Securities Law Prof Blog

Alternative Trading System Settles Charges It Failed to Disclose Trading by Affiliate

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.

Portuguese Bank Settles New York and SEC Charges over Violating Registration Provisions

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. 

DOL Issues Exemption for Certain Types of Investment Advice

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.

Ohio Supreme Court Will Consider Scope of Securities Division's Power to Protect Investors

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.

Franco on Anti-Complicity Strategy under Federal Securities Law

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.

Schwarcz on Managing Systemic Risk

Keynote Address: A Regulatory Framework for Managing Systemic Risk, by Steven L. Schwarcz, Duke University - School of Law, was recently posted on SSRN.  Here is the abstract:

This accessible analysis of systemic risk regulation was delivered as the keynote speech at an October 20, 2011 European Central Bank conference on regulation of financial services. Many regulatory responses, like the Dodd-Frank Act in the United States, consist largely of politically motivated reactions to the financial crisis, looking for villains (whether or not they exist). To be most effective, however, the regulation must be situated within a more analytical framework. In this speech, I attempt to build that framework, showing that preventive regulation is insufficient and that regulation also must be designed to limit the transmission of systemic risk and reduce systemic consequences.

Poser on Janus Capital

The Supreme Court’s Janus Capital Case, by Norman S. Poser, Brooklyn Law School, was recently posted on SSRN.  Here is the abstract:

In Janus Capital Group, Inc. v. First Derivative Traders, a divided Supreme Court created the unprecedented doctrine that the investment adviser to a mutual fund that drafted and distributed a false prospectus for the fund did not “make” a false statement under Rule 10b-5 because the fund, and not the adviser, had “ultimate authority” over the prospectus. The author argues that the decision was out of touch with reality because it failed to give proper consideration to the unique structure of the mutual fund industry. Furthermore, the decision is an illustration of judicial activism, and is likely to protect fund advisers and other corporate officials from liability for their own fraudulent actions

State Securities Commissions & E*Trade Settle ARS Claims

NASAA recently announced that a settlement in principle has been reached between E*TRADE Securities LLC and state securities regulators to return approximately $100 million to the firm’s clients who have had their funds frozen in the auction rate securities (ARS) market since 2008. The firm also will pay a $5 million fine.  The settlement with E*TRADE is the result of a multi-state investigation led by the Colorado Division of Securities into allegations that the firm misled clients by falsely assuring them that auction rate securities were a safe, liquid alternative to cash, certificates of deposit and money market funds. The ARS markets froze in February 2008, triggering complaints from investors who could not withdraw money from their accounts.

Under the terms of the settlement, E*TRADE agreed to buy back at par value all outstanding auction rate securities purchased through the firm by individual investors before February 2008.

Other terms of the multi-state settlement require E*TRADE to:

• Fully reimburse all individual investors who sold their auction rate securities at a discount after the auction market failed;
• Consent to a special, public arbitration process to resolve claims of consequential damages suffered by individual investors who were unable to access their funds;
• Maintain a dedicated toll-free telephone assistance line, website and email address to provide information about the terms of the final order and to answer questions from investors;
• Reimburse certain investors for the cost of loans after the investor took out a loan from E*TRADE because the investor’s auction rate securities were frozen; and
• Pay to the states monetary penalties of $5 million and reimburse certain costs of the investigation.

SEC Announces Roundtable on Measurement Uncertainties

The SEC announced that the inaugural roundtable in the Financial Reporting Series will be held on November 8.  The purpose of the Financial Reporting Series is to proactively help identify risks and potential improvements in the financial information provided to investors.  The inaugural roundtable will examine the extent to which financial reporting should include measurement uncertainties, and the information investors find important to understanding and assessing those uncertainties. The SEC released a briefing paper on the issue.

 

SEC Sues Hedge Fund Manager in Insider Trading Case

The SEC announced additional charges in its insider trading case against Denver-based traders who traded on confidential information in the securities of Mariner Energy Inc. ahead of the oil and gas company’s $3.9 billion takeover by Apache Corporation in April 2010. In its initial complaint filed on Aug. 5, 2011, the SEC alleged that Mariner Energy board member H. Clayton Peterson tipped his son with confidential details about Mariner Energy’s upcoming acquisition. Drew Clayton Peterson, who was a managing director at a Denver-based investment adviser, then used the inside information to purchase Mariner Energy stock for himself and others.

An amended complaint filed today adds two more defendants to the case – money manager Drew K. Brownstein who is a longtime friend of Drew Peterson, and the hedge fund advisory firm he controls, Big 5 Asset Management LLC. The SEC alleges that Brownstein traded Mariner Energy securities on the basis of inside information he received from Drew Peterson and reaped illicit profits of more than $5 million combined in his own account, the accounts of his relatives, and the accounts of two hedge funds managed by Big 5.

According to the SEC, “This case is further evidence of the pervasive nature of insider trading by hedge funds, and a sobering reminder that such conduct is not limited to the immediate vicinity of Wall Street but is taking place in cities around the country.”

Senate Confirms Aguilar and Gallagher as SEC Commissioners

The Senate confirmed the SEC nominations of Luis Aguilar (Democrat) and Daniel Gallagher, Jr. (Republican) so that the Commission is again at full strength.  Mr. Gallagher most recently was a partner at the D.C. office of Wilmer Hale and before that Deputy Director of Division of Trading and Markets.

FINRA Proposes a Rule on Private Placements

FINRA filed with the SEC proposed FINRA Rule 5123, which would require that members and associated persons that offer or sell private placements (as described in the Rule), or participate in the preparation of private placement memoranda (“PPM”), term sheets or other disclosure documents in connection with such private placements, provide relevant disclosures to each investor prior to sale describing the anticipated use of offering proceeds, and the amount and type of offering expenses and offering compensation. FINRA Rule 5123 also would require that the PPM, term sheet or other disclosure document, and any exhibits thereto, be filed with FINRA no later than 15 calendar days after the date of the first sale, and any material amendments to such document, or any amendments to the disclosures mandated by the Rule, be filed no later than 15 calendar days after the date such document is provided to any investor or prospective investor.

SEC Director, Investment Management, Testifies on ETFs

Eileen Rominger, SEC Director, Division of Investment Management, testified before the Subcommittee on Securities, Insurance, and Investment, Senate Committee on Banking, Housing and Urban Affairs, on
October 19, 2011, on Testimony on Market Micro-Structure: An Examination of ETFs.

SEC & Former Inhouse Counsel Settle Backdating Charges

If you remember the backdating stock options scandal of a few years back, you may recall that the SEC brought a number of enforcement actions against inhouse counsel.  Today the SEC announced the conclusion of one of these matters and the settlement of its claims against Lisa C. Berry, the former General Counsel of KLA-Tencor Corp. and Juniper Networks, Inc. The Commission alleged that from 1997 through 2003 Berry caused KLA-Tencor and Juniper to report false financial information to the investing public through her preparation of corporate records that concealed that employee stock option grants were priced with the benefit of hindsight at both companies.  Without admitting or denying the Commission's allegations, Berry consented to pay a $350,000 civil penalty, and also to pay disgorgement totaling $77,120, including interest. The United States District Court for the Northern District of California approved the settlement on October 7, 2011.

In a separate administrative proceeding, Berry also agreed to be suspended from appearing or practicing as an attorney before the Commission. Under the terms of the agreement, Berry may apply for reinstatement in five years. Berry agreed to the suspension without admitting or denying the Commission's allegations.

SEC & Citigroup Settle Charges It Misled Investors About CDO Tied to Housing Market

The SEC and Citigroup settled charges that Citigroup’s principal U.S. broker-dealer subsidiary misled investors about a $1 billion collateralized debt obligation (CDO) tied to the U.S. housing market in which Citigroup bet against investors as the housing market showed signs of distress. The CDO defaulted within months, leaving investors with losses while Citigroup made $160 million in fees and trading profits.  According to the SEC, Citigroup Global Markets structured and marketed a CDO called Class V Funding III and exercised significant influence over the selection of $500 million of the assets included in the CDO portfolio. Citigroup then took a proprietary short position against those mortgage-related assets from which it would profit if the assets declined in value. Citigroup did not disclose to investors its role in the asset selection process or that it took a short position against the assets it helped select.

Citigroup has agreed to settle the SEC’s charges by paying a total of $285 million, which will be returned to investors.  The settlement is subject to court approval.

The SEC also charged Brian Stoker, the Citigroup employee primarily responsible for structuring the CDO transaction. The agency brought separate settled charges against Credit Suisse’s asset management unit, which served as the collateral manager for the CDO transaction, as well as the Credit Suisse portfolio manager primarily responsible for the transaction, Samir H. Bhatt.

 

NASAA Reports 51% Increase in Enforcement Actions in 2010

NASAA reported a 51 percent increase in the number of enforcement actions by state securities regulators in 2010, which led to a nearly 200 percent increase in the amount of money ordered returned to investors.  According to the NASAA report, state securities regulators conducted 7,063 investigations in 2010, which led to 3,475 enforcement actions, up from 2,294 enforcement actions in the previous year. Enforcement actions include criminal, administrative and civil actions. Nearly 1,000 of these actions involved financial abuse of seniors.

PCAOB Criticizes Deloitte Audits for Insufficient Quality Controls

Earlier this week the PCAOB released a previously non-public report on Deloitte criticizing inadequate quality controls for its audits.  According to the report, the auditing firm placed too much reliance on the management of the companies that they audited.  The report was written in 2008 and covered audits conducted in 2007.  According to its website, 

PCAOB prepares a report on each inspection it conducts of a registered public accounting firm, and a portion of each report is made publicly available when issued. Many reports contain nonpublic content, which may include, among other things, discussion of potential defects in a firm's system of quality control. Any such quality control criticisms remain nonpublic if the firm addresses them to the Board's satisfaction within 12 months after the report date. If a firm fails to satisfactorily address any of the quality control criticisms within 12 months, the portion of the report discussing the particular criticism(s) is made publicly available.

Specifically with respect to the Deloitte report, PCAOB stated:

The Public Company Accounting Oversight Board, in anticipation of questions about the publication of previously nonpublic portions of its May 19, 2008 inspection report on Deloitte & Touche LLP, issued the following statement today:

"The quality control remediation process is central to the Board's efforts to cause firms to improve the quality of their audits and thereby better protect investors. The Board therefore takes very seriously the importance of firms making sufficient progress on quality control issues identified in an inspection report in the 12 months following the report. Particularly with the largest firms, which are inspected annually, the Board devotes considerable time and resources to critically evaluating whether the firm did in fact make sufficient progress in that period. The Board can and does make the relevant criticisms public when a firm has failed to do so."

 

SEC & Florida Penny-Stock Promoters Settle Fraud Charges

On October 13, 2011 the U.S. District Court for the Southern District of Florida entered judgments against a group of penny-stock promoters arising out of their repackaging of “news” issued by a series of sham energy companies. The judgments, which the defendants consented to as part of a settlement with the Commission, require them to pay penalties and to disgorge profits from their illicit activities. The judgments also permanently ban the defendants from touting and other dealings involving penny stocks.  SEC v. Wall Street Capital Funding LLC, Philip Cardwell, Roy Campbell, and Aaron Hume, Civil Action No. 11-cv-20413-DLG (S.D. Fla.)

 

SEC Announces Panelists for Oct. 18 Conflict Minerals Roundtable

The Panelists for the SEC's Oct. 18 Roundtable on Conflict Minerals are posted on the agency's website.