SEC Targets Alleged Pricing Violations Inside this issue: SEC - - PDF document

SEC Targets Alleged Pricing Violations ................................... 1 SEC Continues Crackdown against Insider Trading .............. 2 SEC Enforcement Chief Makes Statement on Citigroup Case..... 2 Chairman Schapiro Outlines SEC’s Corporate Governance Regulation Agenda; Evaluates Recent Rulemaking ................... 3 Possible Changes from the Public Company Accounting Oversight Board......................................... 4 Money Market Funds Money Market Fund Regulation under the Dodd-Frank Act .................. 5 Future Regulation Uncertain for Money Market Funds..... 6

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Inside this issue: February 2012

SEC Targets Alleged Pricing Violations

The Securities and Exchange Commission’s (“SEC”) Enforcement Division made headlines this January by targeting, in two separate actions, pricing violations in mutual fund portfolios that occurred in 2008. In the first instance, the SEC fined and censured UBS Global Asset Management (“UBSGAM”) for allegedly not following established fair valuation procedures in pricing certain illiquid fixed-income securities in the portfolios

• f three UBSGAM mutual funds. The SEC alleged as follows. The funds’

Boards of Directors had established valuation methodologies and delegated implementation of those methodologies to UBSGAM, who in turn appointed its Global Valuation Committee (“Committee”) to carry out the valuation responsibilities pursuant to certain pricing hierarchies. Under the procedures, the Boards of Directors reviewed the Committee’s valuations and ratified or adjusted

• them. Among other things, the procedures provided that if the difference

between the purchase price and the valuation from a third party pricing source was 3% or more: (i) the purchase price was to be used for a maximum

• f five business days; (ii) UBSGAM was to issue a “price challenge”

requesting justification from the third party pricing source for the price quoted, and, if justified by the response, UBSGAM could use the pricing source price; and (iii) the Committee was to make a fair valuation determination if no resolution was reached by the end of five business days. According to the SEC order, 48 of 54 purchases of non-agency mortgage- backed securities in 2008 were valued upon purchase at prices substantially higher than the purchase prices – at least 100% higher in a majority of the cases, and in some cases 1,000% higher – using valuations provided by broker-dealers or third party pricing services. The SEC alleged that the valuations provided by these pricing sources in some cases were stale and did not seem to take into consideration the prices at which the funds had purchased the securities. The SEC further asserted that UBSGAM did not fair value the securities until the Committee met more than two weeks after it started receiving “price tolerance reports” triggering the procedure for greater than 3% discrepancies between the purchase prices and the prices provided by the third party pricing sources. Thus, according to the SEC, the procedures were not followed in that: (i) the securities were not valued at their purchase price, (ii) no price challenges were issued to the third party pricing sources for a majority of the securities on the “price tolerance reports” and, when only a handful of responses were received, there was no follow up, and (iii) no fair value determinations were made within the five business day deadline. Once the Committee did meet and fair valued the securities, they decided to fair value the securities at the midpoint between the purchase price and the pricing source quote pending receipt of responses to price challenges, which was later ratified by the Boards of Directors.

2 February 2012

As a result of these actions, according to the SEC, the NAVs of the funds were misstated between

• ne cent and 10 cents per share for several

days in June 2008. UBSGAM settled the charges without admitting or denying the SEC’s findings, and agreed to be censured and to pay a $300,000

• penalty. UBSGAM also consented to a cease-

and-desist order from committing or causing the same violations in the future. In the second proceeding, the SEC’s Enforcement Division alleged that the NAV of the Evergreen Ultra Short Opportunities Fund was materially

• verstated from at least March 2008 to early June

2008 due to the conduct of Lisa B. Premo, at the time the Fund’s lead portfolio manager and CIO of liquidity and structured solutions for Evergreen Investment Management Co. (“Evergreen”). Specifically, the SEC alleged that Premo failed to convey to either the Fund’s board or Evergreen’s valuation committee certain material information she possessed concerning the value of a collateralized debt obligation owned by the Fund that had experienced an event of default. Thus, the SEC asserts that Premo defrauded the Fund and breached her fiduciary duty to the Fund as its portfolio manager. A hearing will be scheduled to consider the allegations. These two proceedings demonstrate the Enforcement Division’s heightened scrutiny of mutual fund portfolio valuation and its focus on valuation practices during the height of the financial crisis in 2008.

SEC Continues Crackdown against Insider Trading

In a move that signals the SEC is still on the

• ffensive against alleged insider trading, on

January 18th the SEC charged seven individual hedge fund traders and analysts, and their respective firms, for allegedly making $78 million from trades based on nonpublic information about Dell, Inc. (“Dell”) and the Nvidia Corporation (“Nvidia”). The U.S. Attorney for the Southern District of New York has also brought criminal charges against the individual defendants. These claims stem from the SEC’s and the Justice Department’s continuing investigations into insider trading in the wake of the high-profile case against the Galleon Group and its founder, Raj Rajaratnam. In the SEC’s Dell and Nvidia case, the SEC alleges that the traders and analysts, each of whom worked for either Diamondback Capital Management LLC or Level Global Investors LP: 

• btained information from insiders at Dell,

regarding Dell’s quarterly earnings performance, and at Nvidia, regarding revenue figures and gross profit margins, in each case in advance of the issuer’s quarterly earnings announcements,  illegally tipped portfolio managers at their firms, which traded on the information, and  benefited their firms with ill-gotten gains in excess of $62.3 million on the basis of inside information about Dell and $15.3 million on the basis of information about Nvidia. The SEC has charged each of the defendants with violations of the federal anti-fraud provisions of Section 17(a) of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (“the Exchange Act”) and has charged each of the individual defendants with aiding and abetting others’ violations of the Exchange Act. The SEC is seeking a judgment

• rdering the defendants to disgorge all of their

illicit gains, with interest and penalties, and permanently enjoining them from future violations of these provisions.

SEC Enforcement Chief Makes Statement on Citigroup Case

The SEC recently found itself on the defensive regarding its established practice of settling enforcement actions without requiring the subject of the action to admit or deny

• wrongdoing. In a high-profile decision, in

November 2011, Judge Rakoff of the U.S. District Court for the Southern District of New York refused to accept a $285 million proposed SEC settlement with Citigroup over the sale of

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Investment Management Update

toxic mortgage securities on the grounds that the SEC’s policy, “hallowed by history, but not by reason,” deprives a reviewing court “of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.” In his decision, Judge Rakoff particularly challenged the settlement for letting Citigroup off the hook on negligence charges

• nly and without admitting anything, and what

he characterized as a penalty that was nothing more than a “modest cost of doing business.” The Director of the SEC’s Division of Enforcement, Robert Khuzami, recently espoused the SEC’s belief that the court committed legal error when it announced that the SEC’s allegations were “unsupported by any proven or acknowledged facts” and claimed the court’s “new and unprecedented standard . . . harms investors by depriving them of substantial, certain and immediate benefits.” The SEC defends its practice of settling cases without requiring an admission of wrongdoing because, the SEC contends, it benefits investors by preventing long, drawn-out trials, which carry the risk the SEC may either lose at trial or not recover as much as the proposed settlement

• amount. According to the Director, the SEC

carefully balances those risks and benefits, and maintains that “settling on favorable terms even without an admission serves investors, including investors victimized by other frauds” because permitting such settlements allows the SEC to more efficiently allocate its resources towards investigating more “frauds” without having to spend time litigating a case that could have been resolved without a trial. While careful to note that the SEC is “fully prepared to refuse to settle and proceed to trial when proposed settlements fail to achieve the right outcome for investors,” Mr. Khuzami contended that the new standards imposed by the district court would force the SEC to take more cases to trial, which would result in the SEC bringing fewer cases

• verall and returning less money to investors.

He added that the $285 million proposed settlement represented most of the total recovery the SEC could have expected to seek at trial and that an SEC settlement does not limit the ability of injured investors from pursuing private claims.

Chairman Schapiro Outlines SEC’s Corporate Governance Regulation Agenda; Evaluates Recent Rulemaking

Undeterred by the vacating of what it believed to be a vital tool in the advancement of corporate governance – the so-called proxy access rule – SEC Chairman Schapiro has indicated an intent to continue to work to improve the manner in which public companies communicate with their

• shareholders. Providing an indication of some

things to come from the SEC in 2012, Chairman Schapiro stated to an audience of policy-making European and American academics and corporate leaders that “economies broadly benefit as well- run companies flourish and grow” and that investors in those companies benefit in particular from “effective engagement” and insight into “management’s priorities.” She continued the theme of “effective engagement” throughout her speech, admitting that there is no exact formula for achieving it. According to the Chairman, the first priority of effective engagement is the accurate disclosure

• f material financial information. Here, the

Chairman acknowledged that the SEC is not short

• n regulatory requirements. The second

priority, and an area in which the SEC has found it difficult to prescribe effective improvements, is shareholder engagement. The Chairman noted that “shareholders should have a voice and a straightforward and transparent process for engaging with companies on issues that are important to them.” While she was careful to note that the SEC is not in the business of “determining the communications strategies of individual companies,” the Chairman remarked that the SEC is interested in “breaking down barriers that may prevent effective engagement, impact investor confidence and, ultimately, diminish financial performance to the detriment of shareholders.” With this foundation, the Chairman began a brief summary of the regulatory environment for corporate governance and a recent history of steps

4 February 2012

the SEC has taken to improve governance, including the ill-fated proxy access rule, which would have given shareholders the right to participate directly in the nomination of directors. She also commented briefly on proxy advisory firms and their role in the system. The Path Ahead Chairman Schapiro highlighted some initiatives the SEC intends to undertake over the coming year, namely, a review of beneficial ownership reporting rules and a renewed focus on proxy access, and took an opportunity to pat the SEC on the back for what she deems the emerging success

• f recent “say-on-pay” rules.

Beneficial Ownership Reporting. The Chairman noted that the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) provided the SEC with the authority to shorten the reporting periods with respect to beneficial

• wnership and to regulate ownership reporting

based on security-based swaps, and she suggested that 2012 is likely to be the year in which the SEC uses some of that authority. Proxy Access. The Chairman noted that, despite the fact that the proxy access rule was vacated, existing rules that allow certain shareholders to submit proposals for inclusion in a company’s proxy materials will still “increase shareholder access to the proxy ballot in key circumstances.” In addition, under various rule amendments, shareholders will be able to submit proposals for proxy access at their individual companies – known as “private ordering.” The Chairman feels that this is forward progress in the proxy process and a positive step toward enhanced shareholder engagement. Say-on-Pay. The last topic the Chairman touched

• n was so-called “say-on-pay,” a Dodd-Frank Act

requirement for companies to periodically give shareholders a non-binding advisory vote on the company’s executive compensation practices. These votes must take place at least once every three years, and a shareholder vote on the frequency of say-on-pay votes must take place at least once every six years. Even though shareholders have no binding authority to set compensation practices, the Chairman noted that: “[i]t has given shareholders a clear channel to communicate to the boards their satisfaction – or lack of satisfaction – with executive compensation practices . . . [a]nd it is giving boards a powerful incentive to clarify disclosure to shareholders, and to make a clear, coherent case for the compensation plans they have approved.” [emphasis added] The Chairman sees the say-on-pay rule as advancing shareholder engagement and corporate governance in general. She noted that companies are required to quickly report the results of the votes on Form 8-K, and proxy statements for the year following a vote will need to include an explanation of how the company responded to the most recent say-on-pay vote. The Chairman said companies are already beginning to file responsive proxy statements. What Now? In closing, the Chairman reiterated that the SEC is taking a varied approach in several different areas to improve company-shareholder communication and particularly “where [it] can increase the quality of communication and the level of responsiveness in the board-shareholder dialogue.” While it is probably too early to tell how effective the SEC’s actions have been, the Chairman believes they will bring “real benefits to investors, companies and the larger economy.”

Possible Changes from the Public Company Accounting Oversight Board

The Public Company Accounting Oversight Board (“PCAOB”), the Congressionally established entity in charge of overseeing public company audits, has recently explored several areas of interest, which, if acted upon, may significantly affect the audit process. These areas include: (1) possible changes to the auditor’s reporting model; (2) the possibility of mandatory audit firm rotation; and

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Investment Management Update

(3) standards on fair valuation, particularly when a third party is used. Auditor Reports On June 21, 2011, the PCAOB issued a concept release requesting information on possible revisions to PCAOB standards related to auditor’s

• reports. The PCAOB is concerned that auditors

have significant financial information about the companies they audit which is not covered by the standard auditor’s report and thus does not reach investors. The concept release discusses several alternatives that could be implemented to increase transparency and relevance in the auditor’s report. These alternatives are not mutually exclusive and include requiring (1) a supplement to the auditor’s report in which the auditor would provide additional information about the audit and the company’s financial statements, (2) the expanded use of “emphasis paragraphs” to highlight the most significant matters in the financial statements, (3) reporting on information

• utside the financial statements, and

(4) clarifying language to provide additional explanations about what an audit represents and the auditor’s responsibilities. All of the alternatives currently considered would retain the auditor’s “pass/fail” opinion on the financial statements while providing additional information. Auditor Independence The PCAOB issued a concept release on August 16, 2011 soliciting comments on ways to improve auditor independence. In particular, this concept release discusses whether the PCAOB should implement mandatory audit firm rotation, which would limit the number of consecutive years a firm could audit a company’s books and records. Similar proposals have been considered at various times since the 1970s, most recently in 2002 when Congress considered including it in the Sarbanes-Oxley legislation. Instead, Congress decided to require audit firms to rotate the partner in charge of a particular company’s audit every five years, even though the audit firm could remain the same. Supporters of mandatory audit firm rotation assert that the practice would improve auditor independence and objectivity. Opponents cite concerns about the increased costs and potentially reduced audit quality involved in getting a new audit firm up to speed. Fair Valuation Fair valuation continues to be an area of focus for the PCAOB. A Staff Audit Practice Alert issued December 6, 2011 highlights auditing fair value measurements as an ongoing concern. In addition, the PCAOB has formed the “Pricing Sources Task Force” to focus on fair valuation as a part of the PCAOB’s Standing Advisory Group. In particular, the Pricing Sources Task Force will study the use of third-party pricing sources.

Money Market Funds

Money Market Fund Regulation under the Dodd-Frank Act

Newly-appointed SEC Commissioner Daniel M. Gallagher recently addressed the conservative U.S. Chamber of Commerce regarding SEC reform after the Dodd-Frank Act. Of particular interest are his remarks on regulation of money market funds, which have been the subject of debate stemming from their possible status as so-called systemically important non-bank financial institutions (“SIFIs”), a responsibility of the Financial Stability Oversight Council (“FSOC”) under the new Dodd-Frank Act oversight structure. With regard to FSOC oversight and regulation in general, Commissioner Gallagher indicated that, in his view, “the framework for regulating SIFIs should allow for these firms to fail.” Moreover, in connection with money market fund regulation, he expressed his views that two key questions should be addressed before further regulating money market funds: first, identifying the specific risks or problems that need resolution and, second, having the necessary data to regulate meaningfully and effectively. With regard to the first point, he noted that the goal of the SEC is to prevent fraudulent and manipulative practices; it is not, as he put it, to

6 February 2012

ensure that investments are risk free. In his words, “in light of the extensive disclosures regarding the possibility of loss, money market funds should not be treated by investors or by regulators as providing the surety of federally insured demand deposits.” Moreover, in considering what risks are presented by money market funds that demand further regulation, Commissioner Gallagher noted that the SEC’s 2010 money market reforms have yet to be tested to understand whether they have adequately stemmed the problems that arose during the crisis of 2008. Dismissing those who “simply hand-wave and speak vaguely

• f addressing ‘systemic risk’ or some other kind
• f protean problem,” he stated that the “risks and

issues justifying a rulemaking must be specifically and thoughtfully defined in relation to the Commission’s mission.” Overall, he noted his “belief that any rulemaking in this space could be premature, and possibly unnecessary.” In any event, he shared his views on the “current proposals being bandied about.” He indicated that he is “hesitant” about any form of capital requirement, “whether it takes the form of a ‘buffer’ or of an actual capital requirement similar to those imposed on banks.” His reasoning was

• twofold. One, he believes that the “level of

capital that would be required to legitimately backstop the funds would effectively end the industry.” Moreover, he expressed his concern that a buffer “could simply create the illusion of protection, and further obscure the well- disclosed risk of investing in money market funds.” He noted that he feels somewhat positive about a stand-alone redemption fee, depending

• n the details. He noted that this “minimal

approach does not set up false expectations of capital protection, externalizes the costs of redemptions, and could be part of an orderly process to wind down funds when necessary.” It also, in his view, “may cause a healthy process of self-selection among investors that could cull out those more likely to ‘run’ in a time

• f stress.” Nevertheless, he would not approve
• f “grafting the [redemption] fee onto a capital

buffer regime,” which he believes “retains all the problems of any capital solution, unless something significant is done to manage investor expectations regarding the level of protection provided.” With regard to a floating NAV, he believes it is “an important option to keep on the table and to subject to further study and consideration.” Overall, however, Commissioner Gallagher believes “the option of doing nothing until we have seriously analyzed the impact of last year’s reforms must be given serious consideration.”

Future Regulation Uncertain for Money Market Funds

In a November 2011 speech to the Securities Industry and Financial Markets Association (“SIFMA”), SEC Chairman Mary Schapiro revealed that the SEC expects to introduce a proposal that would overhaul regulation of the money market fund (“MMF”) industry. Plans for the proposal come despite recent reforms in 2010 to improve the daily and weekly liquidity of MMFs, as the SEC has experienced increased pressure to safeguard the industry amid the

• ngoing financial crisis in Europe and increased

fears of a potential run on MMFs. According to Chairman Schapiro, the proposal would establish a capital buffer designed to provide MMFs with a source of capital to cover potential losses in an emergency, potentially combined with redemption restrictions to further avoid a run on MMFs. She alternatively proposed that MMFs use floating net asset values instead of artificially maintaining a constant $1 price. Chairman Schapiro indicated that the proposal, expected by the end of the first quarter of 2012, will be designed to prevent MMFs from “breaking the buck” as had happened during the 2008 financial crisis. The proposal, however, faces staunch opposition from the MMF industry, members of Congress and various corporate groups, as well as resistance from within the SEC. In a letter to Chairman Schapiro in January 2012, twenty-three large and well-known corporations and business

• rganizations expressed their view that no

additional MMF reforms are required beyond those implemented in 2010. The letter asserted

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Investment Management Update

that MMFs purchase over one-third of commercial paper issued by U.S. companies, which provides significant support to corporate credit markets. The organizations fear that the changes contemplated by the proposal would have substantial negative consequences on the ability of U.S. businesses to raise the capital required to restore economic stability and spark job creation. Currently, the exact form that the proposal will take is not known. The SEC may move directly to issuing a proposed rule and seek comments from the industry. Or it may opt for a more deliberate approach and publish a “concept” release to solicit the public’s views on this matter to better evaluate the need for future rulemaking. In the meantime, the industry and other interested parties will have to stay tuned as these interesting developments unfold.