SECURITIES AND INVESTMENT BLOG-COSGROVE LAW, LLC

Diamond Foods faces SEC and Federal Investigation

2012-01-24T10:10:00.000-06:00

Diamond Foods is facing a formal investigation by theSEC and federal prosecutors as to whether certain financial practicesinvolved criminal fraud. The investigation revolves around howthe company made crop payments to walnut growers.

Diamond made sizable payments to its walnut growers inSeptember that they claimed were an advance on their 2011 crop. However, three walnut growers allege that they told Diamond that theydid not intend to deliver their 2011 crops to Diamond but wereassured by company representatives that they could cash the checksanyway. Some critics believe the payments were used to inflatelast year’s earnings by shifting costs into the current year. Diamonds fiscal year ends in July so the September payment shiftedthe costs into the 2012 accounting year. Diamond contends thatthese “momentum payments” were made in an effort to optimize cashflow for growers and has denied that these payments were compensationfor last year’s crop.

If true, the company’s 2011 margins would besubstantially lower. Because of this investigation, Diamond hasannounced that its plans to acquire Pringles from Proctor &Gamble are on hold. Diamond planed to pay most of the purchaseprice by issuing its stock to Proctor and Gamble shareholders. The deal, which was initially valued at $2.35 billion, is now valuedat $2 billion based on Diamonds current stock price. Thecompany’s stock price was trading around $96 in September are nowtrading around $33.

Diamond intends to cooperate fully with theinvestigation. An audit committee for the company is conductingan internal probe on the accounting treatment of the walnut paymentsand will provide the SEC with a detailed report of their findings. The investigation has also opened Diamond up to severalsecurities class-action lawsuits.

Raising Capital is a Perilous Endeavor: It Could Even Land You in Prison

2012-01-12T12:55:00.004-06:00

Just last month the Court of Appeals of Ohio affirmed the convictions of a business owner for three counts of false representation in the registration of securities, and one count each of engaging in a pattern of corrupt activity, tampering with records, and falsification, but reverse the remainder of his convictions. The appeals court did, however, reverse dozens of convictions on other counts, including securities fraud, and sent the case back to the trial court to reconsider the 10 year sentence of imprisonment it imposed. Notably, however, the pattern of corrupt activity conviction was based solely upon the defendant’s failure to disclose sales commissions on a Reg D filing prepared by his attorney, and the tampering and falsification convictions were predicated upon his failure to disclose a 13 year old misdemeanor bad check conviction on a non-required filing with the Division of Financial Institutions. Below I have set forth excerpts from this remarkable prosecution and conviction. The case citation is State v. Willan, 2011 WL 6749842 (Ohio App. 9 Dist.).

All of Mr. Willan's convictions stemmed from activity conducted by two of his businesses. For several years, Mr. Willan was in the business of buying, renovating, and reselling homes under the name of Summit Redevelopment. Mr. Willan later changed the company's name to Evergreen Homes, LLC. Although Mr. Willan later started building new homes through a business named Evergreen Builders, that entity is not connected to the convictions in this case. Because many potential buyers of renovated homes lacked the ability to secure financing through traditional means, Summit Redevelopment and later Evergreen Homes assisted buyers in obtaining financing.

As Evergreen Homes' sales business grew, it developed a need for an influx of capital. Mr. Willan hired a law firm with attorneys experienced in regulatory and finance area. He worked with the attorneys at the firm for almost a year to develop a business plan to raise capital for Evergreen Homes. Mr. Willan continued to work with these attorneys for the next several years and repeatedly told them that he wanted to do whatever was necessary to ensure that his business complied with the law. Even when the law firm recommended action that exceeded that required under the law, Mr. Willan agreed to the firm's recommendations.

To implement the business plan, Mr. Willan formed a separate company, Evergreen Investment Corporation. Evergreen Investment was formed to purchase and hold the second mortgages that Evergreen Homes had received through its home sales and to secure investors to provide capital that would enable it to purchase the mortgages from Evergreen Homes. To accomplish this goal, Evergreen Investment sold debt securities, which earned interest at a set rate around 10 percent or above. This endeavor required Evergreen Investment to conform to the registration requirements connected with a securities offering. Eventually, Evergreen Homes secured capital directly through the sale of equity securities. These securities represented actual ownership interests in Evergreen Homes.

In raising its capital through the issuance of debt securities, Evergreen Investment registered each offering with the Division of Securities of the Ohio Department of Commerce. Upon the advice of counsel, Mr. Willan hired a certified public accounting firm to prepare audited financial statements for Evergreen Investment to file with the Division prior to the initial offering. Although audited financials were not required by the Division, Mr. Willan followed his counsel's advice to fully disclose the financial condition of the company. With respect to the sale of its equity securities, Evergreen Homes did not register those securities with the Division of Securities, but instead filed forms with the Division to exempt the offerings of those securities from the state's registration requirements.

Mr. Willan hired Daniel Mohler to manage the investment sales. Mohler had no experience with securities sales and was not licensed by the state to sell securities. Mohler received a commission for each security sale. Evergreen Investment sold its debt securities through newspaper advertisements, which were approved by the Division prior to publication. The ads announced the availability of the high-risk, high-yield certificates and provided information about how prospective investors could obtain more information about the offering. The information provided warned the potential investor that the investment was high-risk, was dependent on fluctuations in the lending and housing market, and was not insured. After reviewing the information and determining whether the investment was appropriate, interested investors would purchase certificates. Even though the investment was tied to the continued success of Evergreen Homes, numerous investors were attracted to the high rate of return and good reputation of the company. Mohler's job was to handle the paperwork when potential investors contacted the office. Although he occasionally met outside the office with potential investors who requested information, Mohler's sales role did not involve the active solicitation of new investors.

When the Division conducted an audit of Mr. Willan's companies, it learned that Mohler was selling the securities and was receiving a commission for each sale. Both Mr. Willan and Mohler admitted that Mohler received a commission for each security sale. In fact, Mr. Willan made no attempt to conceal anything about his businesses during the audit, nor did he attempt to alter the companies' books to disguise the form or amount of Mohler's compensation. Mr. Willan stated that he was not aware that he should not have been paying Mohler a commission. The Division described Mr. Willan as “fully cooperative” with its investigation. In furtherance of his cooperation, Mr. Willan agreed to travel to Columbus to give a deposition to the Division. There was no evidence suggesting that Mr. Willan did anything to impair or hinder the Division's investigation.

The Division communicated with Mr. Willan's then-counsel, who had been unaware until that time that Mohler was selling the securities or that anyone was receiving commissions. After learning that Mohler was paid commissions to sell the securities, Mr. Willan's counsel informed the Division that Ohio law did not require Mohler to be licensed as a salesperson because he sold securities on behalf of the issuer, and therefore, the sales were exempted from state licensing requirements. Based on his counsel's advice, Mr. Willan maintained the position that the statutory prohibition on commissioned sales applied only to securities dealers, not salespeople. Nonetheless, in what appears to be an abundance of caution, Mr. Willan's counsel advised Mr. Willan to stop paying Mohler a commission and suggested that instead Mohler be paid a salary. Mr. Willan agreed. It appears that Mr. Willan's counsel believed that such action would be sufficient to resolve the matter with the Division.

In addition to concerns of the Division of Securities that Evergreen Investment and Evergreen Homes were conducting business in violation of Ohio securities laws, the Summit County Sheriff's Department had become aware that many of the homes sold by Mr. Willan were in foreclosure. The sheriff's department had been investigating Mr. Willan and his businesses and had learned that he had withdrawn large sums of money from his companies. It questioned whether these withdrawals had been made at the expense of investors and whether Evergreen Investment was financially solvent. The sheriff's department obtained warrants to search the offices of the Evergreen companies as well as Mr. Willan's current and former residences. The sheriff's department seized numerous items from Mr. Willan's offices that included several computers and file cabinets full of business records of Evergreen Homes and Evergreen Investment. The Evergreen companies were “basically left with a shell of an office.” It does not appear that any evidence was uncovered during the raid that would suggest that the purpose of Mr. Willan's endeavors was to defraud investors in the nature of a “Ponzi” scheme or that the entities were not legitimate operations.

When an attorney at the Division of Securities first began investigating the Evergreen companies, he discovered that the Division had received no complaints from any investors in either Evergreen company. Prior to the raid by the sheriff's department, all investors were paid everything they had been promised, and Evergreen Investment had honored all requests for redemption of certificates. After the raid, however, the Evergreen companies essentially screeched to a halt. The companies had little ability to continue operations because the sheriff's department had seized their computers and business records. Moreover, because the raid had generated a great deal of negative publicity, investors called to demand an immediate return of their investments. Although Mr. Willan's companies remained financially solvent assets sufficient to cover the investments, Mr. Willan lacked the liquidity to refund the investments of everyone at once. As a result, Mr. Willan's Evergreen companies filed for bankruptcy protection.

Mr. Willan initially faced 108 charges. After the close of evidence, the jury considered 68 counts against Mr. Willan: one count of engaging in a pattern of corrupt activity, five counts of false representation in the registration of securities, 20 counts of selling securities as an unlicensed dealer, one count of securities fraud, one count of aggravated theft, one count of theft from the elderly, 17 counts of violating the Ohio Small Loans Act, and 22 counts of acting as an unregistered second mortgage lender. The jury found Mr. Willan guilty of all 68 counts.

The most serious of Mr. Willan's licensing convictions were 20 counts of violating R.C. 1707.44(A)(1) by selling securities without obtaining a license. Although both Evergreen Investment and Evergreen Homes eventually sold securities, the indictment and Mr. Willan's convictions pertained only to specific sales of Evergreen Investment debt securities. The State attempted to prove that Mr. Willan violated R.C. 1707.44(A)(1) by acting through Daniel Mohler in selling securities because Mohler was not licensed to sell securities, nor was Mr. Willan or either of his companies.

On appeal Mr. Willan conceded that the State presented evidence that, Mohler handled and processed customer inquiries and requests for purchases of Evergreen Investment debt securities, that Evergreen Homes paid him commissions for the sales, that he was not licensed to sell securities, and that Evergreen Investment, Evergreen Homes, and Mr. Willan were not licensed as dealers. Mr. Willan's argument was that Mohler was not a “salesperson” within the meaning of R.C. 1707.01(F)(1) because Mr. Willan and his Evergreen companies were not “dealers” within the meaning of R.C. 1707.01(E)(1).

It is clear from R.C. 1707.01(E)(1)(a) that, with respect to Evergreen Homes' own securities, it fell within the issuer exception. Thus, it is not surprising that Mr. Willan was not charged with any crimes under R.C. 1707.44(A)(1) concerning the sale of Evergreen Homes' own securities. The remaining question, therefore, was whether Evergreen Homes was a dealer of Evergreen Investment's securities through the action of its employee, Mohler.

The Court of Appeals noted that the latter half of the definition of dealer, discussing selling securities “for the account of others[,]” requires that the person, here Evergreen Homes, received a commission, fee, or similar remuneration for the sale of the securities. R.C. 1707.01(E)(1). So it concluded that, even assuming that Evergreen Homes was selling securities “for the account of others[,]” because Evergreen Homes did not receive a commission, fee, or similar remuneration for the sale of Evergreen Investment's securities, it was not a dealer as contemplated by the second portion of the statutory definition. R.C. 1707.01(E)(1).

With respect to the first portion of the definition, discussing the sale of securities “for the person's own account,” the Court noted that it was unclear to what extent the sale would have to benefit the person to qualify as “for the person's own account” under the statute. R.C. 1707.01(E)(1). But according to the Court, if the legislature had intended such a tenuous benefit to qualify as “for the person's own account,” it could have inserted language into the statute that would make such an interpretation more reasonable. R.C. 1707.01(E)(1). As the legislature did not do so, it concluded Evergreen Homes was not selling securities for its own account.

Next, the Court turned to examining whether Evergreen Investment was a dealer as contemplated by R.C. 1707.01(E)(1). In that instance, the Court concluded that, even assuming that the activities of Evergreen Investment satisfied the general definition of dealer, by being in the business of selling securities for its own account, R.C. 1707.01(E)(1), Evergreen Investment fell within the issuer exception. Evergreen Investment was the issuer of the securities in question because it sold, offered for sale, or furthered the sale of securities which represented an economic interest in Evergreen Investment, and it did not receive any commission, fee, or similar remuneration for the sale. R.C. 1707.01(E)(1)(a). As Mr. Willan, Evergreen Investment, and Evergreen Homes were not dealers, Mohler was not a salesperson, and Mr. Willan could not be convicted of aiding and abetting him as an unlicensed salesperson. See R.C. 1707.01(F)(1); R.C. 1707.44(A)(1). Therefore, the Court held that the State failed to present sufficient evidence that Mr. Willan aided and abetted Mohler as an unlicensed salesperson of securities, as it failed to establish that Mohler was required to be licensed.

The trial court also gave the statutory definition of the term “dealer.” R.C. 1707.01(E) defines a “dealer” to include “every person, other than a salesperson, who engages * * * in the business of selling securities for the account of others in the reasonable expectation of receiving a commission, fee, or other remuneration[.]” R.C. 1707.01 does not define the phrase “engages * * * in the business,” nor does it otherwise specify the level of involvement required for one to “engage” in the business of selling securities and, therefore, fall within the definition of a “dealer.”

Sheldon Safko, formerly an attorney with the Division of Securities, described dealers as agents who are in the business of selling securities for issuers other than themselves, such as Charles Schwab and Merrill Lynch. He further explained that a dealer is one who can employ a salesperson. See R.C. 1707.01(F). In addition, he testified that, although an individual technically could qualify as a dealer, it was not the practice of the Division to license individuals as dealers and he did not think it was ever done; individuals were licensed as salespeople.

Consequently, the Court concluded that the language of R.C. 1707.01(E) can reasonably be construed to apply only to a person or entity that directs and controls the manner and means of the securities sales activity. Because it was not clear that R.C. 1707.01(E)(1)(a) was intended to define “dealer” to include an employee who performs merely clerical functions and works at the direction and control of his employer, this Court would not construe it to apply to Mohler's securities sales activities. Because the State failed to prove that Mohler, Mr. Willan, Evergreen Homes, or Evergreen Investment qualified as salespeople or dealers within the meaning of R.C. 1707.01(E) and (F), none of them was required to be licensed to sell the Evergreen Investment debt securities. Therefore, the Court held that the State failed to present sufficient evidence to support Mr. Willan's 20 convictions under R.C. 1707.44(A)(1).

Mr. Willan was also convicted of five counts of making a material false representation for the purpose of registering or exempting securities from registration when he registered two separate offerings of Evergreen Investment's debt securities and when he filed for an exemption from registration of three separate offerings of equity securities. At that time, R.C. 1707.44(B)(1) provided that “[n]o person shall knowingly make * * * any false representation concerning a material and relevant fact * * * in any * * * circular, description, application, or written statement, for any of the following purposes: [r]egistering securities * * * or exempting securities * * * from registration, under this chapter[.]”

Mr. Willan's misrepresentation convictions were based on his statements in the securities filings of Evergreen Homes and the offering circular of Evergreen Investment that no commissions would be paid in connection with the sale of the securities. These alleged offenses focused on misrepresentations that were made on securities forms filed with the state and in the offering circular for the Evergreen Investment debt securities. Mr. Willan conceded that the representations were false because Mohler was paid a commission for most of the securities sales. But he challenged the sufficiency of the evidence primarily on whether these misrepresentations were material and/or whether he made them with knowledge that they were false or with a purpose to defraud anyone. Evergreen Investment filed forms with the Division of Securities of the Ohio Department of Commerce to register a $5 million offering of debt securities. The registration paperwork filed by Evergreen Investment included the required Form 6(A)(1), as well as the offering circular that Evergreen Investment would use to inform investors about the Evergreen companies and each security offering. Evergreen Investment filed similar paperwork to register a $10 million offering of debt securities. Each offering circular stated that “[n]o commissions * * * will be paid * * * in connection with the sale of the Certificates.”

Although Mr. Willan conceded that the statement in the circular regarding commissions was false, and that the circular was filed along with his registration paperwork, he maintained that the State failed to prove that the false statements in the circular were made for the purpose of registering securities or that they were material to the registration process. The Court of Appeals agreed.

Although many federal cases involve material misrepresentations in the registration of securities, those cases provided little guidance because they involved civil suits brought by investors and, necessarily, focused on whether the misrepresentation was material to investors' decisions to invest. The focus here was not whether investors' decisions would have been affected by Mr. Willan's misstatement about the commissions but whether the Division of Securities was materially misled in its decision to register the securities.

The Court of Appeals observed that, although the State established that the information in the circular was relevant to the sale of securities, it offered no evidence that Mr. Willan made this misstatement for the purpose of registering the securities or that it was material or relevant to the registration of the security offering. Therefore, the State presented insufficient evidence that he knowingly made material and relevant false statements for the purpose of registering the debt security offerings.

Mr. Willan's remaining convictions of false representation in the registration of securities, focused on entirely different forms that Mr. Willan filed on behalf of Evergreen Homes to exempt its equity securities from state registration. Mr. Willan filed the requisite “Form D” with the Division of Securities to exempt a total of $4 million in equity securities offerings from state registration requirements. Again at issue was Mr. Willan's misrepresentation that no commissions would be paid in connection with the sale of these securities.

Section C, Item 4 of each Form D filed by Evergreen Homes included a line to list the amount of “Sales Commissions” that would be paid in connection with the offering. Each Form D filed by Evergreen Homes left the commission expense line blank and, consequently, no commissions were deducted from the gross amount of the offering to arrive at the “adjusted gross proceeds to the issuer.” In addition to Mr. Willan's failure to include commissions as an expense to be deducted from the issuer's proceeds, each Form D included an affirmative misrepresentation that no commissions would be paid. Each Form D filed by Evergreen Homes included the response “None.” to Section B, Item 4 and no other information.

Form D provides almost an entire page for information about the people who have been or will be paid commissions in connection with the sale of securities in the offering, including the name of their associated broker or dealer. The State explained to the jury that information about who would receive commissions was relevant and material to the Division's review of each Form D because the securities offering would not qualify for a Rule 506 registration exemption if the securities sales involved the payment of commissions to people who were not licensed with the state to sell securities.

R.C. 1707.03(X) provided that an “offer or sale of securities made in reliance on the exemption provided in Rule 506 of Regulation D under the Securities Act of 1933 * * * is exempt provided that all of the following apply:

“(1) The issuer makes a notice filing with the division on form D of the securities and exchange commission within fifteen days of the first sale in this state;

“(2) Any commission, discount, or other remuneration for sales of securities in this state is paid or given only to dealers or salespersons licensed under this chapter;

By misrepresenting that no commissions would be paid, when in fact Mr. Willan knew that commissions would be paid to someone who was not a dealer or salesperson licensed in this state, the Court of Appeals concluded that Mr. Willan made material false statements on each Form D he filed. Had the commission payments to Mohler been disclosed, Evergreen Homes would have been required to fully register each of the three equity securities offerings with the state or commit another offense by selling unregistered securities.

Although Mr. Willan's former counsel completed each Form D, he sent the forms to Mr. Willan for him to review and sign. Regardless, according to the Court, each Form D was only a few pages long and included little information for Mr. Willan to review. The statement about the commissions would have been noticeable from even a brief review of the forms. Moreover, Mr. Willan signed each Form D directly below a series of statements, representing that he was familiar with the conditions that must be satisfied for the exemption, that he understood that the issuer had the burden of demonstrating that it qualified for the exemption, and that he had “read this notification and knows the contents to be true[.]” In sum, Mr. Willan knew that Mohler would be selling the equity securities and receiving a commission at the time he represented otherwise to the Division of Securities on each Form D. Therefore, the Court held that the State presented sufficient evidence to support Mr. Willan's convictions of false representation in the registration of securities, as charged.

Mr. Willan was also convicted of aggravated theft and theft from the elderly under R.C. 2913.02(A)(3) for sales of his securities. And although the State presented the testimony of many alleged elderly theft victims, who testified that they had invested amounts ranging from $20,000 to several hundred thousand dollars in securities in one or both of Mr. Willan's two companies and that they never received a refund of their investment, the State offered no evidence that Mr. Willan, Mohler, or anyone else associated with Mr. Willan had deceived any of the alleged victims about how their money would be invested. Indeed, according to the Court, almost every witness testified that they understood at the time they invested that a high rate of return was associated with a higher risk investment. Each had received a copy of the offering circular, which fully explained that this investment carried many risks. Instead, the deception alleged by the State again focused on Mr. Willan's false representation in the offering circular that no commissions would be paid in connection with the sale of securities. But there was no evidence that any of these investors gave money to Mr. Willan's companies due to his false statement about commissions.

Mr. Willan's position was that he was conducting a legitimate housing business and sought investors to provide capital to purchase more properties to improve. He maintained that his failure to return the investors' money was due to the eventual insolvency of his businesses. Despite the State's attempts to depict Mr. Willan's investment plan as a “Ponzi” scheme, it never presented any evidence to support that characterization. A so-called “Ponzi scheme” was named after Charles Ponzi, who defrauded investors of millions of dollars by convincing them that their money was earning a high rate of return when, in fact, he had not invested their money in anything. His scheme was a total sham because he “made no investments of any kind, so that all the money he had at any time was solely the result of loans by his dupes.” The Court of Appeals, however, observed that nothing in the record supported the State's allegations that Mr. Willan's investment plan was a sham. To the contrary, investors were told that their money would be used to provide capital to allow Evergreen Homes to buy more homes to renovate and the State failed to present any evidence that the investors' money was not used for that purpose. In fact, there was evidence that a reputable accounting firm had prepared the income tax filings and financial statements for the Evergreen companies and that the companies were financially solvent. The State failed to present evidence to support even an inference that the eventual insolvency of the Evergreen companies, and the investors' resulting loss of the money they invested, was due to anything other than a downturn in the housing and mortgage markets and the bad publicity that surrounded the sheriff's department raid of their offices.

As such, the Court concluded that the State failed to present sufficient evidence that Mr. Willan committed the offenses of aggravated theft or theft from the elderly.

Mr. Willan was also convicted of securities fraud under R .C. 1707.44(G). The statute provided that “[n]o person in * * * selling securities shall knowingly engage in any act or practice that is, in this chapter, declared illegal, defined as fraudulent, or prohibited.” R.C. 1707.01(J) defined “fraudulent acts” to include “any * * * scheme * * * to obtain money or property by means of any false * * * representation[.]” But again, Mr. Willan demonstrated that the State failed to present sufficient evidence to support this conviction.

Despite all of these reversals, however, Willan’s conviction of engaging in a pattern of corrupt activity under R.C. 2923.32(A)(1) was upheld by the Court. Although it concluded that there was insufficient evidence to support some of these convictions, there was sufficient evidence to support his convictions under R.C. 1707.44(B)(1) of three counts of making a false representation in the Form D filings of three separate offerings of equity securities. A conviction under R.C. 2923.32 required proof that Mr. Willan acted through an “enterprise” and engaged in a “pattern” of corrupt activity. R.C. 2923.31(C) defines an enterprise to include “any individual, * * * corporation * * * or other legal entity, or any organization, association, or group of persons associated in fact although not a legal entity.” R.C. 2923.31(E) defines a “[p]attern of corrupt activity” as “two or more incidents of corrupt activity, whether or not there has been a prior conviction, that are related to the affairs of the same enterprise, are not isolated, and are not so closely related to each other and connected in time and place that they constitute a single event.” In that regard, the State presented evidence that Mr. Willan, acting through his company Evergreen Homes, made false representations to the Division of Securities so he could exempt Evergreen Homes' equity securities from state securities registration. In connection with three separate offerings of equity securities. According to the Court, each act was directly related to providing funds for the affairs of his Evergreen companies and the acts were not isolated or so closely connected in time that they could be construed to constitute a single event. The pattern of corrupt activity involved a total of $4 million in securities that Mr. Willan was able to exempt from state registration as a result of the false representation. Therefore, the Court concluded that the State had presented sufficient evidence to support Mr. Willan's conviction of engaging in a pattern of corrupt activity.

Luckily, perhaps, the Court of Appeals also concluded that the trial court erred in imposing a ten-year term of incarceration under the former R.C. 2929.14(D)(3)(a) for the conviction of engaging in a pattern of corrupt activity. Because the language and legislative history of former R.C. 2929.14(D)(3)(a) do not clearly indicate that the mandatory ten-year term of incarceration was intended to apply to the general offense of engaging in a pattern of corrupt activity under R.C. 2923.32, the Court resolved this ambiguity in favor of Mr. Willan. Consequently, it concluded that the trial court erred by imposing a mandatory ten-year term under former R.C. 2929.14(D)(3)(a) for Mr. Willan's conviction of engaging in a pattern of corrupt activity based on the first-degree felony offenses of false representation in the registration of securities.

In sum, this case should terrify anyone raising capital, or representing someone who is doing so. Food for thought.

Recent FINRA Awards for Defamatory Statements on Form U-5’s

2012-01-10T16:46:00.003-06:00

In the last few years,broker-dealers have seen a recent trend by its regulatory authority,FINRA, in cracking down on the high standard of accuracy and fairnessthat brokerage-dealers must adhere to in terminating registeredrepresentatives.

Broker-dealers that are members of the FINRA arerequired to file a Form U-5 when terminating their relationship witha registered representative. Broker-dealers must also describethe specific reason(s) that the rep was discharged or permitted toresign. Publishing the reasons or causes for a rep’sdischarge or resignation can be troubling if the reasons disclosed onthe U-5 were false, exaggerated or misleading.

A black mark on one’s U-5 can make it extremelydifficult, and in some cases, impossible, to find another job in theindustry. Therefore, the potential damages against thebroker-dealer for defamatory statements on one’s U-5 can beexponential, especially if the false statements were intentionally orrecklessly published. In addition to compensatory and punitivedamages, the statements on the U-5 can be ordered to be expunged andamended to reflect the truth.

In July 2011, a Philadelphia FINRA Panel awardedGregory Kipple, a former broker of Wells Fargo, $6.83 million forwrongful termination and defamation ($4.3 million for lost earnings;$1 million for defamation; $1 million in punitive damages forviolation of New Jersey’s Conscientious Employee Protection Act;and $530,000 in cost and attorney’s fees). Wells Fargo wasalso ordered to update Kipple’s U-5 to reflect that he was“terminated without cause.” Kipple was fired in August of2009 for his “failure to follow the firm’s policies related to‘know your customers.’” However, Kipple had no directinvolvement or interaction with the specific customer that thestatement was in reference to.

The District Court upheld another FINRA award againstWells Fargo in July 2011 for submitting defamatory statements on adischarged employee’s form U-5. The claimant, Kenneth Schaferalleged that infractions reported on his U-5 were misleading andpretextual because he was discharged for health reasons. Schafer was awarded $75,000 in compensatory damages.

In June of 2011, a FINRA Arbitration Panel awarded aClaimant with a substantial punitive damage award. In Olsen v.World Equity Group, Olsen alleged defamation, breach of contract, andtortious interference. Claimant Olson alleged that RespondentWEG had breached its employment contract with him, wrongfullyterminated him, and maliciously defamed him on his Form U5. Olson was awarded $285,000 in compensatory damages, $575,000 inpunitive damages, and $282,800 in attorney’s fees. The Panelalso ordered expungement of the defamatory comment from his U-5 whichstated, “Disagreement over advertising policy, rules, andadvertising protocol.” The statement was to be replaced with,“FINRA Arbitration Panel ruled discharge was wrongfullyadministered. FINRA Arbitration Panel questions the appearance of thestated internal review and/or its effectiveness. FINRA ArbitrationPanel found no violations of investment-related statutes,regulations, rules or industry standards of conduct.”

In Perales v. Chase Investment Services Corp., alsodecided in June 2011, the claimant sought damages for defamation andexpungement of the statements on her U-5 which alleged that shecommitted fraud and wrongfully took property. Chase was ordered topay Perales $75,000 in compensatory damages and FINRA orderedexpungement of the defamatory statements and recommended replacementlanguage.

Charles Schwab was punished in 2010 with a substantialpunitive damage award by a FINRA Panel. In that case, ClaimantTimothy Leahy, who was a registered representative with CharlesSchwab, was awarded $1.8 million in total damages, of which $1.5million was comprised of punitive damages, as well as expungement ofthe defamatory statement from his U-5. Leahy’s U-5 statedthat he was terminated for “failure to adhere to HR relatedpolicies.” The Panel found that Schwab conducted aninefficient human resources investigation, stated false violations asreasons for his termination, and found that Schwab had the “specificintent” to harm the Leahy.

In 2009, FINRA found that Questar Capital Corporationincluded misleading information on John Saldutte’s U-5 afterterminating him as a registered rep. Saldutte was awarded$68,000 in compensatory damages and the Panel ordered expungement ofthe information contained on his U-5 regarding his termination andrecommended Questar replace the defamatory statement with thefollowing language: “After conducting a deficient investigation,the firm wrongfully terminated representative based on erroneous,misleading, and unjustified conclusion that representative knowinglyparticipated in unregistered person’s submission of business inrepresentative’s name.”

If you’re a registered representative and feel youhave been harmed by false or misleading statements published on yourForm U-5 or to third parties, Cosgrove Law, LLC has substantiveexperience representing reps and advisers in such matters.

New York's Highest Court Holds That Martin Act Does Not Preempt Claims for Breach of Fiduciary Duty and Gross Negligence

2011-12-23T12:30:00.007-06:00

In Assured Guar. (UK) Ltd. v. J.P. Morgan Inv. Management Inc., 2011 N.Y. Slip Op. 09162, 2011 WL 6338898 (N.Y. Dec. 20, 2011), the plaintiff, Assured Guaranty (UK) Ltd., commenced an action against defendant, J.P. Morgan Investment Management Inc., asserting causes of action for breach of fiduciary duty, gross negligence and breach of contract. The gravamen of the complaint was that J.P. Morgan mismanaged the investment portfolio of an entity whose obligations plaintiff guaranteed.

J.P. Morgan moved to dismiss the complaint, arguing that the breach of fiduciary and gross negligence claims were preempted by the Martin Act (New York's "blue sky" law). The Supreme Court granted the motion and dismissed the complaint. The Appellate Division modified by reinstating the breach of fiduciary duty and gross negligence causes of action and part of the contract claim. The Appellate Division granted J.P. Morgan leave to appeal.

J.P. Morgan's position was that plaintiff's common-law breach of fiduciary duty and gross negligence claims must be dismissed because they are preempted by the Martin Act. The Martin Act, argued J.P. Morgan, vests the Attorney General with exclusive authority over fraudulent securities and investment practices addressed by the statute. Therefore, J.P. Morgan contended, it would be inconsistent to allow private investors to bring overlapping common-law claims.

After reviewing the legislative history of the Martin Act, the court found that the plain text of the Act, while granting the Attorney General investigatory and enforcement powers and prescribing various penalties, did not expressly mention or otherwise contemplate the elimination of common-law claims. (citing ABN AMRO Bank, N.V. v. MBIA Inc., 17 N.Y.3d 208, 224 (2011) (stating that, if the Legislature intended to extinguish common-law remedies, “we would expect to see evidence of such intent within the statute”)). The court could find nothing in the legislative history that demonstrated a “clear and specific” legislative mandate to abolish preexisting common-law claims that private parties would otherwise possess.

The court acknowledged that New York courts had previously held that the Martin Act did not “create” a private right of action to enforce its provisions (citing CPC Intl. v. McKesson Corp., 70 N.Y.2d 268, 276-277 (1987)). However, the court found that the fact that “no new per se action was contemplated by the Legislature does not ... require us to conclude that the traditional ... forms of action are no longer available to redress injury” (citing Burns Jackson Miller Summit & Spitzer v. Lindner, 59 N.Y.2d 314, 331 (1983)). Hence, the court agreed with plaintiff that the Martin Act does not preclude a private litigant from bringing a nonfraud common-law cause of action.

J.P. Morgan pointed to past precedent which established that there was no common-law cause of action where the claim is predicated solely on a violation of the Martin Act or its implementing regulations. However, the court distinguished these cases by noting that an injured investor may bring a common-law claim (for fraud or otherwise) that is not entirely dependent on the Martin Act for its viability. In other words, the mere overlap between the common law and the Martin Act was not enough to extinguish common-law remedies.

Finally, the court found that policy concerns militated in favor of allowing plaintiff's common-law claims to proceed. The court agreed with the New York Attorney General that the purpose of the Martin Act is not impaired by private common-law actions that have a legal basis independent of the statute because proceedings by the Attorney General and private actions further the same goal—combating fraud and deception in securities transactions.

For all of these reasons, the court concluded that plaintiff's breach of fiduciary duty and gross negligence claims were not barred by the Martin Act. Accordingly, the court found that the order of the Appellate Division reinstating the breach of fiduciary duty and gross negligence causes of action and part of the contract claim should be affirmed.

TWEETING, POSTING, and FRIENDING: Social media’s two-edged sword for Investment Advisers

2011-09-23T10:42:00.006-05:00

Regulators and compliance departments alike have been shaking their heads at the potential pitfalls of social media. How to support and allow Investment Adviser’s to use social media tools and still protect the investor from bad actors and misinterpreted posts or tweets is no easy task. The rapid fire tweets and the “share everything” mentality become permanent, potentially discoverable, records. But Investment Advisers are finding that social media provides valuable avenues never before available to share and gain information, to find new clients, and to better understand existing clientele.

This week, the Wall Street Journal had an article on this very subject. While little official guidance has been provided to Registered Investment Adviser firms on proper social media policies, reviewing the current guidelines for client communication can offer guidance to compliance and legal departments when they are requested to develop a road map for their firm and its social media policies. The potential pitfall in having a detailed policy is that once it is in black and white, it must be followed, and either an individual or a department must be charged with ensuring this—quite a task for a such a vast medium. However, given the free-range but permanent aspects of social media, RIA’s of all sizes should begin discussing and seeking legal counsel on how they will address this matter given the current regulations in place that govern client and potential client communications. The alternative--waiting for a post or a tweet to cause a problem--can be a dangerous course to take.

Additionally, many employees may appreciate the guidance and opportunity to hear and be heard on this matter as they try to use social media to the best use without exposing their record or license to unnecessary risk. Part of being in a highly regulated industry is staying ahead of the curve so that potential problems don’t become actual ones.

FINRA has provided Broker Dealers with specific guidelines regarding social media. Using these rules as a framework for RIA’s social media policies may be another helpful tool when the RIA firm is looking for a place to start the discussion on this topic.

Cosgrove Law, LLC offers consulting to RIA firms on a wide range of compliance matters.

SECURITIES REGULATORS DISCUSS ENFORCEMENT STATS AND TRENDS

2011-09-19T10:30:00.001-05:00

State securities regulators' enforcement efforts were robust in 2010, according to a panel of regulators at NASAA's annual conference last week. Cosgrove Law, LLC provides both civil and criminal representation in the securities and white-collar arena, so it was interested to learn that there was a substantial increase in criminal prosecutions filed by securities regulators in 2010. For “non-fraud” cases, the regulators scored themselves a 32% increase in “failure to supervise” actions, but filed fewer “suitability” actions.

Other interesting statistics: almost half of the state regulators' enforcement actions were brought against non-registered persons in 2010. As for registered individuals, 12% of those actions were brought against investment adviser representatives (IAR's) and 23% were filed against broker-dealer agents. 5% were brought against registered solicitors, and the balance fell upon insurance industry members. The regulators continued to express ire over insurance industry members dually licensed as investment advisers with what they perceive to be an excess concentration or focus upon annuity sales.

Notably, today's Wall Street Journal has an interesting Adviser Alert that shares an important observation: investment advisers are “among regulators' best tipsters.” In our experience, reputable advisers are also likely to recommend legal counsel to new clients whom they observe to have been victimized by their prior broker or adviser or insurance agent. Food for thought.

STATE SECURITIES REGULATORS AT ANNUAL CONFERENCE LIST PRECIOUS METALS SALES AS ENFORCEMENT PRIORITY

2011-09-15T16:23:00.002-05:00

Members of this firm, financial industry members, and SEC and FINRA staff joined state securities and commodities regulators at their annual conference this week. As always, the conference agenda was relentless—filled with impressive panels discussing trends and developments on the broker-dealer and investment advisory side, State, Federal and SRO enforcement actions and compliance audits, as well as commodities regulation and international financial market policy. When NASAA's Enforcement Section met during the conference, its leaders listed precious metals retail sales as one of their primary concerns and enforcement priorities. The discussion, however, focused on margin sales, with an additional dose of skepticism about precious metals depository services. Notably, many interpret language in the Dood-Frank Act to preclude most transactions that combine the use of margin and storage, although the precious metals industry still awaits belated CFTC rule-making in this area.

In the interest of full disclosure, Cosgrove Law, LLC is a member of the ICTA and provides compliance services to members of the precious metals industry. Is also, however, represents investors defrauded by the less reputable members of an industry arguably vindicated by years of market appreciation. Indeed, today's Wall Street Journal published one of dozens of articles regarding the role of gold and other metals in the personal finances and portfolios of Americans struggling through another year of economic malaise and equity market volatility. To read this full article, please click here.

The Road To Financial Reform Will Be Filled With Landmines

2011-08-19T12:02:00.001-05:00

After the passage of Dodd-Frank, industry leaders, legislators, and all levels of executive agencies have been divided into two camps: those who hail the massive bill as the answer to financial stability and those who plan and plot for its demise. Perhaps this is too harsh a dichotomy; there are likely others who remain neutral or indifferent, as well.

Regardless, because of the strong support and brazen contempt, a storm has been brewing in both camps as they lay in wait for the perfect moment to surge forward into battle. This battle will not invoke the bloody Greek combat scenes of ancient times, but may be just as epic as lawyers take to the battlefield of federal courtrooms across the country to determine the fate of Dodd-Frank.

The time for such a barrage may be upon us after the federal court of appeals decision in July struck down the Securities and Exchange Commission’s proxy access rule stemming from Dodd-Frank. The rule was implemented purportedly to make it easier for shareholders to nominate company directors. This court decision dealt a major blow to the SEC because the agency spent over 21,000 staff hours over two years drafting the rule. Since the SEC’s defeat, industry watchdogs have been examining legal challenges to other rules required by the Dodd-Frank financial oversight law.

Up until this point, Wall Street and interested industries have relied heavily on the work of lobbyists to sculpt the mandatory rulemakings by agencies like the SEC and CFTC. However, shaping the rules through lobbying may only a loophole here or there, judicial intervention could stop the rulemaking indefinitely.

In recent weeks there has been an influx of comment letters, congressional testimony, and trade group meetings, which appear to be laying the foundation to mount possible legal challenges. Apparently, one such meeting held by the U.S. Chamber of Commerce was dubbed “Dodd-Frank Excesses.” Hal S. Scott, a professor at Harvard Law School and director of the Committee on Capital Markets Regulations forecasts “lots of challenges coming down the pike.”

What Happened to the SEC Proxy Rule?

While the SEC currently weighs its options for appeal, another committee within the agency is examining the case and considering how to make adjustments to other proposed regulations in an effort to prevent future rulemaking catastrophes.

The source of the legal challenge to the proxy rule is a 1996 law requiring the SEC to promote “efficiency, competition and capital formation.” This law provided the power to enable the financial industry to build lawsuits around economic costs of rulemaking, instead of its merits. This rule was first harnessed in 2005, when the U.S. Chamber of Commerce successfully challenged SEC rules for the mutual fund industry. The Chamber has since used this provision in a succession of victories in the U.S. Court of Appeals throwing out three financial regulations over the last six years.

For now, the SEC is ramping the number of economists in its employ to ward off future attacks alleging that it did not fully evaluate economic effects of implemented rules.

Why History May Repeat Itself

Because Dodd-Frank is encompasses so many facets of the financial industry and beyond, there is no reasonable constitutional or statutory to the whole. However, arguments challenging individual sections or rules made pursuant Dodd-Frank are more feasible. The demise of the proxy rule opens up other rules to challenges.

Both the SEC and CFTC have been targets of hostile letters from financial trade groups and industry groups threatening legal action. Several of these groups are considering suits against the new SEC whistleblower program that went live last Friday. The U.S. Chamber of Commerce has argued that the whistleblower program allows tipsters to undermine internal compliance departments. Other groups have their sights set on less well-known provisions.

With industry turning up the heat, regulators have spent significant amounts of time and energy trying to shield their rules from litigation. For example, in May, the CFTC’s general counsel and chief economist issued an agency memorandum setting forth specific guidelines for cost-benefit analyses. The effect has been a slow-down of the rulemaking process and the action garnered praise that the agency has been “proactive” in taking steps to address industry concerns. Regardless of these proactive measures, it is unlikely the CFTC will come out of battle unscathed.

The Most Likely Provisions to Come Under Fire

Based on recent comment letters to the regulators and congressional testimony, Reutersreported on the five most likely targets for challenges:

Conflict Metals

First up is the conflict minerals issue. Under this rules, the SEC would require companies to make annual disclosure revealing whether they use any “conflict metals” from the Democratic Republic of Congo. Reuters states, “The proposal has become so contention that the SEC had to reopen the comment period and delay the final implementation.” The U.S. Chamber of Commerce has made comments foreshadowing a possible challenge if the SEC fails to address cost concerns. Tiffany & Company took a more direct route and argued in a recent letter to SEC that the conflict minerals rule “would violate the First Amendment.”

Speculative Position Limits

The next likely target focuses on the CFTC’s imposition of speculative position limits, which would cap the number of futures and related swaps contracts that any one speculative trader can control. The CFTC currently takes the stance that it does not need to make a finding that the limits are necessary to reduce price volatility. However in March, the Futures Industry Association (“FIA”) urged the CFTC to abandon its plan to place position limits, arguing that such limits “may be legally infirm.” In May, the FIA raised a procedural concern regarding this rule. In its letter, the FIA states that in telephone calls to CFTC staff members, they indicated an intent to add a provision in the final rule on aggregated position limits that was not included in the proposed rule. Failing to request comment on a significant change, such as aggregated position limits, could be additional grounds for a challenge.

Capital & Margin for Uncleared Swaps

So far, only the CFTC and the Federal Reserve have issued proposals outlining which traders will be required to post collateral to back up their derivatives trades. The SEC has yet to issue its proposal on this matter. Although the plans differ, they both generally impose margin on large dealers and major traders with exemptions for companies that strictly use derivative to hedge against price risk and interest-rate fluctuations. According to Reuters, the concern is that these “rules are going to impose higher costs on a wide swath of financial market players.” In its letter to the CFTC, the Coalition of Derivatives End-Users accuses that CFTC of not doing an adequate cost-benefit analysis.

Real-Time Reporting of Swap Trades

The fourth controversial issue is the CFTC and SEC’s proposals to “bolster price transparency in the swaps markets” through the use of real-time trade reporting. CFTC Commissioner Scott O’Malia has raised concerns regarding a footnote in the proposal, which admits a lack of public information regarding the proposal’s effect on market liquidity. The Chamber of Commerce, Securities Industry and Financial Markets Association (SIFMA), and several large banks have raised concerns about the costs and inflexible reporting framework of such rules.

Incentive-Based Compensation

Incentive-based compensation is the final point of concern. Both the SEC and federal banking regulators have rule proposals requiring companies to reveal their incentive-based compensation plans in addition to placing restrictions on “excessive rewards.” The potential vulnerability in these rules again lies in flaws in the economic analysis underlying the rules. The Chamber of Commerce claims the analysis, particularly the SEC’s, focuses too much on administrative burdens rather than competitive burdens.

While it is unknown what provisions will actually cause a scene in the courtroom, there is sure to be an ensuing legal skirmish. Stay tuned and watch the battle unfold.

House Financial Services Committee Chairman Aims To Restructure SEC

2011-08-04T12:36:00.003-05:00

On August 2, chairman of the House Financial Services Committee, Rep. Spencer Bachus, announced his intention to “modernize” the Securities and Exchange Commission. He plans to introduce the SEC Modernization Act, which will consolidate certain SEC offices and institute managerial and ethics reform.

Bachus is responding to his view that the SEC is structurally flawed, which results in operational inefficiencies. According to Bachus’ announcement, the forthcoming Act purportedly will address those issues making the agency “more efficient, consolidate duplicative offices, enable the agency to use better technology, and strengthen ethical safeguards to avoid conflicts of interest.” Despite clamoring from the SEC for additional funds, Bachus contends that additional funds will not make the agency improve performance unless these key flaws are fixed.

The draft proposal expressly amends four provisions of the Dodd-Frank Act (Sections 342, 915, 965, and 991). Such amendments would combine the Office of Compliance, Inspections and Examinations; the Division of Trading and Markets; and the Division of Investment Management. As well as consolidate the Divisions of Corporate Finance, Enforcement, Investment Management, and Trading and Markets.

According to a press release from the Financial Services Committee, the draft also makes managerial and ethics reforms, including combining the functions the Executive Director and the Chief Operating Officer, requiring the Office of Ethics Counsel to develop a system for tracking employee recusals, and restore an independent ombudsman.

John Nester, a spokesman for the SEC, responded that such changes should come internally and not imposed legislatively because internal reforms can be more readily adapted to evolving market dynamics. He also stated that the SEC is “actively reviewing a number of similar recommendations from the Boston Consulting Group study to evaluate improvements in the structure, operations, and processes of the agency.”

More detailed information regarding this draft proposal can be obtained from the House Financial Services Committee website.

Bailouts, Whistleblowers, and Fraud: The Whistleblowers (Part 3 of 3)

2011-06-28T11:10:00.000-05:00

This is that final part in a three part series that will analyze the legislation that sets the foundation for the bailout and provides the means for private litigants to come forward and provide an in-depth assessment setting forth the statutory provisions, processes and procedures that whistleblowers must comply with when disclosing information regarding the misuse of TARP and other stimulus funds. We have already discussed the Federal False Claims Act, creating qui tam actions, and the Bailout Bill creating the TARP programs and subsequent fraud. This final part addresses the whistleblower protections and procedures for invoking protection, as well as the procedural requirements for filing a qui tam lawsuit.

The American Recovery and Reinvestment Act of 2009: Creating Whistleblower Protection

In early 2009, Congress enacted the American Recovery and Reinvestment Act of 2009 (“ARRA”), also known as the “Stimulus Act,” amending certain provisions in ESSA. Section 1553 of ARRA contains a broad whistleblower protection provision protecting whistleblowers who report misuse by “non-Federal employers” that received funds under ESSA or ARRA. See Pub. L. No. 111-5, 123 Stat. 115 § 1553 (2009). The purpose of including Section 1553 in ARRA was to ensure that Government funds were not mismanaged or misspent. Specifically, law prohibits non-federal employers from retaliating against an employee for reporting misuse of funds received by their non-federal employer as part of the stimulus or bailout.

The ARRA broadly defines a “non-Federal employer” as an employer that is a contractor, subcontractor, grantee, or recipient of covered funds, any professional organization, agent or licensee of the Federal government or any “person acting directly or indirectly in the interest of an employer receiving covered funds,” any State or local governments receiving “covered funds”, or any contract or subcontractor of such State or local governments. Pub L. 111-5, 123 Stat. 115 § 1553(g)(4).

“Covered funds” are also broadly defined to include "any contract, grant, or other payment received by an non-federal employer if--(A) the Federal Government provides any portion of the money or property that is provided, requested, or demanded; and (B) at lease some of the funds are appropriated or other made available by this Act." Under this definition of "covered funds," TARP funds are included, so the whistleblower protection extends to claimants making disclosure under EESA.

The definition of an “employee” is exceedingly broad to include any “individual performing services on behalf of an employer.” Pub L. 111-5, 123 Stat. 115 § 1553(g)(3). This definition therefore includes not only employees, but also independent contractors of recipient non-federal employers, thus allowing nearly anyone in an organization to become a whistleblower.

The employee disclosure must be regarding information which the employee “reasonably believes” is evidence of:

• Gross mismanagement of an agency contract or grant relating to covered funds;

• A gross waste of covered funds;

• A substantial and specific danger to public health or safety related to the implementation or use of covered funds;

• An abuse of authority related to the implementation or use of covered funds; or

• a violation of law, rule, or regulation related to an agency contract or grant, awarded or issued relating to covered funds.

Protection is even extended to disclosures made in the ordinary course of the employee’s duties. Similar to other whistleblower statutes, the complainant-employee need not be correct about his belief, just that that belief be reasonable.

Obtaining Whistleblower Protection

However, in order to invoke protection under Section 1553, an employee must make the disclosure to the Recovery Accountability and Transparency Board, “an inspector general, the Comptroller General, a member of Congress, a State or Federal regulatory or law enforcement agency, a person with supervisory authority over the employee, a court or grand jury, the head of a Federal agency, or their representatives,” and then there must be some form of retaliatory action from the employer as a result of disclosure to one of these entities. Because disclosure of wrongdoing can be made to a court, a complainant would be able to seek whistleblower protection after filing an qui tam action—if the employer engaged in a retaliatory action or reprisal.

After a retaliatory action, the whistleblowing employee must submit a written complaint to the inspector general of the federal agency administering the covered funds, file a complaint online through an online complaint form or call into the Fraud, Waste, and Abuse hotline. The inspector general has 180 days to review the complaint and complete an investigation, if it decides to pursue the matter. If the inspector general cannot complete the investigation within that time period, the investigation period can be extended up to an additional 180 days, with or without the complainant’s consent. After completion of the investigation, the inspector general issues a report to his agency head. The agency then has 30 days to issue an order awarding or denying any relief, such as reinstatement, back pay, compensatory damages, benefits, attorneys fees, and costs. Ordered relief must then be taken to the District Court to be enforced. At that time, the District Court has discretion to grant additional relief including injunctive relief, compensatory and exemplary damages, attorneys fees and costs. Review of all agency orders is also available directly through appeal to the U.S. Court of Appeals.

If the agency issues an order denying relief, in whole or in part; has not issued an order within 210 days after the submission of the complaint; decides not to investigate; and there is no evidence of bad faith on the part of the complainant-employee, the complainant may bring a private action de novo against the employer for compensatory damages and any additional relief provided for in ESSA and the ARRA. Moreover, if the employee brings a private right of action, Section 1553 expressly provides a jury right in the de novo action.

In order to be successful on a claim, the whistleblower must prove that the protected disclosure was a “contributing factor” in the employer’s retaliation. Pub. L. No. 111-5. 123 Stat. 115 § 1553(c)(1)(A)(i). The ARRA specifies that in order to make this showing, the complainant must show that “the [employer] undertaking the reprisal knew of the disclosure” or that “the reprisal occurred within a time period of time after the disclosure such that a reasonable person could conclude that the disclosure was a contributing factor in the reprisal.” Id. § 1553(c)(1)(A)(ii).

There are several extraordinary measures in Section 1553, which set it apart from predecessor whistleblower statutes. First, rights under it are non-waiveable and cannot be subject to pre-dispute arbitration agreements, unlike the whistleblower provisions in the Sarbanes-Oxley Act of 2002. Further, there is no express statute of limitations for a cause of action. Arguably, however, the default 4-year limitations period will be applicable. See 28 U.S.C. § 1658(a) (providing a four-year statue of limitations for analogous causes of action). Additionally, this Section expressly states that it does not displace State laws providing additional whistleblower protection and relief, further allowing the qui tam relator to recover under both federal and state laws.

Bringing a Qui Tam Action

Remember, a qui tam relator is filing a suit on behalf of the United States. As such, a qui tam relator must follow certain procedural requirements, in addition to the ones imposed under Section 1553 of ARRA for whistleblower protection. A qui tam suit is initiated upon the filing of the complaint under seal for 60 days without service to the defendant, which means the complaint is unknown to the defendant. The purpose of this “blackout period” is to allow the Government time to (1) conduct its own investigation without the defendant’s knowledge and (2) to determine whether to intervene in the action. 31 U.S.C. § 3730(b).

Also, a copy of the complaint and a written disclosure statement is served on the U.S. Attorney and the Department of Justice. This written disclosure statement must contain “substantially all material evidence and information the person possesses.” 31 U.S.C. § 3730(b)(2). The purpose of this disclosure statement is to provide the Department of Justice with the information necessary to conduct a proper investigation that will allow it determine whether to intervene. It also provides the U.S. Attorney with the information required to determine whether it should pursue a criminal action against the defendant. The disclosure statement need not be filed simultaneously with the complaint, however it must be filed within a reasonably short period of time after. If the Department of Justice decides to intervene, it takes over the discovery and litigation process. If not, the qui tam action moves forth under the relator’s original action.

Conclusion

Undoubtedly, the massive amounts of Federal monies distributed under ESSA ($700 billion) and ARRA ($800 billion) coupled with the FCA and Section 1553 of ARRA will (and already have) lead to an influx of whistleblower tips and complaints. This means more federal enforcement activity, potentially subjecting bailout and stimulus recipients to civil and/or criminal liability for fraud, waste, error, and abuse.

The Emergency Economic Stabilization Act of 2008 sets forth a detailed and complex program for receiving federal monies under TARP. The False Claims Act and subsequent amending acts of Congress, such as the Fraud Enforcement and Recovery Act of 2009 and the American Recovery and Reinvestment Act of 2009, provide sources of whistleblower protection for TARP fraud qui tam relators. The interplay between these various Acts further complicates the issues surrounding TARP. Because of the complexity of these issues, it is important to select a law firm that understands the nuances of these issues and can navigate these difficult legislative provisions.

Bailouts, Whistleblowers, and Fraud: The Bailout And The Fraud (Part 2 of 3)

2011-06-26T10:41:00.002-05:00

This is a three part series that will analyze the legislation that sets the foundation for the bailout and provides the means for private litigants to come forward and provide an in-depth assessment setting forth the statutory provisions, processes and procedures that whistleblowers must comply with when disclosing information regarding the misuse of TARP and other stimulus funds. The second part analyzes the legislation setting up the TARP programs, the authority given to the Treasury, some of the specific requirements of imposed on TARP recipients, and finally addresses some of the most common types of TARP fraud.

Since the crash of 2008, words like “bailout” and “stimulus” have swirled around the financial and housing markets across the country. You may even be more familiar with specific programs like TARP or CAP. The bailout and stimulus programs were extraordinary acts of Congress enacted swiftly to react to the dire circumstances facing the nation at the end of 2008. But the bottom line is that the federal government pumped huge sums of money into the markets very rapidly in an effort to stabilize the marketplace. Of course in doing so, the Government opened itself up to potential fraudsters. As such, qui tam whistleblowers, acting under the Federal False Claims Act, are playing a critical role exposing fraud in the government programs created under these Bills.

The Emergency Economic Stabilization Act of 2008: Creating The Troubled Asset Relief Program

After the collapse of Bear Stearns and subsequent bank failures, Congress quickly enacted the Emergency Economic Stabilization Act of 2008 (“EESA”), more commonly known as the “Bailout Bill.” The purpose of EESA was “to immediately provide authority and facilities that the Secretary of Treasury can use to restore liquidity and stability to the financial system of the United States.” See Pub. L. No. 110-343, 122 Stat. § 3765 (2008), codified at 12 U.S.C. § 5201, et seq.

Under this authority, the Government established the $700 billion Troubled Asset Relief Program (“TARP”). Congress delegated authority under TARP to the Secretary of Treasury and the newly created Financial Stability Oversight Board. Pursuant to this authority, the Secretary of Treasury was authorized “to purchase, and make and fund commitments to purchase, troubled assets from any financial institution.” 12 U.S.C. § 5211(a)(1). It should also be noted that EESA created the $200 billion credit pool for the financial industry through the Term Asset-Backed Securities Loan Facility (“TALF”).

According to the new authority delegated to it, the Secretary of Treasury, together with several other executive agencies and departments, setup the Capital Purchase Program (“CPP”) and its successor, the Capital Assistance Program (“CAP”). Both programs operated under TARP to provide a mechanism for additional taxpayer support to stabilize the financial and banking systems whereby the Department of Treasury invested in preferred equity securities or warrants of qualified financial institutions. See GAO Report, GAO-09-161, published December 2, 2008. However, in providing relief under TARP authority, the Secretary of Treasury was required to “take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section.” 12 U.S.C. § 5211(e).

Executive Compensation & Corporate Governance Requirements

After receipt of federal funds, TARP recipients became subject to certain standards for executive compensation and corporate governance. These standards became hotly contested prompting the Treasury to promulgate “TARP Standards for Compensation and Corporate Governance.” 31 C.F.R Part 30 (2009). These new standards require recipients to:

• include a provision allowing the Government to recover “any bonus, retention award, or incentive compensation paid to a senior executive officer...based on statements of earnings, revenues, gains, or other criteria that are later found to be materially inaccurate.” 12 U.S.C. § 5221(b)(3)(B);

• place “limits on compensation that excludes incentives for senior executive officers of the TARP recipient to take unnecessary and excessive risks that threaten the value of such recipients during the period in which any obligation arising from financial assistance provided under the TARP remains outstanding.” 12 U.S.C. § 5221(b)(3)(A); and

• “have in place a company-wide policy regarding excessive or luxury expenditures...which may include excessive expenditures on—(1) entertainment or events; (2) office and facility renovations; (3) aviation or other transportation services; or (4) other activities or events that are not reasonable expenditures for staff development, reasonable performance incentives, or other similar measures conducted in the normal course of the business operations of the TARP recipient.” 12 U.S.C. § 5221(d).

In order in ensure compliance, certain senior executive officers, usually the CEO and CFO, are required to certify annually that the recipient corporation adhered to 12 U.S.C. § 5221, including submittal of an attesting statement verifying that a compensation committee or board of directors performed a semi-annual review of the TARP recipient’s luxury expenditure policy and executive compensation plan. Moreover, a recipient must also report loan volumes to the Department of Treasury on a monthly basis and prepare a quarterly report for the Office of the Comptroller of Currency describing any changes in management, use of TARP funds, and forward planning.

Most Common Types of Fraud Under TARP

The corporate governance and executive compensation standards laid out in TARP are, not surprisingly, a source of TARP fraud. Some of the most common types of fraud under TARP include the false certification of eligibility for funding; conflicts of interest for private parties managing recipient funds; collusion among participants to use Federal funds for personal financial gain; and failure to comply with these standards. Another prevalent type of fraud is known as Mortgage Modification Program Fraud, which is the falsification of residence, income and mortgage values in order to receive FHA and TARP monies. Additionally, the massive distributions of cash into the markets gave rise to money laundering illicit funds through disbursements.

EESA sets forth a detailed and complex program for received Federal funds. TARP alone encapsulates twelve different federally-funded programs to create liquidity and stability in the banking and financial markets. Navigating these complex programs is difficult and requires the skill of an experienced attorney.

Bailouts, Whistleblowers, and Fraud: The Legislation Behind Qui Tam Actions (Part 1 of 3)

2011-06-24T10:11:00.004-05:00

Special Inspector General Neil Barfosky testified to this effect before the House Ways and Means Committee on Oversight:

“We stand at the precipice of the largest infusion of Government funds over the shortest period of time in our Nation’s history. If by percentage, some of the estimates of fraud in recent government programs apply to the TARP programs, we are looking at the potential exposure of hundreds of billions of dollars in taxpayer money lost to fraud.”

As such, qui tam whistleblowers, acting under the Federal False Claims Act, are playing a critical role exposing fraud in the government programs created under these Bills.

This is a three part series that will analyze the legislation that sets the foundation for the bailout and provides the means for private litigants to come forward and provide an in-depth assessment setting forth the statutory provisions, processes and procedures that whistleblowers must comply with when disclosing information regarding the misuse of TARP and other stimulus funds. This first article looks at the legislation which created a qui tam lawsuit, the Federal False Claims Act.

The Federal False Claims Act

The False Claims Act (“FCA”), 31 U.S.C. §§ 3729-3733, was originally enacted in 1863 in response to contractors defrauding the United States Government by selling unfit supplies to both the Confederate and Union armies. It has since been revered as the single-most effective tool for detecting fraud against the U.S. Government by allowing private citizens to bring suit on behalf of the Government and share in the recovery. (Since 1986, claims brought under the FCA have recovered $28 billion).

The FCA provides that any person who knowingly submits or causes to be submitted a false or fraudulent claim to the Government for payment or approval is liable for a civil penalty of not less than $5,500 and not more than $11,000 for each such claim submitted or paid, plus three times the amount of the damages sustained by the Government. 31 U.S.C. § 3729(a); 12 C.F.R. § 85.3(a)(9).

More specifically, liability under the FCA attaches when a person:

• “Knowingly presents, or causes to be presented, to an officer or employee of the United States Government or a member of the Armed Forces of the United States a false or fraudulent claim for payment or approval...” 31 U.S.C. §3729(a)(1);

• “Knowingly makes, uses, or causes to be made or used, a false record or statement material to a false or fraudulent claim...” 31 U.S.C. §3729(a)(2), as amended by, The Fraud Enforcement and Recovery Act of 2009 (Pub. L. No. 111-21, §§ 4(a)(a) and 4(f)); or

• “Knowingly makes, uses, or causes to be made or used, a false record or statement to conceal, avoid, or decrease an obligation to pay or transmit money or property to Government.” 31 U.S.C. § 3729(a)(7).

The terms “knowing” and “knowingly” are defined under the FCA as “a person, with respect to information—(1) has actual knowledge of the information; (2) acts in deliberate ignorance of the truth or falsity of the information; or (3) acts in reckless disregard of the truth or falsity of the information.” Moreover, the FCA does not require “proof of specific intent to defraud.” 31 U.S.C. § 3729(b).

Therefore, the FCA allows a private individual having information regarding a false or fraudulent claim against the Government to bring an action for himself, as “relator,” on behalf of the Government and to share in the Government’s recovery. The legislative intent behind sharing in the Government’s recovery was to entice private individuals to come forward with information.

However, as will be discussed in Part 3 of this series, there are certain procedural requirements with which a qui tam relator must comply. Filing a qui tam action is a complex and detailed process. It is important to choose an attorney who understands these requirements.

Second Circuit Weighs in on Scope of Broker Fiduciary Duty

2011-06-17T17:19:00.007-05:00

On June 7, 2011, the Second Circuit rendered a decision in United States v. Allen Wolfson, Docket Nos. 10-2786-cr(L) and 10-2878-cr(CON), which weighs in on the scope of the fiduciary duty in the broker-customer context. In the case, the defendant appealed from two judgments of conviction entered on a number of different grounds, including securities fraud, relating to the defendant's involvement in a "pump and dump" stock scheme. The evidence at trial showed that the defendant artificially inflated the prices of certain thinly-traded securities in which he had amassed a substantial interest, and then unloaded those holdings on unsuspecting investors. The scheme relied on corrupt stock brokers who sold the securities for prices far above their actual value. In exchange, the defendant rewarded the brokers with exorbitant commissions. Some of the brokers failed to disclose the fact of the commissions to their customers. Others made affirmative misrepresentations about the size of these commissions.

On appeal, the defendant argued that the brokers had no duty to disclose their commissions, and that his fraud convictions, which relied on the breach of that duty to establish a scheme to defraud, must therefore be overturned. The defendant also argued that, even if a duty to disclose might arise in some contexts, the district court gave an improper fiduciary duty instruction.

The court noted that although it had long held that "there is no general fiduciary duty inherent in an ordinary broker/customer relationship," it had also recognized that "a relationship of trust and confidence does exist between a broker and a customer with respect to those matters that have been entrusted to the broker. United States v. Szur, 289 F.3d 200(2d Cir. 2002). The court noted that the fiduciary duty most commonly arises in the broker-customer relationship in situations in which a broker has discretionary authority over a customer's account. However, the court recognized that "particular factual circumstances may serve to create a fiduciary duty between a broker and his customer even in the absence of a discretionary account." United States v. Skelly, 442 F.3d 94 (2d Cir. 2006).

For example, the court noted that in Szur the owner and president of J.S. Securities had convinced brokers to market stock in exchange for unusually large commissions, sometimes as much as 50 percent of the proceeds of the sale. 289 F.3d at 212. The brokers failed to disclose the size of the commissions to their customers. The court held that, although the brokers owed no general fiduciary duty arising from discretionary authority, they were under a duty to disclose the exorbitant commissions because the information would have been relevant to a customer's decision to purchase the stock. Id. This holding was an outgrowth the court's pronouncement in SEC v. First Jersey Securities, Inc., 101 F.3d 1450, 1469 (2d Cir. 1996), where the court explained that "[s]ales of securities by broker-dealers to their customers carry with them an implied representation that the prices charged in those transactions are reasonably related to the prices charged in an open and competitive market."

In other words, the presence of a discretionary account automatically implies a general fiduciary duty, but the absence of a discretionary account does not mean that no fiduciary duty exists. For that reason, the controlling question in the case before the court was whether the jury was properly instructed on the fiduciary duty. The instructions were as follows:

Whether a fiduciary relationship exists is a matter of fact for you, the jury, to determine. At the heart of the fiduciary relationship lies reliance and de facto control and dominance. The relationship exists when confidence is reposed on one side and there is resulting superiority and influence on the other. One acts in a fiduciary capacity when the business which he or she transacts or the money or property which he or she handles is not his own or for his or her own benefit but for the benefit of another person, as to whom he or she stands in a relation implying and necessitating great confidence and trust on the one part and a high degree of good faith on the other part.

If you find that the government has shown beyond a reasonable doubt that a fiduciary relationship existed, such as between any one of the brokers and the customers you next consider whether there was a breach of the duties incumbent upon the fiduciary in the fiduciary relationship and specifically whether the defendant caused the broker or brokers to breach their fiduciary duties to customers. I instruct you that a fiduciary owes a duty of honest services to his customer, including a duty to disclose all material facts concerning the transaction entrusted to him or her. The concealment by a fiduciary of material information which he or she is under a duty to disclose to another, under circumstances where the nondisclosure can or does result in harm to the other is a [b]reach of the fiduciary duty and can be a violation of the federal securities laws, if the government has proven beyond a reasonable doubt the other elements of this offense, as I explained them to you.

The court concluded that the instruction given was identical in all material respects to the charge given in Szur, 289 F.3d at 210. Because the court found no principled basis on which to distinguish the case before it from Szur, the court concluded that there was no error in the charge.

A complete copy of the Second Circuit's decision can be found here.

Focusing Only on Dodd-Frank? Then You Might Be Missing Something

2011-06-17T14:03:00.002-05:00

Because the Dodd-Frank financial reform bill grabs headlines every day, other regulations are entering the scene almost undetected. Broker-dealers and registered investment advisors may not be aware of new upcoming regulations, which could impact their business.

The Dodd-Frank reform bill has shaken the marketplace and the regulatory bodies. In its aftermath, there have been a flurry of mandated studies, proposals and rulemakings, but it has also spurred other agencies and organizations into action. As such, new regulations are on the horizon besides just those implemented under Dodd-Frank authority.

Last summer, in addition to passing Dodd-Frank, Congress also passed the Foreign Account Tax Compliance Act (FACTA), which imposes stricter IRS filing requirements on those having overseas assets of more $50,000 US dollars. This legislation has significant effect on institutions that hold assets for U.S. investors. FACTA will take effect in 2013.

FINRA revised its suitability rule (currently NASD Rule 2310), which is slated to go into effect on July 9, 2012. The revised rule adds five new elements that broker dealers and firms must consider: client liquidity, age, investment experience, time horizon, and risk tolerance.

FINRA also has implemented new trade-reporting requirements. In May 2011, FINRA began requiring brokerage firms to start using its Trade Reporting and Compliance Engine (TRACE) system to report trades of asset-backed securities. This coming October, broker dealers will have to begin reporting more trades and additional, previously undisclosed data into FINRA’s Order Audit Trading System.

The Department of Treasury’s Financial Crimes Enforcement Network (Fincen) has been discussing the possibility of subjecting registered investment advisory firms and hedge funds to its anti-money laundering rules. Although nothing has been implemented yet, Fincen is considering making it a requirement for these firms to file suspicious-activity reports (SARs) like banks and broker dealers.

With all of these new regulations and those yet come, it is important to have legal counsel that knows and understands the changing regulatory environment.

Dodd-Frank Lowers Market Manipulation Standard, Easier for CFTC to Prove

2011-06-08T11:15:00.003-05:00

The U.S. Commodity Futures Trading Commission is on the hunt. The target: market manipulators.

On May 24, 2011 the CFTC filed its biggest market manipulation case ever in CFTC v. Parnon Energy, Inc., et al. On May 25, 2011, CFTC Commissioner, Bart Chilton, confirmed in a press conference the agency’s vow to hunt down market manipulators by stating, “We’re watching and we’ll come and get you.” As if that’s not chilling enough, Dodd-Frank provisions could make it easier for the CFTC and other regulators to bring market manipulation cases by lowering the standard of intent.

Market manipulation is a deliberate attempt to create artificial market prices or market for a particular security, commodity, or currency. In the past, in order to prove a market manipulation claim, the CFTC had to prove (1) an individual actually intended to manipulate prices; (2) that individual had the market power to move the price of a commodity; and (3) that individual actually caused an artificial price in the market. This was a difficult standard to meet--evidenced by the fact that the CFTC only has successfully prosecuted and won one market manipulation case in the futures markets over the agency’s 36-year history.

However, Dodd-Frank sets forth a new standard under which the CFTC will now have to show that a market participant acted in a manner with the potential to disrupt the market. The effect of a lower standard will be two-fold: first, it should make it easier for the CFTC to prove its case, and second, it expands the CFTC’s enforcement jurisdiction by now allowing the agency to prosecute market participants who may have merely acted in a reckless manner to cause a price in the market that otherwise would not have occurred. This standard is analogous to the current SEC standard for market manipulation in securities markets.

Additionally, Dodd-Frank leaves much discretion to the CFTC to determine its own specific enforcement rules. Although final rules have not been approved, the CFTC has stated that it will “crack-down” on three areas under the market manipulator theory: “spoofing”, “banging the close”, and high-frequency trading/algorithmic strategies. “Spoofing” occurs where a trader makes a bid or offer and cancels it before it is carried out. “Banging the close” takes place when a trader acquires a substantial position leading up to the closing period, and then offsets the position before the end of the trading day in an attempt to manipulate closing prices. Finally, the CFTC plans to investigate high-frequency trades and algorithmic strategies to determine whether such techniques have the effect of disrupting markets. If so, then these types of trades will likely face more rules and be subject to the new market manipulation standard.

FINRAs 6-Year Arbitration Eligibility Rule

2011-06-03T08:45:00.002-05:00

In 2007, the Financial Regulatory Authority, FINRA, adopted the National Association of Securities Dealers (NASD) rule setting forth the time period in which claims can be submitted to arbitration. FINRA Arbitration Code Rule 12206(a) provides:

(a) Time Limitation on Submission of Claims

No claim shall be eligible for submission to arbitration under the Code where six years have elapsed from the occurrence or event giving rise to the claim. The panel will resolve any questions regarding the eligibility of a claim under this rule.

FINRA also provides in the introduction to the Rule:

“The Customer Code applies to claims filed on or after April 16, 2007. In addition, the list selection provisions of the Customer Code apply to previously filed claims in which a list of arbitrators must be generated after April 16, 2007; in these cases, however, the claim will continue to be governed by the remaining provisions of the old Code unless all parties agree to proceed under the new Code.”

This six-year time limitation became pivotal in In the Matter of the Arbitration Between Beja Finance International v. RBC Dain Rauscher f/k/a Tucker Anthony, Inc. In this case, the claimant, Beja Finance International (“Beja”), filed a Statement of Claim in November 2009 alleging various causes of actions when Beja provided notice of termination to RBC in the beginning of October 2000 but the termination was not complete until late-2001. Specifically, the Statement of Claim sets forth claims for negligence, breach of fiduciary duty, breach of contract, and unsuitability involving damage to Beja’s discretionary accounts with Respondent RBC after informing Respondent of its intention to terminate the use of RBC’s investment management and advisory services. Between the time of notification and completion of the termination, Beja alleged over $3 million in losses as a result of RBC’s failure to properly implement Beja’s investment objectives and a failure to reasonably execute the requested asset transfers to Julius Baer and VP Bank in 2000 and 2001.

RBC denied the allegations and sought dismissal of Beja’s claims under FINRA rule 12206(a) on the basis that the claims arose more than 6 years prior to Beja’s filing its Statement of Claim. Further, RBC argued that Rule 12206 is an eligibility provision, not a statute of limitations, so the claim cannot be revived by asserting tolling, lack of notice, or other equitable defense to “extend” the statute of limitations period. The FINRA arbitration panel agreed with RBC and dismissed Beja’s claim as being ineligible for FINRA Arbitration.

Although Rule 12206, as cited in this case, will only be effective until June 5, 2011, its successor rule retains the same “eligibility” provision insulating claims made after 6 years of occurrence regardless of claimants’ lack of notice or equitable defenses as to why their claims could not be sought earlier.

Federal Judge Acquits Glaxo Attorney

2011-05-18T14:45:00.001-05:00

On May 10, 2011, Lauren Stevens, former associate general counsel for GlaxoSmithKline, was acquitted of six criminal charges surrounding allegations of obstruction and providing false answers to an FDA inquiry in violation of 18 U.S.C. 1519.

In November 2010, Stevens was indicted on four counts of making false statements, one count of obstruction of justice, and one count of falsifying and concealing documents related to GlaxoSmithKline’s off-label marketing of the anti-depressant, Wellbutrin. Last month, U.S. District Court Judge Roger Titus dismissed the charges after finding that prosecutors had given inaccurate and incomplete information to the grand jury about Stevens’ key defense--that she depended on the advice of counsel. However, the DOJ re-indicted Stevens after dismissal and the subsequent hearing ensued.

Steven’s case is noteworthy for several reasons. First, it raises concerns with in-house counsel that deal with federal government agencies, including those handling FCPA investigations or answering compliance-related questions from the DOJ, SEC, and FDA. Second, it involved an attorney safe harbor provision housed in federal statutes, which protects attorneys who rely on the advice of outside counsel. Finally, Ms. Stevens was not accused of taking part in the actual underlying wrongdoing, but was still charged in connection with the wrongdoing. This is unusual because “in most off-label drug cases, the government charges senior business executives, not attorneys” according to John Wood, former U.S. Attorney in Missouri.

Judge Titus’ ruling was equally unusual—in his tenure as a federal judge, he had never granted a directed verdict of acquittal before the defense presented its case—until now. In his opinion, Titus wrote, “I believe that it would be a miscarriage of justice to permit this case to go to the jury. There is an enormous potential for abuse in allowing prosecution of an attorney for the giving of legal advice. I conclude that the defendant in this case should never have been prosecuted and she should be permitted to resume her career.”

In coming to his decision, he stated, “it is clear that [Ms. Stevens’ statements made to the FDA] were made in good faith which would negate the requisite element [of specific intent to commit a crime] required for all six of the crimes charged in this case.” Moreover, “GlaxoSmithKline did not come to Ms. Stevens and say, assist us in committing a crime or fraud. It came to her for assistance in responding to a letter from the FDA.”

Titus said Congress designed the safe-harbor provision to protect an attorney who is zealously representing her client and “that vigorously and zealously representing a client is no a basis for charging an offense [of] obstruction of justice.” Titus concluded that Steven’s responses to the FDA “were in the course of her bona fide legal representation of a client and in good faith reliance of both external and internal lawyers for GlaxoSmithKline...[and] every decision that she made and every letter she wrote was done by a consensus.”

Accordingly, "I conclude on the basis of the record before me," Judge Titus said, "that only with a jaundiced eye and with an inference of guilt that's inconsistent with the presumption of innocence could a reasonable jury ever convict this defendant."

LIFE SETTLEMENTS UNDER INVESTIGATION ONCE AGAIN

2011-05-18T11:10:00.001-05:00

The SEC has provided a Wells notice regarding its intention to file civil charges, according to publicly traded life settlements company, Life Partners Holdings, Inc. Life Partners Holdings, Inc. is the parent company of Life Partners, Inc., “one of the oldest and largest life settlement companies in the United States” according to its website.

Life Partners and other life settlement companies purchase “unwanted” life insurance policies from the owners of the policies who may or may not be the insured. The purchasing company then proceeds to re-sell fractional interests in the policies to third parties. The “Life Settlement Provider” purchases the policy for an amount below the net benefit of the policy. Since the third-party purchasers of the interests, through a Life Settlement Broker, are in part responsible for the ongoing premiums on the policy, the amount of time between the purchase of the fractional interest and the death of the insured is a critical element in the investors risk/return evaluation. According to The Wall Street Journal, the Wells notice issued to Life Partners provides notice of impending charges against the company and two top executives related to these critical “life-expectancy estimates.”

Allegations of fraud related to life expectancy estimates received public attention almost a decade ago in connection with Mutual Benefits Corporation in Florida¹. In that case, a doctor providing medical reports in support of life-expectancy estimates was indicted and pled guilty to securities fraud in 2007 and the company was ultimately placed under receivership. The SEC took action as well, and federal litigation followed in 2005 which was in part centered on whether or not viaticals or life settlements qualified as “investment contracts” and were therefore securities under federal securities laws.

In 2009, this law firm procured a settlement on behalf of an investor in a suit filed against a life settlement broker/investment advisor that made multiple grossly unsuitable recommendations to our client for the purchase of hundreds of thousands of dollars of life settlements. The value of the investments were based primarily upon the life-expectancy of insured persons who proved to be nearly immortal, despite promises of near-death status at the time of the viatical purchases. The Missouri Securities Division had previously taken preliminary action, albeit belatedly, against both Mutual Benefits Corporation (in 2004) and our civil defendant (investor complaint received in 2004, Cease and Desist Order issued in the fall of 2006), but both the Securities Division and the Missouri Department of Insurance failed to garner a remedy for the investors or take action against the investment advisors and broker-dealers that failed to supervise the representative/life settlement broker/insurance salesman. In sum, it seems the more things change, the more they stay the same!

1The State of Florida also filed a criminal charge in 2001.

Study Finds It Might Be Better to Fight the SEC & FINRA Than Settle

2011-05-17T11:00:00.001-05:00

A study conducted by financial services law firm Sutherland Asbill & Brennan finds that it sometimes pays for broker-dealers and registered representatives to take on regulators. The study analyzes the outcomes of disciplinary and administrative proceedings between October 2008 and September 2010—the SEC’s 2009 and 2010 fiscal years.

Some key findings:

• 57% of the time, the SEC fails to prove fraud charges, but FINRA had a 100% success rate (4 of 4 fraud charges were proven).

• 33% of SEC respondents were successful in receiving reduced sanctions when cases were appealed from SEC Administrative Law Judge (ALJ) to the full Commission

• 33% of the time the ALJ or the Hearing Panel imposed lower monetary sanctions than the amount FINRA or SEC staff initially sought, but 33% of the time the ALJ or Hearing Panel imposed higher monetary sanctions.

• 28% of SEC respondents got charges dismissed compared with 8.6% of FINRA respondents (out of 237 litigated charges)

• FINRA respondents represented by counsel were significantly more successful than pro se respondents. Since 2006, only one pro se FINRA respondent successfully got charges dismissed.

Often firms and individuals think it is better to settle with the regulators. However, based on the findings of this study, in some circumstances—usually where fraud is charged, respondents will fare better if they come before a judge or hearing panel. Further, the study purports to establish that there might not actually be a “settlement discount,” which is a tactic used by the regulators to incentivize settlement before entering into litigation. However, the study admits that the sample used to determine this finding is not likely a representative sample.

The bottom line: seek legal counsel before making the decision to settle or litigate. Again, the study only finds that litigants are more successful some of the time over those who settle.

FINRA's Ketchum Testifies Before Subcommittee on Oversight and Investigations

2011-05-16T10:34:00.008-05:00

On May 13, 2011, Richard Ketchum, Chairman and CEO of FINRA, testified before the House Subcommittee on Oversight and Investigations. Ketchum's testimony related to the changes made at FINRA as a result of the Special Review Committee, established in 2009 by the Board of Governors, which conducted a review of FINRA's examination program as it related to the detection of fraud and Ponzi schemes. Specifically, he focused on the Special Committee's findings relating to the Ponzi scheme perpetrated by R. Allen Stanford. Stanford was behind the orchestration of a fraudulent, multi-billion dollar investment scheme centering on an $8 billion CD program.

Ketchum testified that between 2003 and 2005, the National Association of Securities Dealers—FINRA's predecessor entity—received information from at least five sources claiming that the Stanford CDs were a potential fraud. Despite the existence of these red flags, FINRA did not launch an investigation of whether the Stanford CD program was a fraud until January 2008.

Ketchum testified that FINRA missed a number of opportunities to uncover the Stanford firm's role in the CD scheme. First, FINRA's Dallas office cut off an investigation because they were unsure of the full scope of FINRA's investigative authority and because they believed that the offshore CDs upon which the Ponzi scheme were based were not "securities" regulated under federal securities laws.

Second, FINRA procedures at the time did not set forth criteria for escalation of a matter to senior management or the use of specially trained investigators based on the gravity and substance of the fraud allegations.

Third, FINRA's Dallas staff did not adequately document communications with the SEC, or discussions within FINRA itself, regarding the CD program.

Finally, FINRA at the time did not have a centralized database that gave examiners direct, electronic access to all relevant complaints and referrals associated with a firm. Consequently, no individual FINRA staff member was ever aware of all of the "red flags" related to the Stanford firm.

Following the investigation, the Special Committee made recommendations which sought to remedy the weaknesses revealed at FINRA. Among the recommendations were the following strategic objectives:

(i) greater emphasis should be placed on the detection of fraud;
(ii) potential fraud situations and other situations presenting serious potential risk to investors should be escalated promptly and properly;
(iii) examination staff should be diligent in pursuing potentially serious issues, exercising an appropriate degree of skepticism;
(iv) all FINRA operating units should closely coordinate and communicate in carrying out the examination program; and
(v) FINRA should provide additional resources to strengthen its cause examination program.

As a result of these recommendations made by the Special Committee, Ketchum stated that FINRA made the following changes:

FINRA created the Office of Fraud Detection and Market Intelligence in October 2009. This group houses the Central Review Group, Office of the Whistleblower and the Insider Trading and Fraud Surveillance teams, and is responsible for the centralized intake and triage of regulatory filings and investor complaints.
FINRA enhanced its examination programs and procedures in a variety of ways intended to help FINRA better detect conduct that could be indicative of fraud. Some of the enhancements FINRA has made to its examination program are: 1) focusing resources on highest-priority matters; 2) enhanced expertise of regulatory staff; 3) enhanced use of third-party and other information; and 4) multi-year technology enhancement plan.
FINRA has increased communication and coordination with the SEC relative to our respective programs. FINRA and SEC staffs meet routinely to share details about strategic design and tactical delivery of information to the respective regulatory programs of each organization.
In late 2010 FINRA created a new Office of Risk to begin the process of strengthening its ability to identify high-risk firms, branch offices, brokers, activities and products through broader data collection and more comprehensive analysis.

Ketchum concluded by stating that these steps will cause FINRA to become a more effective regulator, especially in terms of enhancing its ability to quickly identify and investigate conduct that could indicate fraud or other serious customer harm. A complete copy of Ketchum's statements can be found here. The SEC's litigation release with regard to the Stanford Ponzi scheme can be found here.

Client’s Ponzi Scheme Gets Law Firm and Attorney Sued

2011-05-16T09:19:00.003-05:00

A bankruptcy trustee filed suit April 28th against Estate Financial Inc.’s (EFI) former attorney and her employing firm, Bryan Cave LLP, alleging that their legal advice led to more than $100 million in losses from over 1,500 investors.

The complaint claims that Bryan Cave LLP, an international law firm with lawyers in St. Louis, and one of its attorneys from its Los Angeles office, Katherine Windler, failed to advise EFI to conform to various California and federal laws.

The suit, filed in the central district of California, alleges that Windler and Bryan Cave were retained to conduct a compliance review and audit of EFI’s business practices. The compliance review revealed that EFI was in violation of “countless real estate, securities and corporate laws, rules and regulations.” According to the complaint, regardless of this knowledge, Windler “counseled EFI to continue its current business activities,” which allegedly allowed EFI principals Karen Guth and Josh Yaguda to steal over $100 million from investors through a ponzi scheme. The scheme involved selling membership interests in a fund held by EFI, the Estate Financial Mortgage Fund, LLC, under restricted or expired permits. The complaint cites to various documents and email communications between Windler and EFI’s principals evidencing her purported knowledge of the fraud.

In 2009, Guth and Yaguda pleaded guilty to 26 felony counts of fraud. Guth is serving 12 years in prison and Yaguda 8 years.

This lawsuit serves as a tragic reminder to attorneys that performing in accordance with the rules of professional responsibility should always be at the forefront of any client matter. It also provides a chilling warning to corporations about the need for reputable and honest compliance counseling.

Man Convicted of Eleven Counts of Fraud in Connection with Business Opportunity Scheme

2011-05-11T10:44:00.002-05:00

Yesterday, May 10, 2011, a federal jury in Miami convicted Sirtaj Mathauda of nine counts of mail fraud, two counts of wire fraud, and conspiracy related to a fraudulent business opportunity scheme according to a Department of Justice Press Release.

The complaint charged Mathauda and his co-conspirators of operating bogus companies known as Apex Management Group, USA Beverages Inc., Omega Business Systems and Nation West Distribution. According to the complaint, “the companies operated largely out of phone rooms in Costa Rica and marketed to residents in the United States.”

The companies sold “business opportunities” to own and operate vending machine routes, beverage distributorships, and greeting card distributorships. These opportunities were sold as a complete package, including retail display racks or vending machines, access to high-traffic locations, and assistance in maintaining and operating such businesses. However, the promises of good locations and business assistance were fabricated.

Based on evidence presented at trial, salesmen in the phone rooms told potential customers that the companies were located in the United States and would provide profitable distribution routes for either the vending machines or retail display racks. Further, salesmen asserted that the companies had a track record of success. This so-called “record of success” was backed by phony references pretending to be satisfied customers of the companies.

Mathauda owned, managed or worked at the fraudulent companies in Costa Rica between 2004 and early 2009. Several of his co-conspirators Dilraj “Rosh” Mathauda, Stephen Schultz, Silvio Carrano, Donald Williams, Patrick Williams and Gregory Fleming, previously pled guilty in Miami in connection with their roles in these fraudulent business opportunity scams.

All of the defendants were charged as part of the government’s continued nationwide crackdown on business opportunity fraud. A stance supported by Tony West, Assistant Attorney General for the Justice Department’s Civil Division who stated that “The Department of Justice will continue to prosecute aggressively those who are exploiting consumers to make a quick buck for themselves.” The DOJ is honing in on business opportunity fraud because it “imposes major financial hardship on innocent, hardworking victims” especially now during tough economic times.

Financial Crisis—Hollywood Worthy?

2011-05-11T08:09:00.004-05:00

Yes. Well, at least HBO thinks so. On May 23, 2011, the movie “Too Big To Fail” will premiere on HBO. The movie is based on Andrew Ross Sorkin’s book of the same name detailing the financial meltdown three years ago. The movie attempts to capture the “behind the scenes” look at the men and women who were pivotal in determining the fate of the global economy in the weeks after Wall Street collapsed and the housing marketing imploded. The narrative focuses in particular on Henry Paulsen’s perspective, Secretary of the Treasury and former chairman and CEO of Goldman Sachs.

According to Sorkin “this story and this particular film and the book was really an opportunity to try to take the public inside the room so they could see what happened, so they could actually see the decisions that were made and what the opportunities were and the choices were that they actually had.” “In hindsight, everything looks black-and-white. But with 20/20 hindsight, it's different. When you're actually there, the choices were very different. And I think that this particular project really puts a focus on that. You get to see really what we were up against and how this was perhaps the most catastrophic thing that had happened in our economy since the Great Depression and that we were really on the edge. People don't really appreciate often how close to the edge we really were," he says.

The portrayal of the financial crisis boasts a star-studded cast including James Wood, Paul Giamatti, Tony Shalhoub. A synopsis of the film and scenes from the actual movie can be viewed on HBO’s website.

This isn’t the first time real-life financial and corporate disasters have been the subject of entertainment. In 2005, the documentary film “Enron: The Smartest Guys in the Room” was produced chronicling the 2001 collapse of the Enron Corporation. Several movies about big-time fraudster Bernie Madoff are in post-production and are slated to come out this fall, including a spoof, “Tower Heist,” an action comedy starring Ben Stiller.

Whether truthful portrayals or light-hearted comedies, it seems we will be reliving the financial crisis and surrounding events for years to come, moving forward both in real and reel time.

SEC Whistleblower Program: Compliance Nightmare or Missed Opportunity?

2011-05-04T10:32:00.005-05:00

As part of Dodd-Frank Wall Street Reform and Consumer Protection Act passed last summer, the Securities and Exchange Commission was given the authority to establish a whistleblower program with monetary incentives as a way to entice individuals to come forward about corporate financial wrongdoings. Section 21F provides that whistleblowers who provide new information to the SEC about financial misconduct are able to collect monetary awards totaling between ten and thirty percent of the sanctions recovered through civil or criminal proceedings that total more than $1 million. The SEC characterizes “new information” as information that is original and “based on independent knowledge not already known to the Commission nor taken exclusively from public sources.”

According to the SEC, the new whistleblower authority will help the agency maximize its resources and effectiveness by increasing the number of high-quality tips that it might not otherwise receive without the incentives in place. SEC spokesman, John Nester, has already reported that that SEC has seen a “significant increase in high-quality tips.”

However, the whistleblower program is highly controversial. Many argue that such an incentive program pits employees against employers and creates a disincentive for employees to utilize internal compliance structures mandated by the 2002 Sarbanes-Oxley Act. According to Susan Hackett, senior vice president and general counsel for the Association of Corporate Counsel, the new program encourages “a lot of people who are being opportunistic or who are looking to actually help create problems they can then profit from.” She argues that compliance culture morphs from a “let’s fix it” attitude into a self-enterprising one, which creates clear compliance challenges. Tom Quaadman, vice president of the Capital Markets Competitiveness at the U.S. Chamber of Commerce takes a similar stance. Both advocate that whistleblowers should first be required to make use of internal reporting and investigative systems before submitting their complaints to the SEC. Further, these organizations call for a ban on monetary recovery for individuals who were engaged in the underlying misconduct before reporting. Quaadman asserts that whatever rules are finally implemented need to operate in such a way so as to promote good corporate behavior, not employee contrivance.

Another concern about the proposed Whistleblower Program is that there will be an increase in the number of frivolous allegations. This concern arises from acknowledgement that whistleblower complaints can act as a double-edged sword: they can be instrumental in identifying and correcting corporate misconduct but often, such complaints are made by underperforming employees in an attempt to advance personal grievances against their employer.

To counter these arguments, proponents of the whistleblower program cite to other successful programs with robust monetary rewards like that under the False Claims Act, which helped facilitate large settlements with pharmaceutical giants Pfizer and Eli Lilly for corporate misconduct. They take the stance that individuals who become aware of misdeeds are not eager to blow the whistle, but merely do so to keep their jobs or do what is right. Even among supporters, there is dissonance regarding the scope of the SEC’s proposed program. Some advocate for a broader definition of “whistleblower” and others are skeptical about the program’s potential for success because of limited resources and the program’s failure to address coordination of investigations between overlapping federal agencies.

In November 2010, the SEC released its proposed set of rules that will be used to implement the whistleblower program. The comment period for these rules expired on December 17, 2010, but the SEC has not issued final rules yet. Under the deadline set by Dodd-Frank, the SEC was supposed to have its final rules for the Whistleblower Incentives and Protection Program in place by April 21, 2011. In an April 26 interview, Mary Shapiro, chairman of the SEC, disclosed that the SEC is “now finalizing its whistleblower rules.” However, according to the SEC’s implementation calendar, the planned finalization of the rules is slated to be released between now and July. So far, the only completed installation of the program is the establishment of the new Whistleblower Office and appointment of Sean McKessy as the new director of that office.

Despite the delay in final rules and implementation, whistleblowers are currently protected from retaliation and entitled to applicable monetary rewards because Dodd-Frank provided temporary rules applicable for anyone who came forward after July 22, 2010. These temporary rules remain in effect until the SEC passes its final rules.

SENIOR FINRA OFFICIALS SHARE INSIGHTS AT ST. LOUIS MEETING

2011-04-29T16:11:00.001-05:00

The new director of FINRA District #4 (Iowa, Kansas, Missouri, Minnesota, Nebraska, South Dakota, and North Dakota) along with the Deputy Regional Chief Counsel shared excellent insights today on FINRA's priorities and concerns in both the exam and enforcement arenas. Speaking to a small group of attorneys and industry members, District Director Scott DeArmey stated that the best word to describe FINRA is “change.”

According to Mr. DeArmey, the current priorities for FINRA's examiners include:

Short sales and Reg. SHO
Fraud detection
High frequency trading
Municipal securities
Private security transactions
Hiring and compensation practices.

Mr. DeArmey stressed that FINRA's examiners were applying a more stringent risk-based focus in order to respond more effectively with limited resources¹.

Beyond FINRA industry exam issues, Mr. DeArmey announced and described FINRA's new office of Fraud Detection and Market Intelligence (OFDMI) and its whistle blower hotline. Finally, he noted that the FINRA rulebook consolidation process was “85% complete.”

Mr. DeArmey was followed to the podium by Deputy Regional Chief Counsel Jeff Ziesman. Mr. Ziesman gave a refreshingly candid review of issues with which FINRA enforcement is currently grappling. Beyond the noteworthy (and unproductive) conduct engaged in by enforcement targets from time to time, Mr. Ziesman gave a detailed explanation of the inner-mechanics of the enforcement process as well as the standards for awarding subject cooperation. Finally, Mr. Ziesman provided specific examples of prior cases in which members and their representatives were sanctioned for violating Rule 2010 as a result of their conduct during arbitration proceedings and settlements.

The Bar Association of Metropolitan St. Louis (BAMSL) hosted the event, and the chicken and green beans were superb.

1There are four types of FINRA exams: cycle examinations, cause examinations, trading and marketing surveillance examinations, and sweeps.

FINRA SHIFTS FROM NOTICES TO ENFORCEMENT WHEN IT COMES TO PRIVATE PLACEMENT DUE DILLIGENCE

2011-04-22T15:12:00.003-05:00

NASD Rule 3040 regarding Private Securities Transactions of Associated Persons has been around since 1985. NASD issued Notices to Members on the subject in 1985, 1991, 1994, 1996, 2001 and 2003. The title to the 2001 Notice was: “NASD Reminds Members of their Responsibilities Regarding Private Securities Transactions Involving Notes and Other Securities and Outside Business Activities.” In 2002, a law firm issued a “Client Memorandum” entitled “Be Alert: Regulators are Keeping a Watchful Eye on Outside Business Activities.” Notably, the memorandum began by stating: “Selling away and outside business activities have become hot topics for regulators. The NASD, in particular, has brought numerous formal disciplinary actions...”

Perhaps things really do stay the same the more they change. Earlier this month FINRA issued a news release about sanctions it levied against two firms and several registered representatives that failed to satisfy the mandates of Rule 3040.

On its face, Rule 3040 doesn't appear to be particularly complicated. But its compliance has been eluding industry members for over two decades now.

Rule 3040 requires an associated person to provide written notice to its FINRA member “describing in detail the proposed transaction and the person’s proposed role therein” when the person will be receiving “any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security.” The rule defines a “private security transaction.” Once the member receives the written notice, it can either deny approval of the associated person's proposed participation, or, if it approves: “[record] the transaction...on the books and records of the member and...supervise the person's participation in the transaction as if the transaction were executed on behalf of the member.”

Despite the rule's clear mandate, FINRA's recent enforcement actions demonstrate that associated persons continue to forge ahead on private placements without getting permission from their member firm, and members continue to punt on their due diligence obligations before they give approval in response to a request. That due diligence obligation requires the broker-dealer to perform both a client-specific and reasonable-basis suitability analysis. The latter requires a reasonable investigation of the sale of the private transaction or placement. And simply relying upon information provided by the issuer of the security does not pass the muster as a “reasonable investigation.”

FINRA's news release provides additional details regarding the individual’s sanctioned for their participation in the sale of placements offered by Medical Capital Holdings and Provident Royalties, LLC and the firms for their lack of due diligence on these two placements, as well as those issued by DBSI, Inc. According to FINRA: “without performing proper due diligence, the firms could not identify and understand the inherent risks of these offerings.” Considering the multitude of firms that peddled DBSI notes and TICs in apparent oblivion of Rule 3040, one can surely anticipate future enforcement actions in this area.

Federal Judge Denies Preliminary Class Action Settlement, State Securities Regulators Give Sigh of Relief

2011-04-14T13:22:00.005-05:00

On March 18, the Federal District Court for the Northern District of Texas, refused to a $21 million partial class action settlement with Securities America, a division of Ameriprise Financial.

The case stems from the sale of hundreds of millions of dollars of private placement notes in Medical Capital Holdings, which the SEC deemed to be a fraud in 2009. After the fraud was discovered, many investors filed arbitration claims against Securities of America, others joined together in multiple class actions, and others proceeded individually. The Massachusetts and Montana securities regulators also filed enforcement actions in 2010 against the defendants, which are now in the late-stages of litigation. On February 18, Senior District Judge W. Royal Furgeson, Jr. temporarily stayed several of the arbitration actions proceeding through FINRA while the motion was pending, but refused to halt the state enforcement actions.

The settlement was proposed by representative plaintiffs in three related class actions: Billitteri et al v. Securities America et al, Toomey et al v. Hofhines et al, and McCoy et al v. Cullum & Burks Securities Inc. et al. The representative plaintiffs’ motion sought approval of a 23(b)(1)(B) limited fund settlement with two of the defendant broker-dealers, Securities America, Inc. and Securities America Financial Corporation.

The proposed settlement would have affected all investors, regardless of how they decided to make their legal claim. If granted, the settlement also could have enjoined the state enforcement proceedings. According to the North American Securities Administrators Association, “enjoining state securities regulators [could] have a far-reaching impact by undermining investor protection not only in Massachusetts and Montana, but in other jurisdictions as well.” NASAA further stated that such an effect would make citizens “more vulnerable to fraud and abuse in the offer and sale of securities.” On March 14, NASAA filed a Brief in Opposition to Plaintiff’s Motion for Preliminary Approval of Partial Class Settlement, arguing how approval of the settlement would undercut state regulators’ enforcement ability. The organization was one of many that filed briefs and memoranda with the court regarding this motion.

In his Order, Judge Furgeson, notes the large number of outside parties interested in the outcome of the proposed settlement. He also makes specific mention of the enforcement actions proceeding in the two states, which likely weighed on his decision. However, Judge Furgeson’s order explaining the reasoning behind his decision has not yet been filed.

CITIGROUP TAKES MAJOR HIT IN FINRA ARBITRATION

2011-04-14T12:40:00.003-05:00

In what is being reported as the largest Award ever issued by a FINRA panel in favor of an individual investor, Citigroup was ordered to pay over $50 million to two individual investors. The Award includes $17 million in punitive damages and $3 million in legal fees, despite severe limits on the ability to garner punitives and fees in FINRA arbitrations.

As reported in yesterday's Wall Street Journal, the two victorious investors dealt with the same broker at SmithBarney. Beyond the magnitude of the Award, this case is highly unusual in that the broker testified on behalf of the investors. It is unfortunate that this is such an unusual event because the broker's purported testimony is hardly incredible—the broker-dealer misled the broker about the level of risk associated with the municipal bond fund at issue.

Cosgrove Law, LLC has a claim pending against Fisher Investments in which its client alleges that it was misled as to the risk associated with Fisher's 100% equity fund in 2008. According to Fisher's marketing materials, the portfolio was designed to avoid substantial losses due to asset allocations within the portfolio and the hands-on stewardship of Mr. Fischer and his Investment Policy Committee. Ironically, a Fisher Analyst recently published an article in which he states, in part, “Folks...constantly exhibit huge overconfidence in their own great ideas, and display continuous belief they somehow have insights the rest of the world hasn't thought of.” According to the Fisher Investments Education Center, however, “The Fisher Investment Policy Committee…continuously monitors these drivers to ascertain if any of them are indicating an extreme reading, and if so, whether the market has discounted the factors yet. Only material readings not believed to be fully discounted into pricing are acted upon.” Fisher Investments also purports to “discover unique sources of information to exploit inefficiencies uncovered through unique analysis of widely available information.”

Both the Cosgrove Law, LLC client and the Citigroup clients lost over 50% of their portfolio’s value during the market downturn. Fisher Investments denies liability, as did Citigroup. The SEC is reportedly investigating Citigroup, and it will not confirm or deny the existence of an investigation of Fisher Investments.

The Wall Street Journal article can be located at www.wsj.com. An article regarding a prior SEC and NASD investigation of Fisher Investments can be located at www.businessweek.com.

The Supreme Court Reaffirms Total Mix Test for Materiality

2011-04-13T16:36:00.006-05:00

The U.S. Supreme Court adopted the position urged by the SEC’s amicus brief, affirming its traditional test of materiality in 10b-5 actions in Matrixx Initiatives, Inc., v. Siracusano on March 22, 2011. The unanimous ruling rejected the petitioner’s contention that there should be a bright-line test for materiality in a securities fraud suit, a position that the Court also previously rejected in Basic Inc. v. Levinson.

The complaint alleges that Matrixx made false statements in 2003 about a cold remedy nasal spray, Zicam. The statements publicized the success of the nasal spray, which made Matrixx increase its earning guidance based on increased Zicam sales. However, the company had information from multiple sources showing that the nasal spray could cause loss of smell.

After several product liability suits had been filed, Matrixx continued to state that Zicam was safe and that none of the clinical trials supported findings that the nasal spray caused loss of smell. After an FDA investigation report was released, Matrixx’s share price dropped.

The District Court dismissed the original complaint holding that a pharmaceutical company is not required to disclose such reports unless they are statistically significant—consistent with precedent in the Second Circuit. However, the Ninth Circuit Court of Appeals reversed concluding that the statistically significant test was contrary to the test for materiality set forth by the Supreme Court in Basic and TSC Industries, Inc v. Northway, Inc.. In TSC and Basic, the Court articulated the “total mix” test, which sets the threshold for materiality as satisfied when there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available."

The Supreme Court affirmed the Court of Appeals, holding that “the materiality of adverse event reports cannot be reduced to a bright-line rule. Although in many cases reasonable investors would not consider reports of adverse events to be material information, respondents have alleged facts plausibly suggesting that reasonable investors would have viewed these particular reports as material.” Namely, that Zicam is Matrixx’s key product.

In its reasoning, the Supreme Court again rejected adopting a bright-line approach. Arguments in favor of a bright-line rule are based on the idea that statistical significance is the only indication of causation. However, the Court stated that lack of statistically significant data does not mean that medical experts have no reliable basis for inferring a causal link between a drug and adverse events. The Court concluded that investors may utilize a similar approach: considering context, not just statistical significance for determining causation. Similarly, the question of materiality is based on a contextual inquiry.

In Matrixx, the Court held that the total mix standard for materiality was met because Matrixx received information and reports that indicated a plausible causal link between Zicam and loss of smell. The court held this is sufficient to meet materiality at the pleading stages.

SEC Charges Brokerage Executives With Violations of Regulation S-P

2011-04-13T11:32:00.007-05:00

On April 7, 2011, the SEC charged three former brokerage executives for failing to protect confidential information about their customers in violation of Regulation S-P. Regulation S-P prohibits any broker or dealer, any investment company, or any investment adviser registered with the SEC under the Investment Advisers Act of 1940 from disclosing any nonpublic personal information about a consumer to a non-affiliated third party. "Nonpublic personal information" can include, among other things, the fact that an individual is or has been one of your customers or has obtained a financial product or service from you.

The SEC found that while GunnAllen Financial, Inc., was winding down its business operations last year, its former president and former national sales manager violated customer privacy rules by improperly transferring customer records to another firm. The SEC also found that the former chief compliance officer failed to ensure that the firm's policies and procedures were reasonably designed to safeguard confidential customer information.

According to the SEC's orders, GunnAllen's former president authorized the former national sales manager to take information from more than 16,000 GunnAllen accounts to his new employer. The former sales manager downloaded customer names and addresses, account numbers, and asset values to a portable thumb drive, and provided the records to his new employer after resigning from GunnAllen. The SEC found that the record transfer violated Regulation S-P because account holders were only informed about it after the fact.

Without admitting or denying the SEC's findings, the individuals consented to the entry of an SEC order that censures them and requires them to cease and desist from committing or causing any violations or future violations of the provisions charged. The order also imposed financial penalties against them. This is the first time that the SEC has assessed financial penalties against individuals charged solely with violations of Regulation S-P.

A copy of the SEC's press release can be found here.

FINRA Reprimands St. Louis Brokerage Firm for Poor Oversight

2011-03-18T17:54:00.005-05:00

This month, the Financial Industry Regulatory Authority (FINRA) reprimanded First Clearing, LLC, a St. Louis-based brokerage firm, for insufficient anti-money laundering (AML) protections in FINRA Case #2008012791101.

First Clearing consented to the described sanctions, without admitting or denying the findings, submitting the firm to $400,000 in fines. The AML inadequacies focused on the firm’s practice of only reviewing transactions regarding a limited amount of potentially suspicious activity. FINRA findings stated that “the firm generated many exception reports and alerts dealing with potentially suspicious securities transactions and money movements in customer accounts that were introduced by unaffiliated broker-dealers to the firm.” However, a majority of these exception reports were not reviewed. As a result, FINRA concluded that First Clearing did not have an adequate program for detecting, reviewing, and reporting suspicious activities as required by the Suspicious Activities Report (SAR) reporting provisions of 31 U.S.C. 5318(g) and NASD Rule 3011(a).

Previously in March 2009, FINRA levied fines against First Clearing for the firm’s failure to provide the required notifications to customers over a five-year period ending in 2008.

District Court Retroactively Applies Dodd-Frank Ban on Pre-dispute Arbitration in SOX Whistleblower Claims

2011-03-17T11:39:00.005-05:00

The U.S. District Court for the District of Massachusetts applied the Dodd-Frank Act (“the Act” or “Dodd-Frank”) prohibition on pre-dispute arbitration agreements under the Sarbanes-Oxley (“SOX”) whistleblower protection retroactively. In a March 1 ruling, in Pezza v. Investors Capital, et al, Judge Douglas P. Woodlock, reasoned that retroactive application was appropriate due to the lack of clear Congressional intent to restrict the temporal scope and procedural nature of Section 922.

Section 922 of the Act, among other things, confers jurisdiction on the courts, rather than to a Financial Industry Regulatory Authority (FINRA) arbitration panel, by voiding arbitration provisions in employment agreements that purport to force an employee to arbitrate, rather than litigate disputes arising under Section 806 of SOX.

The suit arose from a claim of wrongful retaliation (in violation of SOX) against the plaintiff after he raised concerns about the defendant’s misconduct in connection with securities transactions. (The plaintiff had previously filed the requisite complaints with the Department of Labor.) The defendants, Investors Capital Corp., Investors Capital Holdings, Inc., and Timothy Murphy, argued that the plaintiff was required to submit his dispute to arbitration, not the courts, pursuant to a pre-dispute arbitration provision in his employment agreement. However, while the defendant’s motion to compel arbitration was under advisement, Congress enacted Dodd-Frank, which included the prohibition on pre-dispute arbitration agreements for whistleblower claims brought under SOX.

In determining whether to apply Section 922 retroactively, the court used the framework setup by the Supreme Court in Fernandez-Vargas v. Gonzales, which essentially instructs a court to first look to whether there is any Congressional intent allowing for retroactive application. If there is no clear indication by Congress, the court then must look to whether retroactive application would result in a disfavored consequence affecting a substantive right. If the court answers in the negative, retroactive application is appropriate.

Here, Section 922 did not include any express provisions or clear statements of Congressional intent regarding retroactivity. Further, after applying the standard rules of statutory construction, the court found nothing that indicated Congress intended for the provision to apply to existing arbitration agreements. The court also found it insufficient that Congress vested the authority to limit future pre-dispute arbitration provisions with the new Bureau of Consumer Financial Protection and the CFTC. Thus the court determined that the result regarding retroactivity under Fernandez-Vargas was inconclusive.

However, under Landgraf v. USI Film Prods, the Supreme Court recognized that jurisdictional statutes may be applied retroactively absent specific legislative authorization without raising retroactivity issues. As a result, the District Court construed Section 922 to be a jurisdictional statute and relied on the holding from Landgraf instead of the retroactivity test under Fernandez-Vargas. Accordingly, the court denied the defendants’ motion to compel arbitration and concluded that Section 922 should be applied retroactively to combat bad conduct arising prior to the enactment of Dodd-Frank.

Second Circuit Reaffirms Refusal to Enforce Arbitration Clause

2011-03-12T07:16:00.004-06:00

Arbitration provisions have been the subject of recent lawsuits, especially those found in credit card agreements. In July 2010, the Minnesota Attorney General, Lori Swanson, filed suit against the National Arbitration Forum, alleging, inter alia, that mandatory arbitration provisions in credit card agreements are unconscionable and unenforceable.

Most recently, on Monday, March 8, 2011, the Second Circuit Court of Appeals reaffirmed its earlier decision not to enforce a mandatory arbitration clause in a credit card agreement. The court’s earlier decision in In re Am. Express. Merchs. Litig. in 2009 held that the pre-dispute arbitration clause in American Express’ credit card agreements was not enforceable because it contained a provision requiring card holders to waive their rights to bring a class action suit. The Supreme Court granted certiorari in 2010 and remanded the case back to the Second Circuit.

The Second Circuit’s 2009 decision applied the Supreme Court’s analysis laid out in dicta in Green Tree Financial Corp.-Alabama v. Randolph. In Greentree, the Supreme Court ruled that a mandatory arbitration clause was unenforceable against a party who proves that the costs of arbitration of a federal statutory claim are so high, such that the arbitration costs effectively prohibit that party from vindicating statutory rights. Accordingly, the Second Circuit concluded that individual arbitrations would be cost-prohibitive and preclude cardholders from asserting their statutory rights under federal antitrust laws. Thus, the arbitration clause was unenforceable.

Subsequent to the Second Circuit’s decision, the Supreme Court ruled in Stolt-Nielsen S.A. v. AnimalFeeds Int’l Corp. that arbitration clauses, which are silent on the issue of class arbitrations, could not be read by arbitrators as reflecting the parties’ agreement on the issue of class arbitration. Pursuant to this decision, American Express petitioned for certiorari, which was granted.

Upon remand, the Second Circuit again concluded that the pre-dispute arbitration clause was unenforceable, determining that the Stolt-Nielsen decision did not alter its previous analysis because Stolt-Nielsen focused on the ability of arbitrators, not courts, to interpret clauses in mandatory arbitration provisions.

This spring, the Supreme Court is set to make another decision regarding class arbitrations in AT&T v. Concepcion. The issue in AT&T is whether the Federal Arbitration Act preempts states from mandating that class arbitration be available as part of an arbitration agreement.

New Form ADV Part 2 “Plain English Rule” Deadlines Fast Approaching

2011-03-06T09:54:00.003-06:00

In July 2010, the Securities and Exchange Commission (“SEC”) adopted changes to Form ADV, Part 2, which became effective October 12, 2010. This section is commonly referred to as the “brochure” and explains an investment adviser’s qualifications, investment strategies, and business practices to investors. Essentially, the amendment requires registered investment advisors to now make disclosures in plain English, as opposed to a fill-in-the blank and check box form. To learn more about the substantive changes of the amendment, please visit our previous securities and investment blog regarding these changes.

The Old Deadlines

When the amendments were adopted, the SEC established two separate deadlines for delivering brochure supplements for existing investment adviser registrants (“Existing Registrants”). Originally, Existing Registrants were required to provide brochure supplements to new and prospective clients upon filing their annual updating amendment to Form ADV for the fiscal year end 2010, and to existing clients within 60 days of filing the annual updating amendment. Noting that most Existing Registrants have a fiscal year end on December 31, existing registrants would be required to deliver their first brochure supplements no later than March 31 and to deliver to existing clients no later than May 31.

New investment adviser registrants (“New Registrants”) applying for registration on or after January 1, 2011 would be required to provide brochure supplements to clients upon registration.

The New Deadlines

However, based on concerns expressed about the deadlines, on December 28, 2010, the SEC extended compliance dates for portions of Form ADV, Part 2. Specifically, the compliance date for Form ADV, Part 2B and the provisions of Rule 204-3 concerning the delivery of brochure supplements is extended approximately four months. Note the extension does not apply to the annual updating amendment deadline.

For Existing Registrants with a fiscal year ending on December 31, 2010 through April 30, 2011, delivery of the brochure supplements to new and prospective clients must occur by July 31, 2011. Delivery to existing clients has been extended to September 30, 2011.

For New Registrants filing applications between January 1, 2011 and April 30, 2011, delivery to new and prospective clients must occur by May 1, 2011. New Registrants have until July 1, 2011 to deliver brochure supplements to existing clients.

Important Dates

March 31, 2011

Filing deadline for all applicants for Form ADV annual updating amendment, including the new Part 2A brochure

May 1, 2011

Delivery deadline for new registrants to deliver brochure supplements [Form ADV, Part 2B] to new and prospective clients

July 1, 2011

Delivery deadline for new registrants to deliver brochure supplements to existing clients

July 31, 2011

Delivery deadline for existing registrants to deliver brochure supplements [Form ADV, Part 2B] to new and prospective clients

Sept. 30, 2011

Delivery deadline for existing registrants to deliver brochure supplements to existing clients

The North American Securities Administrators Association has recommended that state securities authorities provide the same extension for state-registered investment advisors. However, state-registered advisers should contact the states where they are registered to confirm compliance dates. The attorneys at Cosgrove Law, LLC have experience with investment adviser registration matters, including annual and as-needed Form ADV updates and reviews. If you or your company has concerns regarding these amendments to ADV Part 2, please do not hesitate to contact us.

FINRA ISSUES PROPOSAL EXPANDING POOL OF ARBITRATORS QUALIFIED TO HEAR INDUSTRY PROMISSORY NOTE DISPUTES

2011-03-02T10:45:00.001-06:00

An exciting blog this will not be. But alas, some of the most routine rule changes carry the potential of consequences worthy of consideration. Most of you readers know that broker-dealers frequently loan funds to their agents in exchange for a promissory note. These loans and notes are frequently exchanged as part of a broker-dealer's retention incentive program. You may also know that many are the times that the incentives prove insufficient and the broker-dealer ends up suing its former agent for repayment. Indeed, at least one major broker-dealer in St. Louis has an entire division of its legal department dedicated to litigating such matters.

SR-FINRA-2011-05, if approved after public comment, will expand the roster of FINRA arbitrators eligible to hear such matters by removing the current statutory discrimination claim qualification requirement. By doing so, it is likely that a more diverse field of arbitrators will begin hearing these cases. Whether that is a positive development for agents or broker-dealers is yet to be seen. Promissory note cases can be particularly difficult to defend, particularly if they are below the threshold for the expedited FINRA procedures. Valid and meritorious affirmative defenses, particularly those based in equity, are already difficult to develop and present with the restricted discovery available in FINRA arbitrations. Defending the case without any discovery or even a hearing is an even greater challenge. But while SR-FINRA-2011-005 will not remove this current barrier to the full development of equitable affirmative defenses, it may bring a fresh set of eyes to the legal debate surrounding the enforceability of promissory notes. That prospect alone is worthy of the entire industry's support of the proposed amendment to Rule 13806.

Click here if you would like to review the entire rule proposal, including FINRA's “Statement of Purpose” for the proposed rule change. Click here for the SEC's subsequent proposal in the Federal Register.

CFTC Tries On New Dodd-Frank Authority for Size

2011-03-01T11:14:00.003-06:00

The Commodity Futures Trading Commission has recently filed over a dozen enforcement actions against entities allegedly involved in illegally soliciting foreign currency (forex) transactions or engaging in unregistered forex transactions. Thirteen of these actions were filed simultaneously across the country in what the CFTC has dubbed a nationwide sweep. The most recent action was filed on February 18, 2011 against a St. Peters, Missouri resident and three of his Missouri-based business entities for $2.8 Million.

These actions represent the CFTC’s first use of its new authority pursuant to Section 742 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under this Section, entities that participate in the forex market must register with the CFTC and abide by new investor protection rules, such as maintaining certain capital requirements. These additional requirements are purportedly to increase transparency and reduce risk.

As previously forecasted on the Cosgrove Law, LLC blog, Section 742 could potentially expand the “Zelener fix” in the 2008 Farm Bill. The “Zelener Fix” authorizes the CFTC to pursue anti-fraud enforcement actions for transactions conducted on a margin or leveraged basis, especially in the retail forex market. Indeed the CFTC interprets the language in Section 742 as expanding on its enforcement authority, citing that it is taking this opportunity to aggressively pursue enforcement in this sector after the Zelener decision effectively quashed the agency’s efforts in 2004 and the 2008 Farm Bill did little to bolster its enforcement position. The CFTC hopes that this sweep will warn unregistered or noncompliant firms to “shape up or be sued.”

In addition to regulating forex transactions, Section 742 also specifically addresses margined or leveraged retail commodity transactions. However, this Section contains an exception for contracts of sale that either “result in actual delivery within 28 days...” or “create an enforceable obligation to deliver between a seller and a buyer that have the ability to deliver and accept delivery, respectively, in connection with the line of business of the seller and the buyer.” This language loosely tracks state commodity regulation language which exempts certain precious metals contracts, but there are some key differences in term usage. The CFTC has yet to define the distinct terms within this Section. However, none of the actions filed so far pursuant to Section 742 have involved retail commodities dealers, but rather have focused on firms engaging in forex transactions. This is consistent with the Legislature’s primary concern in enacting this portion of Dodd-Frank—to deal with unregulated swaps and foreign currency transactions. Regardless, precious metals firms operating in this area should tread carefully until the CFTC fully defines the scope of this exception.

A New Arbitration Option for Investors

2011-02-04T08:07:00.004-06:00

The Securities and Exchange Commission approved a Financial Industry Regulatory Authority, Inc. proposal giving investors the option to have an all-public arbitration panel. Traditionally, FINRA arbitration panels contain three arbitrators: two public arbitrators and one industry arbitrator—with a “nexus to the securities industry.” The public arbitrators are those who do not have any recent ties to the securities industry.

Over the last 27 months FINRA has been testing a voluntary pilot program that presented investors with the option to eliminate the industry arbitrator and replace that arbitrator with a public panelist. Results from the FINRA pilot program showed that the all-public option was chosen about 60 percent of the time. Further, the findings revealed that having the ability to choose the type of arbitration panel improved investor-claimant’s perception of the process.

The SEC cites in its approval that this new all-public option “will enhance the public’s perception that the FINRA securities arbitration process and rules are fair.” Some State regulators and other investor and consumer groups have long-advocated for all-public arbitration panels. The president of the North American Securities Administration Association, David Massey, further supports this move, but suggests that it should go one step further and allow investors to choose between arbitration and litigation.

Although there has been a big push for all-public arbitration panels, the shift has been controversial for some in the industry. Some industry arbitrators argue that because they know how things are supposed to run in the industry, they are in a unique position to be tougher on bad actors, and that they enhance the ability of the panel to reach the correct conclusion.

The option for an all-public arbitration panel is only applicable to future arbitrations and those currently pending before FINRA where the investor has not yet received a list of potential arbitrators. It is important to note that this change does not apply to investor arbitration proceedings in other arbitration forums, such as JAMS or the AAA. The rule change also does not affect disputes between brokerage firms or brokers.

Additional information about the new arbitration rules is available here.

Another Belated Trend in the Investment World?: Litigation Over Secondary-Market Life Insurance Policy Sales Practices

2011-02-03T09:35:00.002-06:00

A few years ago, I represented a law professor in his quest for relief after purchasing life insurance policies on the terminally immortal. The defendant/respondent life insurance/investment-advisory Representative encouraged the good professor to liquidate hundreds of thousands of dollars in mutual funds and to invest those funds in to “viaticals,” in addition to an ever-rotating team of variable annuities. And like a school kid in February, the Representative moved from one RIA to another, spreading an influenza-like strain of failure-to-supervise liability.

It wasn't too long ago that I followed with fascination the story of the untimely death of the mother-in-law of the former CEO of life insurance company Conseco, Inc. The beneficiary of a $15 million life insurance policy on the elderly woman--whose body was found in a bath tub in 2008--was a company owned by a young male companion whose company she shared on the night of her death. The woman's family has brought a federal lawsuit against the policy issuer – American International Group. The Wall Street Journal covered the story with a page-one article in April of last year as well as a follow up article in October of 2010.

In the viatical case I handled, the purchaser of the policy in the secondary market suffered from ongoing premium payments years beyond those estimated in fraudulent life-expectancy documentation provided at the time of purchase. The fraudulent medicals went hand-in-hand with negligent, if not deceptive investment advice. Securities regulators prone to ADD symptomology fixated their fickle eyes upon “viaticals” back in the late 1990's and the first few years of this decade. At the time, viaticals structured upon policies insuring the lives of those suffering from – and unexpectedly still living with – AIDS was the focus on the passing scrutiny. But, in recent months it has been the issuers of the policies that that have brought legal actions, claiming that their underwriters were defrauded with applications failing to disclose a secondary-market purpose.

In the most recent iteration of the litigation fall-out, the insureds themselves are bringing legal actions. Yesterday's Wall Street Journal provided us with an example. Bruce Porter claims that his insurance agent defrauded him with false promises regarding the marketability of a policy on Mr. Porter's life, the premiums for which were being financed by a trust funded by a bank loan Mr. Porter allegedly guaranteed without his knowledge.

I just recently settled a case in which my client was assured that the 20 years of $118,000 annual premiums on a variable whole life policy would be satisfied in their entirety with the cash value of the policy. Not so much.

Most observers attribute the recent uptick of litigation in this area to the market woes of the last three years. I , for one, am unsure that there was actually any abatement in the litigation or finger pointing in this murky area of the already murky “insurance-as-investment” market.

Slaying Goliath?: Reversal of Arbitration Confidentiality Order

2011-01-28T15:35:00.002-06:00

James Dever never imagined his efforts would overturn a gag order imposed upon private arbitration proceedings. In the midst of a long, successful career with Oppenhemier he was forced to resign for apparently unwarranted reasons centering around his involvement in the investigation of a subordinate’s dishonest and unethical business practices with an elderly couple. The subordinate, Stephen Toussaint, was sentenced to four years in prison, whereas, Dever was asked to step down from his branch manager role by the Chief Executive of Oppenheimer and told to be gone in six months, allegedly claiming pressure from the State of Massachusetts.

Common place in the financial industry is the confidentiality given to both financial institutions and customers regarding any arbitration proceedings. Arbitration agreements are standard, but some do more harm to individuals than the very benefit they were intended to provide. Dever encountered this very issue as the confidentially order regarding his investigation of Toussaint’s unethical business practices and other various documents did more harm than good. His name was damaged in the financial sector, causing him great financial stress. Dever fought to reverse the confidentiality order in an effort to clear his name and bring this matter to the public's eye.

Despite strong objections from Oppenheimer arguing attorney-client privileges and customer privacy laws, Judge McIntyre ruled that “the public’s interest in transparency trumps a financial institution’s interest in concealing its dealings with employees, regulatory agencies, and their lawyers.” In the wake of this substantial ruling, we can attest to the need for more transparency within the financial industry. We may see others challenge long-stood assumptions regarding blanket privacy provisions for arbitrations. Letting some sun light in may benefit both customers and the "honest majority" within the financial sector.

For a more detailed review of this case, one may wish to review the articles written by Boston Globe reporter Beth Healy.

New Year, New Fiduciary Standard?

2011-01-27T03:32:00.003-06:00

It has been about six months since the passing of the Dodd-Frank financial reform law—and that means the results from the many studies commissioned by the Act will begin to be released. Dodd-Frank specifically required the Securities and Exchange Commission to look into regulatory standards and oversight gaps between investment advisors and brokers. Last week, the SEC released the results of its study on Section 913 and 914 dealing with the fiduciary duty issue and stricter investment-adviser examinations, respectively.

The issue of whether to impose a uniform fiduciary standard has been met with both fierce support and opposition. Currently, advisers are held to a fiduciary standard that requires them to act in the best interest of their clients, while brokers are only required to offer suitable products to retail customers. The problem with the dual standard arises where brokers offer advice and sell investment products—blurring the lines for retail investors and making it hard to tell when they are receiving sound investment advice or just a sales pitch.

However, last Friday, the SEC handed over its staff study to Congress recommending a uniform fiduciary standard. The study, if implemented as is, would hold brokers to the same fiduciary level as investment advisers under the Advisers Act when brokers are providing personalized investment advice about securities to retail investors. Therefore, under this study, brokers would only be held to a higher fiduciary duty when acting like an investment advisor.

Justification for a uniform standard stems from the issue of retail investors being unable to distinguish between a broker and an investment advisor. According to the SEC, if consumers are receiving investment advice, regardless of the source—broker or advisor—retail consumers should be protected uniformly. Accordingly, such a standard would achieve that goal. The SEC study also states that it attempted to balance retail investors’ need for protection with their ability to have access to various investment products. Because the standard only applied to brokers when giving investment advice, the SEC takes the position that a wide array of products will continue to still be available.

Further, in an attempt to close oversight gaps and keep implementation costs “to a minimum,” the SEC study also “recommends that when broker-dealers and investment advisers are performing the same or substantially similar functions” the regulatory protections should be “harmonized”, but the study lacks specific details on how to achieve this “harmonization.”

Ultimately, however, the staff study suggests additional research and analysis into this area before any implementation. Additionally, there is no statutory deadline for any follow-up rulemaking pursuant to this study, so it seems unlikely that much will be done without further research and analysis. SEC Commissioners Kathleen Casey and Troy Paredes share this view in their Statement Regarding Study on Investment Advisers and Broker-Dealers and emphasized the need for further research before any uniform fiduciary standard rulemaking begins.

The Wrongful Distribution of Retirement Benefits to a Plan Fiduciary is Prohibited by ERISA Section 406(b)

2011-01-21T13:04:00.005-06:00

Although the distribution of benefits to a plan participant is not a “transaction” as that term is used in Section 406(a), the wrongful distribution of benefits to a plan fiduciary is clearly prohibited conduct under Section 406(b). For example, in Lockheed Corp. v. Spink, 517 U.S. 882 (1996), the plaintiff brought suit against his employer (administrator of his 401(k) plan) under Section 406(a)(1)(D) because the employer wrongfully allowed some of its employees to receive early retirement benefits that the plaintiff was unable to receive. Id. at 892-93. The respondent argued that the payment of benefits is not a “transaction” under Section 406(a). Id. at 892. In its holding, the Court agreed with the respondent, but made clear that its holding was strictly limited to the language of Section 406(a). Indeed, the Court clarified that “the payment of benefits is in fact not a ‘transaction’ in the sense that Congress used that term in § 406(a).” Id. at 892 (emphasis added).

The narrow scope of Lockheed becomes clear upon a review of subsequent federal caselaw. See Armstrong, 2004 WL 1745774, at *10 (holding “payments to participants in accordance with plan terms not to be transactions within the meaning of [Section 406(a)]”); Owen v. SoundView Financial Group, Inc., 54 F.Supp.2d 305, 323 (S.D. N.Y. 1999) (holding that “ERISA's “Prohibited Transaction” rules, see 29 U.S.C. §§ 1106(a) [ERISA Section 406(a)]…are not applicable to the payment of Plan benefits to a Plan beneficiary, because the beneficiary is not a “party in interest”). The limited scope of Lockheed is confirmed by the equally limited scope of Section 406(a). For instance, Section 406(a), entitled, “Transactions between plan and party in interest,” is plainly intended to govern only those transactions in which fiduciaries cause a plan to engage. Indeed, Section 406(a)(1) begins with the following language: “A fiduciary with respect to a plan shall not cause the plan to engage in a transaction, if he knows or should know that such transaction constitutes a direct or indirect. . . .” (emphasis added). Section 406(a)(1) then lists five narrow types of transactions in which a fiduciary should not cause a plan to engage. Courts have determined that the purpose of Section 406(a) is limited to “prevent[ing] plan fiduciaries from engaging in certain transactions that benefit third parties at the expense of plan participants and beneficiaries.” Armstrong v. Amsted Industries, Inc., 2004 WL 1745774, at *10 (N.D. Ill. 2004); Marks v. Independence Blue Cross, 71 F.Supp.2d 432, 437 (E.D. Pa. 1999).

The limited holding of Lockheed (and the subsequent federal court decisions) does not, however, apply in many cases. Indeed, a plaintiff’s prohibited transactions claim against a defendant may be brought under a completely separate ERISA provision: Section 406(b). This Section, entitled “Transactions between plan and fiduciary,” may more clearly apply to a defendant’s conduct. Importantly, unlike Section 406(a), Section 406(b) does not specifically limit which types of transactions apply to the Section. As such, the “transactions” contemplated under Section 406(b) are much broader in scope than those specifically set forth in Section 406(a). Moreover, rather than aiming to prevent plan fiduciaries from engaging in transactions that benefit third parties at the expense of plan participants and beneficiaries, Section 406(b) aims to prevent—among other things—plan fiduciaries from engaging in prohibited transactions for their own account. A plan fiduciary wrongfully using his or her power to obtain a higher distribution than is warranted, for example, obviously falls under the broad conduct contemplated under Section 406(b).

Finally, Section 408(c)(1) reads as follows:

Nothing in [ERISA Section 406] shall be construed to prohibit any fiduciary from—

(1) receiving any benefit to which he may be entitled as a participant or beneficiary in the plan, so long as the benefit is computed and paid on a basis which is consistent with the terms of the plan as applied to all other participants and beneficiaries.

A plain reading of this Section establishes that Section 406 should be construed to prohibit a fiduciary from receiving a benefit that is computed and paid on a basis which is inconsistent with the terms of the plan as applied to all other participants and beneficiaries.

Can a 401(k) plan member recover damages to his individual account caused by a Plan Administrator’s breach of fiduciary duty?

2011-01-20T16:20:00.004-06:00

An ERISA Plaintiff cannot seek individual monetary damages for a Plan Administrator’s breach of fiduciary duty to the plan. Importantly, however, seeking damages on behalf of the 401(k) Plan as a result of a Plaintiff’s losses in his individual account is explicitly permitted under LaRue v. DeWolff, Boberg & Associates, Inc., 552 U.S. 248 (2008), which held that ERISA Section 502(a)(2) authorizes recovery by a plan participant for fiduciary breaches “that impair the value of plan assets in a participant's individual account.” 522 U.S. at 256. The Supreme Court in LaRue made clear its reasoning for this holding:

Whether a fiduciary breach diminishes plan assets payable to all participants and beneficiaries, or only to persons tied to particular individual accounts, it creates the kind of harms that concerned the draftsmen of § 409.

Id. at 256.

For instance, a Plaintiff may rely upon ERISA Section 502(a)(1)(B) for a Defendant’s failure to provide the Plaintiff with the full 401(k) benefits owed to him under the 401(k) Plan at issue. And the Plaintiff may also rely upon ERISA Section 502(a)(2) for a Defendant’s breaches of fiduciary duties. A plain reading of Sections 502(a)(1)(B) and 502(a)(2) establishes that the two sections provide for different relief. Indeed, as the 9th Circuit explicitly noted in Harris v. Amgen, Inc.:

Section 502(a)(1)(B) allows a plan participant “to recover benefits due to him under the terms of his plan.” By contrast, Section 502(a)(2) encompasses claims based on breach of fiduciary duty and allows for the more expansive recovery of “appropriate relief,” including disgorgement of profits and equitable remedies.

573 F.3d 728, 734, n. 4 (9th Cir. 2009) (citations omitted).

Regardless, some defendants incorrectly assert that “the Eighth Circuit and other courts alike have repeatedly held that participants cannot state claims for breach of fiduciary duty under ERISA Section 502(a) when they are also seeking to recover the same benefits under ERISA Section 502(a)(1)(B).” The falsity of this assertion is clear upon a review of the federal caselaw. Indeed, the cases usually cited are inapplicable in that each is either irrelevant or is limited in scope to claims brought under ERISA Sections 502(a)(1)(B) and 502(a)(3), not Sections 502(a)(1)(B) and 502(a)(2). See Geissal ex rel. Estate of Geissal v. Moore Medical Corp., 338 F.3d 926, 933 (8th Cir. 2003) (narrowly holding that a beneficiary cannot bring a claim for benefits under Section 502(a)(1)(B) and Section 502(a)(3)(B)); Conley v. Pitney Bowes, 176 F.3d 1044, 1047 (8th Cir. 1999) (citing Wald v. Southwestern Bell Corporation Customcare Medical Plan, 83 F.3d 1002, 1006 (8th Cir. 1996) in holding that “where a plaintiff is ‘provided adequate relief by [the] right to bring a claim for benefits under [Section 502(a)(1)(B)],’ the plaintiff does not have a cause of action to seek the same remedy under [Section 502(a)(3)(B)]”). Some defendants also cite Coyne & Delaney Co. v. BCBS of Va., Inc., 102 F.3d 712 (4th Cir. 1996). However, Coyne is not relevant in that it analyses whether a plan fiduciary can bring a claim for benefits under ERISA Section 502(a)(3). 102 F.3d at 713.

Some plan defendants also rely upon the U.S. Supreme Court’s holding in LaRue v. DeWolff, Boberg & Assoc., Inc., 552 U.S. 248 (2008) for the proposition that duplicative claims under ERISA Section 502(a)(1)(B) and 502(a)(2) are inappropriate. Specifically, defendants may rely upon commentary by Chief Justice Roberts in that case, without revealing that Justice Roberts wrote the concurring opinion rather than the opinion of the Court. Accordingly, his analysis is not binding. Id. at 249. In fact, at the conclusion of his concurring opinion, Justice Roberts acknowledged that his analysis is not binding on the issue: “In any event, other courts in other cases remain free to consider what we have not—what effect the availability of relief under § 502(a)(1)(B) may have on a plan participant's ability to proceed under § 502(a)(2).” Id. at 260.

Indeed, in Crider v. Life Ins. Co. of N. Am., 2008 WL 2782871 (W.D. Ky. 2008), the Western District of Kentucky acknowledged that Justice Roberts’ analysis in LaRue is not binding, and therefore noted that in deciding whether to allow a claim under both ERISA Section 502(a)(1)(B) and Section 502(a)(2), the question for the court is whether the facts the plaintiff alleges “state a claim for breach of fiduciary duty under Section 502(a)(2) which is separate from her claim for benefits under Section 502(a)(1)(B).” Id. at *2. The court further noted that in deciding this question, the Sixth Circuit has on at least three occasions “allowed plaintiffs to pursue both a claim for benefits under Section 502(a)(1) and also to attempt to hold a plan responsible for breaches of fiduciary duty under a separate Section 502(a) action.” Id. Finally, In Hill v. Blue Cross & Blue Shield of Mich., the Sixth Circuit observed that plan-wide claims are distinct from claims seeking to correct the denial of individual benefits. 409 F.3d 710, 718 (6th Cir. 2005).

Finally, it is well-established that “[i]n ruling on a motion to dismiss, a court must view the allegations of the complaint in the light most favorable to the plaintiff.” Guarantee Co. of North America, USA v. Middleton Bros., Inc., 2010 WL 2553693, at *2 (E.D. Mo. June 23, 2010). To survive a motion to dismiss, a claim need only be facially plausible, “meaning that the factual content…allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged.” Id. (quoting Cole v. Homier Dist. Co., Inc., 599 F.3d 856, 861 (8th Cir. 2010)).

When has an ERISA Plaintiff failed to state a claim for failure to exhaust administrative remedies?

2011-01-17T16:53:00.002-06:00

Point #1: Not all ERISA Plaintiffs are required to exhaust administrative remedies prior to filing suit. Indeed, the Eastern District of Missouri has a well-established rule that “ERISA plaintiffs [must] exhaust the plan review procedures before bringing suit, when the plan clearly requires exhaustion.” Wootten v. Monumental Life Ins. Co., 412 F. Supp. 2d 1020, 1024 (E.D. Mo. 2006). So -- does the 401(k) Plan at issue in your case require exhaustion of administrative remedies if a claim for benefits was never denied.

By way of example, some 401(k) Plans provide that:

“[a]ny Participant or Beneficiary who is entitled to a payment of a benefit for which provision is made in this Plan shall file a written claim with the Plan Administrator on such forms as shall be furnished to him by the Plan Administrator…If a claim for benefit is denied by the Plan Administrator, in whole or in part, the Plan Administrator shall provide adequate notice in writing to the Participant or Beneficiary. . . .

As clearly set forth in this 401(k) Plan example, the plan participant need only exhaust administrative remedies—i.e., file a notice of appeal—if the Plan Administrator denied the participant’s claim for benefits. So the next question is: did the Plan Administrator deny, either in whole or in part, a claim for benefits (equivalent to their requests for distribution)? They likely did if, after requesting distribution, the Plaintiff received a distribution notice which clearly stated, “[y]ou are entitled to distribution under the 401(k) Retirement Plan and Trust.”

Some Plan defendants may rely upon a 1997, non-binding Arizona District Court case, McElwaine v. U.S. West, 1997 WL 34609606 (D. Ariz. 1997), to improperly assert that a miscalculation of retirement benefits is somehow a “separate and new claim.” However, the 401(k) Plan at issue in our example does not set forth such a distinction. And again, at least the Eastern District of Missouri has previously held that exhaustion of remedies is only required if a plan “clearly requires exhaustion.” Wootten, 412 F. Supp. 2d at 1024. Since the 401(k) Plan language above does not “clearly require exhaustion” for a miscalculation (as opposed to a denial) of benefits, the Plaintiff in our example should not be required to exhaust his administrative remedies.

Even if the Court deems that a Plaintiff’s claims for benefits were “denied,” a Plaintiff is still not required to exhaust his administrative remedies if he never received any notice of the proper appeals procedure. The Eastern District is clear that plan participants must only exhaust their administrative remedies “when exhaustion is clearly required by the particular plan involved and the beneficiary has notice of the procedure.” Chorosevic v. MetLife Choices, 2009 WL 723357, at *4 (E.D. Mo. 2009).

The Eighth Circuit is also clear that ERISA plaintiffs are not required to exhaust administrative remedies if doing so would be futile. Brown v. J.B. Hunt Transport Services, Inc., 586 F.3d 1079, 1085 (8th Cir. 2009). “When exhaustion is futile, an ERISA beneficiary's claim accrue[s] at the time at which it became futile to apply for benefits, because…at that time there was a de facto denial of [the beneficiary's] claim.” Union Pacific R. Co. v. Beckham, 138 F.3d 325, 332, n. 4 (8th Cir. 1998). A Defendant’s conduct toward a Plaintiff, both before and after the disbursement of their 401(k) funds, may establish that an exhaustion of Plaintiffs’ administrative remedies would be futile.

Should a Court find that a Plaintiff did in fact fail to exhaust his or her administrative remedies, the Plaintiff should move to stay the proceedings in the case to allow him or her sufficient time to exhaust his or her remedies. Both the Eastern District of Missouri and Eighth Circuit (along with other federal courts) have either held or suggested that a stay of court proceedings is a proper procedure to allow an ERISA plaintiff to exhaust administrative remedies. And courts have generally allowed a stay of the proceedings upon request, either directly or in the alternative. For instance, in a recent 2006 case, the defendants moved for a stay or dismissal of the ERISA suit because the plaintiff had not exhausted administrative remedies. Michael v. American Intern. Group, Inc., 2006 WL 5736351, at *1 (E.D. Mo. 2006). Rather than dismissing the plaintiff’s suit, the District Court stayed the case, noting the Eighth Circuit’s previous holding that “where a claimant has prematurely filed suit, a court may stay proceedings to allow the claimant to complete the administrative review process.” Id. at *1; (citing the Eighth Circuit’s holding in Galman v. Prudential Ins. Co. of Am., 254 F.3d 768, 769 (8th Cir. 2001), wherein the Eighth Circuit affirmed the district court’s stay of proceedings to allow for exhaustion of administrative remedies where claimant prematurely filed suit). Moreover, in Painter v. Golden Rule Ins. Co., 121 F.3d 436 (8th Cir. 1997), the Eighth Circuit suggested that a stay of court proceedings to allow time for a plaintiff to exhaust remedies is a proper procedure upon the plaintiff’s request:

We also reject Painter's suggestion that dismissal of Golden Rule's declaratory judgment action was inevitable. The district court never considered Golden Rule's alternative motion to stay the action while contract remedies were exhausted; had Golden Rule pressed that point after the court corrected its subject matter jurisdiction ruling, a stay might have been granted.

Id. at 441. In its opinion, the Eighth Circuit ratified the district court’s determination that a failure to exhaust remedies is not a jurisdictional defect depriving a court of power over a case. See id. at 440.

Other circuits have similarly held that a stay of the case is proper when a court finds that an ERISA plaintiff failed to exhaust administrative remedies. For instance, the Southern District of West Virginia recently held that a stay is proper in an ERISA case to allow a plaintiff to exhaust administrative remedies. In re Workman, 2005 WL 3481509, at *1 (S.D. W.Va. 2005). In that case, the defendants moved to stay the action, and the only issue before the Southern District was whether a stay of the case was proper. Id. After determining that the plaintiff had not exhausted administrative remedies, the court granted the defendants’ motion to stay pending the plaintiff’s exhaustion of administrative remedies. Id. In addition, in Caldwell v. Western Atlas Intern., 871 F. Supp. 1392 (D. Kan. 1994), the Kansas District Court stayed the case pending the ERISA plaintiff’s exhaustion of administrative remedies instead of dismissing the case. 871 F. Supp. at 1397. In its holding, the court opined that “judicial economy will better be served by staying the proceedings related to plaintiff's ERISA claim, rather than dismissing the claim.” Id.

MORE FALLOUT FROM CDO'S AND CMO'S

2011-01-11T17:18:00.002-06:00

APS Financial Corporation (“APS”) recently entered in to a Letter of Acceptance, Waiver and Consent (“AWC”) with the Financial Industry Regulatory Authority (“FINRA”). As a procedural matter, the AWC was submitted to FINRA's Department of Market Regulation for acceptance or rejection.

It should be noted from the outset that APS consented to the terms of the AWC without admitting or denying the findings contained within it, to wit: violations of NASD Rules 2110, 2440 and 3010 due to allegedly unfair pricing practices directed at certain customers purchasing corporate bonds, collateralized debt obligation.

A recent review of the Securities Litigation Commentator and a daily review of the Wall Street Journal amply illustrates the ongoing regulatory and private litigation fall-out born of the 2006 – 2008 CDO and CMO boom. Indeed, even Charles Schwab got hit by the SEC for $119 million for allegedly making misleading statements regarding the risks associated with a bond mutual fund containing mortgage-backed securities. For a more in depth and interesting narrative of the practices and characters associated with the securitization of residential mortgage debt, this author highly recommends Michael Lewis' The Big Short.

COGNITIVE DISSONANCE: STATES WITH EXPANDED INVESTMENT ADVISER REGULATORY RESPONSIBILITIES LIKELY TO RECEIVE STAGNANT OR REDUCED FUNDING

2011-01-04T17:35:00.006-06:00

This coming summer over 4,000 mid-size investment advisory firms will fall under the auspices of a new regulator: their home state. No longer will they be regulated by the SEC, which managed to conduct regulatory examinations of less than 15% of the approximately 12,000 investment advisers it regulated in 2010. The Dodd-Frank Act's shift of a segment of this nearly unregulated group was intended to improve this situation. But over one-third of the 4,100 investment advisers making the migration will have a new state regulator with either no regular examination program or with an umbilical cord to one of the worst budget crises in the nation: New York, California, Illinois and Massachusetts. And while the regulatory staffs in each of these states are among the best of the best, the situation begs for an answer better than: “we will be able to handle it.” Not only does this answer strain credulity, it seems to ignore the initial premise behind the regulatory shift and expansion of power advocated by state regulators: that they would improve investor protection by doing more and by doing it better than the SEC in the area of regulatory audits for mid-market advisers.

The current lack of a convincing and comprehensive public answer or plan by state regulators in response to the skeptics left the door open for the brokerage industry's self-regulatory organization to insert its foot. Apparently FINRA has recommended that it, or a SRO sister-to-be-created, should fill the feared void. Trade associations haven't missed the opportunity to join the turf war either, with the Financial Services Institute backing FINRA and the Investment Adviser Association siding with the state regulators. This author for one, has no interest in joining the fray and is confident that the data for a more informed evaluation and decision making process will be available in a year or two.

Assuming the states will find a way to digest the new regulatory burdens on the way, investment advisers should begin preparing for the advent of more frequent exams, audits, follow-up inquiries, remedial plans and enforcement actions. Lest I miss the opportunity for a plug – Cosgrove Law, LLC has experience assisting mid-market advisers with compliance issues, regulatory inquiries and enforcement actions.

For more information, or a different take on what I discussed in this entry, see The Wall Street Journal's January 3^rd article on the issues and NCSL.org.

AARP AND NASAA FILE JOINT U.S. SUPREME COURT AMICUS BRIEF REGARDING §10(b) LIABILITY

2010-12-28T09:41:00.003-06:00

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

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

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

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

THIRD CIRCUIT COURT OF APPEALS AFFIRMS SEC's PERMANENT BAR OF BROKER FOR SUITABILITY VIOLATIONS

2010-12-23T10:19:00.003-06:00

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

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

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

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

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

CFTC Proposes Draft Rule on Trading Restrictions

2010-12-17T15:25:00.008-06:00

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

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

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

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

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

DEPARTMENT OF LABOR PROPOSES RULE TO HELP ERISA PLAN PARTICIPANTS BETTER UNDERSTAND TARGET DATE RETIREMENT FUNDS

2010-12-17T10:05:00.000-06:00

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

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

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

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

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

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

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

IS FINRA RULE 3040 REALLY THAT DIFFICULT TO FOLLOW?

2010-12-15T16:46:00.001-06:00

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

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

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

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

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

2010-12-06T14:40:00.002-06:00

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

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

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

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

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

2010-11-30T16:35:00.017-06:00

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Future of OTC Retail Precious Metals Transactions

2010-11-18T20:52:00.000-06:00

DODD-FRANK

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

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

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

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

MODEL STATE COMMODITY CODE

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

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

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

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

WHAT HAPPENS NEXT

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

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

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

SEC Proposes Rules for Tipster Program

2010-11-12T07:46:00.002-06:00

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

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

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

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

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

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

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

DEPARTMENT OF LABOR PROPOSES RULE TO EXPAND THE DEFINITION OF “FIDUCIARY” UNDER ERISA

2010-11-01T12:46:00.001-05:00

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

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

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

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

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

CFTC Unveils New Rules for Market Manipulation

2010-10-27T15:52:00.001-05:00

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

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

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

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

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

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

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

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

2010-10-22T10:18:00.003-05:00

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

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

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

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

Moreover, FINRA notes that NASD Rule 2310 requires that, before recommending the purchase, sale or exchange or a security, a firm must have a reasonable basis for believing that the transaction is suitable for the customer. For commodity futures-linked securities, the registered representative and retail customer should discuss, among other things:

The commodity, basket of commodities or commodities index that a given product tracks;
The product's goals, strategy and structure;
That commodities prices, and the performance of commodity futures-linked securities, can be volatile;
That the use of futures contracts can affect the performance of the product as compared to the performance of the underlying commodity or index;
The product's methodology, including its strategy, if any, for managing roll yield and other factors that may affect performance; and
The product's tax implications. (Commodity pools have different tax implications than mutual funds or exchange-traded notes.)

In sum, due to the volatility of commodities prices and, correspondingly, the performance of commodity futures-linked securities, and due to the prospect that commodity futures-linked securities may produce unexpected results for investors who are not familiar with futures markets, firms should take the necessary precautions to ensure that the sales of commodity futures-linked securities comply with federal securities laws and FINRA rules. A complete copy of Regulatory Notice 10-51 can be found here.

U.S. DEPARTMENT OF LABOR ISSUES FINAL RULE MANDATING GREATER DISCLOSURES IN PARTICIPANT-DIRECTED RETIREMENT PLANS

2010-10-19T10:30:00.000-05:00

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

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

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

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

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

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

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

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

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

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

NASAA Identifies Top Broker-Dealer Compliance Issues

2010-10-12T17:02:00.005-05:00

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

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

Based on the examinations project, the NASAA produced a list of best practices:

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

The NASAA press release announcing the 2010 Broker-Dealer Coordinated Examination Report can be found here.