Securities Law Prof Blog

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

Friday, November 13, 2009

SEC Charges Two Computer Programmers with Assisting Madoff's Fraud

The SEC charged two computer programmers for their role in helping convicted Ponzi schemer Bernard L. Madoff cover up the fraud at Bernard L. Madoff Investment Securities LLC (BMIS) for more than 15 years.  The SEC alleges that Jerome O'Hara of Malverne, N.Y., and George Perez of East Brunswick, N.J., provided the technical support necessary to produce false documents and trading records and took hush money to help keep the scheme going.

According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, Madoff and his lieutenant Frank DiPascali, Jr., routinely asked O'Hara and Perez for their help in creating records that, among other things, combined actual positions and activity from BMIS' market-making and proprietary trading businesses with the fictional balances maintained in investor accounts. O'Hara and Perez wrote programs that generated many thousands of pages of fake trade blotters, stock records, Depository Trust Corporation (DTC) reports and other phantom books and records to substantiate nonexistent trading. They assigned file names to many of these programs that began with "SPCL," which is short for "special."

A separate computer internally known as "House 17" was used to process BMIS investment advisory account data at the direction of Madoff, DiPascali and others. The SEC alleges that O'Hara and Perez knew that the House 17 computer was missing a host of functioning programs necessary for actual securities trading and reporting. According to the SEC's complaint, they recognized that the trades being entered into House 17 and the account statements and trade confirmations being sent to investors did not reflect actual trades.

The SEC alleges that O'Hara and Perez had a crisis of conscience in 2006 and tried to cover their tracks by attempting to delete approximately 218 of the 225 special programs from the House 17 computer. But they did not delete the monthly backup tapes. O'Hara and Perez then cashed out hundreds of thousands of dollars each from their personal BMIS accounts before confronting Madoff and refusing to generate any more fabricated books and records.  The SEC's complaint alleges that Madoff responded by telling DiPascali to offer O'Hara and Perez as much money as necessary to keep quiet and not expose the misrepresentations. O'Hara and Perez considered the offer and demanded a salary increase of nearly 25 percent along with one-time bonuses in late 2006 of more than $60,000 each. They stated to DiPascali at the time that they did not ask for more because a greater amount might appear too suspicious. DiPascali then managed to convince O'Hara and Perez to modify computer programs so that he and other 17th floor employees could create the necessary reports themselves.

The SEC's complaint specifically alleges that O'Hara and Perez aided and abetted violations of Sections 10(b), 15(c) and 17(a) of the Exchange Act and Rules 10b-3, 10b-5 and 17a-3 thereunder, and Sections 204, 206(1) and 206(2) of the Advisers Act and Rule 204-2 thereunder. Among other things, the SEC's complaint seeks financial penalties and a court order requiring O'Hara and Perez to disgorge their ill-gotten gains.

November 13, 2009 in SEC Action | Permalink | Comments (1) | TrackBack (0)

Thursday, November 12, 2009

SEC Settles Regulation G Charges against SafeNet, Former Officers and Former Accountants

The SEC settled charges against SafeNet, Inc., its former Chief Executive Officer, Anthony Caputo, its former Chief Financial Officer, Kenneth Mueller, and three former SafeNet accountants, Clinton Ronald Greenman, John Wilroy, and Gregory Pasko. The SEC alleged that, during the period from the fourth quarter of 2000 through May 2006, SafeNet engaged in two fraudulent schemes — one involving the backdating of options and the other earnings management. Each scheme resulted in SafeNet materially misstating its financial results and disseminating materially false and misleading information concerning its financial condition. According to the complaint, Mueller and Caputo were involved in both schemes, while Greenman, Wilroy and Pasko were involved only in the earnings management scheme.

The SEC release states that this is the agency's first enforcement action brought pursuant to Regulation G. Regulation G applies whenever a reporting company discloses publicly any material information that includes a "non-GAAP financial measure." Non-GAAP financial measures, which are not calculated in conformity with Generally Accepted Accounting Principles, often exclude non-recurring, infrequent, or unusual expenses. Regulation G requires companies to reconcile the non-GAAP financial measure to the most directly comparable GAAP financial measure. Regulation G also prohibits companies and their employees from disseminating false or misleading non-GAAP financial measures or presenting the non-GAAP financial measures in such a manner that they mislead investors or obscure the company's GAAP results.

All defendants have agreed to settle this matter, without admitting or denying the allegations in the complaint.  Besides injunctive relief, SafeNet will pay a civil penalty of $1,000,000.  The individual defendants will pay civil penalties ranging from $15,000 to $250,000.

The settlements with SafeNet, Greenman, and Pasko take into account the cooperation with the SEC's investigation by SafeNet and these individuals. All of the settlements of the civil action are subject to the approval of the United States District Court for the District of Columbia.

November 12, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Wednesday, November 11, 2009

Senate Proposed Legislation More Investor Protective than House Version

Senator Dodd, Chair of the Senate Banking Committee, released yesterday a discussion draft of proposed financial reform legislation, entitled Restoring American Financial Stability Act of 2009.Download SenateBankingRegulatoryReformProposal It is a more comprehensive and investor protective reform package than the version recently approved by the House Financial Services Committee, and therefore, we can surmise, is less likely to be passed in its current form.

As one example:  the House proposed legislation contains language that would require the SEC to enact rules to harmonize the regulation of investment advisers and broker-dealers that provide individualized advice to retail customers.  In contrast, the Senate version proposes simply to eliminate the broker-dealer exception from the definition of "investment adviser" in the Investment Advisers Act. Thus, the requirements of the Investment Advisers Act would apply to all broker-dealers and their dealings with all customers.  To deal with the problem of the IAA's prohibition against trading with a customer as a principal without pre-transaction approval, the proposed legislation would give the SEC authority to exempt persons or transactions from this prohibition so long as the adviser provides investors with "adequate protection" against conflicts of interest. 

The Senate legislation would also provide for aiding and abetting liability in private securities fraud actions, unlike the House version.

November 11, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

Tuesday, November 10, 2009

SEC Charges Former Hedge Fund CFO with Securities Fraud

The SEC charged Ezra C. Levy, the former chief financial officer of New York-based hedge fund Boston Provident LP, with securities fraud for arranging secret sales of securities from his personal trading account to the hedge fund accounts at inflated prices to generate his own illicit profits.  According to the SEC's complaint, Levy's job responsibilities required that he have access to the firm's electronic trade entry system. He did not, however, have the authority to make trading decisions for Boston Provident's accounts, and was merely authorized to execute the trading decisions of the firm's chief executive officer. The SEC alleges that Levy made unauthorized, fraudulent trades that resulted in financial losses to the hedge fund accounts while he made a personal profit of more than a half-million dollars. The SEC is seeking a court order to freeze Levy's assets.

The SEC alleges that on two days in June 2009, Levy secretly entered "sell" orders for securities at above-market prices for his personal account. At approximately the same time, he entered "buy" orders for Boston Provident's accounts, for the same securities at the same above-market prices. By placing these matched orders, Levy caused sales of securities from his personal account to Boston Provident's accounts at inflated prices. Levy's profit from these fraudulent trades exceeded $537,000.

November 10, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Bear Hedge Fund Managers Acquitted of Fraud Charges

Ralph Cioffi and Matthew Tannin, two former Bear Stearns hedge fund managers, were found not guilty of all federal securities fraud charges today in Manhattan.  The government charged that they misled investors by failing to disclose that the funds were declining in value.  In addition, Mr. Cioffi was charged with not disclosing that he was selling off portions of his own investments in the fund.  NYTimes, Bear Stearns Managers Acquitted of Fraud Charges.

November 10, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

Senate Banking Committee Chair Introduces Regulatory Reform Proposal

Today Senate Banking Committee Chairman Chris Dodd (D-CT) introduced  draft legislation  to reform the way that our financial system is regulated.  When questioned about his bill Dodd told reporters “This is not a time for timidity.”


Consumer Financial Protection Agency: Creates an independent watchdog to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, while prohibiting hidden fees, abusive terms, and deceptive practices.

Ends Too Big to Fail: Prevents excessively large or complex financial companies from bringing down the economy by: creating a safe way to shut them down if they fail; imposing tough new capital and leverage requirements and requiring they write their own “funeral plans”; requiring industry to provide their own capital injections; updating the Fed’s lender of last resort authority to allow system-wide support but not prop up individual institutions; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.

Protects Against Systemic Risks: Creates an independent agency with a board of regulators to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the financial system. The agency could require companies that threaten the economy to divest some of their holdings.

Single Federal Bank Regulator: Eliminates the convoluted system of multiple federal bank regulators to increase accountability and end unnecessary overlap, conflicting regulation, and “charter shopping;” keeps in place the healthy dual banking system that governs community banks.

Executive Compensation and Corporate Governance: Provides shareholders with a say on pay and corporate affairs with a non-binding vote on executive compensation and director nominations.

Closes Loopholes in Regulation: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated - including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.

Protects Investors: Provides tough new rules for transparency and accountability from investment advisors, financial brokers and credit rating agencies to protect investors and businesses.

Enforces Regulations on the Books: Strengthens oversight and empowers regulators to aggressively pursue financial fraud, conflicts of interest and manipulation of the system that benefit special interests at the expense of American families and businesses.

November 10, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

Monday, November 9, 2009

Attorney Pleads Guilty for Role in Dreier Securities Fraud

Robert Miller, a former SEC enforcement attorney, pleaded guilty to conspiracy in the securities fraud scheme perpetrated by Manhattan attorney Marc Dreier.  InvNews, Ex-SEC lawyer pleads guilty in Dreier fraud case.

November 9, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

More on ARS Arbitrations

In a blog yesterday on ARS arbitrations, I remarked that my impression was that purchasers of auction rate securities were not faring well in claims for damages resulting from the freezing of the credit markets in early 2008.  Today Investment News has an article that provides some support for this.  It reports that both Smith Barney and Raymond James have prevailed in major arbitrations involving both institutional and retail investors.  Smith Barney won against a $118.7 million claim brought by Banco Industrial De Venezuela.  InvNews, Smith Barney, Raymond James victorious in auction rate cases.

November 9, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

Sunday, November 8, 2009

Miller & Rosenfeld on Intellectual Hazard

Intellectual Hazard: How Conceptual Biases in Complex Organizations Contributed to the Crisis of 2008, by Geoffrey P. Miller, New York University - School of Law, and Gerald Rosenfeld, New York University - School of Law, was recently posted on SSRN.  Here is the abstract:

This paper identifies an important but previously unrecognized systemic risk in financial markets: intellectual hazard. Intellectual hazard, as we define it, is the tendency of behavioral biases to interfere with accurate thought and analysis within complex organizations. Intellectual hazard impairs the acquisition, analysis, communication and implementation of information within an organization and the communication of such information between an organization and external parties. We argue that intellectual hazard was a cause of the Crisis of 2008 and suggest that this risk may be an important factor in all financial crises. We offer tentative suggestions for reforms that might mitigate intellectual hazard going forward.

November 8, 2009 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Morgenson on ARS Arbitration

Gretchen Morgenson, the New York Times financial columnist, addresses the plight of investors in auction rate securities (ARS) whose investments, sold on the basis of their liquidity and safety, became illiquid as a result of the credit crisis. A Way Out of the Deep Freeze. Ms. Morgenson, who has been harsh in her assessments of mandatory securities arbitration in the past, finally sees value in arbitration.  She notes the judicial hostility toward class action ligitations involving ARS and recognizes that individual arbitrations may provide the only recovery for investors.  Those of us who have studied this area closely have long recognized that whatever the faults of arbitration, in a legal reality where investor rights are so meager and difficult to enforce, securities arbitration, and its appeal to equity, may be the best solution for investors.  However, my initial assessments of investor recovery in arbitration are less sanguine than Ms. Morgenstern's.  The reported awards, at least, have not shown a willingness on the part of arbitrators to award consequential damages resulting from the investors' inability to liquidate their investments -- to make a down payment on a residence, for example, or pay a child's college tuition.  While it is true that most arbitrations are settled and thus the terms are not publicly disclosed, I have not heard anecdotally that investors are faring well.  If any readers have heard differently or can speak from personal experience, I would appreciate hearing.

November 8, 2009 in News Stories | Permalink | Comments (0) | TrackBack (0)

SEC's Aguilar on Investor Protection

This week the House Financial Services Committee, in the now somewhat ironically called "Investor Protection Act of 2009," added an amendment that would permanently exempt companies with $75 million or less market capitalization from the SOX 404(b) certification requirement, despite the fact that the SEC Chair announced earlier this fall that the current exemption would expire so that investors of these companies would finally receive the protections against accounting fraud that SOX contemplated when it was enacted since 2002.  Can anyone seriously argue that post-SOX events have shown that internal controls are not needed for all publicly traded corporations?  SEC Commissioner Aguilar addressed the problem eloquently in a recent speech:

Everyone knows about the Sarbanes-Oxley Act, which contains a set of hard-won reforms made necessary by Enron, WorldCom, and other frauds. One clear lesson learned from those frauds was that many public companies had weak internal controls. The Sarbanes-Oxley Act tackled these problems by requiring the top executives of all public companies to take responsibility for their internal controls, and, importantly, for an independent auditor to come in and examine these controls. In the financial press, this independent audit requirement is referred to as "404(b)," after the section of Sarbanes-Oxley that requires the audit.

The Investor Protection Act of 2009 in its current form would repeal this important requirement of an independent audit for public companies with a market cap under $75 million. Some are describing this repeal of Sarbanes-Oxley as relief for "small businesses." I think people are confused when they hear the words "small business." The companies that would be exempted are not mom and pop neighborhood stores. These are publicly traded companies that offer their shares to all types of investors. And just so you know, this repeal has wide-ranging ramifications and would appear to affect the majority of public companies. Although the SEC generally does not track companies based on market cap, the SEC does have data on companies that generally have $75 million or less in public float, and our staff estimates that over 6,000 public companies may fall under that threshold.

To repeal this part of Sarbanes-Oxley now is to throw away a substantial amount of work done by regulators, companies, and private organizations to make compliance with 404(b) more cost-effective. Since the passage of Sarbanes-Oxley, the SEC has repeatedly deferred smaller public company compliance with the independent internal control audit requirement. During the period of the SEC deferrals, the SEC and the Public Company Accounting Oversight Board (PCAOB) were active in developing rules and guidance to allow 404(b) to be implemented in a manner that would work for both large and small public companies. A central goal of this work focused on making sure that costs for smaller public company were not overly burdensome.

The SEC alone has held roundtables, chartered an advisory committee, and engaged in a number of other regulatory and staff actions targeted at applying 404(b) to smaller public companies, and followed all of that with a staff study which found these efforts made compliance more cost-effective. In addition, private organizations like the Committee of Sponsoring Organizations of the Treadway Commission (COSO) have published guidance on internal control frameworks specifically targeted at smaller public companies. It is particularly ironic that, if 404(b) is undercut now, we will never see the benefits for investors of all the work by the SEC, PCAOB, COSO and others, and the opportunity for smaller public companies to take advantage of the practical lessons learned from companies that are already complying.

November 8, 2009 in SEC Action | Permalink | Comments (1) | TrackBack (0)

SEC Division of Risk, Strategy & Financial Innovation Announces 3 Senior Appointments

No doubt in response to criticisms that the SEC lacks expertise, the agency announced three senior appointments in the fields of risk management, structured finance and corporate transactions to its newly created Division of Risk, Strategy, and Financial Innovation, headed by University of Texas Law professor Henry Hu.  The Division was created in September to enhance the agency's capabilities and help identify developing risks and trends in the financial markets.

The Division's new senior officials are:

Richard Bookstaber has been appointed a Senior Policy Advisor to the Director. Dr. Bookstaber served as the managing director in charge of firm-wide risk management at Salomon Brothers, director of risk management at Moore Capital Management, and Morgan Stanley's first market risk manager. 

Adam Glass has been appointed a Counsel to the Director. Mr. Glass comes to the SEC from Linklaters LLP, where he founded its Structured Finance and Derivatives Practice. During his tenure at Linklaters, he represented banks, investment banks, monoline insurance companies, and hedge funds. 

Bruce Kraus has been appointed a Counsel to the Director. Mr. Kraus comes to the SEC from Willkie Farr & Gallagher LLP, where he practiced corporate and securities law for more than 20 years. His practice included mergers and acquisitions transactions and other corporate finance work.

The Division of Risk, Strategy, and Financial Innovation combines the Office of Economic Analysis, the Office of Risk Assessment, and other functions to provide the Commission with sophisticated analysis that integrates economic, financial, and legal disciplines. The Division's responsibilities cover three broad areas: risk and economic analysis; strategic research; and financial innovation.

November 8, 2009 in SEC Action | Permalink | Comments (0) | TrackBack (0)

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)