A Compilation of Enforcement and Non-Enforcement Actions

24 June 2008 Publication
Authors: Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Discusses Mutual Fund Exams and Current Chief Regulatory Projects
During a recent public conference, the U.S. Securities and Exchange Commission (SEC) Associate Regional Director, Thomas Biolsi, described the SEC’s strategy while conducting exams of mutual funds. According to Biolsi, during such exams, the SEC will focus more on potential violations regarding material non-public information. Also, as part of the examination process, the SEC is more prominently including interviews with company executives, senior traders, marketing executives, sales staff, and client services professionals.

Mr. Biolsi stated that the SEC, prior to commencing a formal exam, first reviews the structure of the company’s compliance team, starting with the chief compliance officer. The SEC categorizes the firms to be examined as low-, medium-, or high-risk. Low-risk firms will typically be examined every seven years and high-risk firms every three years. Separate from routine exams are exams for “cause,” which can occur at any time, resulting from complaints, media reports, or informants.

The examinations will focus on how the firm calculates asset valuation, especially products whose underlying value are residential mortgage-backed securities and auction rate securities. The SEC also will look at how the firm obtains its investors, how it develops business relationships, and how it generates income.

During the same conference, SEC Senior Special Counsel, Mark Berman, described the SEC’s current chief regulatory projects. They are: (i) coming up with a final rule (first proposed November 2007) regarding mutual fund disclosure requirements (i.e., developing a summary prospectus that is accessible and readable for prospective investors); (ii) formulating changes to the regulatory framework concerning investment advisers and broker-dealers as “the line between the two continues to blur”; and (iii) reforming Rule 12b-1 under the Investment Company Act of 1940, in order to streamline the regulatory approach, providing clearer disclosure rules and overall, coming up with a process that protects investor interests while still providing the type of services that are included within such fees.

Enforcement Matters

U.S. District Court Finds Defendants Had No Duty to Disclose Shelf-Space Arrangements
The U.S. District Court for the District of New Jersey dismissed a suit by a Franklin Funds investor, asserting that the Funds’ investment adviser, distributor, and their parent firm must disclose soft-money (shelf- space) arrangements under federal securities laws. See, Ulferts v. Franklin Resources, Inc. D.N.J., Master File 07-CV-1309 (WJM) April 24, 2008.

The complaint before the district court alleged that the investment adviser, distributor, and parent firm did not disclose directed brokerage and shelf-space arrangements in any prospectus or other statements that were given to shareholders. Both types of shelf-space arrangements result in higher fees for shareholders.

A Franklin Funds shareholder brought suit alleging that he paid inflated fees under this arrangement. The investor believed that the fees were for research and brokerage services. Instead, the funds were used for shelf-space arrangements. The court, however, held that the defendants had no obligation to disclose the shelf-space arrangements to shareholders. The court elaborated that the plaintiff must first allege that the prospectuses and statements contained misleading information that would necessitate disclosure of the shelf-space arrangements for clarification. Absent such misleading information, defendants have no duty to disclose these arrangements. The court also held that there are no statutory or regulatory requirements for defendants to disclose the shelf-space arrangements.

SEC Declares Final ALJ’s Decision Sanctioning Two Investment Adviser Employees in Market-Timing Case
An SEC administrative law judge (ALJ) found two officials of Denver investment adviser Janus Capital Management LLC (Janus) had violated federal securities laws by allowing market-timing transactions in conflict with the funds’ prospectuses. The SEC declared the initial decision final on May 16, 2008. See, In Re Lammert, SEC, Admin. Proceeding File. No. 3-12386, April 28, 2008.

Janus is an investment adviser whose relevant prospectuses stated that its funds did not permit market timing. Contrary to the prospectuses, Janus officer Warren Lammert allegedly granted permission to Trautman Wasserman & Co., Inc. (Trautman) and Brean Murray & Co. (Brean) to market time. The alleged inconsistency between the prospectuses’ language and actual trading practices is a violation of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, Section 206(2) of the Investment Advisers Act of 1940, and Section 34(b) of the Investment Company Act of 1940. The complaint, filed against Janus employees Mr. Lammert, Lars Soderberg, and Lance Newcomb, alleged an act or omission caused the prospectuses to be misleading.

The ALJ held that negligence is sufficient to show violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act of 1933, Section 206(2) of the Investment Advisers Act of 1940, and Section 34(b) of the Investment Company Act of 1940. Mr. Lammert allowed Trautmann and Brean to market time, thereby violating the above acts. Mr. Soderberg failed to stop the transactions, and also was found to have violated the acts. Mr. Newcomb, however, attempted to stop the transactions but did not have much control over the transactions and therefore was not found negligent.

The ALJ ordered Mr. Lammert and Mr. Soderberg to cease and desist future violations, while charges were dropped against Mr. Newcomb.

SEC Charges Banc of America Investment Services With Failing to Disclose That It Favored Affiliated Mutual Funds
On May 1, 2008, the SEC instituted a settled action against Banc of America Investment Services, Inc. (BAISI) for breaching its duty of loyalty to its clients for failure to disclose conflicts of interest. See, Administrative Proceedings 33-8913, 33-8914, 33-8915.

BAISI clients participated in a “wrap” fee program in which they paid a fee based upon the amount of their assets in exchange for advisory and other account services. According to the SEC order, on several occasions BAISI favored its own proprietary funds over non-affiliated funds when selecting mutual funds for clients. The SEC brought action against BAISI for breach of its fiduciary duties to these clients. According to the SEC, BAISI made material misrepresentations and omissions to clients who had given BAISI discretion to select mutual funds for them.

The SEC asserted that BAISI has a fiduciary duty to act in the best interest of its clients, which requires disclosure of material information concerning conflicts of interest and undisclosed use of client assets to benefit BAISI or its affiliates. According to the SEC, BAISI made at least two purchases for clients with “wrap” accounts using a methodology that was contrary to its disclosure policies. Frederic Firestone, the Associate Director of the SEC’s Division of Enforcement, stated that this order was meant to “remind the investment adviser community that the Commission will not tolerate advisers placing their own pecuniary interests ahead of their clients.”

BAISI and its successor agreed to $9.7 million in disgorgement, prejudgment interest, and penalties, and accepted censures and orders to cease and desist from violations of the Investment Advisers Act of 1940. BAISI also is required to review its methods for recommending and selecting mutual funds in discretionary programs and adequacy of disclosures in this area.

IAA Does Not Authorize SEC to Impose Monetary Penalties for Aiding and Abetting Under Section 209(e)
The U.S. District Court for the District of Columbia concluded, on a question of first impression, that Section 209(e) of the Investment Advisers Act of 1940 (IAA) does not authorize the SEC to impose a monetary penalty for aiding and abetting an IAA violation. See, SEC v. Bolla, D.D.C., Civil Action No. 02-1506 (CKK) (May 6, 2008).

Robert Radano co-owned an investment firm, Washington Investment Network (WIN), with the wife of Steven Bolla. Mr. Bolla directed WIN’s activities, but listed his wife as co-owner because he was under SEC investigation at the time. In 2005, WIN was found liable for violating Sections 203(f), 206(1), and 206(2) of the IAA, and Mr. Radano was found liable for aiding and abetting.

On a motion to reconsider the district court stated that “there is no question that Section 209(e) does not explicitly authorize monetary penalties for aiding and abetting violations of the IAA in enforcement actions brought in the district courts.” The court juxtaposed Section 209(e) with other IAA provisions, which specifically authorize penalties for aiding and abetting. The court ruled that under the principles of statutory construction Congress did not intend to impose liability for aiding and abetting under Section 209(e) of the IAA.

The court vacated the defendant’s order to pay a $15,000 civil penalty, but upheld his court ordered injunction from future violations of the IAA.

Investment Adviser Settles Charges on Insider Trading
A Massachusetts-based investment adviser, Global Time Capital Management LLC (GTCM), and former hedge fund manager Michael Tom settled charges on May 8, 2008, in the U.S. District Court for the District of Massachusetts that they misused inside information. See, SEC v. Tom, D. Mass., C.A. No. 05-CV-11966-NMG, May 12, 2008.

According to the SEC: Shengnan Wang, a Citizen’s Bank employee, disclosed non-public information to Mr. Tom, the portfolio manager of GTCM, about a possible acquisition of Charter One Financial. Mr. Tom proceeded to make 52 trades, acquiring 952 Charter One call options and 2,100 common shares in the span of one week. Mr. Tom made these purchases for himself, for the GTMC fund, and for family members whose accounts he controlled.  

According to the SEC complaint, Mr. Tom’s illegal insider trading resulted in total profits of $743,505. Mr. Tom and GTCM consented to the entry of final judgments and personal injunctions against future Section 10(b) and Rule 10b-5 violations under the Securities Exchange Act of 1934. Mr. Tom agreed to pay disgorgement of $543,875.07, prejudgment interest of $107,381.63, and a civil money penalty of $150,000. GTCM agreed to pay a civil money penalty of $39,056.93. The GTCM Growth Fund, which was managed by Mr. Tom, agreed to pay disgorgement of $189,868.93 and prejudgment interest of $23,145.67.

SEC Obtains UK Asset Freeze for UK Citizen in Pending SEC Enforcement Action
On May 16, 2008, the High Court of Justice in London issued an order to freeze a United Kingdom citizen’s assets in the United Kingdom pending a U.S. SEC enforcement action. See, SEC v. Lydia Capital, LLC et al. Civil Action No. 07-10712-RGS, D. Mass; SEC v. Glenn Manterfield, Claim No. HQ08X00798, High Court of Justice, Queen’s Bench Division, Royal Courts of Justice.

According to the SEC, Glenn Manterfield and Evan Andersen of Boston, Massachusetts, the sole owners of Lydia Capital, LLC, (Lydia), a registered investment adviser in Boston, fraudulently induced 60 Taiwanese investors to invest over $34 million in Lydia Capital Alternative Investment Fund LP (Fund). The SEC stated that Mr. Manterfield and Mr. Andersen told the investors the Fund was a pooled investment vehicle for life insurance policies for persons with limited life expectancy.

The SEC’s complaint alleges that Mr. Manterfield and Mr. Andersen, through Lydia, (1) materially overstated the Fund's performance and misstated the nature of the Fund's assets and investment strategies; (2) invented phantom business partners, offices, and investors; (3) failed to disclose Manterfield's status as a convicted felon; (4) failed to disclose that Mr. Manterfield's assets had been frozen by a court in England; and (5) failed to disclose certain material risks inherent to the Fund's investments. Defendants additionally are alleged to have misappropriated investors' funds by withdrawing $8.16 million in cash from “escrow” accounts that were purportedly sequestered.

The U.S. District Court, District of Massachusetts, issued a temporary restraining order freezing the defendants’ assets in 2007. The London High Court of Justice order now freezes the nearly $1 million in assets held by Mr. Manterfield in the United Kingdom.

District Court Grants Temporary Restraining Order and Asset Freeze Against Investment Adviser
The SEC announced that on May 16, 2008, the U.S. District Court for the Southern District of California entered an order preliminarily enjoining Plus Money, Inc. and Matthew La Madrid from violating antifraud provisions of federal securities laws. See, SEC v. Plus Money Inc., S.D. Cal., Case No. 3:08-CV-00764-BEN-NLS, April 30, 2008.

The district court granted the injunction on the basis of the following allegations: Plus Money Inc., which is run by Mr. La Madrid, has managed hedge funds including the Premium Return Funds, which raised $30 million from 300 investors. Mr. La Madrid told investors he would use the money to purchase and sell covered call options. Mr. La Madrid made these investments and paid returns to investors until the fall of 2007.

In 2007, without disclosure to investors, Plus Money and Mr. La Madrid emptied the money from the Premium Return Funds’ brokerage accounts through a series of illicit transfers. These transfers included Vision Quest Investments and Palladium Holding Company, which Mr. La Madrid and a friend controlled. The Palladium Holding Company then engaged in short-sale transactions involving Treasury Bonds, but only $2.4 ultimately remained in the account. Mr. La Madrid also transferred $500,000 to himself, another $1.8 million to real estate title companies, and another $180,000 for other purchases.

In addition to the restraining order from violating antifraud provisions of federal securities laws, the district court also froze the assets of the defendants and the entities to which the money was transferred, including three purported hedge funds. The order also prohibits destruction of documents and assigns a permanent receiver over Plus Money and the Premium Return Funds. The SEC is requesting return of the allegedly ill-gotten gains with prejudgment interest and civil penalties against the defendants. The SEC is seeking a court order directing the third-party entities to return investor funds transferred to them by the defendants.

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