The Market Crisis, Short Sale Rules And Two Enforcement Cases

Hearings on the current market crisis and the proposed bail-out package continued yesterday. During the hearings, additional questions were raised about the Commission’s emergency short sale rules and the old up-tick rule. At the same time, the Commission’s staff clarified a number of points concerning the operation of the short sale orders. The SEC also brought another case concerning an investment advisor and a settled financial fraud case. The former focused on a failure to disclose kickbacks paid by a fund the advisor recommended to its clients, while the latter raises questions about the Commission’s cooperation policies.

The market crisis

The SEC continued to clarify the application of its orders regarding short selling that were instituted last week. In a release, the Divisions of Corporation Finance, Investment Management and Trading and Markets responded to a series of seventeen frequently asked questions focused on compliance with the Commission’s Emergency Order Concerning Disclosure of Short Selling. Topics covered in the guidance include who may be required to file Form SH, the definitions of short sale and short position, what transactions must be reported on Form SH, whether short sales resulting from the exercise of a put or assignment to call writers upon exercise are reportable on Form SH, if short swaps are excluded from reporting on Form SH, and exceptions to the filing requirements.

Testimony also continued in Congress concerning the $700 billion bail out proposed by Treasury and the Federal Reserve. During the hearings, questions were raised regarding the Commission’s short sale orders and whether the up-tick rule, revoked last year after being in place since the 1930s, should be reinstated. SEC Chairman Cox was not present to respond to these questions.

Investment advisor

Earlier this week, the Commission filed its first action against a mutual fund advisor for failing to disclose that it used part of its administrative fees to pay for marketing and other expenses as discussed here. https://www.secactions.com/?p=466 Yesterday, the SEC filed a civil injunctive action against an investment advisor and its owner for failing to disclose kickbacks. Specifically, the complaint claims that investment advisor WealthWise LLC, and its principal Jeffrey A. Forrest, failed to disclose a side agreement they had under which Apex Equity Options Fund, a hedge fund managed by Thompson Consulting, Inc., kicked back about $350,000 of its fees to WealthWise and Mr. Forrest. As the kickbacks were being paid WealthWise and Mr. Forrest recommended to more than 60 clients that they invest about $40 million in Apex Equity Options Fund.

The Commission’s complaint alleged violations of Exchange Act Section 10(b), Securities Act Section 17(a) and Sections 206(1) and 206(2) of the Investment Advisors Act. SEC v. WealthWise, LLC, Case No. CV 08-06278 (C.D. Cal. Sept. 24, 2008). The Commission previously filed an action against Thompson Consulting and others.

Financial fraud – cooperation

The Commission filed another settled financial fraud case on Wednesday. In its papers the Commission acknowledged the cooperation of the company named as a defendant, Beazer Homes USA, Inc., a Georgia based home builder with operations in 21 states.
In the Matter of Beazer Homes USA, Inc., Adm. Proc. File No. 3-13234 (Filed Sept. 24, 2008).

According to the Order for Proceedings, between 2000 and 2007, the company misstated certain of its quarterly and annual net income by intentionally managing its earnings. During a five year period of strong growth, the company decreased net earnings and increased certain operating expenses so that it could improperly inflate its reserves. Nevertheless, the company was able to meet the expectations of analysts. As the financial performance of the company began to decline in the first quarter of 2006, the company drew down those reserves so that it could continue to meet Wall Street expectations. To facilitate its plan, the company also deceived its outside auditors.

In 2008, the company restated its financial statements. According to that restatement, Beazer overstated income for 2005 and 2006 by 5% each year. For the first quarter of fiscal 2007, the loss suffered by the company was increased following the restatement by 36% and by 33% for the second quarter.

To resolve the case, the Commission accepted an offer of settlement by the company. In accepting that offer, the SEC stated that it had considered the remedial acts of the company and its cooperation. Under the settlement, the company agreed to a series of undertakings in which the company essentially pledged to use its best efforts to make its employees available to be interviewed and to appear for testimony or at any trial. In addition, the company agreed to cease and desist from violations of the antifraud and reporting provisions.

Despite the statement in the Order about remedial acts and cooperation which may have influenced the charging decision, the Commission did not specify the nature of any of those acts. As guidance for, and encouragement to, other issuers to cooperate, at least some discussion of the remedial and cooperative acts credited under Seaboard would be useful.

The SEC’s Cox Requests More Authority And A First Against A Fund Advisor

The market crisis continues to dominate the news as the SEC seeks new regulatory powers while expanding its enforcement investigations in an effort to determine what happened. The Commission also filed its first ever administrative action against a mutual fund advisor for the improper payment of administrative fees.

Market crisis

SEC Chairman Christopher Cox, along with the Treasury Secretary, Chairman of the Federal Reserve and others, testified on Tuesday before the Senate Committee on Banking, Housing and Urban Affairs regarding the proposed $700 billion bail out of the mortgage market. In his prepared testimony, the SEC Chairman reiterated the Commission’s recent actions regarding the market crisis, including a discussion of the new rules temporarily limiting short trading.

The Division of Enforcement is devoting what the Chairman called “an extraordinary level” of resources to the current market crisis. The division has over 50 pending law enforcement investigations in the subprime area. This includes a “sweeping investigation” into market manipulation of financial institutions focused on broker-dealers and institutional investors and their trading activity in credit default swaps. The Division is focusing on the CDS market because it is “completely lacking in transparency and completely unregulated,” but involves $58 trillion. According to Chairman Cox, the investigations focus on “using our antifraud authority, even though swaps are not defined as securities, because of concerns that CDS offer” a significant potential for abuse. The Chairman went on to note that a CDS buyer is “tantamount” to a short seller of the bond underlying the instrument. CDS buyers can “naked short” the debt of the companies without restriction. This is of “great concern,” the Chairman told the Senate Committee.

In his testimony, Chairman Cox reiterated his earlier call for authority to regulate investment banks, which he characterized as a failure of the Gramm-Leach-Bailey Act. He also asked for regulatory authority over the CDS market. During questioning by the Committee, the Chairman reiterated these requests for additional authority for the Commission.

The day before the Chairman’s testimony, New York State announced that its insurance department is imposing certain restrictions on the credit derivative market. The new rules are apparently directed at safeguarding companies that buy the instruments. The state will require companies to obtain an insurance license in order to issue a credit default swap to borrowers who also own the bonds or loans they are designed to protect. This would not apply to so-called “naked” credit default swaps. The new rules also impose certain capital requirements.

AmSouth settlement

In In the Mater of AmSouth Bank, N.A., Adm. Proc. File No. 3-13230 (Sept. 23, 2008), the Commission brought its first case against a mutual fund advisor that secretly used part of its administrative fees paid by fund shareholders to pay for marketing expenses. According to the Order for Proceedings, AmSouth entered into undisclosed side agreements with BISYS Funds Services, the administrator of AmSouth Funds, under which BISYS rebated about $16 million of its $49 million administrative fee. The rebates were used to pay expenses unrelated to marketing. Those expenses included salary, bonus, benefits and country club membership for the president of the AmSouth Funds. In addition, BISYS paid AmSouth an additional $1.161 million in what was called consulting fees in exchange for AmSouth recommending to the trustees that BISYS provide securities lending services to the AmSouth Funds. None of these side agreements were disclosed to AmSouth Funds’ independent trustees or the Funds’ shareholders.

To resolve the matter, AmSouth and AmSouth Asset Management, Inc., a registered investment advisor, agreed cease and desist from committing violations of Sections 206(1) and 206(2) of the Investment Advisers Act and from committing or causing any violations or future violations of Sections 12(b) and 34(b) of the Investment Company Act and Rule 12b-1 thereunder. AmSouth also agreed to pay a total $7.7 million in disgorgement, $2.2 million in prejudgment interest and a $1.5 million penalty.