A Compilation of Enforcement and Non-Enforcement Actions

11 October 2010 Publication
Authors: Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

Regulation Requirements for Municipal Advisers Not Clear to All

Some municipal advisers and their counsel believe that the SEC’s temporary rule requiring municipal advisers to register (Rule 15Ba2-6T under the Securities Exchange Act of 1934) lacks clarity and needs to be amended. The temporary rule is effective until December 30, 2011 or until the SEC completes a final rule. By October 1, 2010, municipal advisers are required to register as investment advisers with the SEC. The temporary rule was promulgated by the SEC in response to Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requiring registration of such advisers. In addition, the statute states that such advisers have a fiduciary duty to the municipalities they advise.

Much of the criticism of the temporary rule and the statute itself stems from the lack of clarity about who is included within the definition of a “municipal adviser.” In addition, it is not clear to some as to what constitutes the type of municipal financial products or the type of advice covered within the definition. Certain exclusions from registration are available for, among others, underwriters and certain commodity advisers.

An SEC spokesperson, in an informal response to such criticism, has stated that the SEC will apply a common-sense approach when applying the rule. It is hoped that the final SEC rule will serve to provide clarity as to the scope of the registration requirements.

FINRA Intends to Allow Option of All-Public Arbitration Panel

The Financial Industry Regulatory Authority (FINRA) recently announced that it would seek to provide investors with the option of excluding industry representatives from the arbitration panel hearing their disputes with broker-dealers. FINRA facilitates and oversees the industry’s mandatory arbitration system.

It is widely believed by investors that all-public panels would be fairer to them than the current practice of having at least one industry representative on the panel. Presently, investors are required to enter into agreements with their broker-dealers requiring that all disputes between their customers be conducted through arbitration.

Interestingly, this FINRA proposal comes just two months after the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which, in part, empowers the SEC to ban or otherwise limit mandatory arbitration provisions. State securities law administrators and consumer organizations have expressed the need to ban pre-dispute binding arbitration provisions.

FINRA’s proposal must be filed with and approved by the SEC. FINRA’s Chief Executive Officer Richard Ketchum stated that the option “would enhance confidence in and increase the perception of fairness in the FINRA arbitration process.”

Proxy Access Rule Stayed

On October 4, 2010, the SEC stayed its rule amendments facilitating shareholder director nominations (referred to as the proxy access rule), pending judicial review of a challenge brought by the Business Roundtable and the Chamber of Commerce of the United States. Release Nos. 33-9149, 34-63031, IC-29456 (October 4, 2010). The result is that rule amendments are not expected to be in effect for the 2011 proxy season.

While the proxy access rule applies to mutual funds (open-end management investment companies), most mutual funds rarely have a meeting of shareholders to elect directors. Therefore, in the normal course, the proxy access rule will likely have little impact on mutual funds.

However, should a mutual fund hold a meeting of shareholders to elect directors, the fund would need to first file a Form 8-K (a form heretofore not applicable to mutual funds) indicating a date by which a nominating shareholder or shareholders must give the fund notice of its nominee. This date must be a date that is a reasonable time before the mutual fund mails its proxy material. The SEC’s adopting release did not give any guidance as to what it meant by “reasonable.” While it seems unlikely that a mutual fund investor holding three percent of the fund’s shares continuously for a three-year period would be so dissatisfied with fund management to nominate an independent director, the requirement to give reasonable notice of the period that shareholders have to nominate a director will slow the proxy process.

For a shareholder to be eligible to have its nominee included in a proxy statement, the following (among other) requirements must be satisfied:

  • The nominating shareholder or shareholders must hold at least three percent of the outstanding shares that are entitled to vote in the election (series of a series mutual fund will be aggregated for purposes of this requirement)
  • The nominating shareholder or shareholders must have held the minimum number of shares constituting three percent continuously for a three-year period
  • The nominating shareholder or shareholders may not hold any shares with the purpose, or with the effect, of changing control of the mutual fund
  • The nominee must be an independent director, if elected (the nominee does not need to be independent with respect to the shareholder)
  • The nominating shareholder or shareholders must give the mutual fund notice of its nominee a reasonable time before the mutual fund mails its proxy material
  • The nominating shareholder or shareholders may nominate the greater of the number of nominees that represents 25 percent of the mutual fund’s board of directors (rounded down to the nearest whole number) or one nominee

Whistleblower Developments

In light of recent developments, mutual funds should take steps to protect themselves from potential whistleblower lawsuits by ensuring that they have systems in place to efficiently facilitate internal reporting and that they thoroughly investigate all internal complaints. It is critical to think creatively about the most effective ways to communicate to employees the importance of internal reporting to ensure that any problems are addressed promptly before they become larger problems.

In March, a Massachusetts federal district court ruled in Lawson v. FMR LLC that the Sarbanes-Oxley whistleblower protections apply to employees of investment private firms that operate and advise mutual funds. Then in July, the Dodd-Frank Act enhanced the protections for whistleblowers (the Act did not address the coverage of employees of an investment adviser to a mutual fund).

The Dodd-Frank Act incentivizes whistleblowers to report complaints directly to the SEC. This is in contrast to Sarbanes-Oxley, which required companies to establish whistleblower hotlines to encourage employees and others to report suspected wrongdoing internally, subject to ultimate audit committee oversight. Essentially, the Sarbanes-Oxley provisions were designed to enable companies to identify and redress problems internally as a matter of good corporate governance.

In contrast, the Dodd-Frank Act creates incentives that will likely encourage employees to report directly to the SEC based on the prospect of obtaining substantial financial rewards. Specifically, the Dodd-Frank Act significantly expands the SEC’s bounty authority, allowing the SEC to pay bounties of up to 30 percent of all monies collected, including penalties, disgorgement, and interest, to parties who provide key information in any type of enforcement action (previously, an individual bounty payment could not exceed 10 percent of the penalty collected, and could only be paid in insider trading cases).

The Dodd-Frank Act also significantly expands anti-retaliation employment protections and remedies for whistleblowers. Specifically, the new provisions: (1) extend the statute of limitations to bring retaliation claims from 90 days to six years; (2) exempt whistleblower claims from pre-dispute arbitration agreements; (3) allow whistleblowers to bypass the administrative process to bring claims directly in federal court; (4) clarify that whistleblower claims, including claims under Sarbanes-Oxley, can be tried before a jury; and (5) provide not only for reinstatement and attorneys’ fees, but also double back pay.

Mutual funds should take the initiative to:

  • Review and update compliance policies, including provisions for anonymous reporting and whistleblower policies
  • Cultivate a culture that emphasizes the importance of legal and regulatory compliance and ethical conduct
  • Ensure that the compliance program has appropriate oversight at the board level
  • Offer training on the whistleblower policy and procedures so that employees know the process and appreciate the roles of the people involved
  • Ensure that all employees understand that retaliation for reporting legitimate concerns of potential misconduct will not be tolerated
  • Investigate and evaluate whistleblower complaints expeditiously

Enforcement Matters

Colorado Investment Adviser Faces Fraud Charges

The SEC has charged a Colorado-based investment adviser with fraud and breach of fiduciary duty in connection with the adviser’s allegedly unsuitable recommendations and inadequate disclosures to clients who invested in certain hedge funds operated and managed by the adviser (In re Greenberg, SEC, Admin. File No. 3-14033, 9/7/10).

Neal Greenberg, the CEO of Tactical Allocation Services, LLP, on behalf of his firm recommended to the firm’s clients an investment in its hedge funds based upon Mr. Greenberg’s assertion such investments were suitable for conservative and older investors. The funds attracted about $174 million in investments from about 100 clients. Instead of a conservative investment, the funds utilized leverage while investing in non-diversified securities. The funds suffered heavy losses in 2008 and refused to make redemptions for their investors.

The written disclosure documents for the funds refuted Mr. Greenberg’s oral statements to clients about the use of leverage and diversification of investments. In addition, Mr. Greenberg is charged that his firm failed to have in place adequate compliance policies and procedures with respect to client recommendations. Finally, Mr. Greenberg allegedly failed to inform clients that they would be charged performance and incentive fees on the leveraged portion of the investments in the funds.

If the SEC’s charges are proven, Mr. Greenberg could be subject to, among other things, fines and disgorgement.

California Investment Adviser Agrees to Payment of Fine With Respect to Failure to Disclose Conflict of Interest

Valentine Capital Asset Management, a California-based registered investment adviser, agreed to settle an SEC enforcement action by disgorging approximately $400,000 it received in excess commissions, paying a $70,000 penalty, and agreeing to be censured.

According to the SEC complaint, the adviser recommended to its clients that they switch from one of its principal funds to another principal fund without disclosing to the clients that by switching funds, they would pay commissions, although most had already paid the full extent of commissions in connection with the fund in which they had initially invested. The failure to disclose this information was material according to the SEC, and constituted a violation of the anti-fraud provisions under the Investment Advisers Act of 1940 and a breach of the investment adviser’s fiduciary duties to its clients.

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