A Compilation of Enforcement and Non-Enforcement Actions

29 December 2008 Publication
Author(s): Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

Investment Advisers May Not File Securities Claims on Behalf of Investors Except in Certain Cases
The Second Circuit Court of Appeals (Second Circuit) recently held that an investment adviser lacked standing to file a securities claim on behalf of its injured investors. See W.R. Huff Asset Management Co. v. Deloitte & Touche, Nos. 06-1664-cv(L), 06-1749(con) (2d Cir. December 3, 2008). According to the Second Circuit, investment advisers suffer no injury-in-fact even when their investors may have suffered a constitutionally redressable injury.

Under Article III of the U.S. Constitution, in order to have standing, a claimant must be able to point to a “concrete and particularized harm to a legally protected interest.” To meet this constitutional threshold for standing, the claimant must show: an injury-in-fact, the alleged unlawful conduct must have caused the injury, and the courts must have the ability to redress the alleged injury. If a claimant fails to show any one of these three elements, the court will not hear the case. In Huff, the Second Circuit held that the investment adviser did not have an injury.

The investment adviser (Huff) had complete investment discretion over its investors’ funds, but it did not have legal title to any claims for losses suffered by investors. Huff invested its clients’ funds in Adelphia Communications (Adelphia), but Huff itself never invested in Adelphia. When Adelphia went into bankruptcy, Huff’s clients suffered significant financial losses. Huff, in turn, filed suit against the firms that prepared Adelphia’s disclosure materials, alleging that such materials were misleading.

Because Huff did not have title to the claims, the Second Circuit held that Huff failed to show a particularized and concrete injury. Although Huff may have been injured (e.g., its reputation as an advisor may be hurt by the Adelphia investment and subsequent bankruptcy), Huff brought the claim on behalf of its investors. It had, therefore, claimed the injury of its investors, not its own injury. The Court noted that Huff’s clients did not need to rely on Huff to bring claims against Adelphia’s professional service firms.

Mutual Funds to Have Option of Streamlined Disclosures
Beginning February 28, 2009, mutual funds may opt to send a summary prospectus to investors rather than the statutorily required prospectus. If mutual funds opt to send only a summary prospectus to its investors, the statutory prospectus must be available both online and, at the request of an investor, in hard copy.

Mutual funds are required to provide a prospectus to investors in order to disclose how the mutual fund is using investors’ money. However, the statutory prospectus is too cumbersome for many investors and too chock-full of legalese for many more. Christopher Cox, Chairman of the U.S. Securities and Exchange Commission (SEC), commented that, thanks to these factors, “The entire purpose of disclosure is distorted.”

Thanks to the new SEC rule amendment, the summary prospectus will help investors obtain pertinent information much more easily. The summary prospectus must follow the same order as the statutory prospectus. The SEC also requires that certain key information be included in the summary prospectus, including purchase and sale information, tax consequences, and compensation information. Although the summary prospectus remains voluntary, SEC staff predict that three-quarters of mutual funds will take advantage of the ability to distribute a summary prospectus.

SEC Reminds Investment Advisers of Importance of Compliance
The SEC’s Office of Compliance Inspections and Examinations (CIE) issued an open letter to investment advisers (and others). Although the SEC recognizes that these are tough economic times, the SEC encouraged advisers to continue to ensure that their operations comply with the law. Chairman Cox noted that, “now more than ever,” the SEC will be enforcing compliance laws and rules that are meant to protect investors. Lori Richards, Director of CIE stated, “While many firms are considering reductions and cost-cutting measures, we remind you of your firm’s legal obligation to maintain an adequate compliance program reasonably designed to achieve compliance with the law.”

Enforcement Actions

Investment Adviser/Broker Failed to Consider Clients’ Conservative Investment Objectives
Gary J. Gross, an investment adviser and broker-dealer, failed to consider his clients’ risk tolerance when making investment decisions. For this failure, Mr. Gross violated the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940. The SEC issued an Order Instituting Public Administrative Proceedings (SEC Order) against Mr. Gross.

According to the SEC Order, which Mr. Gross did not contest, Mr. Gross defrauded clients by failing to address the risks of securities. He also fabricated account values and promised greater gains and greater safety in his clients’ investments. Like most things that sound too good to be true, Mr. Gross’s scheme was discovered. Rather than finding “safe” investments, he invested in unsuitable mutual and closed-end funds without addressing the risks of those investments with his clients. The SEC Order bars Mr. Gross from associating with any broker-dealer or investment adviser.

Traders Violated Advisers Act by Failing to Disclose Compensation From Brokerage Firms
According to an Order Making Findings and Imposing Remedial Sanctions and a Cease-and-Desist Order, the SEC found that Scott E. DeSano and 10 traders that he supervised violated the Investment Advisers Act of 1940 by failing to disclose the significant amount of travel, entertainment, and gifts they received from brokerage firms. Mr. DeSano was an equity trader for Fidelity Funds. Mr. DeSano failed to disclose to Fidelity’s clients that he and those traders he supervised received such “compensation” from brokers as trips to Cabo San Lucas, Nantucket, Bermuda, the Caribbean, and Las Vegas; a bachelor party in Miami; more than 50 tickets to Boston Celtics and Red Sox games; tickets to the World Series, Super Bowl, U.S. Open, and Wimbledon.

Because Mr. DeSano and his traders failed to disclose this compensation from brokers (not to mention the romantic and familial ties Mr. DeSano and his traders had with certain brokers), he failed to ensure that the traders used “best execution” to select its investments. Mr. DeSano and his traders were disgorged of their gains, paid a monetary penalty, and were banned from association with investment advisers (among others).

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Terry D. Nelson
Madison, Wisconsin