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

With the rise of internet blogging and now Twitter, more and more individuals are finding an audience for their message, whatever that message may be. Even corporations have jumped on the bandwagon, with brick and mortar giants like Wal-Mart and General Motors joining the ranks of internet-based companies who have set up their own corporate blogs. But while open channels of communication between corporations and the public are arguably beneficial to the general public and perhaps investors, can there be too much of a good thing? Maybe. And that may spell trouble for corporations.

Since Congress enacted the Securities and Exchange Acts of 1933 and 1934, the US Government has sought to provide certain safeguards for investors in publicly traded securities through creation of a mandatory system of periodic disclosure. Boiled down, public companies like GM or Wal-Mart must disclose on a routine basis certain information like their financial status and other material developments that a reasonable investor should know - filings like annual statements which are monitored and reviewed by the Securities and Exchange Commission - the governmental entity tasked with enforcing compliance with US Securities Laws.

Thus, when companies engage in blogging or tweeting with the public, they necessarily expose themselves to a potential liability with the SEC knocking on their door if it determines they failed to make adequate disclosures or otherwise did not put in necessary safeguards to caution the public about the statements and viewpoints being expressed thereby misleading investors. And as well all know, the SEC carries a big stick.

As social networking mediums continue to expand and reach unprecedented levels of use in the months and years ahead, it will be interesting to see how the SEC responds, particularly with respect to enforcement issues concerning adequate disclosure. Indeed, it is not inconceivable to expect SEC rules defining "solicitation" and "offering" to be revisited and perhaps modified to take into account the nature and adequacy of communications in these new mediums. Accordingly, for now, public companies are probably best served by erring on the side of caution and proceeding slowing when exploring new channels of communications.

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Last week, the SEC released its second “ComplianceAlert,” discussing recent exam priorities and summarizing some of the Commission’s key findings and observations. Last year, the Commission put out a similar Alert for the first time, and – observing that the first Alert was well-received – appears poised to make this a regular communication.

The 2008 Alert describes findings for both investment advisors (with a heavy focus on institutional asset managers and mutual funds, rather than retail advisors) and broker-dealers, with a brief nod to transfer agents. The Commission’s observations contain both bad (lunch seminars and mortgage-financed securities purchases) and good (soft dollar compliance). The specific findings are not terribly surprising, but the Alert paints a good picture of the SEC’s recent areas of concern and its current views on those topics.

For investment advisors/mutual funds, the Alert describes: (1) personal trading compliance; (2) proxy voting/use of proxy voting services; (3) valuation and liquidity for high yield municipal bond funds; and (4) soft dollar practices. For broker-dealers, the Alert addresses: (1) “free lunch” sales seminars; (2) valuation and collateral management related to subprime mortgage products; (3) sales issues related to B-Ds affiliated with insurance companies; (4) solicitation by B-Ds of advisory services; (5) mortgage financing of securities puchases; and (6) OSJ supervisory structure and procedures.

The entire seventeen-page report is worth a read, but here are a couple of brief documents that summarize in bullet form some of the Alert’s key observations, for both investment advisors/mutual funds and for broker-dealers.

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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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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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On February 14, 2008, Chairman Cox testified before the U.S. Senate Committee on Banking, Housing, and Urban affairs. His remarks leave no doubt that the SEC views the subprime fallout that began in 2007 to be a prudential concern to all investors and market participants. Citing "the resulting large losses for some market participants, the concern in the markets about the future performance of a range of complex structured finance instruments, and the more generalized concern about the effects on credit markets overall have led to a more risk-averse environment, and have contributed to a slowdown in the rate of the nation's economic growth," Chairman Cox noted the SEC has devoted resources from all of its divisions to tackling the problems at hand. But it is apparent the problems stemming from the subprime debacle will not be easily fixed.

The accounting treatment of special purpose trusts as off balance sheet items that sold securities comprised of residential mortgages bundled together is at the heart of the issue. But the SEC considers there to be a panoply of related issues - "the adequacy of capital and liquidity at the nation's major investment bank, and the strength of their risk management practices; the impact on money market funds from the devaluation of presumptively safe assets; the quality of issuer disclosure by public companies involved in structured finance; the role of the credit rating agencies, over which the SEC gained regulatory authority eight months ago; and the possibility of violations of the securities laws by subprime lenders, investment banks, broker-dealers, and other market participants."

Based on Chairman Cox's comments, an overnight fix is definitely not in the cards. But a flurry of investigations into the activities of those market participants involved seems imminent.

Stay tuned ...

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Teaming up with the FBI, the SEC recently filed civil actions alleging securities fraud in five separate kickback schemes uncovered by an FBI sting operation. Officials are touting the operation as further proof that the organizations can and in fact are working together to prosecute securities fraud. The actions, filed in the Southern District of Florida, are "based upon allegations that the named parties are insiders or promoters of publicly traded companies who made stock sales to a hedge fund in exchange for illegal kickbacks to an individual whom they believed to be a hedge fund manager, but who was in reality an undercover FBI agent." (See SEC.gov for more information)

A sign of things to come? Notably, hedge fund reporting requirements, in general, have been a topic of regulatory inquiry in recent months. This case suggests the SEC may continue to focus on hedge funds but has enlarged its net so as to pursue individuals at the issuers allegedly willing to pay kickbacks to hedge funds to bolster stock price at the expense of investors. 

In somewhat tongue and cheek fashion, the Commission notes that "with one exception, the defendants actually paid the promised kickback after the hedge fund bought the stock defendants were promoting." The Commission also stated that its investigation is still ongoing. 

Heading into 2008, it looks like hedge funds and securities fraud will continue to be at the forefront of regulator attention.
 

 

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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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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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Yesterday the SEC unanimously approved new guidelines for small companies to comply with Section 404 of the Sarbanes-Oxley Act of 2002. The internal controls required by Section 404 are designed to address fraud and financial manipulation, but have been highly criticized for the excessive costs to small companies. The new standards loosen the requirements (and reduce the associated costs) of Section 404 by permitting companies to focus their internal controls on the areas with the greatest risk for fraud. Small companies must begin complying with the new standards by December 15, 2007.  For more information see this article in today's New York Times.

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In an effort to highlight the distinctions between investment advisors and brokers, early in 2006 the SEC adopted rule 202(a)(11)-1 (aka the “Merrill Lynch rule”) under the Investment Advisers Act of 1940. This rule specifically exempts from the definition of investment advisor certain services that brokers provide on a non-discretionary basis, and advice that is “solely incidental” to the brokerage role, regardless of the form of compensations that they receive for those services, does not transform the broker into a fiduciary under the rule. Likewise, and perhaps counter-intuitively, the designation “investment advisor representative” will not be dispositive on the issue. Actual functions, not labels, tend to be the litmus test.

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Co-authored by Jon Harris and Mark Enslin

Life used to be simpler. Years ago, in the Golden Age of transactional-oriented compensation, there were no compelling questions regarding the role that brokers played in servicing non-discretionary accounts. The distinction was readily apparent. They were salespersons, and got paid if they executed a trade. But with the advent and wide-spread acceptance of fee-in-lieu relationships, and the requirement that brokers qualify as investment advisor representatives if they are to share in the fees, the traditional role of the broker has been transformed.

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SEC Chairman Christopher Cox posted an official communication to a blog last week, stating that he was intrigued by the idea of letting companies use Weblogs to disseminate important corporate information.

In late October, avid blogger Jonathan Schwartz, the chief executive of Sun Microsystems Inc., posted an open letter on his blog to Chairman Cox, encouraging the SEC to look to the Internet to achieve the SEC's objectives of greater investor access to information. Last week, Chairman Cox responded by posting a comment on Schwartz’ blog, inviting Schwartz to talk with the agency about the idea of allowing companies to disclose significant financial information through blogs. 

A growing number of major companies, including at least thirty Fortune 500 companies, are now publishing corporate blogs, nearly double the number in December 2005, according to the Fortune 500 Blogging Wiki, a collaborative tracking site.

Currently, one of the main impediments to the use of blogs for the disclosure of financial information is Regulation FD, which requires companies to use a method for disseminating financial information that is “reasonably designed to provide, broad nonexclusionary distribution of the information to the public.” One question Chairman Cox and the SEC must entertain is whether blogs meet the “widespread dissemination” requirement.   

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Summary judgment for defendants in civil cases involving insider trading claims brought by the SEC is a rarity. Courts tend to be hospitable to cases that are necessarily based on circumstancial rather than direct evidence, and the key issues of materiality, intent to defraud, and whether the information is non-public tend to be factbound determinations.

Nevertheless, the Court in SEC v. Heartland Advisors, Inc., 2006 WL 254090 (E.D. Wisc. August 31, 2006) recently granted summary judgment to two individuals accused of insider trading by the SEC in a civil lawsuit. Moreover, the Court expressed hostility to the SEC claims in this case. For example, the Court suggested that the SEC is not unlike Brittany Spears in their misuse of quotes:

[T]he SEC makes much of the Heartland offices tour that Krueger allegedly testified to and never had. SEC's proposed factfinding of fact 87 states, "Defendant Krueger claims that he came back to HAI's offices for a "tour" after lunch. However, a thorough review of citations given for that proposition reveals that Krueger never said anything about a tour.

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