A Compilation of Enforcement and Non-Enforcement Actions

30 May 2013 Publication
Authors: Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters 

  • Board Oversight of Distribution and Financial Intermediaries 
  • New Identity Theft Rules 
  • Investment Management Guidance on Social Media Filings

Enforcement Matters 

  • Fund Manager Agrees to Be Barred From the Securities Industry in Connection With Misappropriating Fund Assets 
  • Father and Son Charged by SEC With Cherry Picking Over the Interests of Clients

Non-Enforcement Matters

Board Oversight of Distribution and Financial Intermediaries

One of the SEC’s stated focuses is on payments for “distribution in guise.” Mutual funds are only permitted to pay for distribution of their shares if they have adopted a Rule 12b-1 plan. Funds are not permitted to pay for distribution outside of Rule 12b-1, but they are permitted to pay for shareholder servicing outside of Rule 12b-1. So, the SEC is assessing whether payments made by funds outside of Rule 12b-1 are really payments for distribution.

This focus comes about because of the increasing role of financial intermediaries (such as broker-dealers, fund supermarkets, and financial advisers) in distributing mutual fund shares, particularly through fund supermarkets. Financial intermediaries are now integral to the distribution of mutual funds. These intermediaries also provide a variety of services to fund shareholders that would otherwise be provided by funds, including their transfer agents. These services may include: trade processing, accounting of investor positions, receipt and processing of investor trade orders, servicing of investor accounts, and tax reporting and distribution of other information. Payments to intermediaries for such shareholder servicing are commonly referred to as “subaccounting” or “sub-transfer agent” fees.

So, payments to financial intermediaries cover both distribution and shareholder servicing. This means mutual funds need to ensure that they only pay for distribution if they have a Rule 12b-1 plan, and to ensure that the payments made for shareholder servicing are reasonable and are not payments for distribution in guise. In order for a board of directors to ensure compliance with these items, the board should fully understand the funds’ distribution and shareholder servicing structure by reviewing the following questions: 

  • What types of intermediaries sell the funds’ shares? 
  • What is the distribution strategy associated with each of the intermediary partners? 
  • What services are provided to fund shareholders by each type of intermediary partner? 
  • How are the intermediaries compensated for their services? 
  • What payments does the investment adviser make to the intermediary partners? How are they calculated? 
  • What process does the funds’ chief compliance officer use to oversee intermediaries’ compliance with regulations and fund policies?

Directors should also review the analysis used to determine that the amounts being paid for shareholder servicing are reasonable. In making this determination, a number of mutual funds follow the “avoided cost” method in which they attempt to determine the “savings” in fees for shareholder servicing that they realized from participating in fund supermarkets, and pay that amount to the sponsors. For example, a transfer agent that charges a fund $18.00 for each account on its records would only charge the fund $18.00 for an omnibus account, where the charge would be much higher if the omnibus account was not used and each customer of the sponsor had an account on the transfer agent’s records. While the “avoided cost” method is utilized by a number of funds, it is not the only permissible method and payments in excess of the avoided costs may be considered reasonable if such payments are comparable to those paid by mutual funds in general for shareholder servicing.

New Identity Theft Rules

The SEC and the Commodity Futures Trading Commission (CFTC) have adopted joint rules to help protect individuals from identity theft. The new rules largely mirror the rules of the Federal Trade Commission (FTC) and the other federal agencies that adopted identity theft rules under the Fair Credit Reporting Act. The adopting release by the SEC and CFTC includes examples and guidance to help entities comply with the rules.

The new rules apply to most investment companies, broker-dealers, and futures commission merchants, some other regulated entities, and a large number of investment advisers. For example, the SEC expects most investment advisers to private funds to be subject to the rules. While most investment companies currently have identity theft prevention programs, because they were required by FTC rules, many investment advisers have not adopted identity theft prevention programs.

If an entity already has an identity theft prevention program in place that meets the requirements of the final rules, its board is not required to reapprove the existing program. However, even if a mutual fund already has an identity theft prevention program in place, the fund should review the program to confirm that it complies with the new rules, and review the examples and guidance contained in the new rules to determine if any improvements or enhancements should be made.

Investment Management Guidance on Social Media Filings

The staff of the SEC’s Division of Investment Management has issued guidance for mutual funds in response to questions about whether certain interactive content posted in social media, chat rooms, or other “real-time electronic forums” is advertising that should be filed under the Investment Company Act or the Securities Act.

The staff said that not all of these communications need to be filed but cited a number of examples of communications that would trigger a filing requirement. Whether a communication needs to be filed depends on its content, context, and presentation. For example, if fund performance is discussed and specific mention is made about the elements of a fund’s performance (for example, one-, five-, or 10-year returns) or if the communication promotes a fund’s returns, then it should be filed. An example would be “Our quarter-end returns have exceeded our expectations!” (The guidance noted that merely using the word “performance” would not trigger the filing requirement, as long as the communication does not mention specific elements of the fund’s returns.)

If the discussion is not related to the investment merits of a fund but incidentally mentions a fund or family of funds, it need not be filed. Examples provided in the guidance include: “Fund X Family of Funds invites you to their annual benefit for XYZ Charity” or “Consumer Reports has written an article in which it mentions our Brand X Rewards Card. Are you a card member?”

Mutual funds should review and understand the guidance, and review their procedures and policies on advertising and sales literature to determine if any modifications are advisable in light of the guidance. They should also ensure that their compliance personnel are familiar with the guidance.

Enforcement Matters

Fund Manager Agrees to Be Barred From the Securities Industry in Connection With Misappropriating Fund Assets

The SEC recently entered an enforcement order against Walter V. Gerasimowicz and his firms, Meditron Asset Management, LLC, a registered investment adviser, and Meditron Management Group, LLC for, among other things, misappropriating and misusing client assets and making repeated material misrepresentations and omissions to clients.

The SEC found that for nearly two years ending September 2011, Mr. Gerasimowicz and his two firms diverted approximately $2.65 million from a fund managed by them to prop up another private company controlled by Mr. Gerasimowicz that is currently in Chapter 11 bankruptcy proceedings. In addition, the SEC found that the respondents repeatedly lied or failed to disclose to the fund’s investors the material deviations from the fund’s stated investment strategy and asset valuation policy, misrepresented the amount of assets under management by the investment adviser on both its Web site and in published articles, and violated the custody rule under the Investment Advisers Act of 1940 (Advisers Act) as the fund’s investors failed to receive the fund’s audited financial statements within the rule’s prescribed time period.

According to the SEC, beginning at least in the fall of 2008 and well into 2011, Mr. Gerasimowicz caused assets of the fund to be siphoned off to SMC Electrical Contracting, Inc. (SMC), which was controlled by Mr. Gerasimowicz and experiencing financial difficulties at the time. Such payments were not disclosed to fund investors. The approximate $2.65 million diverted to SMC from the fund represented about 80 percent of the fund’s assets at the end of 2011. Mr. Gerasimowicz ultimately papered the amounts that were diverted by causing SMC to issue notes to the fund in the amount of $2.7 million which were unsecured and held a non-priority claim in SMC’s bankruptcy filing. Although the notes were both unsecured and non priority, SMC’s notes and loans were valued at cost by the fund.

All during the period when the fund’s assets were being diverted by the respondents to SMC, investors in the fund received misrepresentations and omissions of material fact from the respondents about the value of the fund and the diversion of its assets.

Based on the conduct described by the SEC, the respondents violated the anti-fraud provisions under federal securities laws, including various provisions under the Advisers Act.

Pursuant to the SEC’s order (Administrative Proceeding File No. 3-15024) which was consented to by the parties, Mr. Gerasimowicz is barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal adviser, transfer agent, or nationally recognized statistical rating organization and is prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor, or principal underwriter for a registered investment company or affiliated person of an investment adviser, depositor, or principal underwriter. In addition, Meditron Asset Management, LLC is censured and the respondents further agreed that they will pay disgorgement and civil penalties in amounts to be determined.

Father and Son Charged by SEC With Cherry Picking Over the Interests of Clients

In a recent enforcement action (SEC v. Charles J. Dushek, et al., Civil Action No. 13-CV-3669, N.D. Ill., filed May 16, 2013), the SEC accused a father (Charles J. Dushek) and son (Charles S. Dushek) with defrauding clients by “cherry picking” investments over the interests of their clients, a scheme that resulted in their profiting almost $2 million.

The Dusheks and their Chicago-area registered investment advisory firm, Capital Management Associated, are charged with grouping orders for securities transactions among its clients with the father and son’s personal accounts and then cherry picking the profitable trades for their own accounts while leaving the unprofitable trades for client accounts. Many of the clients were senior citizens. The transactions occurred over a period from 2008 to 2012 and consisted of more than $13,500 purchases of securities totaling more than $350 million. To demonstrate the proficiency of the Dusheks in keeping the profitable trades for themselves and depositing the losers in client accounts, during a period of 17 consecutive months, the Dusheks had positive returns during the entire period while client accounts had negative returns during that same period. The father’s account during the time increased in value by almost 25,000 percent while most of his client account suffered a decrease in value.

The advisory firm’s brochure provided to clients and prospective clients falsely stated that the elder Mr. Dushek personal trades were separately reviewed by an associate when in fact he did not maintain any trading records on site at the firm for anyone to review.

The SEC’s complaint cites violations by the Dusheks and their advisory firm of the anti-fraud provisions under the Advisers Act as well as similar violations under other federal securities law. The SEC has asked the court for a permanent injunction, civil penalties, disgorgement, and prejudgment interest, along with other relief against each of the defendants.

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

Michael G. Dana
Miami, Florida