiracy, bribery, and money laundering in an alleged long-running bribery scheme related to Jefferson County bond transactions and swap agreements. United States of America v. Larry P. Langford, William B. Blount, and Albert W. LaPierre, (United States District Court for the Northern District of Alabama, Case No. 2:08-CR-00245-LSC-PWG). On July 30, 2009, LaPierre pled guilty to the charges of conspiracy and filing a false tax return, and agreed to forfeit $371,932 and pay back taxes. On August 18, 2009, Blount pled guilty to conspiracy and bribery and agreed to forfeit $1,000,000. On October 28, 2009, Langford was found guilty on 60 counts of bribery, mail fraud, wire fraud and tax evasion. All three currently await sentencing.

November 4, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Tuesday, November 3, 2009

Corp Fin Staff Release New Guidance on Shareholder Proposals related to Risk and Succession Planning

The Division of Corporation Finance staff recently issued Shareholder Proposals, Staff Legal Bulletin No. 14E (CF), providing information regarding staff changes of position on two issues: the application of Rule 14a-8(i)(7) to proposals relating to risk; and the application of Rule 14a-8(i)(7) to proposals focusing on succession planning for a company's chief executive officer (CEO).

Proposals related to risk:

"On a going-forward basis, rather than focusing on whether a proposal and supporting statement relate to the company engaging in an evaluation of risk, we will instead focus on the subject matter to which the risk pertains or that gives rise to the risk. The fact that a proposal would require an evaluation of risk will not be dispositive of whether the proposal may be excluded under Rule 14a-8(i)(7). Instead, similar to the way in which we analyze proposals asking for the preparation of a report, the formation of a committee or the inclusion of disclosure in a Commission-prescribed document — where we look to the underlying subject matter of the report, committee or disclosure to determine whether the proposal relates to ordinary business — we will consider whether the underlying subject matter of the risk evaluation involves a matter of ordinary business to the company. In those cases in which a proposal's underlying subject matter transcends the day-to-day business matters of the company and raises policy issues so significant that it would be appropriate for a shareholder vote, the proposal generally will not be excludable under Rule 14a-8(i)(7) as long as a sufficient nexus exists between the nature of the proposal and the company. Conversely, in those cases in which a proposal's underlying subject matter involves an ordinary business matter to the company, the proposal generally will be excludable under Rule 14a-8(i)(7). In determining whether the subject matter raises significant policy issues and has a sufficient nexus to the company, as described above, we will apply the same standards that we apply to other types of proposals under Rule 14a-8(i)(7).

"In addition, we note that there is widespread recognition that the board's role in the oversight of a company's management of risk is a significant policy matter regarding the governance of the corporation. In light of this recognition, a proposal that focuses on the board's role in the oversight of a company's management of risk may transcend the day-to-day business matters of a company and raise policy issues so significant that it would be appropriate for a shareholder vote."

Succession Planning:

"One of the board's key functions is to provide for succession planning so that the company is not adversely affected due to a vacancy in leadership. Recent events have underscored the importance of this board function to the governance of the corporation. We now recognize that CEO succession planning raises a significant policy issue regarding the governance of the corporation that transcends the day-to-day business matter of managing the workforce. As such, we have reviewed our position on CEO succession planning proposals and have determined to modify our treatment of such proposals. Going forward, we will take the view that a company generally may not rely on Rule 14a-8(i)(7) to exclude a proposal that focuses on CEO succession planning.


November 3, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Investment Advisors Resist FINRA Oversight

The investment advisory community continues its opposition to FINRA's assuming oversight over investment advisors.  Investment News reports that industry leaders have expressed opposition to an amendment to the Investor Protection draft legislation that would give the SEC the authority to delegate oversight of investment advisors to FINRA.  NASAA has also expressed concern over possible dilution of the fiduciary standard.  InvNews,  Power play: Advisory industry pressing to halt expansion of Finra's oversight

November 3, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

Madoff's Accountant Pleads Guilty and Settles SEC Charges

Bernard Madoff's accountant, David Friehling, pleaded guilty to nine criminal counts today in federal district court in Manhattan, which carry a maximum sentence of 114 years.  NYTimes, Madoff’s Accountant Pleads Guilty in Scheme.

In addition, the SEC announced that Friehling and the SEC agreed to a proposed partial settlement of SEC charges.  On November 3, 2009, the SEC submitted to the Honorable Judge Louis L. Stanton, a federal judge in the Southern District of New York, the consents of David G. Friehling and Friehling & Horowitz, CPA'S, P.C. ("F&H") to a proposed partial judgment imposing permanent injunctions against them. Friehling and F&H consented to the partial judgment without admitting or denying the allegations of the SEC's complaint, filed on March 19, 2009. If the partial judgment is entered by the Court, the permanent injunction will restrain Friehling and F&H from violating certain antifraud provisions of the federal securities laws.

The proposed partial judgment would leave the issues of the amount of disgorgement, prejudgment interest and civil penalty to be imposed against Friehling and F&H to be decided at a later time. For purposes of determining Friehling's and F&H's obligations to pay disgorgement, prejudgment interest and/or a civil penalty, the proposed partial judgment precludes Friehling and F&H from arguing that they did not violate the federal securities laws as alleged in the Complaint.

November 3, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)