Senate and House Strike Deal on Fiduciary Duty Issue

On June 24, 2010, lawmakers from the House and Senate working to merge two versions of the financial-regulation overhaul into a single bill agreed to let the SEC impose a fiduciary duty on brokers once the regulator completes a six-month review. House lawmakers had earlier proposed implementing stiffer rules without a study period, prompting opposition from senators led by Tim Johnson, a South Dakota Democrat.

Johnson proposed language that could have, among other things, maintained the study requirement. However, Johnson's proposal made it even more difficult for the SEC to act on its findings by allowing the SEC to set new rules regarding the fiduciary duty standard only if the agency concluded after its study that regulatory gaps between certain brokers and investment advisors could not be addressed through other approaches.

A fiduciary duty would obligate brokers to act in the best interest of their clients and to disclose all conflicts of interest. Brokers now only have to ensure a product is suitable before marketing it to a customer. As discussed in an earlier blog post, the expansion of the fiduciary duty has met resistance from the broker-dealer and insurance industries whose sales practices would be subject to the new fiduciary duty standard. Whereas consumer advocates have said the fiduciary obligation is needed because investors can be misled into buying products they don’t understand and are often confused by the titles used by financial advisers.

However, the debate is not over just yet, even if federal lawmakers pass the legislation. Once the job of conducting the study and making the rules goes to the SEC, the debate over the details of just how the new rules will apply will likely continue.

A copy of the Businessweek article discussing this development can be found here, and an article from Financial Advisor Magazine can be found here.

Saving a Buck on Your Compliance Program Might Cost You in the Long Run

If you are an independent investment adviser or small broker dealer that has realized it has a need for compliance assistance, you should choose your compliance counsel carefully. First, if your compliance adviser is not an attorney, your communications with that adviser is unlikely to be protected by the attorney-client privilege in the event of a regulatory inquiry or an enforcement proceeding. If you do choose an attorney in which to place your trust, you should make sure that they have previously been through several SEC, State and FINRA audits, and that he or she is adequately insured. Getting a clear picture of your compliance status is critical, but it might backfire if it can be stolen from you through an investigatory subpoena or civil investigatory demand. Compliance is a far ranging task, and you should apply several sets of eyes to getting it done right. Our firm has helped independent investment advisers with ADV updates and a variety of other regulatory issues. It can be an unnerving task, as there are so many issues and levels that need to be addressed with analytical precision and a depth of knowledge seldom possessed by a single individual. Beyond representing aggrieved investors and brokers in industry disputes, our firm has represented a variety of industry participants that would have been well-served by a preventative compliance program. It will be far more expensive to cure a lapse in compliance than it will to hire a compliance firm or law firm with substantial regulatory as well as industry compliance experience. Members and associates of our firm have been on both sides of regulatory audits and inquiries, and we are ready to help you avoid accidentally triggering a costly customer complaint or regulatory inquiry, investigation or Order.

SEC Proposes New Rules for Target Date Funds

On June 16, 2010, the SEC proposed new rules for target date funds regarding how the funds should be named and marketed. Target date funds have grown in popularity over the past decade. A recent Fortune magazine article noted that, according to Hewitt Associates, about 58% of companies are automatically enrolling employees in 401(k) plans, a number that is expected to grow, and target-date funds are the most popular default investment. The same article stated that target date funds, which held $15 billion of assets in 2002, now hold $269 billion and are expected to hold $1 trillion of retirement savings in just four years, according to Cerulli Associates.

Target date funds are designed to allow investors to hold a diversified portfolio of assets that is rebalanced automatically among asset classes over time. As the target date approaches, a target date fund shifts its asset allocation in a manner that is intended to become more conservative. The schedule by which the fund's asset allocation is adjusted is referred to as the fund's "glide path." Usually the glide path reflects a decreased percentage in stocks as the target date approaches, and an increase in fixed income. At some point, the fund reaches a "landing point," at which time the asset allocation remains fixed.

However, target date fund managers take different approaches to balancing the variety of risks faced by individuals in the marketplace, and thus target date funds with the same retirement year often have different asset allocations. Moreover, some target date funds reach their landing point at or near the target date, while others reach the landing point a significant number of years after the target date.

The SEC noted that as a result of market losses in 2008 along with the increasing significance of target date funds in 401(k) plans, a number of concerns have arisen about how target date funds are named and marketed. Losses in 2008 in funds with a target date of 2010 varied between 9% and 41%. The SEC found that the key factor in this wide variation of losses was the use of different asset allocation models by different funds; i.e. funds with the same target date had significantly different degrees of exposure to volatile asset classes. The SEC acknowledged that this is a result of each fund having a different opinion on what the best "glide path" should be in terms of asset allocation and risk exposure. In the same way, the SEC noted that each investor's ideal "glide path" will depend on factors other than their retirement date including, but not limited to, risk tolerance, other investments, life expectancy, and savings rate.

The SEC found that the name of a target date fund can be cause for concern. Most target date fund names include the year of the target date. This year would presumably coincide with the year of the investor's retirement. However, an investor may not understand the significance of the target date, believing that at the target date their fund's assets will be invested more conservatively to provide a pool of assets for retirements needs. Moreover, they may believe that all funds that have the same date in their name are managed according to a similar asset allocation strategy.

Another area of concern noted by the SEC is the degree to which marketing materials provided to 401(k) participants and other other investors in target date funds may have contributed to a lack of understanding by investors of those funds and their associated investment strategies and risks. The SEC found that the simplicity of the messages in the marketing materials at times belied the fact that the asset allocation strategies among target date fund managers differed. The SEC noted that the appropriateness for an investment depends on not only an investor's retirement date, but also the investor's appetite for risk, other investments, retirement and labor income, expected longevity, and savings rate. In other words, the investor is relying on the fund manager's asset allocation model based only on the year of the target date, which may or may not be appropriate for the particular investor.

In order to remedy these investor concerns, the SEC proposed to amend rule 482 under the Securities Act and rule 34b-1 under the Investment Company Act that, if adopted, would require a target date fund that includes the target date in its name to disclose the fund's asset allocation at the target date immediately adjacent to the first use of the fund's name in the marketing materials. The proposed rule change would also require enhanced disclosure in marketing materials regarding the fund's glide path and asset allocation at the landing point, as well as the risks and considerations that are important when deciding whether to invest in a target date fund.

A complete copy of SEC Release No. 33-9126 can be found here.

SOX Section 307 and ABA Rule 1.13: Corporate Counsel Caught in the Crosshairs

While the duty of loyalty to corporations and the ethical standards of corporate counsel are not new ideas, a periodic reminder about what those standards are is welcome. Corporate counsel owes a duty of loyalty to the corporation, not its officers. Counsel also provides guidance and advice to employees of the organization about how to carry out their fiduciary duties. When counsel has evidence of a misdeed involving an officer or employee that might also have been a client, there are conflicting duties to the corporation and the officer or employee. This is a delicate relationship built on trust and the expectation that generally, communication between corporate employees and corporate attorneys will not be subject to disclosure.

Rule 1.13of the ABA Model Rules of Professional Conduct governs the disclosure standards for corporate counsel and has been adopted by every jurisdiction in some form. (Note that some states, like Missouri, have not adopted the updated version o f Rule 1.13, so reporting outside of the organization is not permissible.) The key elements of Rule 1.13 are the degree of knowledge that triggers attorney reporting of corporate misdeeds and the amount of discretion corporate counsel has in addressing this perceived knowledge. The degree of knowledge that triggers the reporting requirement occurs when the attorney “knows” of ongoing wrongful acts or future wrongful acts. Further, the trigger is only activated when those acts are a violation of law that “reasonably might be imputed to the organization” or that will likely “result in substantial injury to the organization.” Once the attorney learns of such conduct, the attorney is required “to proceed as is reasonably necessary in the best interest of the organization” and accordingly has the discretion to determine how to report: report up within the organization or report outside of the organization.

Reporting outside of the organization is only appropriate when reporting up the chain of command within the organization has been exhausted, no action has been taken by the officers, and when such a violation of law is reasonably certain to result in substantial injury to the organization. Only then may the attorney reveal information to the extent reasonably necessary to prevent substantial injury to the organization. Ultimately, the Model Rules require reporting, but the attorney remains empowered to exercise discretion in determining when to report violations by corporate employees and officers. Giving corporate counsel such discretion is necessary in order to maintain the relationship between corporate counsel and employees of the corporation and avoid discouraging counsel to take action when necessary. The ABA commentators were concerned that weakening the relationship of trust and openness between corporate counsel and corporate employees would lead to less communication and increased risk of corporate employees unintentionally engaging in wrongful behavior.

In addition to the Model Rules, the SEC implemented Section 307 of the Sarbanes-Oxley Act, which sets forth “standards of professional conduct for attorneys appearing and practicing before the [SEC] in any way in the representation of issuers.” The SEC broadly defines “appearing and practicing” to include attorneys that represent issuers and those that do not. Attorneys that have any communications with the SEC or participate in preparing any document that the attorney should anticipate will be submitted to the SEC falls under the scope of “appearing and practicing.” Also, attorneys that have no contact with the SEC may be included under the rule if they advise any party or organization that it is not required to make disclosures or submissions to the SEC or if attorneys represent private companies that do business with public companies and it benefits the public company in any way. This means that in some cases, attorneys may be obligated to report up within an organization that is not their client. For example, the SEC cites a case where a privately held company acts as an investment adviser to a public mutual fund. If the attorney for the private company assists in preparing the mutual fund’s SEC filings, the private company’s attorney will be obligated to report up any misconduct within the public mutual fund’s organization.

Under Section 307, when an attorney becomes aware of evidence of a material violation by the issuer or by any officer, director, employee, or agent of the issuer, the attorney must report up to the chief legal counsel or chief executive officer of the organization. (The SEC defines “material violations” as any material violation of federal securities laws, any material breach of fiduciary duty recognized by common law, or any “similar material violation”.) If the attorney does not receive an appropriate response, the attorney is required to report to the audit committee or the full board.

If the material violation is ongoing or regarding an SEC filing and there is still no appropriate response from the CEO or chief legal counsel, the attorney must notify the SEC that the attorney is disaffirming any “tainted” SEC filing that the attorney participated in preparing. Further, if the participating attorney is outside counsel, the attorney must notify the SEC of withdrawal from representation of the issuer based on “professional considerations,” which the SEC states will “virtually ensur[e]” an immediate SEC inquiry into the matter. Noisy withdrawal and disaffirmation is permitted under Section 307 for material violations that have occurred in the past; however, the SEC has taken the position that failure to disclose past violations may itself be an ongoing violation.

Section 307 also provides for an alternative reporting channel if the issuer’s board of directors establishes a “qualified legal compliance committee.” The QCLC would be comprised of at least one member of the issuer’s audit committee and two or more independent board members. The primary purpose of a QCLC would be to handle attorney reports of misconduct and advise the issuer on how to implement an appropriate response to a report of a material violation.

Further, Section 307 expressly states that it preempts any conflicting state laws unless those state laws impose more stringent requirements. Section 307 is inconsistent with most states’ rules of professional conduct, which are modeled after the ABA Model Rules, to the extent in which they require or permit attorneys to report conduct outside the organization.

When Section 307 was proposed, there was significant controversy. The rule came in the wake of Enron and WorldCom when there was public outcry for more regulation of corporate counsels. Several commentators argued that the rule would create a trap for the unwary because they can apply to attorneys that do not represent public companies. The rule has been criticized because it effectively requires attorneys to “tip” the SEC about misconduct by public companies when state attorney ethics rules would either prohibit disclosure or not require disclosure. Perhaps the biggest concern is that Section 307 would erode the relationship between corporate counsel and corporate employees, which is built on trust and openness, and actually cause more harm than good.

The ethical rules that apply to corporate counsel require attorneys to strike a delicate balance between the attorneys’ duty of loyalty to the corporation and the attorneys’ required conduct regulated by the state and the SEC.

FEDERAL COURTS ADOPT A LIBERAL PLEADING STANDARD FOR ERISA PLAINTIFFS UNDER FEDERAL RULE OF CIVIL PROCEDURE 8

On November 25, 2009, the Eighth Circuit Court of Appeals issued an important decision in Braden v. Wal-Mart Stores, Inc. aimed at preserving employee benefit plan participants’ right to bring suit against ERISA plan fiduciaries despite participants’ limited access to inside information about their plan. In Braden, the plaintiffs brought suit alleging that Wal-Mart’s 401(k) plan paid excessive management fees and that the trustee of the plan breached certain fiduciary duties. Wal-Mart and the other defendants moved for dismissal under Rules 12(b)(1) and 12(b)(6) of the Federal Rules of Civil Procedure—lack of subject matter jurisdiction and failure to state a claim respectively. The District Court for the Western District of Missouri granted the defendants’ motion to dismiss, holding in part that the plaintiff’s complaint was inadequate under Rule 8 of the Federal Rules of Civil Procedure because it did not allege sufficient facts to show how the defendants’ decision-making process was flawed.

On appeal, the Eighth Circuit refused to honor the District Court’s strict interpretation of Rule 8, which requires that a complaint present "a short and plain statement of the claim showing that the pleader is entitled to relief." In order to meet the Rule 8 pleading standard and survive a motion to dismiss under Rule 12(b)(6), a complaint must contain sufficient factual matter, accepted as true, to state a claim to relief that is plausible on its face. A complaint states a plausible claim for relief if its factual content allows the court to draw a reasonable inference that the defendant is liable for the misconduct alleged in the complaint. In Braden, the Eighth Circuit determined that the District Court erred in two ways: (1) the court ignored reasonable inferences supported by the facts alleged, and (2) the court drew inferences in defendants’ favor. As the Eighth Circuit noted, “[e]ach of these errors violates the familiar axiom that on a motion to dismiss, inferences are to be drawn in favor of the non-moving party.”

In its decision, the Eighth Circuit acknowledged that in interpreting Rule 8’s pleading standard, courts must not “ignore the significant costs of discovery in complex litigation and the attendant waste and expense that can be inflicted upon innocent parties by meritless claims.” However, the court further emphasized that in applying Rule 8, courts must be “attendant to ERISA’s remedial purpose and evident intent to prevent through private civil litigation ‘misuse and mismanagement of plan assets.’" Moreover, the court recognized that ERISA plaintiffs often (and perhaps most of the time) lack important information necessary to plead their claims in detail. Accordingly, the court essentially held that the intent behind ERISA requires courts to interpret Rule 8 loosely for ERISA plaintiffs:

Congress intended that private individuals would play an important role in enforcing ERISA's fiduciary duties—duties which have been described as "the highest known to the law." Donovan v. Bierwirth, 680 F.2d 263, 272 n.8 (2d Cir. 1982). In giving effect to this intent, we must be cognizant of the practical context of ERISA litigation. No matter how clever or diligent, ERISA plaintiffs generally lack the inside information necessary to make out their claims in detail unless and until discovery commences. Thus, while a plaintiff must offer sufficient factual allegations to show that he or she is not merely engaged in a fishing expedition or strike suit, we must also take account of their limited access to crucial information. If plaintiffs cannot state a claim without pleading facts which tend systemically to be in the sole possession of defendants, the remedial scheme of the statute will fail, and the crucial rights secured by ERISA will suffer. These considerations counsel careful and holistic evaluation of an ERISA complaint's factual allegations before concluding that they do not support a plausible inference that the plaintiff is entitled to relief.

In the short time since Braden, federal courts have unanimously upheld the Eighth Circuit’s holding, thereby preserving the intent behind ERISA and giving employee benefit plan participants the means to enforce ERISA’s fiduciary duties. See e.g., Jones v. MEMC Electronic Material, Inc., 2010 WL 1038536, at *3-5 (E.D. Mo. March 17, 2010) (denying the defendants’ motion to dismiss and noting that “ERISA plaintiffs generally lack the inside information necessary to make out their claims in detail).

The Eighth Circuit’s decision in Braden will protect future ERISA plaintiffs from motions to dismiss filed by plan fiduciaries which directly conflict with the intent behind ERISA. This will in turn lead to more lawsuits filed against plan fiduciaries for their wrongful conduct, which should ultimately motivate plan fiduciaries to take better care in the administration of their employee benefit plans.

COMPLIANCE ISSUES FINALLY HIT CENTER STAGE

Mr. Walter D. Ricciardi, of Paul, Weiss, Rifkind, Wharton & Garrison, will be lecturing at next month’s ALI-ABA Course of Study on Accountants’ Liability: Litigation and Issues in the Financial Crisis. The conference will address a variety of issues, such as the fact that new federal securities class action filings have significantly increased after the financial collapse in 2008. The ALI-ABA cited that almost half of these new filings are targeted at financial companies and accounting firms, with over 40% of those suits directly related to the subprime crisis.

Mr. Ricciardi was previously the Deputy Director of the Securities and Exchange Commission’s Division of Enforcement and District Administrator of the SEC’s Boston Office. In June 2008, he joined Paul Weiss, Rifkind, Wharton & Garrison and focuses his practice on white collar crime and regulatory defense.

In April 2010, Mr. Ricciardi spoke at the Knowledge Congress’ event on Executing Internal Investigations for Compliance Programs. The webcast primarily focused on the steps necessary to conduct successful internal audits in order to boost corporate compliance programs. Mr. Ricciardi also was a panelist for a National Association of Criminal Defense Lawyers (NACDL) last fall, entitled the Financial Fiasco: Prosecutions & Lawsuites Stemming from the Securities Market Meltdown. During this program, Mr. Ricciardi was reported as stating that “contrary to [the SEC’s] earlier culture where ‘everybody does everything,’ now the SEC has created Specialized Units.” He further noted that although in the past the SEC would only go after the entities and leave out the individuals who has been accused of wrongdoing, this will no longer be the case.

After Mr. Ricciardi spoke, Ira Sorkin, attorney for Bernard Madoff, reportedly agreed that the SEC has changed how it handles white-collar crime investigations and prosecutions. He noted that over the last fifteen years there has been an increase in inter-agency cooperation and parallel proceedings with white collar cases. Mr. Sorkin also commented on the “queen for a day” proffer agreements offered by the SEC and DOJ. He was quoted as stating that these proffers are meaningless because they do not provide much by way of client protection. Instead, Mr. Sorkin suggests that Rule 410 protections are more effective. Sorkin also commented on FINRA and its use of 82(10) proceedings which allow the organization to bring an action to revoke client licenses if clients refuse to talk to FINRA. Furthermore, the transcripts from the 82(10) hearing can be shared with the DOJ or the District Attorney and be the basis for an additional investigation. A full account and commentary of the NACDL presentation can be accessed here.

It is interesting to note that while Mr. Ricciardi was Deputy Director of the SEC’s Division of Enforcement, he led the Division through several proceedings that “significantly advanced” the SEC’s mission to protect investors. For example, a $600 million global settlement involving Prudential Securities’ registered representatives defrauding mutual funds. During his tenure as the District Administrator of the SEC’s Boston Office, Mr. Ricciardi conducted the investigation leading to fraud charges against Biopure Corporation and its then-current general counsel. He also conducted the investigation the led to fraud charges against Raymond James Financial for the Brite Business fraud.

In sum, if you are keeping a watchful eye on compliance, litigation, and regulatory issues—and you should be—the ALI-ABA conference in Boston next month will certainly be worth the price of admission.

About the Author
David Cosgrove is the managing partner of the law firm of Cosgrove Law, LLC. Mr. Cosgrove represents businesses, corporate officers and individuals facing civil, criminal, or administrative enforcement actions by government entities in areas such as securities, annuities, consumer services and products, commodities, and white collar crime. He also has a general litigation and government relations practice. Mr. Cosgrove also serves as the compliance counsel for a national financial products company and represents a national brokerage company, several investment advisors, as well as defrauded investors. Additionally, Mr. Cosgrove has served as an expert witness in various securities litigation matters.
Prior to his return to private practice in 2006, Mr. Cosgrove served as Missouri's Commissioner of Securities where he supervised attorneys, investigators and auditors investigating and prosecuting administrative, civil and criminal violations of the State's securities laws. He can be contacted by phone at (314) 563-2492 or at dcosgrove@cosgrovelawllc.com.

Got Fraud? Delaware’s Corporate Paradise

It’s no secret why most corporations are incorporated in the state of Delaware or require claims against them to be brought in a Delaware court. Delaware is known for having notoriously lax standards for corporate behavior making the state courts very tolerant of corporate misconduct. In fact, the standards are so favorable to corporations, the directors and officers who played an integral role in the demise of Lehman Brothers may not be liable for their conduct because it is protected by the business judgment rule.

The business judgment rule affords limited judicial review of decisions made by the directors of a corporation under the presumption that they are acting on an informed basis, in good faith, and with an honest belief that the decisions made were in the best interest of the company. However, this presumption generally can be overcome by a showing that a director breached his fiduciary duty or a decision was a result of an irrational process. Therefore, the business judgment rule does not protect director decisions made in bad faith. In Delaware, however, the rule protects directors unless there is a showing that their actions rose to the level of gross negligence. Essentially, there is no remedy under Delaware law for nefarious conduct that is not so outrageous so as to be classified as grossly negligent.

Historically, and in most states, the business judgment rule applied only to directors of a corporation because they are held to certain fiduciary standards, unlike corporate officers. However, in a recent Delaware Supreme Court decision, Gantler v. Stephens, the state’s Supreme Court held that corporate officers and directors are bound by the same standard of fiduciary duties. Presumably, this extends the protection of the business judgment rule beyond directors to corporate officers. This conclusion is consistent with the findings of Anton Valukas, the court-appointed examiner of the Lehman Brothers bankruptcy.

Mr. Valukas penned a nine-volume, 2,200-page report on the company’s ruin. In his report, he notes the expansion of officer fiduciary duties and discusses the ramifications of Gantler, most notably, the larger umbrella of the business judgment rule in Delaware. As such, the conduct of Lehman Brothers’ directors and officers is likely insulated from liability because it does not rise to the level of gross negligence, despite alleged fraudulent transactions involving $50-billion in assets moving on and off its financial statements and the failure to heed to warnings from the company’s risk managers.

The business judgment rule and other protections from litigation for directors are necessary, but Delaware’s exceedingly lenient stance on corporate conduct may leave claimants without any recourse and provide even more incentive for companies to incorporate in Delaware.

STATE LAW BREACH OF FIDUCIARY DUTY CLAIMS MAY NOT BE PREEMPTED BY ERISA IF THE DEFENDANT IS NOT AN ERISA FIDUCIARY UNDER THE PLAN

In April 2010, the United States District Court for the Eastern District of Pennsylvania issued an opinion expanding the potential liabilities for ERISA plan advisers who are found not to be fiduciaries under the plan. In Nagy v. De Wese, the plaintiff brought suit against three defendants in part for breach of fiduciary duty under ERISA, unjust enrichment and breach of fiduciary duty under state law. 2010 WL 1375414, at *1 (E.D. Pa. Apr. 7, 2010). One of the defendants, Smith Barney, moved to dismiss the plaintiff’s state law breach of fiduciary duty claim under Rule 12(b)(6) of the Federal Rules of Civil Procedure, asserting that the plaintiff’s state law claim was preempted by ERISA.

In its opinion, the Eastern District offered a detailed analysis of ERISA Section 514(a), which provides that the Act preempts—with certain exceptions—“any and all State laws insofar as they may now or hereafter relate to any other appropriate equitable relief (i) to redress such violations or (ii) to enforce any provisions of this subchapter or the terms of the plan.” (emphasis added). Smith Barney argued that the language of Section 514(a) preempted the plaintiff’s state law breach of fiduciary duty claim because it “related to” an “employee benefit plan” within the meaning of Section 514(a). Significantly, the plaintiff admitted that his state law breach of fiduciary duty claim was preempted if Smith Barney was found to be an ERISA fiduciary. However, the plaintiff asserted that his state law claim was merely an alternative pleading to support recovery if Smith Barney was found not to be an ERISA fiduciary by the court. In response, Smith Barney argued that whether it was an ERISA fiduciary or not was irrelevant to whether the plaintiff’s state law breach of fiduciary duty claim “related to” the plan at issue.

Contrary to Smith Barney’s argument, the Eastern District of Pennsylvania relied upon the Third Circuit’s holding in Glaziers and Glassworkers Union Local No. 252 Annuity Fund v. Newbridge Securities, Inc. in finding that in some instances, ERISA fiduciary status may in fact affect whether a state law claim is preempted. In Glaziers, the Third Circuit Court of Appeals recognized that if a defendant is found not to be an ERISA fiduciary, there is still “room to argue that any fiduciary duty [the defendant] may have had…arises under state law and does not ‘relate to,’ but only ‘affects and involves' an ERISA plan. That is, the state law claim may not relate to the administration of an employee benefit plan at all.”

With Glaziers in mind, the Eastern District analyzed the plaintiff’s state law breach of fiduciary duty claim as follows:

"Unlike plaintiff’s allegations that Smith Barney breached fiduciary duties owed to the Plan, which involve duties owed under state law by virtue of the Plan’s status as Smith Barney’s customer, and not as an ERISA plan, the allegations that Smith Barney breach fiduciary duties owed to the Plan’s participants depend on the existence of, and Smith Barney’s knowledge of, the Plan. Because the existence of the Plan and Smith Barney’s knowledge of the Plan are essential elements of the state law breach of fiduciary duty claim to the extent that the claim alleges breach of duties owed to the Plan’s participants, that claim is preempted."

Relying on Glaziers, the Eastern District ultimately granted in part and denied in part Smith Barney’s Rule 12(b)(6) motion to dismiss. Specifically, the court held that the plaintiff’s state law breach of fiduciary duty claim was preempted to the extent it sought to recover for Smith Barney’s breach of fiduciary duties owed to the plan participants. However, the plaintiff’s breach of fiduciary duty claim was not preempted to the extent that it sought to recover for Smith Barney’s breach of fiduciary duties owed to the plan itself if Smith Barney was determined not to be an ERISA fiduciary.

The Eastern District of Pennsylvania’s holding in Nagy v. De Wese leaves open the possibility that an ERISA plan adviser may incur fiduciary liability for its conduct with regard to an ERISA plan even though that adviser is not an ERISA fiduciary under the plan.

A copy of the Nagy v. De Wese opinion can be found here.

Don’t Allege Fraud In A Federal Securities PPM Claim Unless Scienter is an Element

A Federal District Court in the Northern District of Illinois issued an unforgiving dismissal of a Federal securities law complaint earlier this year. The interesting twist to the case is that the Plaintiffs’ 12(a)(2) 1933 Act claim was dismissed pursuant to Rule 9(b), even though such claims lack a fraud element. The Court acknowledged that Rule 9(b) actually applies to allegations rather than claims, but concluded it’s rightful application to the Plaintiff’s allegations rendered insufficient both the 12(a) and 10(b) claims once the fraud allegations were stricken for lack of specificity. The opinion’s review of the Plaintiff’s allegations, however, seems to undermine itself, at least as to the 12(a)(2) claim. The Plaintiff’s undoubtedly pled that the Private Placement Memorandum at issue omitted to state a material fact, particularly when the Rule 12(b)(a) reasonable inference is applied. As such, the conclusion that the 12(a)(2) claim fails when stripped of the unnecessary scienter accusations is at least harsh if not incorrect. This is particularly true when coupled with the Court’s concession that another district court in the Northern District held that “a Plaintiff should not be required to plead what it need not prove” just the year before.

Regardless, the Court’s opinion clearly indicates that it was dissatisfied with what it considered insufficient allegations of motive, which are almost impossible to specify prior to discovery in arms-length transactions. For example, in this case, the Plaintiffs alleged that the Defendants from Advanced Equities, Inc. stated to the Plaintiffs that they were “significantly involved” for several months with the company whose shares they were promoting and yet the initial PPM issued by the Defendants omitted the fact that the company founder had a felony conviction for embezzlement. A supplemental PPM issued about 12 weeks after the first PPM and only five weeks after the Plaintiffs invested almost $2,000,000 made belated disclosures of material obligations, litigation, and mismanagement. Whether or not the Defendants knew of the material issues prior to their issuance of the first PPM is irrelevant for §12(a)(2) liability, but since the Plaintiffs chose to allege that the Defendants did know and that their representations were fraudulent, they lost the entire claim for lack of specificity as to these allegations. The Court even dinged the Plaintiffs for failing to identify which of the two officer-Defendants made which representations and omissions within the Placement Memorandum. How any outside stock purchaser would be able to know that pre-discovery is a mystery the opinion fails to solve.

In sum, attorneys must be very careful not to plead too little – or too much – in certain courtrooms of the Northern District. The case is Greer v. Advanced Equities, Inc. and can be reviewed by clicking here.

Investors Paying for Rights to Madoff Recovery Funds

There are companies that will pay upfront for the rights to a settlement or recovery of a plaintiff's lawsuit. Other companies will loan money to a plaintiff to fund the lawsuit with no payment until the case settles or the plaintiff is victorious at trial. The Wall Street Journal is reporting that some investors are approaching victims of Mr. Madoff's Ponzi scheme, offering to buy them out at a discount for their claims to what is eventually recovered by the court appointed trustee who is gathering assets for Madoff victims.

One firm, ASM Capital, based in Woodbury, N.Y., is offering either to make an immediate payment of 20% of claims in exchange for the full claim; or make an upfront payment of 16% of the claims, with the investor keeping 33% of future recoveries. For those with claims less than $1 million, the payout could be slightly less. ASM often extends offers to vendors who have claims against companies that seek bankruptcy protection, though it also has purchased claims of investors in frauds.

Whether this offer is fair to an investor hinges on several factors which are unknown at this time. Most important are how much the trustee is likely to recover and how many investors will share in the recovery. So far, the trustee has collected $1.5 billion. But he is expected to recover at least $2 billion from the estate of Jeffry Picower, an investor in Mr. Madoff's scheme who died last fall. A lawyer for the trustee has said the trustee might be able to recover as much as $10 billion for investors.

As for the total amount of investor losses, the trustee has said they could top off at $20 billion or less. But litigation currently under way challenges the trustee's methodology determining which victims of Mr. Madoff should be entitled to claims. So far a court has affirmed the trustee's view, which yields a smaller pool. But, if he ultimately loses on appeal, the loss figure "will approach $60 billion," the trustee said in an interview. Given these factors, victims could see anywhere from around 50 cents on the dollar to less than 15 cents.

A copy of the Wall Street Journal article on this topic can be found here.