Financial Services Alert - October 4, 2011

The SEC issued an order instituting administrative and cease-and-desist proceedings against a registered investment adviser (the “Adviser”) and its founder and majority owner, who also served as its chief executive officer and chief compliance officer (the “Owner” and, collectively with the Adviser, the “Respondents”) for misrepresenting in Form ADV the Adviser’s assets under management and for failing to disclose the Adviser’s poor financial condition to clients.  This article summarizes the SEC’s principal allegations, which have not been proven.

Assets Under Management.  The Adviser registered with the SEC on June 11, 2008 in reliance on Rule 203A-2(d) under the Investment Advisers Act of 1940 (the “Advisers Act”) pursuant to which the Adviser represented that it expected to have $25 million in assets under management within 120 days of registering.  In Form ADV, and amendments thereto, filed with the SEC and made available to clients in June 2008 to May 2010, the Adviser represented that it had assets under management ranging from $30 million to approximately $125 million.  The Respondents further represented to the SEC staff during an examination of the Adviser in 2009 that the Adviser had $98 million in assets under management.  In an October 1, 2010 letter to the SEC staff, the Adviser acknowledged that it failed “to satisfy the $25 million threshold set forth in Section 203A of the Advisers Act.”  The SEC alleges that the Owner knowingly inflated the Adviser’s assets under management by, among other things, including estimated values of prospective clients’ assets in various calculations of the Adviser’s assets under management.

Financial Condition.  The SEC further alleges that the Adviser did not disclose its “poor” financial condition to its clients – despite a net loss of $436,277 in fiscal year 2009 and an inability to pay the salaries and consultant fees of some staff members that resulted in several employees leaving the Adviser in 2010, according to the order.

Alleged Violations.  The SEC alleges that, based on the conduct described above, the Adviser  willfully violated, and the Owner willfully aided and abetted the violation of, the following Sections, and relevant rules, of the Advisers Act: 

• Section 203A: The SEC alleges that, but for the Adviser’s inflated assets under management, it would have been prohibited from registering with the SEC as an investment adviser for failing to meet the relevant $25 million threshold.

• Section 204 and Rule 204-2(a)(8): The SEC alleges that the Respondents failed to “make and keep, true, accurate and current” books and records relating to its advisory business.

• Section 206(4) and Rule 206(4)-4(a)(1): The SEC further alleges that the Respondents failed to properly disclose all material facts regarding the Adviser’s financial condition that are reasonably likely to impair its ability to meet contractual commitments to clients.  The order notes that Rule 206(4)-4(a)(1) applied during the period of the alleged violations, but was repealed effective October 12, 2010 in favor of comparable requirements now included in Items 9 and 18 of Form ADV Part 2A (also known as the “brochure”).  (The SEC release adopting the foregoing disclosure requirements and rescinding Rule 206(4)-4 cautioned “advisers that their fiduciary duty of full and fair disclosure may require them to continue to disclose any precarious financial condition promptly to all clients, even clients to whom they may not be required to deliver a brochure or amended brochure.”)

• Section 207: The SEC further alleges that the Respondents made untrue statements of material facts in registration applications or reports Respondents filed with the SEC and willfully omitted to state in such applications or reports material facts which were required to be stated therein.

The U.S. District Court for the Western District of Tennessee (the “District Court”) (Judge Mays presiding) issued an order (the “Order”) that dismissed without prejudice claims brought by certain shareholders (the “Plaintiffs”) in an investor class action suit against the investment adviser (the “Former Adviser”) to four affiliated closed-end mutual funds (the “Funds”), certain personnel of the Former Adviser and the former directors of the Funds (the “Former Board”), alleging losses incurred as a result of investments in risky illiquid mortgage-related securities that were inconsistent with the Funds’ investment objective, and violated its industry concentration policy.  Additionally, the complaint alleged that the Former Adviser failed to disclose the extent of the Funds’ investment in mortgage-related securities and artificially inflated the net asset value of the Funds’ by overstating the value of the mortgage-related securities.  The allegations in the complaint generally track the findings made by the SEC and FINRA in settled administrative proceedings focused on the Funds’ investments in mortgage-related securities.  Those administrative proceedings were described in the April 20, 2010 Financial Services Alert and the July 5, 2011 Financial Services Alert.  The wrongdoing alleged by the Plaintiffs took place during the period between 2007 and 2009 when the Funds operated as part of the Former Adviser’s mutual fund complex under the oversight of the Former Board.  The Funds currently operate under the oversight of an entirely new board of directors (the “New Board”) and the Funds’ investments are directed by a new investment adviser.

Background.  The Plaintiffs filed the complaint (the “Complaint”) alleging damages on behalf of the Funds on March 18, 2010 and amended the Complaint on December 6, 2010.  Prior to filing the Complaint, the Plaintiffs made demand on the New Board requesting that they bring an action on behalf of the Funds in November 2009.  The New Board responded to the Plaintiffs by letter dated December 12, 2010 (the “Response Letter”) stating that:

“[I]n the course of related pending derivative litigation involving the former directors and/or officers and the former investment adviser of the Funds, the current Boards of Directors of the Funds are conducting an investigation to determine whether the Boards of Directors of the Funds should take action against the Funds’ former directors, officers or investment adviser with respect to similar allegations.”

The Plaintiffs filed the complaint approximately four months after the Demand and two months after delivery of the Response Letter.

Applicable Law.  Based in large part on the fact that the Funds are organized as Maryland corporations, the District Court determined that Maryland law governed its decision.  The District Court stated that because the action is derivative in nature and brought by shareholders on behalf of the Funds, Maryland law requires the Plaintiffs to “overcome a number of procedural hurdles and demonstrate that [they], rather than the corporation itself, should control the litigation.”  The District Court explained that “[b]efore filing suit on the corporation’s behalf, the [Plaintiffs] must (1) ‘make a good faith effort to have the corporation act directly,’ an effort known as making demand on the corporation, or (2) demonstrate that making demand would be futile.”  Further, the District Court explained that once demand has been made, the corporation’s board of directors must conduct an investigation into the allegations in the demand to determine whether bringing an action is in the best interests of the corporation, and that the courts will look to the timing of the filing of the plaintiff’s complaint to determine whether the demand was proper.  If the corporation fails to take the action requested by the demand, the shareholders may then bring an action on a demand-refused basis. 

The District Court noted that there is a limited futility of demand exception that applies “only when the allegations or evidence clearly demonstrate, in a very particular manner, either that (1) a demand, or a delay in awaiting a response to a demand, would cause irreparable harm to the corporation, or (2) a majority of the directors are so personally and directly conflicted or committed to the decision in dispute that they cannot reasonably be expected to respond to a demand in good faith and within the ambit of the business judgment rule.”  The District Court observed that once shareholders have made a demand they may not claim that the board of directors was unable to act independently, but they may allege that the “board did not act independently or that demand was wrongfully refused.”

The District Court’s Analysis.  In filing the Complaint, the Plaintiffs argued that the Response Letter demonstrated that the New Board had not conducted an investigation, did not intend to conduct an investigation and had not provided a “good faith response.”  In dismissing this argument, the District Court stated that having made demand, the Plaintiffs could not bring the action until the New Board completed its investigation.  The District Court also ruled that the futility of demand exception was not available to the Plaintiffs because (1) in making demand on the New Board, they waived any claim that they might have had that the New Board could not “independently act on the demand;” (2) the Plaintiffs could not show that “a majority of the directors are so personally and directly conflicted or committed to the decision in dispute that they cannot reasonably be expected to respond to [the demand] in good faith and within the ambit of the business judgment rule;” and (3) there were no allegations of irreparable harm to the Funds if Plaintiffs could not proceed with their derivative action before the New Board completed its investigation.

The District Court found that the Plaintiffs did not have standing to bring a “demand refused” action because they did not wait for the New Board to complete its investigation of the allegations before filing the Complaint.  The District Court stated that in order to bring a “demand refused” action the Plaintiffs must “exhaust their intra-corporate remedies” before filing the Complaint, noting that “[n]othing in Maryland law suggests that plaintiffs who have made demand on a board of directors may bring a derivative action before the board has completed its investigation.  Maryland law suggests the opposite.”

Dismissal of Complaint.  Having determined that the Plaintiffs lacked standing to bring a demand refused action, the District Court considered whether to dismiss the complaint or to stay the proceeding.  The District Court determined that there was no Maryland authority addressing the situation alleged in the Complaint in which a board had responded to a plaintiff’s demand.  Observing that “[i]n the absence of authority, Maryland generally follows Delaware law,” the District Court looked to a Delaware decision dismissing a derivative action brought before a board of directors had completed its investigation.  The District Court determined that because the New Board responded to the demand via the Response Letter and the Complaint was filed only two months after receipt of the Response Letter it was appropriate to dismiss the complaint without prejudice.

The SEC’s Office of Compliance Inspections and Examinations announced the issuance of the first in a series of Nation Exam Risk Alerts that discusses the risks posed by the master/sub-account trading model with respect to money laundering, insider trading and other types of regulatory, economic and reputational risks resulting from lack of information about the persons making trading decisions at the sub-account level.  The master/sub-account trading model generally involves a limited liability company, limited liability partnership or similar legal entity that opens an account with a registered broker-dealer (the “master account”).  The master account is then divided into subordinate accounts (“sub-accounts”) that can engage in their own trading activities.  The National Exam Risk Alert outlines the potential problems for broker-dealers in ensuring compliance with various federal securities laws (with particular emphasis on the new “Market Access Rule” discussed in the November 16, 2010 Financial Services Alert) and the requirements of self-regulatory organizations to the extent that a master/sub-account arrangement obscures the identity and activities of a sub-account owner.  The National Exam Risk Alert provides examples of effective controls and practices employed by broker-dealers to address these risks that have been observed by SEC examination staff.

In a recent shareholder derivative complaint filed in the U.S. District Court for the Southern District of New York, shareholders of JPMorgan Chase & Co. (“JPMorgan”) brought a derivative action claiming breach of fiduciary duty and unjust enrichment by the directors of JPMorgan in connection with JPMorgan’s $88.3 million settlement with OFAC to resolve “potential civil liability for apparent violations” of regulations and executive orders administered and enforced by OFAC. 

The plaintiffs allege, among other things, that the JPMorgan directors failed to properly supervise and monitor the adequacy of JPMorgan’s internal controls and allowed misleading statements and filings to be issued.  The plaintiffs also claim that the JPMorgan directors were unjustly enriched when they accepted compensation and director remuneration while allegedly breaching their fiduciary duties to JPMorgan.  (Louisiana Municipal Police Employees Retirement System v. Dimon, et al, USDC SDNY, 11 CIV 6231 (Sept. 8, 2011)).

Goodwin Procter’s ERISA Litigation Practice has published its latest quarterly ERISA Litigation Update.  The Update discusses (1) a Second Circuit decision affirming the dismissal of a suit challenging an insurer’s use of a retained asset account to settle life insurance benefits and (2) decisions by the Seventh and Third Circuits addressing the inclusion of retail mutual funds on  401(k) platforms.

The Basel Committee on Banking Supervision (the “Basel Committee”) issued a release reaffirming its proposal (initially disseminated for public comment in July 2011) to impose a capital surcharge on banks deemed to be “too big to fail.”  The surcharge would involve a 1% to 2.5% additional charge (to be held in the form of common equity) for 28 banks (which were not named), with the charge varying with the bank’s perceived systemic importance.  The capital surcharge would be above the minimum capital requirements under the Basel III capital accord.  The Basel Committee also is proposing to dissuade “too big to fail banks” from expanding further by means of the imposition of a 3.5% capital charge on expanding banks that, as a result of such expansion, would become even more systemically important.

The SEC announced that the national securities exchanges and FINRA have filed proposals to revise their market-wide circuit breaker programs which pause trading on a market-wide basis when the volatility of a reference index exceeds specified thresholds.  (The NYSE proposal is available here.)  In simple terms, the proposals would (a) reduce the percentage by which the market must decline to trigger a circuit breaker, (b) shorten the duration of trading halts when a circuit breaker is triggered, (c) reduce the number of relevant trigger time periods, (d) substitute the S&P 500 Index for the Dow Jones Industrial Average as the reference index and (e) recalculate trigger thresholds daily rather than quarterly.  The proposals are subject to SEC approval following a public comment period that ends October 25, 2011.