Financial Services Alert - July 1, 2014

Goodwin Procter’s ERISA Litigation Practice published its latest quarterly ERISA Litigation Update.  The update discusses (1) the Supreme Court’s ruling in Fifth Third Bancorp v. Dudenhoeffer that there is no “presumption of prudence” for fiduciaries of plans that invest in employer stock; (2) Hi-Lex Controls, Inc. v. Blue Cross and Blue Shield of Michigan, in which the Sixth Circuit ruled that that a service provider was liable as a fiduciary under ERISA for unauthorized fees it assessed against a self-funded health plan; (3) a decision by a Seventh Circuit panel in which it declined to apply ERISA’s three-year statute of limitations to bar fiduciary claims in a case arising out of a buy-out transaction involving an employee stock ownership plan; (4) a decision by the Second Circuit in which it affirmed dismissal of claims alleging the imprudent investment of plan assets in employer stock on the grounds that a company’s decision to make contributions to a plan in its stock, as opposed to cash, is not subject to ERISA fiduciary requirements; and (5) a decision by a Ninth Circuit panel recognizing that reformation, equitable estoppel and surcharge were among the “appropriate equitable relief” potentially available under Section 502(a)(3) of ERISA, although the majority held that none was available to the plaintiff under the facts of the case.

The SEC settled administrative proceedings against an investment adviser, Paradigm Capital Management, Inc. (the “Adviser”), and Candace King Weir, the Adviser’s principal owner (the “Principal”), over violations of the principal transactions prohibitions of Section 206(3) of the Investment Advisers Act of 1940 (the “Advisers Act”) and retaliatory action taken by the Adviser against its head trader (the “Head Trader”) after learning that he had reported the transactions in question to the SEC.  The press release announcing the settlement noted that “[t]his is the first time the SEC has filed a case under its new authority to bring anti-retaliation enforcement actions.”  (See the May 31, 2011 Financial Services Alert for a detailed description of SEC’s adoption of final rules implementing the Dodd-Frank Act whistleblower provisions.)  This article summarizes the SEC’s findings in the settlement order, which the respondents have neither admitted nor denied.

Background

The Principal is the founder, chief investment officer, and president of, and a portfolio manager for, the Adviser, which manages hedge funds with total assets of approximately $1.7 billion.  The Principal owns 73% of the Adviser and was found by the SEC to exercise ultimate control and authority over the Adviser.  The order focuses on transactions between one of the Adviser’s hedge funds (the “Fund”) with assets of approximately $275 million, and the Fund’s prime broker, a broker-dealer in which the Principal owned a 73% interest (the “Affiliated Broker‑Dealer”).

Harvesting Tax Losses for the Fund

From at least 2009 to 2011, the Adviser sought to reduce the Fund’s tax liability by selling securities with unrealized losses in the open market and to a proprietary trading account at the Affiliated Broker-Dealer (the “Trading Account”).  As the Fund’s portfolio manager, the Principal would direct the sale of such a security to the Trading Account if she thought she might like to repurchase the security later for the Fund and if it made execution more efficient.  Sales to the Trading Account were effected on the Affiliated Broker-Dealer’s trading systems without any markup or commission.  Between 2009 and 2011, the Adviser sold 47 securities positions from the Fund to the Trading Account, 36 of which were subsequently repurchased by the Fund.  (The settlement order includes no findings regarding any harm or benefit to the Fund from these transactions.)

Compliance with Section 206(3) Disclosure and Consent Requirements

The SEC found that because the Principal owned a controlling interest in both the Adviser and the Affiliated Broker-Dealer, the Funds’ transactions with the Trading Account (the “Trading Account Transactions”) were subject to the prior disclosure and consent requirements of Section 206(3) of the Advisers Act, and further found that review and approval of the Trading Account Transactions by the conflicts committee established by the Adviser for the purpose of satisfying Section 206(3) (the “Conflicts Committee”) were not effective in meeting those requirements.  The Conflicts Committee consisted of the Adviser’s CFO, who also served as CFO of the Affiliated Broker-Dealer, and the Adviser’s CCO. 

The SEC found that the Conflicts Committee could not provide effective consent because the CFO had an obligation to monitor the Affiliated Broker-Dealer’s compliance with net capital requirements which was in conflict with his obligation as a member of the Conflicts Committee to act in the best interests of the Fund.  In this regard, the SEC cited a situation that arose in early 2012 when the Affiliated Broker-Dealer’s net capital declined in part because the Trading Account had purchased large blocks of securities from the Fund in late 2011.  To improve the Affiliated Broker-Dealer’s net capital position, the CFO suggested that the Affiliated Broker-Dealer begin selling securities worth more than $20 million held in the Trading Account either to the open market or back to the Fund.  He also suggested staggering future sales of securities from the Fund to the Trading Account for the benefit of the Affiliated Broker‑Dealer’s net capital.

The SEC also observed that the Principal Owner owned and controlled 99% of the Fund’s general partner (the “General Partner”), and by virtue of her ownership interest in the Affiliated Broker-Dealer shared in the profits and losses resulting from the Trading Account Transactions.  On that basis, the SEC concluded that “any written disclosure to her as the owner of the General Partner was insufficient, and for the same reason she also could not provide effective consent to the principal transactions.”

The SEC found that the Adviser’s Form ADV Part 2A disclosure, which stated that the Conflicts Committee acts on behalf of the Fund when approving principal transactions, was materially misleading because it failed to disclose the conflict of interest to which the Adviser’s CFO was subject as result of also serving as the Affiliated Broker-Dealer’s CFO.

Retaliation Against Whistleblower

The settlement included a determination that the Adviser had impermissibly retaliated against the Head Trader for reporting the Trading Account Transactions to the SEC.   On March 28, 2012, the Head Trader made a voluntary written submission to the SEC that revealed the Trading Account Transactions.  On July 16, 2012, the Head Trader notified the Principal and the Affiliated Broker-Dealer’s Chief Operating Officer that he had reported potential securities law violations to the SEC and identified the general conduct referred to in his submission.  The SEC found that the Adviser subsequently took a series of retaliatory actions against the Head Trader that violated the whistleblower protections adopted under the Dodd-Frank Act.  Among other things, the Head Trader had his job duties changed from head trader to what the SEC characterized as “full-time compliance assistant” analyzing trade data and reviewing trading-related compliance policies, “stripped him of his supervisory responsibilities, and otherwise marginalized him.”  The Head Trader ultimately resigned.

Violations

The SEC found that the Adviser violated (1) Section 206(3) of the Advisers Act, (2) Section 207 of the Advisers Act, which prohibits material misstatement or omissions in any registration application or report filed under the Advisers Act, and (3) Section 21F(h) of the Securities Exchange Act of 1934, pursuant to which an employer may not “discharge, demote, suspend, threaten, harass, or in any other manner discriminate” against a whistleblower in the terms and conditions of employment because of any lawful act done by the whistleblower in, among other things, providing information to the SEC.  The SEC found that the Principal caused the Adviser to violate Section 206(3) of the Advisers Act.

Sanctions

Among other sanctions, the Adviser and the Principal agreed to pay, jointly and severally, (i) disgorgement of $1,700,000 to compensate certain investors in the Fund between 2009 and 2011; (ii) prejudgment interest of $181,771; and (iii) a civil penalty of $300,000.  The disgorgement amount was designed to approximate certain administrative fees the Fund paid in connection with the principal transactions in question.  The Fund’s fee structure provided that the Adviser charged the Fund for compliance-related expenses, including the Conflicts Committee’s administration of the disclosure and consent requirements of Advisers Act Section 206(3).

The Adviser was also required to retain an independent compliance consultant to, among other things, conduct a comprehensive review of the Adviser’s supervisory and compliance policies and procedures designed to detect and prevent prohibited principal transactions, such as the Adviser’s use of any committees and advisory boards involved in reviewing and approving principal transactions.

In the Matter of Paradigm Capital Management, Inc. and Candace King Weir, SEC Release No. 34 – 72393 (June 16, 2014).

In remarks delivered to the FRB’s Third Annual Stress Test Modeling Symposium FRB Governor Daniel K. Tarullo focused on the “qualitative assessment of [large] firms’ capital planning processes” that the FRB conducts “in parallel with [its] quantitative assessment” and offered a “retrospective on the first five years of supervisory stress testing.”

Governor Tarullo noted that while the FRB’s “basic approach to stress testing has not changed materially” since the establishment of the Supervisory Capital Assessment Program, that several things have changed.  For instance: (i) the Dodd-Frank Act made stress testing a statutory requirement; (ii) the annual supervisory stress tests have been incorporated into the Comprehensive Capital Analysis and Review (“CCAR”), which requires large firms to submit an annual capital plan; and (iii) “substantial enhancements” to the supervisory stress test have occurred (including the development of independent supervisory models… [that] have increased [the FRB’s] ability to distinguish risks within portfolios.”  The FRB has through these adjustments developed stress testing into a key year-round element of the FRB’s supervisory program for large banking organizations.

Governor Tarullo highlighted the CCAR, stating that through it, the FRB has “sought to ensure not only that all large BHCs have strong capital positions as determined through our supervisory stress test, but also that they have strong capital planning practices that are appropriately focused on the capital needed to withstand possible losses from the specific risks in each firm’s business model.”  Govenor Tarullo opined that notable improvement has been made in firms’ capital planning processes (including “meaningful investments” in risk-measurement processes such as internal data and management information systems), but that additional improvement is necessary.  Governor Tarullo explained that that the “importance we attach to these risk-management and capital planning processes is reflected in the component of CCAR known as the qualitative assessment,” and that the FRB’s attention has shifted to that component of the CCAR.  The qualitative assessment “covers a range of topics, including the extent to which the design of a firm's internal scenario captures the specific risks from the firm's activities, the firm’s methods for projecting losses under stress scenarios, and how the firm identifies appropriate capital levels and plans for distributions.”

The Federal Financial Institutions Examination Council (the “FFIEC”) announced that it had established a web page on cybersecurity (the “Web Page”), which is designed to serve as a central repository for current and future regulatory guidance and related materials concerning cybersecurity.  The members of the FFIEC are the FRB, FDIC, OCC, NCUA, CFPB and a liaison committee of the state banking supervisors.  The FFIEC also announced that its member federal and state regulators are commencing a pilot program to assess how 500 community financial institutions manage cybersecurity and how those institutions are preparing to mitigate the damage caused by cyber attacks.  The FFIEC stated that its member regulators “are particularly focusing on risk management and oversight, threat intelligence and collaboration, cybersecurity controls, service provider and vendor risk management, and cyber incident management and resilience.”  The pilot examinations, noted the FFIEC, will be conducted by regulatory agencies during regularly scheduled examinations.