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

While the SEC might have hedge fund "late trading" in its crosshairs (see 8/23/07 Overreg’d post), hedge fund managers have found their own targets – former counsel.

With mounting pressure from the SEC and other regulators for increased transparency in operations and reporting, several failed hedge funds and their managers have been sanctioned and forced to repay millions to investors. This has sparked what appears to be a growing trend - complaints against former hedge fund counsel for allegedly giving "bad advice."

In one of the most recent examples, former Veras hedge fund managers James McBride and Kevin Larson have commenced a lawsuit against Akin Gump Strauss Hauer & Feld LLP, Veras' former law firm for alleged bad advice regarding the propriety of the practice of  "late trading" - trading shares of mutual funds after the 4:00 p.m. market close.  Among other things, McBride and Larson allege they explained to Akin Gump attorneys that brokers were engaging in this practice, inquired whether this practice was permissible, and their attorneys told them that it was legal on several occasions. Larson and McBride seek damages in the amount of $4.4 billion.

Akin Gump has since denied the allegations and brought a motion to dismiss multiple counts of the complaint against its attorneys.

Only time will tell the significance of what appears to be a growing trend, but for the moment it would appear that law firms have become the new "deep pockets" for their failed hedge fund clients.

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Think twice before before placing an order to buy, sell or redeem mutual fund shares after the markets close to receive that day's price. This well-known practice, called "late trading," caught and continues to hold regulator attention, and carries with it significant negative repercussions.

Yesterday, Michael Carl Hoffman entered an offer of settlement in an administrative action brought by the SEC. In a nutshell, the SEC alleged that Hoffman, who co-managed the hedge fund Ilytat, learned about and exploited a "loophole" in a clearing broker's mutual fund order entry system to place approximately 2,700 late trades in various mutual funds thereby allowing Ilytat to receive beneficial prices after the market closed.  A copy of the consent order can be found at sec.gov/litigation/admin/2007/ia-2638.pdf

With out admitting or denying the allegations, Hoffman agreed to cease and desist from committing any further violations and was barred from associating with any investment advisor for a period of 18 months with an opportunity to reapply for association after this period expired. Hoffman was also prohibited from serving, acting or affiliating in any material capacity with a registered investment company or like entity for 18 months, and ordered to pay a civil penalty of $100,000.

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Investors frequently pursue “selling away” claims against brokerage firms, alleging that the brokerage firm is somehow responsible for the actions of its registered representative, even if the firm was not aware of the broker’s activities, and did not profit from them. In most cases, brokerage firms vigorously defend against such claims, and in my experience, Courts and NASD Panels justifiably scrutinize such claims with a great deal of skepticism. 

But occasionally such claims are successful. And a recent case demonstrates once again that a claimant who obtains an award in an NASD arbitration almost always will be successful resisting any attempt by the brokerage firm to vacate the award.

In Walnut Street Securities, Inc. v. Bonnie Lisk, 2007 WL 2094902 (M.D. N.C. 2007), 18 investors purchased unregistered securities of a fraudulent investment called ETS Payphones, Inc. But the investors did not purchase these securities through Walnut Securities or its registered representative. Rather, they purchased the securities from a separate corporation owned by the representative and her daughter. 

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            The U.S. Solicitor General has submitted an amicus curiae brief in a pending U.S. Supreme Court case, requesting that the Court narrow the scope of securities fraud claims so as not to encompass third party actors such as accountants, lawyers, and financial institutions.

            The case pending before the U.S. Supreme Court is StoneRidge Investment Partners, LLC v. Scientific-Atlantic, Inc.  The Court below, the Eighth Circuit Court of Appeals, refused to impose Rule 10b-5 liability on a business that entered into an arms-length non-securities transaction with another business that then used the transaction to publish false and misleading statements to its investors. The Court reasoned that a defendant who does not make a fraudulent misstatement or omission or who does not directly engage in manipulative securities trading practices is at most guilty of aiding and abetting and cannot be held liable under Rule 10b-5.

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Check out this article from the Sunday edition of the New York Times which examines potential flaws in the process in which arbitrators disclose their conflicts in securities arbitrations. The story focuses on a couple who lost $48 million of their $60 million stock portfolio, which they had invested primarily in Level 3 Communications and WorldCom. The couple sued their broker for allegedly failing to diversify their portfolio.

Although, at first glance, the case seems like another run-of-the-mill securities case in the wake of the tech bubble burst (albeit an expensive one), the interesting fact is that four days before the arbitration hearing was to scheduled to begin, plaintiffs’ counsel discovered that the chair of the arbitration panel had a significant conflict-of-interest. It turns out the chair’s firm represented  the broker on numerous occasions in the past 5 years. The NASD removed the chair and indefinitely postponed the hearing date until a new chair could be appointed.

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Analysts and investors alike have wanted to know how some of Wall Street's top investment banks have been able to withstand the ongoing onslaught of subprime losses as many of the largest firms have reported few if any in recent months amidst increasing investor losses that have forced some lenders into bankruptcy. According to the Wall Street Journal, now the SEC wants to know too.

In what is being labeled by many firms as a routine check-up, the SEC has indicated it plans to analyze the records of five of Wall Street's biggest investment banks to determine if and how they are treating losses.

A sign of things to come? In June, Bear Stearns faced a preliminary inquiry from the SEC as to a failing hedge fund it managed and why it restated results from a sister fund. Both funds, which invested in subprime mortgage loans, suffered significant losses in recent periods as default rates continued to rise.

For the moment, investment banks and hedge funds investing in subprime mortgages and collateralized-debt obligations appear to be in the regulators' cross-hairs.

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