A Compilation of Enforcement and Non-Enforcement Actions

03 June 2010 Publication
Author(s): Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

Amendments to Part II of Form ADV High on SEC’s List

In recent remarks, SEC staff have indicated that amendments to Part II of Form ADV are high on the SEC’s to-do list. The Director of the SEC’s Division of Investment Management, Andrew J. Donohue, has publicly announced that the SEC staff is working on a recommendation to the SEC for adoption of amendments to Part II soon.

As for the nature of the changes to Part II, SEC Chairman Mary Shapiro has stated that the SEC is “looking to move past the 1960s check-the-box, paper-based approach by requiring a plain English narrative discussion of an adviser’s conflicts, compensation, business activities and disciplinary history.” The SEC views such changes as vital because Form ADV is the core disclosure document for every registered adviser, and Part II of Form ADV is the disclosure document provided to clients. Specifically, it is through Part II that investors receive the information they need to decide whether to hire an adviser, and the SEC believes it “is sadly antiquated.”

Funds Should Review Derivative Use and Related Prospectus Disclosure

On May 11, 2010, Andrew J. Donohue discussed, among other things, mutual funds’ use of derivatives. Specifically, Mr. Donohue mentioned the challenge of how to appropriately inform fund shareholders of market, liquidity, leverage, counterparty, legal, and structural risks as part of the SEC’s disclosure and financial reporting regime. These comments, along with recent SEC staff comments related to prospectus reviews, suggest that a fund that uses derivatives should carefully review its prospectus disclosure to ensure the fund has adequately and clearly described its derivative strategies and the risks they present to investors in the fund.

Mr. Donohue has expressed concerns in the past about the use of derivatives by mutual funds, and he reiterated in the address his belief that these instruments, while affording the opportunity for efficient portfolio management and risk mitigation, also present potentially significant additional risks. He noted that mutual funds that mimic hedge fund strategies, typically involving derivative products, have become commonplace, and that it is not uncommon for investment companies with traditional investment objectives to obtain synthetic market exposure through derivative products such as credit default swaps, rather than invest directly in stocks, bonds, and similar securities.

Mr. Donohue noted that a fund’s use of derivatives presents concerns and risks on many levels — such as market, liquidity, leverage, counterparty, legal, and structure risks. He noted that one of the main challenges posed by derivatives is how to appropriately inform fund shareholders of these and other relevant risks as part of the SEC’s disclosure and financial reporting regime, as losses to the fund and its shareholders can result from a complicated mix of events. Further, he noted that it can be difficult to describe these risks in language that is easily understood by shareholders.

Enforcement Matters

SEC Imposes Five-Year Bar on Principals of Hedge Fund

In separate orders issued on May 5, 2010, the SEC barred Neil Moody and Christopher Moody of Sarasota, Florida from association with any investment adviser for a period of five years.

The SEC orders were in response to offers of settlement by the respondents. On the basis of the orders and respondents’ offers to settle, the SEC determined that during the period of at least 2003 through 2008, the respondents mislead investors and prospective investors in three hedge funds they operated through the distribution of offering materials, account statements, and newsletters containing misrepresentations of the funds’ investment returns and historical performance and overstated the value of the funds’ assets. In addition, the SEC determined that the respondents mislead investors about their role in managing the assets of the funds by claiming that they controlled all of the investment and trading decisions.

Previous to these orders, the respondents were subject to a final judgment entered by consent enjoining each of them from violating Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Section 206(4) of the Investment Advisers Act of 1940.

After the five-year bar period, the respondents may petition the SEC for association with an investment adviser, but their reentry may be conditional upon several factors, including whether any ordered disgorgement or restitution payments have been made with respect to the investors and the hedge funds.

Fund Portfolio Manager Charged With Insider Trading

On May 11, 2010, the SEC issued an order instituting administrative and cease-and-desist proceedings against bond fund portfolio manager David W. Baldt, alleging that he engaged in insider trading by tipping his family members to redeem their shares in the fund he managed, in light of adverse material non-public information he had concerning the fund. While the outcome of the order, including whether the allegations will be found true, remains unknown, the order is a good reminder that portfolio managers may not engage in insider trading by using material non-public information about the funds they manage to their advantage, or to the advantage of others to whom they “tip” the information.

In the order, the SEC alleges that Mr. Baldt knew, or was reckless in not knowing, that tipping his family members to sell their shares of the fund he managed constituted a breach of his fiduciary duties because his actions entailed misuse of confidential information for the benefit of his family.

Specifically, it is alleged that Mr. Baldt knew that the bond fund he managed was receiving mounting and significant redemption requests at a time when sales of portfolio securities were adding downward pressure on municipal bond prices. The order notes that “not only were market conditions rapidly deteriorating, but brokers had extremely limited capital with which to bid on bonds (meaning that regardless of the type of bond the team was attempting to sell, they were likely to get little, if any, interest to purchase that bond).” Given these circumstances, Mr. Baldt knew that the fund faced two options: either the fund could remain open, which he believed would result in a significant drop in the fund’s net asset value, or the fund would be liquidated in an orderly fashion, resulting in near-term illiquidity for shareholders, if redemptions were to be made only “in-kind,” on a pro rata basis.  

Mr. Baldt also knew that management had directed that the fund sell enough portfolio securities to maintain a sufficient cash cushion to meet projected redemption requests. To comply with this directive, the fund had quietly attempted to sell a large portion of its portfolio securities, but very few bids had been received. Mr. Baldt then learned that a broker had discovered that the fund was putting out a large percentage of its bond portfolio to bid and questioned whether the fund was in trouble. In light of these circumstances, it is alleged that Mr. Baldt knew that such information, if it became known by investors, would likely cause redemption requests to increase and cause near-term, detrimental harm to the fund and its shareholders, so he “tipped” his family members to redeem all of their shares in the fund.

With respect to such activities, the SEC alleges that Mr. Baldt violated Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Section 206(1) and 206(2) of the Investment Advisers Act of 1940.

Legal News is part of our ongoing commitment to providing legal insight to our clients and colleagues. If you have any questions about or would like to discuss these topics further, please contact your Foley attorney or any of the following individuals:

Terry D. Nelson
Madison, Wisconsin

Peter D. Fetzer
Milwaukee, Wisconsin