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.

DODD-FRANK: NEW AUTHORITY FOR SEC ENFORCEMENT

As SEC Enforcement savors its settlement in Goldman and continues to retool into a new and more aggressive program, Congress is giving it new tools. The Dodd-Frank Wall Street Reform and Consumer Protection Act has a number of provisions which enhance the authority of SEC Enforcement. These include:

Enhancement to the anti-fraud provisions: Under the new legislation, Exchange Act Section 9, relating to market manipulation, and Section 10(1), concerning short sales, are being extended to cover all except government securities, rather than just those registered on a national securities exchange. In addition, Section 9(b), regarding options, is being extended to cover non-exchange transactions in options while Section 9(c) will now apply to all brokers and dealers, not just members of a national securities exchange. Section 15(c)(1)(A) will now cover exchange transactions, not just those in the over-the-counter market.

Extraterritorial jurisdiction: The Act precludes the application of the Supreme Court’s recent decision in Morrison, discussed here, to actions brought by the SEC or the United States. Rather, it specifies that the antifraud provisions extend in SEC and government actions to any conduct within the U.S. that constitutes “significant steps in furtherance of the violation,” even where the securities transaction is not in the U.S. and involves only foreign investors. The extension also covers any conduct outside the U.S. that has a foreseeable, substantial effect in the United States. The SEC is required to prepare a study on the impact of applying these extensions to private damage suits.

Aiding and abetting: The Act makes it clear that recklessness is sufficient to prove aiding and abetting. It also gives the SEC explicit authority to bring enforcement actions based on this theory under the Securities Act, the Investment Company Act and the Investment Advisers Act. The Act did not include a provision extending aiding and abetting liability to private civil actions. The GAO, however, is required to study the impact of extending such authority to private damage actions.

Formerly associated persons: The Act makes it clear that the SEC can bring an action against a person formerly associated with a registered entity.

Control person liability, Exchange Act: Under the Act, the SEC may impose joint several liability on control persons.

Service of subpoenas: Parties to SEC enforcement actions in federal district court will be able to serve subpoenas nationwide.

Collateral bars: The SEC will be able to impose collateral bars prohibiting offenders from associating with a range of Commission regulated entities.

Penalties: The SEC will now have authority to seek civil penalties in all of its cease and desist proceedings.

While the SEC’s enforcement authority is being enhanced, the Act also sets deadlines to speed the process. The Commission SEC will now have 180 days after giving a written Wells notice to institute an enforcement action. Likewise, the agency will be required to inform the subject of an examination in writing within 180 days from the date the exam is completed if there are no findings or the staff intends to request corrective action. Both time limits can be extended for complex matters.