Thursday, October 27, 2011
Judge Jed Rakoff is, once again, asking tough questions about a proposed SEC settlement. This time it's the agency's $285 settlement with Citigroup involving allegedly misleading CDOs. Before he agrees to the settlement, he again questions the common practice of allowing defendants charged with serious securities fraud to neither admit nor deny wrongdoing. He also wants the SEC to explain why proposed penalty ($95 million of the settlement) is considerably less than the $535 million penalty imposed on Goldman Sachs last year in a settlement involving a complex financial instrument called Abacus, and why the penalty is being paid by the corporation (and its shareholders) and not the culpable individuals. A hearing on the proposed settlement is set for Nov. 9.
Yesterday the SEC voted unanimously to adopt a new rule requiring certain advisers to hedge funds and other private funds to report information for use by the Financial Stability Oversight Council (FSOC) in monitoring risks to the U.S. financial system. The rule, which implements Sections 404 and 406 of the Dodd-Frank Act, requires SEC-registered investment advisers with at least $150 million in private fund assets under management to periodically file a new reporting form (Form PF).
Information reported on Form PF will remain confidential.
Private fund advisers are divided by size into two broad groups – large advisers and smaller advisers. The amount of information reported and the frequency of reporting depends on the group to which the adviser belongs. The SEC anticipates that most private fund advisers will be regarded as smaller private fund advisers, but that the relatively limited number of large advisers providing more detailed information will represent a substantial portion of industry assets under management. As a result, these thresholds will allow FSOC to monitor a significant portion of private fund assets while reducing the reporting burden for private fund advisers.
There will be a two-stage phase-in period for compliance with Form PF filing requirements. Most private fund advisers will be required to begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after Dec. 15, 2012. Those with $5 billion or more in private fund assets must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after June 15, 2012.
The SEC ordered FINRA to hire an independent consultant and undertake other remedial measures to improve its policies, procedures, and training for producing documents during SEC inspections. The SEC found that certain documents requested by the SEC’s Chicago Regional Office during a 2008 inspection were altered just hours before FINRA’s Kansas City District Office provided them. According to the SEC’s order, the production of the altered documents by the Kansas City District Office was the third instance during an eight-year period in which an employee of FINRA or its predecessor (National Association of Securities Dealers) provided altered or misleading documents to the SEC.
FINRA has consented to engage an independent consultant within 30 days that will:
- Conduct a one-time comprehensive review of FINRA’s policies and procedures and training relating to document integrity.
- Assess whether the policies and procedures and training are reasonably designed and implemented to ensure the integrity of documents provided to the SEC.
- Make recommendations for the enhancement of FINRA’s policies and procedures and training as may be necessary in light of the consultant’s review and assessment.
The Financial Industry Regulatory Authority (FINRA) today issued the following statement from Richard Ketchum, FINRA Chairman and Chief Executive Officer:
"As a regulator, FINRA must always hold itself to the highest standards. When we discover shortcomings, it is our obligation to take appropriate corrective action and make it clear that we have zero tolerance for actions that could compromise the integrity of our organization. We self-reported the Kansas City matter to the SEC and have fully cooperated with the agency's review. Following our own internal review we took decisive action, including appointing new leadership in our Kansas City office and instituting a number of changes that strengthened document-handling procedures across the organization. These strengthened procedures include additional online and live ethics training for all employees with an enhanced focus on document handling and integrity. An independent consultant will review these changes to determine if further improvements are warranted.
I am personally committed to taking all possible steps to ensure that this type of conduct does not reoccur. We have taken prompt action to report, investigate and discipline the behavior at issue in this matter. Under no circumstances will such conduct be tolerated at FINRA."
An investor in a Madoff-feeder fund managed by J. Ezra Merkin recently won a $7 million arbitration award in a AAA proceeding (Straus v. Merkin, 13-148-Y-001800-10 Oct. 12, 2011DownloadARBITRAL AWARD V EZRA MERKIN) and seeks to confirm the award in New York Supreme Court. In a reasoned award, the majority of the panel found that Merkin was liable for material misstatements and omissions under the New Jersey Securities Act. Specifically, Merkin did not disclose to this investor (although he did to many others) that the fund was nothing more than a feeder fund for Madoff. Instead, the documentation at the time of the investment represented that Merkin determined the investment strategy. In addition, the panel found that, over their nine-year association, Straus and Merkin had no discussions about the true nature of the investment and that Straus did not learn of other information that should have alerted him to the extent of Madoff's involvement.
What is particularly interesting about the award is that the majority addresses a Sept. 23, 2011 decision from the S.D.N.Y. (In Re Merkin and BDO Seidman Securities Litig.) that found no violation of Rule 10b-5 on similar allegations. Judge Batts determined that there had been insufficient allegations of a material misstatement or omission in the context of the broad discretion in the agreement to use other fund managers. "The answer to Respondent's assertion that Judge Batts' determination warrants a dismissal of the claim before this Panel is that the majority disagrees with Judge Batts' conclusions." While the arbitration award was based on state securities law, "where [the issues] coincide, the majority respectfully disagrees with her conclusion."
Another good example where arbitration can result in a decision that is more pro-investor than would be achieved in court.
Wednesday, October 26, 2011
Well worth reading over at ProPublica: Jesse Eisinger's Why the SEC Won’t Hunt Big Dogs , a blistering critique of the SEC's recent $285 million settlement with Citigroup over misleading investors by selling a CDO created out of mortgage securities junk.
At its open meeting on Oct. 26, the Commission adopted a joint SEC/CFTC form (Form PF) to collect critical systemic risk data about hedge funds and other private funds. This private fund data collection is mandated by Dodd-Frank and is intended to assist the Financial Stability Oversight Council.
See SEC Chairman Schapiro's Opening Statement.
The SEC charged a pair of purported money managers with orchestrating an illegal “free-riding” scheme of selling stocks before they paid for them and netting $600,000 in illicit profits. According to the SEC, Scott Kupersmith and Frederick Chelly portrayed themselves to broker-dealers as money managers for hedge funds or private investors, and they opened brokerage accounts in the names of purported investment funds they created. Kupersmith and Chelly then engaged in illegal free-riding by interchangeably buying and selling the same quantity of the same stock in different accounts – frequently on the same day – with the intention of profiting on swings up or down in the stock price. However, Kupersmith and Chelly did not have sufficient securities or cash on hand to cover the trades, and they instead used proceeds from stock sales in one brokerage account to pay for the purchase of the same stock in another brokerage account.
The SEC alleges that when trades were profitable, Kupersmith and Chelly took the profits. But when the trades threatened to result in substantial losses, Kupersmith and Chelly failed to cover their sales and left broker-dealers to settle the trades at a significant loss. In total, their brokers suffered more than $2 million in losing trades.
In parallel actions, the U.S. Attorney’s Office for the District of New Jersey and the Manhattan District Attorney’s Office today announced the unsealing of criminal charges against Kupersmith.
The SEC obtained an asset freeze against a Boston-area money manager and his investment advisory firm charged with misleading investors in a supposed quantitative hedge fund and diverting portions of investor money into his personal bank account. According to the SEC, Andrey C. Hicks and Locust Offshore Management LLC made false representations to create an aura of legitimacy when soliciting individuals to invest in a purported billion dollar hedge fund that Hicks controlled called Locust Offshore Fund Ltd. Hicks raised at least $1.7 million from several investors for the hedge fund. Among the false claims made to investors were that Hicks obtained undergraduate and graduate degrees at Harvard University, and that he previously worked for Barclays Capital, and that the hedge fund held more than $1.2 billion in assets.
And the other shoe has dropped. Both the DOJ and the SEC have brought insider trading charges against Rajat K. Gupta, a former director of Goldman Sachs and Procter & Gamble, who allegedly provided Raj Rajaratnam with confidential inside information about Goldman Sachs. A federal grand jury charged Gupta with one count of conspiracy to commit securities fraud and five counts of securities fraud. The SEC filed a civil complaint alleging an "extensive insider trading scheme" and also filed new insider trading charges against Rajaratnam. The allegations all relate to inside information involving both Goldman and P&G.
Gupta was named as an unindicted co-conspirator in the Rajaratnam case. It is not clear how strong the government's case is, because, at least at the Rajaratnam trial, there were no tapes of phone conversations from Gupta, only phone calls between Rajaratnam and others that appear to refer to Gupta (i.e., hearsay).
The SEC previously brought an administrative proceeding against Gupta, which was dismissed because Judge Rakoff believed that the SEC's decision to bring an administrative proceeding against Gupta while bringing judicial proceedings against other Rajaratnam defendants was disciminatory. The dismissal was without prejudice to bring a judicial proceeding.
SEC Press Release
Tuesday, October 25, 2011
The Wall St. Journal reports that FINRA has, over a period of nine years, made numerous reports to the SEC about its concerns over hedge fund SAC Capital Advisors' trading activities, detailing in confidential reports that the firm may have profited from inside information. To date, the SEC has not taken any public action against SAC related to the referrals, although it has been previously reported that regulators are examining whether SAC improperly benefited from two takeovers.
To keep it in context, the WSJ points out that in the two years ended Sept. 2010, the SEC received 721 referrals about potential insider trading from SROs. The SEC launched 90 insider-trading enforcement actions in the same time period.
NASAA announced the formation of a committee to examine and propose steps that state securities regulators can take to help small and new businesses raise investment capital and went on record as opposed to a "crowdfunding" bill that has been introduced in Congress that would preempt state regulation. NASAA President Herstein said the committee is expected to report specific recommendations to NASAA’s Board by early next year regarding crowdfunding and other small business capital formation initiatives.
The announcement of the new NASAA committee comes as the House Financial Services Committee is considering measures to stimulate the economy and promote job creation. On October 26, the Committee is scheduled to vote on one proposal, the Entrepreneur Access to Capital Act, H.R. 2930. This bill would deregulate crowdfunding by removing basic federal and state registration filing requirements and would allow businesses to raise up to $5 million from an unlimited number of investors through a crowdfunded offering.
“By prohibiting state securities regulators from being notified and reviewing investment opportunities before they are offered to the public, this bill will weaken investor protection,” Herstein said of H.R. 2930. “Con artists will undoubtedly flock to crowdfunding websites, lured both by the increased dollar amount of investments and the fact that a tough cop has been taken off the beat.”
In an October 21 letter, Herstein urged the Financial Services Committee’s leadership not to take a “rash and premature action” by enacting a blanket federal preemption of the authority of the states to protect their constituents by regulating crowdfunding.
“State securities administrators share the Committee’s goal of promoting small business capital formation and job-growth, including exploring the establishment of a framework that might facilitate the harnessing of investment capital online through techniques like crowdfunding,” Herstein wrote. “At the same time, NASAA believes it is vital that any such framework be crafted carefully and deliberately, as the potential for fraud in this area is real and potentially enormous.”
“Preempting state authority is a very serious step and not something that should ever be undertaken lightly or without careful consideration, including a thorough examination of all available alternatives,” Herstein said. “In the case of crowdfunding, state securities regulators are not only capable of acting, but indeed, are acting, and Congress should allow them the opportunity to continue to protect retail investors from the risks associated with smaller, speculative investments.”
FINRA announced that it fined UBS Securities LLC $12 million for violating Regulation SHO (Reg SHO) and failing to properly supervise short sales of securities. As a result of these violations, millions of short sale orders were mismarked and/or placed to the market without reasonable grounds to believe that the securities could be borrowed and delivered. Reg SHO requires a broker-dealer to have reasonable grounds to believe that the security could be borrowed and available for delivery before accepting or effecting a short sale order.In addition, Reg SHO requires a broker-dealer to mark sales of equity securities as long or short.
FINRA found that UBS' Reg SHO supervisory system regarding locates and the marking of sale orders was significantly flawed and resulted in a systemic supervisory failure that contributed to serious Reg SHO failures across its equities trading business. First, FINRA found that UBS placed millions of short sale orders to the market without locates, including in securities that were known to be hard to borrow. These locate violations extended to numerous trading systems, desks, accounts and strategies, and impacted UBS' technology, operations, and supervisory systems and procedures. Second, FINRA found that UBS mismarked millions of sale orders in its trading systems. Many of these mismarked orders were short sales that were mismarked as "long," resulting in additional significant violations of Reg SHO's locate requirement. Third, FINRA found that UBS had significant deficiencies related to its aggregation units that may have contributed to additional significant order-marking and locate violations.
As a result of its supervisory failures, many of UBS' violations were not detected or corrected until after FINRA's investigation caused UBS to conduct a substantive review of its systems and monitoring procedures for Reg SHO compliance. FINRA found that UBS' supervisory framework over its equities trading business was not reasonably designed to achieve compliance with the requirements of Reg SHO and other securities laws, rules and regulations until at least 2009.
Monday, October 24, 2011
The SEC announced a proposed settlement with Koss Corporation (“Koss”) and Michael J. Koss, its CEO and former CFO, based on Koss Corporation’s preparation of materially inaccurate financial statements, book and records, and lack of adequate internal controls from fiscal years 2005 through 2009. During this period, Sujata Sachdeva (“Sachdeva”), Koss’s former Principal Accounting Officer, Secretary, and Vice-President of Finance, and Julie Mulvaney (“Mulvaney”), Koss’s former Senior Accountant, engaged in a wide-ranging accounting fraud to cover up Sachdeva’s embezzlement of over $30 million from Koss.
Koss and Michael J. Koss have consented to the entry of an injunctive order without admitting or denying the allegations in the Commission’s complaint. The proposed order would order Michael J. Koss to reimburse Koss $242,419 in cash and 160,000 of options pursuant to Section 304 of the Sarbanes-Oxley Act. This bonus reimbursement, together with his previous voluntary reimbursement of $208,895 in bonuses to Koss Corporation represents his entire fiscal year 2008, 2009 and 2010 incentive bonuses.
The SEC settled charges that Pipeline Trading Systems LLC and two of its top executives failed to disclose to customers of Pipeline’s “dark pool” trading platform that the vast majority of orders were filled by a trading operation affiliated with Pipeline. Pipeline agreed to pay a $1 million penalty to settle the matter. Pipeline’s founder and chief executive officer, Fred J. Federspiel, and its chairman and former chief executive, Alfred R. Berkeley III, a former president and vice chairman of the NASDAQ Stock Market, each agreed to pay $100,000.
New York-based Pipeline was launched in 2004 as an SEC-registered alternative trading system, a privately operated platform to trade securities outside of traditional exchanges. Alternative trading systems that display little or no information about customer orders are known as “dark pools.” Institutional investors use these venues to hide their trading intentions from others and avoid moving the market with large orders to buy or sell stock.
According to the SEC’s order, Pipeline described its trading platform as a “crossing network” that matched customer orders with those from other customers, providing “natural liquidity.”
Pipeline’s claims were false and misleading because its parent company owned a trading entity that filled the vast majority of customer orders on Pipeline’s system, the SEC found. It said the affiliate, most recently known as Milstream Strategy Group LLC, sought to predict the trading intentions of Pipeline’s customers and trade elsewhere in the same direction as customers before filling their orders on Pipeline’s platform. The SEC’s order found that Pipeline generally did not provide the “natural liquidity” it advertised.
Pipeline took certain steps to address the conflict of interest it created, including by paying the affiliate’s traders using a formula that rewarded them in part for giving favorable prices to Pipeline’s customers. The SEC’s order found that Pipeline failed to disclose the compensation formula or Milstream’s activities to its customers or in its filings to the SEC.
The New York Attorney General and the SEC both announced that they had settled investigations into Banco Espírito Santo S.A. (BES), a Portuguese bank, for the same alleged conduct. According to the New York AG, BES and its affiliates solicited the sale of securities to BES’s U.S. customers between 2004-2009 without registering itself or any of its affiliates as a securities broker-dealers or investment advisers, or any of their employees as salesmen, as required under New York’s Martin Act. Similarly, the SEC's proceeding found that BES offered brokerage services and investment advice to U.S.-resident customers and clients who were primarily Portuguese immigrants. However, during this time, BES was not registered with the SEC as a broker-dealer or investment adviser, and it offered and sold securities to its U.S. customers and clients without the intermediation of a registered broker-dealer. None of these securities transactions was registered and many of the securities offerings did not qualify for an exemption from registration.
Under the agreement with the AG, BES will cease and desist from any further violations of the Martin Act and Executive Law § 63(12), offer to make its customers whole for all securities it unlawfully sold them, disgorge all profits derived from its unlawful conduct, and pay $975,000 to the State of New York in penalties, fees and costs.
Under the SEC order, BES agreed to cease and desist from committing or causing any violations of Sections 5(a) and 5(c) of the Securities Act, Section 15(a) of the Exchange Act, and Section 203(a) of the Advisers Act, and to pay nearly $7 million in disgorgement, prejudgment interest and penalties. BES also has agreed to an undertaking that requires it to pay a certain minimum rate of interest to its U.S. customers and clients on securities purchased through BES, and to make whole each of its U.S. customers and clients for any realized or unrealized losses with respect to any securities purchased through BES.
Both regulators credited BES for self-reporting the findings of an internal investigation performed by its outside counsel and cooperating with the investigations.
The U.S. Department of Labor's Employee Benefits Security Administration today issued a final regulation that is intended to improve workers' access to quality fiduciary investment advice. The regulation implements a prohibited transaction exemption under an amendment to the Employee Retirement Income Security Act and the Internal Revenue Code that is part of the Pension Protection Act of 2006.
The prohibited transaction rules in ERISA and the IRC generally prevent a fiduciary investment adviser from recommending plan investment options if the adviser receives additional fees from the investment providers. Although these rules protect participants from conflicts of interest, ERISA permits the department to grant exemptions that have participant-protective conditions. To qualify for the exemption in the final regulation, investment advice must be given through the use of a computer model that is certified as unbiased by an independent expert or through an adviser compensated on a "level-fee" basis, meaning that the fees do not vary based on investments selected. Both types of arrangements must also satisfy several other conditions, including the disclosure of the adviser's fees and an annual audit of the arrangement for compliance with the regulation.
This regulation is separate from and does not affect the Labor Department's proposed rule on the definition of fiduciary investment advice, which the department recently announced that it will re-propose.
New York's Highest Court Will Address Investors' Claims for Breach of Fiduciary Duty and Gross Neligence
An important, unresolved question in New York state investor protection law is whether common-law causes of action for breach of fiduciary duty and gross negligence are preempted by the state's Martin Act, which authorizes the Attorney General to investigate and enjoin fraudulent practices in the marketing of stocks, bonds and other securities within or from New York State. The New York Court of Appeals will hear oral argument on this question on November 15 in Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., 915 N.Y.S.2d 7 (App. Div. 1st Dept. 2010). This post provides background on the issue.
A majority of the federal courts in the Southern District of New York have, in recent years, held that, except for fraud, the Martin Act forecloses any private common-law causes of action. In 2010, however, Judge Victor Marrero, in a scholarly analysis of the history of the Martin Act and the preemption doctrine, held that the Martin Act did not preclude any private common law causes of action, in Anwar v. Fairfield Greenwich Limited, 728 F. Supp.2d 354 (S.D.N.Y. 2010). Although the judge acknowledged that a significant body of case law (much of it from the S.D.N.Y.) found a preemptive reading of the Martin Act, in his opinion, better reasoned and more persuasive authority, including the New York Attorney General, rejected that view.
Since then, New York's Supreme Court, Appellate Division, First Dept. addressed the issue in Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc. and also concluded that common-law causes of action for breach of fiduciary duty and gross negligence are not preempted by the Martin Act, In reaching this conclusion, the First Department quoted Judge Marrero's "cogent and forceful" argument that to find Martin Act preemption would "leave [ ] the marketplace arguably less protected than it was before the Martin Act's passage, which can hardly have been the goal of its drafters." The court also relied on the New York Attorney General's amicus brief that argued that "the purpose or design of the Martin Act is in no way impaired by private common-law claims that exist independently of the statute, since statutory actions by the Attorney General and private common-law actions both further the same goal, namely, combating fraud and deception in securities transactions."
The First Department now joins the Second Department and the Fourth Department in rejecting the argument that the Martin Act preempts properly pleaded common-law causes of action.
We will report further on the case after the November 15 oral argument.
Sunday, October 23, 2011
On November 1, the Ohio Supreme Court will hear oral argument in an important case that deals with the power of the Ohio Division of Securities to recover ill-gotten gains on behalf of defrauded investors. The lower court's opinion is Zurz v. Mayhew (2d Dist. Ct. App. Oct. 29, 2010).
Roy Dillabaugh ran a Ponzi scheme that bilked about 150 investors in Ohio and Indiana out of over $12 million. He purchased at least 34 life insurance policies that named his wife, son and secretary as beneficiaries. Before committing suicide, he left instructions to the beneficiaries telling them to use the insurance proceeds to repay his victims. They chose not to do so, however, and his wife was recipient of over $6.5 million. The Securities Division sued the beneficiaries in order to freeze the funds until a receiver could be appointed. The trial court ultimately held that the Division could compel the beneficiaries to return only the amount of the premiums and not the proceeds of the policies.
Upon appeal, the appellate court dealt a harder blow to the Division and held that it could not sue the beneficiaries at all, ruling that the state statute RC 1707.26 allows the Division only to sue those enumerated in the statute, i.e., the alleged violators of the statute and their "agents, employees, partners, officers, directors and shareholders." The court rejected the Division's reliance on the last clause in the statute, which allows it to seek "such other equitable relief as the facts warrant," stating that the clause did not expand the range of defendants.
On appeal, the Division makes two arguments. First, the appellate court erroneously reached an issue that was not before the court, since the defendants had not challenged the grant of temporary injunctive relief. Second, and most important, the appellate court's restrictive reading of the statute, if allowed to stand, creates a significant obstacle in the Division's power to act quickly to protect investors.
Of Complicity and Compliance: A Rules-Based Anti-Complicity Strategy Under Federal Securities Law, by Joseph A. Franco, Suffolk University Law School, was recently posted on SSRN. Here is the abstract:
Most policy analyses aimed at deterring complicity in securities law violations implicitly assume that a standards-based regime (such as liability standards for aiding and abetting) represents the best strategy for accomplishing that objective. Moreover, many commentators regard the restoration of private damage remedies against complicit secondary actors as essential to the success of any anti-complicity regime. These concerns are linked to the Supreme Court’s Central Bank trilogy – Central Bank, Stoneridge Investment Partners and Janus Capital Corp. – decisions that mechanically constrain a principled understanding of the relationship between primary and secondary liability standards. This article offers a fundamentally different policy approach in thinking about the problem of complicity in securities violations. It uses the concept of anti-complicity policies – i.e., policies designed to deter secondary participants from providing assistance to, or to make such participants accountable in monitoring or preventing, more fundamental forms of misconduct – as a rubric to compare the effectiveness of two different classes of strategies: standards-based policies and rules-based policies. The article then argues that enforcement objectives would be better served by refocusing anti-complicity policies on a rules-based regime. First, a rules-based regime may be more effective in a wide variety of contexts than a standards-based regime. Second, while a rules-based regime is not inconsistent with private liability for aiding and abetting, the combination of publicly-enforced standards and robust anti-complicity rules may be more socially efficient than a regime that relies almost exclusively on public sanctions and private remedies for aiding and abetting. Third, a rules-based regime (even if not explicitly conceived of as such) has already begun taking shape within federal securities law on an ad hoc basis that gives some sense of the potential feasibility of a more robust rules-based approach. This article acknowledges two significant caveats. It does not recommend eliminating anti-complicity standards (such as aiding and abetting principles) because such standards provide a powerful and necessary backstop to the inevitable gaps and interstices of a rules-based regime. Furthermore, the article does not argue that the emerging use of rules-based strategies has produced a fully adequate anti-complicity regime. Instead, the article urges continued movement toward a more robust rules-based anti-complicity regime, a result that at a minimum would require a much broader grant of rulemaking authority to the SEC.