An administrative law judge (the “ALJ”) issued an initial decision related to cease and desist proceedings against the portfolio manager (the “Portfolio Manager”) of a short term municipal bond fund (the “Short Term Fund”) as a result of insider trading violations stemming from the Portfolio Manager’s recommendation that certain family members sell their holdings in the Fund. The ALJ found that the Portfolio Manager improperly recommended that his daughter and certain other family members sell their holdings in the Short Term Fund while he was in possession of material non-public information regarding the Short Term Fund (“MNPI”). This article summarizes the ALJ’s principal findings in the order.
Background. From 2003 until 2008 the Portfolio Manager was the head portfolio manager for the Philadelphia office of a registered investment adviser (the “Adviser”), and was responsible for the management of approximately $5 billion in fixed income investments, including the Short Term Fund and a municipal bond fund managed using the same investment approach, but having a longer duration (collectively with the Short Term Fund, the “Funds”). A significant portion of the net worth of certain family members of the Portfolio Manager, including his two daughters, his ex-wife, and his brother-in-law and sister-in-law, was invested in the Short Term Fund. In connection with the market disruptions experienced in 2008, the performance of the Funds began to suffer and the Funds experienced significant redemption pressure, including large redemptions from certain institutional shareholders.
On September 17, 2008, the Portfolio Manager engaged in a telephone conversation with his daughter in which the daughter asked the Portfolio Manager what they were going to do about her investments in light of the economic crisis. In response to his daughter’s concerns the Portfolio Manager gave general responses counseling her that if she was concerned then she should sell her holdings in the Short Term Fund, and that her mother and other family members should, as well.
During the period between September 17, 2008 and October 3, 2008, the Portfolio Manager became aware of certain MNPI regarding the Funds, including: (1) that a large institutional shareholder had indicated that it intended to redeem its holdings in the Short Term Fund that were approximately equal to 10% of the Short Term Fund’s assets, and had commenced a redemption program toward that end, (2) that management of the Adviser had directed the Portfolio Manager to significantly raise the cash level in the portfolios of each of the Funds in order to meet the anticipated demand for redemptions, and (3) that the Adviser was discussing closing the Funds, and had determined that if it determined to close one Fund, then the other would be closed, as well.
On October 3, 2008, the Portfolio Manager and his daughter engaged in another telephone conversation during which the Portfolio Manager brought up the previous discussions regarding the daughter’s holdings in the Short Term Fund and when informed that she had redeemed a portion of her holdings he instructed her that she should “go with the full route.” Following this conversation, several members of the Portfolio Manager’s family, including his two daughters, his ex-wife, his brother-in-law and sister-in-law, took action to redeem their holdings in the Short Term Fund.
Internal Investigation. On October 7, 2008, the Adviser became aware of the series of redemption requests by members of the Portfolio Manager’s family and commenced an internal investigation into the facts of the redemption requests to determine what prompted the activity. As part of the internal investigation the Portfolio Manager was interviewed and provided an account of the telephone conversations with his daughter that significantly differed from the transcripts of those telephone calls, particularly where the Portfolio Manager recounted that he had stated in each conversation that he could not provide investment advice as to the Short Term Fund. As a result of the internal investigation, the Adviser determined not to honor several redemption requests from members of the Portfolio Manager’s family. Further, the Adviser determined that the Portfolio Manager had breached the Adviser’s Code of Ethics (the “Code”) by disclosing MNPI and by not being truthful during the internal investigation. At the conclusion of the internal investigation the Adviser terminated the Portfolio Manager
Insider Trading. The ALJ determined that the facts supported a decision that the Portfolio Manager was guilty of insider trading, which under applicable law generally requires that the actor (a) be in possession of material, non-public information that is intended to be used for a proper purpose, and then, (b) misappropriates or otherwise misuses that information, (c) with scienter, (d) in breach of a fiduciary duty or other duty arising out of a relationship of trust or confidence. In reaching this decision the ALJ found that when the Portfolio Manager recommended that his daughter sell her holdings in the Short Term Fund: (1) the Portfolio Manager was in possession of MNPI; (2) he misused MNPI by advising his daughter that she and his former wife should sell their shares of the Short Term Fund; (3) he acted with the requisite scienter, (i.e., in general terms, having a mental state embracing the intent to deceive, manipulate or defraud); and (4) he acted in breach of his fiduciary duty to the Adviser and the Short Term Fund.
In analyzing whether the Portfolio Manager acted with scienter, the ALJ observed that the intent required for scienter can either be established by willfulness or by extreme recklessness, noting that a number of facts supported a finding that the Portfolio Manager was either willful or extremely reckless with respect to the use of MNPI when “tipping” his daughter. The ALJ found that the Portfolio Manager was aware of the prohibitions against insider trading, as evidenced by his express agreement to comply with the Adviser’s Insider Trading Policy which stated that “[i]t is a violation of United States federal law . . . for any employee to trade in, or recommend trading in, the securities of a company . . . while in possession of material, nonpublic information.” The ALJ held that the Portfolio Manager’s false exculpatory statements in response to questioning during the Adviser’s internal investigation indicated a “consciousness of guilt.” As evidence of the Portfolio Manager’s extreme departure from the standard of ordinary care, the ALJ cited the Portfolio Manager’s failure to seek input from the Adviser’s internal legal or compliance department prior to advising his daughter to sell her shares in the Short Term Fund, which the ALJ contrasted with the actions of another portfolio manager for the Adviser who was also in possession of MNPI regarding the difficulties faced by the Short Term Fund and had sought compliance department pre-approval of a proposed sale of a personal holding in the Fund during the same timeframe (and been refused).
In determining that the Portfolio Manager’s actions violated fiduciary duties to the Adviser and the Short Term Fund the ALJ explained that (a) the Portfolio Manager owed a duty of loyalty and confidentiality to the Adviser as his employer, and had acknowledged such duties through his agreement to comply with the Code, and (b) the Portfolio Manager, as an investment adviser to the Short Term Fund, also owed the Fund a fiduciary duty. The ALJ found that the Portfolio Manager breached his fiduciary duties to both the Adviser and the Short Term Fund when he advised his daughter and his former wife to sell shares in the Short Term Fund with an aggregate value of close to $2 million while in possession of MNPI, in violation of management’s directive to increase the cash position of the Short Term Fund, and against the best interests of the Short Term Fund, which was ill positioned given market conditions to deal with large redemptions.
Violations and Sanctions. The ALJ found that the Portfolio Manager willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, which prohibit fraudulent conduct in the offer and sale of securities and in connection with the purchase and sale of securities. Further the ALJ found that the Portfolio Manager willfully violated Sections 206(1) and 206(2) of the Advisers Act, which prohibit fraudulent conduct by an investment adviser. The ALJ ordered that: (a) the Portfolio Manager cease and desist from committing or causing any violations or future violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Sections 206(1) and (2) of the Advisers Act, (b) the Portfolio Manager be barred from association with an investment adviser, and (c) the Portfolio Manager pay disgorgement in the amount of $9,403.55 representing the amount of the losses avoided by certain family members. The SEC Division of Enforcement recommended that the ALJ impose a civil money penalty in an amount up to $130,000 for each act based on the Portfolio Manager’s intentional misconduct and the risk of substantial loss to the shareholders of the Short Term Fund; however, the ALJ determined that no civil money penalty was warranted because the Portfolio Manager’s reckless disregard of a regulatory requirement did not result in significant harm to the shareholders of the Short Term Fund.