FOR SEC ENFORCEMENT, WHAT IS THE ENCORE?

The commentary, speculation and second guessing about the SEC’s settlement in Goldman may be drawing to a close, or at least diminishing. There is no doubt that Goldman is the most significant market crisis case to come from the numerous investigations the Commission has been conducting. Indeed, simply bringing the case was a significant step in view of the bank’s stature on Wall Street and the fact that the claims took the SEC into uncharted and very difficult waters. At the same time, it is beyond dispute that one big case does not create an enforcement program. So what does the SEC Enforcement Division do for an encore?

One might look for clues in the testimony of SEC Chairman Mary Schapiro before the House Financial Services Committee on Tuesday. The remarks were titled “Evaluating Present Reforms and Future Challenges,” available here. The Chairman’s testimony recounts recent efforts of the Enforcement Division, with the promise of a look at future challenges.

The Enforcement program “is a key element to fair and effective markets,” the Chairman told the Committee. She then rehashed the now familiar reforms such as the delegation of authority to issue a formal order of investigation, as well as the initiatives to encourage cooperation. The new Financial Fraud Enforcement Task Force and the structural changes Enforcement Director Khuzami has implemented, creating new specialty units and hiring new personnel were reviewed. All of these reforms were, as usual, tied to themes of speed and efficiency.

The results of these and other efforts, the Chairman noted, are reflected in part by the statistics. In testimony reminiscent of remarks by Mr. Khuzami in a recent speech, discussed here, the Chairman noted that in 2009 the Commission secured orders for disgorgement and civil penalties in amounts that exceeded those for fiscal year 2009 by, respectively, 46% and 101%. The SEC also sought more than twice as many temporary restraining orders while issuing more than twice as many formal orders of investigation.

Cases brought by the Division bolster the statistics, according to the Chairman. Key examples include the action against American Home Mortgage, the cases naming the officers of Countrywide Financial Corp and New Century as defendants, and the actions against Brookstreet Securities and Morgan Keegan. Interestingly, only after citing these cases did the Chairman mention the high profile settlement in Goldman, discussed here. Ms. Schapiro went on to tell the Committee about other significant cases such as ICP Asset Management, the action against the former chairman of Taylor, Bean and the case against State Street Bank.

Overall the Chairman’s remarks recount where the program has been recently. But where is it going? What is happening with all the market crisis investigations Commissioner Walter and others previously mentioned?

While the SEC press release and litigation release for Goldman each contain the identical statement that the settlement does not apply to “any other past, current or future SEC investigations against the firm,” suggesting there may be other investigations, it seems clear the inquiry is over. Goldman’s 8-K states that it “understands that the SEC staff also has completed a review of a number of other Goldman mortgage-related CDO transactions and does not anticipate recommending any claims against Goldman or any of its employees.” Undoubtedly that language was reviewed in the settlement discussions.

So the Goldman investigation is over. Ms. Schapiro’s testimony, despite its title referencing “Future Challenges,” gives no clue about the future direction of any pending enforcement investigations. The question persists: Is Goldman the beginning of a bold new enforcement program that is about to unravel the roots of the market crisis or the end of the significant cases emanating from all the market crisis investigations? What is the encore?

SIXTH CIRCUIT UPHOLDS CONVICTION OF HEDGE FUND MANAGER

In U.S. v. Lay, No. 08-3893 (6th Cir. July 14, 2010), the court upheld an instruction that permitted the jury to find that a hedge fund adviser had a fiduciary relationship with a client. Defendant Mark Lay began serving as an investment adviser to the Ohio Bureau of Workers’ Compensation when his company, Capital Management, Inc. started to manage the Bureau’s investment in a long-term bond fund, the Long Fund.

Subsequently, in 1998 Mr. Lay started a hedge fund, the Active Duration Fund. The Bureau moved $100 million of its investment from the Long Fund to the Active Duration Fund. The agreement set a non-binding 150% leveraging guidelines which Mr. Lay exceeded. By March 2004, the Active Duration Fund had lost $7 million. In May 2004, the Bureau added $100 million to its hedge fund investment. In September of 2004, the Bureau invested an additional $25 million in the fund. The losses continued.

The Bureau ultimately recovered $9 million of the $225 million that was invested in the hedge fund. Most of the loss involved leveraging over the 150% guidelines. In fact, about one fifth of the trades involved leveraging over 1000% with some trades involving leveraging over 10,000%.

The jury was given an instruction which provided that, to find Mr. Lay guilty of investment adviser fraud, the government had to prove each element contained in either Adviser Section 80b-6-(1) or 80b-2(2) or 80b-6(4). With respect to Section 80-6(1)&(2) the court informed the jury that “it is for you to determine as a matter of fact whether Mark Lay had an investment adviser-client relationship with the [Bureau] with respect to its investment in the . . . Active Duration Fund . . .” With respect to Section 80b-6(4), the jury was told that if it concluded the Bureau was not Mr. Lay’s client with respect to the hedge fund then it should determine as a matter of fact whether he had a fiduciary duty with respect to the hedge fund. The jury returned a verdict of guilty

The Sixth Circuit affirmed, concluding that the jury instructions were correct in the context of this case. Mr. Lay never disputed the fact that he had an investment adviser-client relationship and thus a fiduciary relationship with the Bureau as to its Long Fund investment. Mr. Lay claims however that he did not have such a relationship with the Bureau with respect to the hedge fund based on the decision in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). There, the Court rejected a rule issued by the SEC requiring hedge funds to register based on the number of its clients as discussed here. Previously, the SEC had viewed the fund as the client. In rejecting the rule, the D.C. Circuit concluded that the hedge fund adviser does not tell the individual investor how to spend his or her money. That decision is made when it is put into the fund.

Goldstein did not hold that “no hedge fund adviser could create a client relationship with an investor, but rather held only that the SEC had ‘not justified treating all investors in hedge funds as clients,’” the Sixth Circuit concluded. Indeed, hedge funds have different classes of investors with different rights or privileges with respect to their investments. Accordingly, it was entirely proper for the district court to submit the question to the jury as an issue of fact.