Securities Regulation and Litigation Lawyer & Attorney : OverRegd Blog : Lindquist & Vennum Law Firm, Minneapolis and Denver

The recent slew of lawsuits brought against some of the nation's largest broker-dealers that sold Auction Rate Securities ("ARS") to customers has not gone unnoticed. The SEC and FINRA, on the heels of the lawsuit filings, have each launched independent investigations of their own into the sales and marketing practices employed by firms selling ARS. And commentary submitted in recent days suggests emphasis of the investigations will, at least in part, lead to focus on the suitability of the sales.

In a March 31, 2008 investor alert, FINRA discussed the impact the collapse of the ARS market has had on investors. Significantly, a large portion of its discussion concerned the liquidity of the securities and how "due to recent developments in the credit market—including downgrades in the credit ratings of bond issuers and bond insurers—a significant number of auctions have failed, leaving some investors who counted on immediate access to their funds wondering about their options." FINRA also recently sent a survey to brokerage firms specifically inquiring about who the firm sold ARS to (i.e. retail individual, high net worth individual, non-professional institutional, or professional institutional customer) and whether the firm was willing to offer margin loans to customers using ARS as collateral. And in Regulatory Notice 08-17, effective April 1, 2008, FINRA added "three new product categories for use by member firms in reporting customer complaints relating to auction rate securities."

Taken together, these actions leave little doubt that firm ARS sales and supervision may come under the lens of regulatory inquiry for the foreseeable future and likely remain one of the main topics of inquiry for 2008, given the fact hundreds of billions of dollars of ARS were sold.

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Commissioner Lori Richards revealed the SEC’s “Top 10 Compliance Issues for 2008” during the general session at the 40^th annual SIFMA national conference yesterday in Orlando, Florida.  According to Ms. Richards, the top 10 areas of scrutiny in SEC board exams in 2008 will be:

1. Valuations.
2. Firm controls over non-public information.  In particular, the SEC is interested in whether the firm has identified the type and sources of non-public information to which it is privy, and whether the firm has implemented and properly tested procedures for protecting that information.
3. Retail sales practices – with an emphasis on protecting seniors.
4. Supervision. 
5. Net capital/internal controls (which will receive increased focus given recent developments).  Ms. Richards noted that 20% of the exams last year uncovered errors in net capital calculation.
6. Trading.
7. Fixed Income.
8. Rating agencies.
9. Conflicts of interest.  The “hot list” for this area includes payments by advisors to broker dealers to appear on “recommended advisor lists,” and broker-dealers who sell interests in affiliated hedge funds.
10. Anti-money laundering.
11. Information/account security (refusing to be limited to just 10 areas, Ms. Richard actually named 11 key areas of scrutiny for 2008).  The SEC is particularly interested in whether broker-dealers have adequate control over their customers’ assets and information, and what controls broker-dealers adopt when they outsource regulating activities.  According to Ms. Richards, the SEC will focus on midsized firms this year. 

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Today is the opening day of the annual SIFMA conference, held this year in Orlando. This morning's general session, moderated by Gary Lynch, executive vice president and chief legal officer of Morgan Stanley, included panelists James Brigagliano of the SEC; Richard Ketchum of NYSE Regulation, Inc.; John Moloney of Moloney Securities Company Inc.; and Mary Schapiro, Chief Executive Officer of FINRA. SIFMA's kick-off topic was "NYSE and NASD Merger -- How is it Working?"

Mary Schapiro (FINRA) commented that the merger has gone well and has met her expectations at this stage, noting:

• The governance board is in place;
• The business processes used by NYSE and NASD are largely consolidated;
• A mid-2009 date is anticipated for the completion of combining the technologies from NYSE and NASD, having already retired 14 systems; and
• The completion of a consolidated rule book will take time, and is made more complex by a rapidly changing environment, both on the regulatory side and in the market place. It is likely that there will be rules coming out for comment by Spring.

Although it has not yet been a year since the merger, Richard Ketchum (NYSE Regulation) believes that the industry has already benefitted by a more efficient and effective single examination program, and through the interpretation of the rules through one body. He also noted that the ability to create a consolidated set of rules constitutes a one-in-a-lifetime opportunity to step back and look at the rules fresh.

John Moloney (Moloney Securities) noted that from a small firm perspective, there are varied opinions on the effectiveness of the merger, but many small firms do view the examinations to be more poignant and drill-down as to what is important.

The Panel also discussed whether principle-based regulation or rule-based regulation should control. Mary Schapiro commented that while principles are very valuable, she did not view them as replacing the rule book. Mr. Ketchum agreed, noting that principles can bring a level of confidence, guidance, and framework for the rules themselves.

Gary Lynch (Morgan Stanley) questioned whether a two-tier system of regulation makes sense for institutional and retail markets. In terms of any "carve-out" from the rules for institutional clients, James Brigagliano (SEC) agreed with Mary Schapiro that a broad institutional carve-out would be extremely hard, that there is a need to look at regulation on a rule-by-rule basis, and that the most challenging aspect to any carve-out is determining sophistication (i.e., just because the investor is large with a lot of assets to invest doesn't necessarily mean it is sophisticated).

In terms of enforcement, Mr. Ketchum and Ms. Schapiro noted that taking a more risk-based focus on examinations makes sense, so that regulator's resources are focused on those firms with the highest risk to the public. With that, the hundreds of conference participants packed in the auditorium-style room disbursed to the various break-out sessions.

Stay tuned for an update about tomorrow's general session which focuses on current SEC issues.

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The SEC voted unanimously yesterday to propose a new rule intended to enhance the SEC's ability to crack down on naked short sales and failures to deliver shares that are used in such sales, Reuters reported. 

Short selling involves sales of borrowed shares, in the hope of repurchasing them later at a lower price. Naked short selling involves sales without first borrowing the shares or making an "affirmative determination" that the shares can be borrowed.

The SEC adopted Regulation SHO four years ago in an effort to curtail short-selling abuses. However, the SEC’s enforcement powers under Regulation SHO are limited. Stating the obvious, SEC Chairman Christopher Cox explained, “Reg SHO can’t be effective without enforcement.” According to Mr. Cox, the SEC's new proposed rule is designed to give Regulation SHO “teeth.” Under the new proposal, the SEC would create an antifraud rule specifically targeting targets sellers who intentionally deceive broker-dealers or purchasers about their ability to meet delivery deadlines. 

The SEC is seeking public comment on its proposal.

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John B. Torkelsen, an expert witness heavily utilized by the Plaintiffs' securities bar over the past several years to "testify on such issues as damages allegedly suffered by plaintiffs' classes and the appropriate value of settlements reached in several class action cases around the country," entered into a plea agreement before the Eastern District of Pennsylvania Federal Court, in which he plead guilty to perjury, admitting that "he lied to numerous federal judges across the county who were presiding over securities class actions."

Boiled down, Torkelsen had told various courts that he was an independent expert, yet certain law firms that hired him did so on a contingent fee basis and then concealed the payment arrangement from the courts. According to a Department of Justice litigation release, in furtherance of the scheme, the firms would then "submit to courts requests for reimbursement of fees already paid to Torkelsen when, in fact, the fees had not been paid and would not be paid unless the court awarded fees to the law firms; cause Torkelsen to submit declarations in which he falsely stated under oath that he had been retained on a non-contingent basis when, in fact, he had been retained on a contingent basis; cause Torkelsen to write-off fees he had incurred in class actions in which the law firms did not obtain a successful result; and cause Torkelsen to submit inflated fee requests in other class actions, billing for work that Torkelsen did not actually perform, in order to allow Torkelsen to make up for fees he did not recover in unsuccessful class actions."

Dishonesty has no place in the courtroom. At the end of the day, plaintiffs and defendants alike, as well as their counsel, are well-served by removal of such elements.

A detailed discussion of this case can be found on the Department of Justice's website at www.usdoj.gov/usao/cac/pressroom/pr2008/020.html

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Legislators on Capital Hill reintroduced the "Securities Litigation Attorney Accountability and Transparency Act" last week. The Act, which was initially introduced in 2006, would permit courts to award successful defendants their attorneys’ fees in federal securities class actions when it is determined that the plaintiffs’ position was not “substantially justified,” require the disclosure of conflicts of interest between plaintiffs and their counsel, and allow courts to appoint lead counsel through a competitive bidding system.

Continue Reading...

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There’s a timely article up at Bloomberg regarding the ongoing back and forth between the securities industry and claimants’ bar regard the fairness of mandatory industry arbitration. The article cites the recent survey on claimant perceptions of arbitration fairness commissioned by the Securities Industry Conference on Arbitration ("SICA"), and conducted by the Investor Rights Clinic at Pace University Law School.

The SICA survey, together with a to-be-expected rebuttal piece from SIFMA, point out the sharp differences in perception regarding whether the current arbitration system is fundamentally biased toward firms. The SICA survey pointed to, for example, the declining numbers of hearings ending in awards, as well as the increasing number of early settlements. Does this show that the system is increasingly stacked against investors? Does it indicate, rather, that firms identify meritorious cases and settle, rather than defend through a hearing? Can any generalizations be drawn about the large number of industry and public arbitrators, other than that every lawyer and firm in this area – whether on the claimant or defense side – has had both fair results and real head-scratchers.

One thing is clear: both investors’ groups and state regulators will continue to push FINRA to make its arbitration forum more investor-friendly – or to eliminate mandatory arbitration entirely.

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Yesterday, the U.S Supreme Court handed down an important decision regarding the liability of ERISA plans, and in particular, employer-sponsored 401(k) plans, to individual plan participants.

In LaRue v. DeWolff, Boberg and Associates, Inc., the plaintiff had sued his employer-sponsored 401(k) for breach of fiduciary duty under ERISA § 502(a)(2) after, he alleged, the plan failed to implement his investment directions, resulting in a loss of about $150,000 to his account. The Fourth Circuit affirmed the District Court’s dismissal on the pleadings, holding that ERISA provides such remedies only for entire plans, and not for individual participants.

The Supreme Court reversed, holding that its reasoning in Massachussetts Mutual Life Ins. Co. v. Russell, 473 U.S. 134 (1985) which limited recoveries under § 502(a)(2) to “the plan as a whole” nonetheless did not bar an fiduciary breach claim by the plaintiff in the present case. Interestingly, the majority opinion by Justice Stevens pointed to particular features of defined contribution plans such as 401(k) plans, as opposed to the defined benefit plan at issue in Russell. Justice Steven’s opinion noted that “Russell’s emphasis on protecting the “entire plan” from fiduciary misconduct reflects the former landscape of employee benefit plans. That landscape has changed.” The unanimous court ruled that the plaintiff could proceed with his ¶ 502(a)(2) fiduciary breach claim. (Chief Justice Roberts, joined by Justice Kennedy, concurred in the judgment, noting that he questioned whether the claim was properly brought under § 502(a)(2), rather than the non-fiduciary provisions of § 502(a)(1)(B). Justices Thomas, joined by Justice Scalia, filed a separate concurrence, noting, characteristically, a reliance on the “plain text” of 502(a)(2), and that the decision should not be “contingent on trends in the pension plan market” nor “the ostensible “concerns” of ERISA’s drafters.”

So what does this mean? The short of it is that ERISA plan fiduciaries are now, unequivocally, subject to claims by individual participants based on alleged fiduciary breaches in handling an individual participant’s account. This is a walk-down from what had been understood to be a fair degree of protection under ERISA, at least for ERISA-based fiduciary claims, from lawsuit based on losses in individual participant accounts, as opposed to claims for damages by plan fiduciaries to the “plan as a whole.”

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The latest on the market-timing settlement front: Oppenheimer agrees to pay FINRA $4.5 million for mutual-fund market timing conducted by five of its traders on behalf of hedge fund clients. 

Once again, a firm is stung by an apparent “head in the sand” compliance and supervisory approach to a small group of its reps acting on behalf of a small number of high-value clients. This in the face of what FINRA describes as “about 200 communications from 65 mutual fund companies” regarding the short-term trading those companies were noting.

Lessons: (1) establish and enforce consistent compliance systems; (2) don’t make exceptions for “high value” clients or reps; (3) don’t ignore apparent red flags.

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