A Compilation of Enforcement and Non-Enforcement Actions

23 April 2009 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Seeking Comments on Proposals to Regulate Short Selling
The U.S. Securities and Exchange Commission (SEC) recently announced that it is seeking public comment on which proposed restriction on short selling, if any, would be in the best interests of investors. SEC Chair Mary Schapiro noted that the SEC “has long held the view that short selling provides the market with important benefits, including market liquidity and pricing efficiency.” However, she also was quick to point out that “unrestricted short selling can exacerbate a declining market in a security.”

The proposals break along two main approaches: permanent restrictions or temporary, market-based restrictions. The two options for a permanent approach are: (1) reinstating the “uptick rule,” which permitted short selling only when the last sale price was higher than the previous sale price, and (2) a modified uptick rule, where short selling would be permitted only when the best-available national bid is higher than the previous bid. The three options for a market-based approach each hinge on identifying events that trigger a “circuit breaker,” at which point short selling would be banned. Under one market-based approach, short selling would be banned for the remainder of any day in which a particular security suffers a severe decline. The other market-based approaches would impose either the uptick rule or the modified uptick rule when there is a severe decline in a specific security. Short selling would be banned only as it related to the particular security at issue, not to the entire market.

Comments on these proposals are due to the SEC by June 19, 2009.

SEC May Contact Investors About Adviser’s Custodial Practices
Gene Gohlke, the Associate Director of the SEC Office of Compliance Inspections and Examinations, recently indicated that the SEC is considering contacting investors as part of its efforts to ensure investment advisers are providing sufficient safeguards for investor assets. Mr. Gohlke acknowledged that, should the SEC decide to pursue this method, it might be willing instead to contact parties already engaged by investors, like auditors.

Mr. Gohlke made the comments while sitting on a panel at a Practising Law Institute conference on April 3, 2009. His fellow panel members were not pleased with the possible SEC action. Their objection is that SEC inquiries directly to investors would likely trigger fear and panic among already-nervous investors.

Although there is no proposal pending, Mr. Gohlke indicated the SEC would contact advisers prior to contacting their investors.

Potential New ERISA Regulations for Valuing Private Equity Funds
Private equity funds historically seek investments from benefit plan investors, regulated pursuant to the Employee Retirement Income Security Act of 1974 (ERISA). ERISA requires, among other things, plan fiduciaries to value the plan assets, including investments. Of course, private equity funds tend to be difficult to value prior to their exit from their investments. As a result, most private equity funds value their investments at cost until an exit. Since plan fiduciaries rely on private equity funds (typically the general partner of the fund) to provide a value for the benefit plan investment, they also value the benefit plan assets at cost.

However, the U.S. Department of Labor (Labor) recently indicated that plan fiduciaries might no longer be safe relying entirely on valuations by private equity funds. Instead, Labor will be issuing guidance for plan fiduciaries that will likely instruct them how to value their investments in private equity funds. The guidance also might instruct benefit plan investors on how to evaluate private equity fund investments in general.

Since Labor’s indication that private equity fund valuations might not be sufficient, private equity funds have been required to shift to mark-to-market valuation under the Financial Accounting Standards Board Standard 157 (FAS 157). Further guidance on net asset values for private equity funds is likely to be released in June 2009. It is possible that FAS 157, and forthcoming regulations about valuation, will curb Labor’s desire to alter valuation methods by plan fiduciaries.

Enforcement Matters

Class Action Alleges Registration Statement and Prospectus Were Misleading
Investors in The Charles Schwab Corporation’s Schwab YieldPlus Fund (Fund) sued several entities of Charles Schwab (Schwab) for allegedly making misrepresentations in the registration statements and prospectuses. The investors were permitted to bring claims under both federal and state law, since the court did not believe federal law preempted the state law claims.

According to Schwab, the Fund was an “ultra short term bond fund” with relatively low levels of risk. Schwab compared the Fund to a money market account. The plaintiffs allege that the Fund took on significant risk by investing too heavily in mortgage-backed securities. According to the plaintiffs, the Fund lost significant value, as compared to a money market account.

Although the plaintiffs have not yet proved their case, the Northern District of California District Court noted that even negligent or innocent misrepresentations in registration statements and prospectuses are subject to enforcement under the Securities Act of 1933. Schwab argued that the plaintiffs must plead under the higher pleading standards contained in the fraud rules. The plaintiffs, however, were permitted to make their claims without alleging fraud and without meeting the higher pleading standards.

Moreover, the court permitted the plaintiffs to make securities law allegations based on California state law. Under California law, the Fund may only concentrate 25 percent of its assets in a single industry. Schwab altered its definition of mortgage-backed securities, which allowed it to invest more heavily in them. According to the judge, the claim was not preempted by federal law, because the state is not regulating misrepresentations, only diversification. As a result, state law may be used to enforce alleged violations in the prohibition on changing fundamental policies without shareholder approval, which is typically enforced under the Investment Company Act of 1940.

Investment Adviser’s Failure to Investigate Market Timing Transactions Results in Violation of Investment Advisers Act
The SEC instituted a cease-and-desist proceeding, imposed remedial sanctions, and issued a cease-and-desist order against American Skandia Investment Services, Inc. (ASISI), a registered investment adviser. Pursuant to Section 206(2) of the Advisers Act, an investment adviser may not operate a fraud or deceit upon its clients, even if such fraud or deceit is the result of negligence (as opposed to the result of intent to deceive).

In this case, ASISI was the investment adviser to American Skandia Trust (AST) portfolios, which was the funding vehicle for variable annuities issued by American Skandia Life Assurance Corporation (ASLAC). Advisers of AST accounts complained to ASISI that market timing was impairing the value of those accounts. Market timing refers to frequent buying and selling of shares of the same mutual fund or buying or selling shares of a mutual fund in order to exploit price inefficiencies. Despite the complaints of AST account advisers, ASISI failed to consider, investigate, or analyze whether market-timing activities were causing AST accounts to decline in value. As a result of ASISI’s negligent failure to act, the SEC ordered ASISI to pay disgorgement of $34 million and assessed ASISI a civil money penalty of an additional $34 million. ASISI also will have ongoing reporting and compliance obligations as a result of its violation.

SEC Charges Investment Adviser and Its Principal With Fraud
The SEC filed an action against Crossroads Financial Planning, Inc. (Crossroads), a registered investment adviser, and its owner, principal, and chief operating officer, Julie M. Jarvis. The SEC alleged that Crossroads, with Ms. Jarvis’s help, transferred $2.3 million in investor funds to her personal account.

The U.S. District Court for the Southern District of Ohio granted a temporary restraining order, preventing Crossroads and/or Ms. Jarvis from violating federal securities law and freezing the assets of Crossroads and Ms. Jarvis. The judge also approved the SEC’s request for expedited discovery ahead of the preliminary injunction hearing on April 22, 2009.

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 colleagues. If you have any questions about this update or would like to discuss this topic further, please contact your Foley attorney or the following:


Terry D. Nelson
Madison, Wisconsin

Joseph D. Shumow
Madison, Wisconsin

Peter D. Fetzer
Milwaukee, Wisconsin