On June 30, 2010, a Massachusetts state court overturned a gag order imposed by a FINRA arbitration panel that required an entire arbitration proceeding, including all testimony, documents and hearing transcripts, to remain strictly confidential. The claimant in that proceeding, a former Oppenheimer & Co. branch manager, James F. Dever, said the gag order effectively prohibited him from trying to clear his record after the arbitration proceeding. Judge Frances A. McIntyre of the Suffolk Superior Court in Boston overturned the FINRA panel’s broad-reaching order of secrecy, holding that it offended public policy and violated the First Amendment by restricting free speech. Judge McIntyre’s decision made clear that courts will review and overturn confidentiality orders that unlawfully restrict parties’ constitutional rights.
The decision will likely have important ramifications for customers and financial institutions within the investment industry. Arbitration agreements are standard in the investment industry, and arbitration forums such as FINRA generally require arbitrators to protect the confidentiality sought by the parties. In most instances, customers and financial institutions enjoy the confidentiality of arbitration proceedings. However, the parties do not always wish to remain silent about the nature of the proceedings. Judge McIntyre’s June 30th holding suggests that under the First Amendment, arbitrators cannot cloak arbitration proceedings with secrecy by forcing the parties to remain silent about the proceedings.
In order to protect their clients’ rights, attorneys handling financial industry lawsuits must be familiar with the intricacies of the arbitration process, whether it be through FINRA, JAMS, AAA or some other arbitration forum. Cosgrove Law, LLC has extensive experience in the arbitration process and regularly represents investors in arbitral forums.
Tuesday, July 13, 2010
Friday, July 9, 2010
Investor Who Backed Development of the "Candwich" Sued by the SEC
On July 1, 2010, the Securities and Exchange Commission brought a civil action against Travis L. Wright in the United States District Court for the Central District of Utah. The suit alleges that from the fall of 2001 through the spring of 2009, Wright, directly and through several sales agents, sold securities in the form of secured promissory notes issued by the Waterford Loan Fund, LLC, to approximately 175 investors in unregistered, non-exempt transactions, raising approximately $145 million. The notes bore interest at varying rates, from a rate of 2% up to a rate of 24% per year.
During the offer and sale of these securities, Wright represented to investors that their funds would be used only to make “hard money” loans secured by first liens on commercial real estate and that all the assets belonging to the Fund would be placed into a trust and held for their collective benefit. However, only about $6 million of the funds raised from investors were used in this manner, and no such trust existed. In addition, Wright failed to disclose to investors that he was using a significant amount of their funds for his personal benefit.
The SEC brought claims for 1) employment of a device, scheme, or artifice to defraud in violation of of Section 17(a)(1) of the Securities Act [15 U.S.C. § 77q(a)(1)]; 2) fraud in the sale of securities in violations of Section 17(a)(2) and (3) of the Securities Act [15 U.S.C. § 77q(a)(2) and (3)]; 3) fraud in connection with the sale and purchase of securities in violations of Section 10(b) of the Exchange Act [15 U.S.C. § 78j(b)] and Rule 10b-5 thereunder [17 C.F.R. § 240.10b-5] 4) offer and sale of unregistered securities in violation of violation of Sections 5(a) and (c) of the Securities Act [15 U.S.C. § 77e(a) and (c)]; and 5) offer and sale of securities by an unregistered broker or dealer in violation of Section 15(a) of the Exchange Act [15 U.S.C. § 78o(a)].
While these causes of action are not unusual in an investor fraud case such as this, the facts underling the claims are what makes this case interesting. As noted earlier, Mr. Wright did not use the majority of the funds he raised through the sale of the promissory notes for the purposes represented to the investors. Instead, he used the funds on himself and for a variety of speculative investments, including money put into a company called Mark One Foods, which was developing the sales of canned sandwiches - i.e. the "Candwich."
The New York Times reported that the president of Mark One Foods, Mark Kirkland, who claimed to have patented the idea of putting solid food in a canned beverage container, said Wright pledged financial backing for Candwich. The Candwich is to be available in peanut butter with strawberry or grape jelly, as well as bar-b-que chicken. Pepperoni Pizza Pocket and French Toast in a can are also planned.
This case is yet another reminder to investors to be vigilant in looking out for scammers pitching "too good to be true" investments. A complete copy of the SEC's Complaint (courtesy of www.npr.org) can be found here, and the New York Times article discussing the case can be found here.
During the offer and sale of these securities, Wright represented to investors that their funds would be used only to make “hard money” loans secured by first liens on commercial real estate and that all the assets belonging to the Fund would be placed into a trust and held for their collective benefit. However, only about $6 million of the funds raised from investors were used in this manner, and no such trust existed. In addition, Wright failed to disclose to investors that he was using a significant amount of their funds for his personal benefit.
The SEC brought claims for 1) employment of a device, scheme, or artifice to defraud in violation of of Section 17(a)(1) of the Securities Act [15 U.S.C. § 77q(a)(1)]; 2) fraud in the sale of securities in violations of Section 17(a)(2) and (3) of the Securities Act [15 U.S.C. § 77q(a)(2) and (3)]; 3) fraud in connection with the sale and purchase of securities in violations of Section 10(b) of the Exchange Act [15 U.S.C. § 78j(b)] and Rule 10b-5 thereunder [17 C.F.R. § 240.10b-5] 4) offer and sale of unregistered securities in violation of violation of Sections 5(a) and (c) of the Securities Act [15 U.S.C. § 77e(a) and (c)]; and 5) offer and sale of securities by an unregistered broker or dealer in violation of Section 15(a) of the Exchange Act [15 U.S.C. § 78o(a)].
While these causes of action are not unusual in an investor fraud case such as this, the facts underling the claims are what makes this case interesting. As noted earlier, Mr. Wright did not use the majority of the funds he raised through the sale of the promissory notes for the purposes represented to the investors. Instead, he used the funds on himself and for a variety of speculative investments, including money put into a company called Mark One Foods, which was developing the sales of canned sandwiches - i.e. the "Candwich."
The New York Times reported that the president of Mark One Foods, Mark Kirkland, who claimed to have patented the idea of putting solid food in a canned beverage container, said Wright pledged financial backing for Candwich. The Candwich is to be available in peanut butter with strawberry or grape jelly, as well as bar-b-que chicken. Pepperoni Pizza Pocket and French Toast in a can are also planned.
This case is yet another reminder to investors to be vigilant in looking out for scammers pitching "too good to be true" investments. A complete copy of the SEC's Complaint (courtesy of www.npr.org) can be found here, and the New York Times article discussing the case can be found here.
Thursday, July 8, 2010
IS SCALIA’S RENT-A-CENTER OPINION AS DRASTIC AS SOME DECRY?
Late last month the U.S. Supreme Court handed down a 5-4 decision in the matter of Rent-A-Center, West, Inc. v. Jackson, No. 09-497. Scalia writes for the majority in reversing the 9th Circuit Court of Appeals. The 9th Circuit had overruled, in part, the District Court’s refusal to grant the Defendant’s Motion to Compel arbitration. The usual cast of supporting characters joined Scalia’s majority. Ginsberg, Breyer and Sotomayer joined Steven’s strong dissent. The Consumer Law and Policy Blog announced that the opinion “dealt a major blow to consumers.” So what is all the fuss about?
Generally speaking (for blog purposes), challenges to an arbitration provision are delegated to the Court’s while challenges to the enforceability of the arbitration provision based upon the formation of the contract serving as the repository of the arbitration agreement is reserved for the arbitrator – if explicitly agreed to by the parties. This “basic” demarcation got pretty blurry in Rent-A-Center because the arbitration provision and the contract were one in the same. Scalia’s somewhat incredible conclusion that this unique situation makes no difference is deemed “simply wrong” by the dissent. Scalia’s majority concluded that since 1) the Plaintiff challenged nothing but the contract as a whole, and 2) the arbitration had text delegating this “agreement to arbitrate” threshold issue to the arbitrator in “clear and unmistakable” terms, the Plaintiff had to bring the issue to the arbitrator.
The opinion’s logic is detached from reality and its self-justification is a bit disingenuous when it professes its result to be both obvious and inescapable. For example, the majority again holds that a provision within a contract assigning litigation to an arbitrator (selected by the defendant) is enforceable even if the plaintiff’s execution of the contract was induced by fraud unless the arbitrator hailed aboard the fraudulent vessel concludes -- in effect -- that his employment was fraudulently induced by his or her indirect employer. Although it is a bit unclear, Scalia seems to declare that the plaintiff must specifically allege that, in certain circumstances, the delegation clause within the arbitration provision itself was invalid before the court can evaluate that type of claim. The minority castigates the majority’s reasoning as “fantastic” and characterizes it as “Russian nesting dolls.”
But not all is lost for those challenging an arbitration agreement. For example, claims challenging the conscionability of the delegation clause itself – procedural and substantive – are still reserved for the courts, and so too are challenges to the agreement to arbitrate as a whole in the absence of a “clear and unmistakable delegation provision.” And the Court does not address the situation where the arbitration provision itself contains conflicting “access to court” provisions. Nor does it address the situation where an arbitrator (being paid handsomely) refuses to decide “gateway issues” purportedly delegated to him until the end of the arbitration hearing on the merits. And what about those situations where the party moving to compel arbitration has breached the delegation clause during the arbitration by refusing to litigate certain claims?
Furthermore, Scalia seems to leave open the door to a challenge to whether or not an agreement “was ever concluded” (as opposed to a “validity” challenge to the contract as a whole.) So now ask yourself – if, as both Scalia and the dissent claim, the enforceability of an arbitration agreement is a matter of contract law – can a contract induced by fraud ever “be concluded?” Doesn’t there need to be a meeting of the minds before an “agreement” exists or a contract is formed, and therefore “concluded”? The greatest fiction of all set out in Scalia’s opinion may be this assertion that arbitration analysis is based on contract law. This claim would have more credence but for the absurd yet necessary presumption that a consumer signing a commercial adhesion contract with an arbitration provision would have any ability to comprehend what he or she was actually agreeing to in light of the state of the law reflected in the Rent-A-Center majority and dissenting opinion. In many instances there is nothing wrong with arbitration, but the assumption that consumers understand what they are agreeing to when five Supreme Court Justices disagree with four Supreme Court Justices on the issue seems pretty alien to contract law.
How a delegation clause resting within an invalid arbitration provision could be binding is the new mystery created by Rent-A-Center. But it is merely a evolution of the original mystery: how an arbitration provision within a fraudulently induced contract could be binding so as to send the fraud issue to the arbitrator. So, at the end of this new day, it seems that: 1) Challenges to the validity/unconscionability/legally binding status “of a written agreement to arbitrate” these gateway issues goes to the court in the absence of an explicit delegation of gateway issues; 2) Challenges to the contract as a whole as to whether or not it was “concluded” goes to the court; 3) Challenges to the validity of the delegation clause goes to the court; 4) Challenges to the validity of the “contract as a whole” goes to the arbitrator only if there is a valid delegation provision.
In sum, and to use Scalia’s words – simply be sure to direct your challenge to the arbitration provision, at least in part, “specifically to the agreement to arbitrate” validity and enforceability issues.
Generally speaking (for blog purposes), challenges to an arbitration provision are delegated to the Court’s while challenges to the enforceability of the arbitration provision based upon the formation of the contract serving as the repository of the arbitration agreement is reserved for the arbitrator – if explicitly agreed to by the parties. This “basic” demarcation got pretty blurry in Rent-A-Center because the arbitration provision and the contract were one in the same. Scalia’s somewhat incredible conclusion that this unique situation makes no difference is deemed “simply wrong” by the dissent. Scalia’s majority concluded that since 1) the Plaintiff challenged nothing but the contract as a whole, and 2) the arbitration had text delegating this “agreement to arbitrate” threshold issue to the arbitrator in “clear and unmistakable” terms, the Plaintiff had to bring the issue to the arbitrator.
The opinion’s logic is detached from reality and its self-justification is a bit disingenuous when it professes its result to be both obvious and inescapable. For example, the majority again holds that a provision within a contract assigning litigation to an arbitrator (selected by the defendant) is enforceable even if the plaintiff’s execution of the contract was induced by fraud unless the arbitrator hailed aboard the fraudulent vessel concludes -- in effect -- that his employment was fraudulently induced by his or her indirect employer. Although it is a bit unclear, Scalia seems to declare that the plaintiff must specifically allege that, in certain circumstances, the delegation clause within the arbitration provision itself was invalid before the court can evaluate that type of claim. The minority castigates the majority’s reasoning as “fantastic” and characterizes it as “Russian nesting dolls.”
But not all is lost for those challenging an arbitration agreement. For example, claims challenging the conscionability of the delegation clause itself – procedural and substantive – are still reserved for the courts, and so too are challenges to the agreement to arbitrate as a whole in the absence of a “clear and unmistakable delegation provision.” And the Court does not address the situation where the arbitration provision itself contains conflicting “access to court” provisions. Nor does it address the situation where an arbitrator (being paid handsomely) refuses to decide “gateway issues” purportedly delegated to him until the end of the arbitration hearing on the merits. And what about those situations where the party moving to compel arbitration has breached the delegation clause during the arbitration by refusing to litigate certain claims?
Furthermore, Scalia seems to leave open the door to a challenge to whether or not an agreement “was ever concluded” (as opposed to a “validity” challenge to the contract as a whole.) So now ask yourself – if, as both Scalia and the dissent claim, the enforceability of an arbitration agreement is a matter of contract law – can a contract induced by fraud ever “be concluded?” Doesn’t there need to be a meeting of the minds before an “agreement” exists or a contract is formed, and therefore “concluded”? The greatest fiction of all set out in Scalia’s opinion may be this assertion that arbitration analysis is based on contract law. This claim would have more credence but for the absurd yet necessary presumption that a consumer signing a commercial adhesion contract with an arbitration provision would have any ability to comprehend what he or she was actually agreeing to in light of the state of the law reflected in the Rent-A-Center majority and dissenting opinion. In many instances there is nothing wrong with arbitration, but the assumption that consumers understand what they are agreeing to when five Supreme Court Justices disagree with four Supreme Court Justices on the issue seems pretty alien to contract law.
How a delegation clause resting within an invalid arbitration provision could be binding is the new mystery created by Rent-A-Center. But it is merely a evolution of the original mystery: how an arbitration provision within a fraudulently induced contract could be binding so as to send the fraud issue to the arbitrator. So, at the end of this new day, it seems that: 1) Challenges to the validity/unconscionability/legally binding status “of a written agreement to arbitrate” these gateway issues goes to the court in the absence of an explicit delegation of gateway issues; 2) Challenges to the contract as a whole as to whether or not it was “concluded” goes to the court; 3) Challenges to the validity of the delegation clause goes to the court; 4) Challenges to the validity of the “contract as a whole” goes to the arbitrator only if there is a valid delegation provision.
In sum, and to use Scalia’s words – simply be sure to direct your challenge to the arbitration provision, at least in part, “specifically to the agreement to arbitrate” validity and enforceability issues.
Friday, June 25, 2010
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.
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.
Monday, June 21, 2010
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.
Friday, June 18, 2010
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.
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.
Wednesday, June 16, 2010
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.
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.
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