THE UPWARD TREND IN MUNCIPAL SECURITIES CASE ENFORCEMENT

upwards-trendThe past two weeks has seen the SEC’s continued ratchet upward the number of enforcement actions against municipal securities participants for disclosure violations.

These enforcement actions also continue to ensnare an array of players in municipal securities transactions, that include underlying obligors, their chief executive officers, national and regional investment banks, the heads of public finance departments at several investment banks, as well as individual investment bankers at various levels of seniority, issuers, issuer officials, financial advisers, attorneys and accountants.

The cases have involved everything from  tax or arbitration-driven fraud, pay-to-play and public corruption violations, public pension accounting and disclosure fraud, valuation/pricing issues, and most recently, more offering offering and disclosure fraud, involving misleading statements or omissions in offerings.

Two recent enforcement actions illustrate this trend.  The first, SEC v. City of Miami, Florida and Michael Boudreaux, an SEC complaint filed in federal court in Miami alleged that the City of Miami, through its then Budget Director, charged that beginning in 2008, the City and the budget director made materially false and misleading statements and omissions concerning certain interfund transfers in three 2009 bond offerings totaling $153.5 million, as well as in the City’s fiscal year 2007 and 2008 Comprehensive Annual Financial Reports.  The City puportedly transferred a total of approximately $37.5 million from its Capital Improvement Fund and a Special Revenue Fund to the General Fund in 2007 and 2008 in order to mask increasing deficits in the General Fund.

The complaint alleged that the City and the budget director failed to disclose to bondholders that the transferred funds included legally restricted dollars which, under Miami’s city code, was not permitted to be commingled with any other funds or revenues of the City.  The defendants  also failed to disclose that the funds transferred were allocated to specific capital projects which still needed those funds as of the fiscal year end or, in some instances, already spent that money.  The transfers enabled the City of Miami to meet or come close to meeting its own requirements relating to General Fund reserve levels.  According to the SEC, the results of the transfers, meant that the City’s bond offerings were all rated favorably by credit rating agencies.

The second and most recent case, In The Matter of  West Clark Community Schools, a settled administrative cease-and desist proceeding, involved the West Clark Community Schools, an Indiana school district.  In 2005, the West Clark Community Schools contractually, in accordance with SEC rules, undertook to annually disclose certain financial information, operating data and event notices in connection with a $52 million municipal bond offering.  In 2007, the school district, in connection with a $31 million municipal bond offering, stated in public bond offering documents that it had not failed, in the previous five years, to comply in all material respects with any prior disclosure undertakings. That statement, the SEC alleged, as well as a Certificate and Affidavit signed by the School District attesting that the offering documents did not contain any untrue statement of material fact, was materially false.  To the contrary, the SEC found that between at least 2005 and 2010 the School District never submitted any of its contractually required disclosures.

As a result, the SEC claimed that the school district violated Section 17(a)(2) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5(b) thereunder.  In a separate, but related, settled cease-and-desist proceeding, In the Matter of City Securities Corporation and Randy G. Ruhl, the SEC found that City Securities, the underwiter, and an vice president of City Securities’ municipal bond department conducted inadequate due diligence and, as a result, failed to form a reasonable basis for believing the truthfulness of material statements in an the school district’s  official statement, resulting in City Securities offering and selling municipal securities on the basis of a materially misleading disclosure document.

In addition to being censured, City Securities was ordered to pay disgorgement and civil penalties.  The vice president was barred from the securities industry with a right to reapply after one year and ordered to pay disgorgement and civil penalties.

In July 2012, the SEC  issued a comprehensive report with recommendations aimed at helping improve the structure and enhance disclosure provided to investors for a municipal securities market that has grown to $3.7 trillion in municipal debt outstanding from a level of $361 Billion in 1981.  To that, add potential enforcement actions from the MSRB, states, and other SROs, and there’s little doubt that the enforcement action trend will escalate.

Time For Quarterly Transaction Reports

FE_DA_Deadline_050613425x283A reminder to advisers,  the code of ethics you adopted probably requires quarterly reports to be prepared for all personal securities transactions made by access persons.  If it doesn’t there are two possible reasons (1) chances are you haven’t read it, or (2) you don’t have one — in which case you need to first read Rule 204A-1 of the Investment Advisers Act of 1940.

The Timing of Transaction Reports

Under Rule 204A-1(b)(2), these reports are due no later than 30 days after the close of the calendar quarter.   Access persons who would be submitting duplicate information contained in trade confirmations or account statements that an  adviser holds in its records (provided the adviser has received those confirmations or statements not later than 30 days after the close of the calendar quarter in which the transaction takes place) may be excused by their investment advisers from submitting transaction reports.

Who is an access person?

Rule 204A-1(e)(1) defines an access person as a supervised person who has access to nonpublic information regarding clients’ purchase or sale of securities, is involved in making securities recommendations to clients or who has access to such recommendations that are nonpublic.  Further, a supervised person who has access to nonpublic information regarding the portfolio holdings of affiliated mutual funds is also an access person, but only to the extent they make, participate in, or obtain information regarding, the purchase and sale of the fund’s securities, or if their functions relate to the making of any recommendations for such transactions.

This definition is broad enough to include, for example,

(i) portfolio management personnel and, in some organizations, client service representatives who communicate investment advice to clients;

(ii)  administrative, technical, and clerical personnel if their functions or duties give them access to nonpublic information;

(iii) organizations where  employees may have broad responsibilities, and fewer information barriers are in place  to prevent access to nonpublic information.  On the other hand, as the SEC has noted, organizations that keep strict controls on sensitive information may have fewer access persons; and

(iv) presumably if the firm’s primary business is providing investment advice, then all of its directors, officers and partners would be access persons.

When must access persons report personal securities transactions?

Under Rule 204A-1(b), each of an adviser’s access persons must report his securities holdings at the time that the person becomes an access person and at least once annually thereafter. Further, they must make to the adviser’s Chief Compliance Officer or other designated person a report at least once quarterly of all personal securities transactions in reportable securities.

What are “reportable securities”?

Rule 204A-1 treats all securities as reportable securities, but list five exceptions designed to exclude securities that appear to present little opportunity for the type of improper trading that the access person reports are designed to uncover. These include transactions and holdings in:

  • direct obligations of the Government of the United States.
  • money market instruments — bankers’ acceptances, bank certificates of deposit, commercial paper, repurchase agreements and other high quality short-term debt instruments.
  • shares of money market funds.
  • shares of other types of mutual funds, unless the adviser or a control affiliate acts as the investment adviser or principal underwriter for the fund.
  • units of a unit investment trust if the unit investment trust is invested exclusively in unaffiliated mutual funds.

There are other exceptions. For example, under Rule 204A-1, no reports are required for transactions effected under an automatic investment plan; No reports are required for securities held in accounts over which the access person has no direct or indirect influence or control; and finally, under Rule 204A-1(d), no report is required in the case of an advisory firm that has only one access person, so long as the firm maintains records of the holdings and transactions that rule 204A-1 would otherwise require be reported.

There are other requirements in Rule 204A-1, the Code of Ethics Rule, covering access persons transactions and holdings that advisers should review.  These includes such issues as pre-approval of certain investments, review of personal holdings and transaction reports, procedures to address personal trading and reporting of violations.

 

 

The Consequences For Untimely Producing Records to Regulators

A recent SEC enforcement case illustrates again how an investment adviser’s  failure to  timely respond to SEC requests for books and records during an inspections and examinations can turn into an enforcement action.  The outcome should not surprise.  With the limited facts available, one wonders why the SEC’s restraint in bringing an action lasted as long as it did.  There are, however, a few important takeaways for advisers and their compliance professionals.

The case, In the Matter of  EM Capital Management, LLC and Seth Richard Freeman,  involves the SEC issuing an order instituting administrative and cease-and-desist proceedings against an adviser and its principal for failing, over a year and a half period, to furnish books and records to the Commission’s Investment Adviser/Investment Company examination staff.  The requested records included financial statements, e-mails, and documents relating to the adviser and a mutual fund it managed.

After repeatedly promising to produce the documents following repeated requests from the examination staff, the adviser ultimately did comply.  However,  by then, presumably, the Commision’s patience had finally worn thin, and the staff notified the adviser and its principal that the SEC was considering enforcement action against him and the firm.

The Commission alleged that the adviser violated, and the principal aided and abetted violations of Section 204 of the Advisers Act and Rule 204-2, thereunder.  These  regulations and rules require SEC-registered investment advisers to produce required books and records to the Commission’s staff. The adviser and principal were censured and jointly ordered to pay a civil penalty of $20,000.

The lessons imparted from this and similar cases brought by the Commission are at least three-fold:

  1. Never refuse to produce documents that are subject to the SEC’s inspection powers. i.e. generally, with a few exceptions, Rule 204-2(e) of the Investment Advisers Act of 1940 (“Advisers Act”) requires advisers to maintain their books and records for at least five years, and maintained in an appropriate office of the adviser for the first two years.
  2. Delaying tactics is not a good idea since it probably raise more red flags for the examination staff that’s some rule violation may have occured.  If  additional time is needed to comply bring requests to the staff’s attention and make sure it and any extensions granted are documented.
  3. Despite the lesser sanctions in this case, advisers and their compliance personnel should never forget that, under Section 217 of the Advisers Act, willful failure to permit the SEC to inspect books and records is a felony, punishable by a fine of not more than $10,000 and imprisonment up to five years or both.
  4. Nothing stated above should suggest that advisers may not seek to limit the scope of books and records sought.  This includes, where appropriate, asserting relevant privileges against producing certain documents, seeking clarifications about unclear or open-ended requests, and objecting to burdensome and unreasonable production.

 

The Employee versus Independent Contractor Saga Continues

Last week, in the ever-evolving “employee versus independent contractor” battle, Judge Anthony Battaglia of the U.S. District Court for the Southern California in a decision added additional fuel in a decision in the broker-dealer/registered representative arena.  Battaglia upheld Waddell & Reed’s classification of its reps as independent contractors, ruling against two brokers who claimed that they should have been treated as employees.  Earlier, in 2010, the court refused to dismiss a putative class action against Waddell & Reed that alleged that the financial services giant misclassified its financial advisors or registered representatives as independent contractors rather than employees.  In the current decision, the court granted Waddell’s motion for two summary judgments, but allowed the two former rep/plaintiffs to add a third broker to their suit.

Clearly, the Taylor v. Waddell & Reed  ruling is, by no means, the last word on the issue.  And, don’t expect the SEC and FINRA to weigh in any time soon.  Nor should broker-dealers expect that simply enhancing a boiler-plate  employment contract provision will necessarily do the trick.

Further, the classification of workers as independent contractors will continue to draw scrutiny from the Department of Labor, the Internal Revenue Service, state agencies and legislatures, and the plaintiffs’ bar.  For broker-dealers this may mean, at a minimum, three considerations.  First, broker-dealers will need to review how they utilize their registered representatives’ services.  Second, they’ll need to have a clear understanding of the laws they’re relying on for the independent rep classification.  Finally, they’ll need to consider the legal exposure and what proactive steps may be necessary (i.e. potential liability) if they’ve been misclassifying a particular rep.

Big Firms Fare Better in SEC Enforcement Actions

So says a study conducted by Berkeley Law School professor, Stavros Gadinis.  The article appears in The Business Lawyer, published in the May 2012 issue  (Volume 67, Number 3)  by the American Bar Association. The study covers SEC enforcement actions against investment banks and brokerage houses during a period just before the 2007-2008 economic crisis (the dataset covers 2005, 2006, and the first four months of 2007); and the data suggests that defendants in smaller firms fared far worse in SEC enforcement actions.  According to Professor Gadinis, there are three dimensions to the data.

The first is that when the SEC action involved big firm misconduct, the preferred choice was corporate responsibility as opposed to individual liability.  In short, this sounds,  in part, like some of the criticism heaped on the Bush and Obama Justice Department for failing to bring criminal cases against some individual senior officers in the banking industry responsible for the financial debacle.  Often in these SEC actions, neither the individual who actually participated in the violative conduct nor high-level supervisors were subject to additional sanctions.

Even though both legal venues are open to them, a second factor involves the SEC’s more likely decision to bring adminstrative proceedings against big firms instead of court proceedings.  Hence, the study found that financial professionals subjected to court proceedings resulted in stiffer sanctions, including higher penalties and even bans from the securities industry.

Concomitantly, with administrative proceedings, a third factor arises.  For the same violation and comparable levels of harm to investors, the study found that big firms and their employees were less likely to be banned from the securities industry, even after controlling for violation type and harm to investors.

Skepticism over the legal and public policy implications of not holding individuals liable for violations noted in the Gadinis article (and as we discussed in our January 2, 2012 post) has been raised some courts like Judge Jed Rakoff’s criticism and rejection of the SEC’s settlements with Citi Bank and Bank of America.

To be fair, the article makes clear that “[w]hile… [these theories] seek to explain the SEC’s enforcement strategy… they do not purport to represent an exhaustive list of potential explanations of the [SEC’s] motives.”  Instead, the data raises and addresses major issues about the future implications of the SEC’s activities in recent years.

FINRA Expected to Bring Record Breaking Enforcement Cases in 2012

The Financial Industry Regulatory Authority (FINRA) is on pace to bring a record breaking number of enforcement cases this year compared to 2011.  Last year, FINRA brought approximately 1,500 cases in which 33% of large firms were faced with an enforcement action while less than 5% of smaller firms faced an action.  According to AdvisorOne, Sutherland Asbill & Brennan’s annual FINRA Sanctions Survey, released in early March, found that fines issued by FINRA increased significantly in 2011, jumping 51% to $68 million from fines of $48 million levied by the regulator in 2010.

The top two areas that FINRA cases have focused are dishonesty and unapproved outside businesses, particularly focusing on complex products.  During FINRA’s annual conference, Chairman and CEO of FINRA, Richard Ketchum, explained that a number of FINRA enforcement actions involve complex products where “firms didn’t adequately supervise the sale of the products, then recommended products that were unsuitable for the investors, or the sales material were misleading.”