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.