Monday, December 23, 2013

The SEC’s Compliance Outreach Program for Investment Companies and Investment Advisers

The SEC recently announced that it will be hosting a national compliance outreach seminar for investment companies and investment advisers.  The seminar will be held on January 30, 2014 at SEC headquarters in Washington D.C.  The SEC’s Office of Compliance Inspections and Examinations (OCIE), Division of Investment Management, and the Asset Management Unit of the Division of Enforcement will co-sponsor the event.

The following topics will be covered in the seminar:

-          Program Priorities in 2014 with presentations from OCIE, Division of Investment Management, Division of Enforcement (Asset Management Unit), Joint or Coordinated Initiatives and Large Firm Engagements;
-          Private Fund Advisers with an emphasis on presence exam observations, JOBS Act, private fund initiatives/guidance, and private equity issues; 
-          Registered Investment Companies with an emphasis on 15c process/observations, alternative mutual funds, exchange traded products, and distribution in guise;
-          Valuation Issues specifically focusing on basic legal framework, valuation techniques and practices, difficult-to-value investments, and the role of persons other than the investment adviser (e.g., Board, Pricing Services); and
-          The Role of the CCO including presentations on SEC staff observations, CCO presence, access, and empowerment, and recent enforcement actions.  

“The compliance outreach program is an important part of the Commission’s initiative to share information about observed risks to assist firms in assessing and enhancing their compliance and control programs,” said OCIE Director Andrew Bowden.  “Past compliance outreach program events have been well attended and well received, and we look forward to a candid exchange of ideas with participants at our upcoming event.”

Click here for more information about registration.     

This announcement came just a few days before the SEC issued enforcement results for its fiscal year 2013, which ended in September.  The agency’s 686 enforcement actions in fiscal year 2013 resulted in a record $3.4 billion in monetary sanctions ordered against wrongdoers. Disgorgement and penalties resulting from those actions are 10 percent higher than fiscal year 2012 and 22 percent higher than fiscal year 2011, when the SEC filed the most actions in agency history.

If you need representation in an enforcement proceeding or need compliance consulting, contact the attorneys at Cosgrove Law Group, LLC.  

Furthermore, David Cosgrove, the managing-member of Cosgrove Law Group, LLC and former securities industry regulator, has recently established the Investment Adviser Rep. Syndicate.  This is a group dedicated to the interests of investment adviser representatives through the provision of educational and training opportunities.  In addition to these opportunities, the Syndicate, in general, is intended to address the specific interests and concerns of the representatives, rather than the representatives’ RIA or broker-dealer.

The Syndicate currently intends to hold its first annual conference in Saint Louis in the summer of 2014.  Stay tuned for the launching of the website that will include information on how to become a member, for additional announcements, and blog entries.  We are eager to be a part of the first national organization dedicated solely to the professional interests of investment adviser representatives.   

Wednesday, December 18, 2013

Investment Adviser Fiduciary Duty Standard Requires Reasonable Basis for Client Recommendation

The Securities and Exchange Commission regulates investment advisers under the Investment Advisers Act of 1940 (the “Act”). Perhaps the most significant provision of the Act is Section 206, which prohibits advisers from defrauding their clients. The Supreme Court has interpreted this provision as imposing on advisers a fiduciary obligation to their clients. See Transamerica Mortgage Advisors, Inc. (TAMA) v. Lewis, 444 U.S. 11, 17 (1979) (“[T]he Act’s legislative history leaves no doubt that Congress intended to impose enforceable fiduciary obligations.”).

The federal fiduciary standard requires that an investment adviser act in the “best interest” of its advisory client. Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 503 (3d Cir. 2013) (citing SEC v. Tambone, 550 F.3d 106, 146 (1st Cir.2008) (“[15 U.S.C. § 80b–6] imposes a fiduciary duty on investment advisers to act at all times in the best interest of the fund and its investors.”). Under a “best interest” test, an adviser may benefit from a transaction with or by a client, but the details of the transaction must be fully disclosed. See SEC v. Capital Gains Research Bureau, 375 U.S. 180, 191-92 (1963) (stating that Advisers Act was meant to “eliminate, or at least to expose, all conflicts of interest which might incline as investment adviser–consciously or unconsciously–to render advice which was not disinterested”).

A number of obligations to clients flow from the fiduciary duty imposed by the Act, including the duty to fully disclose any material conflicts the adviser has with its clients, to seek best execution for client transactions, to provide only suitable investment advice, and to have a reasonable basis for client recommendations. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, SEC Release No. IA-2333; Status of Investment Advisory Programs under the Investment Company Act of 1940, SEC Release No. IA-1623.

As noted by the Third Circuit in Belmont, even when a private litigant brings a cause of action for common law breach of fiduciary duty “the evolution of duties governing investment advisers as fiduciaries appears to have been shaped exclusively by the Advisers Act and federal common law.” 708 F.3d at 500-01. The Belmont court noted that one might reasonably wonder why the cause of action is presented as springing from state law if one looks to federal law for the statement of the duty and the standard to which investment advisers are to be held. 708 F.3d at 502. However, the court found that the answer was straightforward: no federal cause of action is permitted. Id. The court found that while “[t]hat reality ought to call into serious question whether a limitation in federal law can be circumvented simply by hanging the label ‘state law’ on an otherwise forbidden federal claim, that is the labeling game that has been played in this corner of the securities field, and the confusion it engenders may explain why there has been little development in either state or federal law on the applicable standards.” Id.

Based on the foregoing, a common law breach of fiduciary duty claim can in all likelihood be based on an investment adviser’s failure to have a “reasonable basis” for making a client recommendation. The question then becomes what constitutes a “reasonable basis” in the context of making such recommendations? This is not an issue that has been faced by many courts in the context of private causes of action brought by clients against investment advisers. For example, no Missouri case has addressed the issue.

However, in other situations where a reasonableness standard is employed, Missouri courts utilize an objective standard. See Graham v. McGrath, 243 S.W.3d 459, 463 (Mo. Ct. App. 2007) (noting that when damages are capable of ascertainment for purposes of statutes of limitations, Missouri utilizes an objective reasonable person standard); Robin Farms, Inc. v. Bartholome, 989 S.W.2d 238, 247 (Mo. Ct. App. 1999) (noting that the test for determining disqualification of a judge based on bias is whether a reasonable person would have factual grounds to doubt the impartiality of the court, “which is an objective standard[.].”).

As such, in Missouri and other jurisdictions that utilize the objective standard for reasonableness in other situations, the determination of whether an investment adviser had a “reasonable basis” for making a particular recommendation will likely be measured by an objective standard. This means that the fact finder will have to determine whether a reasonable person in the investment adviser’s circumstances might have made the same recommendation as the investment adviser, and need not consider what the adviser may have honestly -- but perhaps mistakenly -- believed.

Tuesday, December 17, 2013

Court of Appeals Takes Away Realty Company's Victory

Five years after the collapse and bankruptcy of DBSI, Inc., the Maryland Court of Appeals reversed a trial court's dispositive ruling in favor of a realty company that exposed its client to a TIC1 investment. The Plaintiff was a retired school teacher that reinvested $4 million in proceeds from the sale of various rental properties. In doing so, he sought to take advantage of Section 1031 of the Internal Revenue Code regarding “like-kind exchange property.”

Judge McDonald's opening line to his opinion dispels any suspicions that he ruled in favor of the Plaintiff/Cross-Appellant based on sympathy:

It is sometimes the case that an individual bent on avoiding taxes exchanges the certainty of the tax liability for a risky, and perhaps fraudulent, investment that proves more costly in the long run. The instant litigation arises out of such a situation.

2013 WL 6182531 (MD.2013) at 1.

Despite this mild contempt for the transaction at issue, the Court proceeded to evaluate the characteristics of the transaction in determining that it qualified as an investment contract under the Howe test. As such, it qualified as a security under the ambit of the Maryland Securities Act (pp. 5-9).

But it was not all good news for the investor. The Court concluded that the common law statute of limitations did not supersede the limitations provision set forth in the Act. As such, the investor's claims for violations of the Act's unregistered securities and unregistered broker-dealer provisions were time-barred. But all was not lost. The Court concluded that the investor's claim for fraud in the offer or sale of a security was tolled by a fraudulent concealment statute extraneous to the Securities Act. Moreover, it concluded that whether or not there was, in fact, fraudulent concealment sufficient to toll the statute of limitations was dependent upon a “fact-intensive injury” preclusive of summary judgment2.
Finally, the Court concluded that Mr. Mathew's claim for a violation of the Securities Act's unregistered investment adviser provision, as well as his common law tort and contract claims, were also subject to preservation by the fraudulent concealment statute. (CJ Section 5-203). Whether or not these claims were actually preserved (tolled) would be up to a jury.

This case provides an example of why:

  1. Investors should seek legal counsel as soon as they suspect something is amiss with one of their investments, and
  2. Where appropriate, the court petition or arbitration statement of claim should include both statutory and common law claims.
1TIC is an acronym for “Tenants in Common Interests.” I previously served as an expert witness in a DBSI TIC suitability arbitration.

2“Whether a plaintiff's failure to discover a cause of action was attributable to fraudulent concealment by the defendant is ordinarily a question of fact to be determined by the jury.” Matthews v. Cassidy Turley Maryland, Inc., 2013 WL 6182531 (MD.2013) at 14.

Monday, December 16, 2013

Mississippi Supreme Court Prohibits Sanctions for Each Affected Investor

Last month the Supreme Court of Mississippi handed down its 6-3 split opinion in the matter of Harrington v. Mississippi Secretary of State. The appellants in this case were officers in a real estate investment company. The officers solicited and sold over $1,500,000 of membership interests in the investment company through a private placement memorandum (PPM). The solicitation projected $60,000,000 in revenue and $20,000,000 in earnings over five years. Finally, the PPM provided that full and complete “records and books of accounts would be maintained and available to the investors.”

The Secretary of State's Securities and Charities Division ultimately issued a summary Cease and Desist Order against the company—SteadiVest, LLC. Among other things, the Division alleged that StediVest was a Ponzi scheme and that the PPM misled investors. The Division charged the two officers with five violations of the Mississippi Securities Act.

An administrative hearing was held on the allegations after which the hearing officer recommended that a penalty of $1,585,000 be imposed—the amount raised by the offering. Regardless, the Secretary of State issued a Final Order fining one officer $850,000 and the other $170,000. The officers appealed to the court system. The lower court upheld the Secretary of State's Order, and the officers appealed once again.

The Supreme Court dispensed with ease the officers' challenge to the sufficiency of the evidence against them. It also rejected their claims that the warnings in the PPM were sufficient and that the Division should have been required to prove scienter (knowing or intentional conduct). The Court's scienter analysis was grounded in the parallel between the Model Securities Act and Section 17 of the Federal Securities Act of 1933, as well as the variant scienter requirements within 17(a)(b) and (c). Perhaps more on this aspect of the opinion in a future blog.

This blog is intended to draw the reader's attention to one specific portion of the Supreme Court's analysis that deals with the calculation of fines for the two officers. Why is this important? In my experience, regulators frequently seek to ratchet up the total potential statutory fine by dissecting a single violation into a multitude of violations in order to achieve a drastic multiplier of the statutory fine exposure.

The Supreme Court's analysis in this regard can be found on pp.18-19 of the opinion. The Supreme Court upheld the Secretary of State's determination that two separate violations occurred, segregating the PPM violation from the books and records violation, but it rejected the Secretary of State's subsequent application of a multiplier of 17 for each affected investor.

Finally, anyone who has defended an agent or investment adviser representative before a state securities regulator might take some comfort in the Presiding Justice's dissenting opinion in this case. To give you just a taste:

If the majority intends to say that the Legislature has given the Secretary of State the power and authority to find a violation for ever representation in a securities offering that the Secretary of State subjectively believes might (as opposed to did or, unless abated, is going to) operate as a fraud, then it is enough for me to say that I simply reject that tortured interpretation of the statute. In my view, some proof is required that someone actually did detrimentally rely, or actually would have detrimentally relied, on the representations.


The word fraud is understood by nearly everyone who can spell it (including my esteemed colleagues in the majority), to mean an intentional material, less than truthful, representation upon which the speaker intends the victim to rely, and upon which the victim does actually, detrimentally, rely1. This Court has applied that meaning since before Mississippi became a state, and the English were employing it in the Common Law when Henry VIII schemed a way to marry Anne Boleyn. Law students must know and apply that meaning on law school and bar exams.

Food for thought.

1Hobbs Auto, Inc. v. Dorsey, 914 So.2d 148, 153 (Miss.2005)

Friday, December 13, 2013

Important Factors Considered in Eligibility Proceedings for Statutory Disqualification from a Felony Conviction

Article III, Section 3 of FINRA’s By-Laws provides that no person shall be associated with a member, continue to be associated with a member, or transfer association to another member if such person is or becomes subject to disqualification. Section 15A(g)(2) of the Securities Exchange Act of 1934 (“Exchange Act”) sets forth FINRA’s authority to deny the registration and/or membership of disqualified persons.  Section 3(a)(39) of the Exchange Act defines various ways an associated person or member can become disqualified. 

This article focuses of disqualification of an associated person due to the conviction of a felony.  Disqualification of this sort remains in force for ten years.  Thus, a Member who wishes to employ or contract a disqualified person must file a Membership Continuance Application (“MC-400”) with FINRA Registration and Disclosure (“RAD”).  FINRA Rules 9520-27 set forth procedures for a member to sponsor the proposed association of a person subject to disqualification.  These actions are referred to as “Eligibility Proceedings.”

When the conviction of a felony renders a registered person statutorily disqualified, the standard in determining whether the NAC should approve a MC-400 is “whether the particular felony at issue, examined in light of the circumstances related to the felony, and other relevant facts and circumstances, creates an unreasonable risk of harm to the market or investors.”  See Frank Kufrovich, 55 S.E.C. 616, 625-26 (2002)(emphasis added).  The sponsoring firm has the burden of demonstrating that the proposed association of the statutorily disqualified individual is in the public interest and does not create an unreasonable risk of harm to the market or investors.  In the Matter of the Application of Gershon Tannenbaum, 50 S.E.C. 1138, 1140 (1992).  

A review of numerous prior Statutory Disqualification decisions indicates that the following factors are typically considered:
-          the nature and gravity of the disqualifying event;
-          the length of time that has elapsed since the disqualifying event;
-          whether any intervening misconduct has occurred;
-          any other mitigating or aggravating circumstances that may exist;
-          the precise nature of the securities-related activities proposed in the application; and
-          the disciplinary history and industry experience of both the member firm and the person proposed by the firm to serve as the responsible supervisor of the disqualified person.

These proceedings should not be taken lightly.  It is especially important that the MC-400 application detail the terms and conditions of the proposed employment and contain a strong plan of supervision.  In many of the cases in which the MC-400 application was denied, the NAC cited one of the reasons for denial as being its concern for either the proposed plan of supervision, or the disciplinary history of the sponsoring firm and/or proposed supervisor.  See Continued Ass’n of X, SD09003 (2009)(denied application where plan of supervision lacked sufficient detail); Continued Ass’n of X, SD08007 (2008)(denied application where proposed supervisor directly profited from X’s production and where another employee was responsible for overseeing X’s daily trades); Continued Ass’n of X, SD06012 (2006)(denied application where proposed supervisor was subject to several customer complaints); Continued Ass’n of X, SD04012 (2004)(denied application where sponsoring firm had significant disciplinary and regulatory history and history of customer arbitrations and where plan was not specifically tailored to the type of business X planned to conduct); Continued Ass’n of X, SD02002 (2002)(denied application where proposed supervisor was in another state and hundreds of miles away from X where X operated out of his home with no employees on site).  Thus, the sponsoring firm’s ability to supervise the disqualified person is an extremely important factor in Eligibility Proceedings.    

The attorneys at Cosgrove Law Group, LLC have substantial experience in representing Members and associated persons in Eligibility Proceedings.  We have also thoroughly analyzed other Statutory Disqualification opinions where the associated person has been convicted of a felony.  Thus, we are familiar with the factors that the NAC weighs in making a determination as well as the necessary elements that should be contained in a plan of supervision.  

Thursday, December 12, 2013

Broker-Dealer Submits to State Consent Order

Early this month a Missouri based broker-dealer entered into a Consent Order with the Missouri Securities Division. In doing so, the broker-dealer consented to a finding that it failed to supervise one of its agents and failed to have in place sufficient policies and procedures to detect and identify violations of the securities laws by its agents.

The Cosgrove Law Group represented one of the clients victimized by the broker-dealer's agent. According to the Consent Order, the agent, now deceased, deposited at least eighty (80) checks from clients in his Gateway Financial Resources account, and used a portion of these funds for his personal expenses. The funds were generated in some instances pursuant to the agent's recommendation to client's that they liquidate their investments.

The broker-dealer paid at least $700,000 to the various victims and, pursuant to the Consent Order, over $100,000 to the State.  

Monday, November 25, 2013

SEC’s Investor Advisory Committee Recommends Extending Fiduciary Duty to Broker-Dealers

Section 911 of the Dodd-Frank Act established the Investor Advisory Committee to advise the SEC on regulatory priorities, the regulation of securities products, trading strategies, fee structures, the effectiveness of disclosure, and on initiatives to protect investor interests and to promote investor confidence and the integrity of the securities marketplace.  On November 22, 2013, the Committee issued a recommendation to extend the fiduciary duty to broker-dealers.

The Committee preliminarily stated its conclusion: that personalized investment advice to retail customers should be governed by a fiduciary duty, regardless of whether that advice is provided by an investment adviser or a broker-dealer.  In approaching this issue, the Committee noted that the SEC's goal should be to eliminate the regulatory gap that allows broker-dealers to offer investment advice without beings subject to the same fiduciary duty as other investment advisers.  However, the Committee noted that the SEC should not eliminate the ability of broker-dealers to offer transaction-specific advice compensated through transaction-based payments.

The Committee made two specific recommendations for action by the SEC.  First, the Committee recommended that the SEC should conduct a rulemaking to impose a fiduciary duty on broker-dealers when they provide personalized investment advice to retail investors.  Second, as a part of its rulemaking, the SEC should adopt a uniform, plain English disclosure document to be provided to customers and potential customers of broker-dealers and investment advisers that covers basic information about the nature of services offered, fees and compensation, conflicts of interest, and disciplinary record.

In the stated "Supporting Rationale" for its recommendation that the SEC should engage in rulemaking to impose a fiduciary duty on broker-dealers when they provide personal investment advice, the Commission noted that in arriving at this decision they took into account a broad consensus among widely disparate groups that broker-dealers and investment advisers should be subject to a uniform fiduciary standard.  The Committee also noted that these various stakeholder groups generally agree that the fiduciary duty should not apply to all brokerage services, but only to those services that fall within a reasonable definition of personalized investment advice to retail customers.

The Committee also addressed some of the limited opposition that exists.  First, some argue that broker-dealers are already extensively regulated under existing law and self-regulatory organization rules.  The Committee believed, however, that while the existing regulatory scheme may adequately regulate broker-dealers when they act as salespeople, it does not offer adequate investor protection when they offer advisory services, since under the suitability standard they generally remain free to put their own interests ahead of those of their customers.  Second, some argue that regulation is not needed because investors are capable of choosing for themselves whether they prefer to work with a broker-dealer operating under a suitability standard or an investment adviser who is a fiduciary.  However, the Committee found that various studies had indicated that investors do not distinguish between broker-dealers and investment advisers, do not know that broker-dealers and investment advisers are subject to different legal standards, do not understand the difference between suitability standard and a fiduciary duty, and expect broker-dealers and investment advisers alike to act in their best interests when giving advice and making recommendations.

The Committee noted that the SEC has a range of options available to it in order to implement this regulatory goal.  These include the rulemaking authority under Section 913(g) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as existing authority under the Investment Advisers Act to regulate non-incidental advice by broker-dealers.

The Committee's second recommendation was that the Commission should adopt a uniform, plain English disclosure document to be provided to customers and potential customers of broker-dealers and investment advisers.  The Committee believed that improved disclosure was necessary to help investors select a financial professional.  Relevant topics could include what services are provided, how the broker-dealer or investment adviser is compensated, and what conflicts of interest exist.

The Committee's recommendation is another step towards the establishment of a fiduciary duty standard for broker-dealers.  This position has already been applauded by the NASAA, which in a statement supporting the recommendation said that:  "A fiduciary standard for broker-dealers will guarantee that all financial professionals providing investment advice will act in the best interests of their clients, and in turn, enhance investor confidence in the financial services industry and securities markets."

FINRA Tags St. Louis Bond Underwriter for Improper Sports Ticket Gifting

FINRA recently accepted the offer of settlement of a St. Louis member firm. The uncontested offer of settlement was submitted approximately 9 months after FINRA's Department of Enforcement filed its Complaint. Enforcement accused the firm of improperly gifting tickets to various sporting events to employees of municipal securities issuers. The firm gifted over $2,000 tickets valued at almost $200,000 in a two-year period.

In concluding that the firm violated MSRB Rule G-27, FINRA emphasized three salient factors: 1) the firm did not host the recipients of the tickets at the events, 2) the firm gifted tickets only to those issuers who were clients, and 3) the bigger issuers received more and better tickets. MSRB Rule G-20 has an exemption for occasional gifts of tickets that requires the member firm to host the event. As a result, the St. Louis firm was censured and fined $200,000. Food for Thought! Go to the game!

Friday, November 15, 2013

How Bankruptcy May Affect Your Pending Expungement Claim

         Registered representatives terminated from broker-dealers may face several issues after the firm reports the reason for the reps’ termination on his or her Form U-5.  Depending on that reason, it may be difficult for that broker to become associated with another broker-dealer or find future employment in the financial industry.  As a result, terminated reps may experience financial difficulties while looking for employment.  If a rep believes the reason for termination that was reported on his or her U-5 was false, that rep may consider seeking expungement, or even damages associated with the U-5 filing.  This process takes time and costs money, especially if the rep engages legal counsel to assist with the arbitration.  If this results in financial difficulties for the rep, the rep should consider the case of In re Jimmy W. Clark before resorting to a remedy such as bankruptcy during the pendency of the arbitration. 

            Clark, a broker, was terminated by Charles Schwab after it received and investigated a ‎customer complaint that he placed unauthorized trades in their accounts.‎ ‎ Schwab reported that ‎reason for termination on his Form U-5. Clark instituted a FINRA arbitration proceeding ‎against Schwab and sought both monetary damages for alleged wrongful termination and defamation and CRD expungement of the statements Schwab made on his Form U5.  During the pendency of his FINRA arbitration (two years after his termination), Clark filed ‎for bankruptcy.

            Before the bankruptcy case was closed, Clark failed to disclose his bankruptcy to FINRA or Schwab and failed to include the pending claim as an asset in his bankruptcy or notify the bankruptcy trustee (“Trustee”).  After Schwab discovered Clark’s bankruptcy, Clark moved to re-open his bankruptcy and allowed the Trustee to pursue the arbitration claims on behalf of the bankruptcy estate.  Schwab and the Trustee settled Clark’s claims for a fraction of the alleged damages and broadly released Schwab from all claims.  The $120,000 settlement was essentially enough to pay the fees of the trustee ‎and his counsel and enable a distribution to the creditors. 

            Clark objected to the bankruptcy court arguing that (1) ‎his “claim” for expungement was personal and not property of his bankruptcy estate, (2) only ‎FINRA had authority to adjudicate and approve settlement of expungment claims, and (3) the ‎settlement was unfair.

Expungement as Personal Property

The court rejected Clark’s argument that his claim for expungement was his personal property, finding that it was merely a remedy rather than an independent claim.  In doing so, the court relied on FINRA Rule 2080 which specifically refers to expungement as “relief” and Notice to Members 04-16, which introduced Rule 2080 and advises respondents seeking expungement to request it in “his or her prayer for relief.”  Clark argued that expungement is vital to the preservation of his broker’s license, which is personal, non-transferable, and not part of the property of the Estate. The Court conceded that point, but found that the settlement did not concern Clark’s license.  The Court noted that neither Schwab nor the Trustee were trying to take away Clark’s license.  They were simply settling a cause of action ‎which might have an impact on the debtor’s ability to procure future employment.

FINRA’s Authority over the Settlement of Expungement Claims

            The court also rejected Clark’s claim that FINRA has exclusive jurisdiction over the settlement of expungement claims because the bankruptcy court was not ordering expungement.  The court found that nothing in the FINRA rules precludes parties from settling a dispute and the settlement between Schwab and the Trustee was consistent with the FINRA Rules. FINRA’s approval is required only if settlement of a FINRA ‎action includes the affirmative expungement of the Form U-5.

Fairness of the Settlement

The court noted that when a bankruptcy court considers approval of a settlement, it evaluates: (a) the ‎probability of success in the litigation; (b) the difficulties, if any, to be encountered in collection; ‎‎(c) the complexity of the litigation involved, and the expense, inconvenience and delay ‎necessarily attending it; and (d) the paramount interest of the creditors and deference to their ‎reasonable views on the settlement.  In considering these factors, the court found that while the settlement might not always be in the best interest of a debtor, it’s the interest of the creditors that takes precedent. 

Thus, a rep experiencing financial difficulties during the pendency of an arbitration that includes a request for expungement should consider the consequences of filing for bankruptcy. 

            The attorneys at Cosgrove Law Group, LLC have substantial experience representing individuals in various types of FINRA matters.    

Wednesday, November 13, 2013

FINRA Rule 2010: The Catch-All Provision

FINRA Rule 2010 states: “A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade.”  The rule applies with equal force to associated persons.  This rule was adopted verbatim from its predecessor, NASD Rule 2110.  The foundation of Rule 2010 is Section 15A(b)(6) of the Securities Exchange Act of 1934, which requires FINRA, as a registered securities association, to have and enforce rules that “promote just and equitable principles of trade.”

There is no definition of “commercial honor,” “just and equitable,” or “principles of trade.”  So what exactly does Rule 2010 proscribe? 

In the caselaw developed under the rule, some types of misconduct, such as violations of federal securities laws and FINRA Conduct Rules, are viewed as violations of Conduct Rule 2010 regardless of the surrounding circumstances because members of the securities industry are required to abide by the applicable rules and regulations.

Beyond this strict liability for violation of another law or rule of conduct, only a few federal courts have had the opportunity to analyze the rule.  For example, in Heath v. SEC, 586 F.3d 122, 127 (2nd Cir. 2009), the NYSE Hearing Board found that the petitioner had disclosed confidential information, and had therefore violated NYSE Rule 476(a)(6), which, like Rule 2010, prohibits “conduct inconsistent with just and equitable principles of trade.”

The Chief Hearing Officer found that by disclosing confidential information, the petitioner had acted unethically, and therefore had violated NYSE Rule 476.  She reasoned:

It is commonly accepted that when a financial advisor takes on work that requires the communication of such sensitive, nonpublic information from the client to the advisor, the client has an expectation that the advisor will keep that information confidential.

Id. at 127.

The Chief Hearing Officer noted that employer’s Code of Conduct prohibited employees from disclosing confidential sensitive information learned on the job.  However, she concluded that the duty of confidentiality was not attributable merely to the employer’s Code of Conduct, but also:

[F]rom the ethical obligation to which every financial advisor becomes subject upon learning of sensitive, nonpublic information about a client in the normal course of business. It is a duty that should be self-evident to any experienced financial professional.


Petitioner appealed this decision to the SEC, and advanced two arguments relevant to this discussion: (1) the just and equitable principles of trade rule (“J & E Rule”) requires a finding of bad faith; and (2) petitioner did not receive fair notice that his conduct was sanctionable under the J & E Rule.  Id. at 130.

With regard to the first argument that a finding of bad faith is required for a J & E Rule violation, the court noted that it had long been the view that the J & E Rule is designed to enable SROs to regulate the ethical standards of its members. Id. at 132.  The court noted that in In the Matter of Benjamin Werner, 44 S.E.C. 622, 1971 WL 120499 (July 9, 1971), the SEC rejected the argument that NASD’s J & E Rule could only be violated by an unlawful act.  Id.  The SEC noted, “We have long recognized that [the J & E Rule] is not limited to rules of legal conduct but rather that it states a broad ethical principle which implements the requirements of Section 15A(b)” of the Exchange Act.   Id. at 132 (citing Werner, 1971 WL 120499 at *2 n. 9).  The court also noted that as early as 1966, Judge Friendly stated that the J & E Rule is “something of a catch-all which, in addition to satisfying the letter of the statute, preserves power to discipline members for a wide variety of misconduct, including merely unethical behavior.”  Id. (citing Colonial Realty Corp. v. Bache & Co., 358 F.2d 178, 182 (2d Cir. 1966).

In support of his argument that bad faith was required, the petitioner cited several SEC decisions and the Second Circuit’s decision in Buchman v. SEC, 553 F.2d 816 (2d Cir.1977).   In Buchman, 553 F.2d at 818, a broker-dealer was sanctioned by the SEC for violation of the NASD’s J & E Rule for failure to complete a contract with another broker-dealer for the sale of stock.  The broker-dealer that failed to complete the contract did so out of concern that to complete the contract would be in furtherance of fraud.  The Second Circuit vacated the SEC’s sanction order, finding that a breach of contract is unethical conduct in violation of NASD Rules only if it is found that a breach of contract is in bad faith.  Id. at 820.

The Heath court found that petitioner’s case was entirely distinguishable from the Buchman case in that, in the words of the Chief Hearing Officer, the petitioner “was [not] under any competing obligation to make the disclosures that he did or that any ‘equitable excuse’ relieved him of his ethical obligation to keep the information confidential.”  Heath, 586 F.3d at 136.  Rather, petitioner did it for self-serving reasons. Moreover, the court noted that the SEC correctly understood the bad faith requirement from Buchman to be limited to the breach of contract context.  Id. at 136-37.  Thus, the court concluded that, contrary to petitioner’s contention, the J & E Rule prohibits mere unethical conduct and does not require a showing of state of mind.  Id. at 137.

The petitioner next argued that neither the NYSE nor the SEC had articulated a mental state standard for a J & E Rule violation.  Id. at 139.  He contended that without an articulation of a mental state standard, registered members lacked “fair notice of the conduct that might be sanctioned.”  Id. 

The court stated in response that the SEC had made clear that no scienter is required and mere unethical conduct is sufficient outside the breach of contract context to find a J & E Rule violation.  Id.   Further, the SEC had made clear that “industry norms and fiduciary standards” are determinative as to what constitutes unethical conduct.  Id. (citations omitted).

The court went on to note that the Second Circuit had previously rejected the very argument that petitioner was making in Crimmins v. Am. Stock Exch., Inc., 503 F.2d 560 (2d Cir.1974) which adopted the district court’s conclusion that the J & E Rule was not unconstitutionally vague because “[a]s an experienced registered representative, plaintiff may be fairly charged with knowledge of the ethical standards of his profession . . . ”  Id. (quoting Crimmins, 503 F.2d at  )

The Heath court ultimately concluded that while Petitioner’s conduct was not as egregious as that of others who had been sanctioned by the NYSE, the SEC was correct that any reasonably prudent securities professional would recognize that the disclosure of confidential client information under the circumstances of the case constituted unethical conduct sanctionable under the J & E Rule.  Id. at 141.

As can be seen from the Heath case, Rule 2010 prohibits “unethical” conduct, and there is no requirement that there be a finding of “bad faith” or any other state of mind.  But again, there is nothing that clearly defines when behavior will be considered unethical.  Even the Heath court found that disclosure of confidential client information “under the circumstances of this case” constituted unethical conduct, thus leaving open the possibility that disclosure of confidential information could take place under circumstances in which it would not be considered a violation of Rule 2010.

Here is a sampling of other conduct found by the SEC, FINRA and NASD as violative of Rule 2010:

  • Downloading customer nonpublic information, including account numbers and net worth figures, and sending them to the associated person’s future branch manager at a competitor’s firm.
  • Misappropriating money from insurance customer.
  • Serving as a treasurer of political club and breaching “significant fiduciary obligations” to the club when associated person misappropriated club funds.
  • Improperly obtaining a donation for his daughter’s private school tuition from his member firm’s matching gifts program by misrepresenting that he had contributed personal funds.
  • Improperly obtaining reimbursement for country club initiation fees from his employer firm.
  • Trying to persuade back-office employee to credit associated person unearned commissions.
  • Passing bad checks to associated person’s employer.
  • Forging a client signature to a check and converting the funds to the associated person’s account.
  • Failing to disclose bankruptcy petitions, unsatisfied judgments, and civil lawsuits on Form U-4.
  • Affixing customer signatures or otherwise altering customer documents, including distribution forms, redemption forms, and account transfer forms.
  • Failing to comply with a court judgment by paying attorneys’ fees and costs awarded to a customer in litigation that associated person initiated against customers challenging an arbitration award they had won against him.
As can be seen, while Rule 2010 does not provide regulators with carte blanche to pursue violations, the reach of Rule 2010 is broad.  Even unethical conduct that is not securities-related is prohibited by Rule 2010 if it occurs in the conduct of the member or associated person’s business.  In evaluating what conduct runs afoul of Rule 2010, FINRA members and associated persons must rely on not only the FINRA written Conduct Rules, but also on their experience and exposure to industry norms, as well as their general sense of what is right or wrong.

Friday, November 1, 2013

SEC Proposes Rules on JOBS Act Crowdfunding Provisions

With constant advances in technology, crowdfunding has been a popular source used in a number of areas to raise money for various types of projects.  Its aim is to receive small contributions from a large amount of people.  Prior to the passage of the JOBS Act, this mechanism of raising capital was never used for the offer or sale of securities.  The crowdfunding exemption was intended to bridge the gap in raising funds and overbearing regulations for small businesses.    

The immediate concern for this type of fundraising is investor protection.  Thus, the SEC was tasked with formulating rules that allow for implementation of the crowdfunding provisions while safeguarding the market and investors.  Just recently, the SEC proposed rules that would “permit individuals to invest subject to certain thresholds, limit the amount of money a company can raise, require companies to disclose certain information about their offers, and create a regulatory framework for the intermediaries that would facilitate the crowdfunding transactions.”  Since the proposed rules encompass nearly 600 pages, the following is a brief overview of some of the important issues.  

According to the proposed rules, the maximum amount a company could raise from crowdfunding offering within a 12-month period is $1 million.  Over the course of the 12-month period, the maximum investment per investor is based on the annual income or net worth.  For investors with both an annual income and net worth less than $100,000, the maximum investment is the greater of $2,000 or 5% of their annual income or net worth.  For investors with either annual income or net worth equal to or more than $100,000, the maximum investment is 10% of their annual income or net worth, whichever is greater.  However, investors are not permitted to purchase more than $100,000 of securities through crowdfunding during the 12-month period.   

Companies conducting a crowdfunding offering are required to file certain information with the SEC.  This information is to be made available to investors, potential investors, and the intermediary facilitating the crowdfunding. Such information includes the following: (1) information about officers and directors as well as owners of 20 percent or more of the company; (2) a description of the company’s business and the use of proceeds from the offering; (3) the price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount; (4) certain related-party transactions; (5) a description of the financial condition of the company; and (6) financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor.  Any company relying on the use of crowdfunding to raise capital must file an annual report with the SEC and provide that report to investors. 

In order to achieve investor protection, the JOBS Act requires crowdfunding to take place through an SEC-registered intermediary.  This can be either a broker-dealer or a funding portal.  In a nutshell, the proposed rules would require intermediaries to take measures to reduce the risk of fraud, provide investors with educational materials and information about the issuer and offering, provide communications channels on the online platform that permit investors to discuss the offering, and facilitate the offer and sale of crowdfunded securities. The proposed rules prohibit funding portals from the following: (1) offering investment advice or making recommendations; (2) soliciting purchases, sales or offers to buy securities offered or displayed on its website; (3) imposing certain restrictions on compensating people for solicitations; and (4) holding, possessing, or handling investor funds or securities.

The SEC is providing 90 days of public comment before determining whether to adopt the proposed rules.  To review the proposed rules in their entirety, click here

Monday, October 28, 2013

SEC Finally Issues 568-Page Regulation Crowd funding Proposal

Small start-up companies that applauded the 2012 Jump Start Our Business Start-ups Act have 90 days to respond to the SEC's October 23, 2013 proposal. The single-spaced Table of Contents for the proposal exceeds 2 pages. The goal of the Act the SEC seeks to implement was intended to help small issuers reach numerous small investors via the internet. Yet the proposal contains hundreds of pages of “restrictions,” “limitations,” and requirements. 

The media was all a-buzz last week about the long awaited proposal. In all fairness, the SEC was put in a bit of a bind by the JOBS Act's crowd funding provisions. How does one fashion a new system that keeps the fraudulent wolf at bay while simultaneously making it much easier for less sophisticated sheep to answer his knock at the door? The SEC's primary suggested method is an online portal coupled with the Act's explicit investment caps.

The proposal's introductory comments (pp. 6-11) provide an excellent succinct overview. After that—you are on your own until we at Cosgrove Law Group have a chance to work through it ourselves. And if you are really too busy at the moment, the Wall Street Journal and the Washington Post boil the entire matter down to a couple of dozen paragraphs.   

Thursday, October 17, 2013

D.C. Circuit Court of Appeals Considers Whether Stanford Fraud Victims are “Customers” under the Securities Investor Protection Act

Despite the famous R. Allen Stanford Ponzi scheme being unraveled in early 2009, the past two weeks have been important for the victims of the fraud who are still trying to recover their financial losses.  On October 7, the Supreme Court heard arguments on whether the Securities Litigation Uniform Standards Act precludes investors from bringing state law claims against third-party entities who allegedly participated in Stanford’s fraudulent scheme.  For further discussion on that topic, click here

Yesterday, the SEC argued in front of the D.C. Circuit Court of Appeals seeking to overturn a District Court’s ruling that barred the agency from ordering the Securities Investor Protection Corp. (“SIPC”) to compensate victims of the Stanford Ponzi scheme.  SIPC is a congressionally chartered corporation that oversees liquidation of failed brokerages and may also pay investors’ claims for missing money or securities through an industry-financed fund.    

Since the CD’s at the heart of the Ponzi scheme were marketed to investors by Houston-based Stanford Group Company (“SGC”) – a broker dealer registered with the SEC and SIPC – in 2009, the court appointed receiver of Stanford’s companies asked SIPC to evaluate whether the customers of SGC were entitled to SIPC’s protection.  SIPC declined to file an application for protective decree because it concluded that SGC did not perform a custody function for the customers who purchased CD’s from the Antigua-based Stanford International Bank (“SIB”) which was not a member of SIPC.  However, in 2011, the SEC issued a formal analysis disagreeing with SIPC’s position and filed an application in District Court ordering SIPC to meet its obligations. 

This is the first time the SEC has requested a court to force SIPC to extend its coverage.  During the proceedings in the District Court, the key issue was whether persons who purchased CD’s from SIB were considered customers of SGC within the meaning of the Securities Investor Protection Act.  SIPA defines “customer” as follows:

The term ‘customer’ of a debtor means any person (including any person with whom the debtor deals as principal or agent) who has a claim on account of securities received, acquired, or held by the debtor in the ordinary course of its business as a broker or dealer from or for the securities accounts of such person for safekeeping, with a view to sale, to cover consummated sales, pursuant to purchases, as collateral, security, or for purposes of effecting transfer.
The term `customer' includes—
(i) any person who has deposited cash with the debtor for the purpose of purchasing securities;…

SIPCs argued that although many of the victims purchased the foreign CD’s through SGC, the victims ultimately entrusted their money with SIB which was not a member of SIPC.  Furthermore, investors received disclosures explicitly telling them the Antiguan bank was not SIPC-protected or regulated by the U.S. 

The SEC, however, argued that the location of the Stanford bank is irrelevant because Stanford’s entire business organization was operating one massive fraud, and that no actual certificates of deposit truly existed.

The District Court found that since SGC never physically possessed the investors’ funds at the time of the purchases, the investors were not customers of SGC under the literal construction of the statute.  Click here to review the court’s opinion.   

During oral arguments in front of the D.C. Circuit, much of the hearing was consumed by discussion and debate over the legal definition of “customer” and whether the SEC can force SIPC to construe that term to include victims of a collapse that involves both member and non-member companies.  Just like the highest court last week, the Circuit judges gave no clear indication of how they will rule. 

A few former SEC commissioners filed a friend of the court brief urging the Circuit to uphold the lower court’s ruling because an “unwarranted expansion” of the term “customer” has the potential to substantially increase SIPC’s exposure and could threaten its ability to function as Congress intended.

In sum, the rulings of the Supreme Court and the D.C. Circuit Court of Appeals will both have a substantial impact on the victims’ chances to recover their losses.  

Wednesday, October 16, 2013

U.S. Supreme Court Debates Coverage of the Securities Litigation Uniform Standards Act

The U.S. Supreme Court recently debated whether investors in a consolidated class action suit were precluded by the Securities Litigation Uniform Standards Act (“SLUSA”) from bringing state law causes of action against law firms and other third party entities for their alleged roles in the $7 billion R. Allen Stanford Ponzi scheme. SLUSA bars plaintiffs from bringing state law claims based on misrepresentations made “in connection with the purchase or sale of a covered security.” 

The Ponzi scheme at the center of the allegations involved over 21,000 investors who bought certificates of deposit from R. Allen Stanford’s bank in Antigua. Stanford promised a risk-free investment with above-market rates of return and said the CDs were backed by portfolios of liquid securities.  However, there were no securities and the money went to fund a string of failed businesses, bribe regulators, and support Stanford’s lavish lifestyle. R. Allen Stanford was convicted and sentenced to 110 years in prison in March of 2012.  The receiver, who was court appointed in 2009 to recover money from Stanford’s failed companies to return to investors, recently began mailing checks ranging from $2.81 to $110,000 to hundreds of investors.  That amounts to approximately $55 million of the $6 billion lost from the scheme – less than a penny on the dollar.

The complaints filed by investors alleged that various third party entities made misrepresentations concerning the safety of the investments and that Stanford’s attorneys conspired with and aided and abetted Stanford in violating the securities laws by lying to the SEC and assisting Stanford to evade regulatory oversight.

The District Court examined whether a covered security was applicable in the case because although the CD was not a covered security, the marketable securities purportedly backing the CD’s were a covered security.  During this analysis, the District Court used the Eleventh Circuit’s approach, which asks “whether a group of plaintiffs premise their claim on either ‘fraud that induced [the plaintiffs] to invest with [the defendants] … or a fraudulent scheme that coincided and depended upon the purchase or sale of securities.’” The District Court determined that the belief that the CD’s were backed by marketable securities induced the investors to purchase the CD’s.  Therefore, the District Court dismissed the investors’ claims.

On appeal, the Fifth Circuit reversed the decision, rejecting the test applied in the Eleventh Circuit and adopted the Ninth Circuit test: “A misrepresentation is ‘in connection with’ the purchase or sale of a security if there is a relationship in which the fraud and the stock sale coincide or are more than tangentially related.”  The Fifth Circuit relied on public policy considerations that requires interpretation of the “in connection with” element in a manner not to preclude group claims simply because the issuer advertises that it owns covered securities in its portfolio. 

In order to resolve the circuit split on the interpretation of SLUSA’s “in connection with” requirement, the Supreme Court granted certiorari. The issues considered by the highest court were the following: (1) whether the Securities Litigation Uniform Standards Act (SLUSA) precludes a state-law class action alleging a scheme of fraud that involves misrepresentations about transactions in SLUSA-covered securities; and (2) whether SLUSA precludes class actions asserting that defendants aided and abetted SLUSA-covered securities fraud when the defendants themselves did not make misrepresentations about the purchase or sale of SLUSA-covered securities.

Plaintiffs hinge part of their argument on the fact certificates of deposits were specifically excluded from Congress’s definition of “covered security” and request the Court uphold the 5th Circuit’s ruling.  The defendants claimed that the application of federal law should be broad and because Stanford made the promise to back the CD’s with securities, the SLUSA effectively blocks the state causes of action.

During oral arguments, the nine justices gave no clear indication on how they will rule.  However, Justice Scalia’s questions and comments suggested he felt the suits could go forward because he read the statutory language “in connection with the purchase or sale of a covered security.”  Justice Alito, on the other hand, read “in connection with” broadly.  Stay tuned for and update when the court releases its ruling.   

Tuesday, October 15, 2013

FINRA Releases Comprehensive Report on Conflicts of Interest

Last month FINRA issued a 44-page report on conflicts of interest within the financial services industry. The report focuses specifically on the conflict management practices of broker-dealer firms. During my experience representing both investors and FINRA members, or while serving as an expert witness, I have frequently identified a conflict of interest to as genesis of the legal claim. FINRA's report is an outstanding review of both the source of troublesome conflicts and current best practices within the industry.

FINRA's report does not pull any punches. It comes out of the gate with the following observation: “Conflicts of interest can arise in any relationship where a duty of care or trust exists between two or more parties, and as a result, are widespread across the financial service industry...[M]any broker-dealer firms have made progress in improving their conflicts management practices, but...firms should do more to manage and mitigate conflicts of interest in their businesses.” (report link)

The report is broken out in to a review of “three critical areas.” FINRA evaluates and discusses: 1) firm-level frameworks, 2) new financial products, and 3) registered rep. compensation. FINRA defines firm-level frameworks as “the combination of underlying ethics culture, organizational structures, policies, processes, and incentive structures.” I found the report's second section regarding the introduction and promotion of new financial products to be worthy of a “must read” classification for both the compliance and the executive sales side of any firm. The final section of the report lays out what FINRA believes to be six “effective practices” for mitigating conflicts of interest generated by rep. compensation arrangements.

Now that FINRA has spoken in great detail on the matter, firms should be very hesitant about going forward without implementing the practices suggested in the report. While FINRA specifically disavows the report as rule-making, firms will be caught flat-footed if they face an investor claim or regulatory action rooted in the absence of the suggested best practices.   

Thursday, September 5, 2013

The Importance of Creating an Administrative Record in ERISA Claims

ERISA requires employees to exhaust all administrative remedies before pursuing claims in court.  This means that an employee must follow the claims procedures outlined in his or her Summary Plan Description.  Abiding by these requirements and taking this phase of the process seriously is crucial.   

Typically, a claim is filed with the plan administrator in accordance with the plan’s procedures.  The plan administrator then must provide adequate notice to the employee in writing, setting forth the specific reasons for such denial.  ERISA provides that every plan participant must be afforded a full and fair review of the decision denying the claim.  Any documentation, records, or other relevant information submitted by the claimant along with additional evidence, documentation and records used by the plan administrator constitutes the administrative record. 

Developing a sufficient administrative record is imperative because after an administrative appeal and once a claim is filed in court, various circumstances determine whether or not the court’s review of the administrator’s decision is limited to the evidence in the administrative record or if additional discovery is allowed. Certain language in a plan along with an employee’s location can determine his or her rights.    

The first step in determining whether discovery is allowed outside the administrative record is to decide the applicable standard of review.  As discussed in my prior article, the Supreme Court in Firestone Tire and Rubber Co. v. Bruch, decided that a de novo standard (allowing the court to substitute its own judgment) applies when reviewing a claim denial, unless the language of the plan gives the plan administrator discretion to interpret and apply the plan.  If a plan provides such discretion, the reviewing court applies an abuse of discretion standard and gives the benefit denial deferential treatment. 

Since the abuse of discretion standard assesses the reasonableness of the benefit decision based upon the facts known to the plan administrator at the time, consideration of evidence outside the record is extremely rare. 

However, when a de novo standard applies, the circuits have articulated a variety of rules concerning discovery outside the administrative record. 
  • The Fifth and Sixth Circuits do not permit the introduction of extrinsic evidence reasoning that federal courts are not to function as substitute plan administrators.
  • The Seventh and Eleventh Circuits allow the admission of all extrinsic evidence because de novo review requires an independent decision rather than an independent review. 
  • The First and Second Circuits have limited discovery of extrinsic evidence to show procedural irregularities or conflict of interest
  • The Fourth and Tenth Circuits apply a multi-factor approach.  Generally, review is limited to evidence in the administrative record except where the court finds that additional evidence is necessary for resolution of the claim.  These circuits have discussed a number of exceptional circumstances which may warrant a court to exercise its discretion, such as cases with concerns of impartiality or procedure, complex medical issues, or circumstances where the claimant would not have been able to present the evidence during the administrative process. 
  • The Eighth and Ninth Circuits permit extrinsic evidence upon a showing of good cause.  “Good cause” is similar to the exceptional circumstances articulated by the Fourth and Tenth Circuits.  However, if the plan participant had multiple opportunities to submit evidence to the plan administrator but failed to do so, such evidence will be excluded at trial.   
  • The Third Circuit looks to whether the administrative record was sufficiently developed and may allow the admission of additional evidence where there is a lack of an administrative record. 

Savvy employers will likely include language in the plan that gives the plan administrator discretion to interpret and apply the plan, thus limiting review of the benefit denial to the administrative record.  However, even if a plan does not contain discretionary language, de novo review does not guarantee the admission of extrinsic evidence.  In sum, creating an adequate administrative record is crucial for Plaintiffs. 

If you are a claimant needing assistance in handling a claim, contact the attorneys at Cosgrove Law Group, LLC.

Monday, September 2, 2013


By now most brokers and compliance departments should be aware that a broker becomes statutorily disqualified from associating with a FINRA member firm if convicted of a felony. They should also know by now that it doesn't matter if that conviction has nothing to do with moral turpitude or finances, such as a felony driving while intoxicated conviction. But what many may not realize is that, based upon “guidance” from the SEC, FINRA considers a mere plea of guilty—which is not a conviction under state or federal law—to be a conviction for purposes of statutory disqualifications. So, for example, even if you qualify for a prosecutorial diversion program in which you are never convicted if you satisfy certain probating terms, FINRA is still going to conclude you were convicted if you pled guilty in order to qualify for that program.

The genesis of what some might consider an absurdity lies in the fact that the 1934 Exchange Act does not define the term “convicted” in Section 3(a)(39) when setting forth those events which trigger a disqualification. Now, most attorneys understand that each and every word in a statute need not be defined, particularly if amenable to common understanding. Ironically, the FINRA By-laws also use, but fail to define, the term. So back in 1992, the SEC instructed the NASD to look to the definition of “convicted” in the 1940 Advisor's Act (“The Lederer Letter”).

And herein lies the problem for the unwitting broker or criminal defense attorney that thinks one is only “convicted” when one is sentenced and a judgment of conviction is entered: The 1940 Act includes “a plea of guilty” in the definition of “convicted.” There are, however, situations in which it is arguably unclear as to whether a conviction exists under even this expansive definition because the court might refrain from making a finding of guilt pending a probationary period. The SEC concluded that in such situations a person is convicted until the probationary period is completed. That's right folks—you can actually become “un-convicted!”

The SEC addressed this critical semantic issue again in 2000 in a letter to the NYSE (“The Germino Letter”). In that situation, the SEC looked to California law regarding a first-time drug offender program. In that instance, the SEC concluded that the defendant was not convicted because, although he pled guilty, the court did not “make a finding of guilt or accept the plea of guilty.” Confused yet?

For the most recent review of the nuances and history at issue here, take a look at the National Adjudicatory Council's Opinion in SD Decision No. 04017. In that case the Council looked at the CWOF (convicted without a finding) procedure under Massachusetts law and concluded that the MC-400 application subject in that matter had not in fact been convicted, so the broker should not have been disqualified in the first place! Belated good news for her for sure.

In Puello v. Bureau of Citizenship and Immigration Services, 511 F.3d 324 (2nd. Cir. 2007), the United States Court of Appeals for the Second Circuit evaluated the meaning of the term “conviction” in the Immigration and Nationality Act (“INS”). In doing so, it noted that “well-established principles of (statutory) construction dictate that statutory analysis necessarily begins with the 'plain meaning' of a law's text and, absent ambiguity, will generally end there.” Id. At 327. In 1996, Congress amended the INS to include a definition of conviction that included, in addition to a formal judgment of guilt, “a plea of guilty...or [admission] of sufficient facts to warrant a finding of guilt.” Id. At 328. The court went on to explain that a conviction occurs when the court adjudicates guilt and imposes a sentence. Id. At 329. “The statutory definition of “conviction” speaks of a judgment 'entered by a court' the common understanding of which involves the entry on the docket of the documents envisioned in Rule 32(K)(1) and not a guilty plea alone. Id. The critical point here is that, unlike the INS, the Exchange Act does not involve any ambiguity as to “conviction” and it does not include a definition of conviction that includes anything less than a formal adjudication of guilt. Moreover, the SEC's suggestion that one looks to the 1940 Act to gain insight as to what a different Congress intended by the term “conviction” to mean when it passed the Exchange Act six years earlier is simply absurd. And the Second Circuit certainly agrees with this author's opinion on FINRA's current interpretation of “conviction” for a statutory disqualification: “ Construing a guilty plea alone as a 'formal judgment of guilt' makes little sense in the context of the definition of 'conviction' as a whole.” Id. “Construing a guilty plea alone to constitute a 'conviction' would be a significant departure from normal criminal procedure.” Id. At 330. And best of all: “ the statutory definition appears to lead to the bizarre result that a withdrawn guilty plea would still be a conviction.” Id. And there is no ambiguity in the Exchange Act that justifies a statutory interpretation by the SEC that directs FINRA to give a “bizarre” interpretation to what a “conviction” is for the purposes of statutory disqualifications. To borrow the words of Judge Katzmann: “a statute should be interpreted in a way that avoids absurd results.” Id. In sum, if Congress wanted a mere guilty plea to somehow be a “conviction” for purposes of the Exchange Act, it demonstrated its ability to do so when it so amended the INS.

The problem this author has confronted recently is that FINRA may send your Member firm a notice requiring them to file a MC-400 application or U-5 you without fully analyzing the state law at issue or exactly whether or not the court made the requisite finding of guilt (as opposed to the defendant merely admitting facts sufficient to allow the entry of a finding of guilt). Moreover, a defendant might plead guilty to the underlying offense without pleading guilty and the court finding sufficient facts as to a separate statute that enhances the misdemeanor to a disqualifying felony.

So what is the lesson here? Consult with a securities attorney and make sure you are both aware of and have a very clear record of the procedure before the court when pleading guilty as part of a diversion program lest your effort to avoid a conviction and save your career prove futile in the eyes of FINRA. Food for thought.

Thursday, August 22, 2013

Circuit Split. Which Standard of Review Applies to ERISA Top-Hat Plans?

The Employee Retirement Income Security Act (“ERISA”) regulates the operation of private sector employee benefit plans once a plan has been established by an employer. ERISA requires employers to implement certain safeguards for employee benefit plans by setting minimum standards for things such as for participation, vesting, benefit accrual, funding, and reporting.  In addition, ERISA establishes fiduciary responsibilities for plan administrators.  ERISA generally defines a fiduciary as anyone who exercises discretionary authority or control over a plan's management or assets, including anyone who provides investment advice to the plan.

Generally, when a plan participant has a claim for benefits, there are specific procedures that must be exhausted.  The claims and review process is usually spelled out in the Summary Plan Description.  If a claim for benefits is denied, ERISA requires that the reason for any denial of benefits is explained to the employee in writing and that employee must be given an opportunity for full and fair review of the decision through an internal appeals process. 

If benefits are again denied after the internal appeals process, the employee can then file a claim in court.  Generally, the reviewing court applies a de novo standard (allowing the court to substitute its own judgment) when reviewing a claim denial, unless the language of the plan gives the plan administrator discretion to interpret and apply the plan.  If a plan provides such discretion, the reviewing court applies an abuse of discretion standard and gives the benefit denial deferential treatment.  When announcing this standard of review, the Supreme Court in Firestone Tire and Rubber Co. v. Bruch reasoned that since the plan administrator is a fiduciary, his or her exercise of discretion should not be subject to control by the court. 

This standard of review poses significant problems for ERISA top-hat plans.  To be designated a top hat plan, ERISA requires that the plan be (1) unfunded and (2) maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.  Top hat plans are specifically exempt from ERISA’s provisions on participation, vesting, funding, and fiduciary responsibility but are subject to ERISA’s enforcement provisions.  Thus, top-hat plans are merely contractual agreements. 

Top-hat plans are unique in that plan participants must utilize ERISA’s enforcement provisions when challenging benefit denials, yet none of the substantive and fiduciary provisions apply to such plans.  Under ERISA (modeled after trust law) a plan administrator or fiduciary is required to make all decisions in the plan participant’s best interest.  However, since top-hat administrators are not fiduciaries, they are not required to make any decisions in the best interest of the top-hat plan participant.  Since an unfunded top-hat plan is essentially an unsecured promise to pay benefits at termination or later, an inherent conflict of interest is present when the role of the plan administrator and employer overlap.  Paying the benefits to the top-hat plan participants will always have a direct and immediate impact on the cost to the employer.

Furthermore, when a plan confers discretion upon the administrator in a top-hat plan, the trust principals relied on by the Supreme Court in Firestone are not present.  If following the holding in Firestone, the decision of a plan administrator with discretion to interpret and apply the plan, owing no fiduciary duties to the top-hat employees and where a conflict of interest is present, would still be subject to an abuse of discretion standard.  This hardly seems fair when top-hat employees are afforded no remedies under fiduciary duty claim and their plans are not required to be funded. This nearly renders the promises and obligations of the employer illusory.    

After the holding in Firestone, courts have grappled with whether or not to apply the abuse of discretion standard to top-hat plans because of their unique nature.  The Eight Circuit has concluded de novo review applies to top hat plans even when it give their administrators interpretive discretion because “a top hat administrator has no fiduciary responsibilities” under ERISA.  The Third Circuit has also declined to extend the holding in Firestone to top-hat plans because top-hat plans are unilateral contracts and the principals of federal common law should be applied. 

However, without a discussion distinguishing top-hat plans from ordinary ERISA plans, the Seventh and Second Circuits have held that the abuse of discretion standard articulated in Firestone applies to top-hat plans that provide the administrator with discretion.  The Ninth Circuit also held that abuse of discretion standard applies to top-hat plans with discretionary language reasoning that the application of a de novo standard does not materially change the outcome and applying a different standard to top-hat plans would create unnecessary confusion.  The Sixth Circuit sided with the Ninth Circuit’s reasoning that “the same conclusion would be reached under either standard,” although it was unclear whether it was applying that reasoning solely to the case at bar or more broadly.  The remaining Circuits have taken no position.    

Therefore, top-hat ERISA participants have a higher burden to overcome in “abuse of discretion” circuits than in “de novo” circuits.   

Sunday, August 18, 2013

The Standard for Claims of Aiding and Abetting Securities Fraud

Section 20(e) of the Securities Exchange Act of 1934 allows the SEC, but not private litigants, to bring civil actions against aiders and abettors of securities fraud. The SEC may bring such an action against “any person that knowingly or recklessly provides substantial assistance to another person in violation of a provision of this chapter." 15 U.S.C. § 78t(e). Similarly, the Missouri Securities Act provides under Section 409.6-604 that the Commissioner may bring an enforcement action against a person who has materially aided, is materially aiding, or is about to materially aid an act, practice, or course of business constituting a violation of the Act.

There are no Missouri cases addressing the aiding and abetting liability under the Missouri Securities Act. However, “Missouri courts have often looked to cases decided by courts from other jurisdictions to aid in comprehending the definitional limitations of the [Missouri Securities] Act, particularly when the language of the federal and state securities statutes involved is nearly identical.” Moses v. Carnahan, 186 S.W.3d 889, 904 (Mo. App. W.D. 2006) (finding that the Missouri Securities Commissioner was justified in looking to federal cases interpreting the federal Securities Acts in construing the meaning of the term “offer” as contained in the Missouri Uniform Securities Act).

The only Eighth Circuit case to directly address aiding and abetting liability under § 20(e) of the Securities Exchange Act is S.E.C. v. Shanahan, 646 F.3d 536 (8th Cir. 2011). In that case, the court noted that to establish aiding and abetting liability , the SEC must prove (1) a primary violation of the securities laws; (2) “knowledge” of the primary violation on the part of the alleged aider and abettor; and (3) “substantial assistance” by the alleged aider and abettor in achieving the primary violation. Id. at 547 (citing K & S P'ship v. Cont'l Bank, N.A., 952 F.2d 971, 977 (8th Cir.1991), cert. denied, 505 U.S. 1205, 112 S.Ct. 2993, 120 L.Ed.2d 870 (1992)). The court also stated that “[n]egligence ... is never sufficient,” and “a bare inference that the defendant must have had knowledge” of the primary violator's transgressions is insufficient. Id. The Eighth Circuit found that the SEC failed to make its case against an outside director of a corporation because it failed to prove “knowledge” of the corporation's alleged primary violations.

In a footnote, the court noted that Section 20(e) had recently been amended to include liability for “any person that ... recklessly provides substantial assistance to another person in violation of a provision of this chapter." See Dodd–Frank Wall Street Reform and Consumer Protection Act, Pub.L. No. 111–203, § 929O, 124 Stat. 1376, 1862 (July 21, 2010), codified at 15 U.S.C. § 78t(e). However, this amendment was not applicable to the appeal before the court.

There have been no reported cases located which have addressed the "recklessly" providing substantial assistance element of an aiding and abetting claim. However, it is generally understood that reckless conduct means that the actor realized or should have realized there was a strong probability his conduct would cause the injury. It follows that "recklessly" providing substantial assistance would, at the least, amount to providing substantial assistance in situations where the actor should have realized a primary violation of the securities laws.  This of course lowers the bar for what the SEC must plead and prove in order to make a claim for aiding and abetting.

The SEC has also been aided by recent court decisions interpreting the "substantial assistance" element of an aiding and abetting claim. In S.E.C. v. Apuzzo, 689 F.3d 204 (2d Cir. 2012) cert. denied, 133 S. Ct. 2855 (U.S. 2013), the district court had found that the SEC had not adequately alleged substantial assistance.  Specifically, the court held that “the [C]omplaint contains factual allegations which taken as true support a conclusion that there was a ‘but for’ causal relationship between Apuzzo's conduct and the primary violation, but do not support a conclusion that Apuzzo's conduct proximately caused the primary violation.” Concluding that such proximate causation was required to satisfy the “substantial assistance” component of aider and abettor liability, the district court granted the motion to dismiss.

The Second Circuit found that in the context of an enforcement action by the government, where the goal is deterrence and not compensation, proximate cause is too stringent a standard to apply.  Instead, to satisfy the substantial assistance element, the SEC must allege and prove facts sufficient to show that a defendant “in some sort associate[d] himself with the venture, that he participate[d] in it as in something that he wishe[d] to bring about, [and] that he [sought] by his action to make it succeed.”  Id. at 206.  As such, the Second Circuit reversed the decision of the district court.

The Dodd-Frank amendment and the Apuzzo decision reflect enhancements to the SEC’s ability to bring aiding and abetting claims against individuals who assist in carrying out a fraudulent scheme.  Arguably a claim can now be brought even if an individual did not have actual knowledge of the primary violation and even if the individual's actions do not result in direct harm.