Tuesday, December 28, 2010


Last month the AARP and the Northern American Securities Administrators, Inc. (NASAA) joined forces to file an Amicus Brief in the United States Supreme Court in Janus Capital Group, et al v. First Derivative Traders. At issue was the extent to which a person or entity must be involved in drafting false statements in order to be exposed to potential §10(b) liability. According to the Amici, the mutual fund advisers should fall within the reach of §10(b) liability because the fund's advisers were the primary actors relative to the false statements made within the prospectuses for the mutual fund.

Plaintiff's are mutual fund investors in Janus Funds. Janus Management stands accused of engaging in secret market timing deals to the detriment of the Janus Fund investors. On appeal, Janus Management argues that the Court should apply a “Direct Attribution” standard. AARP and NASAA argue that the application of this restrictive standard would allow the fund advisers to dodge liability and shift it to the Fund's innocent shareholders by simply keeping their name off the prospectus. Seems like a fairly compelling argument.

Perhaps the most interesting angle on the Brief, and the issue on appeal, is NASAA's argument that §10(b) must be afforded an expansive application and interpretation in light of the absence of an alternative state court remedy. But its primary basis for this argument is not the absence of a remedy, but the absence of a procedure – class actions. Indeed, the 1998 Securities Litigation Uniform Standards Act (“SLUSA”) imposed heavy restrictions upon the utilization of class litigation in the state courts. The Amici noted as somewhat of an after-thought the absence of a remedy as well, due to the absence of a state common law fraud-on-the-market cause of action.

The Supreme Court heard oral argument on the matter on December 7th. A transcript or the oral argument can be retrieved by clicking here. The Amicus Brief can be reviewed by clicking here.

Thursday, December 23, 2010


According to the Third Circuit Court of Appeals, the SEC Department of Enforcement's imposition of a permanent bar upon a Merrill Lynch “Investment Service Advisor” for recommending unsuitable mutual fund switches was not a disproportionate sanction.

Former Merrill Lynch Investment Service Advisor Scott Epstein appealed the SEC's affirmation of the Enforcement Division’s imposition of the permanent bar, claiming that the sanction was grossly disproportionate and that the FINRA hearing process was flawed. In rejecting these claims, the U.S. Court of Appeals noted that Merrill Lynch provided a financial incentive for its advisors to switch its customer's funds between both classes of mutual fund shares and families of mutual funds. Epstein was accused of recommending unsuitable switches to 12 customers between the ages of 71 and 93 without providing a proper explanation of, or rationale for, the expenses associated with the switches.

One of the customers sent a letter of complaint, in response to which Merrill Lynch's Legal Department sent the standard “We regret...but too bad” letter. In an interesting twist, Epstein subsequently complained to FINRA about Merrill Lynch's application of pressure to make the switches after FINRA served him with a Wells Notice.

Almost four months after his lawyer walked out in the middle of Epstein's disciplinary hearing, the SEC issued a permanent bar for violating FINRA Conduct Rules 2310 and 2110, even though the FINRA sanctions guidelines called for a maximum penalty of $75,000 and a maximum suspension of one year. The National Adjudicatory Council (NAC) and SEC denied Epstein's appeals. In doing so, “the commission concluded that Epstein's case was egregious because he violated the suitability rule with numerous elderly, unsophisticated and retired customers, and because his involvement was 'more than a mere mistake'.”

The Third Circuit Court of Appeals agreed with this somewhat stunning conclusion in Epstein v. SEC, No. 09-1550 2010 W.L. 4739749 (Nov. 23, 2010). It did so despite noting that – where it comes to permanent bars - “the Commission has a greater burden of justification [and] has an obligation to explain why a less dramatic remedy would not suffice.” Investment advisors employed by insurance companies that recommend switches in pre-existing brokerage accounts or unlicensed recommendations to liquidate securities in order to fund annuities should pay heed to this remarkable case.

Friday, December 17, 2010

CFTC Proposes Draft Rule on Trading Restrictions

The Commodity Futures Trading Commission on Thursday, December 16, 2010, released a proposal that aims to curb speculative trading in commodities such as oil and precious metals. The proposal is part of the effort to increase oversight of the over-the-counter derivatives market as required of the CFTC under the Dodd-Frank bill passed in July. Specifically, the Dodd-Frank Act amended the Commodity Exchange Act to require, among other things, the Commission to limit the amount of positions, other than bona fide hedge positions, that may be held by any person with respect to commodity futures and option contracts in exempt and agricultural commodities traded on or subject to the rules of a designated contract market.

The draft plan would set a cap on spot-month positions (the month when a contract expires) to 25% of deliverable supply for a given commodity. Non-spot-month position limits will be set for each referenced contract at 10 percent of open interest in that contract up to the first 25,000 contracts, and 2.5 percent thereafter. The proposal is on position limits in 28 different commodities, among which are included gold, silver and platinum. The Commission estimates that at most seventy traders in referenced agricultural contracts, six traders in referenced base metals contracts, eight traders in referenced precious metals contracts, and forty traders in referenced energy contracts may be affected by the proposed spot-month position limits.

"Spot-month" limits are based on estimates of deliverable supply, which information is currently available from designated contract markets. On the other hand, the CFTC currently does not have the data available for the proposed formula to be used for position limits outside of the spot-month, which is based on the overall size of the physical commodity swap markets.

According to the CFTC, the proposed position limits would enable the Commission to combat excessive speculation and manipulation. However, there was some skepticism among the commissioners of the CFTC as to whether this proposal will be effective. Voting on making the proposal formal for public comment was postponed so that further deliberation can take place.

A copy of a Wall Street Journal article discussing the CFTC proposal can be found here. A CFTC fact sheet on the proposal can be found here, and a CFTC Q&A on the proposal can be found here.


On November 29, 2010, keeping in line with its goal to enhance ERISA plan disclosures, the Department of Labor’s Employee Benefits Security Administration announced a proposed rule to help plan participants better understand target date retirement funds. Specifically, the proposed rule would expand the information required to be disclosed to plan participants and beneficiaries concerning investments in target date funds.

Many target date funds are found within participant-directed plans, which are ERISA plans that provide for allocation of investment responsibilities to participants or beneficiaries. According to the Department of Labor, an estimated 72 million participants are covered by participant-directed plans, which contain nearly $3 billion in total assets.

Target date funds have become popular with 401(k) plan participants because they allocate investments among different asset classes such as stocks, bonds and cash equivalents. But unlike other mutual funds, target date funds automatically reallocate their asset mix according to a set time frame that is appropriate for a particular participant. Generally, the funds are set up to become more and more conservative as the participant nears retirement age to minimize the participant’s risk.

Despite their convenience for investors, many plan participants do not realize that investing in a target date fund is not a “one-size-fits-all” investment strategy. Indeed, target date funds with the same target date may have very different investment strategies and asset allocations. This distinction is dangerous for plan participants because the varying investment strategies and asset allocations can lead to very different investment results over time. Unless plan participants understand this, they run the risk that these “autopilot” funds will earn too little for their retirement needs.

The new proposed rule would amend the “qualified default investment alternative regulation” (29 C.F.R. § 2550.404c-5) and the “participant-level disclosure regulation” (29 C.F.R. § 2550.404a-5) to require new disclosures about the design and operation of target date funds, including:

• The investment’s asset allocation;
• How that allocation will change over time, with a graphic illustration; and
• The significance of the investment’s “target” date.

Comments on the proposed rule must be received by January 14, 2011. A copy of the proposed rule can be found here.

Wednesday, December 15, 2010


A recent enforcement action and consent order highlights the broker-dealer community's ongoing struggle with FINRA Rule 3040. Huntleigh Securities Corp. was fined $300,000 by the Missouri Securities Division for failing to supervise a broker that engaged in over $4 million of private securities transactions. In most instances, the broker simply fails or ignores the need to obtain his or her broker-dealer's approval for the transactions. In the Huntleigh matter, as was the case with certain broker-dealers approving the sale of non-registered but securitized 1031 exchanges, the broker-dealer approved the transactions but failed to supervise them. They also failed to even recognize that the broker was selling unregistered securities.

To simplify a very simple rule, Rule 3040 requires a broker to submit a detailed written request to engage in the sale of a product that is outside the scope of his or her broker-dealer's normal course of business. If the broker is receiving any kind of compensation for the transaction – even a finder's fee – the broker-dealer is required to supervise the transactions and carry it on it's book and records as if it were a non-private securities transaction. That means, among other things, that the broker-dealer is required to engage in a reasonable-basis product suitability analysis and provide the broker the training necessary to conduct a thorough customer-specific suitability analysis. And as part of the reasonable-basis analysis, the broker-dealer must conduct a due diligence analysis which goes beyond a mere spoon-feeding by the third-party product sponsor.

As part of the consent order with the Securities Division, Huntleigh “agreed” to – among other onerous measures – retain at its expense an outside consultant to review and report back on its compliance and supervisory policies and procedures relating to the outside business activities of its agents.

Cosgrove Law, LLC provides consulting and auditing services and works in tandem with other industry experts to assist securities and commodities broker-dealers in achieving compliance with rules such as FINRA 3040. We also represent investors that suffer severe consequences when they are persuaded to participate in unsuitable private securities transactions. But, when it's all said and done, it doesn't matter who you hire for assistance if you remain ignorant of Rule 3040 and its mandates.

Monday, December 6, 2010

DID YOU JUST BUY OR SELL AN UNREGISTERED SECURITY? Pinnacle Partners Financial Issues Denial

Generally speaking, if an investment is a security it either needs to be registered or exempt from registration. Sound simple? Maybe not, but it certainly isn't rocket science. And yet it is far too commonplace to read headlines about enforcement actions related to the sale of unregistered securities, or about defrauded investors lured in to the glittery promises of unvetted, unregistered, high-risk products.

Just this past Friday FINRA filed a Notice seeking a Temporary Cease and Desist Order against Pinnacle Partners Financial Corporation (“Pinnacle”) of San Antonio, Texas. FINRA alleges that, among other things, Pinnacle was selling private placements in unregistered security interests in oil and gas ventures. Pinnacle issued a statement denying that its sales suffered from fraudulent material omissions, but it is unclear if they claim that their oil and gas investments qualified as a security under the Federal Howey test and the various state securities codes, or if they were securities that met a registration exemption. Sadly, many in the industry, as well as consumers, fail to appreciate the distinction between a security, a security that is exempt from registration, and a security transaction that is exempt from registration. And, of course, even exempt transactions, such as those pursuant to Reg. D, Rule 506 require a filing with the SEC and state regulators.

So what's all the fuss about? If a Broker-Dealer cannot distinguish a security from a non-security, there may be other basics for which they lack competence. Sure registration is not a panacea. Many investors get snookered on registered investments. But the fact that a security is illegally unregistered, or misidentified as a non-security, is frequently the tip of the ice berg. Indeed, Broker-Dealers such as Pinnacle take on substantial due diligence, record keeping and compliance obligations pursuant to FINRA Rule 3040 when their sales force is pushing securities sponsored by third-parties. And, of course, FINRA has issued substantial guidance regarding the heightened risks and ancillary Broker-Dealer obligations of non-conventional investments.

So: Buyer and Broker beware. If you are a buyer, and it looks, walks and quacks like a security—it probably is one. Same holds true for the Broker-Dealer and it's representatives. Once one realizes it is a security, both the customer and the salesperson should expect to receive an open and thorough PPM as well as back-up due diligence upon request. If it is not available, you cannot do your due diligence, which is a good sign that you shouldn’t be buying or selling it. Let's see how this Pinnacle matter unfolds.

Tuesday, November 30, 2010

Changes in Federal Expert Disclosure Rules Shed Light on Corresponding Illinois Rules

On December 1, 2010, changes to Federal Civil Rule 26 become effective that will affect the use of expert witnesses in federal courts. This amendment adds new subparagraphs 26(b)(4)(B) and (C):

(B) Trial-Preparation Protection for Draft Reports or Disclosures. Rules 26(b)(3)(A) and (B) protect drafts of any report or disclosure required under Rule 26(a)(2), regardless of the form in which the draft is recorded.

(C) Trial-Preparation Protection for Communications Between a Party's Attorney and Expert Witnesses. Rules 26(b)(3)(A) and (B) protect communications between the party's attorney and any witness required to provide a report under Rule 26(a)(2)(B), regardless of the form of the communications, except to the extent that the communications:

(i) relate to compensation for the expert's study or testimony;

(ii) identify facts or data that the party's attorney provided and that the expert considered in forming the opinions to be expressed; or

(iii) identify assumptions that the party's attorney provided and that the expert relied on in forming the opinions to be expressed.

The amendments essentially extend the work-product protection to draft reports by testifying expert witnesses and protect most communications between attorneys and experts.

Prior to the change, Rule 26 had been interpreted by most federal courts to allow discovery of all materials considered by testifying experts, all communications between counsel and testifying experts, and all draft reports of testifying experts. See In re Pioneer Hi-Bred Int'l, Inc., 238 F.3d 1370, 1375 (Fed. Cir. 2001) (“[T]he 1993 amendments to Rule 26 . . . make clear that documents and information disclosed to a testifying expert in connection with his testimony are discoverable by the opposing party, whether or not the expert relies on the documents and information in preparing his report,” including an attorney’s “core work product.”); see also Manufacturing Admin. & Mgmt. Sys. Inc. v. ICT Group, Inc., 212 F.R.D. 110, 113-14 (E.D.N.Y. 2002) (same); see also Krisa v. Equitable Life Assur. Soc., 196 F.R.D. 254, 256 (M.D.Pa. 2000) (holding that documents prepared by expert witnesses, including draft expert reports, are not protected by the work product doctrine); Ladd Furniture, Inc. v. Ernst & Young, Case No. 95-00403, 1998 WL 1093901, at *11 (M.D.N.C. Aug. 27, 1998) (noting other courts have found draft expert reports are discoverable).

As a result, lawyers and experts operating under Federal Rule 26 took steps to avoid creating a trail of discoverable information. Judge Lee Rosenthal, chair of the Judicial Conference Committee on Rules of Practice and Procedure, noted that this frequently resulted in lawyers hiring two sets of experts—one for consultation, to do the work and develop the opinions, and one to provide the testimony—to avoid creating a discoverable record of the collaborative interaction with the experts. The reason for the use of two experts is that under former Federal Rule 26(b)(4)(B) (now Federal Rule 26(b)(4)(D)) the facts known or opinions held by a consulting expert who was not expected to be called as a witness at trial were only discoverable as provided in Rule 35(b) [Physical and Mental Examinations]; or “on showing exceptional circumstances under which it is impracticable for the party to obtain facts or opinions on the same subject by other means.” The rule change is designed to eliminate this inefficient practice.

How does Illinois treat the disclosure of information with regard to experts? Illinois Rule 213(f)(3) states: “A ‘controlled expert witness’ is a person giving expert testimony who is the party, the party’s current employee, or the party’s retained expert. For each controlled expert witness, the party must identify: (i) the subject matter on which the witness will testify; (ii) the conclusions and opinions of the witness and the bases therefor; (iii) the qualifications of the witness; and (iv) any reports prepared by the witness about the case.”

The rule regarding consulting experts, Rule 201(b)(3), provides that the identity, opinions, and work product of a consultant are discoverable only upon a showing of “exceptional circumstances under which it is impracticable for the party seeking discovery to obtain facts or opinions on the same subject matter by other means.” For purposes of Rule 201(b)(3), a “consultant” is a person who has been retained or specially employed in anticipation of litigation or preparation for trial but who is not to be called at trial.

The consequences of the Illinois expert disclosure rules as contained in Rules 201 and 213 would seem to boil down to an interpretation of the term “bases” as used in Illinois Rule 213(f)(ii). If "bases" means only the information relied upon by the expert in forming his or her opinion, then counsel would arguably not be required to turn over anything considered by an expert but not used by him or her in forming an opinion. There are both reported and unreported cases which are useful on this issue.

In McGrew v. Pearlman, 710 N.E.2d 125, 131 (Ill. App. 1 Dist. 1999) the defendant’s accident reconstruction expert was furnished with a recorded statement of the defendant taken just days after the accident at issue. The defendant did not disclose to the plaintiff that the defendant’s expert reviewed the statement prior to trial. The court found no violation of Illinois Rule 213 because 1) the plaintiff had obtained the recorded statement as a part discovery; 2) the court allowed great leeway in plaintiff's cross-examination of defendant’s expert along with the offer for plaintiff to recall his expert to testify based upon the recorded statement; and 3) it was clear that the report did not form the “bases” of the defendant’s expert’s opinion. Id. Although this case did not address the discoverability of any information reviewed by a testifying expert, the court’s interpretation of “bases” could support an argument that information is not discoverable unless it is relied upon by the expert in forming his or her opinion.

However, the court in Coleman v. Abella, 752 N.E.2d 1150 (Ill. App. 1 Dist. 2001) seemed to reach a different result. In Coleman, the plaintiff’s expert reviewed the deposition testimony of other lay and expert witnesses in the case after her deposition took place but prior to trial. Id. at 1155. The defendant moved to strike the testimony of the expert because the plaintiff failed to supplement the expert's deposition with the information that the expert had reviewed these additional depositions. This argument was based on Rule 213's requirement that a party supplement new or different “bases” of any opinion to be offered by an expert. The court agreed with the defendant, stating that even when the “bases” for the expert’s opinion are not broadened by the supplementary material and the opinion itself remains unchanged from that expressed at the deposition, an obligation remains on counsel to update answers to Rule 213 interrogatories so the new material supplied to the expert is disclosed to the opposing side. Id. This case would arguably support the contention that any information conveyed to an expert is discoverable, regardless of whether the information forms the "bases" for the expert's opinion.

At least one Illinois Circuit Court has found that the application of Illinois Rule 213 mirrors exactly the consequences of pre-amendment Rule 26. In Andrade v. General Motors Corp., No. 98 L 585, 2000 WL 35486903 at *1 (Ill. Circuit Court February 28, 2000), the plaintiff moved to compel the defendant’s Litigation Study, a 3,400 page document began at the request of corporate counsel with a view toward then pending and future litigation. In opposition, the defendant represented that its expert would not rely upon the study for his opinions. Id. at *3. The court held: “While there is no Illinois authority on point, this Court holds that the materials, having been considered by the expert, are discoverable and should be provided despite the privilege claims.” Id. at *3 (citing Karn v. Rand, et al., 168 F.R.D. 633 (N.D. Ind. 1996)).

In sum, under the current expert disclosure rules in Illinois, out of an abundance of caution attorneys may be inclined to follow a procedure which emulates Judge Rosenthal’s observed practice. That is, attorneys may work with two experts - one testifying and one consulting - to avoid the creation of a discoverable record. As a matter of practice, until Illinois changes its expert discovery rules counsel and client should proceed with the assumption that a court will compel production of all information received by a testifying expert - whether relied upon or not - and all draft expert reports. On the other hand, counsel should seek discovery of all information received by an opposing party’s testifying expert and all draft expert reports.

Thursday, November 18, 2010

The Future of OTC Retail Precious Metals Transactions


The Dodd-Frank Wall Street Reform Act (“Act”) amends the Commodity Exchange Act (“CEA”) by adding multiple provisions that place additional restrictions on commodity transactions. Section 742(a)(2)(D) within Title VII of the Act specifically addresses margined or leveraged retail commodity transactions. The new provisions

“shall apply to any agreement, contract, or transaction in any commodity that is—entered into with, or offered to, a person that is not an eligible contract participant or eligible commercial entity; and entered into, or offered, on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.” [emphasis added]

However, this Section contains an exception for contracts of sale that either “result in actual delivery within 28 days...” or “create an enforceable obligation to deliver between a seller and a buyer that have the ability to deliver and accept delivery, respectively, in connection with the line of business of the seller and the buyer.”

Arguably, this means that the Act prohibits most people from entering into, or offering to enter into, a transaction in any commodity with a person that is not an eligible party on a leveraged or margined basis in the absence of actual delivery within 28 days. This expands the “Zelener fix” in the 2008 Farm Bill, that authorizes the CFTC to pursue anti-fraud enforcement actions for transactions conducted on margin or leverage basis. Notably, there is nothing in the Act, the CEA, nor legislative history that defines the terms “seller”, “buyer”, or “actual delivery” within the meaning of this provision. As such, a look the Model State Commodity Code (“Model Code”) may be shed some light onto these new restrictions.


The Model Code was originally drafted to provide a guide for state jurisdiction over generic commodities-themed transactions and contains language similar to that found in the Act. Similar language specific to the prohibition of margin and leverage account transactions appears in Section 1.02 as follows:

“no person shall sell or purchase or offer to sell or purchase any commodity under any commodity contract or under any commodity option or offer to enter into as seller or purchaser any commodity contract or any commodity option.”

Under the Model Code, the definition of a “commodity contract” includes margin contracts and leverage contracts.

Like the Act, the Model Code creates an exemption for margin and leverage contract commodity transactions, but the exemption only specifically applies to precious metals transactions. The exemption is available if the purchaser receives physical delivery of the precious metals within seven days from payment of any portion of the purchase price. Only the amount paid for, not the entire purchase amount, is required to be delivered within seven days. Additionally, “physical delivery” is satisfied when the precious metals have been delivered for storage to a financial institution or an approved depository that issues a confirmation and is not also the seller.


The new federal regulations will become effective in July 2011. They will likely pre-empt the state requirements of margin and leverage contract commodities transactions. Unfortunately, many of the key terms in the federal exemption are left undefined. It is unknown how the courts or the CFTC, if at all, will define “seller”, “buyer”, or “actual delivery”. Additionally, because the new provision does not include any language regarding storage requirements for margin and leverage contracts, it is possible that the new legislation will prohibit individual consumers from purchasing precious metals on margin and then storing their precious metals with an approved depository or financial institution.

However, the legislature’s primary concern in enacting Title VII was to deal with unregulated swaps and foreign currency transactions. Therefore, because OTC precious metals transactions were not the key target of this legislation, it is conceivable that an exemption similar to that found in the Model Code, which is specific to precious metals purchases and prescribes “actual delivery” requirements, could result as opposed to the broad exemption that currently applies to all margin and leverage commodity contracts.

The bottom line (for now): the retail commodity market for over-the-counter precious metals transactions sold on margin or through leverage is uncertain. Those who participate in this market should understand the existence of two concurrent, but conflicting, standards for these types of transactions.

Friday, November 12, 2010

SEC Proposes Rules for Tipster Program

On November 3, 2010, the Securities and Exchange Commission voted unanimously to propose a whistleblower program pursuant to Section 922 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Dodd-Frank substantially expands the SEC’s authority to compensate individuals who provide information that results in a successful action for violations of securities laws.

Cosgrove Law, LLC has previously written about the specific provisions in Section 922, which an in-depth discussion of this Section can be found here. The SEC’s rule proposals maintain the original language and definitions provided by Dodd-Frank; however, the proposed rules go a bit further to address concerns about the beefed-up tip program. According to an SEC press release, the primary concern was that companies feared the program would undermine existing anonymous hotlines and other internal whistleblower programs put into place after Sarbanes-Oxley in 2002.

To address those fears, the SEC proposal includes a protection that will not disqualify tipsters if they first report internally provided they report to the SEC within 90 days and to give them extra bounty for first reporting wrongdoing through the proper company channels.

Additionally, the SEC’s proposed rules set out a list of ineligible informants. Generally, compliance staff, outside accountants, attorneys who attempt to use information gathered from internal investigations, people within a company who are in positions of responsibility, and people who have a pre-existing duty to report their information are all barred from the award system.

Despite these exclusions, the bounty program is very broad. It allows tips on any securities law violation by an individual or company, public or private. The program also awards people that have no insider knowledge, but provide an analysis to help uncover or detect fraud. Further, even tipsters who were complicit in the fraud can get an award if they are not convicted of any wrongdoing.

The promise of potentially multi-million dollar payouts for tipsters could provide the agency with more information from insiders with knowledge of big frauds than in the past.

The rule comment period will be open until December 17, 2010.

Monday, November 1, 2010


On October 21, 2010, in an effort to further protect employee benefit plan participants and beneficiaries, the U.S. Department of Labor’s Employee Benefits Security Administration announced a proposed rule to expand the definition of “fiduciary” under ERISA. Specifically, the proposed rule would more broadly define the circumstances under which a person is considered to be a “fiduciary” by reason of giving investment advice to an employee benefit plan or a plan’s participants.

ERISA Section 504 imposes a number of duties on plan fiduciaries, including a duty of undivided loyalty, a duty to act for the exclusive purposes of providing plan benefits and defraying reasonable expenses of administering the plan, and a duty of care grounded in the prudent man standard. Despite the care taken to protect plan participants from poor fiduciary conduct, the definition of “fiduciary” has been left unchanged since ERISA’s enactment in 1975. And given the significant changes to employee benefit plans, the financial industry and the expectations of plan participants, the Department of Labor recognizes that the current definition of “fiduciary” may inappropriately limit the types of investment advisory relationships that give rise to fiduciary duties on the part of the investment advisor. Indeed, the Department of Labor noted in the new proposed rule that since 1975:

the retirement plan community has changed significantly, with a shift from defined benefit (DB) plans to defined contribution (DC) plans. The financial marketplace also has changed significantly, and the types and complexity of investment products and services available to plans have increased. With the resulting changes in plan investment practices, and relationships between advisers and their plan clients, the Department [of Labor] believes there is a need to re-examine the types of advisory relationships that should give rise to fiduciary duties on the part of those providing advisory services.

The proposed rule was published in the Federal Register on October 22, 2010, and written comments on the proposed regulations must be submitted to the Department of Labor on or before January 20, 2011.

A complete copy of the proposed rule can be found here.

Wednesday, October 27, 2010

CFTC Unveils New Rules for Market Manipulation

Now that the dust has settled from the passing of Dodd-Frank, federal agencies are beginning the arduous task of complying with its laundry list of new provisions, which require various rulemakings and studies to be completed over the next year. The Commodities Futures Trading Commission is no exception.

The CFTC is currently working on rulemaking in 30 different topic areas. The most recent rule proposals were announced Tuesday, October 26, 2010. The new rules are focused on preventing manipulative and disruptive trading in commodities markets, such as precious metals, natural gas, and agricultural products.

The CFTC’s new rules regarding market manipulation create a new prohibition that bans all fraud-based market manipulation derived from “intentional and reckless conduct” that deceives or defrauds market participants, including making false or misleading statements of material facts, omitting material facts, and knowingly providing false or misleading information regarding crops or conditions that affect commodities. According to Commissioner Bart Chilton, the new rule is intended to be a “broad, catch-all” for violations that would otherwise fall through the existing “gaps” in market manipulation rules.

Currently, there is a four-prong test for manipulation that requires (1) showing that prices were outside the bounds of normal supply and demand (i.e. “artificial”), (2) proving that the actor has the ability to cause an “artificial price”, (3) showing that the actor took actions to cause the artificial price, and (4) that those acts be intentional.

On its face, the new rule language lowers this existing standard for proving manipulation from specific intent to recklessness. The penalties include a $1 million fine or triple the monetary gain, whichever is greater, and restitution to customers.

If approved, the proposed rules will expand the CFTC’s authority to the OTC market. These rules come partly in response to the recent allegations of manipulation in the silver market. (The CFTC announced that it would release more information on its investigation soon.) Although partially aimed at the OTC precious metals markets, the proposed rules are not intended to reach into retail OTC precious metals transactions.

The comment period for the new rules will be open for 60 days.

Friday, October 22, 2010

FINRA Issues Regulatory Notice on Sales Practices for Commodity Futures-Linked Securities

On October 20, 2010, FINRA issued Regulatory Notice 10-51 regarding sales practice obligations for commodity futures-linked securities. FINRA notes that in recent years, securities that offer exposure to commodities have become increasingly popular to retail investors - presumably due to a low correlation with other asset classes and enhanced portfolio diversification. FINRA notes that commodity futures-linked securities can be an effective tool for gaining exposure to this asset class that in some cases can be difficult for investors to access.

FINRA recognizes, however, that in some cases the performance of the commodity futures-linked security can deviate significantly from the performance of the referenced commodity. This deviation can produce unexpected results for investors who are not familiar with futures markets, or who mistakenly believe that commodity futures-linked securities are designed to track commodity spot prices (i.e., the immediate delivery value of the commodity).

Therefore, FINRA issued Regulatory Notice 10-51 to remind firms that offer commodity futures-linked securities that they must ensure that communications with the public about these securities are fair and balanced, that recommendations to customers are suitable, and that their registered representatives adequately understand and are able to inform their customers about these securities before they recommend them. FINRA notes that under NASD Rule 2210, firms must ensure that all communications with the public are fair and balanced, and provide a sound basis for evaluating the facts about any particular security or type of security, industry or service.

FINRA states that firms should not suggest that a commodity-futures linked security offers direct exposure to the commodity's spot price, overstate the degree of correlation between the the spot price and the commodity-futures linked security, or understate the risks inherent in investing in commodity futures. Firms should also not overstate the hedging value value of commodity futures-linked products, or commodities generally, for, by example, implying that their performance is always negatively correlated with equities or other asset classes. That a prospectus may convey such information does not excuse the firm's duty to ensure that its communications regarding the product are fair, balanced and not misleading.

Moreover, FINRA notes that NASD Rule 2310 requires that, before recommending the purchase, sale or exchange or a security, a firm must have a reasonable basis for believing that the transaction is suitable for the customer. For commodity futures-linked securities, the registered representative and retail customer should discuss, among other things:
  • The commodity, basket of commodities or commodities index that a given product tracks;
  • The product's goals, strategy and structure;
  • That commodities prices, and the performance of commodity futures-linked securities, can be volatile;
  • That the use of futures contracts can affect the performance of the product as compared to the performance of the underlying commodity or index;
  • The product's methodology, including its strategy, if any, for managing roll yield and other factors that may affect performance; and
  • The product's tax implications. (Commodity pools have different tax implications than mutual funds or exchange-traded notes.)
In sum, due to the volatility of commodities prices and, correspondingly, the performance of commodity futures-linked securities, and due to the prospect that commodity futures-linked securities may produce unexpected results for investors who are not familiar with futures markets, firms should take the necessary precautions to ensure that the sales of commodity futures-linked securities comply with federal securities laws and FINRA rules. A complete copy of Regulatory Notice 10-51 can be found here.

Tuesday, October 19, 2010


On October 14, 2010, the U.S. Department of Labor issued a final rule requiring the disclosure of certain plan and investment-related information, including fee and expense information, to participants and beneficiaries in participant-directed individual account plans (e.g., 401(k) plans). The regulation is intended to help ERISA plan participants better manage their retirement savings by ensuring that they have the information they need to make informed decisions about their investments.

The Department of Labor estimates that 72 million people are invested in participant-directed retirement plans nationwide, compiling a total of nearly $3 trillion in assets. A “participant-directed plan” is one that provides for the allocation of investment responsibilities to participants or beneficiaries. While participants in these plans are responsible for making their own investment decisions, “current law does not require that all workers be given the information they need to make informed investment decisions or, when information is given, that it is furnished in a user-friendly format.” This is particularly true with respect to the fees and expenses associated with certain investment choices.

The final rule aims to assist plan participants in this regard, and will impact plan sponsors, fiduciaries, participants and beneficiaries, as well as the service providers of such plans. To be sure, the final rule provides that when a plan allocates investment responsibilities to participants or beneficiaries, the plan administrator must take steps to ensure that such participants and beneficiaries (1) are made aware of their rights and responsibilities with respect to the investment of their assets, and (2) are provided sufficient information regarding the plan and the plan's investment options to make informed decisions with regard to the management of their individual accounts. The plan administrator must also provide each participant with certain plan-related and investment-related information.

In addition, the final rule provides that the investment of plan assets is governed by the fiduciary duties set forth within ERISA Section 404(a)(1)(A)-(B), which require plan fiduciaries to act prudently and solely in the interest of the plan’s participants and beneficiaries. Accordingly, the regulation requires plan fiduciaries to:

• Provide plan participants with quarterly statements of plan fees and expenses deducted from their accounts;

• Provide plan participants with core information about investments available under their plan, including the cost of these investments;

• Use standard methodologies when calculating and disclosing expense and return information to achieve uniformity across the spectrum of investments that exist in plans;

• Present the information in a format that makes it easier for plan participants to comparison shop among the plan's investment options; and

• Provide plan participants with access to supplemental investment information in addition to the basic information required under the final rule.

A complete copy of the final rule can be found here. In addition, for a concise overview of the final rule, please click here.

Tuesday, October 12, 2010

NASAA Identifies Top Broker-Dealer Compliance Issues

The North American Securities Administrators Association (NASAA) identified the top compliance deficiencies and offered a series of recommended best practices for broker-dealers to consider in order to improve their compliance practices and procedures. The securities examiners from 30 states provided information to compile the report. These examinations took place between January 1, 2010, and June 30, 2010.

The examinations focused on number of different areas: Sales Practices, Supervision, Operations, Books & Records, and Registration/Licensing. From the 290 examinations reported, 567 deficiencies were found. The greatest number of deficiencies (33 percent or 185 deficiencies) involved books and records, followed by sales practices (29 percent or 164 deficiencies), supervision (20 percent or 115 deficiencies), registration and licensing (10 percent or 56 deficiencies), and operations (8 percent or 47 deficiencies). The top five deficiencies were: 1)failure to follow written supervisory policies and procedures (57 instances), 2) advertising and sales literature (46 instances), 3) variable product suitability (38 instances), 4) maintenance of customer account information (37 instances), and 5) suitability (34 instances).

Based on the examinations project, the NASAA produced a list of best practices:
  1. Develop effective standards and criteria for determining suitability.
  2. Ensure that exception reports are generated when necessary and that “red flags” are documented and resolved in a timely manner. If the BD elects to electronically recreate an exception report, the BD must not only be able to recreate the report but also document how the exception was resolved.
  3. Develop, update and enforce written supervisory procedures. BDs should also ensure that staffing and expertise are commensurate with the size of the BD and type(s) of business engaged in by the firm.
  4. Develop a branch audit program that includes a meaningful audit plan, unannounced visits, a means to convey audit results and a follow-up plan for requesting that the branch take corrective action.
  5. Firms must ensure that adequate procedures are in place to prohibit and detect unauthorized private securities transactions (selling away). If this activity is permitted, the firm’s written supervisory procedures should be adequate to monitor this activity on an ongoing basis.
  6. Outside business activity requests from registered representatives must be received and reviewed by the firm prior to the activity. The firm and its registered representatives are obligated to report the outside business activity on the representative’s Form U-4. The firm should have a supervisory procedure in place to address its approval/denial process.
  7. Advertisements and sales literature must be balanced, make full and fair disclosure, and be approved, as necessary, prior to use.
  8. Seminar notices/advertisements, seminars and seminar materials utilized must be approved by the BD prior to use and the seminar being held. Additionally, any guest speakers and their materials must also be reviewed and approved prior to the seminar. In instances where registered representatives routinely conduct seminars, a supervisory representative of the firm should randomly attend the seminar for compliance purposes.
  9. Correspondence, both electronic and hard copy, must be effectively monitored by the BD including a system of capturing and maintaining e-mails sent by registered representatives from websites and Internet Service Providers outside the firm.
  10. Upon receipt of a complaint, the firms must acknowledge receipt, update the registered representative’s Form U-4, if required, and conduct and document a thorough review of the customer’s allegations. In situations where the firm discovers wrongdoing, the firm should redress customer harm. Failure to do so may result in enhanced penalties under NASAA guidelines.
The NASAA press release announcing the 2010 Broker-Dealer Coordinated Examination Report can be found here.

Congress Listening to Cosgrove Law, LLC Blog: Repeals Provision in Dodd-Frank

In an August 2, 2010 blog, our firm’s fearless leader, David B. Cosgrove, wrote about the SEC’s stingy grants to information requests pursuant to the Freedom of Information Act (“FOIA”). Our firm takes the stance that industry confidential information is certainly worth protecting, but protecting it cannot go so far as to enfeeble the right to access provided by the FOIA. Well, it seems the Senate is finally taking heed and agreeing with us.

On Wednesday, September 22, 2010, the Senate Judiciary Committee unanimously approved a bill (S. 3717) that repeals Section 929I, of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”), which permits the SEC to withhold certain records from the public. The House concurred the following day and the legislation is awaiting signature from President Obama.

Section 929I states that the Securities and Exchange Commission (“SEC”) cannot be compelled by FOIA requests to disclose records or other information obtained from its registered entities if this information is used for “surveillance, risk assessments, or other regulatory oversight activities” as defined by the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1941.

Proponents of Section 929I fought to keep this language in the Act and justified their position by stating that the Act’s language codified existing practice and was intended to guarantee that certain protections already given to financial institutions will be extended to other types of entities.

However, the Senate stated that it voted to repeal this Section in order to “restore stability and accountability to [the] financial system.” The Senate further justified its action by stating that exemptions to the FOIA’s disclosure requirements should be narrowly applied to uphold the public interest is transparency and accountability. Cosgrove Law, LLC is excited that the Senate has finally tuned into its blog and is taking it seriously.

Friday, October 1, 2010

FINRA Proposes to Make Option of All Public Arbitration Panels Permanent

On September 28, 2010, FINRA announced that it will file a rule proposal with the SEC next month that would allow all investors filing arbitration claims to have the option of an all-public arbitrator panel. Currently under FINRA Rule 12401, on claims greater than $100,000 there are three arbitrators. Under FINRA Rule 12402, if the panel consists of three arbitrators, one will be a non-public arbitrator and two will be public arbitrators. The revised rule will allow the investor filing the arbitration to select the option of having an all-public arbitration panel.

This rule proposal will expand to all investors a two year FINRA pilot program that has provided for investors filing an arbitration claims against certain firms the option of choosing the all-public panel of arbitrators. FINRA Chairman and Chief Executive Richard Ketchum stated that "Giving each individual investor the option of an all-public panel will enhance confidence in and increase the perception of fairness in the FINRA arbitration process[.]" FINRA notes that since the program began in October 2008, of the 560 cases given the power to eliminate all non-public arbitrators only 50% have elected to do so.

The effect on the results of arbitration due to having all-public arbitration panels is yet to be determined. FINRA spokesman Nancy Condon said that among the small sample size of 17 cases heard by all-public panels, investors were awarded damages 71 percent of the time. The Reuters story containing the quote from FINRA spokeswoman Nancy Condon can be found here. FINRA reports that of the 555 arbitration cases heard and decided through August of 2010, 279 of the cases (approximately 50%) resulted in cases where the customer received damages. The FINRA dispute resolution statistics can be found here.

The FINRA news release announcing the rule change can be found here.

Friday, September 24, 2010


The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act” or “Dodd-Frank Act”) was enacted by Congress on July 21, 2010. The purported purpose of the Act is to promote financial stability by improving accountability and transparency within the financial industry and to protect consumers from abusive financial services practices. To help reach this goal, the Act contains powerful incentives for whistleblowers to come forward with information to the SEC.

Specifically, Section 922 of the Act, entitled “Whistleblower Protection,” defines a “whistleblower” as “any individual who provides…information relating to a violation of the securities laws to the [SEC].” The Act broadly mandates that in any judicial, administrative or related action, the SEC shall pay an award to any whistleblower who “voluntarily provided original information to the [SEC] that led to the successful enforcement of the covered judicial, administrative or related action” in an amount equal to between 10% and 30% of what has been collected if the monetary sanctions imposed upon the wrongful party exceed $1,000,000.00. “Original information” is defined as information that is derived from the independent knowledge or analysis of the whistleblower and that is not known to the SEC from any other source. The total amount of the award is within the discretion of the SEC based upon a number of criteria set forth in Section 922; but the whistleblower is entitled to no less than 10% of the amount collected.

Moreover, for those whistleblowers who do come forward with information, Section 922 makes clear that “[n]o employer may discharge, demote, suspend, threaten, harass, directly or indirectly, or in any other manner discriminate against, a whistleblower in the terms and conditions of employment because of” the whistleblower’s submission of information to the SEC. And if a whistleblower feels that he or she has been discharged or discriminated against, Section 922 provides for a private cause of action against the employer which includes reinstatement, two times the back pay, attorneys’ fees and costs.

Section 922’s powerful provisions will likely result in a substantial increase the SEC’s enforcement capabilities by providing it with a greater means to access inside information. Indeed, insiders within the financial industry will inevitably come forward with information that they likely would not have come forward with in the past. To add to whistleblowers’ incentives, Section 922 explicitly provides that “[a]ny whistleblower who makes a claim for an award…may be represented by counsel.” With this provision in place, in the two months since the enactment of the Dodd-Frank Act, law firms around the country have already begun establishing “Section 922 practices” aimed at assisting individuals in providing information to the SEC.

For more information on the 2,300+ page Dodd-Frank Act, or to make sure your company is in compliance with its sweeping provisions, please feel free to contact one of our knowledgeable and experienced attorneys.

A complete copy of the Dodd-Frank Act can be found here.

Wednesday, September 22, 2010

FINRA Files Proposed Rule Change to Amend the Codes of Arbitration Procedure to Permit Arbitrators to Make Mid-case Referrals

On September 17, 2010, the SEC published a notice to solicit comments on a proposed rule change originally submitted by FINRA on July 12, 2010. Rule 12104(b) of the Code of Arbitration Procedure for Customer Disputes and Rule 13104(b) of the Code of Arbitration Procedure for Industry Disputes currently allow for referrals to FINRA for disciplinary investigation any matter that has come to the arbitrator's attention only at the conclusion of an arbitration. The proposed rule change would allow an arbitrator to refer to FINRA any matter or conduct that has come to the arbitrator’s attention during the prehearing, discovery, or hearing phase of a case, which the arbitrator has reason to believe poses a serious, ongoing, imminent threat to investors that requires immediate action. The proposed rule would state further that arbitrators should not make mid-case referrals based solely on allegations in the statement of claim, counterclaim, cross claim, or third-party claim.

FINRA's purported basis for the rule change is that, in light of recent well-publicized securities frauds that resulted in harm to investors, FINRA has reviewed its rule on arbitrator referrals and determined that it should be amended to permit arbitrators to make referrals during an arbitration proceeding. FINRA believes that restricting arbitrators from making referrals until the conclusion of an arbitration may hamper FINRA’s efforts to uncover fraud as early as possible. Therefore, FINRA proposes to amend Rules 12104 and 13104 of the Codes to permit referrals to the Director during the prehearing, discovery, or hearing phase of an arbitration proceeding.

A complete copy of the notice can be found here.

Monday, September 13, 2010

Ninth Circuit Court of Appeals Rejects Private Cause of Action Under Section 13(a) of the Investment Company Act

On August 12, 2010, the Ninth Circuit Court of Appeals issued a decision in which it found that there is no private cause of action to enforce the provisions of Section 13(a) of the Investment Company Act of 1940 ("ICA"), 15 U.S.C. Section 80a-13a. Section 13(a)(3) prohibits an investment company from deviating from its investment policies recited in its registration statement unless authorized by the vote of a majority of its outstanding voting securities.


The court of appeals began its analysis of the case before it by noting that Congress enacted the ICA in 1940 to provide comprehensive regulation of investment companies and the mutual fund industry. The ICA was the counterpart in the area of mutual fund regulation to the Securities Act of 1933 and the Securities Exchange Act of 1934, which were designed to regulate corporate securities. Section 8 of the ICA states that once an investment company registers with the SEC, it must file a registration statement that contains a recital of certain types of investment policies adopted by the company, including the company’s policy with respect to concentration of investments in a particular industry or group of industries; any policy that is only changeable through a shareholder vote; and any policy the company deems “fundamental.” 15 U.S.C. § 80a-8(b).

To ensure compliance with the requirements of the ICA, the court noted that Congress gave the SEC broad authority to police violations of the ICA. Only one section of the ICA as originally enacted authorized anyone other than the SEC to sue for violations of the Act. Section 30(f) of the 1940 Act incorporated a remedy under the 1934 Act. The Supreme Court has said that by incorporating the provisions of § 16(b) of the Securities Exchange Act of 1934 into § 30(f) of the ICA, Congress expressly authorized private suits for damages against closed-end investment company insiders who make short-swing profits. Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 20 & n.10 (1979). Later, the 1970 amendments to the ICA included a change to Section 36 of the ICA, which authorized the security holders of a registered investment company to bring a derivative suit against the company's investment advisor and its affiliates for breach of the advisor's fiduciary duty. 15 U.S.C. Section 80a-35(b).

In 2007, Congress imposed economic sanctions on two Sudanese government officials and thirty-one Sudanese companiesas a result of their involvement with the genocide in Darfur. These sanctions barred the companies from doing business within the US financial system or with US companies. To facilitate the efforts of state and local governments and private asset fund managers to divest from companies involved in business sectors in Sudan, Congress enacted the Sudan Accountability and Divestment Act ("SADA") in 2007. As a part of SADA, Congress added subsection (c) to Section 13 of the ICA. Subsection (c) expressly barred any kind of civil, criminal, or administrative action against an investment company to challenge the company's divestment from the securities of companies conducting the affected business operations in Sudan.


The litigation involved in the case before the Ninth Circuit involved claims by investors that a large investment trust operating a series of mutual funds unlawfully deviated from the investment policies set forth in its registration statement, to the detriment of the fund's shareholders and in violation of Section 13(a) of the ICA. The plaintiff brought a claim against the defendant alleging that defendant violated Section 13(a) when it allegedly deviated from the defendant fund's fundamental investment policies. The plaintiff alleged that the deviations exposed the fund and its shareholders to tens of millions of dollars in losses stemming from a sustained decline in the value of non-agency mortgage-backed securities.

The defendant moved to dismiss for failure to state a claim under ICA Section 13(a), asserting that there is no private right of action to enforce that section's terms. The district court denied this motion, declining to adopt the Second Circuit's reasoning in Olmsted. Pruco Life Ins. Co. of New Jersey, 283 F.3d 429 (2d. Cir. 2002), because Olmsted predated the 2007 amendment of Section 13 by SADA. Relying on the language of subsection (c) added to Section 13 by the SADA, the district court held that Congress recognized a private right to enforce Section 13(a) when it enacted Section 13(c) - i.e., there was no basis for Congress to bar actions based on Sudanese divestments if the statute did not authorize other private causes of action.


The court of appeals noted that a statute must explicitly or implicitly contain a private right of action. In the case before it, the parties agreed that Section 13(a) did not expressly create a right of action. Therefore, if Section 13(a) implicitly contained a private right of action, it had to be determined from the statute's language, structure, context, and legislative history. In. re Digimarc Corp. Derivative Litig., 549 F.3d 1223, 1229 (9th Cir. 2008).

The court of appeals first found that Section 13(a)'s language contains no "rights creating language." Alexandar v. Sandoval, 532 U.S. 275, 290 (2001). Instead, Section 13(a) merely contains the types of actions an investment company can take without first obtaining shareholder approval.

The court next found that the structure of the ICA did not suggest any congressional intent to allow private enforcement of Section 13(a). The Court noted that in both Bellikoff v. Eaton Vance Corp., 481 F.3d 110 (2nd Cir. 2007) and Olmsted v. Pruco Life Ins. Co. of New Jersey, 283 F.3d 429 (2nd Cir. 2002), the Second Circuit focused on the fact that the ICA authorizes SEC enforcement and that there is a private right of action for certain breaches of fiduciary duties of investment advisors in Section 36(b). The Ninth Circuit noted additionally that in Lewis, 444 U.S. at 20 & n.10, the Supreme Court found that Section 30(f) provides for a private right of action for short-swing profits made by insiders of closed-end investment companies. The court agreed with the Second Circuit that this leads to the conclusion that Congress did not intend to imply a private right of action in the ICA to enforce Section 13(a).

The court further found that the legislative history of amendments to the ICA did not evince a clear congressional intent to allow private lawsuits to enforce the statute's provisions. The court first noted that the 1970 amendments dealt with the need for shareholder votes to change investment policy. The court found that the language and legislative history reflected that purpose and that purpose only.

The court found that the 2007 amendment by the SADA, which added Section 13(c), while a stronger argument, was unpersuasive. Section 13(a) is a bar to actions any person or goverment agency might file to challenge divestment from Sudanese investments. The court of appeals noted that the district court focused on the fact that Section 13(c) referred to actions that a "person" could file. The court of appeals found that this would have some validity if the bar applied only to causes of action to enforce the other provisions of Section 13. But it extends to any civil, criminal, or administrative action brought under any state or federal law. Thus, Congress included the term "person" to describe the entities restricted from bringing the types of actions barred by Section 13(c). The court further noted that the legislative history revealed that a primary purpose of the SADA was to permit public and private asset managers to adopt Sudanese divestment measures without fear of legal reprisals.


Based on its analysis, the Ninth Circuit Court of Appeals concluded that the neither the language of Section 13(a), the structure of the ICA, nor the statute's legislative history, including the addition of Section 13(c) by the SADA, reflected any congressional intent to create, or recognize a previously established, private right of action to enforce Section 13(a). Therefore, the court of appeals reversed the order of the district court and remanded the matter with instructions to grant the defendant's motion to dismiss the plaintiff's federal ICA claims.

A complete copy of the Ninth Circuit's opinion can be found here.

Monday, September 6, 2010

Is Broker/Trader liable for what Broker-Dealer approves?

There is an interesting albeit short article in this month's edition of Corporate Counsel regarding Goldman Sachs and its very own "Fabulous Fab". As you may recall, Goldman settled with the SEC recently for $550 million (without admitting wrongdoing) for its role in allegedly selling a mortgage backed securities vehicle to its customers that Goldman allowed a hedge fund to both assemble and bet against. Goldman's trader Fabrice Tourre became infamous for not only reducing to writing his callous appreciation for the irony of Goldman's position, but also for dubbing himself "Fabulous Fab." Now wonder pride is one of the 7 deadly sins. But I digress. General Counsel notes that one of the defenses Fabulous is asserting in response to the SEC's claims against him is that the product and procedures at issue had been vetted and approved by Goldman's compliance and legal departments. General Counsel oddly characterizes this as a "novel defense." I'm not sure it is novel or without merit. Indeed, it reminds me of a case I worked on where I represented the former brokers of a large regional broker dealer that was sued by a state regulator for its role in the traditional sale, but unexpected liquidity demise, of Auction Rate Securities. The regulator sued the broker-dealer and its trading desk employees for failing to train and disseminating inaccurate information regarding the risks and characteristics to its sales force/registered representatives. But it also simultaneously sued the allegedly untrained and inadequately informed representatives that sold the product to investors (why chose a coherent theory of liability unless you have to?). Of course, as predicted, the regulator dismissed the suit against the individual brokers--one months away from dieing from cancer--once the broker-dealer coughed up millions of dollars. So while Fab's arrogance may provide some insight in to a culture on Wall Street that needs to evolve for the better, his affirmative defenses aren't so novel, and may just have some merit. It is one thing when a broker disregards compliance and legal and engages in negligent or self-serving conduct, but it seems to be an entirely different story when he or she is merely selling a product that has structural deficits literally designed by his employer and principle, including legal and compliance experts. Stay tuned.

Monday, August 30, 2010


Brokers and Investment Advisors facing demands for repayment of training fees, retention bonuses, or promissory notes should bite the bullet and retain legal counsel. While their new current employer may be willing to offer unofficial advice or moral support, it is rarely willing to assign its legal department to your defense. No surprise, as its legal department is probably busy sending similar demands out to its former account executives or representatives.

The truth of the matter is that, despite demand letters that inaccurately portray your indebtedness as an unassailable fundamental truth, there are frequently either legal or equitable defenses to your former employer’s demand for money. And even if you owe and should therefore remit some funds, the broker frequently owes less than the total being demanded. Few like to hire attorneys, and even less like to pay for them. But you might actually have a legal right to save yourself some hard-earned cash in the long run—even after paying for that damn lawyer.

Friday, August 20, 2010


On August 13, 2010, the California Court of Appeals issued a clear message to companies seeking to use mandatory arbitration provisions to force consumers to waive fundamental statutory rights. Specifically, in Fisher v. DCH Temecula Imports LLC, the Court of Appeals held that arbitration provisions that purport to waive unwaivable statutory rights violate public policy and are therefore void.

In Fisher, Plaintiff Fisher brought a class action lawsuit seeking injunctive relief, restitution, rescission and damages arising from—among other things—Defendant DCH’s violation of the California Legal Remedies Act (“CLRA”) in connection with a retail sales contract (“Contract”). DCH filed a petition to stay the lawsuit and compel arbitration (as a single individual rather than a class) under a mandatory arbitration clause contained within the Contract. The arbitration clause contained three important provisions:

“Either you or we may choose to have any dispute between us decided by arbitration and not in court or by jury trial.”

“If a dispute is arbitrated, you will give up your right to participate as a class representative or class member on any class claim you may have against us including any right to class arbitration or any consolidation of individual arbitration.”

“You expressly waive any right you may have to arbitrate a class action.”

In her opposition to the petition to compel arbitration, Fisher contended that she had a right under the CLRA to file a class action lawsuit, and that she could not be required to waive that right through a mandatory arbitration clause. Fisher relied upon two provisions of the CLRA in support of her argument:

“…any consumer entitled to bring [an individual consumer claim] may…bring an action on behalf of himself and such other consumers to recover damages or obtain other relief.”

“Any waiver by a consumer of the provisions of this title is contrary to public policy and shall be unenforceable and void.”

The California trial court agreed that the CLRA prohibited Fisher from waiving her right to bring a class action. Accordingly, the court denied DCH’s petition to compel arbitration.

On appeal, DCH argued that Fisher’s anti-waiver argument had no application because the Federal Arbitration Act (“FAA”) preempted California law in the determination of the enforceability of the arbitration clause at issue. The California Court of Appeals dismissed DCH’s assertion, noting that Fisher was entitled to contest the arbitration clause on the basis that it was a private agreement in contravention of public rights under the CLRA. Accordingly, Fisher’s defense to the enforcement of the arbitration clause was a “separate, generally available contract defense not preempted by the FAA.”

The Court of Appeals ultimately affirmed the trial court’s order denying DCH’s petition to compel arbitration. In doing so, the Court relied upon its prior holding in Gutierrez v. Autowest, Inc. In that case, the Court of Appeals made clear that “a mandatory arbitration agreement cannot undercut unwaivable state statutory rights by, for example, eliminating certain statutory remedies or erecting excessive cost barriers.” Relying on Gutierrez, the Court noted that “[t]he arbitration clause at issue here required Fisher to waive an unwaivable statutory right under the CLRA to bring a classwide arbitration or classwide lawsuit, which violates the public policy underlying these rights. This qualifies as a private agreement in contravention of public rights.”

Although companies will certainly argue that Fisher is limited to class action provisions, the better argument is that the analysis provided by the California Court of Appeals applies to any waiver of fundamental statutory rights within a mandatory arbitration provision. Accordingly, the ramifications of this decision will likely spread beyond merely class action waivers. Notably, Missouri courts have handed down similar decisions in recent years, demonstrating a clear emphasis on the protection of individual state statutory rights when consumers are forced to sign boilerplate, pre-dispute arbitration agreements.

Wednesday, August 18, 2010

New Broker-Check Disclosure & Dispute Process Begins August 23, 2010

Last month, the Securities and Exchange Commission approved changes to FINRA Rule 8312. The changes will expand the information available in BrokerCheck and codify the dispute process regarding inaccuracies in the disclosed information. The amendments will be implemented in two phases, the first of which goes into effect on Monday, August 23, 2010. This first phase of implementation deals with the changes to historic complaints and the dispute process.

On Monday, all customer complaints will be publicly available in BrokerCheck. This includes any complaints that had previously been deemed “non-reportable” when the Central Registration Depository (CRD) was implemented (i.e. complaints made after August 16, 1999).

Also to be implemented on Monday is FINRA’s new dispute process regarding inaccuracies in BrokerCheck. Under the new dispute process, only an “eligible party” will be able to bring a dispute. FINRA defines an “eligible party” as any current member firm, a CXO of a former member firm, or any person associated with or formerly associated with a member firm that has a BrokerCheck report. In order to file a dispute under the amended rule, an eligible party must (1) submit a BrokerCheck Dispute Form (which will become available on FINRA’s website), (2) identify and explain the inaccuracy, and (3) provide any supporting documents.

The next (and final) implementation of the new amendments regarding the disclosure period and permanently available information will occur on November 6, 2010.

A complete discussion of all the rule changes and commentary on those changes can be accessed here.

Monday, August 2, 2010

SEC Claims New Information Disclosure Restriction in Financial Regulation Law will Simply Validate its Current Practices: So What's the Good News?

According to a recent Wall Street Journal article, a 2009 report by the SEC's inspector general revealed that the agency is far stingier then other federal agencies when it comes to responding to the public's requests for information under the Freedom of Information Act (“FOIA”). For example, the SEC fully granted information requests at a measly rate of 10.5% and granted partial responses at a rate of 3%. And yet despite what one must assume were legally valid outright rejections of the remaining 85% of all FOIA requests, the SEC garnered a provision in the new financial regulation overhaul law that empowers them to reject any request implicating documents it has received from members of the financial industry pursuant to SEC surveillance and risk assessments “or other regulatory oversight activities.”

The SEC's response to the uproar over this provision has been both anemic and incomplete - arguing that they didn't really need what they supposedly really needed. According to a recent FOX Business report, an SEC spokesman explained that the provision was tied to the SEC's expanded examination program, and the new provision simply “makes certain that we can obtain documents from registrants for risk assessment and surveillance under similar conditions that already exists by law.” Of course, prohibiting the SEC from using its regulatory authority to comb through a company's records to turn around and disgorge them out of context to the public is hardly outrageous. But the SEC seems unable to provide any justification for the the true source of the uproar; the final clause of the new provision: “or other regulatory...activities.” The final clause has nothing to do with confidential records gathered during examinations of industry participants. And yet it would provide the SEC ample justification to ramp up its FOIA swat-down rate from 85% to 100%.

The SEC receives and generates a lot of information outside of its exam function as a part of its “regulatory oversight activities.” Perhaps new legislation can be drafted to protect a legitimate interest in protecting the industry's confidential information without completely emasculating the right to access provided by the FOIA.

Tuesday, July 27, 2010


On July 21, 2010, the SEC unanimously approved amendments to Form ADV, Part 2, the disclosure document investment advisers are required to provide to clients. ADV Part 2 is a detailed document, explaining investment advisers’ qualifications, investment strategies and business practices.

For more than 30 years, the SEC has required registered investment advisers to deliver this written disclosure statement to clients. In 2000, the SEC proposed a complete overhaul of Form ADV. However, the overhaul did not result in a change to Part 2. Accordingly, in 2008, the SEC proposed additional amendments to ADV Part 2, which they finally approved on July 21st.

SEC Chairman Mary L. Schapiro commented that “[i]n its current form, [ADV Part 2] requires advisers to respond to a series of multiple-choice and fill-in-the-blank questions organized in a ‘check-the-box’ format. But, the format frequently does not correspond well to an adviser's business. And, in some cases, the required disclosure may not describe the adviser's business or conflicts in a way that is truly accessible to the investor.”

The new amendments will require investment advisers to provide a narrative that is “well-suited to serve investors’ needs.” The narrative will include the investment advisers’ conflicts, compensation, business activities and disciplinary history. The amendments will further require that ADV Form 2 be available electronically through the SEC website, thereby providing investors with greater and more easily attainable access to investment adviser disclosures.

Chairman Schapiro expressed the utmost confidence in the new amendments at a recent SEC open meeting, stating that the new changes “will allow clients ready access to information about advisers of a wholly different character and quality than is available under the current regime. It will enable investors to better evaluate their current advisers, or comparison shop for a new adviser that best serves an investor's needs.” Chairman Schapiro even went so far as to predict that the new disclosure requirements “may result in advisers modifying business practices and compensation policies which might pose conflicts, in ways that better serve the interests of clients.”

The amended rules will be effective 60 days after publication in the Federal Register, and investment advisers should begin distributing and publicly posting new ADV Form 2 disclosure in early 2011.

Our attorneys have experience with investment adviser and broker state registration matters, including annual and as-need ADV updates and reviews. If you or your company has concerns about the new amendments to ADV Part 2, please do not hesitate to contact us.

A copy of the SEC press release detailing the ADV Part 2 amendments is available here.

The Murky Waters of State Commodity Laws

State commodity laws are notoriously antiquated and hard to follow. For many precious metals dealers, it can be difficult to navigate the applicable state laws in the various states where they do business.

This difficulty arises for several reasons. First, the Model State Commodity Code (“Model Code”) was drafted in the early 1980s, and it has not been updated since its inception to account for changes in technology that affect the way legitimate precious metals dealers do business. Second, the Model Code has only been enacted as it was written by a handful of states, so there is a lack of uniformity from state to state. Third, some states, like Arizona and Montana for example, have adopted substantive provisions of the Model Code, but these provisions have been incorporated into the state securities laws, instead of a separate Chapter or Act. Finally, there are states that have chosen not to regulate commodity transactions at all or that have decided to regulate them using a different approach than that set out in the Model Code.

The Model Code originally was drafted to provide state jurisdiction over generic commodities-themed frauds because the state securities acts were inadequate to address such schemes. As a result, the Model Code devised the concept of a “commodity contract”, which is defined as “a contract for the purchase or sale of commodities, primarily for speculative or investment purposes, and not for use or consumption by the offeree or purchaser.” Therefore, this new concept was intended to provide a better means of jurisdiction over only certain commodity transactions.

Unfortunately, for precious metals dealers, the two most common schemes at the time the Model Code was drafted were centered around the sale of precious metals that were never delivered or promises to store precious metals that were subsequently never purchased. Accordingly, there are stringent provisions defining and regulating the purchase of precious metals. However, the Model Code drafters included an exemption for transactions involving the purchase of precious metals if certain very specific requirements were met. One of those requirements is that delivery must be completed within 28 days, purportedly making it easier for retailers to avoid and regulators to identify unregistered futures contracts.

Essentially, the Model Code should have streamlined the process for determining whether illegal transactions have taken place. But though the Model Code may seem straightforward on its face, the inconsistency in adoption between the states and nuances among those states that have adopted the Model Code has created a veritable trap for unwary precious metals dealers and necessitates the need for experienced counsel who are aware of the these subtle differences.

The attorneys of Cosgrove Law, LLC have a unique knowledge and understanding of state and federal commodity regulations and exemptions, with an emphasis in the area of precious metals. Our firm is a member of the Industry Council for Tangible Assets that has compiled a 500-page, nationally recognized 50 state commodities survey. Our attorneys regularly provide advice to commodity dealers about relevant state and federal regulations and assist in internal review of company procedures. As part of our firm’s compliance services, we are also available to conduct audits or assist in developing an audit program to ensure ongoing compliance.

Monday, July 26, 2010

SEC Approves New Rules For Investment Adviser’s ADV, Part 2

SEC registered Investment Advisers are required to give each of their customers a copy of Part 2 of their Form ADV, commonly referred to as “the brochure.” According to the SEC, the brochure is supposed to explain the Investment Adviser’s investment strategies and business practices, and yet it may not describe them “in a way that is truly accessible to the investor.” Early last week, amendments to the current format of the brochure were approved by the Commission unanimously. According to the SEC, “these changes are designed to provide clients with greater information about the individuals who will provide them with investment advice.” Since Investment Advisers owe their clients the highest of fiduciary duties when it comes to peoples’ life savings, “greater information” doesn’t seem like a bad idea. For a full copy of the SEC’s press release regarding the amendments, click here.

Two of the more critical amendments require the Investment Adviser to disclose any disciplinary or legal event relevant to the client’s evaluation of the integrity of the Investment Adviser as well as background information regarding information about the specific individuals that will be serving the clients. Currently, certain large national Investment Advisers distribute slick brochures that fail to disclose legions of customer lawsuits and that hype up the background of only high-profile managers who actually have no contact whatsoever with the client or his or her portfolio.

Wednesday, July 21, 2010

FINRA Files Proposed Revised Discovery Guide with SEC

On July 12, FINRA filed a new Discovery Guide with regard to FINRA arbitrations for approval by the SEC. The Guide provides guidance to parties on which documents parties should exchange without arbitrator or staff intervention, and to arbitrators in determining which documents customers and member firms or associated persons are presumptively required to produce in customer arbitrations. This new Discovery Guide will replace the existing Guide, which was approved by the SEC in 1999. The process of updating the Guide has been an ongoing undertaking in one form or another since 2004.

The revisions to the Guide include: 1) substantive changes to the Guide's introduction; 2) changes in the list of documents the firm or associated person shall be required to produce in all customer cases; and 3) changes in the list of documents the customer will be required to produce in all customer cases.

An example of a substantive change in the introduction of the Guide is an expansion of the discussion on confidentiality to include a statement relating to the burden of establishing that documents require confidential treatment. This statement enumerates factors that arbitrators should consider when deciding questions about confidentiality. The factors include:
  • Whether the disclosure would constitute an unwarranted invasion of personal privacy (e.g., an individual's social security number, or medical information);
  • Whether there is a threat of harm attendant to disclosure of the information;
  • Whether the information contains proprietary confidential business plans and procedures or trade secrets;
  • Whether the information has previously been published or produced without confidentiality or is already in the public domain;
  • Whether an excessively broad confidentiality order could be against the public interest or could otherwise impede the interests of justice; and
  • Whether there are legal or ethical issues which might be raised by excessive restrictions on the parties.
A complete copy of the revised Discovery Guide can be found here.

Tuesday, July 20, 2010


On July 16, 2010, the U.S. Department of Labor issued an interim final rule aimed at enhancing disclosure requirements to fiduciaries of employee benefit plans. Specifically, the rule requires that certain service providers disclose specified information to assist plan fiduciaries in assessing the reasonableness of contracts or arrangements, including the reasonableness of the compensation paid for services and the conflicts of interest that may affect a service provider’s performance of services to the plan.

As the Department of Labor points out, in recent years, employee benefit plans have undergone a number of changes to improve efficiency and reduce the cost of administrative services for the plans and their participants. However, these changes are quite complex, making it difficult for plan fiduciaries to understand what service providers are actually paid for the specific services they render. Nonetheless, ERISA § 404(a)(1) provides in pertinent part that:

[A] fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and—

(A) for the exclusive purpose of:

(i) providing benefits to participants and their beneficiaries; and

(ii) defraying reasonable expenses of administering the plan.

In order to comply with Section 404(a)(1), fiduciaries must have access to information sufficient to determine the reasonableness of the compensation paid for administrative services. The interim final rule is intended to provide fiduciaries with this key information by requiring certain service providers to disclose both the direct and indirect compensation they receive in connection with the services they provide to the plan. According to Phyllis Borzi, Assistant Secretary for the Employee Benefits Security Administration, the rule should allow plan fiduciaries to make more informed decisions about plan services, including the costs of services and potential conflicts of interest.

In addition to protecting and assisting plan fiduciaries, the Department of Labor believes that “mandatory proactive disclosure will reduce sponsor information costs, discourage harmful conflicts, and enhance service value.”

A complete copy of the final interim rule is available here.

Friday, July 16, 2010


On Wednesday of this week, the Court of Appeals for the Sixth Circuit affirmed the conviction of Ohio investment adviser Mark Lay. See U.S. v. Lay, 2010 WL 2757123 (CA.6, July 14, 2010). Lay was indicted for violating 15 U.S.C. § 80b-6(2) and (4) for engaging in a course of business which operated as a deceit upon his client and engaging in a practice that was deceptive or manipulative. Specifically, Lay was accused of violating a leverage cap of 150% within an advisory agreement and then failing to disclose that failure to his client.

On appeal, Lay argued unsuccessfully that the District Court should have granted him relief after the jury convicted him because the alleged victim – The Ohio Bureau of Worker’s Compensation – wasn’t actually a client to whom he owed a fiduciary duty. The Court concluded that a reasonable jury could have found Lay guilty of investment adviser fraud for failing to disclose his leveraging activity to his client -- even if the 150% was merely a guideline, rather than an agreed upon cap.

The District Court opinion affirmed by the Appellate Court provides a thorough and detailed review of the jury instructions utilized at trial. A review of the instruction’s expansive definitions of Investment Adviser Act terminology – such as “scheme” and “deceptive” – may very well prompt some sleepless nights for investment advisers who never even considered the possibility of imprisonment. See U.S. v. Lay, 566 F.Supp.2d 652 (N.D. Ohio 2008).

Wednesday, July 14, 2010

SEC Approves FINRA’s Proposal to Expand BrokerCheck Disclosure

Yesterday, the Financial Industry Regulatory Authority (FINRA), announced in a News Release that its proposal to expand the information made available through its database, BrokerCheck, was approved by the Securities and Exchange Commission.

According to the FINRA News Release, “the changes will increase the number of customer complaints reported publicly; extend the public disclosure period for the full record of a broker who leaves the industry from two years to 10 years; and, make certain information about former brokers available permanently, such as criminal convictions and certain civil injunctive actions and arbitration awards against the broker.”

The changes will be implemented in two phases. The first is slated for August and will add historic complaints. Finally, during the fall months, the full 10-year record for brokers who exited the industry will be made public. The additional information should be fully available to the public by the end of the year.

We have previously contemplated the issues surrounding additional disclosure on our blog. This posting can be accessed here.

Florida Supreme Court Decision Strips Asset Protection for Single Member LLCs

In a 5-2 decision entered on June 24, 2010, the Florida Supreme Court reviewed the issue of “[w]hether Florida law permits a court to order a judgment debtor to surrender all right, title, and interest in the debtor’s single-member limited liability company to satisfy an outstanding judgment.” The Court concluded that the statutory charging order provision does not preclude application of the creditor’s remedy of execution on an interest in a single-member LLC. The Court primarily justifies its conclusion by the uncontested right of the owner of a single-member LLC to transfer the owner’s full interest. Also supporting the decision is the fact that Florida’s Limited Liability Company Act does not have a provision prohibiting a creditor’s remedy of levy and sale under execution.

In Olmstead v. FTC, the appellants, owner-members of the LLCs at issue, were several single-member LLCs that effectively operated an advance-fee credit card scam. The FTC brought suit against the LLCs for violations of §5(a) of the Federal Trade Commission Act, 15 U.S.C. §45(a). The appellants argue that the sole statutory remedy available against their ownership interests in single-member LLCs is a charging order. A charging order is a statutory remedy that allows judgment creditors to access a judgment debtor’s rights to profits and distributions from the business entity, in this case single-member LLCs, where a judgment debtor has full ownership interest. However, under a charging order, a judgment creditor is not authorized to obtain full rights, title, and interest of the membership interest.

An LLC is a type of corporate entity that allows for a taxation structure similar to a partnership, but affords limited liability similar to that of a corporation. According to the Court, an ownership interest in an LLC is equivalent to ownership of corporate stock, and therefore, it qualifies as personal property. Because an LLC ownership interest is classified as “corporate stock,” it falls within the scope of the levy and sale under execution remedy. See Florida Statutes § 56.061 (2008) (providing a list of personal and real property within the purview of the remedy of levy and sale under execution). Under this Section, a judgment creditor is authorized to levy a membership interest and obtain full title and rights to that interest.

Additionally, interests in LLCs are assignable if all non-assigning members consent to the assignment. See Florida Statutes § 608.433 (2008). Because this interest is assignable, it can be used to pay for an owner’s debts. See Bradshaw v. Am. Advent Christian Home & Orphanage, 199 So. 329, 332 (Fla. 1940). The Olmstead Court rendered § 608.433 inapplicable to the case of one-member LLCs because single owner-members can assign full rights, title, and interest to any assignee without any consent, but their own. The Court reasoned then that because single-owner-members can fully assign their interest, this full interest can be reached by judgment creditors if the judgment equals or exceeds the value of the full ownership interest.

Finally, the Court determined whether levy and sale under execution remedy should apply to LLCs and whether the charging order provision in the LLC Act limits the scope of the levy and sale under execution remedy. The Court looked to statutory construction and legislative intent. It concluded that the charging order provision is not an exclusive remedy under the LLC Act because, unlike the Florida Uniform Partnership Act and Limited Partnership Act (ACTs), the LLC Act does not include exclusive language similar to those Acts, so the remedy of levy an sale under execution serves an additional remedy to judgment creditors with respect to LLCs. Further, the charging order does not limit a levy and sale under execution in the context of single-member LLCs because like the inapplicability of §608.443 of the LLC Act, the legislature did not intend for all provisions in the LLC Act to apply to single-member LLCs. Because single-member LLCs are the only LLC entity that can fully assign all LLC rights, the limits on a charging order were not meant to apply to single-member LLCs. Accordingly, the Court held that a judgment debtor can be ordered to “surrender all right, title, and interest in the debtor’s single-member LLC to satisfy an outstanding judgment.”

This begs the question, what should single-member LLCs do to protect their assets? Unfortunately, the answer to that question is: only time will tell. It is uncertain whether Florida courts will interpret and apply this decision broadly or if they will apply it strictly. Further, this decision was made in the context of single-member LLCs engaged in deceptive business practices, perhaps courts will decide to limit its application to these types of cases and render it inapplicable to cases where the judgment debtor is a legitimate single-member LLC. In the mean time, single-member LLCs should tread lightly.