A Compilation of Enforcement and Non-Enforcement Actions

30 October 2012 Publication
Author(s): Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • Principal Trade Rule Extension for Investment Advisers/Broker-Dealers 
  • Mutual Fund Boards and Communications With Auditors 
  • Mutual Fund Directors and Proxy Statement Disclosure

Enforcement Matters

  • SEC Charges Another Hedge Fund Adviser With Fraud

Non-Enforcement Matters

Principal Trade Rule Extension for Investment Advisers/Broker-Dealers

A temporary rule under Rule 206(3)-3T under the Investment Advisers Act of 1940 was set to expire at the end of this year. The temporary rule permits those registered investment advisers who are also registered broker-dealers an alternative to complying with Section 206(3) under the Advisers Act, which prohibits certain principal transactions with clients. The SEC recently acted to extend the effectiveness of the temporary rule until December 31, 2014.

Section 206(3) prohibits an adviser from engaging in or effecting a transaction for a client while acting either as a principal for its own account, or as a broker for a person other than the client, without providing certain disclosures and obtaining the client’s prior consent. The extension of the effectiveness of the temporary rule relief from the prohibition under Sec. 206(3) allows such advisers to conduct principal transactions under certain circumstances.

The SEC’s extension of the temporary rule under Rule 206(3)-3T further demonstrates that the SEC has, to date, failed to complete certain mandates by U.S. Congress, in this case, under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. In that Act, Congress mandated that the SEC conduct a study as to the future regulation of investment advisers and broker-dealers. Early in 2011, the SEC’s staff, in partial response to that mandate, made several recommendations about rules necessary to create a uniform fiduciary standard for all investment advisers, regardless if they were also registered as broker-dealers. To date, the SEC has not acted on the staff recommendations. Accordingly, the temporary rule under Rule 206(3)-3T which takes into account the special needs of investment advisers who are also registered broker-dealers to comply with the principal trading prohibition, is still necessary until formal rulemaking is conducted based on the staff’s recommendations as to uniformity among all registered investment advisers.

Mutual Fund Boards and Communications With Auditors

The Public Company Accounting Oversight Board voted to approve a new Auditing Standard No. 16, Communications with Audit Committees. The SEC has to approve the Standard before it becomes effective, and it only applies to fiscal years beginning on or after December 15, 2012. Nonetheless, mutual fund boards should prepare now for the changes adoption of the new Standard will bring.

The biggest changes for mutual fund audit committees are:

  • The Standard requires communications to be made to the audit committee in a timely manner and before the audit report is issued. This may affect the timing of the audit committee meetings. 
  • The Standard requires the auditor to establish an understanding of the terms of the audit engagement with the audit committee, rather than management. This will require the audit committee to be more engaged in the details of the audit with the auditors. 
  • The Standard requires the auditor to inquire of the audit committee whether it is aware of matters relevant to the audit, including, but not limited to, violations or possible violations of laws or regulations. This will put on the committee increased urgency for overseeing compliance at the company. 
  • There are new subjects that need to be expressly discussed with the auditors. Specifically, the Standard requires discussion of: 
    • Certain matters regarding the fund’s accounting policies, practices, and estimates 
    • The auditor’s evaluation of the quality of the fund’s financial reporting 
    • Information related to significant unusual transactions, including the business rationale for such transactions 
    • The auditor’s views regarding significant accounting or auditing matters when the auditor is aware that management consulted with other accountants about such matters and the auditor has identified a concern regarding these matters 
    • An overview of the overall audit strategy, including timing of the audit, significant risks the auditor identified, and significant changes to the planned audit strategy, or identified risks  Information about the nature and extent of specialized skill or knowledge needed in the audit; the extent of the planned use of internal auditors, company personnel, or other third parties, and the involvement of other independent public accounting firms or other persons not employed by the auditor during the audit 
    • The basis for the auditor’s determination that he or she can serve as principal auditor, if significant parts of the audit will be performed by other auditors 
    • Situations in which the auditor identified a concern regarding management’s anticipated application of accounting pronouncements that have been issued but are not yet effective and might have a significant effect on future financial reporting
    • Difficult or contentious matters for which the auditor consulted outside the engagement team 
    • The auditor's evaluation of going concern 
    • Departures from the auditor’s standard report 
    • Other matters arising from the audit that are significant to the oversight of the company’s financial reporting process, including complaints or concerns regarding accounting or auditing matters that have come to the auditor’s attention during the audit

As for current action items for mutual fund boards, audit committees should: 

  • Discuss with the auditor the anticipated timing of the required communications and whether changes to meeting agendas will be necessary to accommodate the additional communication requirements 
  • Prepare for the possibility of increased auditor requests for formal representation letters from the audit committee or audit committee chair, and assess whether it is appropriate to provide such representations 
  • Re-evaluate the audit committee’s processes for receiving information about investigation and compliance matters, to determine if any changes are advisable 
  • Once the Standard is adopted (in case there are changes), the audit committee charter and annual calendar should be reviewed and updated as appropriate

Mutual Fund Directors and Proxy Statement Disclosure

While the directors of mutual funds do not often face the need to be involved in the preparation of a proxy statement, they should be prepared when the need arises. In this regard, it is important for directors to understand their liability for proxy statement disclosures.

Liability for proxy statement disclosures is not a hypothetical, as shareholders have brought a number of recent lawsuits against companies alleging, among other things, that the proxy statements used to solicit their votes were false or misleading. These lawsuits stand as a reminder that when a company is soliciting shareholder votes, directors owe a duty to shareholders to ensure that the proxy statement fully and accurately discloses the material facts necessary for shareholders to make an informed vote.

This duty arises under Section 14(a) of the Securities Exchange Act of 1934, specifically Rule 14a-9 promulgated thereunder. Rule 14a-9 prohibits a company from soliciting the votes of its shareholders with a proxy statement that contains materially false or misleading information, or fails to disclose material information that is necessary for full and fair disclosure to shareholders.

To help ensure that shareholders are provided with the material information they need to make an informed decision on how to vote, Schedule 14A was promulgated. Schedule 14A identifies the minimum disclosure standards for proxy statements. It is key to note that while Schedule 14A sets minimum disclosure standards for proxy statements, compliance with Schedule 14A does not necessarily guarantee that a proxy statement will satisfy Rule 14a-9’s requirement that the proxy statement contain full and fair disclosure regarding the matters on which shareholders are voting.

To increase the incentives for directors to carefully read proxy statements, the proxy rules provide that negligence alone can result in liability for a director involved in a proxy solicitation. The courts have stressed that this negligence standard does not impose upon directors the role of guarantors or insurers of the accuracy of proxy statements. This means, for example, that directors are not required to recalculate or reassemble financial reports (absent some evident misstatement or irregularity that should be within the director’s knowledge).

On the other hand, this negligence standard does increase the incentives for directors to more rigorously police proxy statements. These incentives exist because a director that fails to carefully read a proxy statement to correct statements and facts that the director knew or should have known were erroneous or misleading may be held liable for such false or misleading statements and facts. In this regard, directors should note that shareholders and investors who have been injured as a result of a false or misleading proxy statement may directly bring an action for damages or other appropriate relief.

Fortunately, for a shareholder or investor to successfully recover damages against an individual director, the shareholder or investor must be able to establish some degree of culpability. Therefore, an individual director can take steps to insulate himself against liability for a false or misleading proxy statement by carefully reading the proxy statement to correct statements and facts that the director knew or should have known were erroneous or misleading.

Enforcement Matters

SEC Charges Another Hedge Fund Adviser With Fraud

The SEC continues to bring enforcement actions against advisers of hedge funds for, among other things, overvaluing hedge fund assets and providing false performance reports to current and prospective investors. Another example of the SEC’s concentrated efforts to go after such advisers is the recent announcement by the SEC of the commencement of enforcement actions against New Jersey-based Yorkville Advisors LLC, and its president and chief financial officer (SEC v. Angelo, S.D.N.Y., 12-Civ.-7728, 10/17/12). The parties are charged by the SEC with misrepresenting the safety and liquidity of the assets held by the funds they managed and, because the funds’ asset values were inflated, charging investors excessive management fees.

Interestingly, the charges in this matter are a result of the SEC’s application of the so-called Aberrational Performance Inquiry or API. According to the SEC, its Asset Management Unit uses analytical data to help identify “suspicious returns” within a fund’s report performance. According to the SEC, six other cases have been opened based on the results from the API analysis. Based on the reported performance results of the Yorkville funds, the API analysis determined that there was reason to doubt the performance numbers.

More specifically, the SEC alleges that the adviser and its principals failed to follow its own stated valuation practices for the funds’ assets, withheld adverse information from the funds’ auditor, and misled investors about the liquidity of the funds, related collateral, and third-party valuation firms supposedly engaged by the adviser. According to the SEC calculations, the parties collected more than $280 million from pension fund investors in their funds, which allowed the adviser to charge at least $10 million in excessive fees.

The defendants are charged with violations of the anti-fraud provisions under various federal securities laws as well as under 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