by T. GormanPosted on Posted in SECActions

The valuation of assets held by advisers has been a key issue for the Commission. Likewise, insider trading on political intelligence is also a focus of SEC Enforcement. The Commission’s latest case involving an adviser involves each of these key areas and culminates with the adviser withdrawing its registration. In the Matter of Visium Asset Management, L.P., Adm. Proc. File No. 3-18473 (May 8, 2018).

Visium was a registered investment adviser with more than $7.8 billion of assets under management. Two related investment vehicles were involved here: Visium Credit Master Fund, LT. – the Credit Fund – and Visium Balanced Master Fund Ltd. – the Balanced Fund. Credit Fund Series A investors paid a 1.5% management fee and a 1.5% performance fee. Series B investors paid a 2% management fee and a 20% performance fee based on a high-water mark and the fund’s NAV.

In May 2009 the adviser launched the Credit Fund. It focused on higher risk investments such as thinly traded corporate debt instruments issued by healthcare companies. Those bonds and loans were not listed on an exchange. They did trade over the counter where market makers provided price quotes.

From July 2011 to December 2012 portfolio managers Christopher Plaford and Stefan Lumiere engaged in a mismarking scheme to falsely value certain securities held by the Credit Fund and improperly inflate the NAV and apparent performance. Sham price quotes were used to override those which should have been used by Credit fund’s independent administrator.

The sham quotes were obtained by the two portfolio managers from at least three outside brokers, each of whom was at a different firm. The two men made the sham quotes appear legitimate by asking the brokers involved in the practice for specific prices they wanted in an email or instant message sent back to them. The brokers would then send back what were called U-turn quotes.

During the eighteen months this practice was used, the Credit Fund had, on average, about 72 bond or loan positions at month-end. The U-turn prices were used for anywhere from 6 to 28 positions. Virtually all of the U-turn prices resulted in higher valuations for long positions or lower valuations for short positions held by the Credit Fund. The scheme caused the Credit Fund to routinely overstate its month-end NAV by amounts which ranged from 2.4% to 7.2%. As a result of this practice investors purchased and sold interests at incorrect prices. It also resulted in the Credit Fund over paying its performance fees by $2,622,709 and its management by $544,700.

The improper valuations also resulted in deceptive disclosure to investors. FASB Accounting Standards Codification Topic 820 regarding fair value has a three tier framework for measuring fair value based on the quality of the inputs used. Since Mr. Platford used the sham quotes to keep the values at Level 2 for those where quotes were not available but fair value could be determined, it was incorrect. The scheme also resulted in misstatements about the performance of the Fund, the limited partner’s total capital, net investment income and monthly and yearly returns as well as Visium’s firm-wide assets under management. Likewise, the scheme was contrary to the disclosed valuation methods and the firm’s policies and procedures.

The two portfolio managers also engaged in an insider trading scheme. Initially, between 2005 and 2011 there was considerable speculation as to whether the Office of Generic Drugs or OGD at the Federal Food and Drug Administration would approve pending enoxaparin applications or Abbrevited New Drug Applications. During the period Gordon Johnston, a former OGD official retained by Visium, furnished information that certain applications were moving to approval. As that information was transmitted regarding an application for Momenta Pharmaceuticals, Inc. the Balance Fund traded in advance of the announcement. Mr. Johnston continued to furnish information on the applications that was used to formulate the Balanced Fund’s trading before the announcement on an application by Watson Pharmaceuticals, Inc. This resulted in trading profits of $6,982,396.

The Balanced Fund and the Credit Fund also traded on inside information obtained by CMS in May 2012 from consultant David Blaszczak. Mr. Blaszczak, a former Centers for Medicare and Medicate Services or CMS employee, was convicted of illegal tipping in connection with another insider trading case centered on inside information he obtained from CMS in April, 2018. This resulted in trading profits of $284,939. While the firm had an insider trading policy it was not effectively implemented since inadequate steps were taken to monitor employee communications with consultants.

The Order alleges violations of Securities Act section 17(a), Exchange Act section 10(b), and Advisers Act sections 204A, 206(1), 206(2), 206(4), and 207. To resolve the proceedings Respondent undertook to return all investor funds no later than one year from the date of the Order and filed a Form ADV-W to withdraw its registration as an investment adviser. Respondent also consented to the entry of a cease and desist order based on the sections cited in the Order as well as a censure. The firm will pay disgorgement of $4,755,223 and prejudgment interest of $720,711. In addition, Respondent will pay a penalty equal to the amount of the disgorgement. See also In the Matter of Steven Ku, Adm. Proc. File No. 3-18474 (May 8, 2018)(proceeding against CFO for failure to supervise two portfolio managers re valuation; resolved with the suspension of Respondent from the securities business for a period of twelve months and the payment of a $100,000 civil penalty).

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by T. GormanPosted on Posted in SECActions

Scienter has been a critical element of a claim based on Exchange Act Section 10(b) in an SEC enforcement action since the Supreme Court’s decision in Aaron v. SEC, 446 U.S. 680 (1980). It has also been a key element in private damage actions based on the cause of action implied under Section 10(b) and Rule 10b-5 since Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). Both decisions are based largely on the text and language of Section 10(b).

Section 14(e), added to the Exchange Act by the Williams Act in 1968, has also been held to require proof of scienter by the Circuit Courts – the Supreme Court has not considered the questions. Flaherty & Crumrine Preferred Income Fund, Inc. v. TXU Corp., 565 F. 3d 200 (5th Cir. 2009); SEC v. Ginsburg, 362 F. 3d 1292 (11th Cir. 2004); Aaron, Adams v. Standard Knitting Mills, Inc., 623 F. 2d 422 (6th Cir. 1980); Smallwood v. Pearl Brewing Co., 489 F. 2d 579 (5th Cir. 1974); Chris-Craft Indus. Inc. v. Piper Aircraft Corp., 480 F. 2d 341 (2nd Cir. 1973).

Now however, the decisions by the five Circuit Court regarding Section 14(e) are being called into question by the Ninth Circuit. That Circuit recently examined the statutory language of Section 14(e) as well as its purpose and history, all of which lead the Court to conclude that the clause prohibiting a misrepresentation/omission only requires proof of negligence. Variabedian v. Emulex Corporation, No. 16-55099 (9th Cir. Filed April 20, 2018).

The decision

Variabedian is a securities class action based on Exchange Act Section 14(e) and Section 20(a) centered on the tender offer by Avago Technologites Wireless Manufacturing, Inc. for Emulex Corporation, announced on February 25, 2015. Following the deal announcement a punitive class action was brought alleging that the tender offer materials contained a material omission because they did not summarize a Premium Analysis prepared by one of the investment bankers in the deal which would have shown that the premium to market offered was below market. The District Court dismissed the complaint with prejudice, concluding that Section 14(e) required scienter which plaintiff failed to plead.

The Circuit Court reversed, concluding that one of the two parts of Section 14(e) only requires that a securities law plaintiff plead and prove a cause of action based on negligence: “We now hold that Section 14(e) of the Exchange Act requires a showing of negligence, not scienter.

The Ninth Circuit’s decision is based on the statutory text, bolstered by its purpose and history. The statute states in pertinent part: “It shall be unlawful for any person (1) to make any untrue statement of a material fact or omit to state any material fact . . . or (2) to engage in any fraudulent, deceptive, or manipulative acts or practices . . .” (emphasis added). The use of the word “or” separates the two clauses of the Section, the Court stated. This shows that there are two different offenses proscribed by the statute. The first focuses on misstatements and omissions. The second, on manipulative acts and practices.

Careful consideration of the Supreme Court’s decisions parsing the language of Section 10(b) of the Exchange Act demonstrates that there are important distinctions between that provision and Section 14(e). When the Supreme Court began its examination of rule 10b-5’s language in Hochfelder it initially focused on the phrase stating that “It shall be unlawful . . . [t]o make any untrue statement of a material fact or omit to state any material fact . . .” That passage, the Court allowed, could be read as proscribing any type of material misstatement, regardless of intention. In Hochfelder the Court held, however, that Section 10(b) and the rule require proof of scienter. That conclusion was based on the fact that the rule could not be broader than the Section which in fact requires scienter: “Rule 10b-5 requires a showing of scienter because it is a regulation promulgated under Section 10(b) of the Exchange Act, which allows the SEC to regulate only ‘manipulative or deceptive device[s].’”

Three years later the Supreme Court decided Aaron which considered the knowledge requirement of Section 10(b) and Securities Act Section 17(a) in the context of an SEC enforcement action. There the Court reaffirmed its decision in Hochfelder as to Section 10(b). As to Securities Act Section 17(a)(2) however, the Court reached a different conclusion. That subsection prohibits “’any untrue statement of a material fact or any omission to state a material fact . . .’” In view of this language the Aaron Court held “that Section 17(a)(2) does not require a showing of scienter.” (emphasis original).

The language of Section 17(a)(2) is substantially similar to that of the first part of Section 14(e). Both prohibit misrepresentations and omissions. Under these circumstances Aaron compels the conclusion that the first part of Section 14(e) requires proof of negligence.

The Court bolstered its conclusion, citing the purpose and history of Section 14(e). Under this Section the SEC has the authority to prohibit acts which are not fraudulent, in contrast to Section 10(b) which requires proof of fraud. The broader reach of Section 14(e) suggests that it not be limited to prohibiting fraud like Section 10(b). This conclusion also finds “some support” in the legislative history which reflects the fact that the Williams Act “places more emphasis on the quality of information shareholders receive in a tender offer than on the state of mind harbored by those issuing a tender offer.”

Finally, while five other circuits reached the opposite conclusion, at least three did not have the benefit of Aaron at the time of decision. Chris-Craft and Smallwood, for example, were both decided before Hochfelder. While the Sixth Circuit’s Standard Knitting Mills was decided after Hochfelder but just before Aaron and thus did not have the benefit of that decision.

Despite Hochfelder and Aaron, however, the circuit courts have continued to conclude that Section 14(e) requires proof of scienter. Flaherty however relied on Smallwood. Ginsburg relied on another Eleventh Circuit case which based its conclusion on a comparison of the Section 14(e) language to that of Rule 10b-5 but did not mention the limitation on the rule from Section 10(b). Thus with the benefit of Hochfelder and Arron it is clear that one portion of the Williams Act provision only requires proof of negligence, the Court concluded.

Comment

Varjabedian is based squarely on the language of the statute. While the Court sought additional support from the purpose of the statute as well as the legislative history, the opinion leaves doubt that it is the statutory text which compelled the decision. The fact that the negligence conclusion is based on a comparison of an Exchange Act provision to one from the Securities Act is of little real moment given the virtually identical statutory language from two securities statues.

Perhaps more importantly, the mode of analysis fits squarely with the approach being used by the Supreme Court. In Digital Realty Trust, Inc. v. Somers, No. 16-1276 (S.Ct. Feb. 21, 2018), for example, the Court resolved a question regarding the whistleblower provisions of the Exchange Act and the Sarbanes-Oxley Act by construing the text of the of the statute, citing the purpose of the provisions only to bolster its conclusion. Five members of the Court joined Justice Ginsberg’s majority opinion. Justice Thomas, however, joined by Justices Alito and Gorsuch concurred only in the judgment but declined to join the majority opinion because of its citation to the Senate Report, deeming that inappropriate.

Each member of the Court joined Justice Kagan’s majority opinion in Cyan, Inc. v. Beaver County Employees Retirement Fund, Case No. 15-1439 (S.Ct. Decided March 20, 2018) which relied solely on the statutory text in construing a section of SLUSA, the Securities Litigation Uniform Standards Act. Viewed in this context, if Varjabedian reaches the High Court – and it might given the clear circuit split – it may well be affirmed – but without any references to the legislative materials.

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