Friday, February 28, 2014

Supreme Court Rules in Favor of Stanford Fraud Victims’ Ability to Bring State Law Claims  

When I covered Chadbourne & Parke LLP v. Troice during oral arguments in the Supreme Court, I promised I would update you when the High Court rendered its decision.     

Yesterday, the Supreme Court decided in a 7-2 decision whether investors in a 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 certain class action plaintiffs from bringing state law claims based on misrepresentations made “in connection with the purchase or sale of a covered security.”  SLUSA narrowly defines “covered security” as “[a security] listed, or authorized for listing, on a national securities exchange” such of which must be listed or authorized to be listed “at the time during which it is alleged that the misrepresentation, omission, or manipulative or deceptive conduct occurred.”

The class action at the center of this case concerned a Ponzi scheme by R. Allen Stanford involving certificates of deposits (“CDs”) sold to investors.  Part of the misrepresentations made to the investors were that the CDs were backed by a portfolio of marketable securities.  Recovery against Stanford has been unsuccessful, with investors receiving about a penny on the dollar for their losses, so the victims brought claims against various third-party entities alleging they 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 central question of the case was whether the purported securities-backed CDs sold to investors qualified the transactions as a covered security.  Plaintiffs argued that since SLUSA specifically exempted CDs from the definition of a covered security, they were not preempted from bringing state law claims.  Defendants, however, argued that since Stanford represented that the CDs were backed by marketable securities, a covered security under SLUSA, plaintiffs were barred from asserting state law claims. 

The test applied by the District Court, used in the Eleventh Circuit, 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.’”  Since the District Court determined that the investors were induced to purchase the CDs under the belief that they were backed by marketable securities, it denied plaintiffs’ state law claims. 

On appeal, the Fifth Circuit reversed the decision, rejecting the test applied in the Eleventh Circuit and instead adopting 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 upholding the Fifth Circuit’s decision, the Supreme Court relied on several factors.  First, the basic focus of SLUSA seeks to include transactions in covered securities, not upon transactions in uncovered securities.  Second, a natural reading of SLUSA’s language supports the interpretation that a connection between the representation and a sale matters where the misrepresentation makes a significant difference to someone’s decision to purchase or to sell a covered security, not to purchase or to sell an uncovered security.  The Supreme Court noted that the plaintiffs never alleged the defendants’ misrepresentations led anyone to buy or to sell (or to maintain positions in) covered securities.  Third, the Supreme Court found that prior case law supports its interpretation because every securities case brought before the Court where fraud was “in connection with” a purchase or sale of a security has involved a covered security as defined by SLUSA. 

In its fourth point, the Supreme Court pointed out that their interpretation of SLUSA was consistent with the underlying regulatory statutes: the Securities Exchange Act of 1934 and the Securities Act of 1933.  The opinion states, “[n]ot only language but also purpose suggests a statutory focus upon transactions involving the statutorily relevant securities” and nothing in those acts or SLUSA provides a reason for interpreting its language more broadly.  Writing for the majority, Justice Breyer went on to explain that “to interpret the necessary statutory “connection” more broadly…would interfere with state efforts to provide remedies for victims of ordinary state ­law frauds.”  For instance, the Court noted that a broader interpretation would allow SLUSA to prohibit a lawsuit brought by creditors of a small business that falsely represented it was creditworthy, in part because it owns or intends to own exchange-traded stock.

Finally, the majority rejected the dissent’s argument that the Court’s ruling would significantly curtail the SEC’s enforcement powers, especially since enforcement powers are enumerated in other statutes and the dissent could not point to one example of a federal securities action—public or private—that would now be impermissible under the Court’s decision.   

While the case did not consider the merits of the plaintiffs’ claims, it allows the victims to proceed in their fight to recovery for the billions lost in the Ponzi Scheme. 

*I owe credit to this prompt update to Gerhard Petzall, an attorney here in St. Louis who started his own firm in 1963.  Meeting him for the first time last night at a high school mock trial competition, we sparked up a conversation about securities law and how technology has changed the landscape of our profession and personal lives.  I had extreme admiration for the fact that Gerhard practiced during a time where information was not readily at your fingertips the way it is now.  I couldn't even imagine.  Gerhard read about the Supreme Court decision in the financial section of the newspaper.  I told him that I believed I sat near him for a reason because I had been following this case and had been waiting for the decision to be released.  Had he not mentioned it, I might not have gotten the news right away.  We had a good laugh and I promised him that I would make sure to give him credit when I wrote my article.  Since I keep my promises, thank you Gerhard! 

Thursday, February 20, 2014

Investment Adviser Fiduciary Duty Standard Includes a Duty to Explain Investment Activity

The Securities and Exchange Commission regulates larger investment advisers under the Investment Advisers Act of 1940 (the “Act”). In a previous posting, we noted that perhaps the most significant provision of the Act is Section 206, which prohibits advisers from defrauding their clients and which has been interpreted by the Supreme Court as imposing on advisers a fiduciary duty 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.”).

A number of obligations to clients flow from the fiduciary duty imposed by the Act, including the duty to act in the clients’ best interests, 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.

From these fiduciary obligations arises the duty to properly explain investments or an investment strategy to clients. Where a financial adviser provides advice about investments, “a fiduciary duty is breached when the client is encouraged to purchase an investment with a level of risk that is not appropriate for the client, or is not properly informed of the speculative nature of an investment.” Sakai v. Merrill Lynch Life Ins. Co., C-06-2581 MMC, 2008 WL 4193058 (N.D. Cal. Sept. 10, 2008) (citing Vucinich v. Paine, Webber, Jackson & Curtis, Inc., 803 F.2d 454, 460-61 (9th Cir.1986) (holding that broker had fiduciary duty to fully inform client of nature and risks of selling short, “in terms capable of being understood by someone of [client’s] education and experience.”)).

 “A fiduciary must provide a proper disclosure and explanation of the investment activity, and should warn a client to exercise caution if an investment presents a greater risk than tolerable, given the client’s goals and circumstances.” Id.; see also Gochnauer v. A.G. Edwards & Sons, Inc., 810 F.2d 1042, 1049-50 (11th Cir. 1987) (finding that where adviser assisted clients in establishing speculative option trading account, “[a] more studied opinion of the risks of option trading in light of the [clients’] then-existing investment objective was owed by [the adviser] to [his clients]. This he failed to do, in breach of his fiduciary duty.”); In re Old Naples Sec., Inc., 343 B.R. 310, 324 (Bankr. M.D. Fla. 2006) (stating that “failing to disclose and fully explain the risk of an investment to an investor can be a breach of the broker’s fiduciary duty.”); Rupert v. Clayton Brokerage Co. of St. Louis, Inc., 737 P.2d 1106, 1109 (Colo. 1987) (“A broker who becomes a fiduciary of his client must act with utmost good faith, reasonable care, and loyalty concerning the customer’s account, and owes a duty . . . to keep the customer informed as to each completed transaction, and to explain forthrightly the practical impact and potential risks of the course of dealing in which the broker is engaged.”).

A good example of the application of the fiduciary duty to explain comes from Faron v. Waddell & Reed, Inc., 930 S.W.2d 508 (Mo. App. E.D. 1996).  Although this case involves a broker-dealer as opposed to an investment adviser, Missouri imposes an unambiguous fiduciary standard on broker-dealers.  In Faron, the client approached a registered representative of the broker-dealer inquiring whether he could obtain money from a trust to purchase a new home. He asked whether it would “cost any money.” Id. at 510. After he consulted with the registered representative he felt assured he could get the money and the transaction would result in no cost to him. He did not specifically consider tax ramifications nor did he directly ask about tax consequences. He assumed Waddell & Reed was lending the money to him to use, at no cost. However, instead of a loan the transaction actually consisted of a redemption of mutual funds. Id. He obtained the $250,000 from Waddell & Reed, returning the same amount within the required 21 days. The client’s accountant discovered the tax liability in the amount of approximately $32,000 while preparing an income tax return. The accountant brought it to the attention of the client, who brought suit against Waddell & Reed.

The trial court granted summary judgment for Waddell & Reed, finding that Waddell & Reed had no duty to provide tax information because none was requested.  On appeal, the court noted:

In Missouri, stockbrokers owe customers a fiduciary duty. This fiduciary duty includes at least these obligations: to manage the account as dictated by the customer's needs and objectives, to inform of risks in particular investments, to refrain from self-dealing, to follow order instructions, to disclose any self-interest, to stay abreast of market changes, and to explain strategies. Implicit in these obligations is a duty to disclose to the customer material facts.
 Id. at 511 (emphasis added).

The court of appeals found that Waddell & Reed was privy to information and had expertise not yet proven on summary judgment to be equally or reasonably available to the client. In particular, the registered representative was aware of details of the transaction which consisted of a redemption of mutual funds, while the clients understood the transaction to amount to a short-term loan. Id. Waddell & Reed had a duty to manage the account according to the client’s expressed needs and objectives, to bridge finance by use of trust assets with “no loss whatsoever,” if possible, or to inform the client of the costs. Id. The client communicated his concerns about possible costs associated with the proposed transaction to the registered representative. The client was not told how the transaction would occur but was told it would not cost any money. The court of appeals concluded that what was meant by “costs” in the discussions between the parties remained uncertain. This implicated an unresolved question of fact, making summary judgment for Waddell & Reed inappropriate. Id.

In sum, the fiduciary duty standard requires that the client be properly informed of the nature of an investment or investment strategy. What is necessary in order to meet this standard will depend on the facts and circumstances of each case. A more in depth explanation of the risks of an investment or investment strategy will be necessary where the client’s related education and experience is minimal. Similarly, a more detailed explanation of strategy will become necessary where the strategy being implemented is more speculative in nature. Whether the fiduciary duty to explain has been met will usually be a question of fact to be decided by the judge, jury, or arbitrator after hearing all of the evidence.

Friday, February 14, 2014

David Cosgrove Interviews the Chair of NASAA'a Investment Adviser Section

Earlier this month, David Cosgrove of Cosgrove Law Group and The Investment Adviser Rep Syndicate interviewed Ms. Patricia Struck, Chair-Person of the Investment Advisor Section for the North American Securities Administrators Association (NASAA) and the Administrator of the Division of Securities of the Wisconsin Department of Financial Institutions.  The interview, relevant to state and SEC registered Investment Adviser Representatives and Registered Investment Advisers is posted below. 

David Cosgrove:    Let's start with the basics - What is NASAA?

Patricia Struck:   The North American Securities Administrators Association is oldest international organization devoted to investor protection. It’s a voluntary association whose membership consists of 67 state, provincial, and territorial securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada, and Mexico.

DC:                 For how long have you been the administrator of the Wisconsin Division of Securities?

PS:                   I’ve been the administrator since 1995.

DC:                 What advisers do the states regulate as opposed to the SEC?

PS:                   Generally, the states regulate “small” (with assets up to $25 million) and “mid-sized” (with assets up to $100 million) advisers.  Of the 28,366 advisers currently on IARD, more than 17,000 are state advisers. The rest of the universe – nearly 11,000 advisers – are SEC advisers.

DC:                 It is my understanding that NASAA has different "working groups". Is there a working group focused on the advisory as opposed to the broker industry?

PS:                   NASAA has “sections” divided into 5 subject matter areas; one of the five is the investment adviser section and another is the broker-dealer section. But while the sections are separate on paper, they work very closely together – especially the investment adviser and broker-dealer section.

DC:                 For how long have you been the head of NASAA's Investment Advisor Section?
PS:                   I just became chair of the section in October of 2013. This is my third term as chair.

DC:                 Can you give me some examples of some of the positions held by the folks in this section?  What exactly does this section seek to accomplish and how does it go about meeting those goals?

PS:             The section includes nearly 50 volunteers from across the US and Canada with vast expertise in the whole range of regulatory issues relating to investment advisers. Some are the administrators in their jurisdictions. Some are registration chiefs or lead examiners in their states. Many are examiners who perform exams in advisers’ offices. All have specific subject matter expertise in issues 

DC:                       As you know, the Investment Adviser Rep. Syndicate focuses on the training, compliance, and business goals of the representative rather than the RIA. What observations did you make in 2013 that would be of interest to advisory representatives? 

PS:             In 2013, as state securities regulators assumed the increased regulatory oversight of investment advisers managing under $100 million in assets, NASAA released an updated series of recommended best practices that investment advisers should consider to minimize the risk of regulatory violations. These recommendations were based on the sample data reported by examiners in 44 state and provincial securities agencies between January and June 2013. The 1,130 reported examinations uncovered 6,482 deficiencies in 20 compliance areas, compared to 3,543 deficiencies in 13 compliance areas identified in a similar 2011 examination of 825 investment advisers.
As regulators, we are concerned about investor confusion stemming from the blurred lines between traditional brokerage, investment advisory, and financial planning services; partially because of the expectations the brokerage industry has set, and partially because of the marketing approach the industry uses – the proverbial ‘financial adviser’ who is your partner in retirement every step of the way. As long as the broker-dealer industry continues to engage in advice driven marketing the confusion will persist. That’s one reason why state securities regulators have long advocated that broker-dealers must be held to the fiduciary duty standard of care currently applicable to investment advisers and be required to place retail investor interests ahead of their own.

DC:                       What are the section's goals for 2014? 

PS:             The section always strives to look for ways to enhance uniformity in investment adviser firm and investment adviser representative registration practices. We also will continue our ongoing efforts to support states in conducting investment adviser exams. And of course, we will review our existing “best practices” for IA firms to consider while developing their own compliance programs and evaluate whether additional practice areas are necessary.

DC:                       How is the migration of RIA's pursuant to the Dodd-Frank Act going? 

PS:             The IA Switch, involving the transfer of more than 2,100 investment advisers from federal to state oversight, was one of the most significant achievements in the history of the North American Securities Administrators Association (NASAA).
The Switch stemmed from Section 410 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which raised the assets under management (AUM) threshold for state regulation of investment advisers from $25 million to $100 million. 
This report documents the work that went into the successful completion of the Switch.

DC:                       If there were three things you would like to see the Syndicate accomplish what would they be?  

PS:             1. Helping IARs have a better understanding of the role of their state regulator
2. Helping to create an ongoing dialogue between the IAR and regulatory communities
3. Helping IARs appreciate investor confusion stemming from the blurred lines between traditional brokerage, investment advisory, and financial planning services – and work to cut through that confusion

DC:                       What is the one thing you would be grateful to see investment adviser representatives take away from this interview?

PS:                   I would like them to appreciate that we are their partners in putting investors first. State       securities regulators are accessible, both to investors and to the people we regulate. We work closely with     the IAR communities in our states and appreciate the value and importance of communication. We share       the same goal of providing the best level of service to investors. We’re in this together. 

Thursday, February 13, 2014

Missouri House Bill 1480 Seeks to Create Whistleblower Program under the Missouri Securities Act

Missouri House Representative Steven Weber is sponsoring House Bill 1480 (“HB 1480”) which proposes to amend the Missouri Securities Act to include provisions that establish a whistleblower program. 

HB 1480 defines whistleblower as a person who, under the whistleblower program, discloses information regarding a violation or potential violation of securities law or a rule adopted or order issued under securities laws.  The whistleblower must be employed by or associated with the following: (1) a broker dealer; (2) an issuer; or (3) a person that receives compensation for advising others of the value of securities or the advisability of investing, purchasing, or selling securities or issues or promulgates analyses or reports relating to securities as a regular part of their business. 

Since many whistleblower programs would not be as effective without the promise of anonymity, HB 1480 permits the Commissioner of Securities to collaborate with the Attorney General or other appropriate prosecuting attorney to implement procedures to ensure the confidentiality of the whistleblower.  However, the actual language of the bill states, “The ‘Whistleblower Program’ is created to receive information or records from whistleblowers and, in the discretion of the Commissioner, to maintain the confidentiality of whistleblowers.”  Thus, while it appears that maintaining the confidentiality of a whistleblower is a goal of the program, it is not guaranteed.   

In line with the notion that the identities of whistleblowers should remain anonymous, records maintained by the Commissioner as a part of the program are not public records unless the Commissioner finds that disclosure is necessary or appropriate in the public interest or for the protection of investors.  The records can also be disclosed through the legal process if they are subject to a subpoena or court order.     

The Bill would also provide whistleblowers with a cause of action against an employer for retaliation if adverse action is taken against the employee for participation in the whistleblower program.  Whistleblowers are afforded one year to bring such claims and can request the following relief: (1) reinstatement to their position without loss of seniority; (2) back pay; (3) punitive damages; and (d) costs and reasonable attorneys’ fees.  However, whistleblowers are prevented from obtaining relief if their employer proves the employee participated in the violation, was criminally convicted for the violation, or the action is clearly frivolous or vexatious. 

Whistleblower programs also exist for federal violations of securities law.  In 2010, the Dodd-Frank Act amended the Securities Act of 1934 to add a section titled, “Securities Whistleblower Incentives and Protection.” Under this program, individuals who voluntarily provide the SEC with original information that leads to successful enforcement actions resulting in monetary sanction over $1,000,000 may be eligible to receive an award from 10 – 30% of the monies collected by the SEC.  The program also prohibits retaliation from employers. 

In January, the SEC issued its 2013 report to Congress on the Dodd-Frank Whistleblower Program.  The report noted that Fiscal Year 2013 was historic for the SEC’s Office of the Whistleblower (“OWB”), paying $14,831,965 to whistleblowers whose information contributed to the success of enforcement actions.  Of the 3,238 tips received in 2013, 17.2% concerned corporate disclosures and financials, 17.1% concerned offering fraud, and 16.2% concerned manipulation, with the most over-all tips coming from California, New York, Florida, and Texas.  Missouri ranked 26th on the number of reported tips with only 31.  Whistleblower submissions were also received from individuals from fifty-five foreign countries.   

Since the program’s creation, six individuals have received awards, four of them occurring in 2013.  The report also indicates that the program paid its largest award of over $14 million to one whistleblower whose information led to the recovery of substantial investor funds.  Thus, the awards given to the other three individuals in 2013 were much less substantial.   

Dodd-Frank’s Whistleblower Program prompted Utah to pass a similar Act in 2011 that also allows for payment to a whistleblower for voluntarily providing information that leads to the successful enforcement of a judicial or administrative action. 

Unlike Dodd-Frank’s or Utah’s Whistleblower Programs, the HB 1480 doesn’t provide for any payment for information that assists in the prosecution of securities violations.  Should this bill pass, the likelihood of the program’s success remains to be seen since there is no financial incentive to report potential wrongdoings, the anonymity of the whistleblower doesn’t appear to be guaranteed, and Missouri residents are less active in submitting tips under Dodd-Frank’s program.    

Currently, HB 1480 has been introduced and referred to the Missouri House Financial Institutions Committee.  We will keep you updated on the Bill’s progress.