Financial Services Alert - February 28, 2012 February 28, 2012
In This Issue

Federal District Court Finds in Part for SEC in Enforcement Proceeding Against Hedge Fund Adviser and its Chief Executive Over Market Timing and Late Trading

The U.S. District Court for the Southern District of New York (the “Court”) issued an opinion finding in part for the SEC in an enforcement proceeding brought against a U.K.‑based hedge fund adviser and its chief executive officer that also named as a relief defendant the fund through which they were found to have engaged in market timing and late trading of U.S. mutual funds during the period from June 1999 to September 2003.  The action was brought under Section 17(a) of the Securities Act of 1933 (the “Securities Act”), and Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Rule 10b-5 thereunder, which, among things, “prohibit the use of fraudulently misleading representations in the purchase or sale of securities.”  The Court held that the SEC had established the defendants’ liability for their late trading activities, but failed to establish liability for their market timing activities.

Market Timing.  The Court found that the defendants had engaged in frequent trading of U.S. mutual funds by (a) using multiple broker-dealers, accounts and registered representative numbers, (b) trading in small amounts and (c) “cloning” trading accounts, in order to avoid or circumvent the enforcement of fund policies limiting frequent trading activity.  The Court held, however, that the SEC had failed to establish that market timing rules prior to September 2003 were sufficiently clear to permit liability.  “Defendants’ actions thus took place in an atmosphere of uncertainty.  There were no definitions or prohibitions from the [SEC] with respect to market timing, and the [mutual funds’] enforcement of their provisions relating to timing was discretionary, inconsistent, and occasionally conflicted with [agreements in which mutual fund sponsors agreed to provide market timing capacity to certain parties].”  The Court acknowledged that the defendants “generally sought to outwit the funds and knew that the funds in at least some instances did not permit market timing;” however, in the absence of definitive SEC guidance and “[w]ithout the clarity of what the funds’ rules were, despite Defendants’ general intent to deceive, the SEC has failed to establish the requisite scienter required by Section 10(b), Rule 10b-5, and Section 17(a(1).”  Having made this finding, the Court observed that SEC disclosure requirements for mutual funds adopted in response to the market timing scandals may provide “sufficient clarity . . . so as to establish that market timing of a [mutual fund], in contravention of its now published rules and practices, may violate the federal securities laws.”

Late Trading.  In contrast to its view regarding the permissibility of market timing during the relevant time frame, the Court found that late trading, the violation of mutual forward pricing practices (which require that purchase and redemption orders be priced at a fund’s next established net asset value (“NAV”) following receipt of the order by the fund or an appropriate intermediary), clearly is and was, during the relevant period, a violation of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, noting that every other court to have considered the issue had made a similar finding.  The Court also held that the defendants “knew that late trading was impermissible and that they were obtaining an advantage over other investors contrary to the mutual funds’ rules and SEC regulation,” and that “the evidence as a whole demonstrates that Defendants were the creators, directors, and chief beneficiaries of the fraudulent scheme, and as such they are primarily liable.”

Injunctive Relief and Disgorgement.  The Court granted the SEC’s request for the entry of injunctions against future violations of the antifraud provisions of the securities laws as to the defendant hedge fund adviser and its chief executive officer.  The Court found all the defendants jointly and severally liable for disgorgement in the sum of $38,416,500, which represented the approximate amount of the profits realized by the defendants from their late trading activity.  The Court also imposed civil penalties of $38,416,500.

SEC v. Pentagon Capital Management, 2012 U.S. Dist. LEXIS 18504 (S.D.N.Y. Feb. 14, 2012).

FinCEN Issues Notice Concerning Temporary Exemption from Mandatory Electronic Filing of FBARs and Describes Other FinCEN Electronic Filing Requirements

On February 24, 2012 the Financial Crimes Enforcement Network (FinCEN) issued a notice (the “Notice”) in which it announced a general temporary exemption from mandatory electronic filing with FinCEN of Reports of Foreign Bank and Financial Accounts (FBARs) until July 1, 2013.  Prior to the granting of the temporary exemption, the deadline for filing FBARs electronically was July 1, 2012.  The exemption from electronic filing does not relieve individuals and businesses from a requirement to file an FBAR in non-electronic form.  In December 2011, FinCEN announced that it was extending, to March 31, 2013, the deadline for financial institutions’ mandatory use of FinCEN’s new Currency Transaction Report form and new Suspicious Activity Report form.

FinCEN also reminded financial institutions that they must begin electronically filing all reports to FinCEN other than a Report of International Transportation of Currency or Monetary Instruments (CMIR) and a Report of Cash Payments Over $10,000 Received in a Trade or Business (Form 8300) by July 1, 2012.

The Notice also describes the process that a financial institution must use if it wishes to apply to FinCEN for a limited duration hardship exemption from the electronic filing requirements.

OCIE Issues National Examination Risk Alert on Unauthorized Trading

The SEC’s Office of Compliance Inspections and Examinations has issued a National Examination Risk Alert designed to assist registered broker-dealers and investment advisers in strengthening their controls and supervisory systems for detecting and preventing unauthorized trading and similar activities.  The Risk Alert discusses specific measures that may assist firms in complying with their supervisory and compliance obligations in this area.

OFAC Releases FAQs on Iranian Sanctions under Section 1245 of National Defense Authorization Act of 2012

The Office of Foreign Assets Central (“OFAC”) released guidance in the form of frequently asked questions (“FAQs”) concerning Section 1245 of the National Defense Authorization Act of 2012 (the “NDAA”).  The NDAA designates the entire Iranian financial sector as a “jurisdiction of primary money laundering concern” and takes additional actions to isolate Iran from the global economy.  The FAQs provide guidance on, among other things, OFAC’s interpretation of key terms under the NDAA and the scope of institutions that may be subject to sanctions under the NDAA.  In addition, the FAQs discuss the interaction of Section 1245 of the NDAA with somewhat similar sanctions applicable to foreign financial institutions under the Comprehensive Iran Sanctions, Accountability and Divestment Act of 2012.  Subsequently, on February 27, 2012, OFAC issued regulations, effective February 27, 2012, under Section 1245(d) of the NDAA regarding the imposition of sanctions with respect to the Central Bank of Iran and designated Iranian financial institutions.

Treasury Large Position Reports on January 2019 Treasury Notes Due March 2

The US Treasury announced a call for entities whose reportable positions in the 1-1/4% Treasury Notes of January 2019 that equalled or exceeded $2 billion as of the close of business on Tuesday, February 21, 2012 to report these positions to the New York Federal Reserve Bank before 12:00am (Noon) EMT on Friday, March 2, 2012.