Securities Law Blog

On April 6, 2010 a securities arbitration panel ordered a former Morgan Stanley & Co. broker to pay the firm $1.6 million to resolve a case involving his signing bonus.

When Thomas G. Hicks III joined Morgan Stanley in 2006, he received his signing bonus in the form of loans secured by three separate promissory notes.

The bonuses, handed out to attract brokers to join a firm, come in the form of a loan that is forgiven in annual installments until completely forgiven. Since the loans are secured by promissory notes, if a broker leaves, before the repayment term is over, the broker is required to repay the remaining balance.

Morgan Stanley filed a case against Hicks back in 2008 alleging a breach of the three promissory notes for the signing bonus. According to the Financial Industry Regulatory Authority (FINRA), Hicks left the firm in the fall of 2007, less than two years after joining. FINRA ordered Hicks to pay his former employer $1.6 million, which includes Morgan Stanley’s legal fees, costs and $196,000 in interest. In a similar case, on April 7, 2010 FINRA ordered a Las Vegas financial adviser to pay Citigroup Inc. $384,000 plus interest for leaving the firm before his signing bonus had been completely forgiven.

A temporary restraining order and asset freeze has been issued against Minnesota-based investment advisor Renee Marie Brown, and Investors Income Fund X, LLC. On April 8, 2010 the Securities and Exchange Commission (SEC) alleged that Ms. Brown, the president of the Real Estate Investment Securities Association (REISA), misappropriated advisory clients’ money to the tune of $1.1 million.

According to the SEC complaint, from July 2009 until March 2010, Ms. Brown raised the $1.1 million by allegedly scamming six investors into transferring their money into Fund X. Ms. Brown allegedly told investors that Fund X was a legitimate and successful investment opportunity, and promised clients a fixed annual return of 8% or 9%. She allegedly would distribute bogus returns to investors to further facilitate the fund’s illusion of success.

The misappropriated funds allegedly went towards Ms. Brown’s purchase of a condominium for herself and to build-out office space for her new business.

According to the SEC, Ms. Brown has several investment adviser affiliations. Until about a month ago, Ms. Brown was a registered representative affiliated with Capital Quest Securities Inc. She had recently started her own investment adviser business, Aaria Capital Inc. and was one of the founders of due-diligence firm FactRight LLC.

Ms. Brown was also a founder and registered investment advisor with Wildwood Wealth Management LLC. It was during her time at Wildwood that Ms. Brown allegedly opened the unregistered Fund X and began competing for clients with her employer. According to the SEC complaint, Ms. Brown “either discreetly convinced Wildwood clients to withdraw their money from Wildwood and invest with the fund or forged a client’s signature to facilitate the fund’s transfer.”

Following a December 2009 guilty verdict, Minnesota businessman Tom Petters was sentenced in the U.S. District Court in St. Paul, Minnesota on April 8, 2010. Petters received 50 years in prison for his alleged role in the $3.65 billion Ponzi scheme run through Petters Co. Inc.

Back in December 2009, Petters was found guilty of 20 counts of wire fraud, mail fraud, conspiracy and money laundering. During the trial he testified that we was unaware that his close associates were running a Ponzi scheme through the company and only became aware when federal agents raided his Minnetonka headquarters in 2008.

Prosecutors alleged that the scheme worked by using fraudulent documents such as purchase orders and bank statements forged by Petters Co. Inc. Vice Presidents Deanna Coleman and Bob White to trick investors into thinking they were financing purchases of TVs and other electronic goods that would be resold to discount retailers such as Sam’s Club, Costco and BJ’s Wholesale Club. The sales allegedly never took place. Instead, the funds were allegedly used to make payments to other investors, fund Petters’ other businesses and finance his extravagant lifestyle.

The massive fraud, which the government expects has affected more than 500 victims, could have earned Petters the statutory maximum of 335 years. Despite the defense’s attempt to argue for a 4 to 12 year sentence, Petters, 52, is expected to spend the rest of his life behind bars.

At the sentencing hearing, Petters apologized to family, friends, co-workers and others who had been hurt but did not concede guilt. “Every day, I am filled with pain and anguish for all the lives that have been destroyed and touched by this episode,” Petters said.

Petters maintains his innocence and plans to appeal the conviction.

The Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), and numerous state regulators filed complaints against Morgan Keegan & Company and Morgan Asset Management on April 7, 2010.

Regulators claim that Morgan Keegan and its asset management division misrepresented the bond funds to investors and brokers, manipulated the funds’ net asset value (NAV), and failed to supervise the sale of the funds and due-diligence efforts.

According to the FINRA complaint, from January 2006 through December 2007, Morgan Keegan sold over $2 billion of the bond funds, in particular the Regions Morgan Keegan Select Intermediate Bond Fund. These funds were invested heavily in risky asset- and mortgage-backed securities, including sub-prime products. The funds began experiencing significant financial difficulties in 2007 following the collapse of the subprime securities market.

Specifically, FINRA’s complaint alleges that:

*In its research, investment advice and performance updates to its brokers regarding the Intermediate Fund, Morgan Keegan failed to disclose the material characteristics and risks of investing in the fund, misstated the appropriate use of the fund and otherwise portrayed the fund as a safer investment than it was, even though the firm was aware of material, special risks that made the fund unsuitable for many retail investors.

*Morgan Keegan failed to ensure the accuracy of the advertising materials prepared by the fund manager and distributed by the firm, and failed to ensure that those materials disclosed all material risks, were not misleading and did not contain exaggerated claims.

*Morgan Keegan failed to train its brokers regarding the features, risks and suitability of the fund and, in its communications with its brokers, the firm failed to adequately describe the nature of holdings and material risks of the Intermediate Fund.

*When Morgan Keegan became aware, beginning in early 2007, of the adverse market effects on the bond funds, the firm failed to timely warn its brokers or revise its advertising materials to reflect the disproportionately adverse effect the market was having on the performance of the securities that compromised the bond funds – which Morgan Keegan brokers continued to sell widely. At this time, the firm reassured, rather than warned, its sales force about the riskiness of the bond funds. As a result, some of the firm’s brokers were unaware of the then-turbulent market’s effects on the funds and failed to disclose the negative effects caused by market forces.

According to FINRA, in a May 2007 email from the Director of Investments for the Morgan Keegan Wealth Management Services division, Gary Stringer wrote, “What worries me about this [Regions Morgan Keegan Select Intermediate] bond fund is the tracking error and the potential risks associated with all that asset-backed exposure. Mr. & Mrs. Jones don’t expect that kind of risk from their bond funds. The bond exposure is not supposed to be where you take risks. I’d bet that most of the people who hold that fund have no idea what it’s actually invested in. I’m just as sure that most of our FAs have no idea what’s in that fund either.”

The complaint filed by the SEC points a finger more directly at two “architects” behind the alleged scheme. The SEC alleges that James C. Kelsoe Jr., the portfolio manager of the funds and employee of Morgan Asset Management and Morgan Keegan, instructed the firm’s Fund Accounting department to make “price adjustments” that increased the fair values of certain portfolio securities. The price adjustments allegedly issued by Mr. Kelsoe were routinely entered into a spreadsheet to calculate the NAVs of the funds, without any supporting documents. Mr. Kelsoe also allegedly told the Fund Accounting department to ignore month end quotes from other broker-dealers, which are intended to be used to validate the prices the firm has assigned to the funds’ securities.

According to the SEC, in an October 2009 deposition, Carter Anthony, president of Morgan Asset Management from 2001 to 2006, testified, “Time and time again I was told by Mr. Morgan and Mr. Edwards to leave Mr. Kelsoe alone, he’s doing what we want him to do, he’s also a little bit strange, he gets mad easy, leave him alone.”

The second party named, Joseph Thompson Weller, CPA and head of the Fund Accounting Department and member of the Valuation Committee, allegedly did nothing to remedy the deficiencies in Morgan Keegan’s valuation procedures, nor did he make sure that fair-valued securities were being accurately priced and NAVs were being accurately calculated, according to the SEC’s Division of Enforcement.

FINRA is seeking a fine, disgorgement of all ill-gotten profits and full restitution for affected investors. The SEC will be holding a hearing before an administrative law judge to examine the allegations and determine what sanctions or penalties, if any, should be imposed.

Citigroup Global Markets, Inc. was hit with a $650,000 fine by the Financial Industry Regulatory Authority (FINRA) on Tuesday April 6, 2010 for disclosure and supervisory violations related to its Direct Borrow Program (DBP). The program operated from January 1, 2005 until November 30, 2008.

According to FINRA findings, during this time Citigroup’s DBP borrowed fully paid hard-to-borrow securities owned by the firm’s customers and pooled them together to facilitate Citigroup’s clients’ short-selling strategies. Over 770 different securities were borrowed from more than 2,300 customers, with an average annual value of outstanding loans upwards of $301 million.

According to the FINRA report “Citigroup failed to disclose, or to adequately disclose, certain material information to customers participating in the DBP, including that the securities were hard-to-borrow; that the interest rates could be reduced by the firm; that the brokers received commissions for the duration of the loan; that while the securities were on loan, dividends were paid as “cash-in-lieu” of dividends and were therefore subject to higher tax rates; and, that shares on loan could be sold by the customers at any time.”

So what did they tell customers? Apparently little more than what they told branch managers and supervisors. FINRA found that branch managers and supervisors were not notified that customers of brokers they supervised were involved in the DBP and that many were not even aware that the DBP existed. The report alleges significant failure on the part of Citigroup to monitor DBP, including having no procedures in place to supervise staff, brokers, or client accounts involved in the program.

FINRA also found that the tools traditionally used by supervisors to monitor customer accounts were compromised when shares were lent through the program. Once shares were lent, a customer’s account no longer reflected the customer’s position in the security. This left the account open to the risk of becoming overly concentrated in the security or of losing a significant amount of market value due to the lent security’s loss in value, without detection.

The report claims that three versions of misleading marketing materials about the DBP were distributed to the public by Citigroup. The materials allegedly claimed that the program had little risk, that no customers suffered losses and that the firm tried to avoid interest rate changes.

Citigroup consented to FINRA’s findings, while neither admitting nor denying guilt.