Securities Law Prof Blog

SEC & FINRA Issue Risk Alert on Broker-Dealer Branch Inspections

The SEC’s Office of Compliance Inspections and Examinations (OCIE) and FINRA today issued a Risk Alert and a Regulatory Notice on broker-dealer branch inspections, and offered suggestions to help securities industry firms better perform this key supervisory function.

Along with specific requirements outlined in the report, effective practices observed by examiners include:

Using risk analysis to identify whether individual non-supervising branches should be inspected more frequently than the FINRA-required minimum three-year cycle, with more frequent inspections of branches meeting certain risk criteria. In addition, some firms conduct “re-audits” when routine inspections reveal a high number of deficiencies, repeat deficiencies, or serious deficiencies. Typically, these re-audits and audits for cause are conducted as unannounced inspections.

Using surveillance reports and employing current technology and techniques to help identify risks and develop a customized approach for branch office inspections based on the type of business conducted at each branch.

Employing comprehensive checklists that incorporate previous inspection findings and trends noted in internal reports such as audit reports.

Conducting unannounced branch inspections either randomly or based on certain risk factors. “Surprise” exams may yield a more realistic picture of a broker-dealer’s supervisory system as they reduce the risk that individual RRs and principals might attempt to falsify, conceal, or destroy records in anticipation for an internal inspection.

Involving qualified senior personnel in several branch office examinations each year.

Incorporating findings of branch office inspections into management information or risk management systems and using a centralized, comprehensive compliance database that enables compliance personnel in various offices to access to information about all of the firm’s RRs and their business activities. Such a system appears to be very useful when supervising independent contractor RRs dispersed across a broad geographic area.

Providing branch office managers with the firm’s internal inspection findings and requiring them to take and document corrective action.

Tracking corrective action taken by each branch office manager in response to branch audit findings.

Elevating the frequency of branch inspections, or their scope, or both, in cases where registered personnel are allowed to conduct business activities other than as associated persons of a broker-dealer, for example away from the firm.

This is the second in a continuing series of Risk Alerts that the SEC’s national examination staff expects to issue. These documents are intended to alert senior management, risk management, and compliance managers in the securities industry to significant risks identified by the SEC’s national examination staff, so that industry members can more effectively address those risks.

Senate Committee Hearing Focuses on Congressional Trading on Confidential Information

The Senate Committee on Homeland Security and Governmental Affairs will hold a hearing tomorrow December 1, at 2:30 p.m., on Insider Trading and Congressional Accountability.  Speakers include Donna Nagy (Indiana), Donald Langevoort (Georgetown) and John Coffee (Columbia).

Defending the Securities Fraud Class Action

William W. Bratton and Michael L. Wachter’s  recent article, The Political Economy of Fraud on the Market (appearing in 160 U. Pa. L. Rev. 69), is a thoughtful and thought-provoking critique of the federal securities class action.  Their criticism is harsh.  Indeed, they flatly declare that “[t]he fraud-on-the-market (FOTM) cause of action just doesn’t work” because it poorly serves both the compensatory and the deterrence function.  They propose a bargain: the SEC should propose a rule eliminating the FOTM presumption in exchange for which Congress should increase the budget of the SEC’s enforcement division and the agency should increase its efforts to hold individuals liable for corporate wrongdoing.  Expensive private litigation of marginal utility will be substantially reduced, and fraud will be more effectively deterred.

After reading the article, I have serious misgivings about their proposal because I am skeptical that SEC enforcement alone can adequately protect investors and deter fraud.  I am not alone in this concern.  James D. Cox has written an eloquent response to Bratton & Wachter, Securities Class Actions as Public Law (160 U. Pa. L. Rev. PENNumbra 73), in which he argues that the authors “commit an even more fundamental error by taking the narrow view that securities class actions have only a private and not a public mission.”  Because Professor Cox  has effectively developed the policy implications, I want to focus here on three practical concerns:  money, Janus, and Judge Rakoff.

1. Money.  Frankly, it is simply not realistic to think that Congress will ever commit, on a long-term basis, sufficient funds for effective enforcement.   The infusions of money after Enron were reduced in subsequent years, and every year there is a prolonged colloquy between the SEC Chair and Congressional leaders over the SEC budget.  Congress has refused to give the SEC control over its budget, and perhaps maintaining Congressional oversight through the power of the purse is justified, given the agency’s record of failures.  Congress remains committed to a lean SEC budget, despite the fact that the agency is funded by industry fees.

The current debate over who should examine investment advisers illustrates this reality.  A recent SEC staff study reports that the agency does not have sufficient resources to conduct effective examinations of registered investment advisers with adequate frequency; no one seriously disputes this.  In recent months, the Consumer Federation of America, which has long opposed the creation of an SRO to examine investment advisers, acknowledged the reality that years of advocating for increased SEC resources for examinations had achieved no results and reluctantly concluded that an SRO was realistically the only option.

2. Janus.  Academics on both sides of the debate over securities fraud class actions agree that deterrence would be improved if more corporate officials and other individuals complicit in the fraud were held accountable.  Unfortunately, the Supreme Court, in a trilogy of cases (Janus, Stoneridge, Central Bank) has made it exceedingly difficult to hold individuals primarily liable for securities fraud.   In the recent Janus opinion, the Court articulates its most restrictive reading of the securities statute and defines the “maker” of a statement as “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it….One who prepares or publishes a statement on behalf of another is not its maker.”  At least the SEC, unlike private parties, has the power to impose liability on secondary participants.  Nevertheless,  since Janus was handed down, corporate officers named as defendants in SEC enforcement actions have sought to have complaints against them dismissed  because they did not have ultimate authority over the alleged misstatements.  The Supreme Court thus has thwarted enhancing the deterrence function, particularly with respect to private litigation.  While Congress could remedy this situation, it has not chosen to do so.

3. Judge Rakoff.  I have great respect for Judge Rakoff and admire his efforts to improve transparency and accountability in the settlement of SEC claims.  To date, he remains an outlier.  If other judges start to apply a more rigorous standard of review, however, fewer SEC enforcement actions will settle (at least at the early stages of litigation), and the SEC’s caseload will necessarily have to shrink.  In particular, if defendants are no longer permitted to deny liability, settlement may become virtually a thing of the past.  Even if Judge Rakoff’s standard of review does not become prevalent, individual defendants are less likely to settle as readily as corporate defendants do, so an SEC enforcement policy targeting individual defendants will result in more protracted litigation and fewer actions.

Finally, elimination of the private securities fraud class action may be only the first battle in a war against investor protection.  I have previously written that I view with great suspicion arguments that SEC enforcement can provide adequate deterrence as well as compensation for investors (Should the SEC Be a Collection Agency for Defrauded Investors?, 63 Bus. Law. 317). As Judge Rakoff suggests, business may consider quick SEC settlements with relatively modest fines a cost of doing business that it can live with.  When the SEC starts to exert its muscle, however, and makes life difficult for corporate America, business groups call for changes at the SEC.  Thus, when in the aftermath of Enron, the SEC substantially increased the amount of penalties it collected in settlements, there was an uproar and calls for the agency to mitigate its anti-business policies.  I worry that if the SEC ever really became an effective investor protection agency, we would see a concerted campaign to hobble it.

SEC Hears Cross-Appeals in Proceeding Raising Issues of Supervision

The SEC will hold an open meeting on December 6 to hear oral argument in an administrative proceeding that generated a fair amount of press.  The matter concerns Theodore W. Urban, formerly general counsel, head of compliance, and member of the Board of Directors of Ferris, Baker Watts, Inc. (“FBW,” now operating under the name RBC Wealth Management), a registered broker-dealer and investment adviser; Urban and the Division of Enforcement filed cross-appeals from the decision of an administrative law judge.

The law judge found that Stephen Glantz, an FBW registered representative, engaged in various securities law violations while employed by FBW. She further found that Glantz was subject to Urban's supervision within the meaning of Section 15(b) of the Securities Exchange Act of 1934 and Section 203(f) of the Investment Advisers Act of 1940; however, the law judge dismissed the proceeding against Urban because she concluded that Urban did not fail to exercise that supervision reasonably.

Among the issues likely to be argued are (1) whether Glantz engaged in violations of the securities laws; (2) whether Urban was a supervisor of Glantz under applicable law; (3) if so, whether Urban failed to exercise that supervision reasonably; and (4) if so, whether and to what extent sanctions should be imposed.

 

NASAA Launches Coordinated Review Program for Investment Advisers

NASAA announced that it has developed a coordinated review program for investment advisers switching from federal to state securities regulatory oversight as mandated by the Dodd-Frank Act, which requires investment advisers with assets under management of between $25 million and $100 million to switch from federal to state registration by mid-2012.

The Investment Adviser Coordinated Review Program is open to SEC-registered investment advisers switching their registration to between four and 14 states. (Under Dodd-Frank, investment advisers registered in 15 or more states can remain with the SEC.) To participate in the program, eligible investment advisers must complete and submit the Coordinated Review Form found in the IA Switch Resource Center on the NASAA website, in addition to filing all materials required by the states in which the adviser is applying for registration.  The states where the investment adviser has filed a registration application will conduct a coordinated review of the investment adviser’s registration materials. Advisers will be subject only to the filing fees specified by the states in which the investment adviser is applying for registration.

FINRA Fines 8 Firms for Selling Interests in Troubled Private Placements

FINRA sanctioned eight firms and 10 individuals and ordered restitution totaling more than $3.2 million, for selling interests in private placement offerings without having a reasonable basis for recommending the securities. The firms and individuals sold interests in several high-risk private placements, including those issued by Provident Royalties, LLC, Medical Capital Holdings, Inc. and DBSI, Inc., which ultimately failed, causing significant investor losses. FINRA previously sanctioned two firms and seven individuals in April 2011 for selling interests in private placements without conducting a reasonable investigation.

FINRA imposed sanctions against the following firms and individuals for failing to conduct a reasonable investigation or for failing to enforce procedures with respect to the sale of private placements offered by Provident Royalties, LLC, Medical Capital Holdings, Inc. or DBSI, Inc.:

• NEXT Financial Group, Inc. of Houston, TX, was ordered to pay $2 million in restitution to affected customers and fined $50,000; Steven Lynn Nelson, the firm's Vice President for Investment Products and Services, was suspended in any principal capacity for six months and fined $10,000 in connection with the sale of three Provident Royalties private placements.
• Investors Capital Corporation of Lynnfield, MA, was ordered to pay roughly $400,000 in restitution to affected customers in connection with the sale of two Provident Royalties private placements and was also sanctioned in connection with an additional offering issued by CIP Leveraged Fund Advisors.
• Garden State Securities, Inc. of Red Bank, NJ, and Kevin John DeRosa, a co-owner of the firm, were ordered to pay $300,000 in restitution on a joint-and-several basis to affected customers in connection with the sale of a Medical Capital private placement. DeRosa was also suspended for 20 business days in any capacity and for an additional two months in any principal capacity, and fined $25,000. Vincent Michael Bruno, the firm's Chief Compliance Officer at the time, was suspended for one month in a principal capacity and fined $10,000.
• Capital Financial Services of Minot, ND, was ordered to pay $200,000 in restitution to affected customers, and Brian W. Boppre, a former principal, was suspended in any principal capacity for six months and fined $10,000 in connection with the sale of three Provident Royalties private placements and a Medical Capital private placement.
• National Securities Corporation of Seattle, WA, was ordered to pay $175,000 in restitution to affected customers, and Matthew G. Portes, Director of Alternative Investments/Director of Syndications, was suspended in any principal capacity for six months and fined $10,000 in connection with the sale of three Provident Royalties private placements and a Medical Capital private placement.
• Equity Services, Inc. of Montpelier, VT, was censured, fined $50,000 and ordered to pay nearly $164,000 in restitution in connection with the sale of a private placement DBSI, Inc. issued; Stephen Anthony Englese, Senior Vice President for Securities Operations, was suspended from association with any FINRA-regulated firm in any capacity for 30 business days and fined $10,000; and Anthony Paul Campagna, a registered representative, was suspended from association with any FINRA-regulated firm in any capacity for 30 business days and fined $25,000.
• Securities America, Inc. of La Vista, NE, was censured and fined $250,000 in connection with the sale of two Provident Royalties private placements.
• Newbridge Securities Corporation of Fort Lauderdale, FL, was fined $25,000; Robin Fran Bush, the former Chief Compliance Officer of Newbridge, was suspended in any principal capacity for six months and fined $15,000 in connection with the sale of four DBSI private placements and a Medical Capital private placement.
• Leroy H. Paris II, former President and Chief Executive Officer for the now-defunct Meadowbrook Securities, LLC (fka Investlinc Securities, LLC), of Jackson, MS, was suspended for six months in any principal capacity and fined $10,000 in connection with the sale of two Provident Royalties private placements and a Medical Capital private placement.
• Michael D. Shaw, formerly associated with VSR Financial Services, Inc. of Baton Rouge, LA, was barred from the industry in connection with the sale of a private placement offered by DBSI, Inc. and several additional private placements offered by other issuers. In addition, Shaw falsified customer account documents.

From 2001 through 2009, Medical Capital Holdings, a medical receivables financing company based in Anaheim, CA, raised approximately $2.2 billion from over 20,000 investors through nine private placement offerings of promissory notes. Medical Capital made interest and principal payments on its promissory notes until July 2008, when it began experiencing liquidity problems and stopped making payments on notes sold in two of its earlier offerings. Nevertheless, Medical Capital proceeded with its last offering, Medical Provider Funding Corporation VI, offered through an August 2008 private placement memorandum. In July 2009, the SEC filed a civil injunctive action in federal district court in which it sought, and was granted, a preliminary injunction to stop all Medical Capital sales. The court appointed a receiver to gather and conduct an inventory of Medical Capital's remaining assets. The SEC action is pending.

From September 2006 through January 2009, Provident Asset Management, LLC, marketed and sold preferred stock and limited partnership interests in a series of 23 private placements offered by an affiliated issuer, Provident Royalties. The Provident offerings were sold to customers through more than 50 retail broker-dealers nationwide and raised approximately $485 million from over 7,700 investors. Although a portion of the proceeds of Provident Royalties' offerings was used for the acquisition and development of oil and gas exploration and development activities, millions of dollars of investors' funds were transferred from the later offerings' bank accounts to the Provident operating account in the form of undisclosed and undocumented loans, and were used to pay dividends and returns of capital to investors in the earlier offerings, without informing investors of that fact. In July 2009, the SEC filed a civil injunctive action in the Northern District of Texas naming Provident and others for violations of the federal securities laws. The Court granted the SEC's request for a temporary restraining order, an emergency asset freeze and appointment of a receiver to take control of Provident and preserve the assets for the benefit of the defrauded investors. The SEC action is pending. On March 18, 2010, FINRA announced that it had expelled Provident Asset Management, LLC, a Dallas-based broker-dealer, for marketing a series of fraudulent private placements offered by its affiliate, Provident Royalties, LLC.

 

Khuzami Defends SEC-Citigroup Settlement

Here is the response of Robert Khuzami, SEC Director of Enforcement, to Judge Rakoff's rejection of the Citigroup settlement:

While we respect the court's ruling, we believe that the proposed $285 million settlement was fair, adequate, reasonable, in the public interest, and reasonably reflects the scope of relief that would be obtained after a successful trial.

The court's criticism that the settlement does not require an 'admission' to wrongful conduct disregards the fact that obtaining disgorgement, monetary penalties, and mandatory business reforms may significantly outweigh the absence of an admission when that relief is obtained promptly and without the risks, delay, and resources required at trial. It also ignores decades of established practice throughout federal agencies and decisions of the federal courts. Refusing an otherwise advantageous settlement solely because of the absence of an admission also would divert resources away from the investigation of other frauds and the recovery of losses suffered by other investors not before the court.

The settlement provisions cited by the court have been included in settlements repeatedly approved for good reason by federal courts across the country — including district courts in New York in cases involving similar misconduct.

We also believe that the complaint fully and accurately sets forth the facts that support our claims in this case as well as the basis for the proposed settlement. These are not 'mere' allegations, but the reasoned conclusions of the federal agency responsible for the enforcement of the securities laws after a thorough and careful investigation of the facts.

Finally, although the court questions the amount of relief obtained, it overlooks the fact that securities law generally limits the disgorgement amount the SEC can recover to Citigroup's ill-gotten gains, plus a penalty in an amount up to a defendant's gain. It was for this reason that we sought to recover close to $300 million — all of which we intended to deliver to harmed investors. The SEC does not currently have statutory authority to recover investor losses.

We will continue to review the court's ruling and take those steps that best serve the interests of investors.

What Role did Derivatives Play in the Collapse of Lehman Brothers?

The Stanford Law Review Online has just posted a succinct and provocative article on Misconceptions About Lehman Brothers' Bankruptcy and the Role Derivatives Played, by Kimberly Summe, who identifies herself as former Managing Director, Lehman Brothers.  It is especially timely as on Nov. 4, 2011 Lehman Brothers' creditors voted on the firm's liquidation plan, with approval from the bankruptcy court expected to follow on December 6, 2011.  The Article offers a brief overview of some of the most persistent misconceptions regarding Lehman Brothers' bankruptcy and the role that derivatives played in it.  In particular, she emphasizes that the 2,209 page report prepared by Lehman Brothers' bankruptcy report never mentions derivatives as a cause of the bank's failure, instead identifying poor management choices and a sharp lack of liquidity as driving factors.  She also notes that, according to the bankruptcy expert's report, regulatory agencies (SEC) had considerable data about the firm's financial situation but took no action to regulate the firm's conduct.  Moreover, "[u]ltimately, then, the largest bankruptcy filing in U.S. history has shown that resolution can be achieved in just over three years, and that derivatives caused the largest enhancement to the bankruptcy estate."  Finally, she rejects the notion that the bankruptcy code is not optimal for systemically important bankruptcies. 

Judge Rakoff Rejects SEC-Citigroup Settlement

In a decision that probably surprises no one, Judge Jed Rakoff refused to approve the proposed $285 million settlement between the SEC and Citigroup resolving charges that the bank failed to disclose to investors its role in selecting investments in a $1 billion mortgage-bond deal and taking a short position in those assets.(Download SECCITI11282011[1]) The judge stated that the settlement did not provide the Court with a sufficient evidentiary basis to know whether the requested relief was justified, and, as he has done previously, he criticized the agency's policy of allowing defendants to enter into consent judgments without admitting or denying the allegations.

[W]hen a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance.

The judge goes on to say that "[i]t is harder to discern from the limited information before the Court what the S.E.C. is getting from this settlement other than a quick headline."

The court concludes by directing the parties to be ready to try the case on July 16, 2012.

Judge Batts Directs Cy Pres Donation to Pace Investor Rights Clinic

Congratulations to Professor Jill Gross and the Pace University Law School Investor Rights & Advocacy Clinic!  Judge Deborah A. Batts (S.D.N.Y.) recently issued an Order Authorizing Cy Pres Donation of the Unclaimed Balance of Class Action Settlement Fund to Charity in In re American Express Financial Advisors Securities Litigation (Nov. 16, 2011).  The order directs plaintiffs' counsel to distribute the balance remaining in the net settlement fund -- approximately $64,400 -- to the Clinic.

Ninth Circuit Upholds FINRA's Immunity from Suit

Two recent short, interesting opinions from the Ninth Circuit address FINRA's immunity.  

In Central Registration Depository #1346377 (Paul Merritt Christiansen) v. FINRA (9th Cir. Nov. 23, 2011, not for publicationDownload CentralRegistration.112311[1]), the plaintiff sued FINRA alleging violation of his right to be nominated for and serve on FINRA's board of directors and disclosure of false and injurious information about about him to a prospective employer through its Central Registration Depository (CRD) computer database.  The appellate court affirmed the trial court's dismissal because the lower court properly concluded that FINRA enjoys absolute immunity from money damages for its regulatory activity.  In addition, his request that he be reinstated and that certain information be purged from his record would require the court to contravene FINRA's properly adopted rules.

In Sacks v. Dietrich (9th Cir. Nov. 23, 2011Download Sacks.112311[1]), plaintiff appealed from the dismissal of his claims against two arbitrators who disqualified him from representing an investor.  The Ninth Circuit agreed that the claims were barred by arbitral immunity.  Two of the three arbitrators assigned to the panel disqualified the plaintiff because he was barred from the securities industry and thus ineligible to represent investors before FINRA under FINRA rule 13208.  However, the panel noted that it would allow plaintiff "to assist a representative qualified under Rule 13208" in a future proceeding. 

The 9th Circuit first affirmed the district court's ruling that it had jurisdiction over the action.  Although plaintiff's claims were all state law causes of action, the alleged wrongful conduct underlying those claims turned on a federal question: whether the arbitrators exceeded their jurisdiction under FINRA arbitration rules by applying Rule 13208 and barring plaintiff from representing the investor.  The appellate court also agreed with the lower court that the arbitrators were protected from liability under the doctrine of arbitral immunity.  FINRA rules and applicable law dictate that the arbitrators were acting within their jurisdiction in applying FINRA rules.  Even though plaintiff was not a party to the arbitration agreement between the parties, he was still bound by it under ordinary contract and agency principles.  Because the arbitrators acted with full authority under the arbitration agreement, they cannot be subject to suit by a party representative.

Rose on FOTM

Fraud on the Market: An Action Without a Cause, by Amanda M. Rose, Vanderbilt Law School, was recently posted on SSRN.  Here is the abstract:

This is a response to William W. Bratton & Michael L. Wachter, The Political Economy of Fraud on the Market, 160 U. PA. L. REV. 69 (2011). Bratton and Wachter argue that fraud-on-the-market class actions (FOTM) should be eliminated and replaced with stepped-up public enforcement efforts targeted at individual wrongdoers (rather than the corporate enterprise, the FOTM target of choice). In this Response, I do not disagree: My own scholarship has similarly emphasized the benefits of shifting away from FOTM to greater reliance on public enforcement mechanisms. Instead, I take the opportunity to elaborate on the deterrence and corporate governance shortcomings of FOTM, strengthening further the case Bratton and Wachter make for an enhanced public enforcement role

Choi et alia on Sovereign Debt Contracts

Political Risk and Sovereign Debt Contracts, by Stephen J. Choi, New York University (NYU) - School of Law; G. Mitu Gulati, Duke University - School of Law; and Eric A. Posner, University of Chicago - Law School, was recently posted on SSRN.  Here is the abstract:

Default on sovereign debt is a form of political risk. Issuers and creditors have responded to this risk both by strengthening the terms in sovereign debt contracts that enable creditors to enforce their debts judicially and by creating terms that enable sovereigns to restructure their debts. These apparently contradictory approaches reflect attempts to solve an incomplete contracting problem in which debtors need to be forced to repay debts in good states of the world; debtors need to be granted partial relief from debt payments in bad states; debtors may attempt to exploit divisions among creditors in order to opportunistically reduce their debt burden; and debtors and creditors may attempt to externalize costs on the taxpayers of other countries. We support this argument with an empirical overview of the development of sovereign bond terms from 1960 to the present.

Langevoort on In-House Lawyers

Getting (Too) Comfortable: In-House Lawyers, Enterprise Risk and the Financial Crisis, by Donald C. Langevoort, Georgetown University Law Center, was recently posted on SSRN.  Here is the abstract:

In-house lawyers are under considerable pressure to "get comfortable" with the legality and legitimacy of client goals. This paper explores the psychological forces at work when inside lawyers confront such pressure by reference to the recent financial crisis, looking at problems arising from informational ambiguity, imperceptible change, and motivated inference. It also considers the pathways to power in-house, i.e., what kinds of cognitive styles are best suited to rise in highly competitive organizations such as financial services firms. The paper concludes with a research agenda for better understanding in-house lawyers, including exploration of the extent to which the diffusion of language and norms has reversed direction in recent years: that outside lawyers are taking cognitive and behavioral cues from the insiders, rather than establishing the standards and vocabulary for in-house lawyers

Should the Fed Be Talking to Investors Behind Closed Doors?

There has been much discussion the last few weeks about whether Congress-people and their staff have profited by trading on confidential information acquired through their positions.  Today the Wall St. Journal reports on other privileged investors that may have access to confidential information.  According to the WSJ, certain investors and analysts meet frequently with top Fed Reserve officials, who may provide them with clues about its policy changes.  It gives an an example an August 15 meeting between Ben Bernanke and Nancy Lazar, an economist with International Strategy & Investment Group, after which Lazar, according to the Journal, called clients and told them the Fed was about to implement a strategy that would boost long-term bonds.

Of course, meetings between regulators and industry representatives are not by themselves nefarious.  It makes sense that the Fed wants to hear from those affected about the impact of its policies.  Nonetheless, close contacts between regulators and industry it regulates are troublesome, particularly if the industry may derive more value from these meetings than the regulators do.

WSJ, Investors Bullish on Fed Tips

FINRA Fines REIT Wholesaler for Misleading Sales Literature

FINRA announced that it fined Wells Investment Securities, Inc. $300,000 for using misleading marketing materials in the sale of Wells Timberland REIT, Inc., a non-traded Real Estate Investment Trust (REIT).  Wells was the dealer-manager and wholesaler for the public offering of Wells Timberland REIT, which invested in timber-producing land.

As the wholesaler, Wells reviewed, approved and distributed the marketing materials for Wells Timberland. FINRA found that from May 2007 through September 2009, Wells reviewed, approved and distributed 116 advertising and sales materials containing misleading, unwarranted or exaggerated statements. The majority of the sales literature failed to disclose the significance of Wells Timberland's non-REIT status or suggested that Wells Timberland was a REIT at a time when in fact it had not qualified as a REIT. The communications also contained misleading statements regarding Wells Timberland's portfolio diversification and ability to make distributions and redemptions.

 Although non-traded REITs are generally illiquid, often for periods of eight years or more, they can avoid particular tax consequences if they qualify under certain Internal Revenue Service requirements. The Wells advertisements at issue did not make it clear to potential investors who might be seeking such favorable tax treatment, that the investment at issue was not yet a REIT and therefore would not be able to offer the desired tax benefits at the time the ads were being used.

In concluding this settlement, the firm neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

 

A New Survey Reports the Costs of Going Public

It is commonplace to state that there is a high cost to going public, and the costs of compliance with SEC regulation, in particularl Sarbanes-Oxley 404, are usually blamed for those high costs.  A recent Ernst & Young survey points to another source:  increased compensation paid to officers, directors and advisors.  The survey (which is described in a recent CFO.com post) looked at data from 26 companies that went public in the last two years and reports that being public adds about $2.5 million, on average, to costs, with $1.5 million attributable to higher compensation for CEOs, CFOs and others in the finance function, as well as increased board costs. CFO.com, The True Costs of Being Public: More Than You Think

Former E&Y Accountant Settles Insider Trading Charges Involving Vivendi Acquisition

The SEC settled charges against Mark A. Konyndyk, CPA, for insider trading in advance of a tender offer. The SEC alleged that Konyndyk, a former manager in the Transaction Advisory Services Group of Ernst & Young (“E&Y”), learned through his work at E&Y that Activision, Inc. was the target of highly confidential acquisition talks, code-named “Project Sego,” in which Vivendi S.A. was the potential acquirer. In particular, Konyndyk performed due-diligence work on Project Sego for E&Y’s client, Vivendi, billing 36 hours to the engagement. Both before and shortly after his departure from E&Y’s employ on November 2, 2007, including just days before the December 2, 2007, public announcement of the Vivendi-Activision merger, Konyndyk bought Activision out-of-the-money call options with near-term expirations. He sold the options shortly after the public announcement, earning gross profits of $9,725.

Without admitting or denying the allegations, Konyndyk has agreed to settle the Commission’s allegations against him. The final judgment to which Konyndyk consented would order that he is liable for disgorgement of $9,725 (comprising all the profits flowing from his own illegal trading) plus $1,789.28 in prejudgment interest thereon as well as a $9,725 civil penalty, but allow him one year to pay the foregoing sums. Additionally, Konyndyk consented, in related administrative proceedings, to the entry of a Commission order that would suspend him, pursuant to Commission Rule of Practice 102(e), from appearing or practicing before the Commission as an accountant, with a right to seek reinstatement after two years. If approved by the Court, this settlement would fully resolve this case.

Former Schwab Executive Settles Fraud Charges Involving YieldPlus Fund

The SEC announced that Randall Merk settled SEC charges related to the Schwab YieldPlus Fund. Merk was an Executive Vice President at Charles Schwab & Co., Inc., President of Charles Schwab Investment Management, and a Trustee of the Schwab YieldPlus Fund and other Schwab funds.

In January 2011, the Commission filed a complaint alleging that Merk and another official committed securities law violations in connection with the offer, sale, and management of the YieldPlus Fund. YieldPlus is an ultra-short bond fund that, at its peak in 2007, had $13.5 billion in assets and over 200,000 accounts, making it the largest ultra-short bond fund at the time. The fund suffered a significant decline during the credit crisis of 2007-2008 and saw its assets fall from $13.5 billion to $1.8 billion during an eight-month period.

According to the complaint, Merk misled or failed to inform investors adequately about the risks of investing in YieldPlus. The complaint also alleged that Merk approved other Schwab funds’ redemptions of their investments in YieldPlus at a time when he knew or was reckless in not knowing that a portfolio manager for those funds had received material, nonpublic information about YieldPlus without the authorization of the YieldPlus Fund’s board of trustees.

Without admitting or denying the Commission’s allegations, Merk consented to the entry of a final judgment permanently enjoining him from aiding and abetting violations of, or otherwise violating, Sections 206(2) and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder. The proposed final judgment also would enjoin Merk from future violations of Section 34(b) of the Investment Company Act of 1940, which prohibits the making of untrue statements of material fact, or material omissions, in documents filed with the Commission. Merk also agreed to pay a $150,000 civil penalty, which the Commission is seeking to have included in an existing Fair Fund for distribution to injured YieldPlus investors. The proposed judgment is subject to the Court’s approval.

If the Court enters the injunction, Merk also has agreed to settlement of a yet-to-be instituted administrative proceeding in which the Commission would suspend Merk for 12 months from associating with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization, and from participating in any penny stock offering.

The Commission previously entered into a $118 million settlement with three Schwab entities regarding the YieldPlus Fund and another bond fund.

Longtime Madoff Trader Pleads Guilty and Settles SEC Fraud Charges

The SEC charged David Kugel, a longtime Bernie Madoff employee, with fraud for his role in creating fake trades to facilitate the massive Ponzi scheme.  According to the SEC, Kugel, who worked at Bernard L. Madoff Investment Securities LLC (BMIS) for nearly four decades, was asked by Madoff to provide the firm’s investment advisory operations with backdated arbitrage trade information to be formulated into fictitious trading on investors’ account statements. Kugel’s own account at BMIS was among those in which backdated trades were entered, and he withdrew nearly $10 million in “profits” from the fictitious trading over several years.  Kugel's illegal activities began sometime in the early 1970s.

The U.S. Attorney’s Office for the Southern District of New York has filed parallel criminal charges against Kugel, who has pled guilty and also agreed to settle the SEC’s civil charges. Subject to court approval, the civil case will result in a permanent injunction against Kugel, who must forfeit his ill-gotten monetary gains upon entry of a criminal forfeiture order in the criminal case.