A Compilation of Enforcement and Non-Enforcement Actions

01 June 2011 Publication
Author(s): Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

Helpful Guidance for Investment Advisers on California Lobbyist Law

A number of questions have arisen around the implementation of California’s new law requiring placement agents to register as lobbyists pursuant to the California Political Reform Act. In particular, the application of the law to investment advisers and their personnel has been subject to some ambiguity.

Investment advisers and their personnel are potentially subject to registering as lobbyists because the law defines placement agents broadly. As investment advisers grapple with the application of the law, it is helpful to note some recent guidance provided by the Fair Political Practices Commission (FPPC), the agency that enforces the California Political Reform Act.

In a letter to Peter C. Williams, dated April 20, 2011 (the “April 20 Letter”), the FPPC stated that the law does not apply retroactively to contracts that an investment adviser had with a California state pension plan before the law took effect on January 1, 2011. However, to the extent that the investment adviser makes updates to the contract or enters into new or additional contracts, the law applies.

In the April 20 Letter and in a letter to Mayer Brown LLP dated April 7, 2011 (the “April 7 Letter”), the FPPC addresses issues related to the implementation of the following two exemptions:

  • Employees, officers, or directors of an investment adviser are not placement agents required to register as lobbyists if all of the following apply: (1) the investment adviser is registered as an investment adviser under federal or state law, (2) the investment adviser has been selected through a competitive bidding process, and (3) the investment adviser has agreed to a fiduciary standard of care (referred to as the “Competitive Bidding Process Exemption”)
  • Employees, officers, directors, equityholders, partners, members, or trustees of an investment adviser who spend one-third or more of their time during a calendar year managing the securities or assets of the investment adviser are not placement agents required to register as lobbyists (referred to as the “Portfolio Manager Exemption”)

Competitive Bidding Process Exemption
In the April 7 Letter, the FPPC provided guidance on the second prong of the Competitive Bidding Process Exemption. With respect to the second prong, the FPPC addressed questions that had arisen as to whether the exemption is effective before the competitive bidding process begins, during the process, or upon selection. The FPPC made it clear that the second prong applies to the entire process of obtaining a contract, from the time the California state pension plan issues a request for proposal (RFP) until the contract is awarded, and made it clear that the second prong only applies to RFPs.

The FPPC’s position means the following are outside of the scope of the second prong of the Competitive Bidding Process Exemption and, therefore, the exemption would not be available:

  • Communicating with a California state pension plan before an RFP is actually issued, provided, however, that an investment adviser and its personnel may (a) inquire as to whether the state pension plan intends to contract out certain services and (b) respond to inquiries as to the adviser’s capabilities and pricing
  • Any other activity with a California state pension plan before an RFP is actually issued

Furthermore, the FPPC made it clear that the Competitive Bidding Process Exemption is not a systematic exemption. So, even though an investment adviser has been awarded a contract through an RFP process and qualified for the exemption, efforts outside of an RFP process to obtain contracts for other types of services from the same California state pension plan would fall outside of the exemption. On the other hand, the adviser may engage in efforts to obtain an extension of an existing contract.

Portfolio Manager Exemption and Other Exclusions
In the April 7 Letter, the FPPC provided guidance on the Portfolio Manager Exemption. Under this exemption, a question has arisen as to whether employees of an investment adviser other than portfolio managers who have a limited role in soliciting contracts, such as the CFO, would qualify for the exemption. The FPPC stated in the letter that it could not answer this question without knowing more about the duties of such employees (adhering to a strict interpretation of the exemption), but then provided a possible exclusion for such employees outside of the Portfolio Manager Exemption.

Specifically, the FPPC turned to the regulation defining lobbyists and determined by analogy that if a knowledgeable employee of an investment adviser, such as the CFO, occasionally attends meetings with a California state pension plan to provide information about the investment adviser, and attends any such meetings with a registered placement agent, then such employee does not need to register as a lobbyist.

In the April 20 Letter, the FPPC provides another possible exclusion outside of the Portfolio Manager Exemption. The exclusion arises in the context of employees of an investment adviser who make trades “under the direction” of a California state pension plan. Presumably, these employees did not qualify for the Portfolio Manager Exemption (although this is not expressly addressed in the letter). So, the FPPC looks by analogy to guidance it has provided under lobbyists regulations concluding that consultants whose duties extend only to providing advice to a state pension plan are not required to register as lobbyists because they are analogous to employees of the state pension plan.

The FPPC then states that by analogy this guidance applies to consulting work that an investment adviser provides to a California state pension plan, meaning that under the “limited circumstances of performing trades” for a state pension plan “under its direction,” the employees performing those trades would not need to register as lobbyists.

New Whistleblower Rules

On May 25, 2011, the SEC adopted final rules implementing the whistleblower program Congress prescribed in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). In light of this development, investment advisers and investment companies 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.

Action Items for Investment Advisers and Investment Companies

Investment advisers and investment companies should take the following actions to minimize exposure and encourage internal dialogue under the new rules. Review and update compliance policies and procedures to ensure that they:

  • Affirmatively require employees and outside consultants to report violations internally through corporate compliance programs first
  • Articulate a clear anti-retaliation policy
  • Impose express time limits for internal investigations, in an effort to self-report (where necessary) in a timely fashion
  • Detail the process for determining whether to self-report, and the documentation required to support this determination
  • 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

If you learn your company has no exposure or a rogue whistleblower is off track, request a proactive meeting with the government to inform the SEC that there are two sides to the allegations.

If you learn of a complaint, ask the SEC for an opportunity to formally respond before making a decision whether to accept the whistleblower’s referral.

Brief Summary of Rules
Section 922 of Dodd-Frank added new Section 21F to the Securities Exchange Act of 1934 entitled, “Securities Whistleblower Incentives and Protection.” Section 21F directs the SEC to pay awards to whistleblowers who voluntarily provide the SEC with original information about a violation of the securities laws that leads to the successful enforcement of an action brought by the SEC or a related action and that results in monetary sanctions exceeding $1 million. A brief summary of the key provisions of Section 21F and the new rules follows.

Persons Eligible to Receive an Award

  • A whistleblower is an individual who, “alone or jointly with others, provides information to the Commission relating to a potential violation of the securities laws”
  • A whistleblower must be an individual; a company or other entity is not eligible to receive a whistleblower award
  • The following persons are generally not eligible to receive a whistleblower award:
    • Company employees who use original information provided by another employee (for example, through a hotline)
    • Persons who obtained the information through an audit of a company’s financial statements
    • Individuals who knowingly made false statements or representations in connection with their dealings with law enforcement or the SEC

The rules allow persons to report either actual or potential violations of the law.

Amount of Award

  • The SEC will pay an award of at least 10 percent and not more than 30 percent of the total monetary sanctions collected in successful SEC and related actions
  • When determining the amount of an award, a whistleblower’s voluntary participation in a company’s internal compliance and reporting systems is a factor that can increase the amount of an award

No Amnesty

  • The fact that a whistleblower may assist in SEC investigations or enforcement actions does not preclude the SEC from bringing an action against the whistleblower based upon his or her own conduct in connection with violations of the federal securities laws

Internal Reporting

  • While the new rules incentivize internal reporting, they do not require whistleblowers to first report violations internally to qualify for a bounty
  • To incentivize potential whistleblowers to work with their employer’s compliance department, the rules: (1) do not preclude recovery for whistleblowers who report violations to the company, which then self-reports to the SEC; (2) allow recovery for whistleblowers who report to the SEC and their employer at the same time; and (3) provide that a whistleblower’s voluntary participation in an entity’s internal reporting system may increase a whistleblower’s award

SEC Proposes Rule That Would Ban Bad Actors From Exempt Offerings

Included in Dodd-Frank was the requirement that the SEC implement a rule to ban persons, subject to certain sanctions and disciplinary proceedings, who have been convicted of a felony or misdemeanor related to the purchase or sale of a security, from being able to utilize the securities registration exemption under Rule 506 of Regulation D under the Securities Act of 1933. That particular rule, which can be used for any amount of securities offering, is, by far, the most widely used exemption by issuers under Regulation D.

The SEC’s proposed rule, now out for public comment until July 14, 2011, if implemented as proposed, would apply the bad-actor events that occurred prior to the enactment of the provision under Dodd-Frank. This application of the proposed rule to pre-existing convictions and sanctions is likely to cause the most opposition to the proposed rule. The opposition would argue, and properly so, that if Congress wanted pre-existing convictions and sanctions to serve as a disallowance of the use of the exemption, they could have stated so in the law. Indeed, two of the SEC’s commissioners, Kathleen Casey and Troy Paredes, stated that the retroactive approach included in the proposed rule was the primary reason they could not support the proposed rule. The vote by the Commission was 3-2 in favor of going forward with the rule as proposed.

The disqualifying events that are applied to the issuer of the securities, its directors, officers, managing members, 10 percent or more beneficial owners, and promoters include: criminal convictions; court injunctions and restraining orders; final orders of state securities, insurance, banking, or credit union regulators; certain SEC disciplinary orders; and SEC stop orders to suspend exemptions. The SEC, in its proposed rule, asks for public comment whether final orders issued by the SEC or the CFTC also should be included as a disqualifying event.

The SEC also asks for comment whether these disqualifying events should be applied to other securities registration exemptions under Rule 504 of Regulation D, and Regulation A and Regulation E. Congress did not address those exemptions in its Dodd-Frank provision regarding the disqualification of bad actors from the use of the securities registration exemption under Rule 506 of Regulation D.

The proposed rule would provide an exception to the disqualification if the issuer relying upon the exemption could show that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.

The proposed bad-actor disqualification rule by the SEC should be of interest to investment advisers who manage or sponsor private funds that rely primarily upon Rule 506 under Regulation D for an exemption from securities registration. When the proposed rule becomes final, such advisers will need to ensure that there are no bad actors connected with the issuer so not to disqualify the utilization of the exemption. In addition, advisers to a fund of funds will need to include in its due diligence whether such funds have any bad actors involved that could risk the loss of the exemption.

Enforcement Matters

Investment Adviser Charged With Fraud in Connection With Management of Real Estate Funds

The SEC charged a New-York-based investment adviser, Lloyd V. Barriger, with fraudulently conducting a private placement offering of two New York real estate funds he managed.

According to the SEC’s complaint as filed in federal court on May 13, 2011, Mr. Barriger misled investors who invested in his Gaffken & Barriger Fund about the risks of such investment while the actual performance of the Fund indicated that such an investment included substantial risk of losing the entire investment. In addition, Mr. Barriger defrauded investors in Campus Capital Corp. by not telling them that their investments in Campus Capital would be used to basically prop up the ailing Gaffken & Barriger Fund. Mr. Barriger, according to the SEC complaint, used new investor funds to pay off investors who requested redemptions and/or preferred return distribution payments promised by Mr. Barriger. The SEC claims that Mr. Barriger used the funds from investors in Campus Capital to inject nearly $2.5 million into the Gaffken & Barriger Fund without informing such investors about that fund’s financial distress. Between the two funds, Mr. Barriger raised approximately $32 million from investors during the period of 1998 to 2008.

The SEC’s complaint alleges that Mr. Barriger violated Sections 206(1) and (2) of the Investment Advisers Act of 1940 (i.e., “anti-fraud” provisions) and anti-fraud provisions under the Securities Act of 1933 and the Securities Exchange Act of 1934.

The SEC is seeking a permanent injunction enjoining Mr. Barriger from further violations of the anti-fraud provisions under the federal securities laws, civil penalties, and disgorgement of ill-gotten gains.

Investment Adviser Analyst Who Traded on Material Non-Public Information Subject to Industry Bar

The SEC issued an administrative order on May 19, 2011 under Section 203(f) of the Investment Advisers Act of 1940 against Jonathan Hollander, a former analyst of a registered investment adviser (In the Matter of Jonathan Hollander, File No. 3-14398, SEC IAA Release No. 3208).

The SEC’s administrative action follows the settlement of a civil action against Mr. Hollander (SEC v. Jonathan Hollander, Civil Act No. 11-CV-2885, U.S. Dist. Ct. S.D.N.Y.), which resulted in the imposition of a permanent injunction against Mr. Hollander from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, ordering him to pay disgorgement and a civil penalty. The SEC’s complaint alleged that Mr. Hollander, among other things, used material non-public information to trade in securities and tipped others who traded on such information.

The administrative order issued against Mr. Hollander serves to bar him from association with any broker, dealer, investment adviser, municipal securities dealer, or transfer agent, with the right to reapply for association after three years. Any reapplication for association will have to be accompanied by the satisfaction of any or all of the following: (a) any disgorgement ordered against Mr. Hollander or the SEC’s waiver of such payment, fully or partially; (b) any arbitration award related to the conduct that served as the basis of the SEC’s order; (c) any self-regulatory organization arbitration award to a customer; and (d) any restitution order by a self-regulating organization, whether or not related to the conduct that served as the basis for the SEC’s order.

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