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.
Tuesday, July 27, 2010
SEC APPROVES AMENDMENTS TO FORM ADV, PART 2 TO ENHANCE DISCLOSURE REQUIREMENTS FOR INVESTMENT ADVISERS
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.
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 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.
Posted by David Cosgrove at 3:19 PM
Wednesday, July 21, 2010
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.
Posted by Kurt J. Schafers at 9:43 AM
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
SIXTH CIRCUIT COURT OF APPEALS AFFIRMS 12-YEAR SENTENCE FOR INVESTMENT ADVISER CONVICTED OF VIOLATING INVESTMENT ADVISERS ACT
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
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.
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.
Tuesday, July 13, 2010
On June 30, 2010, a Massachusetts state court overturned a gag order imposed by a FINRA arbitration panel that required an entire arbitration proceeding, including all testimony, documents and hearing transcripts, to remain strictly confidential. The claimant in that proceeding, a former Oppenheimer & Co. branch manager, James F. Dever, said the gag order effectively prohibited him from trying to clear his record after the arbitration proceeding. Judge Frances A. McIntyre of the Suffolk Superior Court in Boston overturned the FINRA panel’s broad-reaching order of secrecy, holding that it offended public policy and violated the First Amendment by restricting free speech. Judge McIntyre’s decision made clear that courts will review and overturn confidentiality orders that unlawfully restrict parties’ constitutional rights.
The decision will likely have important ramifications for customers and financial institutions within the investment industry. Arbitration agreements are standard in the investment industry, and arbitration forums such as FINRA generally require arbitrators to protect the confidentiality sought by the parties. In most instances, customers and financial institutions enjoy the confidentiality of arbitration proceedings. However, the parties do not always wish to remain silent about the nature of the proceedings. Judge McIntyre’s June 30th holding suggests that under the First Amendment, arbitrators cannot cloak arbitration proceedings with secrecy by forcing the parties to remain silent about the proceedings.
In order to protect their clients’ rights, attorneys handling financial industry lawsuits must be familiar with the intricacies of the arbitration process, whether it be through FINRA, JAMS, AAA or some other arbitration forum. Cosgrove Law, LLC has extensive experience in the arbitration process and regularly represents investors in arbitral forums.
Friday, July 9, 2010
On July 1, 2010, the Securities and Exchange Commission brought a civil action against Travis L. Wright in the United States District Court for the Central District of Utah. The suit alleges that from the fall of 2001 through the spring of 2009, Wright, directly and through several sales agents, sold securities in the form of secured promissory notes issued by the Waterford Loan Fund, LLC, to approximately 175 investors in unregistered, non-exempt transactions, raising approximately $145 million. The notes bore interest at varying rates, from a rate of 2% up to a rate of 24% per year.
During the offer and sale of these securities, Wright represented to investors that their funds would be used only to make “hard money” loans secured by first liens on commercial real estate and that all the assets belonging to the Fund would be placed into a trust and held for their collective benefit. However, only about $6 million of the funds raised from investors were used in this manner, and no such trust existed. In addition, Wright failed to disclose to investors that he was using a significant amount of their funds for his personal benefit.
The SEC brought claims for 1) employment of a device, scheme, or artifice to defraud in violation of of Section 17(a)(1) of the Securities Act [15 U.S.C. § 77q(a)(1)]; 2) fraud in the sale of securities in violations of Section 17(a)(2) and (3) of the Securities Act [15 U.S.C. § 77q(a)(2) and (3)]; 3) fraud in connection with the sale and purchase of securities in violations of Section 10(b) of the Exchange Act [15 U.S.C. § 78j(b)] and Rule 10b-5 thereunder [17 C.F.R. § 240.10b-5] 4) offer and sale of unregistered securities in violation of violation of Sections 5(a) and (c) of the Securities Act [15 U.S.C. § 77e(a) and (c)]; and 5) offer and sale of securities by an unregistered broker or dealer in violation of Section 15(a) of the Exchange Act [15 U.S.C. § 78o(a)].
While these causes of action are not unusual in an investor fraud case such as this, the facts underling the claims are what makes this case interesting. As noted earlier, Mr. Wright did not use the majority of the funds he raised through the sale of the promissory notes for the purposes represented to the investors. Instead, he used the funds on himself and for a variety of speculative investments, including money put into a company called Mark One Foods, which was developing the sales of canned sandwiches - i.e. the "Candwich."
The New York Times reported that the president of Mark One Foods, Mark Kirkland, who claimed to have patented the idea of putting solid food in a canned beverage container, said Wright pledged financial backing for Candwich. The Candwich is to be available in peanut butter with strawberry or grape jelly, as well as bar-b-que chicken. Pepperoni Pizza Pocket and French Toast in a can are also planned.
This case is yet another reminder to investors to be vigilant in looking out for scammers pitching "too good to be true" investments. A complete copy of the SEC's Complaint (courtesy of www.npr.org) can be found here, and the New York Times article discussing the case can be found here.
Posted by Kurt J. Schafers at 12:03 PM
Thursday, July 8, 2010
Late last month the U.S. Supreme Court handed down a 5-4 decision in the matter of Rent-A-Center, West, Inc. v. Jackson, No. 09-497. Scalia writes for the majority in reversing the 9th Circuit Court of Appeals. The 9th Circuit had overruled, in part, the District Court’s refusal to grant the Defendant’s Motion to Compel arbitration. The usual cast of supporting characters joined Scalia’s majority. Ginsberg, Breyer and Sotomayer joined Steven’s strong dissent. The Consumer Law and Policy Blog announced that the opinion “dealt a major blow to consumers.” So what is all the fuss about?
Generally speaking (for blog purposes), challenges to an arbitration provision are delegated to the Court’s while challenges to the enforceability of the arbitration provision based upon the formation of the contract serving as the repository of the arbitration agreement is reserved for the arbitrator – if explicitly agreed to by the parties. This “basic” demarcation got pretty blurry in Rent-A-Center because the arbitration provision and the contract were one in the same. Scalia’s somewhat incredible conclusion that this unique situation makes no difference is deemed “simply wrong” by the dissent. Scalia’s majority concluded that since 1) the Plaintiff challenged nothing but the contract as a whole, and 2) the arbitration had text delegating this “agreement to arbitrate” threshold issue to the arbitrator in “clear and unmistakable” terms, the Plaintiff had to bring the issue to the arbitrator.
The opinion’s logic is detached from reality and its self-justification is a bit disingenuous when it professes its result to be both obvious and inescapable. For example, the majority again holds that a provision within a contract assigning litigation to an arbitrator (selected by the defendant) is enforceable even if the plaintiff’s execution of the contract was induced by fraud unless the arbitrator hailed aboard the fraudulent vessel concludes -- in effect -- that his employment was fraudulently induced by his or her indirect employer. Although it is a bit unclear, Scalia seems to declare that the plaintiff must specifically allege that, in certain circumstances, the delegation clause within the arbitration provision itself was invalid before the court can evaluate that type of claim. The minority castigates the majority’s reasoning as “fantastic” and characterizes it as “Russian nesting dolls.”
But not all is lost for those challenging an arbitration agreement. For example, claims challenging the conscionability of the delegation clause itself – procedural and substantive – are still reserved for the courts, and so too are challenges to the agreement to arbitrate as a whole in the absence of a “clear and unmistakable delegation provision.” And the Court does not address the situation where the arbitration provision itself contains conflicting “access to court” provisions. Nor does it address the situation where an arbitrator (being paid handsomely) refuses to decide “gateway issues” purportedly delegated to him until the end of the arbitration hearing on the merits. And what about those situations where the party moving to compel arbitration has breached the delegation clause during the arbitration by refusing to litigate certain claims?
Furthermore, Scalia seems to leave open the door to a challenge to whether or not an agreement “was ever concluded” (as opposed to a “validity” challenge to the contract as a whole.) So now ask yourself – if, as both Scalia and the dissent claim, the enforceability of an arbitration agreement is a matter of contract law – can a contract induced by fraud ever “be concluded?” Doesn’t there need to be a meeting of the minds before an “agreement” exists or a contract is formed, and therefore “concluded”? The greatest fiction of all set out in Scalia’s opinion may be this assertion that arbitration analysis is based on contract law. This claim would have more credence but for the absurd yet necessary presumption that a consumer signing a commercial adhesion contract with an arbitration provision would have any ability to comprehend what he or she was actually agreeing to in light of the state of the law reflected in the Rent-A-Center majority and dissenting opinion. In many instances there is nothing wrong with arbitration, but the assumption that consumers understand what they are agreeing to when five Supreme Court Justices disagree with four Supreme Court Justices on the issue seems pretty alien to contract law.
How a delegation clause resting within an invalid arbitration provision could be binding is the new mystery created by Rent-A-Center. But it is merely a evolution of the original mystery: how an arbitration provision within a fraudulently induced contract could be binding so as to send the fraud issue to the arbitrator. So, at the end of this new day, it seems that: 1) Challenges to the validity/unconscionability/legally binding status “of a written agreement to arbitrate” these gateway issues goes to the court in the absence of an explicit delegation of gateway issues; 2) Challenges to the contract as a whole as to whether or not it was “concluded” goes to the court; 3) Challenges to the validity of the delegation clause goes to the court; 4) Challenges to the validity of the “contract as a whole” goes to the arbitrator only if there is a valid delegation provision.
In sum, and to use Scalia’s words – simply be sure to direct your challenge to the arbitration provision, at least in part, “specifically to the agreement to arbitrate” validity and enforceability issues.