A Compilation of Enforcement and Non-Enforcement Actions

03 October 2011 Publication
Author(s): Peter D. Fetzer Terry D. Nelson

Legal News: Investment Management Update

Non-Enforcement Matters

Legislation Intended to Create an SRO for Investment Advisers

The Chairman of the House Financial Services Committee (House Committee), Spencer Bachus (R-Ala.), intends to introduce legislation that would require both SEC- and state-registered investment advisers to join a self-regulatory organization (SRO) overseen by the SEC.

In January 2011, the SEC issued a report to the House Committee in which it recommended that the U.S. Congress enact legislation to require the creation of one or more SROs to oversee investment advisers, allocate the task to the Financial Industry Regulatory Authority (FINRA), or impose “user fees” on registered investment advisers to fund the SEC’s investment adviser examination program. Currently, SEC-registered investment advisers are examined about every 11 years and the state examination process over state registered investment advisers varies in both quality and quantity from state-to-state.

Under the legislation, the SRO would be required to register with the SEC and meet certain criteria. The SRO would need to demonstrate to the SEC that it would be able to enforce compliance by its members, effectively examine those members, and submit an annual report to the SEC and Congress. The proposed legislation contemplates that certain advisers would be exempt from becoming a member of the SRO. Such exempt advisers would be those advisers who: (i) have 90 percent or more of assets under management attributable to non-U.S. clients; (ii) manage assets of less than $25 million; or (iii) manage venture capital funds and 401(k) plans.

It is believed that the creation of an SRO to regulate the registered investment advisers would allow the SEC to transfer more of its resources from its examination program to the area of complex and emerging issues within the securities industry that have arisen. It is no secret that the current system in which the SEC attempts to oversee and enhance its examination program over registered investment advisers is, at best, an uphill battle.

The North American Securities Administrators Association, representing the 50 state securities regulators, has voiced its opposition to the creation of an SRO that also would require state registered investment advisers to be a member. Apparently, most, if not all, of the state securities regulators believe that they can effectively regulate the investment advisers registered in their jurisdictions. The hedge fund industry also opposes creating an SRO to regulate investment advisers. In recent testimony before the House Committee, Richard Baker, head of the Managed Funds Association, testified that an SRO would, among other things, lack the expertise to conduct an effective examination over hedge fund managers. Others believe that dedicating fees imposed on investment advisers to the SEC for the hiring of staff examiners makes the most sense. The most common fear vocalized by detractors is that an SRO would need time (perhaps a couple of years) to hire and educate staff to conduct effective examinations. In addition, some dislike the fact that creating an SRO would, in effect, be another layer of regulation for its members.

What is clear to almost all parties is that the SEC needs help if it is to fulfill the examination program mandates under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Congressman Bachus believes that creating one or more SROs would best fulfill that mandate.

Investment Advisers and the Large Trader Rules

The SEC recently adopted large trader rules (Rule 13h-1 under the Securities Exchange Act), which will impact certain investment advisers. If an investment adviser meets the definition of a large trader, the investment adviser will need to file a Form 13H with the SEC by December 1, 2011 to identify itself as a large trader. Form 13H is filed electronically through the SEC’s EDGAR system.

The information that large traders provide to the SEC is confidential, and is not subject to public disclosure. However, the information is subject to disclosure to Congress, other federal departments, and agencies acting within the scope of their jurisdictions, and pursuant to federal court orders in an action commenced by the U.S. government, including the SEC.

Definition of a “Large Trader.” The definition of a large trader is very technical, as it involves a number of different terms defined in the new rule. Initially, investment advisers need to understand the concept of “identifying activity level,” as this triggers the need for a person who exercises investment discretion over one or more client accounts to identify itself as a large trader.

The identifying activity level is essentially a measure of the level of trading in exchange-listed securities, including equities and options (referred to as NMS securities in the new rule), that the person is effecting on behalf of the client accounts over which the trader has investment discretion. If a person effects aggregate “transactions” in NMS securities of at least 2 million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month, the trader must file a Form 13H to identify itself as a large trader.

While the above summary of the definition of large trader may seem straightforward, the definition has a number of nuances that investment advisers should note:

  • Employees of an investment adviser who exercise investment discretion within the scope of their employment are deemed to do so on behalf of the investment adviser.
  • The term “transaction” is defined to exclude numerous types of transactions such as the purchase or sale of securities pursuant to exercises or assignments of options, securities purchased in most types of offerings by the issuer, and transactions to effect a business combination.
  • All transactions in securities within all client accounts over which an investment adviser has investment discretion must be aggregated in order to determine whether the investment adviser is a large trader. In making this determination, an investment adviser is not allowed to offset or net transactions in client accounts against each other, whether for hedged positions or otherwise.
  • An investment adviser has investment discretion if the adviser or its employees are authorized to determine what securities or other property are to be purchased or sold by or for the client account.
  • The definition of a large trader is designed to focus on the ultimate parent company of an investment adviser or advisers that employ or otherwise control the individuals that exercise investment discretion, with the intention of easing the administrative burden of both the large trader, by allowing the parent company to comply with the registration requirement on behalf of its subsidiaries (or vice versa), as well as the SEC. So, a large trader need not comply with the new rule if a controlling person complies with the rule on its behalf. Similarly, a controlling person need not comply with the new rule’s requirements if a large trader it controls complies with the rule on its behalf and on behalf of all others under common control who trade.
  • A person is presumed to be in “control” of another person if it owns 25 percent or more of the voting securities of such other person.

Information Provided in Form 13H and Ongoing Filing Requirements for Large Traders. Form 13H requires that a large trader report a significant amount of information regarding itself and its affiliates, including, without limitation: contact information; general information concerning the business and the nature of the operations of both the large trader and any affiliate of the large trader that exercises investment discretion over NMS securities (referred to as securities affiliates in the new rule), including a general description of the securities affiliates' trading strategies; an organizational chart; a list of the broker-dealers at which the large trader and its securities affiliates have accounts; and other information regarding regulatory status, governance, and ownership of the large trader.

Upon receiving a large trader’s Form 13H, the SEC will assign the large trader a unique large trader identification number. The large trader will be required to provide its large trader identification number to each of its broker-dealers and identify to the broker-dealers all of its accounts to which the large trader identification number applies.

After making its initial filing, a large trader is required to submit an annual filing on Form 13H within 45 days of the end of the calendar year. Furthermore, in any calendar quarter during which any of the information contained in the Form 13H becomes inaccurate for any reason, a large trader is required to submit an amended Form 13H promptly after the end of such calendar quarter.

Going In and Out of Status as a Large Trader. A person who does not meet the definition of large trader by December 1, 2011, but later effects aggregate transactions equal to or greater than the identifying activity level threshold, must file an initial Form 13H “promptly.” In normal circumstances, the SEC has interpreted promptly to mean that the filing must be made within 10 days of meeting or exceeding the identifying activity level threshold.

If during any full calendar year a large trader does not effect transactions meeting the identifying activity level threshold, the large trader may file for inactive status with the SEC in the following calendar year. During inactive status, a large trader is not required to submit Form 13H filings or disclose its large trader identification number to its broker-dealers. An inactive large trader must reactivate his/her status by filing a Form 13H if he/she again meets or exceeds the identifying activity level threshold, presumably within 10 days of meeting or exceeding identifying activity level threshold.

Enforcement Matters

SEC Charges Co-Founder of Institutional Money Manager With Fraud

The SEC, on September 22, 2011, charged Ben M. Rosenberg, a co-founder of California-based institutional money manager AXA Rosenberg, with fraud for concealing a significant error in the computer code of the quantitative investment model that he developed and provided to his firm and related entities for managing client assets.

According to the SEC, Mr. Rosenberg knew of the error in June 2009 but directed others in the firm to not reveal or correct the error. Mr. Rosenberg eventually disclosed the error to the SEC in March 2010 just prior to the SEC conducting an examination of AXA Rosenberg. Clients were informed by Mr. Rosenberg of the error in April 2010. According to the SEC, the failure to disclose the error resulted in $217 million in losses in 600 client accounts managed by AKA Rosenberg and related entities.

Mr. Rosenberg has agreed to settle the SEC’s charges by paying a $2.5 million penalty and agreeing to a lifetime bar from the securities industry. The SEC had previously charged AXA Rosenberg and its affiliated investment advisers, who agreed to pay $217 million to clients harmed from the concealment of the error and a $25 million penalty.

The quantitative model that Mr. Rosenberg created and used to manage client assets included a material error, as early as June 2009, in the model’s computer code. The error served to disable one of the model’s key components for managing risk and affected the model’s ability to perform as expected. Although the error was brought to Mr. Rosenberg’s attention by staff in June 2009, he directed staff and others to conceal the error and declined to fix it. Instead, in response to client concern about the effectiveness of the model, Mr. Rosenberg informed clients that the model’s underperformance was due to other factors and that the model was controlling risk effectively, although he knew that was not the case. To compound the problem, Mr. Rosenberg did not act to fix the error although he had the capacity to do so.

The SEC’s complaint cited violations by Mr. Rosenberg of willfully violating the anti-fraud provisions of the Investment Advisers Act of 1940, under Sections 206(1) and 206(2). For more complete information about this matter, see SEC Release 2011-189 and IA-3285.

SEC Bars Registered Investment Adviser From Securities Industry for Misleading Clients

On September 23, 2011, the SEC settled administrative proceedings against James Peister, the CEO and President of Northstar International Group, Inc., an unregistered investment adviser based in New York, in connection with allegations that Mr. Peister acted to defraud investors in a hedge fund for whom his firm served as general partner and investment adviser.

The SEC charged that Mr. Peister and Northstar, during the period of 2003 through 2009, intentionally overstated the assets of the hedge fund and, by doing so, they provided investors and prospective investors with materially false and misleading information about the fund’s track record, and issued false and misleading quarterly reports and financial statements to such investors. According to the SEC, the statements were made at a time when the fund’s actual assets were at a state that all of the investors could not be paid back their investment. In spite of the fund’s dire financial status and underperformance, Mr. Peister and Northstar continued to solicit new investors using the materially false performance numbers.

To settle the SEC charges, Mr. Peister agreed to be barred from association with any broker, dealer, investment adviser, municipal securities dealer, or transfer agent.

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

A. Michael Primo
Boston, Massachusetts