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.