A Compilation of Enforcement and Non-Enforcement Actions

22 May 2009 Publication
Author(s): Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

SEC Proposes Rule Amendments to Help Guard Against Misappropriation of Client Assets by Investment Advisers
The U.S. Securities and Exchange Commission (SEC) recently proposed rule amendments designed to increase protections for clients whose assets are being maintained by investment advisers. The proposed rule would require investment advisers who have “custody” of client assets to engage an independent public accountant to conduct an annual “surprise exam” of the investment adviser to verify client assets. Moreover, if the investment adviser (or an affiliate) holds a client’s funds directly, an accountant would review the custody control measures as well. Custodians holding assets of investment adviser clients also would have increased responsibility under the new rule: They would be required to deliver their statements of client assets directly to the client (rather than delivering the statements through the investment adviser).

The proposed rule is intended to promote independent custody of client assets. However, even for client funds held by independent custodians, the SEC has proposed additional safeguards. If accountants find any problems or potential problems in the custody of client assets, the accountants are required to notify the SEC.

The SEC will ask for comments 60 days from the date of publication of the proposed rule in the Federal Register. As of publication of this newsletter, the proposed rule has not yet been published.

Authorities Weigh-In on Potential Changes in Hedge Funds, Short Selling
Observers of the financial markets tend to agree that many new rules and regulations are imminent. However, predictions on the nature of those changes vary. Several important figures have recently weighed-in on what changes they would like to see. Topping the list are reforms to regulation of hedge funds and action on the proposed rules about short selling.

In the wake of several scandals with respect to hedge funds, SEC Chair Mary Schapiro recently commented that hedge fund registration is necessary. She further noted that additional government officials would be required for this increased oversight responsibility. The Obama administration appears to have heard Chair Schapiro’s call; the 2010 budget submitted by the White House included a seven percent increase in funding for the SEC, the largest share of which is for enforcement.

FINRA Chief Executive Officer Richard Ketchum called the regulatory gaps in the financial markets “very frustrating.” Although Ketchum has warned that there “will always be Ponzi schemes,” he believes they are allowed to fester in unregulated or under-regulated instruments, like hedge funds. Mr. Ketchum wants Congress to legislate to provide the SEC and FINRA with additional regulatory authority over not only hedge funds, but also fraud in credit default swaps.

Paul Kanjorski (D-PA), Chair of the U.S. House of Representatives Financial Services Committee, agrees that reform in hedge funds regulation is necessary. However, Representative Kanjorski would prefer congressional action to action by the Obama administration. Representative Kanjorski warned that if Congress fails to act and the administration acts without congressional authority, it might cause a constitutional crisis. In addition, he believes that allowing the Executive Branch to act without congressional delegation would set a troubling precedent for future financial crises. For that reason, Representative Kanjorski called on Congress to act quickly.

Not everyone agrees that massive regulatory overhaul is necessary. SEC Commissioner Troy Paredes, appointed to the SEC last year, noted that hedge funds serve an important role in the market. Mr. Paredes believes excluding hedge funds from registration requirements under the Investment Company Act of 1940 is “important” and “well-reasoned.” Mr. Paredes also criticized efforts to curb the practice of short selling. He noted that if, after new short-selling rules are implemented, investors see drops in a specific stock price, investors might worry that the dip is due to general market forces rather than to any weakness in the particular stock. In other words, the restrictions on short selling could have the exact opposite effect than what regulators hope for: igniting, not suppressing, market panic.


SEC Pursues First-Ever Proxy Rule Enforcement Action Against Investment Adviser
A 2003 proxy-voting rule under the Investment Advisers Act of 1940 requires, among other things, that investment advisers adopt proxy-voting policies that protect clients from, in particular, material conflicts of interest between the adviser and its clients. The SEC has not enforced the rule until this month when it settled charges against INTECH Investment Management LLC (INTECH) and its former Chief Operating Officer David Hurley for violating the proxy-voting rule. Although INTECH adopted and implemented written proxy voting policies in accordance with the rule, according to the SEC it failed to properly follow those conflict-of-interest rules embedded in its proxy voting policies.

Under pressure from certain of its organized labor clients, INTECH voted in accordance with the AFL-CIO proxy recommendations. Simultaneously, the AFL-CIO was completing its annual Key Votes Survey, which ranks investment advisers based on their proxy voting on labor issues. According to the SEC, this was a violation of conflict-of-interest policy in the proxy voting rules. INTECH and Mr. Hurley settled the charges with the SEC by agreeing to pay a fine of $300,000 and $50,000, respectively.

Oregon Attorney General Files Suit Against Investment Adviser for Investments in Risky Bonds
The Oregon 529 College Savings Board (Board) engaged OppenheimerFunds Inc. (Oppenheimer) to be the investment manager for its 529 College Savings Plan (Plan). The Board instructed Oppenheimer to invest only in conservative or ultraconservative bond funds. According to a complaint filed by the Oregon attorney general on behalf of the Board, Oppenheimer initially invested the assets of the Plan in high-quality corporate bonds. In 2007, according to the attorney general, Oppenheimer began investing the Plan’s assets in risky credit default swaps and total return swaps.

The attorney general filed a suit against Oppenheimer in the Oregon Circuit Court for Marion County for mismanaging the Plan. According to the complaint, the Plan lost 35 percent of its value in 2008 and an additional 10 percent of its value in 2009. The complaint calls for in excess of $36 million in damages. Oppenheimer has countered that the losses were due to market volatility, noting that many mutual funds underperformed in 2008.

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