A Compilation of Enforcement and Non-Enforcement Actions

18 November 2009 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

Supreme Court Hears Case on Allegedly Excessive Investment Advisory Fees
Earlier this month, the United States Supreme Court (Court) heard the case of Jones v. Harris Associates, which we reported on in our March 2009 Update (http://www.foley.com/publications/pub_detail.aspx?pubid=5873). When the Court granted certiorari to hear the case, the question presented was whether an investment adviser charged an impermissibly excessive fee to mutual fund shareholders when the fee was more than twice the amount charged to institutional investors. The oral arguments, however, focused on the issue of whether Harris Associates violated its fiduciary duty with respect to compensation by charging this higher fee on the mutual funds.

Under the Investment Company Act of 1940 (Company Act), as amended, investment advisers have a fiduciary duty with respect to compensation for services. Although investment-adviser compensation must be approved by a fund’s board of directors, the fund shareholders retain the right to bring a lawsuit against the investment adviser in some situations. Just what those situations are, though, was the heart of this argument.

The lower court had held that the advisory fee was not excessive because the fees were the product of market forces. Simply put, the investment adviser disclosed the fees to the fund, whose board of directors approved the fees. Based on that logic, the lower court did not believe this was a situation in which fund shareholders could successfully bring a claim. However, even the investment adviser’s lawyer was not willing to agree with the test the lower court used.

Instead, the investment adviser argued that the lower court got the answer right, even if it did not apply the precise test for when a fund shareholder may bring a claim. Where a fee is fair, the adviser argued, no successful claim may be brought. Here, the adviser argued the fee was fair because it met the two requirements laid out by law: (1) the fee was the product of a fair process, having obtained the consent of the fund’s board of directors, and (2) the fee amount was fair, in that it was in line with what other advisers were charging mutual fund shareholders.

Meanwhile, the fund shareholders, together with the U.S. government, argued that this is the precise situation in which fund shareholders are permitted to bring a successful claim under the Company Act. The fund shareholders argued that the Court should send the case back to the trial court level, because there were important issues still in dispute, namely whether Harris Associates provided the same or similar services to institutional investors and fund shareholders. Importantly, the fund shareholders argued that the disparity between what advisers charge institutional investors and what they charge fund shareholders should be considered when deciding whether a fee is “fair.” According to the fund shareholders, the adviser provides “similar” services to institutional investors and fund shareholders, but charges a smaller expense ratio to the institutional investors than to the fund shareholders.

With regard to the disparity between fees charged, Justice Breyer probed, “Wouldn’t that be a normal question to ask?”, leading some to believe he might side with the fund shareholders. However, Chief Justice Roberts and Justice Scalia seemed less sympathetic to the fund shareholders’ arguments. The Chief Justice pointed out that fund shareholders have the ability to move to a different fund in “30 seconds” if they are unhappy with the fees charged. Justice Scalia seemed to give that argument some credence as well.

Most court observers believe the Court will come to a narrow ruling on this case. There are predominantly two reasons for this theory. First, the Roberts Court —and the Chief Justice himself in his confirmation hearings —has indicated a desire for narrow rulings that do not spawn litigation or cause major changes in legal standards or expectations. But the second reason was explained by the adviser’s attorney in oral arguments: If courts are the first stop for determining what is “fair and reasonable” for an adviser to charge a mutual fund, and if institutional accounts must be considered in that calculus, the Court would “consign 8,000 mutual funds to a trial.” That is exactly what the Roberts Court has said it wants to avoid.

Ban on Placement Agents Decried by Many Commenters
As we reported in our August 2009 Update (http://www.foley.com/publications/pub_detail.aspx?pubid=6359), the SEC proposed a rule intended to curb adviser pay-to-play practices. The proposed rule is a modified version of a similar rule introduced but not adopted by the SEC in 1999. The proposed rule included three new restrictions: a ban on certain political contributions; a ban on advisers and their executives from soliciting political contributions; and a ban on the use of placement agents.

As we reported in August, the rule drawing the most ire from commenters is the ban on placement agents. That has not changed now that the comment period has ended. The most common complaint was that the ban on placement agents would disproportionately affect small and mid-sized investment managers. At this point, the SEC can modify the proposed rule (e.g., by removing the ban on placement agents), adopt the proposed rule as submitted for public comment, or reject the proposed rule as submitted for public comment. Stay tuned. We will report again on this after the SEC determines the final language for the proposed rule.

Enforcement Matters

SEC Charges Investment Adviser and Affiliated Broker-Dealer in Fraudulent Commission Recapture Scheme
The SEC recently announced an Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions (Order) against Value Line, Inc. (Value Line), a registered investment adviser for all relevant periods, Value Line Securities, Inc. (VLS), a registered broker-dealer for all relevant periods, Jean Bernhard Buttner, the controlling holder, chair of the board, CEO, and president of Value Line and chair of the board and president of VLS, and David Henigson, an executive with Value Line and VLS who had knowledge of the fraud.

According to the SEC Order, Value Line, under the direction of Ms. Buttner and Mr. Henigson, misappropriated assets from the Value Line Family of Mutual Funds (Funds) by participating in a commission-recapture program. The SEC alleged that Value Line used unaffiliated brokerage firms (Rebate Brokers) to execute, clear, and trade securities. The Rebate Brokers provided the services at $0.01 or $0.02 per stock, at a discount from $0.0488 per share. Rather than provide the rebate to Value Line (and its investors), Value Line, Ms. Buttner, and Mr. Henigson directed the Rebate Brokers to provide the rebate to VLS, Value Line’s affiliated broker-dealer. VLS therefore received a rebate for services it never provided.

The SEC also alleged that Value Line, VLS, Ms. Buttner, and Mr. Henigson misled the independent directors of the Funds’ board of directors as well as the Funds’ shareholders by falsifying public filings with the SEC. Value Line, VLS, Ms. Buttner, and Mr. Henigson each consented to the issuance of the Order without admitting or denying the facts contained therein. In addition to the cease-and-desist orders against Value Line and VLS, (1) Value Line was required to pay disgorgement of more than $24 million; interest of more than $9.5 million; and a civil penalty of $10 million; (2) Ms. Buttner was required to pay a civil penalty of $1 million; and (3) Mr. Henigson was required to pay a civil penalty of $250,000. Ms. Buttner and Mr. Henigson also were barred from association with any broker, dealer, or investment adviser (with limited exceptions for Ms. Buttner).

Ponzi Scheme Enforcement Continues to Be Active
The federal government remains vigilant in pursuing purported perpetrators of Ponzi schemes. (See our January 2009 Update (http://www.foley.com/publications/pub_detail.aspx?pubid=5653) for a full description of Ponzi schemes and why they are more easily rooted out in a “bust” economy.) Following is a sampling of recent enforcement actions related to Ponzi schemes.

The U.S. Department of Justice (DOJ) recently unsealed a grand jury indictment, alleging that an investment manager in Michigan, Edward May, fraudulently convinced people throughout the country to invest in excess of $200 million in more than 150 limited liability companies (LLCs). According to the indictment, Mr. May told potential investors that the LLCs had agreements to provide telecommunication equipment and services to a number of national hotel chains. According to the indictment, though, the invested money was used to pay for gambling, travel expenses, incentive referral fees, and paying off early investors to convince them they were receiving returns. This indictment by DOJ follows on the heels of an SEC suit against Mr. May in 2007, arising from activities related to soliciting investors in the LLCs.

The U.S. District Court for the Southern District of New York recently sentenced Democratic fundraiser Norman Hsu to more than 24 years in prison for, among other things, running a $50 million Ponzi scheme. This is not Mr. Hsu’s first time being convicted of defrauding investors. He faced similar charges by California authorities in the early 1990s. That prior history likely factored into Judge Victor Marrero’s decision to sentence Mr. Hsu to 24-and-1/3 years in prison. Mr. Hsu’s attorney decried the sentence, claiming that it is longer than Mr. Hsu would have received had he committed armed robbery of a bank.

Finally, the SEC and the Commodity Futures Trading Commission each filed a complaint in the U.S. District Court for the Middle District of Florida alleging that David Merrick and certain associated funds were responsible for a Ponzi scheme of $22 million that defrauded more than 2,500 investors. The money allegedly was used to pay for Mr. Merrick’s personal expenditures and repay early investors in the funds, with the remainder transferred to foreign accounts. The district court ordered that the assets of Mr. Merrick and the named funds be frozen and repatriated to the United States.


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 these topics further, please contact your Foley attorney or the following:


Terry D. Nelson
Madison, Wisconsin

Joseph D. Shumow
Madison, Wisconsin

Peter D. Fetzer
Milwaukee, Wisconsin