A Compilation of Enforcement and Non-Enforcement Actions

22 September 2008 Publication
Author(s): Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

Modernizing and Consolidating Insider Trading Enforcements
The U.S. Securities and Exchange Commission (SEC), New York Stock Exchange Regulation Inc. (NYSER), and FINRA announced an agreement among 10 securities self-regulating organizations to consolidate surveillance, investigation, and enforcement of insider trading of equity securities. Prior to the implementation of this plan, each exchange remains responsible for enforcing its own (unique) insider trading program. As such, the exchanges must cooperate with one another to ensure that the exchanges catch insider trading.

The proposed plan aims at reducing redundancy and eliminating “gaps” in enforcement from one market to the next. SEC Chairman Christopher Cox said, "We have immediately published this proposal for public comment because of its potential to increase the likelihood that those who engage in insider trading will be caught and punished. This should send a strong warning to those who would undermine market integrity and undercut investor confidence for their own personal gain."

Comments are due 21 days after the plan’s formal publication in the Federal Register.

Use of Shareholder Information for Marketing Purposes Generally Prohibited
After publication of an article that promoted funds’ and advisers’ use of shareholders’ identities for marketing purposes, the SEC issued a letter to correct the article’s premise. In fact, use of shareholder identity for marketing purposes is generally not allowed.

Funds must enter agreements with financial intermediaries, whereby financial intermediaries must provide funds with shareholder identity and transaction information. However, the privacy rules of the Gramm-Leach-Bliley Act require that those entities that wish to use shareholder information for marketing purposes, including funds and advisers, must (1) disclose such purpose to the shareholder, (2) give the shareholder the option to opt out, and (3) wait to determine that the shareholder has not opted out.

Thus, funds may not use shareholder information for marketing purposes unless the fund has clearly provided for such use in its privacy policy and the shareholders have not “opted out” of the information sharing for marketing purposes.

Enforcement Matters

Excessive Fees Not a Violation of Fiduciary Duties in Recent Case
The Seventh Circuit recently dismissed a lawsuit by investors claiming that the investment adviser breached fiduciary duties when the adviser received “excessive” fees from a captive fund. Jones v. Harris Associates (No. 07-1624, 7th Cir., August 8, 2008). The court held that the size of the management fee is not to be considered in deciding whether a mutual fund adviser has breached its fiduciary duties. The Second Circuit had previously held that courts may consider whether the fee is “so disproportionately large that it bears no reasonable relationship to the services rendered.” Gartenberg v. Merrill Lynch Asset Management Inc., 694 F.2d 923 (2d. Cir. 1982).

The dissent argued that the entire Seventh Circuit should have reviewed the case, because this decision created a split among the circuit courts. Circuit splits are solved only by appeal to the U.S. Supreme Court. Of particular concern to the dissenters was that the adviser charged its captive funds more than twice as much as it charged its independent funds. The Seventh Circuit is apparently the minority opinion on this issue, and most courts tend to review excessive advisory fees as a potential violation of the adviser’s fiduciary duties.

SEC Files Fraud Charges for Cover-Up of Misuse of Funds
The SEC filed charges of fraud against now-bankrupt Sentinel Management Group, Inc. (Sentinel) and two of its former executives: Eric Bloom, the former President and CEO and Charles Mosley, the former Senior Vice President in charge of investment decisions. Sentinel was a registered investment adviser under the Investment Advisers Act of 1940 and managed several funds registered under the Investment Company Act of 1940. Sentinel purported to have one such fund (Client Account) invested in low-risk and highly liquid assets. Sentinel also had a fund (House Account), which was mostly comprised of investments of insiders, including Mr. Bloom and Mr. Mosley.

The SEC alleges that Mr. Bloom and Mr. Mosley’s joint conduct resulted in the misuse of its clients’ investments, namely by misappropriating funds from its Client Accounts to secure leveraged trading that benefited the House Account. Moreover, the House Account invested in risky, highly illiquid assets (i.e., the exact opposite type of assets Sentinel purported to be investing in on behalf of its clients). The SEC further alleges that Sentinel used its Client Account assets as collateral to secure funding for the benefit of the House Account. Moreover, the SEC alleges, Sentinel fabricated its daily updates to investors in the Client Account, purporting to have sufficient funds in the Client Account should investors want their investments back — after all, the Client Account was to be highly liquid investments.

When the credit markets tightened, many Client Account investors requested their funds. In fact, so many requested that Sentinel was unable to comply with requests, because the investments were tied up in favor of the House Account. Shortly after the credit markets tightened, Sentinel had to file for Chapter 11 bankruptcy. The SEC alleges that as a result of Sentinel’s conduct, through Mr. Bloom and Mr. Mosley, Sentinel lost hundreds of millions dollars of its clients’ investments on a $1.4 billion fund.

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