Category: SEC News

SEC is Probing Hedge Funds

They’re looking at you.

Rob Kaplan and Bruce Karpati, co-chiefs of the Asset Management Unit of the SEC enforcement division, held their first full staff meeting last week. This new unit will be focusing on misbehavior by private-equity funds, hedge funds, buyout firms, mutual funds and other asset managers. The unit is one of the five specialty units the SEC formed earlier this year.

Side Pockets

Hedge funds use side pockets to protect new investments, long term investments and other assets that they do not want to liquidate in the face of redemptions in the fund. In the Great Panic of 2008 funds used side pockets to limit redemption.

Valuations

One issue related to the side pocket is valuation of the assets. One reason for keeping the assets is because the fund managers feel the assets are not being properly valued in the market. On the bad side, the fund may be charging fees against the inflated value of those side pockets assets. Most side pocket assets are illiquid, which makes valuations difficult to determine.

Management Investment

One surprising priority for the unit is evaluating whether fund managers really have their own wealth invested in the fund when they are saying so in the prospectus and marketing materials.

It sounds like some enforcement proceedings are likely to appear in this area in the next few months.

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Picture is by Daniel Rosenbaum for The New York Times

The SEC Drinks Its Own Champagne

The SEC has named its first chief compliance officer: Kathleen Griffin.

She will be tasked with oversight of employee securities transactions and financial disclosure reporting. The creation of a compliance program to prevent insider trading came from last year’s insider trading scandal at the SEC. The Office of the Inspector General reported that “the Commission lacks any true compliance system to monitor SEC employees’ securities transactions and detect insider trading.”

Ms. Griffin will have her hands full. From the SEC OIG Report:

The current disclosure requirements and compliance system are based on the honor system. and there is no way to determine if an employee fails to report a securities transaction. There are no spot checks conducted and the SEC does not obtain duplicate brokerage account statements. In addition. there is little to no oversight or check;ing of the reports that employees file to determine their accuracy or even whether an employee has reported at all. Moreover. different SEC offices receive each of those reports and do not routinely share that information with each other.

It’s good to see the SEC drinking its own champagne and hiring someone to focus on their own internal compliance issues. (Doesn’t “drinks its own champagne” sound better than “eat its own dog food.”)

Since the announcement came on April 1, I thought it was an April Fool’s Day joke. Why would the SEC hire the comedian Kathy Griffin? Clearly, I was being overly cautious about my news intake. I was not alone in this confusion and I’m sure will not be the last to draw the comparison between the two.

I’m sure Kathleen’s comments to the SEC employees will be less controversial than Kathy’s comments at the Emmy Awards.

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Did you “Make” an Untrue Statement under 10b-5?

The First Circuit threw out the SEC’s 10b-5(b) claim in SEC v. Tambone. This time it was the entire court after an earlier decision of a three judge panel reached the opposite decision.

The SEC alleged that James Tambone and Robert Hussey engaged in fraud in connection with the sale of mutual fund shares tied to market timing claims. The two were senior executives of a registered broker dealer, Columbia Funds Distributor, Inc. The prospectuses for the funds told investors that market timing was not permitted. Unfortunately, Tambone and Hussey permitted a number of customers to engage in market timing transactions. The SEC took the position that Tambone and Hussey were responsible for the false statements in the prospectuses since they commented on the market timing passages prior to their inclusion in the documents.

This case presents the two-part question of whether a securities professional can be said to “make” a statement, such that liability under Rule 10b-5(b) may attach, either by (i) using statements to sell securities, regardless of whether those statements were crafted entirely by others, or (ii) directing the offering and sale of securities on behalf of an underwriter, thus making an implied statement that he has a reasonable basis to believe that the key representations in the relevant prospectus are truthful and complete. The answer to each part of this two-part question is “no.”

Rule 10b-5(b), promulgated by the Securities and Exchange Commission under of section 10(b) of the Securities Exchange Act of 1934, renders it unlawful “[t]o make any untrue statement of a material fact . . . in connection with the purchase or sale of any security.” 17 C.F.R. § 240.10b-5(b).

The Tambone case turns on the meaning of the word “make” as used in Rule 10b-5(b). The SEC advocated “an expansive definition, contending that one may “make” a statement within the purview of the rule by merely using or disseminating a statement without regard to the authorship of that statement or, in the alternative, that securities professionals who direct the offering and sale of shares on behalf of an underwriter impliedly “make” a statement, covered by the rule, to the effect that the disclosures in a prospectus are truthful and complete.”

The court rejected the SEC’s position.

In 1994 the US Supreme Court held that private civil liability does not an aiding and abetting suit under Rule 10b-5 in the case of Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164. So private parties can only bring a suit against primary violators of Rule 10b-5. As a result of that decision, Congress amended the Exchange Act to make it clear that the SEC can bring a suit againstanyone who provides substantial assistance to a primary violator of securities laws. That is, the SEC can impose secondary liability.

The First Circuit decided that the SEC was trying to impose primary liability on Tambone and Hussey for conduct that would be a secondary violation (at most). The Court acknowledged that there is a split in the courts over the right test, but held that the facts of this case would fail both tests.

“If Central Bank is to have any real meaning, a defendant must actually make a false or misleading statement in order to be held liable [as a primary violator] under section 10(b). Anything short of such conduct is merely aiding and abetting.” Shapiro v. Cantor, 123 F.3d 717, 720 (2d Cir. 1997).

The next step is up to the SEC. They need to decide if they will appeal to the Supreme Court and use this case to try to reconcile the law in this area.

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The Problem with Selective Disclosure

If you want to see a classic case of the problems with selective disclosure take a look at the recent SEC case against Presstek, Inc. and its former CFO.

Presstek was having a bad quarter in 2006. The CFO knew that the company would be reporting bad financial performance for the quarter. The CFO told an investor that the results would be bad. The investor immediately sold its shares in Presstek. The next day Presstek publicly released its poor financial performance for the quarter.

Slam dunk.

It’s that kind of selective disclosure that the SEC was trying to prevent when it enacted Regulation FD. It is bad that some investors could preferential treatment to material information and be able to act on that information before the general public.

“This investigation related to matters that occurred prior to the changes in executive leadership which took place in 2007,” said Jeff Jacobson, Presstek’s Chairman, President and Chief Executive Officer. “We feel very strongly about corporate governance and we are pleased to put this legacy issue behind us.”

In addition to the $400,000 settlement with the SEC, Presstek also had to pay a $1.25 million to settle a securities class action case related to the matter.

Even though it was a straightforward violation, the question I have is: How did the SEC find out? Perhaps they noticed the spike in the selling of shares and the purchasing of puts by the investor. Perhaps somebody blew the whistle? Perhaps the company self-reported?

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Another Charge in Madoff Fraud

The SEC has charged Daniel Bonventre, Madoff’s Director of Operations, with securities fraud.

“According to the SEC’s complaint, Bonventre was responsible for the firm’s general ledger and financial statements that were materially misstated because they did not reflect the manner in which investor funds were maintained and used. Bonventure ensured that BMIS financial reports did not reflect the firm’s massive liabilities to investors or the corresponding assets received from investors. To hide the fact that BMIS normally operated at a significant loss, the firm used more than $750 million in investor funds to artificially improve reported revenue and income.

The SEC alleges that Bonventre also helped Madoff, his lieutenant Frank DiPascali, Jr., and others orchestrate lies to investors and regulators when investment advisory operations at BMIS came under review. With Bonventre’s assistance, they made serial misrepresentations to external reviewers by manufacturing reams of false reports and data.”

…

This is the SEC’s seventh enforcement action in the Madoff fraud since the scheme collapsed in December 2008. The Commission previously charged Madoff and BMIS, DiPascali, and auditors David G. Friehling and Friehling & Horowitz CPAs, P.C., who have all pleaded guilty to criminal charges related to their conduct. The SEC also charged certain feeder funds with committing securities fraud, and charged two computer programmers at Madoff’s firm for their roles in covering up the scheme.

Sources:

SEC Press Release – SEC Charges Madoff’s Director of Operations with Falsifying Accounting Records and Siphoning Investor Funds

SEC Decides to Think Further About IFRS

The Securities and Exchange Commission voted to issue a statement that lays out its position regarding global accounting standards. They want to make it clear that “the Commission continues to believe that a single set of high-quality globally accepted accounting standards would benefit U.S investors.”

By 2011, the SEC will decide whether to incorporate IFRS into the U.S. financial reporting system, and if so, when and how. In trying to reach a decision, the SEC has published a Work Plan. It has six key areas:

  • Sufficient Development and Application of IFRS for the U.S. Domestic Reporting System
    • Comprehensiveness
    • Auditabilitity and Enforceability
    • Consistent and High-Quality Application
  • The Independence of Standard Setting for the Benefit of Investors
  • Investor Understanding and Education Regarding IFRS
  • Examination of the U.S. Regulatory Environment that Would Be Affected by a Change in Accounting Standards
  • The Impact on Issuers, Both Large and Small, Including Changes to Accounting Systems, Changes to Contractual Arrangements, Corporate Governance Considerations, and Litigation Contingencies
  • Human Capital Readiness

Certainly it would be better to have a single universal accounting standard. But is IFRS better than GAAP, worse than GAAP, or just different?

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SEC Commissioner is a Blog Commenter

So you write a blog post about the fiduciary duty of financial service providers to their clients. Actually, the real story is about the lack of fiduciary duty that brokers have to their customers. Then an SEC Commissioner chimes in.

Tara Siegel Bernard writes for New York Times blog, Bucks: Making the Most of Your Money. On February 16 her post was Will You Be My Fiduciary? Her proposal was to arm consumers with fiduciary rights, regardless of what the law says. Merely ask our provider to sign a fiduciary pledge so they have a contractual obligation to be a fiduciary.

Perhaps to her surprise, she got a comment from Elisse Walter, Commissioner, Securities and Exchange Commission:

This well-written, easy-to-understand proposal captures the way that all financial professionals should treat investors. It recognizes that all financial professionals should be subject to a fiduciary duty. And in a simple and straightforward way it articulates the scope of the duty and cuts through what has become non-productive debate on this issue.

This articulation allows us to move on to another critical issue: financial professionals are unfortunately subject to different obligations when they are performing virtually identical services for investors. For example, a person cannot start a brokerage firm unless she demonstrates to a securities regulator that she has the expertise and operational capacity to engage in the type of business she proposes to start. No equivalent process exists for investment advisers. And, the law requires an adviser to disclose to his client the full range of circumstances where their interests may conflict, while the law governing brokerage firms does not impose that blanket obligation.

These are only two examples of the obligations that should be harmonized. I’m ready to see us get on with that work.

According to a message I got from Mark Story, the SEC’s Director of New Media, it’s only the second time that a senior-level SEC official has commented in a public forum.

The first was when former SEC Chairman Christopher Cox commented on a blog post by Jonathan Schwartz: Sunlight on a Cloudy Day….

It looks like an SEC Commissioner posts a blog comment every three and half years. Plan ahead for 2013.

Actually, I’m surprised that the SEC Commissioners have commented at all. I recognize that high-level government officials have to be much more cautious about what they say in a public forum. They run into a similar problem with the dissemination of information that public companies have with Regulation FD. Surprisingly (or not), that just so happens to be the subject of that first SEC comment.

SEC Guidance Regarding Disclosure Related to Climate Change

Last week, the Securities and Exchange Commission voted to provide public companies with interpretive guidance on existing disclosure requirements as they apply to business or legal developments relating to the issue of climate change. The SEC has now released the text of the guidance:
Guidance Regarding Disclosure Related to Climate Change

Those who are fired up about global warming will be quickly underwhelmed by the guidance. At its most basic it merely reminds public companies that they need “to consider climate change and its consequences as they prepare disclosure documents to be filed with us and provided to investors.”

The guidance claims that it will does not create any new disclosure requirements. Given the increased regulation of emissions, cap and trade, and insurance company adjustments, companies need to disclose the potential impact of these changes on the future prospects of the company.

I expect we will see a new section in the annual filings this spring, some interesting reading and some inflammatory news reports.

The globe image is by Jackl under the Creative Commons Attribution ShareAlike 3.0 in Wikimedia: http://commons.wikimedia.org/wiki/File:Global_warming_ubx.svg.png

The SEC and Climate Change

Last week, the Securities and Exchange Commission voted to provide public companies with interpretive guidance on existing disclosure requirements as they apply to business or legal developments relating to the issue of climate change.

Chairman Mary Schapiro pointed out in her speech that the SEC is not commenting or opining on the issue of climate change; rather the guidance is intend to “provide clarity and enhance consistency” to help companies decide what does and does not need to be disclosed.

There has been a fair amount of discussion, mostly because climate change is such a lightning rod issue. I think most people, even Republicans, have agreed that the planet is going through some fairly rapid climate change. The debate has shifted to how much of it is caused by man and what we can do to slow climate change. But not the SEC: “We are not opining on whether the world’s climate is changing, at what pace it might be changing, or due to what causes.” If they are going to regulate, they should at least admit that there is climate change.

Maybe they should take a trip to McCarty Glacier in Alaska.

Image from Global Warming Art under CC-BY-SA

As with most SEC rules, the press release was short on details and we are still waiting for the actual interpretive notice to see what will be required.

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The globe image is by Jackl under the Creative Commons Attribution ShareAlike 3.0 in Wikimedia: http://commons.wikimedia.org/wiki/File:Global_warming_ubx.svg.png