More On Legal & Compliancefrom The Advisor's Professional Library
- Where Are We Headed? The ultimate compliance goal is to help ensure that everyone associated with an advisory firm acts ethically at all times. Advisors and RIAs should do the right thing, even when regulators are not looking over their shoulders.
- Do’s and Don’ts of Advisory Contracts In preparation for a compliance exam, securities regulators typically will ask to see copies of an RIAs advisory agreements. An RIA must be able to produce requested contracts and the contracts must comply with applicable SEC or state rules.
In recent enforcement news, an appeals court reinstated a suit against UBS subsidiaries by two Puerto Rico-based pension funds over a $757 million bond purchase.
Shareholder Suit Against UBS Reinstated by Appeals Court
The U.S. Court of Appeals for the First Circuit has reversed the 2011 decision of the U.S. District Court for the District of Puerto Rico in dismissing the shareholder lawsuit of two Puerto Rico-based pension funds, Unión de Empleados de Muelles de Puerto Rico AP Welfare Plan and Unión de Empleados de Muelles de Puerto Rico PRSSA Welfare Plan, against UBS subsidiaries over the purchase of $757 million in bonds.
In 2010, the two plans filed a shareholder derivative suit against UBS Trust Co. of Puerto Rico, advisor to the plans, and UBS Financial Services of Puerto Rico, underwriter of the bonds, which were issued by Puerto Rico’s Employee Retirement Service (ERS).
The suit alleged that the UBS defendants manipulated trading by using the plans’ four investment funds—the Puerto Rico Fixed Income Fund II Inc., the Puerto Rico Fixed Income Fund III Inc., the Puerto Rico Fixed Income Fund IV Inc., and the Tax-Free Puerto Rico Fund II Inc.—to engineer the appearance of market interest in the bonds, which in actuality sold very little elsewhere.
UBS Financial had to find buyers for the bonds in order to make money, and UBS Trust advised the funds to buy them. However, within a year of the purchase by the retirement plans’ funds of $757 million worth of the bonds—a sufficient quantity to overweight the funds’ exposure—the value of the bonds fell by 10%, “dragging down the worth of the funds,” according to the court ruling.
At that point, the two plans filed their suit in the District of Puerto Rico. The suit named members of the funds’ board of directors as defendants as well as the UBS subsidiaries, and said that “a presuit demand [to the boards of directors of the funds] would have been futile.”
The complaint in shareholder actions is required to assert either that the corporation declined to protect its own interests after a suitable demand was made on the board of directors, or that such a demand would have been futile. The UBS subsidiaries moved to dismiss the derivative claims, saying that the two plans had inadequately pleaded demand futility in their suit. Their move was successful at first; the district court dismissed the plans’ derivative claims without prejudice for failure to properly plead demand futility with regard to the funds’ directors.
However, the appeals court looked at the pleadings “de novo” and found that, because of information provided on six of the eleven directors involved, there was indeed reasonable cause to believe that a presuit demand would have failed. The case was reinstated and may now proceed.
GFI Securities LLC was censured by FINRA and fined $2,100,000, and two of its registered principals and two of its registered reps were suspended and fined for their actions in using credit default swaps (CDSs). Michael Scott Babcock and Donald Patrick Fewer, registered principals, were fined $100,000 each; Stephen Falletta and Lainee Dale Steinberg, registered representatives, were fined $200,000 and $125,000, respectively.
Without admitting or denying the allegations, the respondents consented to the sanctions and to the entry of findings that a client sought to reduce its brokerage costs by proposing that the broker it used to effect certain CDSs forgo charging the client commissions when it was the counterparty whose bid had been hit or whose offer had been lifted by the other counterparty.
The findings stated that through a series of communications, Steinberg and a broker at another member firm coordinated their respective firms’ responses to the proposal and discussed an alternative fee schedule that might be proposed to the client. The broker convinced GFI to give the client aggressor-only terms on CDS index transactions and CDSs associated with a particular country, rather than the blanket concession the client requested.
The findings also stated that another client also sought aggressor-only terms on CDS transactions from GFI and other CDS brokers. Steinberg and Falletta coordinated GFI’s response to the client with another broker’s response on his firm’s behalf, so the client did not get the blanket aggressor-only terms it had sought. The findings also included that other clients proposed a new fee schedule or reduction of fees on CDS transactions. The proposals precipitated a flurry of communications among brokers at affected firms, including Babcock and others at GFI, to collaborate with competitors to defeat the clients’ proposals.
One client circulated a modified proposal that provided for higher commissions than its original proposal, which GFI and the other firms accepted. The other client agreed to accept price reductions that were smaller than it had originally proposed.
FINRA found that through these numerous communications, GFI sought to frustrate its customers’ efforts to obtain brokerage services at rates reflecting a bona fide competitive market. FINRA also found that, through these same communications, Babcock, Fewer, Falletta and Steinberg sought to frustrate GFI’s customers’ efforts to obtain brokerage services at rates reflecting a bona fide competitive market.
FINRA also found that Babcock and Fewer knew, or ignored red flags indicating, that GFI’s registered representatives under their supervision, including Steinberg and Falletta, were engaging in improper communication with firm competitors regarding CDS brokerage rates but failed to take adequate steps to prevent them from doing so. Babcock personally participated in such improper communications.
In addition, FINRA determined that GFI’s WSPs were not reasonably designed to ensure compliance with Interpretative Material 2110-5 and other securities law requirements concerning anticompetitive conduct. The firm’s WSP section concerning anticompetitive or collusive conduct lacked specificity and did not provide for ongoing systematic reviews of brokers’ electronic and telephonic communications for that purpose. The firm failed to review employees’ Bloomberg messages until a certain date and failed to document that it conducted any supervisory reviews of other instant messaging forms of communication.
The SEC announced that it has charged two KPMG auditors for their roles in a failed audit of TierOne, a Nebraska-based bank, which hid millions of dollars in loan losses from investors during the financial crisis and eventually was forced to file for bankruptcy. These actions come after previous charges against three former TierOne bank executives responsible for the scheme.
The new charges are against KPMG partner John Aesoph and senior manager Darren Bennett. The investigation found that they failed to appropriately scrutinize management’s estimates of TierOne’s allowance for loan and lease losses (known as ALLL).
According to the SEC’s order instituting administrative proceedings against Aesoph, who lives in Omaha, and Bennett, who lives in Elkhorn, Neb., the auditors failed to comply with professional auditing standards in their substantive audit procedures over the bank’s valuation of loan losses resulting from impaired loans. Instead they relied principally on stale appraisals and management’s uncorroborated representations of current value, and ignored evidence that management’s estimates were biased and inconsistent with independent market data.
According to the SEC’s order, the internal controls identified and tested by the auditing engagement team did not effectively test management’s use of stale and inadequate appraisals to value the collateral underlying the bank’s troubled loan portfolio. For example, the auditors identified TierOne’s Asset Classification Committee as a key ALLL control. But there was no reference in the audit work papers to whether or how the committee assessed the value of the collateral underlying individual loans evaluated for impairment, and the committee did not generate or review written documentation to support management’s assumptions. Given the complete lack of documentation, Aesoph and Bennett had insufficient evidence from which to conclude that the bank’s internal controls for valuation of collateral were effective.
The SEC’s order alleges that Aesoph and Bennett engaged in improper professional conduct as defined in Section 4C of the Securities Exchange Act of 1934 and Rule 102(e)(1)(ii) of the Commission’s Rules of Practice. A hearing will be scheduled before an administrative law judge to determine whether the allegations contained in the order are true and what, if any, remedial sanctions are appropriate pursuant to Rule 102(e). The administrative law judge will issue an initial decision no later than 300 days from the date of service of the order.
The SEC announced that it has charged three former executives at Norfolk, Va.-based Bank of the Commonwealth for understating millions of dollars in losses and masking the true health of the bank’s loan portfolio at the height of the financial crisis.
The SEC alleges that Edward Woodard, who was CEO, president, and chairman of the board, was responsible along with CFO Cynthia Sabol and executive vice president Stephen Fields for misrepresentations to investors by the bank’s parent company, Commonwealth Bankshares. The consistent message in Commonwealth’s public statements and SEC filings was that its portfolio of loans, comprising approximately 94% of the company’s total assets in 2008, was conservatively managed according to strict underwriting standards aimed at keeping the bank’s reserved losses low during a time of unprecedented economic turmoil.
In reality, the SEC alleges that internal practice deviated significantly from what the public was being told. According to the SEC’s complaint filed in U.S. District Court for the Eastern District of Virginia, Commonwealth understated its allowance for loan and lease losses (known as ALLL) by approximately 17–25% from November 2008 to August 2010. This caused the bank to understate its reported loss before income taxes by approximately 64% for fiscal year 2008. Commonwealth also understated its losses on real estate repossessed by the bank (known as OREO) in two fiscal quarters, which caused the bank to understate its reported loss before income. For eight consecutive fiscal quarters, Commonwealth underreported its total nonperforming loans.
The SEC alleges that Woodard knew the true state of Commonwealth’s rapidly deteriorating loan portfolio, yet he worked to hide the problems and engineer the misleading public statements, particularly those made in earnings releases. Sabol knew of the activity to mask the problems with the company’s loan portfolio and the corresponding effect these masking practices had on the bank’s financial statements and disclosures, yet she signed the disclosures and certified to the investing public that they were accurate. Fields oversaw the bank’s largest portfolio of construction and development loans and was involved in the masking practices.
The SEC’s complaint alleges that Commonwealth obtained an appraisal for its largest collateral-dependent loan that falsely inflated the value of the collateral. The bank executed hundreds of “change-in-terms agreements” at the end of the quarter to remove tens of millions of dollars of loans from its reported nonperforming loans.
Woodard, Sabol, and Fields helped enable the bank to artificially bring otherwise-delinquent loans current by permitting checking accounts associated with the guarantors of the delinquent loans to be overdrawn. The bank also disbursed loan proceeds without inspecting the property to confirm that the work requiring the disbursement had actually been performed.
The SEC’s complaint charges Woodard, Sabol and Fields with violations of the antifraud, reporting, recordkeeping, internal controls, deceit of auditors and Sarbanes-Oxley certification provisions of the federal securities laws. The investigation is continuing.