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

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

The following topics will be covered in the seminar:

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

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

Click here for more information about registration.     

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

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

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

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

Investment Adviser Fiduciary Duty Standard Requires Reasonable Basis for Client Recommendation

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

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

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

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

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

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

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

Court of Appeals Takes Away Realty Company's Victory

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

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

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

2013 WL 6182531 (MD.2013) at 1.

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

But it was not all good news for the investor. The Court concluded that the common law statute of limitations did not supersede the limitations provision set forth in the Act. As such, the investor's claims for violations of the Act's unregistered securities and unregistered broker-dealer provisions were time-barred. But all was not lost. The Court concluded that the investor's claim for fraud in the offer or sale of a security was tolled by a fraudulent concealment statute extraneous to the Securities Act. Moreover, it concluded that whether or not there was, in fact, fraudulent concealment sufficient to toll the statute of limitations was dependent upon a “fact-intensive injury” preclusive of summary judgment².

Finally, the Court concluded that Mr. Mathew's claim for a violation of the Securities Act's unregistered investment adviser provision, as well as his common law tort and contract claims, were also subject to preservation by the fraudulent concealment statute. (CJ Section 5-203). Whether or not these claims were actually preserved (tolled) would be up to a jury.

This case provides an example of why:

1. Investors should seek legal counsel as soon as they suspect something is amiss with one of their investments, and
2. Where appropriate, the court petition or arbitration statement of claim should include both statutory and common law claims.

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1TIC is an acronym for “Tenants in Common Interests.” I previously served as an expert witness in a DBSI TIC suitability arbitration.

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

Mississippi Supreme Court Prohibits Sanctions for Each Affected Investor

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

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

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

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

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

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

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

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

And:

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

Food for thought.

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

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

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

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

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

A review of numerous prior Statutory Disqualification decisions indicates that the following factors are typically considered:

-          the nature and gravity of the disqualifying event;
-          the length of time that has elapsed since the disqualifying event;
-          whether any intervening misconduct has occurred;
-          any other mitigating or aggravating circumstances that may exist;
-          the precise nature of the securities-related activities proposed in the application; and
-          the disciplinary history and industry experience of both the member firm and the person proposed by the firm to serve as the responsible supervisor of the disqualified person.

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

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

Broker-Dealer Submits to State Consent Order

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

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

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