WealthManagement Magazine

Under Siege

ON ITS WEB SITE, THE NASD SAYS THE HEART OF ITS MISSION IS TO ENFORCE SECURITIES LAWS IN A VIGOROUS, FAIR AND EFFECTIVE MANNER. ASK ANY BROKER/DEALER EXECUTIVE OR COMPLIANCE CHIEF AND THEY WOULD LIKELY GROAN, VIGOROUS, YES, BUT FAIR? Executives of b/d firms are not exaggerating when they say it seems like regulators are locked into a competitive battle to collect the most pelts on Wall Street. Since


Executives of b/d firms are not exaggerating when they say it seems like regulators are locked into a competitive battle to collect the most pelts on Wall Street. Since May 2002, when New York attorney general Eliot Spitzer extracted a $100 million penalty from Merrill Lynch to settle accusations that its investment advice was tainted by conflicts of interest, the enforcement actions have been arriving nonstop. “I experienced a lot of this regulatory competition first hand,” says Brian Rubin, now a b/d defense lawyer with Sutherland Asbill & Brennan in Washington, D.C., and a former deputy chief counsel of the NASD's enforcement department. “Now regulators are competing to get record fines, to get press and to appear that they are getting their jobs done.”

Of course, Spitzer had the goods on the analysts: In that case, to great public fanfare, he uncovered emails in which Henry Blodget, Merrill's highflying Internet analyst, was publicly recommending Net stocks as he privately voice misgivings, even telling colleagues that one particular issue was a “piece of junk.” At the same time, Spitzer goaded the traditional securities regulators — who had done nothing about the obvious conflicts between investment banking and legitimate research. That December, the industry agreed to a $1.4 billion “global settlement” to sever the links between research and investment banking.

Playing Harder Ball

More recently, though, regulators are filing cases that are on much more shaky ground, Rubin says. “Many [regulators] are focused on getting as much press or as many dollars as they can, and as part of that, they are using unprecedented and untested legal theories.”

Defense lawyers see several trends in the push for stiffer penalties: The agencies are targeting not just companies but executives in their complaints. Settlements contain a standard clause in which the accused neither admits nor denies the charges brought. But now the SEC is insisting that fraud charges be included in the mix, even for books and records violations where there is no clear motive and not a nickel of profit made. And defense attorneys complain that they cannot divine rhyme or reason in the penalty figures that the agency drums up. “The settlement demands have become more unacceptable, thereby forcing cases into litigation,” says Gene Goldman, a partner in the Washington, D.C., office of McDermott Will & Emery, who specializes in cases before the SEC.

The defense bar alleges that regulators are now making up the rules as they go along, a phenomenon they call “regulation by enforcement.” The enforcement cases keep coming, even as the SEC proposes rules to broaden and clarify the duties that it says b/ds have been violating. Several rules are sitting at the SEC now, under a pile of comment letters from the industry, complaining that they are unworkable and will create added costs that will, inevitably, be passed along to investors. It begs the questions: Should there be a limit to new regulation? Isn't there enough on the books to protect investors already?

And when does it pay to litigate? B/ds are savoring a victory won by Rubin on behalf of IFG Network Securities, Inc., a b/d owned by ING Groep N.V, the Dutch financial services giant. IFG's former president, David Ledbetter, was also charged in the SEC complaint. The SEC's enforcement division had accused three IFG registered representatives of committing fraud by selling class B shares of mutual funds and failing to disclose that, at a $250,000 investment level, class A shares would have produced materially higher returns. The reps also failed to tell their customers they would receive higher commissions on class B shares. IFG and Ledbetter were charged with failure to supervise the reps.

The SEC's enforcement division is appealing the ruling by Administrative Law Judge Carol Fox Foelak, who dismissed all of the charges and issued a stinging rebuke of the enforcement division. (The SEC is not appealing the ruling on two reps in the case.) The defendants admitted they had not told customers about the differences in returns between A and B shares, and also neglected to mention the higher commissions they would receive from B shares. But they pointed out that this information is in the fund prospectuses distributed to clients. “The respondents argue that if there is a need for greater disclosure, new requirements should be adopted prospectively by rulemaking, rather than imposed retroactively through enforcement action.”

Judge Foelak agreed. Over a 22-day hearing, she heard a great deal of evidence on whether A shares outperform B shares at the $250,000 level. She found that A shares are a better investment in “many, but not all, circumstances” — a crucial distinction, given that the three brokers were being charged with fraud for not informing their customers of the differences. Lawyers for William Kissinger, a 50-year-old CPA from Maryland, owner of Kissinger Financial Services and one of the independent brokers charged, subpoenaed all of the major mutual fund companies, proving that the disclosure requirements of their prospectuses have never required any mention that A shares will always out perform B shares at the $250,000 level.

Judge Foelak also slammed the agency's enforcers for charging the reps with fraud based on their failure to disclose they would receive higher commissions from the B shares. She pointed out the SEC has proposed a rule that would require such point-of-sale disclosures, but has yet to adopt it. “If it decides to adopt such a rule, then going forward, the problem sought to be addressed will be addressed globally, and all industry participants, including Kissinger…will have fair notice,” Judge Foelak wrote. On the other hand, if the SEC decides not to go ahead with its rule, Foelak made it clear that brokers like Kissinger could not “in fairness” be charged with fraud violations. (In fact, the SEC asked for more comments on the rule this spring. The Securities Industry Association warned the disclosures would cost about $7 billion a year for the industry to implement — costs that will inevitably be borne by customers.)

It came down to principles of due process. “To charge somebody with something they had no notice of is really fundamentally unfair,” says Kissinger's lawyer, Timothy Katsiff of Blank Rome in Philadelphia.

Kissinger lives on to fight another day. But there is little question that the B share is virtually dead. In March, Citigroup Global Markets, American Express Financial Advisors and Chase Investment Services paid more than $21 million to settle charges that the firms violated suitability rules by selling class B shares when class A shares would have provided a higher rate of return. The NASD said that breakpoint discounts on A shares generally begin at the $50,000 investment level. Several other firms are still hanging tough, refusing to settle with the NASD, according to a lawyer involved in the negotiations. The AEFA/Chase settlement is seen as creating a de facto rule that B shares are not suitable investments.

The SEC had been targeting individual brokers since at least 2000. Lawyers at the SEC's Atlanta office began focusing on alleged problems with B shares even earlier, according to defense attorneys. In fact the SEC brought — and lost — a case accusing broker Michael Flanagan of fraud by recommending B shares to his clients at the $100,000 level as far back as 1993. None of the customers had complained about the practice. The Flanagan case was argued before the commission in July 2000. Later that month, Flanagan won his appeal. The SEC dismissed all of the fraud charges against Flanagan. But that didn't stop the SEC from pursuing Kissinger, “The SEC is really persecuting these brokers,” says Kissinger's lawyer, Katsiff.

Most brokers realize that B shares are a historical phenomenon. If anything, the NASD's March settlement against Citigroup and the others, in which the firms coughed up $21 million, established that. For them, settling with the NASD was a cost of doing business. But lawyers for the indie brokers have more serious concerns. “The stakes are different for them,” says Kissinger's lawyer, Katsiff.

The B share had even rankled reform-minded former SEC Chairman William Donaldson. “Why do we really care?” he asked during a July 2003 hearing. “If the clients don't seem to mind right now, even after all this time and this discipline…Why are we here and why are we spending your [the SEC's] time and their money?”

Now, the SEC is appealing its loss in the Kissinger and IFG case. “Kissinger was obligated to paint a full picture for his customers, including a discussion of the relative performance of the class A and class B shares,” according to the SEC's filings on appeal.

Spitzer Sweep

Does it pay to litigate? B/d executives made much over the Theodore Siphol III win, the only time Spitzer was fought, and beaten, in court. Consumer advocates play down the significance of the case: You can't win them all. In September 2003, he made the headlines again when he charged Canary Capital Partners, a New Jersey hedge fund headed by Edward Stern, scion of the pet food/real estate/publishing clan, with gaming the system by “late trading” mutual funds. Spitzer's investigators had learned that Stern had an arrangement with Banc of America Securities, under which he routinely bought funds after their daily net asset values were set — beating other investors. That led to a quick settlement from BofA and $3 billion in settlements from the mutual fund industry, plus agreements to lower fees to investors.

But Spitzer got nowhere with his prosecution of Siphol, the rookie broker who brought in Stern's business. Rather than cut a deal, Siphol went to trial — facing up to 33 years in prison if convicted of charges that included grand larceny. After a five-week trial, a jury acquitted Siphol on June 9 on all counts — a rare set back for Spitzer. Siphol is not out of hot water, but b/ds are still embolden.

Sweep Wall Street

Complaints of overzealous prosecutors and regulation by enforcement carry no weight with investor advocates, who believe the agencies have a lot farther to go to clean up the securities industry. “Even the industry would agree that the SEC has been lax on the mutual fund front in the past,” says Mercer Bullard, a former SEC lawyer and founder of Fund Democracy, who has been agitating for mutual fund reforms for the past five years. For too long, the SEC took “a much too lawyerly approach” to its role, Bullard says.

Spitzer came along and put a spotlight on what looked like blatant breaches of fiduciary duty. One example was the practice of “directed brokerage,” in which mutual fund companies steered business in exchange for having their funds promoted by the brokers. Citigroup paid $20 million to settle SEC charges that it took “shelf-space” payments from 70 mutual fund companies, and Putnam Investments paid a $40 million penalty for not telling its investors that it was rewarding brokers who promoted Putnam products. In June, the NASD weighed in, charging 15 firms with directed brokerage violations and imposing fines of more than $34 million.

Edward Siedle, another former SEC lawyer and outspoken critic of the mutual fund industry, is even more blunt about directed brokerage, which the agencies knew was a blatantly unfair practice, but failed to address for years. “It's been clear to anybody in the legal community that it was a breach of fiduciary duty. And it was clear to the NASD and the SEC and they just didn't do anything about it,” says Siedle, who owns Benchmark Financial Services, a Florida brokerage firm. “What suddenly happened is that Eliot Spitzer entered the world of regulation with fresh eyes. Instead of it being explained away by high-priced lawyers, he basically said it was wrong.”


Key enforcement statistics from the NASD.
2004 2003 2002 2001
Examinations for Cause Initiated 10,545 3,384 2,100 1,841
Examinations for Cause Resolved 13,760 3,453 1,950 1,988
New Discplinary Actions Filed 1,360 1,410 1,271 1,257
Individuals Suspended 380 333 374 346
Discplinary Fines Collected (in millions) $102 $33.30 $68.20 $13.20
Source: NASD
Hide comments


  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.