Tuesday, December 22, 2009


On December 16, 2009, the SEC adopted rules to enhance the custody controls for investment advisers in an effort to provide greater protections for investors in situations where there is a heightened potential for fraud. Investors are particularly susceptible to fraud when they turn over control of their assets to their investment advisers.

Investment advisers generally do not maintain custody of their clients’ assets, but instead such assets are maintained by a third-party custodian. This arrangement helps minimize the potential for misappropriation of the clients' assets. However, the more control an adviser has over its clients' assets, the greater the risk of misuse of those assets.

One of the main situations in which there is an inherent potential for misuse of client assets is when an adviser serves as the custodian of its clients’ assets. This type of arrangement does not allow for an independent, third-party custodian to serve as a safeguard against any potentially self-serving actions by the adviser. To enhance investor protection, the new rules adopted by the SEC provide that advisers in this situation will be subject to a “surprise exam” at least once every year to verify client assets. In addition, these advisers will have to undergo an annual review of the controls they have in place regarding custody. SEC Chairman Mary L. Shapiro is confident in the potential effect of the new rules, stating her belief that “the new rules will encourage the use of fully independent custodians,” thus minimizing the potential for fraud on investors.

Another situation in which the potential for fraud is heightened is when an investment adviser does not maintain physical control over its clients’ assets, but still has authority over the assets (i.e., when an adviser serves as trustee to a trust, has a power of attorney, or has the ability to write checks on a client’s account). Under this arrangement, the only way to supervise the adviser is for the clients to closely monitor their accounts and try to identify any abnormalities. As a safeguard for investors in this situation, the new rules will again provide for an annual surprise exam to verify client assets. As Chairman Shapiro acknowledged, “[w]hen an adviser takes on the privilege and responsibility of having unfettered access to a client’s money…there is…the need to have an auditor’s ‘second set of eyes’ confirm that those assets exist.”

Recognizing that the new rules may be particularly burdensome for small investment advisory firms, the SEC is conducting a one-year study to discern the impact of the surprise exams on small firms to determine whether modifications to the new rules will be necessary.

Monday, December 21, 2009


In October we commented on the lawsuit brought in the United States District Court for the Southern District of New York by Phyllis Molchatsky and Stephen Schneider against the SEC for failure to detect Bernard L. Madoff’s Ponzi scheme. Last week the SEC filed its motion to dismiss, and as expected the SEC argued that the lawsuit brought by the two plaintiffs is barred by the discretionary functions exception to the Federal Tort Claims Act.

In the motion, the SEC notes that the discretionary functions exception "provides that the United States may not be held liable based upon the exercise or performance or the failure to exercise or perform a discretionary function or duty on the part of a federal agency or an employee of the Government, whether or not the discretion involved be abused." The motion notes that the Supreme Court has prescribed a two-part test for the discretionary functions exception. First, the challenged conduct must involve an element of judgment or choice. Second, the conduct must involve considerations of public policy.

With regard to the first element, the SEC's motion alleges that "[u]nder the 1934 Securities Exchange Act, the SEC has complete discretion in deciding whether, and to what extent, it should investigate suspected violations of the securities laws." Moreover, the SEC argues that it "enjoys similar discretion in its examinations of brokers, dealers, and investment advisors." With regard to the second element, the SEC argues that "[t]he challenged conduct here—for example, whether to refer a complaint to a particular investigative team, to obtain evidence from one source or another, or to assign significance to a specific fact—are all decisions that are susceptible to policy analysis."

As we noted in our previous post regarding this case, defeating the SEC's argument that this exception applies will be an uphill battle for the plaintiffs. However, given what is at stake - not just for the two plaintiffs but also for the system at large due to the precedent which will be set - we can expect this case to be hard fought at every turn. We will continue to monitor the case as it progresses.

A copy of the AmLaw Litigation Daily article discussing and linking to a copy of the SEC's motion to dismiss can be found here.

Wednesday, December 16, 2009


In February 2009, new changes to the Financial Industry Regulatory Authority’s (FINRA) Code of Arbitration Procedure became effective. These changes came in response to a study commenced in 2004 finding the “number of motions to dismiss in customer cases” began to increase. Also, FINRA received feedback that prehearing motions were “routinely and repetitively” being filed, which delayed hearings, increased customer costs, and intimidated customers. Despite that most of these motions to dismiss were denied, FINRA was still concerned that if motions to dismiss were not regulated, it would effectively limit access to arbitration. The new rule changes are set forth below.

Under the changes, motions to dismiss arbitration claims were severed from the general rule for motions and given separate provisions. Now, motions to dismiss fall under Rule 12504 (customer) and Rule 13504 (intra-industry) instead of Rule 12503 and Rule 13503. Further, new Rules 12206 and 13206 were written regarding eligibility of claims. However, the definition of a motion to dismiss remains the same.

Rules 12504 and 13504 change some of the filing requirements and the requirements for deciding the motion. These requirements are as follows:

Requirements for Filing
The motion must be in writing
The answer must be filed before a motion to dismiss
The motion must be filed separately from the answer
The filing date must be at least 60 days prior to the hearing, responses
within 45 days
After denial, parties may not re-file a motion to dismiss unless special
permission to do so

Requirements for Deciding the Motion
The full panel must decide the motion
There must be a hearing, unless parties waive the hearing
The non-moving party must sign a settlement and release barring claims OR
the moving party must not be associated with the account, security, or
conduct at issue
The claim must not be eligible for arbitration because it does not meet the
six-year eligibility requirement where the motion is filed under 12206 or
13206 (i.e. the panel cannot act on the motion to dismiss on grounds for
ineligibility until the panel determines that the claim is in fact
Hybrid claims, if decided ineligible, cannot be ruled on other grounds
Denial must be unanimous and explained in writing

FINRA has also modified the panel’s powers and parties’ filing times in regards to motions to dismiss arbitration claims in the new rules 12206 and 13206.
The panel may decide eligibility on a motion to dismiss prior to the end of
the case
Moving parties must file their eligibility motions at 90 days prior to the
hearing, responses in 45 days
The panel can issue sanctions where the motion to dismiss for eligibility
was brought in bad faith

These changes are consistent with FINRA’s previous policy statements disfavoring motions to dismiss, promoting efficiency, and recognizing parties’ rights to a hearing on the merits.

Sunday, December 13, 2009


On Friday, December 11, 2009, the House of Representatives passed the Wall Street Reform and Consumer Protection Act. This is a comprehensive piece of legislation aimed at responding to the worst economic crisis since the Great Depression. This legislation seeks to address the many causes that led to the crisis, including predatory lending and unregulated derivatives.

Among the many reforms included in the Act are the creation of two new federal agencies. The Consumer Financial Protection Agency (CFPA) is an independent federal agency solely devoted to protecting Americans from unfair and abusive financial products and services. The Financial Stability Council will be made of of regulators that will identify financial firms so large, interconnected, or risky that their collapse would put the entire financial system at risk. This Council would have the power to break up these financial companies even when healthy if it is believed they pose a risk to the financial system.

The Act also focuses on various areas which are aimed at minimizing systematic risk. Although not a comprehensive list, the Act:
  • Establishes an orderly process for shutting down large, failing financial institutions like AIG or Lehman Brothers in a way that ends bailouts and prevents adverse effects spreading to the rest of the financial system.
  • Enables regulators to ban inappropriate or imprudently risky compensation practices, and requires financial firms to disclose incentive-based compensation structures.
  • Strengthens the SEC's powers so that it can better protect investors and regulate the nation's securities markets.
  • Regulates the $600 trillion over-the-counter (OTC) derivatives marketplace by requiring all standardized swap transactions between dealers and "major swap participants" to be cleared and traded on an exchange or electronic platform. A "major swap participant" is defined as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions create such significant exposre to others that it requires monitoring.
  • Incorporates the tough mortgage reform and anti-predatory lending bill the House passed earlier this year. This legislation outlaws many of the industry practices that led to the subprime lending boom.
  • Requires registration of hedge funds by forcing all advisers to private pools of capital to register with the SEC. These advisers will be subject to systematic risk regulation by the Financial Stability regulator.
Large financial companies will be greatly affected by the Act. Not only will there by additional restrictions on operations, but the firms will be charged billions of dollars in new fees as a result of the creation of a fund to pay for future failures of large financial institutions.

For more information, the House Committee on Financial Services issued a press release which can be found here. A Wall Street Journal article addressing the Act can be found here.

Monday, December 7, 2009


On December 3, 2009, SEC Chairman Mary Schapiro spoke at the Consumer Federation of America's 21st Annual Financial Services Conference. Ms. Schapiro noted that as a result of last year's financial turmoil the country is undergoing a "financial services revolution." While the market has improved in recent months, the SEC Chairman reminded the audience that this does not mean that the weaknesses in our financial regulatory system have been resolved. To the contrary, Ms. Schapiro urged that the country must continue efforts to reform the financial regulatory system - both at the Congressional level and at the agency level.

On the legislative front, Ms. Schapiro noted that the regulatory regime needs to focus on identifying and minimizing systematic risk. In this regard, the Chairman identified a number of areas where regulations are being reinforced or need to be reinforced by proposed legislation: 1) the creation of a regime that permits large institutions to fail without taking the system or taxpayers down with them; 2) a need to bring managers of hedge funds and other private funds under the regulatory umbrella; 3) a strong fiduciary standard for all securities professionals; and 4) greater transparency and stability to the over the counter derivatives markets - including real-time data on securities-related OTC derivatives.

Ms. Schapiro also identified that regulatory reform does not exist solely at the Congressional level. She noted that the SEC must put thought and energy into how to protect individuals who are entrusting their money to the capital markets. Ms. Schapiro discussed initiatives underway at the SEC to address issues encountered by individual investors - and she did so by discussing them from the perspective of such an investor.

First, Ms. Schapiro addressed the move to a singular standard for brokers and investment advisors. She noted that when an investor steps into the office of a local securities professional, he does not often look to see whether it says broker-dealer or investment advisor. All he wants is helpful, investor-focused advice. However, currently the duty owed to an investor is different depending on the securities professional's designation. If it is a broker-dealer, the investor is sold a product that is "suitable" for him. If it is an investment adviser, he gets treated under the higher "fiduciary duty" standard.

Ms. Schapiro stated that she is of the belief that all securities professionals should be subject to the same fiduciary duty, same licensing and qualification requirements, and the same oversight regime. Although this may disrupt a number of entrenched interests, Ms. Schapiro noted that the SEC is doing no service to retail investors by continuing with a different regulatory approach for professionals who perform virtually the same or similar services.

Second, Ms. Schapiro addressed the disclosures made by securities professionals with regard to compensation and conflicts. She noted that after an investor sits down with a securities professional, he is not always provided with understandable information about the products that his securities professional is trying to sell him. Ms. Schapiro stated that retail investors should be provided clear, simple, and meaningful disclosure at the time they are making an investment decision.

This should include information about the product being sold, including the compensation being received by the professional and information regarding any conflicts that may be causing the advisor or salesman to steer the investor to a certain investment. Directly related to this is the issue of 12b-1 fees which are automatically deducted from mutual funds to compensate securities professionals for sales and services provided to mutual fund investors. Ms. Schapiro stated that she believes these fees must be rethought not just with respect to their disclosure, but also with respect to whether they continue to be appropriate. This is an area Ms. Schapiro has asked the staff for a recomendation on the 12b-1 fees for SEC consideration in 2010.

Finally, Ms. Schapiro noted that while the SEC has the will to succeed, it is stretching existing resources and will not likely be able to achieve all it seeks to do without additional funding. As an example, Ms. Schapiro noted that the examination staff numbers less than 500, but is tasked with inspecting 11,000 investment advisory firms and 8,000 mutual funds. As a result, she noted that an investor has about a 10% chance of walking into an investment adviser who has been inspected by the SEC in the previous year. For this reason, Ms. Schapiro has been advocating for the SEC to be able to fund its own operations through fees it currently collects. The amount of these fees currently surpasses the amount appropriated by Congress to the SEC each fiscal year.

Ms. Schapiro wrapped up by noting that 2010 will be another year in which the SEC will pursue an ambitious reform agenda in order to restore confidence and provide the protections investors expect and deserve. We at Cosgrove Law, LLC will continue to monitor the steps taken by the SEC in carrying out this agenda. A complete copy of Ms. Schapiro's speech can be found here.

Tuesday, December 1, 2009


Secretary of State Robin Carnahan today suspended the broker-dealer agent registration of a Moberly, Missouri broker, Craig McClaskey, under R.S.Mo. § 409.4-412(f) for alleged securities laws violations stemming from Mr. McClaskey’s mishandling of an 85 year-old woman’s life savings. According to the Suspension Order, the elderly woman was a neighbor and almost like family to Mr. McClaskey, who was also the beneficiary on some of the woman’s assets.

Mr. McClaskey allegedly initiated a change of beneficiary on two of the woman’s variable annuity policies, listing himself as the beneficiary on one of the policies and his wife as the beneficiary of the other policy. Mr. McClaskey and his wife were also named as beneficiaries on the woman’s mutual fund and an IRA.

In addition, Mr. McClaskey allegedly persuaded the elderly woman to liquidate approximately $52,000.00 from her savings accounts to purchase a Florida investment property that was in a depressed area, was in foreclosure and was vacant. According to the Suspension Order, the Florida property was purchased in both Mr. McClaskey’s and the woman’s name, and was to be used as Mr. McClaskey’s retirement home upon the women’s death. Mr. McClaskey also allegedly transferred the woman’s home into his name for one dollar only three months after the death of her only son.

The actions of Mr. McClaskey are a textbook example of what Secretary of State Carnahan aims to prevent under Missouri’s recently-enacted Senior Protection Act. According to Ms. Carnahan, this case only confirms Missouri's commitment to “stand up for Missouri seniors and crack down on anyone who attempts to prey on their life savings.”

Mr. McClaskey will be one of the first individuals to face the Missouri Senior Protection Act, which went into effect in August and imposes steep penalties on fraudsters who take advantage of elderly investors. The Act establishes a minimum penalty of $50,000.00 for anyone who commits criminal securities fraud against such individuals—with the maximum penalty being $1,000,000.00 and up to ten years in prison—along with an additional penalty of up to $5,000.00.

Mr. McClaskey’s actions are still being investigated, and Secretary of State Carnahan has already indicated that she will take all further action as necessary, including a possible permanent bar from the securities industry.

A complete copy of the news release from the Missouri Securities Division can be found here.

Wednesday, November 25, 2009


The SEC and CFTC recently issued two joint orders related to securities-based futures contracts which went into effect on November 17 and November 19, 2009, respectively. As the recent SEC press release explains, “[t]he first joint order excludes certain foreign and domestic volatility indexes that are based on broad-based security indexes from the definition of "narrow-based security index". As a result of the joint order, futures on foreign and domestic volatility indexes that meet the criteria contained in the joint order are treated as "broad-based security indexes" and subject to the exclusive jurisdiction of the CFTC. Options on such volatility indexes are subject to the federal securities laws and the jurisdiction of the SEC…The second joint order allows security futures products to be based on any security that is eligible to underlie an exchange-listed security option, including certain unregistered debt securities.”

The joint orders are consistent with the Joint Report of the SEC and CFTC on Harmonization of Regulation issued on October 16, 2009, which assessed problems with the current regulatory schemes of the two agencies. Specifically, the Joint Report identified significant differences between securities markets and futures markets, and recommended legislative and regulatory actions to address the inconsistencies.

A complete copy of the joint order that went into effect on November 17, 2009 can be found here. A copy of the November 19, 2009 joint order can be found here.

Tuesday, November 24, 2009


The SEC's Office of Inspector General (OIG) issued a report making recommendations to improve the Office of Compliance Inspections and Examinations’ (OCIE) process for selecting investment advisers and investment companies for examination. The report focused on the reasons OCIE did not perform an examination of Bernard Madoff Investment Securities, LLC’s (BMIS) investment advisory business soon after the firm registered as an investment adviser in 2006.

The OIG noted that OCIE’s practice is to assign each registered investment adviser a “low,” “medium,” or “high” risk rating, which is initially based on each adviser’s response to certain questions in Part 1 of the Uniform Application for Investment Adviser Registration (Form ADV). When BMIS registered as an investment adviser in 2006, BMIS was classified as “medium risk,” based on its answers to the questions provided on its Form ADV Part 1. BMIS filed two subsequent Form ADVs in 2007 and 2008. Each of the three Form ADVs received by the Commission resulted in BMIS being assigned a “medium risk” designation in 2006, 2007, and 2008. The OIG found that only firms categorized as “high risk” trigger routine OCIE examinations within three years of receiving the “high risk” rating.

The OIG found that a contributing factor to OCIE’s failure to conduct an examination of BMIS’s advisory business was Enforcement’s and OCIE’s broker-dealer examination unit’s failure to communicate with OCIE’s investment adviser unit. An OCIE Branch Chief testified that BMIS might have been subject to a “cause exam” immediately after it registered had the investment adviser examination staff been informed that Madoff had made misrepresentations to Enforcement and OCIE broker-dealer examination staff.

The OIG also found that OCIE’s risk rating process did not adequately weigh an investment adviser’s level of assets under management and the number of clients that receive investment advisory services. The OIG’s belief is that advisers with more assets under management and more clients who receive advisory services should receive progressively higher risk scores.

The report presents 11 specific recommendations designed to improve OCIE’s process for selecting investment advisers and investment companies for examination:

1. OCIE should implement a procedure requiring, as part its process for creating a risk rating for an investment adviser, that OCIE staff perform a search of Commission databases containing information about past examinations, investigations, and filings related to the investment adviser.

2. OCIE should change the risk rating of an investment adviser based on pertinent information garnered from all Divisions and Offices of the Commission, including information from OCIE examinations and Enforcement investigations, regardless of whether the information was learned during an examination conducted to look specifically at a firm’s investment advisory business.

3. The Division of Enforcement and OCIE should establish and adhere to a joint protocol providing for the sharing of all pertinent information (e.g., securities laws violations, disciplinary history, tips, complaints and referrals) identified during the course of an investigation or examination or otherwise.

4. OCIE should establish a procedure to thoroughly evaluate negative information that it receives about an investment adviser and use this information to determine when it is appropriate to conduct a cause examination of an investment adviser. OCIE should ensure its procedure provides for timely opening of a cause examination.

5. When the OCIE becomes aware of negative information pertaining to an investment adviser, OCIE should examine the investment adviser’s Form ADV filings and document and investigate discrepancies existing between the adviser’s Form ADV and information that OCIE previously learned about the registrant.

6. OCIE should establish a procedure to thoroughly evaluate an investment adviser’s Form ADVs when OCIE becomes aware of issues or problems with an investment adviser. OCIE should document areas where it believes a Form ADV contains false information and initiate appropriate action, such as commencing a cause examination.

7. OCIE should re-evaluate the point scores that it assigns to advisers based on their reported assets under management. OCIE should assign progressively higher risk weightings to firms that have greater assets under management.

8. OCIE should re-evaluate the point scores that it assigns to firms based on their reported number of clients to which they provide investment advisory services. OCIE should assign progressively higher risk weightings to investment advisers that serve a larger number of clients.

9. OCIE should recommend to the Chairman’s office that it institute a Commission rulemaking that would require the following additional information to be reported as part of Form ADV: Performance information; A fund’s service providers, custodians, auditors and administrators, and applicable information about these entities; A hedge fund’s current auditor and any changes in the auditor; and the auditor’s opinion of the firm.

10. The Commission should finalize the proposed rule titled Amendments to Form ADV [Release No. IA-2711; 34-57419]. In finalizing this rule, the Commission should consider what, if any, additional information investment advisers should include in Part II of Form ADV by consulting with OCIE and the Division of Investment Management (IM). Further, the Commission, in consultation with OCIE and IM, should consider provisions that would assist OCIE to efficiently and effectively review and analyze the information in Part II of Form ADV.

11. OCIE should develop and adhere to policies and procedures for conducting third party verifications, such that OCIE verifies the existence of assets, custodian statements, and other relevant criteria.

A complete copy of the OIG's report can be found here.

Wednesday, November 18, 2009


By Executive Order dated November 17, 2009, President Obama established a new interagency Financial Fraud Enforcement Task Force (“Task Force”). The Task Force, led by the Department of Justice and chaired by Attorney General Eric Holder, will work with state and local law enforcement agencies to strengthen efforts to “investigate and prosecute significant financial crimes and other violations relating to the current financial crisis and economic recovery efforts, recover the proceeds of such crimes and violations, and ensure just and effective punishment of those who perpetrate financial crimes and violations.”

In particular, the Task Force will serve the following functions:

(1) Provide advice to the Attorney General for the investigation and prosecution of financial fraud and other financial crimes and violations;

(2) Make recommendations to the Attorney General for action to enhance cooperation among all levels of government responsible for the investigation and prosecution of significant financial crimes and violations; and

(3) Coordinate law enforcements operations with representatives of State, local, tribal and territorial law enforcement.

Robert S. Khuzami, Director of the Division of Enforcement for the SEC, acknowledged that the Task Force will help the government “mount an even better-organized and more collaborative response to the pain and losses caused by the financial crisis.” He also noted that “[t]he creation of the Task Force occurs at a time that we at the SEC have taken a series of steps to optimize our effectiveness. These will make us an even more effective partner to other Task Force members.

The creation of the Task Force is yet another example of the combined efforts by federal, state and local agencies to aggressively combat financial fraud and other wrongdoings, and to provide investors and the public with a more stable financial system to help prevent another financial meltdown.

In accordance with the terms of Obama’s Executive Order, the Attorney General will convene the first meeting of the Task Force within the next 30 days. A copy of the Order can be found here.

Sunday, November 15, 2009


The anticipated escalation of securities and investment fraud cases prompting criminal charges got off to an unexpected start with the acquittal of two Bear Stearns hedge fund managers last week. Regardless, financial industry members and their attorneys should continue to defend civil investigations and suits and administrative actions with an eye on the possibility of an indictment. Administrative enforcement personnel are in constant referral contact with criminal enforcement agencies such as the US Postal Service and the FBI. It is still all too common for either pro se defendants or targets, or defendants with counsel lacking financial or white-collar defense experience, to "T-up" a criminal prosecution by blindly participating in, or refusing to participate in, a civil or administrative action. Of course, in some cases, such as the Rothstein case coming out of Ft Lauderdale this month, the civil defendant and FBI target would have to be utterly clueless not to contemplate the advent of an indictment. But as the line between civil and criminal cases becomes less clear, and the public and political pressure to bring criminal cases persists, the brazen attorney or arrogant defendant may be in for a rude surprise.

Litigating a civil matter with an eye towards a potential criminal case is not an easy task. For example, asserting the privilege against self-incrimination in a civil or administrative matter is not without significant consequence, but the cost-benefit analysis of such an invocation should be evaluated and given serious and learned consideration. On the other hand, certain conduct in a civil matter--such as a lack of cooperation, witness tampering, or continuing on with the very conduct the regulator considers illegal--may frustrate the regulator or civil litigant to the point of seeking the involvement of a criminal enforcement agency. There are dozens of such points of decision or strategy during the course of any civil investigation or litigation. As such, there are seldom clear answers or boilerplate strategies. But the odds of making it through the treachery without blowing up yourself (or your client)are pretty slim if you don't even realize you are walking through a legal minefield. Remember, even an acquittal is only partial solace and seldom redemtive. The months of stress and distraction, public disgrace and incredible financial burden are not cured by the rare acquittal garnered by the Bear Stearns defendants. The line between civil and criminal investment or securities fraud is in the eyes of the beholder, and the beholder is the government until the case is submitted to the jury.

Thursday, November 5, 2009


On November 3, 2009, the Financial Planning Coalition sent a letter to members of the House Financial Services Committee expressing the Coalition's concern regarding an amendment to the Investor Protection Act of 2009 (“IPA”), which was passed by the Committee on October 25, 2009. The amendment would extend FINRA’s authority to cover investment advisors who are associated with broker-dealers already under FINRA’s authority.

The Coalition, made up of the Certified Financial Planner Board of Standards, Inc., the Financial Planning Association, and the National Association of Personal Financial Advisors, is concerned with how the amendment extends FINRA’s authority to approximately 88 percent of investment adviser representatives and implicates application of the fiduciary duty to investment advice. The members and stakeholders of the Coalition’s respective organizations believe that the issue warrants greater deliberation and through the letter are urging the committee to conduct a more thorough examination before allowing the delegation of authority from the SEC to FINRA, a self-regulatory organization ("SRO") that has no experience overseeing advisers or enforcing the provisions of the Investment Advisers Act of 1940.

The Coalition believes that the amendment would be inconsistent with the Committee’s intent with respect to the IPA because, among other things, the Committee has already approved an amendment that would change the assets under management threshold for SEC registration of advisers which would shift responsibility for the oversight of some 4,200 advisers from the SEC to the states, freeing up substantial SEC resources to enhance oversight of advisers under its jurisdiction. Moreover, the IPA allows the SEC to collect user fees from advisers to cover the costs of compliance examinations. This, along with the IPA’s authorization for a doubling of the SEC’s budget over the next five years and the shifting of the oversight burden to the states, would provide the SEC the funding necessary to oversee advisers.

The Coalition also states that the SEC is more appropriate as a primary regulator for advisers for several reasons. First, the SEC has been overseeing advisers for seven decades under a principles-based approach designed to regulate those providing advice, while FINRA has no experience in regulating investment advice. FINRA’s rules-based regulatory approach and focus, while fine for the brokerage community, is not readily adaptable to advisers. Moreover, FINRA oversight of advisers who are associated with broker-dealers would create a new, parallel system of regulation for advisers. The Coalition argues that this could create a new opportunity for regulatory arbitrage, with advisers and brokers making decisions on their business models based on a preferred regulatory model. Finally, FINRA is an SRO comprised of broker-dealers and would be inclined to bring a broker’s perspective to adviser regulation. The Coalition believes that this conscious or subconscious conflict of interest could result in a broker bias in FINRA oversight of advisers, and otherwise increase the differences in how broker-associated advisers are regulated versus independent advisers.

A copy of the Coalition's letter to the House Financial Services Committee can be found here.

Saturday, October 31, 2009


Cosgrove Law, LLC has locked horns with nationally known investment adviser Fisher Investments, Inc. on behalf of one of its clients. The matter is currently being litigated in the JAMS arbitration forum. Cosgrove Law, LLC has brought claims alleging, among other things, that Fisher Investments failed to satisfy its fiduciary duty to its clients by funneling their clients in to inappropriately aggressive portfolios comprised almost entirely of equities. Needless to say, these portfolios got destroyed by excess market exposure in 2008. Cosgrove Law, LLC has also asserted claims for unlawful merchandising, unregistered investment advice, negligent representations and an unlawfully fraudulent investment advice scheme. Fisher Investments Inc' CEO is best-selling author and Forbes columnist Ken Fisher. Mr. Fisher was recently deposed by Mr. Cosgrove in San Francisco. The case should go to hearing or trial in the first half of 2010. Stay tuned.


During the financial industry meltdown over the last two years, countless individuals have witnessed their life savings and retirement funds dwindle. At the SIFMA annual meeting on October 27, 2009, FINRA Chairman Rick Ketchum addressed these concerns and discussed some of the new patterns emerging within the financial industry, including proposed regulations and emerging business practices. The highlights of Chairman Ketchum’s address are set forth below:

Regulatory Shift

One of the main points of emphasis with regard to regulatory reform over the past few months has been the harmonization of the standard of care for broker-dealers and investment advisers. As Chairman Ketchum noted, most investors cannot distinguish between the two, in part because their services have begun to overlap each other in many respects. Accordingly, FINRA “whole-heartedly embraces” the Obama administrations goal of harmonizing the fiduciary standard for broker-dealers and investment advisers.

In addition to reforming the standard of care, the financial industry must find a way to harmonize the oversight and enforcement of that standard to ensure compliance by industry professionals. As Chairman Ketchum emphasized, for such a reformation to be effective, compliance “must be regularly and vigorously examined and enforced to ensure the protection of investors.”

Fraud Detection

Chairman Ketchum also discussed FINRA’s renewed focus on detecting and combating fraud. Namely, FINRA has enhanced its examination programs, procedures and training to help deter fraudulent conduct. In addition, FINRA recently established an Office of the Whistleblower—which handles high-risk tips—and announced the creation of an Office of Fraud Detection and Market Intelligence—which will in essence provide FINRA with a centralized anti-fraud division.

Technology Shift

With the emergence of social networking as a means to keep in contact with friends and interact with potential customers, FINRA is facing new regulatory challenges. As Chairman Ketchum noted, many younger registered representatives use sites such as Facebook, LinkedIn and Twitter as part of their everyday lives, and financial institutions cannot easily supervise their employees’ communications on these sites. As such, most firms have established rules prohibiting their employees from using these sites for business purposes. In reality, however, there is no cost-effective way to enforce these rules.

Accordingly, FINRA recently formed a Social Networking Task Force to “explore how regulation can embrace technological advancements in ways that improve the flow of information between firms and their customers.”

As is evident, the financial industry is currently facing an emergence of new patterns and challenges, both in regulation and in business practices. FINRA, as a self regulatory organization, is charged with embracing these paradigms and enacting regulations to ensure that investors stay protected. Click here for a complete copy of Chairman Ketchum’s address at the SIFMA annual meeting.

Friday, October 23, 2009


On October 22, 2009, Missouri Secretary of State Robin Carnahan announced that Merrill, Lynch, Pierce, Fenner & Smith, Inc. (“Merrill Lynch”) will pay $367,500.00 to the Missouri Investor Education and Protection Fund for failure to comply with Missouri’s registration laws. Acting on a tip from a former Merrill Lynch employee, the firm was the subject of a multi-state investigation into its registration practices. In total, the firm has been ordered to pay more than $26.5 million in “fines, penalties and other monetary sanctions and payments to the 50 states, the District of Columbia, Puerto Rico, and the U.S. Virgin Islands.”

According to the Order, Merrill Lynch violated Missouri's securities laws by “failing to ensure that its associates were properly registered in each state where they were doing business.” Under Missouri Revised Statute § 409.4-402, “it is unlawful for an individual to transact business in this state as an agent unless the individual is registered under [the Missouri Securities Act] as an agent.” Section 409.4-402 further provides that “it is unlawful for a broker-dealer engaged in offering, selling, or purchasing securities in this state, to employ or associate with an agent who transacts business in this state on behalf of broker-dealers unless the agent is registered.”

The Order also states that Merrill Lynch violated its own written policies and procedures in failing to properly supervise its client associates. Specifically, the firm generally requires its associates to pass the series 7 and 63 qualification exams and to maintain registrations in all necessary jurisdictions.

In today’s environment of heightened scrutiny and elevated enforcement actions, it is vital for financial institutions to ensure compliance with both state and federal regulations. With that in mind, our firm has the requisite knowledge and experience to ensure that you are in compliance with applicable securities laws. Please give us a call at (314) 563-2490 before you become the subject of an enforcement action.

A complete copy of the Order can be found here.

Thursday, October 22, 2009


Today, the SEC launched its new investor-focused website, Investor.gov, which aims to help investors invest wisely, avoid fraud and plan for their future. In addition, the website contains an entire section devoted to protecting senior investors.

Investor.gov also serves as a tool for individuals to seek help from the SEC, report complaints and provide tips for securities laws violations.

Click here to go directly to Investor.gov.

Friday, October 16, 2009


On October 1, 2009, we reported that the SEC and CFTC were planning to issue a joint report to Congress addressing the differences between the regulatory schemes for futures and securities. Today, the two agencies released their Joint Report of the SEC and CFTC on Harmonization of Regulation (“Joint Report”), which identifies these differences and recommends legislative and regulatory actions to address the inconsistencies.

As the Joint Report explains, there are significant differences between securities markets and futures markets. For instance, “[w]hile both regimes seek to promote market integrity and transparency, securities markets are concerned with capital formation, which futures markets are not.” Rather, futures markets are primarily concerned with the management and transfer of risk. Given that capital formation is the driving force in securities markets, securities regulation is in large part directed at proper disclosure to investors, whereas such disclosure is of less importance in futures markets.

In addressing these and other concerns, the lengthy 94 page Joint Report focuses on eight main areas in which the statutory and regulatory structure for the SEC and CFTC differ, including:

• Product listing and approval;
• Exchange/clearinghouse rule changes;
• Risk-based portfolio margining and bankruptcy/insolvency regimes;
• Linked national market and common clearing versus separate markets and exchange-directed clearing;
• Price manipulation and insider trading;
• Customer protection standards applicable to financial advisers;
• Regulatory compliance by dual registrants; and
• Cross-border regulatory matters.

In addition to identifying the differences between the two agencies’ statutory and regulatory structure in the above-referenced areas, the Joint Report contains twenty recommendations to Congress “for strengthening the agencies’ oversight and enforcement, enhancing investor and customer protection, rendering compliance more efficient, and improving coordination and cooperation between the agencies.”

Now that the SEC and CFTC have fully complied with the Obama administration’s recommendation in its White Paper, it is up to Congress to carefully consider these recommendations and work together with the SEC and CFTC to implement them.

A complete copy of the Joint Report can be found here.


Phyllis Molchatsky and Stephen Schneider, both New York residents, have sued the SEC in the United States District Court for the Southern District of New York for failure to detect Bernard L. Madoff’s Ponzi scheme.

The two claim that they would not have suffered losses from the Ponzi scheme if the SEC was not negligent in failing to detect the fraud perpetrated by Madoff despite receiving tips about Madoff’s scheme. The lawsuit seeks the $2.4 million lost by the two plaintiffs.

However, the lawsuit faces an uphill battle due to the doctrine of sovereign immunity, which shields the federal government from civil and criminal prosecution unless it has waived its immunity or consented to suit. The Federal Tort Claims Act (“FTCA”) is the statute by which the United States waives immunity and authorizes tort suits to be brought against itself. With exceptions, it makes the United States liable for injuries caused by the negligent or wrongful act or omission of any federal employee acting within the scope of his or her employment, in accordance with the law of the state where the act or omission occurred.

The plaintiffs claim that the SEC staff members were negligent in carrying out their duties by failing to investigate tips about Madoff’s Ponzi scheme. Therefore, their argument is that the FTCA applies and the SEC is not shielded by the doctrine of sovereign immunity.

Although the plaintiffs face a difficult battle, a decision in their favor would have a profound effect on the regulatory environment. Such a decision would open the door for investors to pursue the regulators where the facts may provide for a cause of action. As a result, it can be expected that the any decision in favor of the plaintiffs will likely be appealed to the highest level. We will continue to monitor this case as it progresses.

A copy of the Wall Street Journal article discussing this case can be found here.

Monday, October 12, 2009


On October 8, 2009, the SEC published for public comment its Draft Strategic Plan that outlines the Commission’s strategic goals for fiscal years 2010 through 2015. The plan was prepared in accordance with the Government Performance and Results Act of 1993.

The SEC noted that its goals and priorities were influenced by a number of external factors, including the demands imposed by changes in the past two years. Specifically, the subprime mortgage crisis exposed weaknesses in financial industry regulation and the global financial system. The crisis brought an abrupt end to the credit boom, which had pervasive financial and economic ramifications. Businesses failed and financial institutions collapsed, were acquired under duress, or became subject to government control.

The SEC noted that financial products and practices were evolving in the U.S. and in global capital markets before the recent crisis and continue to change today. As a result, it is impossible for anyone to predict with certainty how the markets will evolve and what new issues will arise. The SEC recognizes this is because it is the nature of the market environment that the search for higher or more stable returns will foster the development of new products and different practices. This makes it difficult to plan for issues that may arise in the future as a result of these innovative products and practices.

Although financial reforms are well underway, the SEC acknowledges that Members of Congress, the President’s Working Group on Financial Markets, and others have debated and will continue to debate the legislative initiatives that have been proposed. Hence, even though there is uncertainty as to the precise outline of the future legislative landscape, the SEC is using the lessons learned from the financial crisis to make improvements in areas already within its own operations as well as its regulations.

The initiatives outlined in the Strategic Plan are designed to address specific problems brought to light by the global financial crisis. These Strategic Goals are: 1) Foster and enforce compliance with the federal securities laws; 2) Establish an effective regulatory environment; 3) Facilitate access to the information investors need to make informed investment decisions; and 4) Enhance the Commission’s performance through effective alignment and management of human, information, and financial capital. The Strategic Plan outlines just over 70 initiatives to it plans to implement to achieve its Strategic Goals.

A complete copy of the SEC’s 2010-2015 Strategic Plan can be found here.

Friday, October 9, 2009


Members of Cosgrove Law, LLC recently attended the 2009 Securities Symposium, which included discussions with the Missouri Commissioner of Securities, Matthew D. Kitzi, and various other local and national securities industry leaders. The symposium covered a broad range of topics, including the current and anticipated trends in securities regulation and important issues facing Compliance Professionals today.

According to Commissioner Kitzi and his staff, the Missouri Securities Division is currently experiencing the most active period in its 80 year history in the wake of the 2008 financial crisis. Specifically, the Securities Division is on pace to receive over 2300 complaints this year, well above the previous one year high. According to the Securities Division, the most frequent complaints it has received from investors in 2009 have been in the following areas: (1) activity on accounts; (2) annuities; (3) complex products; (4) non-real estate business opportunities; and (5) real estate.

Along with an increased number of complaints, the Securities Division emphasized its commitment to step up its enforcement actions. In that regard, the Securities Division is on pace to set a record for the highest ratio of complaints vs. enforcement actions in its long history.

In addition, as we discussed on September 21, 2009, NASAA, with the help of the states, conducted a comprehensive audit sweep of Investment Advisers in 2008. Upon review of Missouri’s audit sweep, Missouri found that the most frequent deficiencies were as follows: (1) dearth of suitability on customers; (2) incomplete or out of date customer contracts; (3) incomplete or out of date ADVs; (4) inadequate computer back-up systems and poor books and records retention; and (5) financial deficiencies.

Are you concerned about the recent spark in enforcement activity from state and federal securities regulators in the wake of the Obama administration’s proposed regulatory overhaul? If so, contact a member of our firm to review and analyze your firm’s registration practices to ensure that your current practices are compliant with state and federal regulations.

Thursday, October 8, 2009


The Financial Industry Regulatory Authority (FINRA) is a private regulatory body charged with protecting investors and keeping an eye on the financial industry. As part of its services, FINRA offers BrokerCheck, an online database where investors can obtain information about registered brokers. The information made available is known as a CRD Report and contains information about employment and registration history, qualifications, as well as reportable customer disputes, disciplinary, and regulatory events. BrokerCheck allows users to access a full report and a consolidated report. Currently, under Rule 8312, this information is available for two years after a broker’s registration expires.

A recent proposal to amend the rule would make the consolidated reports available for a longer period of time, but the full reports will still be removed after the two year time period. However, this proposed change would only apply to brokers who have had a final regulatory action against them. Full reports would still be available through state agencies as they are now.

A recent Wall Street Journal article discussed the changes being made and the author took the position that the amendment was a step in the right direction, but still insufficient. In the article, the WSJ follows an insurance agent who was a former broker, but was banned from the securities industry after misappropriating $9,000. His CRD report was no longer available, but WSJ obtained it from Kentucky state regulators. After the Journal disclosed his expulsion to his current employer, he was fired from his job even though both he and his company acknowledged he had never provided financial advice in his then-current position.

One of the concerns with the proposed amendments is that only consolidated reports will be available. Consolidated disclosure does not mean better disclosure. The consolidated reports do not disclose the details about customer disputes, disciplinary, and regulatory events. Instead, the report merely states “customer dispute” or “criminal.” Because there is no full disclosure into the details of the criminal action, the information available can be very misleading. Those looking at the CRD will likely develop a bias against that person as they will not know if the criminal action is relevant to the practice of brokering. The Wall Street Journal’s chronicle ironically demonstrates this potential bias in that the former broker was fired from his job after the WSJ author disclosed the man’s CRD report.

Advocates of this amendment claim it will help delineate the “bad” brokers from the “good” brokers and better protect investors. However, this is flawed logic as more disclosure does not mean all the “bad” brokers will turn up. For example, a quick search on BrokerCheck reveals that Joseph Cassano, a former A.I.G. executive who was recently indicted for securities fraud, had a clean CRD report until the Department of Justice filed a complaint against him recently. Until the DOJ suit, there was no evidence on his consolidated report or his full report that suggested he was a “bad” broker. Our firm has also seen where incomplete or inaccurate information in the consolidated CRD report or other “public records” can have misleading results to the detriment of a “good” broker. Because the CRD also requires the reporting of information unrelated to brokers’ ability to perform their jobs well, irrelevant information in little to no context unduly punishes registered persons and does not provide real value to consumer protection.

If consumer protection is truly the goal, this proposed change would not meet that goal and would in fact provide more confusing information to the public. A more comprehensive approach would better serve all parties involved.


Last week, the House Financial Services Committee introduced the expansive Investor Protection Act of 2009. A copy of the bill can be found at www.financialservices.house.gov. Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, released discussion drafts of three pieces of legislation aimed at reforming the regulatory structure of the U.S. financial services industry. The draft bills include the Investor Protection Act, the Private Fund Investment Advisers Registration Act, and the Federal Insurance Office Act. These drafts contain many of the items that have been a part of the discussions surrounding regulatory reform. The Investor Protection Act proposes “to provide the Securities and Exchange Commission with additional authority to protect investors from violations of the securities laws and other purposes.” The Bill includes, among other things, establishing a fiduciary duty for broker-dealers and granting additional enforcement authority and remedies to the SEC by allowing the SEC to restrict mandatory arbitration.

On October 6th, the full committee held a hearing on capital markets regulatory reform and heard testimony from the President of NASAA, Denny Crawford (Texas Commissioner of Securities) and Richard Ketchum (CEO of FINRA), among others. Much discussion is taking place on the delineation of regulatory powers. States continue to be aggressive in advocating their assumed role in the regulatory enforcement community as the “cops on the beat.”

Friday, October 2, 2009


The SEC held a Securities Lending and Short Sales Roundtable on September 29 - 30, 2009, at its headquarters in Washington, D.C. The purpose of the roundtable was to review securities lending practices and also analyze possible short sale pre-borrowing requirements and additional short sale disclosures.

Day one of the roundtable focused on securities lending. In SEC Chairman Mary L. Schapiro’s opening statement, she noted that as the global securities market and investing have expanded, so have short selling and related strategies. As a result, the demand for securities lending has also grown. Ms. Schapiro noted that the recent credit crisis revealed that securities lending was much riskier than most of the players had thought in the past. This was revealed particularly in cases where the cash collateral for borrowed securities was reinvested in programs which experienced unanticipated illiquidity and losses.

In order to address this issue, day one consisted of four panels. The first panel was an overview of the securities lending regime. The second panel discussed investor protections concerns, including cash collateral reinvestment and the problems created by the credit crisis and potential solutions. The third panel discussed whether there was sufficient “transparency” in the current securities lending marketplace, and whether steps needed to be taken to improve it. The final panel discussed the future of securities lending, and whether there were any regulatory gaps in the marketplace and a need for additional SEC action to enhance investor protection.

Day two of the roundtable focused on short selling issues. Ms. Schapiro stated that due to the strong opinions on short selling of both supporters and detractors, she has made it a priority to evaluate the issue of short selling regulation in her tenure as SEC chairman.

The second day roundtable discussions consisted of two panels. The first panel considered the merits of imposing a pre-borrow or “hard locate” requirement on short sellers, or alternative forms of such proposals to enhance their benefit to investors. The purpose of this discussion was to address the abusive “naked” short selling and fails to deliver and the manipulative effect this activity can have on the market. Ms. Schapiro noted that the discussion would take into account the Commission’s existing “locate” requirement under Regulation SHO, which required short sellers to borrow or at least have reasonable grounds to believe that the securities can be borrowed, and Rule 204, which requires that clearing firms immediately purchase or borrow securities to close out the fail to deliver position by no later than the beginning of regular trading hours on the settlement date following the day the participant incurred the fail to deliver position.

Ms. Schapiro announced that the second panel would consider additional means to foster short selling transparency so that investors and regulators could have more and meaningful information about short sale activity. The panel would consider what additional public or non-public disclosure of short selling transactions and short positions would be beneficial, and if so, what type of disclosure should be implemented.

Ms. Schapiro made clear in her day two opening statement that the purpose of these roundtable discussions is to ensure that forthcoming regulation in this area is the result of a deliberate and thoughtful process. This indicates that these discussions will likely lead to SEC policy changes in the future.

A complete copy of Ms. Schapiro's opening remarks on September 29 can be found here, and a copy of her opening remarks on September 30 can be found here.

Thursday, October 1, 2009


On September 2-3, 2009, pursuant to the recommendation of the Obama administration, the SEC and CFTC held joint meetings to discuss assessments of the current regulatory schemes for futures and securities, a first for the two agencies. Within the next two weeks, the chairmen of the SEC and CFTC plan to issue a joint report to Congress addressing the differences between the regulatory schemes for futures and securities and recommending legislative and regulatory actions to close the regulatory gaps and address the inconsistencies.

A release by the SEC indicated that the report will likely discuss the following issues:

• Product listing and approval
• Exchange/clearinghouse rule approval under rules—versus principal-based approaches
• Risk-based portfolio margining and bankruptcy/insolvency regimes
• Linked national market and common clearing versus separate markets and exchange-directed clearing
• Market manipulation and insider trading rules
• Customer protection standards applicable to broker-dealers, investment advisors and commodity trading advisors
• Cross-border regulatory matters

The upcoming report will surely verify the SEC and CFTC’s efforts during recent months to harmonize the two agencies and “reduce regulatory arbitrage, avoid unnecessary duplication and close regulatory gaps.” We will provide a further update once the report is issued.

For a complete reading of the SEC’s press release, click here.

Monday, September 28, 2009


Broker-Dealers, have you ever thought about what a state regulator considers when initiating an enforcement action?

There are a number of considerations that a state regulator takes into account in a regulatory action. Below are a few of them taken from the NASAA Broker-Dealer Section Report on Principal Considerations for Regulatory Actions. We urge you to contact us if you have been contacted by a regulator. Hiring counsel experienced in these matters and doing so promptly can greatly help you going through an investigation and/or an enforcement action.

• Did the firm have adequate written supervisory policies and procedures in place to identify and prevent the alleged misconduct? The regulator will consider whether the firm’s internal compliance procedures were sufficient to detect the misconduct by reviewing the firm’s WSPs. If the firm’s procedures were inadequate, has the firm adopted new and more effective internal controls and procedures designed to prevent the misconduct?

• Did the firm conduct a thorough review of the misconduct? A regulator will consider what steps the firm took to reasonably identify the extent of the misconduct and identify all the parties involved. Did the firm spend the time and resources required to find the problem and address it?

• Were there “red flags” present that the firm missed? Are the firms WSPs adequate in regards to “red flags”? Remember, adequate WSPs are supposed to prevent and detect misconduct and identifying red flags and having procedures in place to address them is a good tool in your prevention and detection efforts.

• How did the firm respond to the State’s requests in the investigation and did they cooperate? This doesn’t mean you have to jeopardize any defense. But having good counsel to help you respond to a regulator’s inquiry and advocate on your behalf is an important component when on the receiving end of an enforcement action.

These are just a few of the considerations. You can see how important it is to have knowledgeable counsel to help you respond to an audit or enforcement inquiry. If you find yourself contacted by a regulator we urge you to contact us to ensure you have experienced counsel assisting you.

Friday, September 25, 2009


Recently, Cosgrove Law members attended the North American Securities Administrators (NASAA) annual conference in Denver. One of the topics presented focused on the hotly contested issue of Rule 506 transactions.

The Securities and Exchange Commission, in response to criticism that compliance with federal securities laws disadvantages small business, promulgated Regulation D. Rule 506 is one of the rules created and provides an exemption from registration under Section 4(2) of the 1933 Act. This exemption is the most frequently used exemption from Regulation D. Rule 506 limits the number of purchasers to 35, but there is no limit on the number of offerees. In determining the total number of purchasers, an offeror can exclude the same classes of accredited investors and related persons/entities as in Rule 505. However, unlike the other provisions in Regulation D, Rule 506 does not cap the cumulative amount of offered securities. Most states have a corollary provision to Rule 506 in their state securities laws that includes the same or similar exemption.

Ultimately, Regulation D is intended to simplify, clarify, and expand the already existing limited offering exemptions from registration. These regulations are also supposed to facilitate uniformity between state and federal exemptions, which would effectively level the playing field for costs of raising capital in small business. In 1996, Congress passed the National Securities Markets Improvement Act of 1996 (NSMIA) to further promote uniformity.

However, some argue that this legislation is a federal attempt to preempt state legislation and actually poses a threat to investors’ state law protections. To support their argument, proponents specifically claim the NSMIA effectively restrains state regulators’ authority and ability to oversee securities markets, especially Rule 506 transactions because covered securities are no longer subject to substantive state review. As such, state regulators are having a more difficult time catching early-stage fraud.

Others argue that despite the NSMIA, states still have enough regulatory and oversight authority for securities transactions under Rule 506 exemptions. They note that NSMIA permits states to require filings and fees for the offer and sale of covered securities in their state. Furthermore, because the NSMIA only preempts state securities registration requirements, states still can impose requirements on broker-dealer registration, which allows states to examine whether action is required in connection with a particular offer or transaction. Therefore, although covered securities are not subject to state law review, states still have authority under blue-sky laws to oversee offerings involving covered securities.

Following the wake of several financial scandals recently, there has been a push for reform, so undoubtedly, this debate will continue.

Thursday, September 24, 2009


A recent article in BusinessWeek raised an interesting argument about the logic of shareholder class action suits. After the Bank of America settlement agreement was rejected by New York Federal District Court Judge Rakoff, an interesting perspective in opposition of shareholder class action suits emerged. In the settlement between BofA and the SEC, Rakoff criticized the SEC for not providing adequate justification for not filing suit against BofA executives who were allegedly responsible for the false and misleading information, but instead pursuing a civil action against the corporation. Rakoff pointed out that the shareholders, who were the victims of the misconduct, would also be the ones ultimately responsible for paying the settlement.

Private investor suits are usually brought by large institutional investors and are separate from any government actions brought against a company. These suits garner settlements much larger than those typically seen in government actions. Shareholder class action suits against corporations have generally been thought to provide additional corporate policing to deter fraud and as a way for shareholders to hold corporations accountable for their misdeeds. However, Rakoff and other proponents argue the opposite: shareholders pay the price for the corporate misdeeds, while executives and other wrongdoers escape the costs.

They claim, rather, that class action suits pit shareholders against each other. Shareholders who acquire a company’s stock generally do so in an aftermarket transaction, not directly from the stock offering of a company. This effectively means investors who sold their stock at a loss are bringing suit against the shareholders who did not sell their shares or who acquired shares after the price drop. Former SEC Commissioner and Stanford University law professor, Joseph A Gundfest, notes that these aftermarket fraud cases end up causing “a wealth transfer among equally innocent third parties.” According to Judge Rakoff, this is precisely the setup in the BofA suit and is also the reason why he rejected the settlement.

Therefore, the shareholders who still hold the stock end up paying the settlement and attorneys’ fees. This “circularity” of funds circumvents those who actually perpetrated the fraud and places the cost with the shareholders still holding the stocks. This is a direct contradiction to the original purpose of compensating investors for their losses due to fraudulent behavior and does not deter fraud. As such, advocates of this view believe that financial system reforms should include new rules about shareholder lawsuits that target corporate executives rather than aftermarket investors. However, this is a view that remains largely in the academic arena, not the public. Currently, the new proposals in the legislature do not include any such reforms.

The full article can be found here.


SEC Chairman Mary L. Schapiro appeared before the House Committee on Agriculture on September 22, 2009, to testify regarding the regulation of over-the-counter (“OTC”) derivatives. In particular, she spoke about the Over-the-Counter Derivatives Markets Act of 2009, which was proposed in August by the Department of the Treasury. Ms. Schapiro noted that the recent financial crisis had revealed serious weaknesses in U.S. financial regulation, including a lack of regulation of OTC derivatives.

Ms. Schapiro noted that the framework provided by the Treasury proposal is designed to achieve four broad objectives: (1) preventing activities in the OTC derivatives markets from posing risk to the financial system; (2) promoting efficiency and transparency of those markets; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties. However, she laid out several broad areas in which the proposal could be strengthened to further avoid regulatory gaps and eliminate regulatory arbitrage opportunities.

One of Ms. Schapiro’s suggestions was aimed at minimizing regulatory arbitrage and gaming opportunities by regulating swaps like their underlying “references.” Ms. Schapiro noted that gaming, or regulatory arbitrage, possibilities abound when economically equivalent alternatives are subject to different regulatory regimes.

Under the Treasury’s proposal, regulatory responsibility for securities-related OTC derivatives would be divided between the SEC and the CFTC. Regulatory responsibility for other OTC derivatives would be given to the CFTC. Ms. Schapiro noted that although this could help to eliminate differences within the broad and varied world of “swaps,” it could result in significant regulatory differences between “swaps” products and the currently “regulated” securities and futures products. These regulatory differences could perpetuate existing regulatory arbitrage opportunities that encourage the migration of activities from the traditional regulated markets into the differently regulated swaps market.

Ms Schapiro suggested that the Treasury’s proposal be modified so that all securities-related OTC derivatives be regulated more like securities; and commodity and other non securities-related OTC derivatives be regulated more like futures. This would result in securities-related OTC derivatives and the underlying securities being regulated consistently. Ms. Schapiro suggested that Congress could implement this strategy by extending the federal securities laws to all securities-related OTC derivatives and extending the Commodity Exchange Act to all commodity-related and non-securities related OTC derivatives. This could significantly reduce the arbitrage opportunities between the regulated markets (securities or futures) and the differently regulated swaps market.

A complete copy of Ms. Schapiro’s testimony before the House Committee on Agriculture can be found here.

Monday, September 21, 2009


Cosgrove Law members attended the North American Securities Administrators (NASAA) annual conference last week. The conference provided us with great opportunities to interact with state regulators from around the country and directly hear from these regulators about their issues. They focused on a wide variety of topics involving broker-dealers and investment advisers because the regulatory changes being discussed at the federal level was on everyone’s mind. Where these discussions will lead and what effect any regulatory changes might have on everyone is not known at this time. What we did take away is that all of us need to be aware of the changes being proposed e.g. the Consumer Financial Protection Agency, understand the implications to our businesses, and be ready to implement best practices to ensure compliance.

Blue Sky Compliance for Investment Advisers-NASAA’s findings from Audit Sweep

NASAA coordinated a comprehensive audit sweep by the states of Investment Advisers this year. At the conference, they presented their findings and the deficiencies they most often found. Registration, Books and Records, Unethical Business Practices, Supervision, Privacy policy and Fees and Custody were the most frequent violations uncovered, but inaccurate ADV filings were the number one deficiency found. We can assume that States will now be closely looking at Investment Adviser ADV filings. Are your ADV filings compliant? Is your firm ready to face a regulator’s scrutiny? Are you aware of FINRA’s recent releases for changes to the IARD/CRD system? If not, or you just want to ensure your current practices are compliant, contact us to review and analyze your firm’s registration practices.

Friday, September 18, 2009


On September 17, 2009, the SEC voted unanimously to adopt or propose several measures aimed at improving the overall quality of credit ratings. The proposals are intended to provide a more robust regulatory framework for Nationally Recognized Statistical Rating Organizations (“NRSROs”) by (1) requiring greater disclosure; (2) fostering competition; (3) helping to address conflicts of interest; (4) shedding light on rating shopping; and (5) promoting accountability.

In particular, the SEC has agreed to consider six proposals related to NRSROs:

• A recommendation to adopt rules to provide greater information concerning ratings histories — and to enable competing credit rating agencies to offer unsolicited ratings for structured finance products, by granting them access to the necessary underlying data for structured products.

• A recommendation to propose amendments that would seek to strengthen compliance programs through requiring annual compliance reports and enhance disclosure of potential sources of revenue-related conflicts.

• A recommendation to adopt amendments to the Commission's rules and forms to remove certain references to credit ratings by nationally recognized statistical rating organizations.

• A recommendation to reopen the comment period to allow further comment on Commission proposals to eliminate references to NRSRO credit ratings from certain other rules and forms.

• A recommendation to require disclosure of information including what a credit rating covers and any material limitations on the scope of the rating and whether any "preliminary ratings" were obtained from other rating agencies — in other words, whether there was "ratings shopping"

• A recommendation to seek comment on whether we should amend Commission rules to subject NRSROs to liability when a rating is used in connection with a registered offering by eliminating a current provision that exempts NRSROs from being treated as experts when their ratings are used that way.

SEC Chairman Mary S. Schapiro stated that the proposed measures “are needed because investors often consider ratings when evaluating whether to purchase or sell a particular security.” In 2006, with the passage of the Credit Rating Agency Reform Act, the SEC was given exclusive authority over rating agency registration and qualifications.

A copy of Ms. Schapiro’s opening statement before the SEC Open Meeting can be found here.

Friday, September 11, 2009


For our readers' convenience, we recently added a social networking feature to our site. You can now share our blog on Twitter and Facebook by clicking on the links under "Share this Page" (located on the left hand side of the page).

In addition, Cosgrove Law, LLC is pleased to announce that it is now a member of Twitter.com.


On August 28, 2009, Missouri’s new “Senior Protection Act” took effect with the goal of better protecting investors from fraud. The Act, which gained bipartisan support from Missouri legislators, was influenced by Secretary of State Robin Carnahan’s pledge to enact stronger protections for those particularly susceptible to fraud—seniors and disabled investors.

The Senior Protection Act creates harsh penalties for those who wish to take advantage of these individuals. In particular, the Act establishes a minimum penalty of $50,000.00 for anyone who commits criminal securities fraud against an elderly or disabled person—with the maximum penalty being $1,000,000.00 and up to ten years in prison—along with an additional penalty of up to $5,000.00. The Act defines an “elderly person” as a person sixty years of age or older.

The newly-enacted Senior Protection Act can be found here, under Missouri Revised Statute § 409.5-508.

Friday, September 4, 2009


The Executive Summary of the Inspector General’s report regarding the Bernard Madoff fraud was released on August 31, 2009. In a statement issued by SEC Chairman Mary L. Schapiro upon the release the report, Ms. Schapiro acknowledged the Madoff fraud as a failure by the SEC to protect investors. However, Ms. Schapiro emphasized the SEC’s quick and drastic reaction in the wake of the fraud, stating that the SEC has since been “reviewing [its] practices and procedures, addressing shortcomings, and implementing the lessons learned.” Ms. Schapiro anticipates that the changes implemented by the SEC will help the agency better detect fraud in the future, thus preventing the financial turmoil caused by the Madoff fraud.

Our previous blog entry discussing some of the SEC's recent changes can be found here. In addition, click here for an in-depth analysis of the SEC’s post-Madoff reforms.

Tuesday, September 1, 2009


SEC Chairman Mary Schapiro issued an order yesterday to broker-dealer firms addressing concerns regarding the recruiting methods for broker-dealer registered representatives. Ms. Schapiro noted that some types of recruiting methods, such as enhanced compensation practices wherein firms provide large up-front bonuses and enhanced commissions for sales of investment products, may in turn lead to greater risks for investors. In particular, recruiting methods based on these types of financial rewards create the risk that broker-dealer registered representatives will act in their own interest when selecting investment products for their customers, thereby violating their obligations to investors.

As such, Ms. Chapiro issued the order to remind broker-dealer firms, and in particular their CEOs, of the “significant supervisory responsibilities [they] have under the federal securities laws to oversee broker-dealer activities, particularly with respect to sales practices.”

A copy of the order can be found here.

Sunday, August 30, 2009


Both attorneys and the targets of civil securities investigations need to understand that the dotted line between civil and criminal investigations is becoming more hazy, and criminal prosecutions of alleged securities law violators are becoming more common. At Cosgrove Law, LLC, we have had civil defendants come to us that had previously and unknowingly waived their constitutional rights to remain silent and testified (and incriminated themselves) in response to a civil investigatory demand. Some of them were represented by prior counsel when they did so.

State securities regulators frequently and contemporaneously share the fruits of their investigations with federal and state criminal investigatory authorities, such as the FBI or the U.S. Postal Service. Some state regulators--namely Attorneys General--have contemporaneous civil and criminal jurisdiction. Although we had thorough written guidelines regarding the need to erect and maintain "Chinese Walls" and avoid crossover during parallel proceedings when I ran the Missouri Attorney General's Consumer Protection Division, and worked as the Chief Consumer Protection Prosecutor in the Massachusetts Attorney General's Criminal Division, many regulators confronted with the case law regarding the prohibitions against using civil compulsory process to feed a criminal investigation appear to have been confronted with alien information. Counsel for a civil defendant must quickly identify the potential for criminal exposure and understand the limitations on purported civil investigations. On the other hand, attorneys representing defrauded investors should have the knowledge and experience necessary to identify those situations when a report to a criminal investigatory agency is appropriate. They must also understand that threatening to do so in an attempt to foster a civil resolution is strictly prohibited.

On a side note, just this past week, the Missouri Securities Division's most recent Chief Enforcement Counsel joined our law firm. We expect that she will be a great asset to our versatile securities, white collar defense and commercial litigation practice.

Thursday, August 27, 2009


On August 17, 2009, the SEC announced that it has reopened the comment period for its proposed "Amendments to Regulation SHO" for 30 days to allow additional feedback on the alternative uptick rule, an alternative short selling price test that would allow short selling only at a price above the current national best bid.

In its original "Amendments to Regulation SHO," proposed April 2009 in Securities Exchange Act Release No. 59748, the SEC proposed two approaches to restrictions on short selling: the "short sell price test," which would apply on a market-wide and permanent basis; and the "circuit breaker," which would apply only to a particular security during a severe market decline in the price of that security. The SEC also sought comment on the alternative uptick rule in its April 2009 proposal, including whether it would be preferable to the "short sell price test," and whether it would be more effective as a market-wide permanent price test restriction or in conjunction with the "circuit breaker" approach.

The SEC received almost 4,000 comments to its April 2009 proposal, and there was some evidence of support for the alternative uptick rule. As such, to ensure that investors and industry professionals have a full opportunity to comment on the alternative uptick rule, the SEC has published a supplemental request for comment specifically on the rule.

Click here for the SEC's complete notice of re-opening of the comment period and its supplemental request for comment.

Tuesday, August 25, 2009


In June 2009, the Obama administration released its White Paper on Financial Regulatory Reform, which called on the SEC and CFTC (“Commodity Futures Trading Commission”) to “make recommendations to Congress for changes to statutes and regulations that would harmonize regulation of futures and securities.” On August 20, 2009, in accordance with the Obama administration’s recommendations, the two agencies announced that they will hold joint meetings to discuss assessments of the current regulatory scheme, harmonization of the agencies’ rules, and recommendations for changes to statutes and regulations. SEC Chairman Mary Schapiro said she hopes the joint meetings will help “increase transparency, reduce regulatory arbitrage and rebuild confidence in our markets.”

The meetings, which will be held on September 2-3, 2009, will consist of five panels and will cover a wide range of topics, including the regulation of exchanges and markets; the regulation of intermediaries; the regulation of clearance and settlement; enforcement; and the regulation of investment funds.

For more information on the joint meetings, please see the Meeting Notice.

Thursday, August 13, 2009


Since Robert Khuzami took over as Director of the SEC’s Enforcement Division (“Division”), the Division has introduced a number of new initiatives to increase its effectiveness. These initiatives include a restructuring of the Division, an overhaul of its operation, and a renewed effort to bring enforcement actions against wrongdoers.

In a recent speech by Mr. Khuzami before the New York City Bar Association, he acknowledged the criticism the SEC has endured as a result of the Bernard Madoff scandal, and responded by saying that the Madoff scandal “should not be permitted to obscure the 75-year tradition of vigorous enforcement [by the Division]…to protect the investing public.” With that mindset, Mr. Khuzami has put into motion four main initiatives with the goal of increasing investor protection.

First, the Division will be creating national specialized units focused on particular, specialized areas of securities law. Mr. Khuzami indicated that the Division will initially have five specialized units: (1) Asset Management Unit; (2) Market Abuse Unit; (3) Structured and New Products; (4) Foreign Corrupt Practices Act; and (5) Municipal Securities and Public Pensions. The goal of this initiative is to make the Division more efficient and more knowledgeable, thereby leading to better investigations.

Second, the Division plans to streamline its management structure and internal processes. With regard to the management structure, the Division will be moving away from its decentralized structure and redeploying its branch chiefs to focus on conducting investigations, thereby minimizing the number of managers (i.e., decision-makers). In addition, Mr. Khuzami will be assuming full power to issue formal orders of investigations, which he plans to delegate to senior officers throughout the Division. This initiative aims to move cases along more quickly, thereby giving the Division more time to focus on new matters.

Third, the Division has created an Office of Market Intelligence, which will have the sole responsibility of collecting, analyzing and monitoring all tips, complaints and referrals the SEC receives each year. This Office will give the Division the ability to focus its investigations on the most credible tips, thereby increasing the efficiency of its investigations.

Finally, the Division is working to increase the incentives offered to individuals to promote cooperation with SEC investigations. This would provide the Division with access to more concrete information, thereby allowing the Division to more effectively uncover wrongdoing.

As is evident, Mr. Khuzami has implemented a plan to once again make the SEC a powerful enforcement mechanism. The results are already apparent in that since late January 2009, the Division has opened 10% more investigations, has filed 147% more temporary restraining orders, and has filed roughly 30% more enforcement actions.

A complete copy of Mr. Khuzami's speech can be found here.

Tuesday, August 4, 2009


On July 31, 2009, we briefly discussed the SEC's decision to make permanent its temporary Rule 204T, which attempts to curb short-sale abuses by strengthening the close-out requirements of Regulation SHO for failures to deliver securities resulting from investor short-selling in the securities market. As we noted, since the SEC's adoption of temporary Rule 204T, there has been a significant decline in the number of "failures to deliver" resulting from short-selling.

A recent article by the Wall Street Journal indicates that the SEC's permanent enactment of Rule 204T is already having an impact on the nation's largest stock exchanges. Specifically, "[b]oth NYSE Euronext (NYX) and Nasdaq OMX Group Inc. (NDAQ) are now aggregating daily company-by-company short-sale data on all trades that take place on their exchanges." According to the article, Nasdaq plans to eventually seek SEC approval to charge for this information, a request which seems clearly inconsistent with the SEC's purpose behind Rule 204T.

Our attorneys have more than two decades of combined experience in the areas of securities regulation and securities fraud litigation.

Click here to read the entire Wall Street Journal article.

Friday, July 31, 2009


In an effort to curb abusive short sales and provide public investors with greater disclosure, the SEC made permanent the amendments contained within Interim Final Temporary Rule 204T of Regulation SHO. The temporary rule, enacted in 2008, was originally set to expire on July 31, 2009. However, due to the documented success of Rule 204T, the SEC decided to adopt the rule long-term with some minor modifications.

Short selling is a form of advanced trading whereby a trader essentially bets on the failure, at least in the short-term, of a company. In a typical scenario, an investor sells borrowed securities to a particular buyer for full ownership, with the intent to buy back equivalent shares once the price has declined. The seller then returns the equivalent shares to the lender, thus satisfying any obligations to the lender and profiting from the decline in share price.

In a second and more problematic scenario, an investor sells securities to a particular buyer without having first arranged to borrow the shares which the investor sold. In essence, the investor sells securities in which he or she has no rights with the hope that the investor will then be able to purchase equivalent securities at a diminished price prior to the clearing time period at which delivery to the buyer must be made. This type of trading is commonly known as “naked” short-selling.

Abusive short-selling, and particularly naked short-selling, has been of particular concern to the SEC in that the practice often results in a “failure to deliver,” whereby an investor is unable to deliver the shares he or she has borrowed or sold within the specified time frame. A “failure to deliver” can create a misleading impression of the market for investors, and can have the effect of depriving rightful shareholders of the benefits of ownership.

As such, in 2005 the SEC enacted Regulation SHO, which targets abusive “naked” short-selling by attempting to reduce failures to deliver. Rule 204T, adopted on a temporary basis in October 2008, strengthens the close-out requirements of Regulation SHO for failures to deliver securities resulting from investor short-selling in the securities market. The SEC’s permanent enactment of Rule 204T provides strong evidence of the SEC’s determination to tackle the problems associated with abusive short-selling.

Wednesday, July 29, 2009


NASAA proposed a new model rule today pertaining to solicitors. The stated goal of the Proposed Rule is to keep intact the increased investor protection standards presently required by the states and at the same time it seeks to limit or clarify the conditions under which investment advisors, their representatives, and solicitors must operate.

This rule should be examined by investment advisors who use solicitors to help in their business as well as investors or potential investors who have been contacted by others on behalf of an investment advisor or investment firm.

The Proposed Rule defines a “Solicitor” as an individual or entity who, either directly or indirectly, receives a fee or economic benefit for referring, offering, or otherwise negotiating for the sale of investment advisory services to clients on behalf of an investment advisor.

This rule offers exemptions for a solicitor who provides impersonal services such as written marketing materials or statistical information that is not directed towards the needs of a specific client. An additional exemption exists where there is a written agreement between the investment advisor and the solicitor for the solicitor to provide services and this relationship is disclosed in writing to the client prior to the time the client signs a written investment advisory contract. The rules for solicitors do not apply to a partner, officer, director or employee of an investment advisory firm. This Proposed Rule does not relieve a person of any fiduciary duties or other obligations to which they may be subject to under any law.

NASAA is accepting comments on the Proposed Rule until Monday, August 17. A complete copy of the proposed rule can be found at this website: http://www.nasaa.org/issues___answers/regulatory_activity/11095.cfm#

This Proposed Rule follows the SEC’s announcement on July 22, 2009 that it has proposed a rule aimed to end “pay to play” practices by investment advisors who seek to manage public funds for state and local governments. The overall goal of this proposed rule is to restrict the use of campaign contributions in exchange for the opportunity to manage such funds. One of the provisions of the proposed rule specifically bans the use of solicitors to act directly or indirectly on their behalf in securing an opportunity to manage funds for state and local governments.

The full text of this Proposed Rule has not yet been released by the SEC.

Friday, July 24, 2009


During recent years, more and more individual investors have entered into the municipal securities market. Particularly troublesome has been the noticeable discrepancy between the information disclosed to investors in municipal securities and the information available to corporate securities investors. Accordingly, on July 17, 2009, the SEC issued a proposal to amend the current municipal securities disclosure requirements provided under Rule 15c12-12 of the Securities Exchange Act of 1934.

The proposed amendments would serve five main functions, including:

(1) Requiring a broker, dealer or municipal securities dealer to reasonably determine that the issuer or obligated person has agreed to provide notice of specified events in a timely manner;

(2) Amending the list of events for which a notice is to be provided;

(3) Modifying the events that are subject to a materiality determination before triggering a notice to the MSRB;

(4) Revising an exemption from the rule for certain offerings of municipal securities with put features; and

(5) Providing interpretive guidance intended to assist municipal securities issuers, brokers, dealers and municipal securities dealers in meeting their obligations under the antifraud provisions.

Chairman Mary L. Schapiro summarized the likely impact the proposed amendments would have by explaining that they would “help investors make more knowledgeable investment decisions about municipal securities, while at the same time enabling broker-dealers to satisfy their obligations.”

Public comments on the SEC’s most recent proposal are due September 8, 2009.

Monday, July 20, 2009


Under the current FINRA rules for customer disputes and industry disputes, “no claim shall be eligible for submission to arbitration under the Code where six years have elapsed from the occurrence to the event giving rise to the claim.” Rule 12206(a) of the Code of Arbitration Procedure for Customer Disputes; Rule 13206(a) of the Code of Arbitration Procedure for Industry Disputes. Neither rule extends applicable statutes of limitations, but each provides that “where permitted by applicable law,” the time limit for filing a claim in court is tolled while FINRA maintains jurisdiction after an arbitration claim has been filed. Rule 12206(c); Rule 13206(c).

Although the language of the above-referenced tolling provisions is intended to toll all statutes of limitations while an arbitration claim is pending, at least one state court has interpreted the phrase, “where permitted by applicable law,” to mean that the time limit for filing a claim in court is only tolled if state law expressly permits such tolling. FINRA has expressed concern over the state court decision, noting that the holding may allow courts to dismiss customer claims on the basis that the statute of limitations ran while the arbitration claim was still pending.

As such, with the approval of the SEC, FINRA recently decided to remove the phrase, “where permitted by applicable law.” The amendment will negate any concern over state court interpretations as to the tolling provisions, thereby preserving FINRA’s original intent. The amendment becomes effective on August 10, 2009, and will apply to all claims filed on or after that date.

You can read FINRA’s Regulatory Notice 09-36 here.