Securities Law Prof Blog

New York AG Sues Schwab over ARS

Attorney General Andrew M. Cuomo today filed a lawsuit against Charles Schwab & Co. (“Schwab”) charging the discount brokerage firm for falsely representing auction rate securities as liquid, short-term investments without discussing the risks. According to the Attorney General, Schwab brokers repeatedly and persistently misrepresented the liquidity risks in auction rate securities, comparing them to money market funds or certificates of deposit, selling auction rates as suitable for cash management purposes, or otherwise telling customers they would always be able to retrieve their cash.

The Attorney General referred to audio recordings obtained during the investigation that allegedly confirm that Schwab brokers repeatedly misled investors about the risks of investing in auction rate securities. One Schwab broker “guaranteed” that his customer would be able to “get out of [his auction rate security] on the auction date.” Another assured a customer that she just needed to “call me … and then the next month I’ll stop the auction and all the cash [invested in auction rate securities] will come back to your account.” Another Schwab broker described preferred auction rate securities as a “short-term institutional holding instrument” that was particularly suitable for managing the customer’s cash balances:

If you need to have that access to them at any time, that’s a good place for those to be. You know if you think you might need to get into that money, that’s probably as good a place if not better than anywhere to leave them.

Another broker represented that the hardest part of investing in an auction rate security “is getting into it. That would be the tough part. I mean, getting out is something as easy as just selling it.”

According to the Attorney General, while Schwab publicly touted its “extensive fixed-income research,” “expertise” and “seasoned bond traders, who have an average of 15 years of industry experience,” Schwab’s persistent fraud was possible because Schwab failed to train or otherwise ensure that its brokers had even a basic understanding of auction rate securities. Brokers interviewed during the investigation all confirmed that they received no formal training from Schwab relating to auction rate securities. As a result, many Schwab brokers misunderstood or knew little about the auction rate securities they were selling to Schwab’s customers. While Schwab sold customers on its fixed income “expertise,” one broker stated: “I don’t know what measuring scale you would want to use to assess my knowledge about auction rate securities … but on whatever measuring scale my knowledge was pretty low.” The lack of training and understanding at Schwab proved devastating to Schwab’s customers. When one broker was asked if his customers adequately understood the risks of auction rate securities, the broker replied: “No. . . . They probably didn’t know that here is a product you might not be able to sell. It wasn’t conveyed by myself or the financial consultant because we didn’t know either.” Just one week before the auction rate securities market collapsed, during a call with another broker-dealer, one Schwab broker still did not understand the risks that were about to haunt Schwab’s customers, asking “how could an auction fail?”

Today’s action seeks, among other things, to compel Schwab to buy-back auction rate securities from the Schwab investors still holding illiquid securities, penalties, costs, disgorgement, restitution, and other equitable relief.

Here is the complaint.

New York AG Announces Two More Assurances of Discontinuance in ARS Settlements

The New York Attorney General announced Assurances of Discontinuance with Credit Suisse Securities LLC and Merrill Lynch, Pierce, Fenner & Smith Incorporated relating to the auction rate securities settlements reached last summer. The Assurances detail how the firms have and will continue to provide liquidity to investors who purchased auction rate securities.  Last year the New York AG and other regulators settled allegations with eleven securities firms that theymade misrepresentations in their marketing and sale of auction rate securities.  The New York AG's website has posted the eleven Assurances. The settling firms are Banc of America Securities LLC and Banc of America Investment Services, Inc., Citigroup Global Markets, Inc., Credit Suisse Securities (USA) LLC, Deutsche Bank Securities Inc., Goldman, Sachs & Co., JPMorgan Chase & Co., Merrill Lynch, Pierce, Fenner & Smith Incorporated, Morgan Stanley & Co. Inc., RBC Capital Markets Corporation, UBS Securities LLC and UBS Financial Services LLC, and Wachovia Securities LLC and Wachovia Capital Markets LLC.

BofA, RBC & Deutsche Bank Finalize ARS Settlements with SEC & New York

The SEC today announced finalized settlements with Bank of America, RBC Capital Markets, and Deutsche Bank to resolve SEC charges that the firms misled investors regarding the liquidity risks associated with auction rate securities (ARS) that they underwrote, marketed, or sold.  These settlements provide nearly $6.7 billion to approximately 9,600 customers who invested in ARS before the market for those securities froze in February 2008. 

Previous ARS settlements include Wachovia, Citigroup and UBS and a settlement in principle with Merrill Lynch.

In addition, New York Attorney General Andrew M. Cuomo today announced Assurances of Discontinuance with Banc of America Securities LLC and Banc of America Investment Services, Inc., Deutsche Bank Securities Inc., Goldman, Sachs & Co., JPMorgan Chase & Co., Morgan Stanley & Co. Inc. and RBC Capital Markets Corporation relating to the auction rate securities settlements reached last summer. The Assurances detail how the firms have and will continue to provide liquidity to investors who purchased auction rate securities.

The settlements, which are subject to court approval, will restore approximately $4.5 billion in liquidity to Bank of America customers, $800 million in liquidity to RBC customers, and $1.3 billion in liquidity to Deutsche Bank customers.

Without admitting or denying the SEC's allegations, Bank of America, RBC and Deutsche Bank agreed to be permanently enjoined from violations of the broker-dealer fraud provisions and to comply with a number of undertakings, some of which are set forth below.

• Each firm will offer to purchase ARS at par from individuals, charities, and small or medium businesses that purchased those ARS from the firm, even if those customers moved their accounts.
• Each firm will use its best efforts to provide liquidity solutions for institutional and other customers and will not take advantage of liquidity solutions for its own inventory before making those solutions available to these customers.
• Each firm will pay eligible customers who sold their ARS below par the difference between par and the sale price of the ARS.

The Commission wishes to alert investors that, in most instances, they have received or will receive correspondence from Bank of America, RBC, and Deutsche Bank, and that they must advise the respective firm that they elect to participate in these settlements, or they could lose their rights to sell their ARS. If eligible customers incurred consequential damages because of the illiquidity of their ARS, they may participate in special FINRA arbitrations.

Investors should review the full text of the consents executed by Bank of America, RBC and Deutsche Bank. Customers with questions about these settlements may contact Bank of America, RBC, or Deutsche Bank through the firms' Web sites or at the following toll-free telephone numbers:

• Bank of America: 1-866-638-4183
• RBC: 1-866-876-5469 or Web site
• Deutsche Bank: 1-866-926-1437

Bank of America, RBC and Deutsche Bank also will be permanently enjoined from violating the provisions of Section 15(c) of the Exchange Act of 1934, which prohibit the use of manipulative or deceptive devices by broker-dealers. The Commission reserves the right to seek a financial penalty

Connecticut Plans to Regulate Hedge Fund Managers

Tired of waiting for the federal government to regulate hedge funds, Connecticut, home to many hedge funds, may enact legislation requiring fund managers that have not registered with the SEC as investment advisers to disclose material conflicts of interest.  The legislation, which would apply to funds located or doing business in the state, has passed the Senate and is pending in the House.  WSJ, Can Connecticut Stay Hedge-Fund Haven?

New York AG's Statement on Code of Conduct for Pension Fund Industry

STATEMENT FROM ATTORNEY GENERAL ANDREW CUOMO ON COMPTROLLER THOMPSON'S DECISION TO URGE NYC PENSION FUNDS TO ADOPT REFORM CODE OF CONDUCT
"I commend Comptroller Bill Thompson for his quick and decisive action in asking that the City pension funds adopt the principles in the Code of Conduct we have developed in our pension fund investigation. The public pension fund industry is badly in need of reform and it is high time we ended pay to play. I appreciate Comptroller Thompson's commitment to doing his part to promote needed reforms like banning the use of placement agents and eliminating campaign contributions to those who make or influence pension fund investment decisions. My hope is that our Code of Conduct will become a model for reform and Comptroller Thompson's action is yet another step in that direction."

Cuomo and Other States Form Task Force on Pension Fund Abuse

New York Attorney General Andrew Cuomo announced the creation of a multi-state task force to explore pension fund abuse so that states can share information to prosecute wrongdoing and facilitate nationwide reform. 

His office also announced that it has issued subpoenas to over 100 investment firms and their agents in its expanding investigation into corruption and kickback schemes involving the New York State and City pension funds. Today’s announcement stems from the Attorney General’s broadening investigation into individuals and companies who make or receive improper payments in connection with lucrative business opportunities with state and city pension funds. Under state and federal law, securities brokers are generally required to be licensed and registered with a broker-dealer in order to protect the investing public from unscrupulous and unqualified brokers. In occasional cases, a registered broker is not required. But, after Cuomo’s investigation found that 40 to 50 percent of agents obtaining investments from New York pension funds were unregistered, his Office issued subpoenas. 

NASAA President Testifies on Life Settlement Fraud

State securities regulators continue to see problems of fraud and abuse in the growing life settlement industry and outlined for Congress the need for strong regulation of these financial products by appropriate regulatory authorities, NASAA President and Colorado Securities Commissioner Fred Joseph told the U.S. Senate Special Committee on Aging in a hearing exploring the life settlement industry and its impact on seniors.  “Thousands of investors, many of them senior citizens, have been victimized through fraud and abuse in the sale of viaticals and life settlements,” Joseph testified. “Notwithstanding substantial successes by securities regulators in their enforcement actions, and higher standards among some industry participants, abuses continue and diligent oversight of these products remains necessary.”
 

Joseph told the panel that effective regulation of life settlements requires a joint effort by securities and insurance regulators. “Life settlements are complex financial arrangements, involving both securities and insurance transactions,” he said. “Consequently, regulating them effectively requires a joint effort by securities and insurance regulators, each applying their laws and expertise to different aspects of the product.”
   

New York AG Charges Madoff Feeder Funds with Fraud

New York Attorney General Andrew M. Cuomo today announced charges against J. Ezra Merkin and the funds he controlled for violating New York’s Martin Act by concealing from his clients the investment of more than $2.4 billion with Bernard L. Madoff.  In a 54-page complaint filed in New York State Supreme Court, Cuomo alleges that investors, including several prominent charities and non-profits, entrusted their investments to Merkin, who then steered the money to Madoff without their permission, in exchange for $470 million in management and incentive fees.

The complaint also charges that Merkin ignored irregularities and other glaring red flags related to Madoff’s investments. As a result, hundreds of investors lost millions in investments, tragically including important charity organizations that were specifically targeted by Merkin. Attorney General Cuomo’s lawsuit seeks payment of damages and disgorgement of all fees by Merkin. The complaint also charges Merkin’s management company, Gabriel Capital Corporation (“GCC”). Merkin managed several funds, including Ascot Fund Limited, Gabriel Capital L.P., and Ariel Fund.

In a pattern of fraudulent concealment and misrepresentation spanning nearly two decades, according to the complaint, Merkin held himself out as a skilled money manager and used his social and charitable connections to raise over $4 billion from hundreds of individuals, charities, and other investors.  Merkin turned virtually all of this money over to third-party money managers, including Madoff.

During individual conversations with investors, and through fraudulent quarterly reports, investor presentation materials, and offering documents, Merkin concealed the role Madoff played and misrepresented the role he played in managing the funds, according to the complaint. Though acting primarily as a marketer and a middleman, Merkin pocketed hundreds of millions of dollars in management and incentive fees from his investors.

Charities and non-profit organizations were particularly susceptible to and victimized by Merkin’s deceptive tactics.  Over 10 percent of the assets managed by Merkin belonged to non-profit organizations.  Merkin collected his customary fees from nonprofits that invested with him, but typically did not disclose, or actively obscured, that Madoff was actually managing some or all of the funds they invested.

Merkin kept a total of $2.4 billion of investors’ funds in Madoff – funds that Merkin had fiduciary obligations to protect – even though he knew of irregularities and other glaring red-flags related to Madoff’s investments.  Indeed, at least two of Merkin’s most trusted colleagues repeatedly told Merkin that Madoff’s returns were too good to be true— one warning that it could be a Ponzi scheme. Merkin knew that investment professionals were suspicious of Madoff because, beyond Madoff’s uncommonly steady returns, there were fundamental questions about Madoff’s money management business that suggested fraud.  Merkin read, and kept in his files, two press articles questioning Madoff’s practices and returns, and several of Merkin’s own investors told Merkin that due to these questions, they would not invest with Madoff. 

Merkin commingled his personal funds, including his management fees from Ascot and Gabriel, with the funds of his management company, GCC.  Merkin used GCC funds to make purchases for his personal benefit, including purchases of over $91 million of artwork for his apartment. 

The Complaint charges Merkin with violations of the Martin Act, General Business Law § 352 et seq., for fraudulent conduct in connection with the sale of securities, Executive Law § 63(12) for persistent fraud in the conduct of business, and New York’s Not-For-Profit Corporation Law §§ 112, 717, and 720 for breaches of fiduciary duty in connection with Merkin’s service on the boards of certain non-profit organizations.  Attorney General Cuomo’s lawsuit seeks payment of damages and disgorgement of all fees by Merkin, restitution and other equitable relief.

Massachusetts Charges Fairfield Greenwich with Fraud

Secretary of the Commonwealth of Masssachusetts Galvin today filed fraud charges against Fairfield Greenwich, a Madoff feed fund.  All the documents are available on the website.

NASAA Posts Information on ARS Claims Procedures

NASAA has posted on its website information on how to file ARS claims, specific to the firm and the investor's state.  NASAA explains:

Several brokerage firms have entered, or are expected to enter into, settlements with state securities regulators in cases arising from the sale by those firms of auction rate securities. Those settlements provide, among other things, that many customers of those firms are entitled to receive a refund of the purchase price of those securities from the firm. Despite receiving those refunds, some customers may believe they have incurred consequential damages as a result of their purchase and ownership of the auction rate securities. The settlements also provide for a “special arbitration procedure” which may be used by customers attempting to recover those consequential damages. This site describes those special procedures.

Wachovia and Citigroup Agree to Buy Back ARS from California Residents

Wachovia Securities and Citigroup Global Markets entered settlements with California to buy back $4.7 billion in ARS from California residents and companies.  California regulators say these are "the first two" investment banks to settle with the state and "it won't be the last" settlement.  Bizjournals, Citigroup, Wachovia reach 'significant' settlement with California.

State Securities Regulators Testify Before Financial Services Committee

Delaware Securities Commissioner James Ropp and Massachusetts Secretary of the Commonwealth William Galvin appeared before the House Financial Services Committee on Friday, March 20. The hearing, led by Committee Chairman Barney Frank (D-MA), brought together federal and state securities regulators and law enforcement officials to discuss the enforcement of investor protection laws at the federal and state levels.

Testifying on behalf of the North American Securities Administrators Association (NASAA), Commissioner Ropp urged Congress to support the valuable contributions of state securities regulators through federal grants. “  Ropp also suggested deputizing state securities attorneys to serve as special prosecutors for complex securities cases; allowing states to review securities offerings currently exempt from state oversight under Rule 506 of Regulation D; including representatives from the state banking, insurance and securities regulatory agencies on the President’s Working Group on Financial Markets; toughening civil and criminal penalties for those who commit financial crimes, especially those who target senior investors; and increasing opportunities for victims of fraud to seek private actions.

Secretary Galvin, the top securities official in Massachusetts, urged the committee to “give the states the tools we need to maintain and enhance our ability to regulate effectively and protect investors.” Galvin also asked Congress to require that brokerages be in a fiduciary relationship to their individual retail customers. Under current law, broker-dealer firms deal with their customers on an arm’s-length basis, subject to an obligation of fair dealing. This means that customers cannot rely on their brokers to meet fiduciary obligations of loyalty, care and competence. In contrast to brokers, investment advisers work solely for their customers and have an acknowledged fiduciary duty to them.

NASAA Statement on President Obama's Principles for Regulatory Reform

Fred Joseph, President of the North American Securities Administrators Association (NASAA) and Colorado Securities Commissioner, released a statement on President Obama’s announcement yesterday of the core principles that will guide his administration’s efforts to reshape how the nation’s financial  industry and markets are regulated. NASAA Statement on Obama Administration's Principles for Financial Services Regulatory Reform.

NASAA Requests Comment on Policy Statement on Multi-State Review of Requests for Interpretive Opinions

The NASAA Coordinated Interpretations Project Group requests comment from the public on the adoption of a new Statement of Policy Regarding Multi-State Review of Requests for Interpretative Opinions and No-Action Letters.  The comment period begins February 20, 2009 and will remain open for 30 days.  Here is the introduction to the proposed statement of policy:

Many state securities regulators have the authority issue “no-action letters” in which staff confirms that a transaction carried out under a set of assumed facts will not result in a recommendation for enforcement action. Some states also issue “interpretive opinions” in which staff provides guidance by indicating how a provision of law applies to a situation presented. These types of no-action letters and interpretive opinions are authorized by subsection 413(e) of the Uniform Securities Act of 1956, as amended, and subsection 605(d) of the Uniform Securities Act (2002).
Subsection 420(b)(7) of the 1956 USA and subsection 608(c)(9) of the 2002 USA authorize the states to cooperate with each other in the development of no-action letters and interpretive opinions in order to encourage uniform interpretation of laws and maximize the effectiveness of regulation. Toward those ends, NASAA proposes this Statement of Policy.

New Hampshire Enacts NASAA's Model Rule on Senior Certifications

New Hampshire becomes the first state to legislatively adopt NASAA’s Model Rule on the Use of Senior Certifications and Professional Designations.  Last month Washington and Virginia became the first jurisdictions to adopt rules based on NASAA’s model. NASAA’s model rule prohibits the misleading use of senior and retiree designations and also provides a means by which a securities administrator may recognize the use of certain designations conferred by an accredited organization.  The model rule addresses the growing use of financial designations or certifications that ostensibly convey expertise in advising seniors and retirees.

Massachusetts Files Complaint Against UBS for Marketing of Auction Rate Securities

The Massachusetts Securities Division has filed a complaint against UBS Securities LLC and UBS Financial Services, alleging violations of the Massachusetts Uniform Securities in connection with the sale of auction rate securities (ARS) to retail customers.  According to the complaint, the sales were typically made with the express representation that the investments were liquid, safe, money-market instruments, whose interest rates would reset at periodic auctions, and that they could be sold at the next auction.  Instead, as UBS knew, no true auctions existed for many of these securities.  In addition, UBS failed to disclose to its customers the conflicts of interest because of UBS's dual role in underwriting the securities and selling them to their customers.  The requested relief includes requiring UBS to offer rescission of the ARS sales at par, censure, and administrative fines.  In re UBS Securities, LLC (filed June 26, 2008).

SEC Obtains Temporary Relief Against Alleged Ponzi Scheme

The federal district court for the Western District of New York granted the SEC's motion for preliminary injunction and other relief against defendants Watermark Financial Services Group, Inc. ("Watermark Financial"), Watermark M-One Holdings, Inc. ("Watermark Holdings"), M-One Financial Services, LLC ("M-One"), Watermark Capital Group, LLC ("Watermark Capital"), Guy W. Gane, Jr., and Lorenzo Altadonna. The SEC's complaint, filed on May 15, 2008, alleges that from at least May 2005 to the present, Gane and M-One orchestrated a securities offering fraud that has raised at least $5.7 million from approximately 90 investors, including a number of senior citizens, through the sale of debentures and promissory notes issued by the various entity defendants. Gane is a principal of each of the issuing entities. The complaint further alleges that the defendants told investors that their money would be used to purchase or develop real estate, but instead Gane: (i) used new investor funds to pay back earlier investors; (ii) misappropriated investors' funds by using them to pay himself, his family, and others; and (iii) transferred substantial portions of investor funds to Denkon, Inc., Guy W. Gane, III, and Jenna Gane for no apparent consideration. In addition, the complaint alleges that the debentures offering was not registered with the Commission and that Gane violated the broker-dealer registration provisions of the federal securities laws.

Entered on June 18, 2008, the court's order continues in place various forms of interim relief initially ordered by the court on May 16, 2008, when the court granted the Commission's application for a temporary restraining order and other relief to halt the fraud orchestrated by Gane and the other defendants. The litigation is pending.

New York Law Firm Can be Liable as Aider & Abettor of Securities Fraud under Oregon Statute

A disappointed investor in a hedge fund, residing in Oregon, can sue the New York law firm that drafted the offering documents for aiding and abetting the securities fraud of the principal, who had already pleaded guilty to securities fraud violations, under the Oregon securities statute.  The federal district court for the S.D.N.Y.  ruled against the defendant on a motion to dismiss and rejected its arguments that federal law preempted the statute statute and the state statute violated the dormant commerce clause.  The court did, however, agree with defendant that plaintiff failed to allege that the securities were not federally covered securities and dismissed the claim based on sale of unregistered securities.  The court noted that the U.S. Supreme Court, as recently as Stoneridge Investment Partners v. Scientific-Atlanta, Inc., recognized state authority to regulate and enforce its own fraud statutes in the securities area independent of federal law.  It also found nothing in National Securities Markets Improvement Act (NSMIA) that preempts state oversight of fraud or deceit in the securities area.  The Oregon Blue Sky Statute, modeled on the ALI's 1956 Uniform Securities Act, expressly provides a cause of action against aiders and abettors of securities fraud, and the Oregon Supreme Court has previously found that attorney preparation of legal materials for an offering qualifies as participating in or materially aiding under the statute.  The court noted that while the principal probably lied to the law firm, the statute requires the defendant to establish its due diligence as an affirmative defense.  Houston v. Seward & Kissel, LLP, 2008 WL 818745 (S.D.N.Y. Mar. 27, 2008).

NASAA's Legislative Agenda

The North American Securities Administrators Association (NASAA) identified its initiatives and legislative agenda for the second session of the 110th Congress.  The initiatives fall into five broad categories: 1.  Preserving the authority of state regulators to protect investors; 2. strengthening the mechanisms currently in place that provide redress to investors for wrongdoing by industry participants; 3. maintaining federal laws designed to insure corporate accountability and shareholder confidence; 4. promoting sound and effective regulatory initiatives, and 5. improving the scope and breadth of investor education efforts.  NASAA, 2008 Pro-Investor Legislative Agenda.

SEC Sustains NASD's Findings in Research Reports Case

The SEC sustained  NASD's  findings  of  violation  against Donner Corporation International, a former NASD member  firm,  Jeffrey L. Baclet, its former president and sole owner, and Vincent M.  Uberti and Paul A. Runyon, former registered representatives of Donner.  NASD found that Donner, Baclet, Uberti, and Runyon violated  Section  10(b)and Rule  10b-5,  and NASD Rules  2120,  2210,  and  2110  by  preparing  and  disseminating research reports which contained material misstatements and omissions.  NASD found further that Donner, Baclet, and Uberti violated NASD  Rule 2110 by failing to disclose in certain  Donner  research  reports  the compensation Donner  received  for  writing  the  reports.  NASD  also determined that Donner and Baclet violated NASD Rules 3010, 2210,  and 2110 by failing to establish and maintain adequate written supervisory procedures and by failing  to  ensure  written  approval  of  Donner's  research reports by a firm principal.