On February 6th, the U.S. District Court for the Southern District of Florida entered final judgments against Peter and Sheldon Krieger and John Madey. The SEC had filed a complaint on April 15, 2005, alleging that the three individuals, as principals of a hedge fund, had misappropriated nearly half the money the fund had raised. The complaint alleged that the defendants diverted funds to pay for the operations of a broker-dealer the defendants also controlled. The SEC’s complaint claimed the defendants concealed their misappropriation of funds and trading losses in the fund by issuing false account statements.

The final judgments against the Kriegers, entered by consent, enjoin them from violations of various antifraud provisions of the federal securities laws, and order each of the Kriegers to pay a $110,000 civil penalty. The Final Judgment against John Madey, also entered by consent, orders him to pay disgorgement of $223,094.90, prejudgment interest in the amount of $48,224.80, and waives the SEC’s civil penalty claim.

SEC v. Peter Krieger, Sheldon Krieger and John Madey, Case No. 05-80312-CIV-MIDDLEBROOKS/ JOHNSON (S.D. Fla.)

The SEC’s litigation release can be found at http://www.sec.gov/litigation/litreleases/2008/lr20488.htm 
 

On March 14th, the SEC announced that the U.S. District Court in Massachusetts had entered a final judgment against Marc J. Bilotti, a defendant in a civil injunctive action brought by the SEC. The complaint had charged that Bilotti defrauded mutual fund companies and fund shareholders by making market-timing trades on behalf of his customers at Prudential Securities, Inc. The district court's order, entered March 3, 2008, permanently enjoins Bilotti from violating the antifraud provisions of the federal securities law and orders Bilotti to pay a penalty of $20,000. In a separate related action, the SEC issued an order barring Bilotti from associating with any broker, dealer or investment adviser, with a right to reapply after three years. Bilotti consented to the orders without admitting or denying the allegations.

SEC v. Druffner, Lit. Rel. No. 20497; In the Matter of Marc J. Bilotti, Rel. No. 34-57501

The SEC’s litigation release can be found at http://www.sec.gov/litigation/litreleases/2008/lr20497.htm 
 

On March 11th, the SEC filed civil fraud charges against Linda Woolf and David Gengler, alleging they illegally profited through sales of a stock trading system. The SEC’s complaint alleges the promoters preyed on the elderly and others who had attended free introductory seminars at hotels in dozens of cities nationwide. According to the complaint, Woolf and Gengler lied about their success with the trading program to persuade victims to pay as much as $40,000 for the system. Instead, the Commission alleges, Woolf had never declared a trading profit on her federal tax returns and Gengler typically declared losses or no profits. The SEC alleges that through false stories of their own trading success and bogus claims of a 96.5 percent success rate for students who purchased personal mentoring, courses and software, Woolf and Gengler convinced attendees that they would make extraordinary profits in the stock market if they followed trading strategies that emphasized options trading and short-term swing trading.

The complaint against Woolf and Gengler seeks disgorgement, civil money penalties and permanent injunctions enjoining the defendants from violating the antifraud provisions of the federal securities laws. The SEC investigation is continuing. In a related action, the U.S. Attorney’s Office for the Eastern District of Virginia announced the filing of an indictment against Woolf and Gengler.

The SEC’s press release can be found at http://www.sec.gov/news/press/2008/2008-39.htm 
 

On February 19th, the U.S. Attorney’s Office for the Southern District of Florida unsealed an indictment charging a hedge fund founder and manager and four associates with conspiracy to commit mail, wire and securities fraud in connection with their efforts to manipulate the month-end closing prices of shares of thinly-traded shell company securities and overstate the value of the funds’ holdings. According to the indictment, the manager purchased large quantities of restricted stock at pennies per share in private transactions and then purchased small amounts of the same securities for the funds he managed in order to drive up the price by the end of the trading day. Those securities held by the funds were then valued at the higher closing price to pump up the performance fees paid to the management companies, attract new investors, and induce current investors to remain.

If convicted, the manager faces a prison sentence and fines. The indictment seeks fines and forfeiture of properties obtained as a result of the alleged criminal violations.

SEC v. Michael Lauer, et al., Case No. 03-80612-CIV-MARRA/VITUNAC (S.D. Fla.)

The SEC Litigation Release can be found at http://www.sec.gov/litigation/litreleases/2008/lr20505.htm 
 

On March 11th, the SEC settled administrative proceedings against Michael R. Donnell, a former vice president of a registered investment adviser, Mercantile Capital Advisors, Inc. Donnell had recommended to Mercantile the hiring of a subadviser for Mercantile’s new funds of hedge funds. The subadviser in turn paid referral fees in excess of $78,000 to Donnell’s mother. Donnell’s supervisor discovered the arrangement when he received a letter from the subadviser stating that the subadviser was going to pay a referral fee to Donnell’s mother. Donnell denied knowledge of the payment. However, in March 2004, Mercantile’s parent company received an anonymous letter disclosing the payments to Donnell’s mother by the subadviser. Soon thereafter Mercantile terminated both Donnell and the agreement with the sub-adviser.

The order asserted that Donnell aided and abetted his employer’s violations of Sections 206(1) and (2) of the Advisers Act, and barred Donnell from association with any investment adviser and prohibited him from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter, with the right to reapply for association after three years. Donnell consented to the issuance of the order without admitting or denying any of its findings. Donnell also was ordered to pay a $50,000 civil money penalty.

The SEC order can be found at http://www.sec.gov/litigation/admin/2008/ia-2718.pdf 
 

The SEC issued a “Report of Investigation” on the Retirement Systems of Alabama (“RSA”), a system managing a retirement plan for state employees, and exempt from investment adviser registration pursuant to Advisers Act Section 202(b). In the report, the SEC alleged that RSA purchased securities while in possession of material, non-public information about a pending acquisition. At the time of the transaction, RSA had no program, policy, practice or training to ensure that its investment staff understood and complied with the federal securities laws in general, or insider trading laws in particular. RSA also did not have a compliance officer, and the responsibilities of its general counsel did not include oversight of RSA’s investment activities. The SEC, however, did not charge RSA with insider trading. It noted that the system cooperated in the SEC’s investigation and that no individual had personally profited from the insider trading.

The release announcing the report, Exchange Act Rel. No. 57446 (Mar. 6, 2008), can be found at http://www.sec.gov/litigation/investreport/34-57446.htm 
 

The SEC has recently created a six-person surveillance group within OCIE to identify risky investment advisers. OCIE Director Lori A. Richards stated that the team will examine advisory firm information, including public news reports, information contained in Form ADV filings, and private, subscriber-based information, to assess risk, and pass on relevant public and non-public information to SEC examiners.

The relevant Ignites article can be found at http://www.ignites.com/articles/20080311/creates_risk_surveillance_team 

 

The SEC has released a schedule for upcoming CCOutreach Regional Seminars for 2008. Discussion topics include the compliance rule, information processing and protection, performance advertising and marketing, personal trading, brokerage arrangements and execution, information disclosures, reporting and filings, and portfolio management. Some seminars will feature a session addressing concerns specific to smaller and newly registered advisers.

Information regarding the regional seminars, including dates and locations and registration instructions, is available at http://www.sec.gov/info/iaicccoutreach.htm 
 

On March 12, 2008, OCIE chief counsel John Walsh addressed the ACA Compliance Group conference. Mr. Walsh noted that the SEC’s recent proposal to enhance Regulation S-P regarding the privacy of consumer financial information aims at harmonizing the standards for advisers that are dual-registrants or are affiliated with a broker-dealer.

Under the current proposal, advisers and other types of registrants must file a new form, Form SP-30, with the SEC (or other authority) if there has been a security breach. Walsh noted in the case of an attack from overseas, U.S. regulators may have only a few days to freeze assets before those assets leave the country, and the requirement to file SP-30 promptly would allow the SEC’s Division of Enforcement to take quick action.

Mr. Walsh also noted employees working from home with laptops that do not have any kind of security protection have led to deficiency findings in the past.

Mr. Walsh suggested that if an adviser anticipates that departing portfolio managers will take with them client account statements as performance backup per Rule 204-2(a)(16), then the adviser should amend its privacy notice and notify clients that their account statements might go to another firm.

Mr. Walsh also announced that the SEC has created a new technology office within OCIE to focus on easing the burden on advisers and other registrants to produce electronic records during SEC examinations. According to Mr. Walsh, the goal of the new office is to enable the SEC to handle issues relating to the conversion of electronic documents produced by regulated firms.

The relevant Ignites article can be found at http://www.ignites.com/articles/20080314/bigwig_focus_data_security 
 

On March 20th, Lori A. Richards, the Director of the SEC’s Office of Compliance Inspections and Examinations (“OCIE”), addressed the IA Compliance Best Practices Summit 2008. Ms. Richards noted that the number of registered investment advisers has grown by over 40% since 2001, but that OCIE staffing has not increased over the same period. As a result, OCIE has tried to direct its attention to the most significant areas that pose the greatest potential harm to investors and markets. She provided an overview of OCIE’s risk-based exam program and detailed the top ten compliance concerns surrounding investment advisers, including (1) valuation controls, particularly as these controls relate to the pricing of structured products or illiquid securities; (2) controls over non-public information, personal trading, and codes of ethics; (3) firm dealings with senior/elderly investors; (4) compliance and supervision, including the broad issue of a reasonably designed, risk-focused compliance program and more specific issues such as addressing conflicts posed by revenue sharing arrangements, gifts and gratuities, and the supervision of remote offices; (5) portfolio management issues, including determining whether securities recommendations and investments made for clients and funds are consistent with the adviser’s disclosures and the client’s investment objectives and restrictions; (6) brokerage arrangements and best execution, including determining whether brokerage arrangements are consistent with fiduciary obligations and whether soft dollar and other arrangements are adequately disclosed; (7) allocation of trades; (8) performance advertising, marketing and fund distribution activities; (9) safety of fund and client assets; (10) information processing and protection, including effective policies and procedures for capturing, compiling, maintaining, and reporting relevant and timely information in books and records (including email and instant messages), and in reports to clients and regulators.

Ms. Richards’s speech can be found at http://www.sec.gov/news/speech/2008/spch032008lar.htm 
 

On March 17, 2008, SEC Commissioner Paul S. Atkins addressed the 2008 ICI Mutual Funds and Investment Management Conference. He discussed recent efforts by regulators to respond to market volatility and the collapse of Bear Stearns, but cautioned that regulators must “not give in to the urge to do something if that something would be harmful.” Commissioner Atkins’s speech also focused on the interaction between the U.S. and global markets, including regulatory cooperation. To this end, he suggested that it may be time to reconsider amending Section 7(d) of the Investment Company Act of 1940 to allow for mutual recognition of certain high quality foreign regulatory regimes and products. Commissioner Atkins concluded his speech with praise for ICI’s efforts to survey investors on potential improvements to mutual fund prospectus disclosure. He promised that the SEC will focus on a number of issues identified by the ICI and other commenters, such as potential difficulties associated with the quarterly update requirement, prescriptions for a standardized format, the advisability of multiple-fund summary prospectuses, and the meaning of “greater prominence” in the requirement that the summary prospectus be given greater prominence than other materials with which it is mailed.

Commissioner Atkins’s speech can be found at http://www.sec.gov/news/speech/2008/spch031708psa.htm 
 

According to news reports, the Massachusetts Secretary of the Commonwealth, William Galvin, has begun an investigation into certain investment managers’ actions with respect to auction rate securities. A Reuters news story reported that Brian McNiff, a spokesman for the Secretary’s office, said that “the inquiry seeks to learn if there have been any redemption problems in closed-end funds, and if they have used auction rate markets for leverage.” Secretary Galvin gave the firms being investigated until March 7th to respond to his request regarding information about what the firms are telling their clients in the wake of apparent liquidity problems in the auction rate securities markets.

The Reuters news story can be found at: http://www.reuters.com/article/fundsFundsNews/idUSN2037296220080220  

FINRA settled with a broker-dealer in connection with alleged supervisory and other failures resulting in improper market timing of mutual fund shares in 2003. FINRA alleged that the broker-dealer failed to prevent a group of five traders from market timing mutual funds on behalf of hedge fund customers.

The broker-dealer maintained hundreds of accounts for 15 hedge fund customers to conceal the real identity of the account holders and to allow the hedge funds to spread timing money across accounts, instead of trading a single lump sum, which the mutual funds might have rejected. The broker-dealer also permitted the hedge funds to use over 50 different registered representative numbers to create the appearance that the trades were coming from registered representatives who had not previously been blocked from trading.

The broker-dealer settled with FINRA without admitting or denying the charges, but consented to the entry of FINRA’s findings and agreed to pay a fine of $250,000 and to pay $4.25 million in restitution to more than 60 mutual fund companies.

The FINRA press release announcing the settlement can be found at: http://www.finra.org/PressRoom/NewsReleases/2008NewsReleases/P038019
 

On February 25th, the SEC issued an order to a family of open-end registered investment companies that invest in other registered investment companies (“Registered Funds of Funds”). The Registered Funds of Funds rely on Section 12(d)(1) of the Investment Company Act and Rule 12d1-2 under the Act to acquire securities issued by other registered investment companies. Prior to receiving the order, the Registered Funds of Funds were only permitted to invest in (1) securities issued by other affiliated and unaffiliated registered investment companies, (2) government securities, (3) short-term paper, (4) other securities as defined in Section 2(a)(36) of the Act and (5) securities issued by money market funds. The order permits the Funds of Funds to also invest in futures contracts, options on futures contracts, swap agreements, derivatives, and certain other financial instruments that are not securities as defined in Section 2(a)(36) of the Act. The order was conditioned on the Funds of Funds’ continued compliance with all other aspects of Rule 12d1-2. The ETF Rule proposal discussed above also contains a proposed amendment to Rule 12d1-2 that would eliminate the need for exemptive relief for those investments.

A copy of the SEC order can be found at: http://www.sec.gov/rules/ic/2008/ic-28167.pdf; a copy of the SEC notice can be found at: http://www.sec.gov/rules/ic/2008/ic-28133.pdf 
 

The SEC has approved amendments to NASD Rule 2210 that create an exception from the principal pre-approval requirements for sales materials, including mutual fund sales material, previously filed by another FINRA member. The amendments create an exception to Rule 2210’s pre-approval requirements allowing a FINRA member to use sales material without principal pre-approval if another FINRA member had already filed the sales material and received an approval from FINRA for its use. A FINRA member relying on the new exception may not materially alter the sales material or use it in a manner inconsistent with the FINRA advertisement review letter.

The SEC release approving the amended rule can be found at: http://sec.gov/rules/sro/finra/2008/34-57257.pdf 
 

On February 14th, the SEC issued orders settling with a chief financial officer, chief compliance officer and a registered representative of a broker-dealer for their participation in a scheme to defraud mutual funds through, among other misconduct, deceptive market timing. The CFO, CCO and registered representative did not admit or deny the SEC’s findings on the orders. The SEC alleged that the broker-dealer employed deceptive tactics on behalf of its hedge fund customers to evade mutual funds’ efforts to restrict market timing. The SEC further alleged that several mutual funds notified the broker-dealer that frequent trading by the broker-dealer’s customers violated prohibitions in the mutual funds’ prospectuses, and the mutual funds instructed the broker-dealer to stop permitting its customers to trade those funds. The broker-dealer then employed deceptive tactics to continue trading the mutual funds that had requested the broker-dealer’s customers to stop.

The orders direct the CFO, CCO and registered representative to cease and desist from committing or causing any violations and any future violations. The orders also suspend the CCO and CFO from associating with any broker or dealer, and prohibits both from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter, for a period of six months. The registered representative is barred from association with any broker or dealer and is prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter.

A copy of the SEC orders can be found at: http://www.sec.gov/litigation/admin/2008/33-8894.pdf, http://www.sec.gov/litigation/admin/2008/33-8895.pdf and http://www.sec.gov/litigation/admin/2008/34-57329.pdf  

On March 4th, the SEC voted unanimously to propose amendments to Regulation S-P, which sets forth privacy obligations for entities regulated by the SEC. The proposed amendments are intended to help prevent and address security breaches at the institutions the SEC regulates, such as identity theft and intrusions into online brokerage accounts.

The proposed amendments would provide more detailed standards for information security programs, as well as a new exception to permit the disclosure of limited personal information without the required notice and opt out when representatives move from one broker-dealer or registered investment adviser to another.

The proposed amendments would provide more specific requirements for safeguarding information and responding to information security breaches and would update Regulation S-P’s safeguarding and disposal provisions. They also would extend the application of the disposal provisions to individuals associated with brokers, dealers, investment advisers registered with the SEC and transfer agents registered with the SEC, and would extend the application of the safeguarding provisions to registered transfer agents.

Finally, the proposed amendments also would permit a limited transfer of information without the required notice and opt out when personnel move from one broker-dealer or registered investment adviser to another.

A copy of the SEC proposing release can be found at: http://www.sec.gov/rules/proposed/2008/34-57427.pdf  

On March 4th , the SEC voted unanimously to propose two new rules under the Investment Company Act to permit exchange-traded funds (“ETFs”) to operate without the need to obtain individual exemptive orders from the SEC. The SEC also proposed amendments to Form N-1A to include additional information for ETF investors who purchase shares in the secondary markets.

According to Andrew J. Donohue, Director of the SEC’s Division of Investment Management, “[t]he proposed rules would increase investor choice by eliminating a barrier to entry for new participants in this fast-growing market, while preserving investor protections.” Donohue added that “[p]ermitting most ETFs to come directly to market without the cost and delay of obtaining an exemptive order would also allow staff to focus on more novel and difficult requests.”

The following are some of the highlights of the SEC’s proposal:

Proposed Rule 6c-11. Proposed Rule 6c-11 would provide several exemptions from the Investment Company Act to permit ETFs to form and operate without the need to obtain individual exemptive relief from the SEC. The rule would codify most of the exemptions previously granted by the SEC to index-based ETFs and, pursuant to several recently-issued exemptive orders, to fully transparent actively managed ETFs. Specifically, Rule 6c-11 would establish that (1) ETF shares are “redeemable securities” for purposes of Section 2(a)(32) of the Investment Company Act; (2) a dealer in ETF shares is exempt from the pricing provisions of Section 22(d) of, and Rule 22c-1(a) under, the Investment Company Act; (3) the fund is exempt from the limitation on postponing payment of redemptions of Section 22(e) of the Investment Company Act; and (4) certain affiliates of an ETF are exempt from prohibitions on affiliate transactions applicable to the deposit or delivery of basket assets in connection with the issuance or redemption of creation units.

Proposed Rule 12d1-4. Proposed Rule 12d1-4 under the Investment Company Act would allow investment companies to make investments in ETFs that are larger than currently permitted by the Investment Company Act, which generally limits one investment company to acquiring no more than 3% of another registered investment company’s shares, investing more than 5% of its assets in another fund, or investing more than 10% of its assets on other funds in the aggregate. The exemptions in the proposed rule would be subject to several conditions designed to address the historical abuses associated with “pyramiding” schemes that often occurred with fund investment in other funds. Notably, these conditions exemplify the conditions that were historically included in ETF exemptive orders. It is not completely clear from the proposing release whether the rule applies to private funds that rely on the exceptions to the definition of “investment company” in Section 3(c)(1) or 3(c)(7) of the Investment Company Act (e.g., hedge funds). There may be additional guidance that will clarify the application of the rule to unregistered funds.

Amendments to Form N-1A. The proposed amendments to Form N-1A, which open-end funds use to register under the Investment Company Act and offer their securities under the Securities Act of 1933, would accommodate the use of the form by ETFs. The proposed amendments are designed to provide key information to investors who purchase ETF shares in secondary market transactions, where most ETF investors (including retail investors) purchase their shares.

A copy of the SEC press release can be found at: http://www.sec.gov/news/press/2008/2008-
30.htm and the proposing release can be found at: http://www.sec.gov/rules/proposed/2008/33-8901.pdf  

On March 3rd, the SEC released its reproposal of a new Part 2 to Replace the Current Part II of Form ADV and proposed related rules under the Investment Advisers Act of 1940 (the “Advisers Act”). If adopted as proposed, the new Part 2 of Form ADV would require registered investment advisers to provide current and prospective clients with narrative brochures containing “plain English” descriptions of their businesses, services, fees, risks, conflicts of interest and disciplinary history. The proposal would also require advisers to electronically file their brochures in PDF format through the Investment Adviser Registration Depository, and the brochures would be available to the public through the SEC’s web page.

Under the proposal, advisers generally would be required to deliver a current brochure to clients annually and to deliver updates of the brochure to clients if the adviser amends its brochure to add a disciplinary event. Advisers would not be required to deliver brochures to advisory clients who (1) receive only impersonal investment advice, (2) are investment companies registered under the Investment Company Act of 1940 (the “Investment Company Act”), or (3) are business development companies that are subject to Section 15(c) of the Investment Company Act.

The new Part 2A of Form ADV would contain nineteen separate items, each covering a different disclosure topic. Advisers would be required to respond only to the items that apply to their business. The following are some of the highlights of the proposing release:

Summary of Material Changes. Item 2 would require advisers to provide clients with a summary of any material changes to their brochures since the last annual update.

Performance Fee Disclosure. Item 6 would require an adviser that charges performance-based fees or that has a supervised person who manages an account that charges such fees to disclose this fact. In addition, if such an adviser also manages accounts that are not charged a performance-based fee, the item would require the adviser to discuss the conflicts that arise from its (or its supervised persons’) side-by-side management of these accounts with those charged a performance-based fee, and to describe generally how the adviser addresses those conflicts.

Soft Dollar Disclosure. Item 12 would require an adviser that receives soft dollar benefits in connection with client securities transactions to disclose its soft dollar practices. Advisers would be required to describe the types of conflicts it has when it accepts soft dollar benefits and to disclose how it addresses those conflicts. The item would require the adviser to explain whether it uses soft dollars to benefit all client accounts or only those accounts whose brokerage “pays” for the benefits, and whether the adviser seeks to allocate the benefits to client accounts proportionately to the soft dollar credits those accounts generate.

Brochure Supplements. The proposal also includes a requirement that adviser brochures be accompanied by supplements that provide information about the advisory personnel on whom clients rely for investment advice. Ordinarily, each resume-like supplement would be less than one-page long and would include the educational background, business experience, and any disciplinary information about each individual who provides advisory services to the client.

Transition Schedule. Finally, in order to provide advisers already registered with the SEC with sufficient time to prepare the new brochure and supplements, the SEC is proposing to implement a transition schedule. The transition schedule would require advisers to comply with the new Part 2 requirements on their next annual updating amendment to Form ADV after the new form becomes effective. In no case, however, would any adviser be required to comply with the new requirements until at least six months after they become effective.

A copy of the SEC proposing release can be found at: http://www.sec.gov/rules/proposed/2008/ia-2711.pdf