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QUESTION: What were the most significant trends in SEC enforcement cases in 2002, and what areas should Advisers be most concerned about in 2003?

ANSWER: The SEC instituted a record number of cases against investment advisers in 2002. In all, 48 new cases were filed, a 26% increase from the 38 instituted in 2001. The SEC had previously instituted 40 cases against advisers in 2000, and 41 cases in 1999. The good news for advisers is that, despite the record number of cases filed, the types of cases filed were fairly routine. Roughly two-thirds of the new actions involved some form of outright fraud or deception on the part of the respondents. Ponzi schemes, affinity frauds and the misappropriation of investor funds were all seen in abundance. In addition, nearly half of the filed cases involved a failure to disclose important facts that went to the heart of investments made or services provided by those charged by the Commission.

There were, however, three categories of cases brought in 2002 that advisers should heed. These cases involved failure to supervise, advertising and breach of fiduciary duty, perennial issues that continue to vex some advisers.

Failure-to-Supervise Cases
The adviser community was still unraveling the implications of the Western Asset Management case, filed at the close of FY 2001 (finding a duty on behalf of Legg Mason to supervise a sub-adviser), when a series of new supervision cases hit. ND Money Management, Inc., Ranson Capital Corporation, and Monte L. Avery, IA-2027, IC-25523, Rels. No. 34-45743, Adm. Proc. No. 3-10757 (April 12, 2002), although not technically a supervision case, faulted two advisory firms for failing to institute procedures that would have prevented certain violations of the advisers’ codes of ethics (regarding the reporting of employees’ personal trades), and for failing to inform employees of their duties under the codes.

In Vanderbilt Capital Advisors LLC, Rel. No. IA-2053, Adm. Proc. No. 3-10882, (September 3, 2002), the SEC imposed sanctions on an advisory firm that had failed to properly supervise a portfolio manager who manipulated the prices of bonds purchased for various clients’ accounts as part of an “adjusted trading” scheme. According to the SEC, adjusted trading is a fraudulent trading practice whereby a person sells a security at a price above the prevailing market price and purchases another security at a corresponding price above the prevailing market price to offset the overpayment in the first transaction. On the same day the SEC brought and settled a companion case against another adviser arising out of the same facts and transactions as Vanderbilt. See Harvey I. Rubenstein, Rel. Nos. 33-8126, 34-46449, IA-2054, Adm. Proc. No. 3-10883 (September 3, 2002).

Two more recent cases, although filed in FY 2003, continue the failure-to-supervise case trend. In Dean Witter Reynolds, Inc., n/k/a Morgan Stanley DW, Inc., Mark Rodgers, and Paul Grande, Rels. No. 34-46578, Adm. Proc. No. 3-10905, (October 1, 2002), a broker-dealer and branch manager were sanctioned for failing to properly supervise an employee who engaged in unsuitable and unauthorized trading in the accounts of certain customers. In another recent case, Millenium Capital Advisors of Pennsylvania, Inc. and Louis J. Sozio, Rels. No. IA-2092, Adm. Proc. No. 3-10971 (December 13, 2002), an advisory firm and its vice-president and compliance officer were charged with failing to adequately supervise a portfolio manager who violated a client’s express investment restrictions. The case is of particular concern because it represents one of the few occasions in which the SEC has brought a failure-to-supervise action against a compliance officer. The case was settled without admitting or denying the allegations.

Advertising/Marketing/Disclosure Cases
Cases in the advertising, marketing and disclosure area represent, numerically, the greatest number of actions brought last year after the fraud-in-the-offering type cases discussed above. The impact that performance data has on the selection of advisers has not escaped the SEC, and they perennially grapple with advisers who misrepresent their performance and make otherwise unsupportable claims.

Davis Selected Advisers NY, Inc., Rels. No. IA-2055, IC-25727, Adm. Proc. No. 3-10885, (September 4, 2002) involved the failure of an advisory firm to disclose the impact short-term IPO trading had on a new fund’s performance. These IPO-disclosure cases have posed significant concerns to both advisers and funds because they represent – at least in some people’s views – an attempt to expand the duty of disclosure beyond established boundaries. True or not, it bears mention that the SEC, in its order settling the Davis case, expressed its view that the portion of performance related to IPO returns in Davis “was easily isolated and separately identifiable from other performance factors.”

Other cases in the advertising and marketing area include Market Timing Systems, Inc., Gregory Meadors and Mark Shinnick, IA-2002, Adm. Proc. No. 3-10652 (December 14, 2001), where the respondents created allegedly false and misleading advertisements containing hypothetical performance results, and allegedly failed to disclose that the marketed results were obtained using models, that other factors were involved, and that the firm’s actual performance was inferior to that shown by the model. The SEC also alleges that the firm failed to maintain records to substantiate its hypothetical performance results, and failed to maintain financial books and records. The case is pending.

Three other advertising cases should be noted. In Merrimac Advisors Company and Fredric J. French, IA-2009, IC-25356, Adm. Proc. No. 3-10594 (January 4, 2002) the SEC imposed sanctions by default on an advisory firm and its principal for failing to contest charges that the two obtained business by using false track records in presentations made to clients, as well as by failing to keep accurate records that would enable them to make calculations about performance that could be verified.

Cambridge Equity Advisors, Inc. and Michael E. Goldston, IA-2001, Adm. Proc. No. 3-10651 (December 12, 2001) involved a settled case in which the president, portfolio manager, and sole stockholder of the advisory firm allowed marketing folders containing inaccurate information and failed to inform clients that some of the reported performance numbers came from models and not actual company performance. In the contested proceeding of FXC Investors Corp., Adm. Proc. No. 3-10625, Release No. IA-1991 (October 18, 2001), the Administrative Law Judge found that FXC provided investors with misleading advertisements concerning the firm’s annual performance results and sent misleading rankings to the publishers of investment guides.

In the pending case of Oxford Capital Management, Inc., and John G. Danz, Jr., Rels. No. IA-2061, Adm. Proc. No. 3-10895, (September 23, 2002) , the SEC charged that respondents submitted false and inflated performance results and the amount of assets in communications to clients, prospective clients and third-part reporting services. According to the order instituting proceedings, the firm’s composite performance figures for a seven-year period were inflated, thereby allowing Oxford to rank much higher in the surveys disseminated by the reporting services than they would have otherwise. The SEC also alleges that Oxford was unable to demonstrate how its advertised performance claims were calculated, and failed to maintain the required books and records (including internal working papers or other records) that would substantiate its advertised performance claims. Respondents have denied the charges.

Thurlow Funds, Inc., Thurlow Capital Management, Inc., and Thomas F. Thurlow, Rels. No. 33-8136, IA-2065, IA-25761, Adm. Proc. No. 3-10907, (October 2, 2002), a settled case, involved the dissemination of outdated performance returns on a fund’s Internet website. Despite written representations to the SEC that the fund would remove or update the performance data on its site quarterly, it failed to do so, and, according to the SEC’s order, prominently proclaimed a 422% return from inception through a specified date, when in fact the fund’s total returns had declined by more than half in the six months following the specified date.

Breach of Fiduciary Duty / Trade Allocation Cases
The SEC was not shy about bringing cases involving breach of fiduciary where the interests of the adviser and the client diverged. The SEC’s focus on the duties owed by investment advisers to clients, including the need to avoid conflicts of interest, comes directly out of the Investment Advisers Act of 1940, which was enacted in order to eliminate such problems. While the particular types of conflicts between advisers and clients change with the times, the SEC’s interest in and concern over them does not.

In Zion Capital Management LLC and Ricky A. Lang, Rels. No. 33-8046, 34-45175, IA-2003, IC-25322, Adm. Proc. No. 3-10659 (December 20, 2001) , an adviser and its principal were charged with allocating more profitable trades to an entity in which the principal had a financial interest and more unprofitable trades to the firm’s sole advisory client. Respondents have denied the charges and the matter is still pending. In Schwendiman Partners, LLC, Gary Schwendiman, and Todd G. Schwendiman, Rels. No. 33-8111, 34-46184, IA-2043, Adm. Proc. No. 3-10829 (July 11, 2002), a firm and two individuals settled charges that they breached their fiduciary duties to clients by favoring their own interests over those of the clients, giving preferential treatment to certain clients, and making untrue and misleading statements to clients. Finally, in Renberg Capital Management, Inc., and Daniel H. Renberg, Rels. No. IA-2064, Adm. Proc. No. 3-10906, (October 1, 2002), an adviser and its sole owner settled charges that they violated their fiduciary duty to clients by failing to seek or obtain best execution on trades.

Concealed Commissions to Barred Individual Case
Another case, Christopher P. Roach and East West Institutional Services, Inc., Rels. No. 34-45486, IA-2016, Adm. Proc. No. 3-10007 (February 28, 2002), deserves mention because it points out the age-old problem of what role, if any, a “barred” individual may play in the investment process. In this case, a former registered representative lost his securities license after being terminated for unauthorized trading. Thereafter, the barred individual entered into an agreement whereby for two years a company he controlled received commissions from another advisory firm in exchange for referring clients. The agreement was concealed from clients who were told that broker-dealers were selected on the basis of research.

FY 2003 Case:
One of the most significant cases in calendar year 2002 is the SEC’s settlement with five Wall Street firms for their failure to preserve electronic mail communications and/or to maintain them in an accessible place. Pursuant to a settlement with the government, the firms collectively were fined over $8 million and required to take certain steps to ensure their operations have come into compliance with their record-keeping obligations. In the Matter of Deutsche Bank Securities, Inc., Goldman Sachs & Co., Morgan Stanley & Co. Inc., Salomon Smith Barney Inc., and U.S. Bancorp Piper Jaffray Inc., Rels. No. 34-46937, Adm. Proc. No. 3-10957, (December 3, 2002). This case points up the importance of properly preserving books and records – including “newer” non-paper forms of communication such as e-mails and web pages. Advisers can expect SEC examiners to continue checking such record-keeping procedures as they perform their exams. The SEC’s 2002 Annual Report states that the examination cycle for advisers is now every 4.7 years, compared to 5.3 years in FY 2001.