VERDICT RETURNED AGAINST INVESTMENT ADVISER IN FRAUD CASE

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

Jury Returns Verdict Against Massachusetts Investment Adviser in SEC Fraud Case

The Securities and Exchange Commission announced that, on August 13, 2014, a federal court jury in Boston, Massachusetts, returned a verdict against registered investment adviser Sage Advisory Group, LLC, and its principal, Benjamin Lee Grant, both of Boston, MA, in a fraud case filed by the SEC.

In its complaint, filed on September 29, 2010, the Commission alleged that starting on or about October 4, 2005, Grant engaged in a scheme to induce his former brokerage customers to transfer their assets to Sage, his new advisory firm.

The Commission's complaint further alleged that prior to October 2005, Grant was a registered representative of broker-dealer Wedbush Morgan Securities and had customer accounts representing approximately $100 million in assets, virtually all of which were managed by California-based investment adviser First Wilshire Securities Management. According to the complaint, Grant resigned from Wedbush on September 30, 2005 so that he could operate Sage, his own investment advisory firm. In a letter dated October 4, 2005, Grant told his former Wedbush customers that, at the suggestion of First Wilshire, their accounts were being moved from Wedbush to a discount broker and that Sage had been formed to handle their investments. The complaint alleged that the letter told Grant's customers that the charge for their accounts was changing from a 1% management fee paid to First Wilshire plus Wedbush's brokerage commissions to a 2% "wrap fee" paid to Sage, and that First Wilshire had indicated that the wrap fee had been historically less expensive than the previous arrangement. According to the complaint, the letter also told Grant's customers that if they wanted to avoid any disruption in First Wilshire's management of their assets, they had to sign and return the new advisory and custodial account documents as soon as possible. According to the complaint, in subsequent communication with customers, Grant told them that First Wilshire was no longer willing to manage their assets at Wedbush and that they had to transfer to the discount broker and sign up with Sage.

The Commission contended that these statements were materially false and misleading because First Wilshire had not required a transfer from Wedbush, had not refused to continue managing the customers' assets at Wedbush, and had not authorized Grant's statements. Moreover, Grant's wrap fee statements were without factual basis. The complaint further alleged that Grant failed to disclose that the switch from Wedbush to the discount broker would result in significant savings that would flow to Grant and Sage rather than to the advisory clients and that, as a result, Grant and Sage's compensation would be substantially increased. Indeed, once Grant's customers transferred their accounts from Wedbush to Sage, Grant more than doubled his own compensation.

After a trial that began on August 4, 2014, the jury deliberated for approximately two hours before rendering its verdict of liability against both defendants under Sections 204A and 206(1), (2), and (4) of the Investment Advisers Act of 1940 and Rules 204A-1 and 206(4)-7 thereunder. The Court will later determine whether and what relief to impose against the defendants. The case was tried by Marc Jones and J.R. Drabick, with assistance from Stephanie DeSisto and Frank Huntington, of the Commission's Boston Regional Office.

For further information, see Litigation Release No. 21672 (September 29, 2010).

On September 1, 2011, the Commission filed a separate civil injunctive action against Sage, Benjamin Lee Grant, and his father Jack Grant alleging that Jack Grant, a lawyer and former stockbroker, had violated a Commission bar from association with investment advisers by associating with his son Benjamin Lee Grant's investment advisory firm, Sage, and by acting as an investment adviser himself. The Complaint further alleged that Jack Grant, Benjamin Lee Grant and Sage fraudulently failed to disclose Jack Grant's barred status and disciplinary history to Sage's advisory clients. On May 30, 2013, Jack Grant consented to settle the charges, but the action against Sage and Lee Grant is still pending and a trial date is to be determined. For further information, see Litigation Release No. 22081 (September 1, 2011) (SEC Charges Massachusetts-Based Attorney for Violating an Investment Adviser Bar and his Son for Failing to Disclose his Father's Bar to Advisory Clients); and Litigation Release No. 22708 (May 30, 2013) (SEC Obtains Final Judgment and Issues Administrative Orders against John A. ("Jack") Grant).

SEC COMMISSIONER AGUILAR'S DISSENTING STATEMENT REGARDING CPA PUNISHMENT

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION

Dissenting Statement In the Matter of Lynn R. Blodgett and Kevin R. Kyser, CPA, Respondents

Commissioner Luis A. Aguilar

Aug. 28, 2014

During my tenure, I have been a strong supporter of the SEC’s Enforcement program.  I have advocated for an effective Enforcement program by focusing on individual accountability, effective sanctions that deter and punish egregious misconduct, and policies designed to eradicate recidivism.[1]  The importance of a strong and robust Enforcement program cannot be overstated.  It is a vital component of an effective capital market on which investors can rely.  Much of the agency’s enforcement decisions are to be commended.  However, I am obligated to speak out when it appears that the agency falters.

Accordingly, I respectfully dissent from the Commission’s Order accepting the settlement offer of Kevin R. Kyser, a Certified Public Accountant and former Chief Financial Officer (“CFO”) of Affiliated Computer Services, Inc. (“ACS” or “Company”). 

Given the egregious conduct that Mr. Kyser engaged in at ACS, the Commission’s settlement, which lacks fraud charges or a timeout in the form of a Rule 102(e) suspension, is a wrist slap at best.   

First, let’s discuss the improper accounting at issue here.  As the Commission’s Order[2]states, ACS violated generally accepted accounting principles (“GAAP”) by inserting itself into pre-existing sales transactions between a manufacturer and a reseller for the primary purpose of booking revenues from those transactions.[3]  Thus, the Company’s involvement in those transactions had no economic substance.[4]  ACS’s misconduct enabled it to improperly report approximately $125 million in revenues,[5] and, crucially, gave the misleading impression that it had met its internal revenue growth guidance.[6]  ACS failed to disclose the true nature of these improper transactions,[7] and falsely reported its internal revenue growth in public filings.[8]

Second, let’s discuss how Mr. Kyser, in his critical role as CFO, facilitated ACS’s misconduct.  As described in the Commission’s own Order, Mr. Kyser:

• Understood that ACS had inserted itself into these pre-existing transactions and that they would impact ACS’s reported revenue growth;[9]
• Was responsible for the content of ACS’s false and misleading public filings with the Commission, earnings releases, and analyst conference calls;[10]
• Highlighted ACS’s false and misleading internal revenue growth in earnings releases and analyst conference calls;[11]
• Failed to ensure that ACS adequately disclosed and described the significance of these transactions in ACS’s public filings and analyst conference calls;[12]
• Signed false certifications in connection with the Company’s periodic filings;[13] and
• Received an inflated bonus based on ACS’s financial performance that was overstated by 43%.[14]

Accountants—especially CPAs—serve as gatekeepers in our securities markets.  They play an important role in maintaining investor confidence and fostering fair and efficient markets.  When they serve as officers of public companies, they take on an even greater responsibility by virtue of holding a position of public trust.  To this end, when these accountants engage in fraudulent misconduct, the Commission must be willing to charge fraud and must not hesitate to suspend the accountant from appearing or practicing before the Commission.  This is true regardless of whether the fraudulent misconduct involves scienter.

The Commission instead chose to charge Mr. Kyser with limited, narrow non-fraud charges, comprising of violations of the books and records, internal controls, reporting, and certification provisions of the federal securities laws.  In the past, respondents with the same state of mind and similar type of misconduct as Mr. Kyser have been charged with violations of the antifraud provisions of the Securities Act, in particular, Sections 17(a)(2) and/or (3), as well as the books and record and internal control violations.[15]

In addition, where CPAs engage in this type of egregious securities fraud—especially misconduct that relates to the CPAs’ core expertise of financial reporting—the Commission has rightly required such persons to forfeit their privilege to appear and practice before the Commission by imposing a suspension under Rule 102(e) of the Commission’s Rules of Practice.[16]  

Beyond this particular matter, I am concerned that the Commission is entering into a practice of accepting settlements without appropriately charging fraud and imposing Rule 102(e) suspensions against accountants in financial reporting and disclosure cases.  I am also concerned that this reflects a lack of conviction to charge what the facts warrant and to bring appropriate remedies. 

The statistics on financial reporting and disclosure cases and related Rule 102(e) suspensions reflect a troubling trend.  In fiscal year 2010, the Commission brought 117 financial reporting and disclosure cases against issuers and individuals, and imposed Rule 102(e) suspensions in 54% of those cases.[17]  In 2011, the number of financial reporting and disclosure cases against issuers and individuals brought by the Commission fell to 86, and the Commission imposed Rule 102(e) suspensions in 53% of those cases.[18]  In 2012, again the number of similar cases brought by the Commission fell, this time to 76, and the Commission imposed Rule 102(e) suspensions in 49% of those cases.[19]  In 2013, the Commission brought only 68 similar cases, and imposed Rule 102(e) suspensions in only 41% of those cases.[20]  These declining numbers reveal a departure from the Commission’s efforts to keep bad apples out of the securities industry, and this puts investors and the integrity of the Commission’s processes at grave risk.

In my six years as a Commissioner, I have watched defendants fight charging decisions on all fronts, including fighting tooth-and-nail to avoid being suspended from appearing or practicing before the Commission pursuant to Rule 102(e).  This is to be expected, as a suspension order takes a fraudster out of the industry, and often has a far more lasting impact on the fraudster than the imposition of a monetary fine.[21]

A Rule 102(e) suspension is an appropriate sanction to be imposed when people choose to engage in deception and perpetuate fraud—in other words, when people engage in flagrant, harmful misconduct.  Thus, to avoid sanctions under Rule 102(e), defendants strenuously object to scienter-based and non-scienter-based fraud charges[22] (as opposed to lesser charges, such as books and records or internal control violations).  That is to be expected. 

What is not to be expected is when defendants engage in fraud and the Commission affirmatively accepts a weak settlement with lesser charges.  This leaves the investing public significantly at risk, as bad actors are not appropriately charged or sanctioned and are permitted to continue to operate in the securities industry.  This is completely unacceptable.

I am concerned that this case is emblematic of a broader trend at the Commission where fraud charges—particularly non-scienter fraud charges—are warranted, but instead are downgraded to books and records and internal control charges.  This practice often results in individuals who willingly engaged in fraudulent misconduct retaining their ability to appear and practice before the Commission. 

I fear that cases in the future will continue to be weak.  More specifically, I fear that when the staff determines not to seek a Rule 102(e) suspension, it will also forgo bringing fraud charges.  Likewise, I am concerned that Commission Orders may, at times, be purposely vague and/or incomplete, and written in a way so as to lead the public to conclude that no fraud had occurred.  When this happens, the public is denied a full accounting and appreciation of the egregious nature of a defendant’s misconduct.  In addition, this practice muzzles my voice by not allowing any statement by me (including this dissent) to include a fulsome description of facts that support the view that the Commission should have brought fraud charges.[23]  This adversely impacts my ability as a Commissioner to provide the American public honest and transparent information—including a description of facts discovered by the staff during its investigation.  In the end, these behind-the-curtain decisions can make fraudulent behavior appear to be an honest mistake.

In my view, Mr. Kyser’s egregious misconduct violated, at a minimum, the non-scienter-based antifraud provisions of the Securities Act.  Accordingly, charges under Sections 17(a)(2) and/or (3) are warranted and a Rule 102(e) suspension is necessary and appropriate in this case.

The Commission must send a strong and consistent message to the industry that the Commission takes seriously its responsibility of requiring integrity in the financial markets.  For these reasons, I dissent.

---

[1] See, for example, Commissioner Luis A. Aguilar: A Stronger Enforcement Program to Enhance Investor Protection (Oct. 25, 2013), available at http://www.sec.gov/News/Speech/Detail/Speech/1370540071677; Taking a No-Nonsense Approach to Enforcing the Federal Securities Laws (Oct. 18, 2012), available athttp://www.sec.gov/News/Speech/Detail/Speech/1365171491510; Combating Securities Fraud at Home and Abroad” (May 28, 2009), available athttp://www.sec.gov/news/speech/2009/spch052809laa.htm;   Reinvigorating the Enforcement Program to Restore Investor Confidence (Mar. 18, 2009), available at http://www.sec.gov/news/speech/2009/spch031809laa.htm; Empowering the Markets Watchdog to Effect Real Results (Jan. 10, 2009), available athttp://www.sec.gov/news/speech/2009/spch011009laa.htm.  

[2] Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order, Securities Exchange Act of 1934 Release No. 72938, Accounting and Auditing Enforcement Release No. 3578, Administrative Proceeding File No. 3-16045 (Aug. 28, 2014) (hereinafter “Order”), available at http://www.sec.gov/litigation/admin/2014/34-72938.pdf.

[3] “At or near the end of each quarter ended September 30, 2008 through the quarter ended June 30, 2009, Affiliated Computer Services (“ACS”) arranged for an equipment manufacturer to re-direct through its pre-existing orders through ACS, which gave the appearance that ACS was involved.”  Order at p. 2.  “ACS improperly applied GAAP in determining the amount of revenue to report in each of its quarters in FY 2009.  In making a determination of the amount of revenue to report, ACS did not appropriately take into account all of the critical terms of the arrangement and therefore failed to reflect the lack of economic substance of the ‘resale transactions’ under GAAP.”  Order at p. 4.  See also SEC Press Release, “SEC Charges Two Information Technology Executives With Mischaracterizing Resale Transactions to Increase Revenue” (Aug. 28, 2014) (hereinafter “Press Release”),available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370542786775 (“The Securities and Exchange Commission today charged two executives at a Dallas-based information technology company with mischaracterizing an arrangement with an equipment manufacturer to purport that it was conducting so-called “resale transactions” to inflate the company’s reported revenue.”).

[4] “ACS, however, had no substantive involvement in the orders, and there were no changes to the terms of the pre-existing orders.”  Order at p. 2.  “In making a determination of the amount of revenue to report, ACS did not appropriately take into account all of the critical terms of the arrangement and therefore failed to reflect the lack of economic substance of the ‘resale transactions’ under GAAP.”  Order at p. 4.    

[5] “ACS improperly reported approximately $125 million in revenue due to such arrangements.”  Order at p. 2.  “In total, ACS reported revenue of $124.5 million from such arrangements during fiscal 2009. …  In making a determination of the amount of revenue to report, ACS did not appropriately take into account all of the critical terms of the arrangement and therefore failed to reflect the lack of economic substance of the ‘resale transactions’ under GAAP.  In addition, ACS’s internal controls were insufficient to provide reasonable assurance that ACS reported revenues in conformity with GAAP, primarily because ACS failed to appropriately evaluate the economic substance of the ‘resale transactions.’”  Order at p. 4.

[6] “The revenue from these ‘resale transactions’ enabled ACS to meet its publicly disclosed internal revenue growth (“IRG”) guidance for three of the four quarters for that fiscal year.”  Order at p. 4.

[7] “Even though the ‘resale transactions’ were the largest contributors to ACS’s internal revenue growth, ACS did not disclose them in its September 30, 2008 Form 10-Q.  In subsequent quarters, ACS disclosed these transactions as ‘information technology outsourcing related to deliveries of hardware and software.’  This description did not accurately disclose the nature of these transactions, and falsely suggested that they were executed as part of existing ACS outsourcing contracts.”  Order at p. 4.

[8] “As a result, ACS falsely reported its internal revenue growth, which Blodgett and Kyser highlighted in earnings releases and analyst conference calls during the period.”  Order at p. 2.

[9] “Blodgett and Kyser understood the origination of these ‘resale transactions’ and their impact on ACS’s reported revenue growth.”  Order at p. 5.  See also Press Release, supranote 3 (“ACS positioned itself in the middle of pre-existing transactions without adding value, but still improperly reported the revenue.  Blodgett and Kyser knew the truth about these deals, and they were responsible for ensuring that ACS accurately disclosed the full story to investors.”) (quoting David R. Woodcock, Director of the SEC’s Fort Worth Regional Office and Chair of the SEC’s Financial Reporting and Audit Task Force).

[10] “During all relevant periods, Respondents Blodgett and Kyser were, respectively, ACS’s chief executive officer and chief financial officer.  As such, they were responsible for the content of ACS’s filings with the Commission, as well as ACS’s earnings releases and analyst conference calls.”  Order at p. 2.

[11] “As a result, ACS falsely reported its internal revenue growth, which Blodgett and Kyser highlighted in earnings releases and analyst conference calls during the period.”  Order at p. 2.

[12] “Blodgett and Kyser understood the origination of these ‘resale transactions’ and their impact on ACS’s reported revenue growth.  However, Blodgett and Kyser did not ensure that ACS adequately described their significance in ACS’s public filings and on analyst calls.”  Order at p. 5. 

[13] “Blodgett and Kyser certified each of ACS’s fiscal year 2009 Forms 10-Q and 10-K.”  Order at p. 5.

[14] “As a result of the improperly reported revenue, Blodgett and Kyser received bonuses based on fiscal 2009 performance that were 43% higher than they would have received if ACS had properly applied GAAP with respect to determining the amount of revenue to report from the resale transactions.”  Order at p. 5.

[15] It has long been held that the second and third subsections of Section 17(a) of the Securities Act, Sections 17(a)(2) and (3), can be satisfied by proof of negligence, rather than scienter as is necessary for Section 17(a)(1) of the Securities Act.  See Aaron v. SEC, 446 U.S. 680, 697 (1980) (stating that “It is our view, in sum, that the language of §17 (a) requires scienter under § 17 (a)(1), but not under § 17 (a)(2) or § 17 (a)(3).”).  For examples of accountants found to have negligently violated the federal securities laws and charged with violations of Securities Act Sections 17(a)(2) and (3), see e.g., In the Matter of Fifth Third Bank and Daniel Poston, Securities Act Release No. 9490 (Dec. 4, 2013) (Misclassification of loans; imposing a Rule 102(e) suspension on a CFO in a matter in which the individual was charged with violations of Sections 17(a)(2) and (3) of the Securities Act), available athttp://www.sec.gov/litigation/admin/2013/33-9490.pdf; In the Matter of Craig On (CPA), Exchange Act Release No. 66051 (Dec. 23, 2011) (Understated loan losses; imposing a Rule 102(e) suspension on a CFO in a matter in which the individual was charged with, among other things, violations of Sections 17(a)(2) and (3) of the Securities Act), available athttp://www.sec.gov/litigation/admin/2011/34-66051.pdf; In the Matter of Larry E. Hulse, CPA, Exchange Act Release No. 62589 (July 29, 2010) (Improper reserve adjustments; imposing a Rule 102(e) suspension on Sunrise Senior Living, Inc.’s CFO in a matter in which the individual was charged with violations of Sections 17(a)(2) and (3) of the Securities Act),available at http://www.sec.gov/litigation/admin/2010/34-62589.pdf; In the Matter of Lawrence Collins, CPA, Exchange Act Release No. 64808 (July 5, 2011) (Improper revenue reporting; imposing a Rule 102(e) suspension in a matter in which a finance division employee was charged with violations of Sections 17(a)(2) and (3) of the Securities Act),available at http://www.sec.gov/litigation/admin/2011/34-64808.pdf; In the Matter of Gregory Pasko, CPA, Exchange Act Release No. 61149 (Dec. 10, 2009) (Earnings management; imposing a Rule 102(e) suspension on the Director of External Reporting at SafeNet, Inc. after he was charged with non-scienter-based violations of the antifraud (Sections 17(a)(2) and (3) of the Securities Act), books and records and internal controls violations of the federal securities laws), available at http://www.sec.gov/litigation/admin/2009/34-61149.pdf.

[16] Id.   Indeed, in the last five years, there is only one case where the Commission did not obtain a suspension against a CPA/CFO who was subject to an antifraud injunction.  See SEC v. John Michael Kelly et al., Lit. Rel. No. 22109 (Sept. 29, 2011), available athttp://www.sec.gov/litigation/litreleases/2011/lr22109.htm.  In that matter, the Commission agreed to a settlement with Mr. Kelly permanently enjoining him from violations of the non-scienter antifraud provisions of the federal securities laws (Securities Act Sections 17(a)(2) and (3)), but did not impose a Rule 102(e) suspension against him.  In my view, agreeing to that settlement was an abdication of the Commission’s responsibility to police the financial reporting system and maintain the integrity of the securities markets.  Thus, I dissented in that case.

[17] Select SEC and Market Data, Fiscal 2010, at 11, available athttp://www.sec.gov/about/secstats2010.pdf.

[18] Select SEC and Market Data, Fiscal 2011, at 16, available athttp://www.sec.gov/about/secstats2011.pdf.

[19] Select SEC and Market Data, Fiscal 2012, at 14, available athttp://www.sec.gov/about/secstats2012.pdf.

[20] Select SEC and Market Data, Fiscal 2013, at 13, available athttp://www.sec.gov/about/secstats2013.pdf.

[21] See, Jayne W. Barnard, When Is a Corporate Executive “Substantially Unfit to Serve?" 70 N.C.L. Rev. 1489, 1522 (1992).

[22] For the same reasons, defendants who are accountants have also been known to object to charges under Exchange Act Section 13(b)(5) (knowingly circumventing or failing to implement internal controls or knowingly falsifying records) and/or Exchange Act Rule 13b2-2 (lying to auditors).

[23] Facts and information discovered by the investigative staff in the course of an investigation that are not described in a Commission Order or other public document are deemed confidential and, therefore, SEC representatives are prohibited from revealing to the public such non-public information that are not made a matter of the public record.  See, e.g., 17 C.F.R. Section 230.122, which provides that “[e]xcept as provided by 17 C.F.R. 203.2, officers and employees are hereby prohibited from making … confidential [examination and investigation] information or documents or any other non-public records of the Commission available to anyone other than a member, officer or employee of the Commission, unless the Commission or the General Counsel, pursuant to delegated authority, authorizes the disclosure of such information or the production of such documents as not being contrary to the public interest.”

SEC Chairman Whites Statement at SEC Open Meeting

Statement at SEC Open Meeting

ASSET-BACKED SECURITIES REFORM RULES ADOPTED BY SEC

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

SEC Adopts Asset-Backed Securities Reform Rules

08/27/2014 02:30 PM EDT

The Securities and Exchange Commission today adopted revisions to rules governing the disclosure, reporting, and offering process for asset-backed securities (ABS) to enhance transparency, better protect investors, and facilitate capital formation in the securitization market.

The new rules, among other things, require loan-level disclosure for certain assets, such as residential and commercial mortgages and automobile loans.  The rules also provide more time for investors to review and consider a securitization offering, revise the eligibility criteria for using an expedited offering process known as “shelf offerings,” and make important revisions to reporting requirements.

“These are strong reforms to protect America’s investors by enhancing the disclosure requirements for asset-backed securities and by making it easier for investors to review and access the information they need to make informed investment decisions,” said SEC Chair Mary Jo White.  “Unlike during the financial crisis, investors will now be able to independently conduct due diligence to better assess the credit risk of asset-backed securities.”

ABS are created by buying and bundling loans, such as residential and commercial mortgage loans, and auto loans and leases, and creating securities backed by those assets for sale to investors.  A bundle of loans is often divided into separate securities with varying levels of risk and returns.  Payments made by the borrowers on the underlying loans are passed on to investors in the ABS.

ABS holders suffered significant loss

es during the 2008 financial crisis.  The crisis revealed that many investors in the securitization market were not fully aware of the risks underlying the securitized assets and over-relied on ratings assigned by credit rating agencies, which in many cases did not appropriately evaluate the credit risk of the securities.  The crisis also exposed a lack of transparency and oversight by the principal officers in the securitization transactions.  The revised rules are designed to address these problems and to enhance investor protection.

The revised rules become effective 60 days after publication in the Federal Register.  Issuers must comply with new rules, forms, and disclosures other than the asset-level disclosure requirements no later than one year after the rules are published in the Federal Register.  Offerings of ABS backed by residential and commercial mortgages, auto loans, auto leases, and debt securities (including resecuritizations) must comply with the asset-level disclosure requirements no later than two years after the rules are published in the Federal Register.

*   *   *

FACT SHEET

Asset-backed securities are created by buying and bundling loans – such as residential mortgage loans, commercial mortgage loans or auto loans and leases – and creating securities backed by those assets that are then sold to investors.

Often a bundle of loans is divided into separate securities with different levels of risk and returns.  Payments on the loans are distributed to the holders of the lower-risk, lower-interest securities first, and then to the holders of the higher-risk securities.  Most public offerings of ABS are conducted through expedited SEC procedures known as “shelf offerings.”

During the financial crisis, ABS holders suffered significant losses and areas of the securitization market–particularly the non-governmental mortgage-backed securities market–have been relatively dormant ever since.  The crisis revealed that many investors were not fully aware of the risk in the underlying mortgages within the pools of securitized assets and unduly relied on credit ratings assigned by rating agencies, and in many cases rating agencies failed to accurately evaluate and rate the securitization structures.  Additionally, the crisis brought to light a lack of transparency in the securitized pools, a lack of oversight by senior management of the issuers, insufficient enforcement mechanisms related to representations and warranties made in the underlying contracts, and inadequate time for investors to make informed investment decisions.

SEC Proposals

In April 2010, the SEC proposed rules to revise the offering process, disclosure and reporting requirements for ABS.  Subsequent to that proposal, the Dodd-Frank Act was signed into law and addressed some of the same ABS concerns.  In light of the Dodd-Frank Act and comments received from the public in response to the 2010 proposal, the SEC re-proposed some of the April 2010 proposals in July 2011.  In February 2014, the Commission re-opened the comment period on the proposals to permit interested persons to comment on an approach for the dissemination of loan-level data.  The proposals sought to address the concerns highlighted by the financial crisis by, among other things, requiring additional disclosure, including the filing of tagged computer-readable, standardized loan-level information; revising the ABS shelf-eligibility criteria by replacing the investment grade ratings requirement with alternative criteria; and making other revisions to the offering and reporting requirements for ABS. 

The Final Rules:

Requiring Certain Asset Classes to Provide Asset-Level Information in a Standardized, Tagged Data Format

To provide increased transparency about the underlying assets of a securitization and to implement Section 942(b) of the Dodd-Frank Act, the final rules require issuers to provide standardized asset-level information for ABS backed by residential mortgages, commercial mortgages, auto loans, auto leases, and debt securities (including resecuritizations).  The rules require that the asset-level information be provided in a standardized, tagged data format called eXtensible Mark-up Language (XML), which allows investors to more easily analyze the data.  The rules also standardize the disclosure of the information by defining each data point and delineating the scope of the information required.  Although specific data requirements vary by asset class, the new asset-level disclosures generally will include information about:

• Credit quality of obligors.
• Collateral related to each asset.
• Cash flows related to a particular asset, such as the terms, expected payment amounts, and whether and how payment terms change over time.

Asset-level information will be required in the offering prospectus and in ongoing reports.  Providing investors with access to standardized, comprehensive asset-level information that offers a more complete picture of the composition and characteristics of the pool assets and their performance allows investors to better understand, analyze and track the performance of ABS.  The Commission continues to consider the best approach for requiring information about underlying assets for the remaining asset classes covered by the 2010 proposal.

Providing Investors With More Time to Consider Transaction-Specific Information

The final rules require ABS issuers using a shelf registration statement to file a preliminary prospectus containing transaction-specific information at least three business days in advance of the first sale of securities in the offering.  This requirement gives investors additional time to analyze the specific structure, assets, and contractual rights for an ABS transaction.

Removing Investment Grade Ratings for ABS Shelf Eligibility

The final rules revise the eligibility criteria for shelf offerings of ABS.  The new proposed transaction requirements for ABS shelf eligibility replace the prior investment grade requirement and require:

• The chief executive officer of the depositor to provide a certification at the time of each offering from a shelf registration statement about the disclosure contained in the prospectus and the structure of the securitization.
• A provision in the transaction agreement for the review of the assets for compliance with the representations and warranties upon the occurrence of certain trigger events.
• A dispute resolution provision in the underlying transaction documents.
• Disclosure of investors’ requests to communicate with other investors.

The final rules also require other changes to the procedures and forms related to shelf offerings, including:

• Permitting a pay-as-you-go registration fee alternative, allowing ABS issuers to pay registration fees at the time of filing the preliminary prospectus, as opposed to paying all registration fees upfront at the time of filing the registration statement.
• Creating new Forms SF-1 and SF-3 for ABS issuers to replace current Forms S-1 and S-3 in order to distinguish ABS filers from corporate filers and tailor requirements for ABS offerings.
• Revising the current practice of providing a base prospectus and prospectus supplement for ABS issuers and instead requiring that a single prospectus be filed for each takedown (however, it is permissible to highlight material changes from the preliminary prospectus in a separate supplement to the preliminary prospectus 48 hours prior to first sale).

Amendments to Prospectus Disclosure Requirements

The Commission approved amendments to the prospectus disclosure requirements for ABS, which include:

• Expanded disclosure about transaction parties, including disclosure about a sponsor’s retained economic interest in an ABS transaction and financial information about parties obligated to repurchase assets.
• A description of the provisions in the transaction agreements about modification of the terms of the underlying assets.
• Filing of the transaction documents by the date of the final prospectus, which is a clarification of the current rules.

Revisions to Regulation AB

The Commission also approved other revisions to Regulation AB, including:

• Standardization of certain static pool disclosure.
• Revisions to the Regulation AB definition of an “asset-backed security.”
• Specifying, in addition to the asset-level requirements, the disclosure that must be provided on an aggregate basis relating to the type and amount of assets that do not meet the underwriting criteria that is described in the prospectus.
• Several changes to Forms 10-D, 10-K, and 8-K, including requiring explanatory disclosure in the Form 10-K about identified material instances of noncompliance with existing Regulation AB servicing criteria.
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Dissenting Statement at SEC Open Meeting on Nationally Recognized Statistical Rating Organizations

Dissenting Statement at SEC Open Meeting on Nationally Recognized Statistical Rating Organizations

Dissenting Statement at Open Meeting Regarding Final Rules on Nationally Recognized Statistical Rating Organizations

Dissenting Statement at Open Meeting Regarding Final Rules on Nationally Recognized Statistical Rating Organizations

Statement at Open Meeting: Asset-Backed Securities Disclosure and Registration

Statement at Open Meeting: Asset-Backed Securities Disclosure and Registration

MERRILL LYNCH TO PAY CFTC FINE FOR SUPERVISORY FAILURES

FROM:  COMMODITY FUTURES TRADING COMMISSION 

CFTC Orders Merrill Lynch to Pay $1.2 Million Fine for Supervision Failures

Firm’s Supervisory Failures over Fee Processing Led to Client Overcharges at Times

Washington, DC — The U.S. Commodity Futures Trading Commission (CFTC) today issued an Order filing and simultaneously settling charges against Merrill Lynch, Pierce, Fenner & Smith Incorporated (Merrill Lynch) for failing to diligently supervise its officers’, employees’, and agents’ processing of futures exchange and clearing fees charged to its customers from at least January 1, 2010 through April 2013. Merrill Lynch is a CFTC-registered Futures Commission Merchant and approved swap firm located in New York, New York.

The CFTC Order finds that Merrill Lynch’s fee reconciliation process for identifying and correcting discrepancies between the invoices from the exchange clearinghouses and the amounts charged its customers had been faulty for more than two years. As a result, Merrill over-accrued fees from some clients and under-accrued fees from others. These fee reconciliations show that Merrill paid more than $318 million in exchange and clearing fees to the CME and Chicago Board of Trade during that time, but had unexplained over-accruals of approximately $451,318 (0.14% of fees paid) from 196 clients, according to the Order.

Additionally, the CFTC Order finds that Merrill Lynch did not hire qualified personnel to conduct and oversee its fee reconciliations and did not provide any completed procedures manuals regarding fee reconciliations to its staff until at least April 2013. The Order also finds that procedures Merrill Lynch did have up until that time were viewed as ”not fit for purpose” because they were “fundamentally flawed.” Merrill Lynch also did not provide any meaningful training to employees regarding how to conduct fee reconciliations until 2013, the Order finds.

The CFTC Order requires Merrill Lynch to pay a $1.2 million civil monetary penalty and cease and desist from violating CFTC Regulation 166.3 governing diligent supervision. The Order also requires Merrill Lynch to comply with undertakings that include, hiring an outside consulting firm to assist in training staff and reviewing and updating its current procedures regarding exchange and clearing fee reconciliations.

The CFTC Division of Enforcement staff members responsible for this case are Susan Gradman, Joseph Patrick, Brigitte Weyls, Scott Williamson, Rosemary Hollinger, and Richard Wagner.

SEC CHARGES ACCOUNTING FIRM PARTNER FOR INSIDER TRADING BASED ON CONFIDENTIAL INFORMATION

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission today announced charges against an accounting firm partner in Atlanta for insider trading in the stock of a restaurant company based on confidential information he learned from a client on the board of directors who came to him for tax advice in advance of a tender offer announcement.

SEC investigators also identified and charged three other traders who traded illegally on tips from the accountant.  The traders were discovered by comparing trading records from stock exchanges with names on the accountant’s client list.

The SEC alleges that Donald S. Toth disregarded his fiduciary duty to a client when he illicitly purchased stock in O’Charley’s Inc. – which operates or franchises restaurants under the brands O’Charley’s, Ninety Nine Restaurant, and Stoney River Legendary Steaks – after the client revealed to him in a tax-planning meeting that Fidelity National Financial was planning to purchase the company.  Toth contacted his financial advisor within the hour after this meeting with the O’Charley’s board member and began making plans to purchase 5,000 shares of O’Charley’s stock.  Toth also tipped two other clients, James A. Nash and Blair G. Schlossberg.  Nash purchased 10,000 shares and tipped others who separately traded.  Schlossberg tipped his business partner Moshe Manoah and they jointly invested in O’Charley’s stock using a brokerage account held in the name of Manoah’s wife. 

According to the SEC’s complaints filed against Toth, Nash, Schlossberg, and Manoah, when the tender offer was publicly announced approximately two months later, the price of O’Charley’s stock closed 42 percent higher than the previous trading day.  The insider trading activity garnered illegal profits of more than $160,000. 

The four have agreed to pay a combined total of more than $420,000 to settle the SEC’s charges.

“As an accountant, Toth had a duty to keep confidential the information shared by his client for tax-planning purposes, but instead he misused it for personal investments and provided the details to other clients for their misuse,” said William P. Hicks, associate director of enforcement in the SEC’s Atlanta Regional Office. 

The SEC’s complaints were filed against Toth and Nash yesterday in federal court in Atlanta and against Schlossberg and Manoah today in federal court in Tampa, Fla.  They are charged with violating Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 and Rules 10b-5 and 14e-3.  Without admitting or denying the allegations, they consented to the entry of judgments permanently enjoining them from violating these provisions of the securities laws.  The settlements are subject to court approval.

Toth, who lives in Atlanta, agreed to pay disgorgement of $19,036.00 in trading profits plus prejudgment interest of $1,224.09 and a penalty of $103,935.50 for a total of $124,195.59.

Nash, who lives in Buford, Ga., agreed to pay disgorgement of $52,500.00 – which represents his own trading profits and those of others who he tipped – plus prejudgment interest of $3,375.96 and a penalty of $52,500.00 for a total of $108.375.96.

Schlossberg, who lives in Holmes Beach, Fla., agreed to pay disgorgement of $46,358.50 in trading profits plus prejudgment interest of $2,981.02 and a penalty of $46,358.50 for a total of $95,698.02.

Manoah, who lives in Davie, Fla., agreed to pay disgorgement of $46,358.50 in trading profits plus prejudgment interest of $2,981.02 and a penalty of $46,358.50 for a total of $95,698.02.

The SEC’s investigation was conducted by Elizabeth P. Skola with assistance from Aaron W. Lipson and Robert Schroeder in the Atlanta Regional Office.  The SEC appreciates the assistance of the Financial Industry Regulatory Authority.

Statement at Open Meeting regarding Proposed Amendments to Regulation D, Form D and Rule 156 under the Securities Act

Statement at Open Meeting regarding Proposed Amendments to Regulation D, Form D and Rule 156 under the Securities Act

The Case for User Fees

The Case for User Fees

SEC ANNOUNCES $16.65 BILLION SETTLEMENT WITH BANK OF AMERICA

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

The Securities and Exchange Commission today announced a settlement in which Bank of America admits that it failed to inform investors during the financial crisis about known uncertainties to future income from its exposure to repurchase claims on mortgage loans.

Bank of America also is resolving securities fraud charges that the SEC filed last year related to a residential mortgage-backed securities (RMBS) offering.

Bank of America has agreed to settle the two cases by paying $245 million as part of a major global settlement announced today by the U.S. Department of Justice in which Bank of America will pay $16.65 billion to resolve various investigations involving violations of laws regulated by other federal agencies.

“Bank of America failed to make accurate and complete disclosure to investors and its illegal conduct kept investors in the dark,” said Rhea Kemble Dignam, regional director of the SEC’s Atlanta office.  “Requiring an admission of wrongdoing as part of Bank of America’s agreement to resolve the SEC charges filed today provides an additional level of accountability for its violation of the federal securities laws.”

In new charges filed by the SEC today in a settled administrative proceeding, Bank of America admits that it failed to disclose known uncertainties regarding potential increased costs related to mortgage loan repurchase claims stemming from more than $2 trillion in residential mortgage sales from 2004 through the first half of 2008 by the bank and certain companies it acquired.  In connection with these sales, Bank of America made contractual representations and warranties about the underlying quality of the mortgage loans and underwriting.  In the event that a loan buyer claimed a breach of a representation or warranty, the bank could be obligated to repurchase the related mortgage loan at its outstanding unpaid principal balance. 

According to the SEC’s order, Regulation S-K requires public companies like Bank of America to disclose in the Management’s Discussion & Analysis (MD&A) section of its periodic financial reports any known uncertainties that it reasonably expects will have a material impact on income from continuing operations.  Bank of America failed to adhere to these requirements by not disclosing known uncertainties about the future costs of mortgage repurchase claims when filing its financial reports for the second and third quarters of 2009.  These uncertainties included whether Fannie Mae, a mortgage loan purchaser from Bank of America, had changed its repurchase claim practices after being put into conservatorship, the future volume of repurchase claims from Fannie Mae and certain monoline insurance companies that provided credit enhancements on certain mortgage loan sales, and the ultimate resolution of certain claims that Bank of America had reviewed and refused to repurchase but had not been rescinded by the claimants.

In the SEC’s original case against Bank of America filed in August 2013, the agency alleged that the bank in its own words “shifted the risk” for losses to investors when it failed to disclose that more than 70 percent of the mortgages backing the RMBS offering called BOAMS 2008-A originated through its “wholesale” channel of mortgage brokers unaffiliated with Bank of America entities.  Bank of America knew that such wholesale channel loans – described internally as “toxic waste” – presented vastly greater risks of severe delinquencies, early defaults, underwriting defects, and prepayment.

As part of the global settlement, Bank of America agreed to resolve the SEC’s original case by paying disgorgement of $109.22 million, prejudgment interest of $6.62 million, and a penalty of $109.22 million while consenting to permanent injunctions against violations of Sections 5, 17(a)(2), and 17(a)(3) of the Securities Act of 1933.  The settlement is subject to court approval.  To settle the new case, Bank of America agreed to pay a $20 million penalty while admitting to facts set out in the SEC’s order, which requires Bank of America to cease and desist from causing any violations and any future violations of Section 13(a) of the Securities Exchange Act of 1934 and Rules 12b-20 and 13a-13. 

The SEC’s investigation into Bank of America’s MD&A-related violations was led by Mark A. Troszak, Kristin B. Wilhelm, and Peter J. Diskin in the SEC’s Atlanta office.  The investigation into Bank of America’s RMBS-related violations was led by Mark Eric Harrison and Aaron W. Lipson, and the litigation was led by Ms. Wilhelm with assistance from Mr. Harrison.  The investigations were supervised by Ms. Dignam and William P. Hicks, associate regional director for enforcement in the Atlanta office.  The SEC appreciates the assistance of the Justice Department and the U.S. Attorney’s Office for the Western District of North Carolina.