Securities Law Blog

Since the boom of investment fraud uncovered during the financial crisis, lawmakers and state securities regulators are attempting to assume oversight of many investment advisers currently under the supervision of the Securities and Exchange Commission (SEC).

According to the testimony given by Texas Securities Commissioner and the North American Securities Administrators Association (NASAA) President Denise Voigt Crawford, “As the regulators closest to the investors, state securities regulators provide an indispensable layer of protection for Main Street investors.”

Crawford was one of many industry leaders to testify before the U.S. Financial Crisis Inquiry Commission (FCIC) during its first round of hearings in January 2010. The FCIC is a 10-member bipartisan panel established to examine the cause of the financial crisis with the intention of producing a report offering recommendations to prevent a reoccurrence.

The financial regulation proposals in Congress could bring about 4,000 advisers who manage between $25 million and $100 million in assets under the supervision of state regulators, according to NASAA. Currently the SEC says it inspects from 9% to 12% of the 11,000 advisory firms it oversees. Allowing each state to oversee anywhere up to around 600 additional advisers, as would be the case in California, would lead to more frequent examinations. State regulators are in the process of generating a mutual agreement to cooperate with one another in policing additional advisers if the proposal passes.

“Our presence did not contribute to the crisis; rather, the fact that our regulatory and enforcement roles have been eroded was a significant factor in the severity of the financial meltdown,” testified Crawford.

Since the passage of the National Securities Markets Improvement Act of 1996 (NSMIA), the responsibility of enforcement shifted from state to federal government. Now the states are fighting to get it back.

The NASAA President offered a series of recommendations to improve the ability of state regulators to pursue financial fraud. A few of these recommendations include: restoring state regulatory oversight of all Regulation D Rule 506 offerings; increasing state regulation of investment advisers; reexamining and removing the hurdles facing securities plaintiffs in private actions; and providing additional resources to uncover and prosecute securities fraud cases.

The collapse of Bernard Madoff’s estimated $65 billion dollar Ponzi scheme in 2008, was the precursor to the “Year of the Ponzi” in 2009. Defrauded investors saw an estimated $16.5 billion dollars disappear as more than 150 pyramid schemes unraveled, according to the Associated Press analysis of scams in all fifty states. Madoff’s very public decline brought a heightened public awareness and increased scrutiny to Ponzi schemes. But he wasn’t the only securities fraudster who made headlines.

Following the breakdown of Ponzi schemes nationwide, there was a drastic increase in federal securities fraud investigations opened in 2009. The FBI alone increased its securities fraud investigations by 1,750 from 2008. The Securities and Exchange Commission (SEC)’s Ponzi scheme investigations now make up 21 percent of the SEC’s enforcement workload. The Commodity Futures Trading Commission more than doubled its amount of civil actions in Ponzi cases this past year.

In its continuing effort to avoid being burned by another major Ponzi scheme, the SEC is developing new investigative units to improve its enforcement. A major focus will be to encourage companies and individuals to cooperate more closely in providing information, and to better analyze tips and complaints the SEC receives. The cooperation efforts will include similar incentives that have been used by the Justice Department in its criminal investigations. Included in these incentives will be written cooperation agreements under which SEC attorneys recommend leniency for parties providing information in their proposals to the SEC commissioners.

With the surge of federal fraud investigations in 2009 and those that date back to the credit crisis in 2007, an increase in federal prosecutions of financial crimes is expected to follow in 2010.

The maker of Valvoline motor oil has filed a lawsuit against Oppenheimer & Co., a subsidiary of Oppenheimer Holdings, over the sale of $194 million of auction-rate securities. According to the complaint by Ashland Inc., Oppenheimer misrepresented the liquidity and risks of the instruments at the time it sold them to the chemical company in 2007 and early 2008.

When the market for auction-rate securities collapsed in February 2008, Ashland, like thousands of institutional and retail investors, found itself stranded with an illiquid investment that no one wanted to buy. Several months later, in an effort to settle investigations by state and federal regulators, many Wall Street firms, including Citigroup, UBS and Merrill Lynch, agreed to buy back billions of dollars of auction-rate securities from investors. Oppenheimer, however, opted not to participate in the ARS buy-back programs, contending it didn’t issue or underwrite the securities but only sold them.

In November 2008, Massachusetts’ Secretary of State William Galvin sued Oppenheimer, charging the firm with fraud and dishonest and unethical conduct in connection to its auction-rate securities business. Galvin not only wanted Oppenheimer to rescind all sales of auction-rate securities at par and make full restitution to investors who already had sold their securities but also sought to revoke Oppenheimer Chairman and CEO Albert Lowenthal’s Massachusetts registration as a broker-dealer agent of Oppenheimer, as well as fine the company and several senior-level executives.

Ashland filed its lawsuit against Oppenheimer on April 17,2009 in the U.S. District Court for the Eastern District of Kentucky.

Massachusetts Secretary of the Commonwealth William Galvin confirmed last week that the Securities Division has opened a probe of State Street its funds. In a story appearing April 30, 2009 in Investment News, it was reported that the fund is among several fixed-income strategies managed by State Street’s investment unit, State Street Global Advisors, to lose substantial amounts of money because of exposure to the subprime mortgage market. In an interview, Secretary Galvin is looking at whether State Street made “ representations that were either flat-out untrue or potentially deceptive” to conservative investors.

According to published reports, pension funds and other institutional investors initially invested in the State Street Limited Duration Bond Fund as an “enhanced cash fund,” with the idea to generate better returns than ultra-safe, conservative money market funds with just slightly more risk. Investors now say the Limited Duration Bond Fund took on large positions of high-risk mortgage-related assets, a move that ultimately proved devastating for investors.

More than a year ago, several lawsuits were filed against State Street over charges the firm misrepresented the risks of various bond funds, including the Limited Duration Fund. A State Street spokeswoman declined to comment to the Wall Street Journal regarding the investigation.

According to a published report in Investment News, a Florida Senate bill that would levy heavy penalties on agents and financial advisers who make fraudulent annuity sales has moved closer to becoming law. The Safeguard our Seniors Act, or SB 1372, on April 2, 2009 moved to Florida’s Policy and Steering Committee on Ways and Means, placing it a step away from a full Senate vote.

Under the bill’s original provisions, which would apply to consumers over age 65, surrender periods — the length of time the investor must hold the annuity — would have been cut to five years. It also set the maximum surrender fees, which investors must pay for exiting the product too soon, at 5% and reduced the fee 0% by the end of the fifth policy year. Additionally, the original bill also extended the free-look period to 60 days from the normal 14-day limit. In its new form, however, legislators have loosened the restrictions on the annuity sales, allowing for surrender charges to go as high as 10%, with the charge to fall by one percentage point each year, so that there is no surrender fee at the end of the 10th policy year.

Under the revised bill, the surrender fee changes don’t apply to accredited investors, defined as individuals with a net worth of greater than $1 million or with an annual income of more than $200,000 in each of the past two years, or $300,000 a year in joint income. The amended bill also cuts the free-look period to 30 days. The original bill also made “twisting” and “churning” annuities a third-degree felony punishable by up to five years in prison. The penalty has been expanded so as to cover fraudulent conduct in connection with the sales of all financial products. The American Council of Life Insurers in Washington, the Florida chapter of the Falls Church, Va.-based National Association of Insurance and Financial Advisors and the National Association for Fixed Annuities of Milwaukee had combined efforts to fight the early version of the bill. NAIFA-Florida had also asked state finance chief Alex Sink to consider a maximum 10-year surrender period and 10% surrender charge limit.