Commissioner Campos Speaks on Mutual Fund Director Issues
2.28.2007 SEC Commissioner Roel C. Campos spoke in Coral Gables, Florida at the Mutual Fund Directors Forum First Annual Directors Institute. He spoke about recent developments impacting directors. He noted that Chairman Cox announced at a recent meeting of the Commissioners to seek public comment on two papers prepared by the SEC's Office of Economic Analysis relating to the costs of controversial proposals that would require the chairman and 75% of the directors of mutual fund boards to be independent from management. He stated that most of the data gathered so far supported his view that the independent chair and 75% board independence provisions had not imposed great expense and that the rule has been implemented widely across the industry, with generally very positive results.
He next spoke about mutual fund activism. He stated that funds may do well to seriously consider the power of effective shareholder activism. Rather than automatically voting with its feet any time a fund becomes unhappy with the current corporate structure or business strategy, it may be worthwhile for a fund to seriously assess the costs and benefits of using its significant leverage to generate value through management or other business changes.
He also spoke on mutual funds versus hedge funds and funds of hedge funds. With respect to the latter topic, Commissioner Campos addressed the issue of whether fund of hedge funds may be too risky or unsuitable for the average investor. He stated that this comment simply misses the mark. The SEC has never been, and is not in the business of eliminating investment risk. Rather, we protect investors and their investments by regulating fund disclosures, conflicts-of-interest, and governance. We have always held that the determination of appropriate investment risk and investment suitability with respect to a particular product is to be made by the market and professionals and investors that operate in that space, not by the SEC.
Please click http://www.sec.gov/news/speech/2007/spch022807rcc.htm to access a copy of the speech.
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Adviser Charged with Cherry-Picking
2.26.2007 The SEC brought charges against against Melhado, Flynn & Associates, Inc. (MFA), George M. Motz (Motz)
and Jeanne McCarthy (McCarthy). The alleged that, from at least January 2001 through April
2005, George M. Motz, the President, CEO and Chairman of the Executive
Committee of MFA, engaged in fraudulent trade allocation - "cherry-
picking" - at MFA, a registered investment adviser and broker-dealer.
During the initial period of the scheme, from at least January 2001
until approximately September 2003, Motz unfairly allocated trades
that had appreciated in value during the course of the day to MFA's
proprietary trading account and allocated purchases that had
depreciated in value during the day to the accounts of his advisory
clients. Beginning in the summer of 2003, Motz engaged in cherry-
picking to favor one of the firm's advisory clients, a hedge fund
affiliated with MFA, over his other advisory clients. In addition, in
the fall of 2003, Motz, with the assistance of McCarthy, altered order
tickets in an attempt to cover-up these fraudulent trade allocations.
As a result of this fraud, MFA realized ill-gotten gains of
approximately $1.4 million. In addition, MFA and Motz earned
commissions and fees from advisory clients who were disadvantaged by
the cherry-picking scheme.
Based on the above, the Division of Enforcement alleges that MFA, Motz
and McCarthy committed primary or secondary violations of the
antifraud provisions of the securities laws, among other provisions.
The Division of Enforcement seeks cease-and-desist orders,
disgorgement, civil penalties, prejudgment interest, and all other
remedial sanctions that are appropriate and in the public interest.
Please click http://www.sec.gov/litigation/admin/2007/34-55356-o.pdf to access a copy of the administrative action.
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SEC Brings Charges Against Hedge Fund Adviser
2.26.2007 The SEC filed a settled civil injunctive action against a
Crestview Capital Partners,
LLC (Crestview), a hedge fund adviser located in Illinois, and one of its managing members, Stewart R. Flink,
charging them with making fraudulent representations in connection
with investments by Crestview-managed funds (Crestview funds) in two
registered direct offerings. Registered direct offerings generally
are characterized as privately negotiated sales of securities by
public companies pursuant to an effective shelf registration
statement. Crestview and Flink made false representations in the
offering documentation for the two registered direct offerings that
Crestview funds had not shorted the respective issuer's stock in the
ten trading days preceding the signing of the documentation. Without
admitting or denying the Commission's allegations, Crestview and Flink
have agreed to a civil injunction for violations of the federal
securities laws. In addition, Crestview agreed to pay $394,640 in
disgorgement and civil penalties and to retain an independent
consultant to monitor Crestview's compliance procedures. Also, Flink
agreed to pay $120,000 in civil penalties. After filing, the Court
entered final judgments against Crestview and Flink today.
The SEC's complaint, filed in the United States District Court
for the Northern District of Illinois, alleges that Crestview funds
agreed to invest $1.4 million in a registered direct offering by
Introgen Therapeutics, Inc. (Introgen) that was publicly announced on
November 26, 2003 and agreed to invest $1.25 million in a registered
direct offering by Targeted Genetics Corporation (Targeted Genetics)
that was publicly announced on February 2, 2004. The complaint
further alleges that as a condition to participating in the offerings,
Introgen and Targeted Genetics required the Crestview funds to
represent in the subscription agreements for the offerings that
Crestview funds had not shorted Introgen and Targeted Genetics stock
respectively in the ten days preceding the execution of the
agreements. The complaint alleges that Flink, who is 50 years old and
resides in Deerfield, Illinois, acting with full authority for
Crestview, knowingly or recklessly signed the Introgen and Targeted
Genetics subscription agreements on behalf of Crestview funds even
though Crestview funds had short sold 108,218 and 255,000 shares
respectively of Introgen and Targeted Genetics stock in the ten days
preceding the execution of the subscription agreements for each of the
companies. Flink's shorting of Introgen and Targeted Genetics stock
yielded Crestview funds $197,320 in illegal profits.
The complaint allegef that Crestview and Flink violated Section 10(b)
of the Securities Exchange Act of 1934 (Exchange Act) and Rule 10b-5
thereunder. Without admitting or denying the Commission's
allegations, Crestview and Flink have agreed to the entry of final
judgments permanently enjoining them from violations of Section 10(b)
of the Exchange Act and Rule 10b-5 thereunder. Crestview also has
agreed to disgorge $197,320 in unlawful profits, plus 37,879 in
prejudgment interest and to pay a civil penalty of $197,320.
Crestview further agreed to retain an independent consultant to
monitor Crestview's compliance procedures for 18 months and to report
to the Commission staff every 6 months during the 18 month period.
Flink also agreed to pay a $120,000 civil penalty.
Please click http://www.sec.gov/litigation/litreleases/2007/lr20017.htm to access a copy of the administrative action.
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President's Working Group Releases Guidelines on Hedge Funds
2.22.2007 The President's Working Group on Financial Markets released the Principles and Guidelines Regarding Private Pools of
Capital. This documents is a set of guidelines that apply to hedge funds and other
private investment pools. Issues are covered from the perspectives of investors, counterparties, hedge funds and regulators. In general, the guidelines recommend:
- Private Pools of Capital: maintain and enhance information, valuation, and risk management systems to provide market participants with accurate, sufficient, and timely information.
- Investors: consider the suitability of investments in a private pool in light of investment objectives, risk tolerances, and the principle of portfolio diversification.
- Counterparties and Creditors: commit sufficient resources to maintain and enhance risk management practices.
- Regulators and Supervisors: work together to communicate and use authority to ensure that supervisory expectations regarding counterparty risk management practices and market integrity are met.
The Working Group concluded that investors can best be protected and risk minmimized by regulation and public policies that support market discipline, participant
awareness of risk, and prudent risk management.
The Working Groupis made up of the:
- Secretary of the Treasury (Chair)
- Chairmen of the Board of Governors of the Federal Reserve System
- Chairman of the SEC
- Chairman of the CFTC
The guidelines support the SEC proposal
to raise the accredited investor standard for private placements of
private funds. They do not recommend hedge fund manager registration with the SEC.
The guidelines recommend that bank regulators increase their focus on
counterparty credit exposures.
Please click http://www.sec.gov/news/press/2007/2007-12.htm to access the press release announcing the proposal.
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Please click http://www.treasury.gov/press/releases/reports/hp272_principles.pdf to access a copy of the guidelines.
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Adviser Sanctioned for Inflating Assets Under Management to Remain a SEC-Registered Adviser
2.15.2007 Warwick Capital Management, Inc., and its owner,
Carl Lawrence, were sanctioned because the adviser overstated its assets under
management over a period of several years in Form ADV (adviser registration statement) filings with the SEC. An investment adviser must have $25 million or more in assets under
management in order to remain SEC-registered. The SEC found that the adviser supplied inflated performance data, as well as inflated values for
its assets under management, to three database services that
published it to subscribers.
Please click http://www.sec.gov/litigation/aljdec/2007/id327cff.pdf to access a copy of the administrative action.
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24f-2 Fees for Mutual Fund Filings Rise
2.15.2007 The SEC set a new rate under Section 6(b) of the Securities Act of 1933 of $30.70 per $1 million of sales. This rate applies to 24f-2 filings.
Please click http://www.sec.gov/news/press/2007/2007-22.htm to access a copy of press release announcing the new rate.
The new rate will take effect five days after enactment of House Joint Resolution 20.
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No-Action Letter Issued on Hedge Clauses in Advisory Contracts
2.12.2007 The SEC staff issues a no-action letter to an investment adviser permitting the adviser to include a certain type of hedge clause and related disclosure in its advisory contract. The no-action letter was issued to Heitman Capital Management, LLC, Heitman Institutional Advisors, Heitman Endowment Advisors, L.P., Heitman Institutional Realty Advisors L.P., and Heitman Real Estate Securities LLC (each, a “Heitman Advisor”).
Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 make it unlawful for any investment adviser to employ any device, scheme, or artifice to defraud, or to engage in any transaction, practice, or course of business that operates as fraud or deceit on clients or prospective clients. Those antifraud provisions may be violated by the use of a hedge clause or other exculpatory provision in an investment advisory agreement which is likely to lead an investment advisory client to believe that he or she has waived non-waivable rights of action against the adviser that are provided by federal or state law. The SEC staff has previously taken the position that hedge clauses that purport to limit an investment adviser’s liability to acts involving gross negligence or willful malfeasance are likely to mislead a client who is unsophisticated in the law into believing that he or she has waived non-waivable rights, even if the hedge clause explicitly provides that rights under federal or state law cannot be relinquished.
The SEC staff stated that whether an investment adviser that uses hedge clauses in investment advisory agreements that purport to limit that adviser’s liability to acts ofgross negligence or willful malfeasance violates sections 206(1) and 206(2) of the Advisers Act would depend on all of the surrounding facts and circumstances. In making this determination, the SEC staff would consider:
- the form and content of the particular hedge clause (e.g., its accuracy),
- any oral or written communications between the investment adviser and the client about the hedge clause,
- the particular circumstances of the client.
When a hedge clause is in an investment advisory agreement with a client who is unsophisticated in the law, the SEC would consider factors including, but not limited to, whether:
- the hedge clause was written in plain English;
- the hedge clause was individually highlighted and explained during an in-person meeting with the client;
- enhanced disclosure was provided to explain the instances in which such client may still have a right of action; and
- the presence and sophistication of any intermediary assisting a client in his dealings with the investment adviser and the nature and extent of the intermediary’s assistance to the client.
The SEC staff granted no-action relief to Heitman Advisors, whose hedge fund clause was as follows:
Non-Waiver of Rights: Notwithstanding the foregoing, nothing contained in this paragraph or elsewhere in this Agreement shall constitute a waiver by Client ofany of its legal rights under applicable U.S. federal securities laws or any other laws whose applicability is not permitted to be contractually waived.
The SEC staff noted that the clients of Heitman Advisors are sophisticated persons that have the resources and experience to understand the investment advisory agreements with the applicable Heitman Advisor, and the bargaining power to negotiate, and in some cases even dictate, the terms of the investment advisory agreements. The no-action letter listed the types of clients:
The SEC staff noted that the Wrap Account Sponsors and the Qualified Sponsors act as intermediaries (the “Intermediaries”) between the appropriate Heitman Advisor and the Wrap Account Clients and the CFE (and its investors), respectively, and enter into investment advisory agreements with the appropriate Heitman Advisor on behalf of the Wrap Account Clients and the CFE, respectively. Heitman Advisiors represented that an Intermediary could evaluate, and assist a Client in interpreting, the hedge clause and the non-waiver disclosure in the unlikely event that a Heitman Advisor’s conduct gave rise to a cause of action under the investment advisory agreement.
Please click http://www.sec.gov/divisions/investment/noaction/2007/heitman021207.pdf to access a copy of the no-action letter.
CFTC Issues Guidance on Audit of Financial Statements of Futures Commission Merchants
2.8.2007 The CFTC issued a letter to assist futures commission merchants ("FCMs") with meeting their obligation under the Commodity Exchange Act (“Act”) and regulations thereunder to file an audited annual financial report with the CFTC and with their designated self-regulatory organizations (“DSROs”).
FCMs are required to file an audited annual financial report with the Commission and with their DSROs within the timeframe specified in Commission Regulation 1.10(b)(1)(ii). Each FCM is required to supplement its audited annual financial report with a report on material inadequacies issued by the FCM’s public accountant. Depending on whether material inadequacies were found to exist, or to have existed, since the date of the previous audit, the accountant’s report will consist of either: (1) a statement that the audit did not disclose any material inadequacies; or (2) a description of any material inadequacies and the corrective action that the FCM has taken or proposes to take to address them.
In determining whether to report an item as a material inadequacy, the CFTC reminded auditors to test not only the financial statements, but also the following required regulatory supplementary schedules, which also must be audited:
- the Computation of Minimum Capital Requirements;
- the Statements of Segregation Requirements and Funds in Segregation for customers trading on U.S. commodity exchanges and for customers’ dealer option accounts (“segregated funds”); and
- the Statements of Secured Amounts and Funds held in Separate Accounts for foreign futures and foreign options customers (“secured funds”).
The CFTC also reminded FCMs and their auditors that the term “material inadequacy” is defined in Commission Regulation 1.16(d)(2), and that the Division has provided additional relevant guidance in Financial and Segregation Interpretation No. 4-1, issued in 1985.
In keeping with Financial and Segregation Interpretation No. 4-1, errors in FCM financial reporting that result in changes of 10 percent or more in the FCM’s excess net capital or its excess segregated or secured funds, or result in the FCM falling below required net capital “early warning” levels, require the FCM to file amended financial reports with the Commission.
Please click http://www.cftc.gov/files/tm/tmfcmguidanceletter2006.pdf to access a copy of the letter.
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Hedge Fund Charged with Insider Trading
2.7.2007 The SEC filed a civil action in federal
district court in New York involving an insider
trading scheme that generated more than $3.7 million in profits and
losses avoided for a family and certain friends. From at least 2001 through 2005, seven individuals, including
lawyers and accountants, participated in a scheme to trade in the
stock and option contracts of Taro Pharmaceuticals Industries, Ltd.
(Taro), an Israeli-based publicly traded pharmaceutical company, ahead
of eight earnings announcements and five Food and Drug Administration (FDA) approval announcements.
In the later stages of the scheme, certain of the defendants broadened
the scheme by trading on information stolen from Pricewaterhouse
Coopers LLP (PwC) and Ernst & Young, LLP (E&Y) concerning two possible
mergers.
The SEC in its complaint alleged that Zvi Rosenthal (Zvi), a
Vice President at Taro, abused his position at Taro by systematically
stealing material, nonpublic information concerning 13 separate
company announcements, including earnings results and pending generic
drug approvals by the FDA. Zvi then traded on
the information and passed it on to his family members who then traded
in Taro stock and options. Typically, Zvi provided information to his
son, Amir Rosenthal (Amir), who traded in personal accounts he
controlled, and in the account of the family-owned and controlled
hedge fund, Aragon Partners, LP. Amir also tipped his brothers, Oren
Rosenthal (Oren) and Ayal Rosenthal (Ayal); his father-in-law, Bahram
Delshad (Delshad); his friend, David Heyman (Heyman); and his
work supervisor, Young Kim (Kim), with information he received from
Zvi, and each of them traded. The complaint further alleges that in
its later stages, certain of the defendants broadened the scheme to
include trading on nonpublic information stolen from entities other
than Taro. On at least two occasions, Ayal and Heyman misappropriated
material, nonpublic information concerning impending mergers from
their respective employers, PwC and E&Y, and tipped Amir with the
information. Amir then traded on it. Amir also tipped Kim with the
information from Ayal and Heyman, and Kim traded on the information.
Please click http://www.sec.gov/litigation/complaints/2007/comp19995.pdf to access a copy of the administrative order.
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