The U.S. Securities and Exchange Commission (SEC or Commission) issued a cease and desist order on June 16, 2014 (the Order) against Paradigm Capital Management, Inc. (Paradigm) and its founder, Director, President and Chief Investment Officer, Candace King Weir (Weir).  The Order alleged that Weir caused Paradigm’s hedge fund client, PCM Partners L.P. II (Fund), to engage in certain transactions (Transactions) with a proprietary account (Trading Account) at the Fund’s prime broker, C.L. King & Associates, Inc. (C.L. King). Paradigm and C.L. King were allegedly under the common control of Weir. The Order further alleged that, because of Weir’s personal interest in the Transactions and the fact that the committee designated to review and approve the Transactions on behalf of the Fund was conflicted, Paradigm failed to provide the Fund with effective disclosure and failed effectively to obtain the Fund’s consent to the Transactions, as required under the Investment Advisers Act of 1940 (Advisers Act).
Posts Tagged ‘Dechert’
My recent article, Mutual Fund Sales Notice Fees: Are a Handful of States Unconstitutionally Exacting $200 Million Each Year?, forthcoming in the Hastings Constitutional Law Quarterly, describes the political compromise struck in 1996 between Congress and state securities regulators. That year, Congress enacted the National Securities Markets Improvement Act of 1996 (NSMIA), which effected multiple changes to the federal securities laws to promote efficiency and capital formation by eliminating overlapping federal and state securities regulations.
With respect to mutual funds, NSMIA resolved the problem of overlapping regulation by preempting state substantive regulation and registration requirements of mutual funds, thereby providing for exclusive federal jurisdiction over the contents of a mutual fund’s prospectus and operation of each fund. NSMIA was welcomed by the mutual fund industry because it eliminated the “crazy quilt” of regulation that had made registration of mutual fund shares unnecessarily cumbersome—in some cases leading mutual funds to restrict their fund offerings to residents of certain states.
However, in order to secure the acquiescence of the states and secure NSMIA’s enactment, NSMIA preserved state authority to require mutual funds to file sales reports and to pay state filing fees based on those sales in connection with the sales reports. A handful of states have taken unfair advantage of this fee loophole.
In a decision that could sharply curtail the potential liability of mutual funds and their advisers and directors for non-fraudulent prospectus misrepresentations, on March 31, 2011, the U.S. District Court for the Southern District of New York dismissed a putative class action arising out of the precipitous decline in the share price of a mutual fund during the 2007 and 2008 credit crisis.  The plaintiffs asserted claims under §§ 11 and 12(a)(2) of the Securities Act of 1933 (Securities Act), alleging that the prospectus for the SSgA Yield Plus Fund misrepresented the Fund’s exposure to mortgage-related securities.
The court rejected the plaintiffs’ claims on loss causation grounds. The measure of permissible damages under §§ 11 and 12(a)(2) is limited to the decline in a security’s value that results from the revelation of the artificial inflation of the security’s purchase price by a misrepresentation. Because the only price at which a mutual fund may sell or redeem its shares is determined by a statutory formula based on the net asset value (NAV) of the securities owned by the fund, prospectus misrepresentations cannot inflate a fund’s NAV nor, upon revelation, cause the NAV to decline. Accordingly, the court found that the plaintiffs’ complaint failed to allege the requisite loss causation and, therefore, dismissed the action with prejudice.
On the heels of the Administration’s recently published report to Congress outlining its objectives for reforming the housing finance market,  new legislative action may come that would encourage the issuance of covered bonds. Secretary of the Treasury Timothy Geithner on March 1, 2011 in testimony before the House Committee on Financial Services (“Committee”) stated that the development of a legislative framework for a covered bond market should be included as part of the consideration of new means to provide mortgage credit.  Notwithstanding earlier delays in implementing reform for this industry,  proposals for legislative action addressing covered bonds are likely to be a focal point for the Committee  during this session of Congress. A discussion draft of a bill sponsored by Representative Scott Garrett (R-NJ), which aims to establish standards for covered bond programs and a covered bond regulatory oversight program, has been circulated to members of Congress and securitization market participants. The draft bill, if enacted in its current form, would (i) define the issuers and asset classes that would be subject to the oversight program; (ii) establish a framework for a federal regulatory oversight program for covered bonds; and (iii) implement a default and insolvency resolution process. This memorandum summarizes the February 2011 discussion draft, entitled the “United States Covered Bond Act of 2011” (the “Act”), which is expected to be introduced later this year.
The Credit Crisis and Reform
Largely in response to the recent credit crisis (Credit Crisis), the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was enacted in July 2010. The Dodd-Frank Act is an historic and wide-ranging piece of legislation and constitutes the most significant legislative change in the regulation and supervision of financial institutions since the Great Depression.
Registered investment companies and registered investment advisers (also referred to herein as “funds” and “advisers,” respectively) were minor players in the Credit Crisis.  Nevertheless, the Dodd-Frank Act contains several provisions, rulemaking directives, and required studies that could impact funds and their advisers. The Dodd-Frank Act defers many of its effects to future studies and regulations by federal regulators, which are directed under the Dodd-Frank Act to promulgate a variety of regulations in the six to 18 months following the Dodd-Frank Act’s enactment.  These studies and regulations have the potential to impact funds and their advisers significantly.
Prior to the last decade, most litigation against funds (both open-and closed-end) and their advisers and directors involved claims of excessive fees pursuant to § 36(b) under the Investment Company Act of 1940 (ICA) and non-disclosure lawsuits under the Securities Act of 1933 (Securities Act). The collapse of the “dot com” bubble post-2001 left the mutual fund industry under stress, as assets under management for many managers had deflated materially. The aggressive quest for new assets to manage led some managers to adopt or expand marketing practices that became the focus of regulatory inquiries.
Beginning in 2003, the industry saw the beginning of several highly publicized regulatory investigations concerning market timing and improper revenue sharing arrangements. Scores of lawsuits were instigated against advisers, distributors, funds, and, in some cases, a fund’s independent directors. While independent directors were named defendants in prior lawsuits—for example, § 36(b) excessive fee lawsuits—the scope of litigation that followed 2003 was without precedent both in terms of the number of lawsuits and the number of those suits naming directors as defendants. Moreover, the lawsuits against fund directors coincided with an increase in suits against directors of companies outside of the fund industry. Both the number of lawsuits and the scope of litigation reflect the increased scrutiny to which the conduct of fund directors is subject.
My recent article, “A Shaky Future for Securities Act Claims Against Mutual Funds“, considers the liability of mutual fund issuers under §§ 11(a) and 12(a)(2) the Securities Act.
In a Securities Act § 11(a) or § 12(a)(2) action, a plaintiff complains of a materially misleading statement (misstatement) in an issuer’s registration statement (prospectus). In the article, I explain why a mutual fund issuer, by establishing a loss causation defense, should prevail in defending these actions. For a mutual fund, establishing a loss causation defense is straightforward, and a mutual fund can defeat § 11(a) and § 12(a)(2) claims at the pleading stage of a lawsuit.
Courts have described an issuer’s liability under § 11(a) and § 12(a)(2) as “strict” or “near-strict.” Therefore, the regular and successful deployment of loss causation defenses by mutual funds marks a significant change. In effect, mutual funds are largely and, perhaps, wholly insulated from Securities Act § 11(a) and § 12(a)(2) claims.
In Parts I and II of the article, I describe the elements of claims under § 11(a) and § 12(a)(2) in the context of mutual funds, including the price-depreciation measure of damages in both statutes.
The article’s core analysis is contained within its Part III, where I explain why, for a mutual fund, establishing a loss causation defense is straightforward. Unlike a security traded on an exchange, the price of a mutual fund share is calculated each day according to a statutory formula that relies on the market value of the portfolio securities owned by the fund. Shares are offered for sale by the fund continuously at each day’s calculated price and redeemed by the fund, when a fund shareholder chooses, at that day’s calculated price. There is no secondary market for a mutual fund’s shares.
Accordingly, there is no mechanism for a misstatement in a mutual fund’s prospectus to affect a fund share’s price and, therefore, there is no mechanism for a misstatement or its revelation to cause a plaintiff’s losses. Because changes in a fund share’s price cannot be caused by a prospectus misstatement, a mutual fund defendant can prevail by establishing the loss causation defense permitted by § 11(e) or § 12(b). The defense simply is that any misstatement identified by the plaintiff could not cause the fund share’s price to depreciate and, therefore, did not cause the plaintiff’s losses.
If that outcome seems harsh, consider that the justification for liability without reliance under § 11(a) and § 12(a)(2) is that a misstatement causes the market to overestimate the value of a security. A purchaser is harmed by the misstatement, even if he did not rely on it, because the market price is inflated by the misstatement. However, Congress did not consider how § 11(a) and § 12(a)(2) should apply to mutual funds. This includes considering that neither price inflation nor overpayment occurs when an investor purchases shares of a mutual fund while the fund’s prospectus contains a misstatement. Thus, price inflation and overpayment, which justify liability without reliance for non-fund issuers, do not justify similar liability for mutual funds.
Part IV presents the practical implications if plaintiffs cannot succeed against a mutual fund under § 11(a) and § 12(a)(2). A plaintiff’s inability to make out a claim under § 11(a) and § 12(a)(2) should deter plaintiffs from instigating lawsuits under the Securities Act against mutual funds based on prospectus misstatements. Plaintiffs may be relegated to claims under Rule 10b-5, the Investment Company Act and state law.