A Compilation of Enforcement and Non-Enforcement Actions

31 July 2013 Publication
Author(s): Terry D. Nelson Peter D. Fetzer

Legal News: Investment Management Update

Non-Enforcement Matters

  • Insider Trading in Mutual Fund Shares
  • Incentive for Whistleblowers to Bypass Internal Reporting
  • SEC Announces Compliance Outreach Sessions
  • Implementation of FATCA Reporting and Withholding Requirements Delayed Again

Enforcement Matters

  • High-Profile Failure to Supervise Case Commenced by SEC


Insider Trading in Mutual Fund Shares

In a recent decision by the U.S. Court of Appeals for the Seventh Circuit, the court has left open the possibility that insider trading prohibitions may apply to trading in mutual fund shares (SEC v. Bauer, No. 12-2860 (7th Cir. July 22, 2013)). In the case, the SEC charged a mutual fund insider with insider trading in connection with the insider’s redemption of fund shares. The court’s decision remands the case to the district court so that the district court can rule on whether the insider’s alleged conduct properly fits under the misappropriation theory of insider trading.

The case signals that the SEC continues to be very focused on insider trading in all industries, as the SEC has never previously brought an insider trading claim in the mutual fund context. So funds should be extra vigilant in developing and adhering to insider trading policies, both in regard to trading in portfolio securities and trading in shares of the fund itself. The case also indirectly highlighted the fact that items like a fund freezing redemption and selling off portfolio securities at discounted prices to generate cash are most likely material to investors, and care should be taken to disclose such material information to shareholders on a timely basis.

According to the SEC’s allegations, the general counsel of the investment adviser to a bond fund was aware that the fund would likely have to sell portfolio securities into an illiquid market to meet redemption demands, which would result in significant markdowns and a reduction in the fund’s net asset value per share. The insider redeemed her own holdings in the fund, avoiding the loss that resulted from the reduction in the fund’s net asset value subsequent to her redemption.

Initially, the SEC argued that the insider had engaged in insider trading under the classical theory of insider trading. Under the classical theory, an insider is prohibited from trading in securities on the basis of material, non-public information because this gives the insider an unfair advantage over uninformed purchasers or sellers of the company’s stock. The insider argued that mutual fund redemptions cannot entail insider trading under the classical theory because the counterparty to the transaction, the mutual fund itself, is always fully informed. The court acknowledged the various arguments regarding the classical theory, but ultimately declined to consider the applicability of the classical theory to insider trading of mutual fund shares.

The court then turned to the misappropriation theory of insider trading. The misappropriation theory holds that an insider is prohibited from trading in securities on the basis of material, non-public information because such information was entrusted to the insider for non-trading purposes, and to use it for trading purposes defrauds the company. The court concluded that insider trading in mutual fund shares might be prohibited under the misappropriation theory and remanded the case to the district court so that the district court can rule on whether the insider’s alleged conduct properly fits under the misappropriation theory of insider trading.

Incentive for Whistleblowers to Bypass Internal Reporting

In a recent case, the U.S. Court of Appeals for the Fifth Circuit narrowly interpreted the definition of whistleblower under the Dodd-Frank Act by finding that the anti-retaliation provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) protects only whistleblowers who provide information to the SEC (Asadi v. G.E. Energy (USA), No. 12-20522 (5th Cir. July 17, 2013)). However, once an individual has become a whistleblower under the Dodd-Frank Act, he or she is entitled to protection for any of the protected whistleblower actions, including those that have nothing to do with the SEC. While the narrow interpretation of who qualifies as a whistleblower may initially seem a welcome development, the court’s statements in its ruling provide incentive for whistleblowers to bypass internal reporting of violations and go directly to the SEC with any such violations.

In contrast to the court’s finding, the SEC takes the view that the anti-retaliation provision of the Dodd-Frank Act protects individuals who provide information to persons or governmental authorities other than the SEC, as reflected in the SEC’s rules. Several district courts have also found that the anti-retaliation provisions of the Dodd-Frank Act apply more broadly. While the court acknowledged the SEC’s position, it gave no deference to the SEC’s position and ruled that the plain language of the Dodd-Frank Act protects only whistleblowers who provide information to the SEC.

In the court’s ruling, the court presented a hypothetical example illustrating the court’s belief that whistleblowers who report to the SEC are entitled to protection against retaliation under the Dodd-Frank Act, even if the employer is unaware that the individual is a whistleblower. The court acknowledged in a footnote that this means there is “an incentive not only to report such violations internally, but also to inform the SEC of the securities violation.” So, employees now may be incentivized to bypass internal compliance programs and report concerns to the SEC as quickly as possible in order to secure protection under the Dodd-Frank Act.

SEC Announces Compliance Outreach Sessions

On July 16, 2013, the SEC announced its schedule for the Compliance Outreach Program sessions across the country. The sessions are geared toward investment adviser chief compliance officers and senior officers of registered investment companies.

The first session on the announced schedule will occur in Chicago on August 28, 2013. This session will focus on the SEC’s examination program and common deficiencies found. In addition, custody issues will be discussed.

The next session occurs in New York on September 13, 2013, geared primarily toward newly registered investment advisers, and those advisers who are registered also as a broker-dealer or their affiliated broker-dealers. On September 25, 2013, a session will be conducted in Atlanta and will focus on enterprise risk management and effective compliance as well as on key issues identified during the staffs’ examination program.

The final announced session will occur in San Francisco on November 6, 2013. During this session, the topic will primarily be the SEC’s examination program and asset valuation issues, including best practices for valuation of assets in both private and public funds.

More information about the sessions can be obtained by emailing complianceoutreach@sec.gov.

Implementation of FATCA Reporting and Withholding Requirements Delayed Again

One of the looming deadlines for investment fund managers has been the fast-approaching deadline to comply with the reporting and withholding requirements of the Foreign Account Tax Compliance Act (FATCA). Investment fund managers can breathe easy for now because the Internal Revenue Service (Service) and the U.S. Treasury announced in Notice 2013-43 that the implementation of FATCA will again be delayed. On July 12, 2013, the Service announced that the deadline for reporting and withholding would be delayed by six months, until July 1, 2014.

In 2011, the Service released hundreds of pages of draft regulations relating to the implementation of FATCA, which became final on January 17, 2013. Since then, financial institutions and the Service have struggled with the systems and processes needed to track the information required to be reported under FATCA. For example, the Service was scheduled to open access on July 15, 2013 to an Internet portal that would allow entities qualifying as foreign financial institutions. The Service has delayed opening this portal until August 19, 2013. In addition, many financial institutions have struggled to implement IT systems that would facilitate their reporting requirements. With the new delay, financial institutions now have more time to implement the appropriate systems to help them comply with FATCA.

This delay has several key implications for investment fund managers.

First, offshore funds constituting foreign financial institutions now have until April 25, 2014, to register as foreign financial institutions and be listed as such on the first published list of participating foreign financial institutions. For offshore funds, it is important to be included in this list; otherwise, these offshore funds could be subject to withholding on payments that otherwise might not be subject to withholding.

Second, offshore funds that are participating foreign financial institutions will not have to file their first report under FATCA until March 31, 2015. Previously, it was expected that offshore funds participating as foreign financial institutions would have to file their first report in 2014 with respect to 2013.

Third, withholding agents will not be required to conduct withholding on certain payments that are “withholdable payments” made in connection with any obligations outstanding on or before July 1, 2014. Thus, withholding agents will only be required to withhold in connection with FATCA on certain withholdable payments made in connection with obligations that arise on or after July 1, 2014. However, as stated in Notice 2013-43, the present delay in implementation does not “affect the timing provided in the final regulations for withholding on gross proceeds, passthru payments, and payments of U.S. source FDAP with respect to offshore obligations by persons not acting in an intermediary capacity.”

Investment managers would be advised to consult with their tax counsel regarding Notice 2013-43 and the requirements of FATCA regarding registration, reporting, and withholding.


High-Profile Failure to Supervise Case Commenced by SEC

On July 19, 2013, the SEC announced the commencement of administrative proceedings against Steven A. Cohen for failing to supervise over two senior employees who engaged in insider trading (In re Cohen, SEC, Admin. Proc. File No. 3-15382, 7/19/2013).

The SEC will seek administrative penalties against Mr. Cohen, which could include financial penalties and an industry bar from overseeing investor funds, for the failure to supervise the employees, thereby preventing violations of the federal securities laws.

In a related development, SAC Capital Advisors, founded by Mr. Cohen, was indicted on criminal charges by federal prosecutors on July 25, 2013 with respect to insider trading allegations (U.S. v. S.A.C. Capital Advisors, LP, S.D. N.Y., 13 Crim. 541, 7/25/13).

The two senior employees, Matthew Martoma and Michael Steinberg, are facing civil and criminal charges over their alleged activities of insider trading. According to the SEC, Cohen’s hedge funds earned profits and avoided losses of more than $275 million as a result of employees’ alleged activities, all under Cohen’s watch. The conduct by the employees of Cohen’s hedge funds occurred in 2008 when they traded, as portfolio managers, on material non-public information about certain publicly traded companies. Both employees have been charged by the SEC with insider trading of CR Intrinsic. An affiliate of Cohen’s firm, S.A.C. Capital Advisors, has agreed to pay more than $600 million in the largest-ever insider trading case settlement. Another Cohen affiliate, Sigma Capital, has agreed to pay nearly $14 million to settle insider trading charges.

According to the SEC, Cohen received “highly suspicious information” about the trading activities of the two portfolio managers that should have caused Cohen to investigate further as to possible trading on material non-public information. Instead, according to the SEC, Cohen ignored the red flags, allowing the trading activities to continue. In fact, according to the SEC, Cohen praised the work of the two employees and rewarded one with a $9 million bonus.

The SEC, through the commencement of this action and the recently announced criminal indictment against S.A.C. Capital Advisors, has underscored the intention of regulatory and other law enforcement agencies to take enforcement action against persons who are in a supervisory role and fail to take reasonable actions to detect and prevent violations of the securities laws, and against the entities who conduct the unlawful acts.

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