A Compilation of Enforcement and Non-Enforcement Actions

21 May 2008 Publication
Author(s): Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Director Describes Examination Focus
During a recent conference in Washington, D.C., Lori Richards, Director of the Office of Compliance Inspections and Examinations of the U.S. Securities and Exchange Commission (SEC) described the top 10 focus areas of current SEC examinations, which are described below. In addition, Associate Director Gene Gohlke of the same office recently reported that approximately 11,000 investment adviser firms are currently registered with the SEC. In 2007, approximately 1,400 exams of such firms were conducted. SEC Division of Enforcement Chief Counsel Joan McKown reported that her division conducted 655 enforcement actions, of which approximately 12 percent involved investment adviser firms. (IA Compliance Best Practices Summit 2008, Washington, D.C. (March 20 – 21, 2008))

Portfolio Management
The SEC will review as to whether the securities investments made for investment advisory clients and funds are consistent with the client’s investment objectives and restrictions and with disclosure in the fund’s offering document. In particular, the SEC has been focusing on derivative investments as to suitability for clients.

Best Execution and Soft Dollars
The SEC is reviewing the investment advisory’s brokerage arrangements as to determining best execution for clients. In addition, the examiners are reviewing for disclosure to clients with respect to best execution, soft dollars, and brokerage arrangements.

Performance Advertising and Marketing
The SEC examiners are reviewing for advertisements and brochures with respect to past investment performance to determine if it is accurately stated.

Use of Solicitors
The SEC reviews the use of solicitors and the agreements required for each. The examiners will review to determine if the solicitors are providing the required disclosure to persons they solicited and whether or not investment advisers have procedures in place to ensure that such disclosures are provided timely.

Evaluation Issues
The SEC is reviewing the types of controls used by the investment advisers to ensure that pricing of illiquid or other non-public securities are accurately priced. The examiners are concerned about accurate valuation of such securities so their clients are not overbilled for such investments.

Allocations of Trades
The SEC examiners will focus on the investment adviser’s system for allocating trades and whether or not such allocation has been accurately disclosed to the clients.

Maintaining Client Funds Assets
The examiners will review the procedures put in place to prevent client assets from theft, loss, and misuse.

Maintenance of Books and Records
Included in the books and records requirements is the maintenance of correspondence. The examiners focus on maintenance and review of e-mail and instant messages to determine if appropriate controls are in place.

Compliance Risks and Conflicts
Examiners will focus on whether or not the firm has identified the high-risk areas and developed procedures to deal with those areas. In particular, the examiners will determine if the firm has developed a way to help reduce the level of risk inherent in such areas.

Controls Over Non-Public Information
The examiners are focusing on the control over non-public information and its availability to the firm’s employees.

Most Financial Planners Undecided About SRO
More than 61 percent of financial planners who responded to a survey conducted by the Financial Planning Association (FPA) said they would need more information before deciding whether or not it would favor an SEC proposal to create a self-regulatory organization (SRO) for federally registered investments advisers.

Survey results, which the FPA announced on April 14, 2008, were based on responses from 1,893 FPA members. Although a majority of FPA members who responded to the survey were undecided about an SRO for investment advisers, 23 percent of respondents said they favored the idea and only 14.4 percent said they opposed it. When asked to identify the single most important factor affecting their support or opposition to a federal professional regulatory organization, 38.8 percent cited excessive regulation, while more than 11 percent identified the entity selected as the regulatory organization. Respondents opposed regulation by the Financial Industry Regulatory Authority, but a majority of respondents supported regulation by the CFP Board of Standards (62.8 percent in favor to 13.6 percent in opposition). (40 Sec. Reg. & Law Rep. 629 (2008))

If the FPA were to undertake an initiative regarding regulation of the financial planning profession, 53.3 percent of respondents said they would prefer that the FPA pursue federal regulation, and fewer than 20 percent said they would prefer no regulation at all. A large majority of respondents (70 percent) indicated support for the SEC’s proposal for a new, plain-English narrative disclosure form to replace the current Form ADV Part II, while 60 percent felt the SEC should require individual investment advisers to disclose their qualifications and disciplinary history to clients as part of the new Form ADV Part II. When asked to rate the FPA’s lobbying priorities in order of importance, a majority of respondents rated support of initiatives to license financial planners as professionals as their first priority, and opposition to state sales taxes on financial services as their second priority. Support of a National Financial Planning Week resolution in Congress was viewed as unimportant by survey participants.

Enforcement Matters

SEC Charges Trader and Broker With Defrauding Investment Adviser and Its Clients
David K. Donovan, Jr., a former equity trader at Fidelity Investments (Fidelity), and David R. Hinkle, a former broker at Capital Institutional Services, Inc., were charged by the SEC in the U.S. District Court in Boston for defrauding Fidelity and its advisory clients. According to the SEC’s complaint, Mr. Donovan and Mr. Hinkle used confidential information about intended purchases by Fidelity’s advisory clients, including the Fidelity mutual funds, to trade ahead of those transactions. (SEC v. Donovan, No. 08-CA-10649-RWZ (D. Mass. Apr. 16, 2008))

The SEC alleges, in particular, that Mr. Donovan accessed Fidelity’s internal order database to determine when Fidelity and its clients were going to purchase stock of Covad Communications Group, Inc. (Covad). The information was then communicated to Mr. Hinkle, who purchased Covad shares before the Fidelity transactions occurred. According to the SEC, Fidelity refused to give Mr. Donovan authority to purchase Covad stock in his personal account, but Mr. Donovan used the information to cause Covad stock to be purchased in an account for his mother, also ahead of the Fidelity transactions. Allegedly, both Mr. Donovan’s mother and Mr. Hinkle realized profits when they sold the Covad stock during the weeks after the purchases.

The SEC’s complaint seeks permanent injunctions, disgorgement, and civil penalties.

Executive Officer of Investment Adviser Sentenced to Prison for Defrauding Investors
Marc Freedman — former President, Chief Compliance Officer, and part-owner of TriCapital Advisors, Inc., a registered investment adviser in North Potomac, Maryland — was sentenced on April 17, 2008 for defrauding investors and using their money for his personal benefit. On charges of wire fraud and money laundering, the U.S. District Court in Maryland sentenced Mr. Freeman to 63 months in prison and ordered him to pay $1.2 million in restitution and a $200 assessment. (SEC Litig. Rel. No. 20534 (Dec. 5, 2007) [U.S. v. Freedman, No. 07-0514 (D. Md.)])

Mr. Freeman plead guilty to using money from client accounts for his personal benefit or to surreptitiously reimburse the funds of other clients he had used for his personal benefit. In such instances, Mr. Freeman misrepresented to clients that he was using the money for stock purchases for their accounts.  

SEC Charges Investment Adviser With Aiding and Abetting Market Timing of Purchases of Its Mutual Fund
The SEC instituted and settled administrative proceedings on April 24, 2008, against Gabelli Funds, LLC (Gabelli Funds), a registered investment adviser, for an undisclosed market-timing arrangement regarding an affiliated mutual fund, then known as Gabelli Global Growth Fund (GGGF). Contrary to the understanding of its board of directors, Gabelli Funds allowed a market timer to time purchases of GGGF interests in exchange for making investments in a Gabelli-Funds-affiliated hedge fund. According to the SEC, the market timing was detrimental to GGGF’s other shareholders. In addition, Gabelli Funds allowed the market timer to acquire an aggregate investment in GGGF that exceeded three percent of GGGF’s total outstanding shares, thereby violating federal securities laws. (SEC, Investment Advisers Act of 1940 Rel. No. 2727 and Investment Company Act of 1940 Rel. No. 28253, Apr. 24, 2008; SEC v. Gabelli, No. 1: 08-CV-3868-DAB (S.D.N.Y.))

Under the order, Gabelli Funds was censured, ordered to cease and desist its securities law violations, and required to pay $16 million in disgorgement, prejudgment interest, and penalties. Gabelli Funds’ payment on the order will be distributed to shareholders who incurred damages by reason of the market-timing activity. In a related action, the SEC filed a civil fraud complaint in U.S. District Court against Mark Gabelli, the former portfolio manager of GGGF, and Bruce Alpert, the Chief Operating Officer of Gabelli Funds, for their role in the market-timing activity. Further, Mr. Gabelli was charged with securities law violations for misleading public statements regarding Gabelli Funds’ efforts to identify and restrict market timers.

SEC Obtains Injunction Against Unregistered Investment Advisers
On April 18, 2008, acting on a complaint filed by the SEC, the U.S. District Court for the Northern District of Illinois issued an emergency injunction against Hyatt Johnson Capital, LLC (HJ Capital), and two unregistered broker-dealers/investment advisers, Jason R. Hyatt and Jay D. Johnson, imposing an asset freeze on all assets under the control of the company and the individual defendants. (Complaint, SEC v. Hyatt, No. 1: 08-CV-02224 (N.D. Ill. Apr. 18, 2008))

According the SEC’s complaint, the defendants offered and sold to investors membership shares in at least 10 limited liability companies controlled and managed by HJ Capital and then misappropriated the investments. According to the complaint, defendants raised at least $24.5 million from approximately 120 investors in at least 12 states. The complaint alleges that after promising investors to use the funds to purchase commercial aircraft on lease to commercial airlines, the defendants misappropriated at least $5.4 million, which was used to operate a restaurant in Chicago, make personal mortgage payments and home improvements, and to purchase art and expensive vehicles. According to the complaint, some of the funds were misappropriated in the form of undisclosed commissions.

Legal News: Investment Management Update is part of our ongoing commitment to providing up-to-the minute information about pressing concerns or industry issues affecting our clients and our colleagues. If you have any questions about this issue or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:


Terry D. Nelson
Madison, Wisconsin

Gregory F. Monday
Madison, Wisconsin