978-1285428222 Chapter 18 Lecture Note Part 3

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Add. Case: Jones v. Harris Assoc. (7th Cir., 2009)–Harris Associates advises the Oakmark

mutual funds. Plaintiffs, who own shares of Oakmark, contend that the fees paid by Oakmark to

Harris are too high and thereby violate the Investment Company Act of 1940. Plaintiffs

requested that Harris be required to return investment advisor fees to Oakmark. The district

court granted summary judgment for Harris; plaintiffs appealed.

Decision: Affirmed. Plaintiffs had no right to bring the suit. Oakmont had to be a party to the

action against the investment advisor under the Investment Company Act. It would have to claim

that the compensation paid to Harris was too high for the court to have jurisdiction. As a matter

Limiting Conflicts of Interest—At least 40% of the board of directors of an investment company

must be outsiders—that is, persons with no direct business relationship with the firm or the

firm’s officers. Outside directors help limit the possibility of conflicts of interest within the firm.

Investment companies may not use funds people have invested with them to “do deals” with

persons connected to the firm. A number of firms have also started, on their own, to limit trading

by their analysts in the stocks that analysts are responsible for tracking for the company and its

customers.

Investment Advisers—Investment advisers manage the assets of investment companies. Assets

are oftentimes extremely large (billions of dollars). Registered investment advisers manage the

funds of pensions and insurance/bank portfolios. Investment advisers typically receive 0.5% of

the net assets of the funds they manage as yearly compensation.

THE INVESTMENT ADVISERS ACT—This regulates professionals who work in the

securities industries, investing in, purchasing, selling, or managing portfolios of securities.

Brokers and Dealers—Brokers are persons who buy and sell securities for other peoples’

accounts. Dealers are persons who buy and sell securities for their own accounts. Brokers,

dealers and investment advisers must register with the SEC.

Professional Responsibility to Clients—Securities professionals must avoid conflicts-of-interest

in their professional dealings. They owe a fiduciary duty to their clients and may not charge

clients excessive (over 5% normally) markups on transactions. The focus of the SEC is on

making sure investors are given adequate information about available securities. Securities

professionals may not churn—that is, buy and sell excessively in order to earn large

commissions. They may not scalp—that is, buy stocks for themselves, then urge clients to buy

the same stock so the professional may profit from subsequent price rises. They must also

provide clients with adequate information to make informed investment decisions. Failure to do

so may result in securities fraud charges.

Add. Info.: Small Advisers—Advisers managing less than $25 million in assets are rarely

subject to regulation. As of 2011, advisers managing between $25 and $100 million will be

subject to state regulation, which is generally more extensive than SEC review, which rarely

inspects firms. Many states have a more active inspection program.

Add. Case: Rizek v. SEC (1st Cir., 2000)–Rizek was VP of PaineWebber. In 1993 he churned the

accounts of five customers, causing losses of $200,000 on accounts with average balances of

$700,000. The customers had all asked for conservative investment strategies; the opposite of

what Rizek did. The SEC ordered Rizek, in addition to paying a civil penalty of $100,000, and

disgorging over $120,000, be barred from the securities industry. The SEC admin. law judge had

recommended only a two-year suspension from the industry. Rizek appealed, contending that a

permanent bar is arbitrary and capricious, is improperly punitive, and is not meant to protect

the public.

Decision: Affirmed. A sanction ordered by the SEC must be upheld unless the order is a “gross

abuse of discretion.” The SEC has the authority to order a permanent bar (which may be lifted)

from the securities industry if it finds such a bar “is in the public interest.” Rizek knew what he

was doing when he churned the accounts in violation of the trust given him by his clients. He

tried to conceal his activities from his firm. He acted willfully and recklessly. The SEC did not

abuse its discretion.

Add. Case: Lewis v. Fresne (5th Cir., 2001)–Lewis was a customer of Bear Stearns brokerage

house. His broker, Fresne, tried to interest him in buying stock in a private placement for a

start-up ice cream retailer. Lewis declined to buy stock, but loaned $650,000 for 90 days to the

business promoter. The business collapsed and went into bankruptcy before a stock offering was

made. The loan was never repaid. Lewis sued his stockbroker for securities fraud, contending he

gave him misleading information about the business, which induced him to make the loan. The

court dismissed the suit, holding that the loan was not a security. Lewis appealed.

Decision: Affirmed in part and reversed in part. The loan was a private transaction outside the

scope of the Securities Act governing the sale of securities. Lewis has no cause of action against

Add. Info.: In practice, there is little direct oversight of investment advisers. The SEC examines

only about 9% of the advisers annually. Broker-dealers are subject to much more frequent SEC

inspection—on average, every other year. FINRA has been proposed as an alternative examiner

of advisers, but industry trade groups have resisted that suggestion.

STOCK MARKET REGULATION—The New York Stock Exchange is a self-regulating

organization that handles trillions of dollars of public stock market transactions that occur in the

U.S. The volume and value of such transactions has increased rapidly over the past decade and is

likely to continue to grow as trading becomes more international.

Self-Regulation of Securities Markets—Private associations of securities professionals

establish rules of behavior for members, under the 1934 Act. The SEC monitors the exchanges

and the rules they impose on their members, including NYSE, AMEX and NASDAQ.

Rules for Exchange Members—Each stock exchange develops and enforces rules of behavior for

its members. Rules specify how securities may be listed, how prices are set, who may handle

transactions, etc. These rules codify a great deal of the mechanics of a securities professionals’

business. The over-the-counter market is composed of dealers who may or may not be members

of another exchange. The market generally handles stock of small firms or the stock of larger

firms that have only a small amount of stock outstanding. The Financial Industry Regulatory

Authority (FINRA), an independent authority (formerly NASD), governs the OTC market; the

SEC monitors FINRA rules.

Liability and Penalties—Persons who violate the rules of the securities markets/organizations

may face suspension of their privileges or expulsion from the organization. An exchange that

knowingly disregards the wrongdoing of a member may itself be liable for the harms caused by

the member. Exchanges do, therefore, have significant incentives to monitor the behavior of their

members.

Add. Case: MFS Securities Corp. v. NYSE (2nd Cir., 2002)–MFS was alleged to have engaged

in stock flipping –– buying or selling security for a customer followed by the sale or purchase of

the same security for a profit of one-eighth of a point, the spread between bid and ask prices, so

as to collect that profit, plus charge the customer a commission on the transaction. Under the

securities laws, it is illegal for floor brokers to trade on an exchange for their own accounts or

for accounts in which they have an interest. MFS had charges filed against it by the SEC. The

same day, the NYSE expelled MFS from NYSE membership and revoked its trading privileges.

MFS sued, contending that it did not receive a hearing before the NYSE, in violation of NYSE

rules.

Decision: MFS must seek administrative review before the SEC before suing the NYSE. Once the

SEC has reviewed the matter, then the decision may be appealed. The securities law, which gives

the exchanges substantial authority to regulate their own conduct and that of their members,

Regulation of Securities Transactions—The SEC, along with FINRA, regulates the behavior of

securities professionals. They are prohibited from using their position to benefit personally. On

and off-floor trading is strictly limited to registered experts. Specialist firms, which handle

securities transactions for brokers, are also prohibited from exploiting their positions for their

own good.

Add. Info: Margin requirements—The Federal Reserve sets the margin requirements for stocks

that are bought on credit. There is a list of approved stocks (generally stocks on major

exchanges) that may be bought on credit; the requirement is usually that no more than 50% of

the stock may be financed.

Arbitration of Disputes—Most persons who have trading accounts with stock brokers or

investment firms sign contracts stating that in the event of a dispute between the investor and the

firm, the parties will arbitrate their dispute, rather than resorting to litigation. The investor must

be made aware of this provision before establishing an account with a firm. In arbitration,

arbitration boards composed of one securities professional and two members of the public follow

SEC rules and regulations to decide cases. The Supreme Court has affirmed that arbitral

decisions are binding. Benefits of arbitration include more speedy resolution of conflicts and

greater predictability of results. Arbitration is widely used.

Add. Info: From 2002 through 2004, there were an average of 8,000 NASD (FINRA) securities

arbitration cases per year. Investors won 55% of the cases. Because securities professionals are

believed to play too strong a role in the arbitrations, changes to the process are under

consideration to reduce likelihood of favoritism.

Add. Info: Arbitration: The courts strongly uphold arbitration clauses. In Olde Discount v.

Tupman (3rd Cir., 1993) the court held that a state securities commissioner could not intervene

in a complaint against a stock broker that was brought by a customer who has entered into an

account agreement containing an arbitration clause. The arbitration procedure pre-empted state

regulatory intervention because the Federal Arbitration Act, together with the contract calling

for arbitration, controls the manner of resolving the dispute.

Add. Case: Pfannenstiel v. Merrill Lynch (10th Cir., 2007)–Pfannenstiel complained to

Merrill Lynch that it made accounting mistakes in his account. ML denied there were mistakes.

After five years of complaining, Pfannenstiel submitted his claim to a three-member panel of

NASD (now FINRA), requesting $217,785 plus damages. The terms of his account required

disputes to go to NASD arbitration. Pfannenstiel’s claim was denied. He then claimed to have

new evidence but that NASD representatives lost it after he gave it to them. He then sued ML on

his original claim of accounting errors and sued the NASD, requesting that the arbitration ruling

be vacated and that NASD be held liable for his alleged losses. The district court dismissed the

complaint, holding that NASD was protected by arbitral immunity. Pfannenstiel appealed.

Decision: Affirmed. The doctrine of arbitral immunity generally rests on the notion that arbitrators acting within

their quasi-judicial duties are the functional equivalent of judges. The NASD is entitled to arbitral immunity against

Dodd-Frank Wall Street Reform and Consumer Protection Act—The Dodd-Frank Act,

passed in 2010, will take some time to come into effect in practice as the regulatory scheme is

fleshed out under the law. Focus is on oversight of existing markets, not on issuance of new

securities. Regulators are instructed to watch for “systemic risk”—massive potential risk such as

from the securities based on weak mortgages that triggered the financial meltdown in 2007-08.

The trading of derivatives and other exotic instruments will face more regulation.

Securities Scams—It is useful to distinguish for students the difference between scams that are

intended to fleece victims of their money versus mistakes in judgment in the risk of securities.

Scam artists often go through the motion of compliance with federal and state regulation, but

since they falsify many things, without thorough audits, are unlikely to be uncovered. Given the

huge number of investment advisors out there, detailed oversight will never be possible, so

investors are more on their own than many like to think.

Discussion Question

The purchasers of registered and unregistered securities have the protection of common law

fraud rules. If an investment is not a security, so that it does not have to be registered, then the

securities laws do not apply. Common law fraud always applied and, in some cases, there may be

mail fraud, FTC deception, or other law violations. Some fraud artists get nailed by the IRS

because most do not report all their ill gotten gains (there is usually almost nothing left for the

defrauded investors).

Securities fraud is established by Rule 10b-5, which allows successful suits to be brought for

securities fraud that may not meet the standard of common law fraud. Rule 10b-5 is stricter in the

sense that it is easier to be convicted of securities fraud than it is to be convicted of common law

fraud. A suit brought and won under common law fraud is a stronger suit than one that is brought

under Rule 10b-5. A common law fraud suit that is won can recover punitive damages as well as

actual damages. Under Rule 10b-5 only actual damages may be recovered.

Case Questions

1. (answer on Internet for students) The Court said that just because the shares sold in this

housing cooperative were called “stock,” the law looks to the reality of the situation, not the

word that is used in a non-legal manner. There was no evidence of an intent in this case to

2. The district court granted defendants a directed verdict on the securities fraud claims, but this

was reversed by the appeals court. Whether lifetime partnerships (LTPs) could be considered

“securities” was a question for the jury to decide. As the Supreme Court noted in the Forman

decision (last question). “when a purchaser is motivated by a desire to use or consume the item

3. (answer on Internet for students) The accounting firm Ernst & Ernst had audited the books of

a Chicago investment firm for twenty years. Those audits were prepared for filing with the SEC

under the annual report required of investment housing. The accountants never discovered that

The Supreme Court held that the accounting firm was not responsible. The Court held that for

there to be securities fraud under the securities law, there must be scienter. There was no

4. No. “Forward-looking representations are … immaterial when the defendant has provided the

investing public with sufficiently specific risk disclosures or other cautionary statements

concerning the subject matter of the statements at issue to nullify any potentially misleading

5. (answer on Internet for students) District court granted summary judgment for the insiders,

which was reversed on appeal. The appeals court noted that economic forecasts and predictions

may for the basis of securities fraud action, even when such statements are couched in cautionary

6. Reversed. Under the Howey test, these are investment contracts, given how they were

marketed to the public. It does not matter if the promoter presents the enterprise as a serious

7. (answer on Internet for students) Affirmed. The case is subject to the Private Securities

Litigation Reform Act (PSLRA) which was designed “to curb abuse in private securities

lawsuits.” The Act mandates a more stringent pleading standard for securities fraud actions,

especially for scienter requirements. Other courts agree that “plaintiffs can adequately plead

8. The SEC was correct that Gebhart could be barred for life. He acted recklessly, making false

statements promoting the security when he had no basis for doing so. As a professional, he could

not rely on the word of a friend, so there was scienter present and securities fraud existed. He did

Ethics Question

You might be foolish not to exploit the information to your advantage and there would be

nothing unethical about it. It clearly would not violate the rules against insider trading since you

were a bystander who picked up the information—not one of the executives. If you do not earn

the profits someone else will and there is nothing to say that they deserve it more than you. If

Internet Assignment

Securities and Exchange Commission:

www.sec.gov/

Financial Industry Regulatory Authority (FINRA), www.finra.org/

Investopedia: www.investopedia.com/

The Securities and Exchange Commission Web site provides access not only to SEC rules, but to

company filings in the EDGAR database. FINRA’s Web site provides information about the

largest private regulatory authority in the securities area. Investopedia is the most comprehensive

online financial dictionary as well as being an educational resource for investors. It, too, features

much information related to the securities markets.