Securities Lawyer Blog

The Securities Lawyer Blog often posts on SEC and FINRA enforcement proceedings that involve marketing materials and supervision issues. This week, Morgan Keegan & Company, Inc. has reached a settlement with both the SEC and FINRA for claims involving various bond funds. The firm has agreed to pay $200 million in restitution to their customers who invested in seven affiliated bond funds.

The allegations involved in this matter were that for a period of nearly two years, the firm used "sales materials that contained exaggerated claims, failed to provide a sound basis for evaluating the facts regarding the fund, were not fair and balanced, and did not adequately disclose the impact of market conditions in 2007 that caused substantial losses to the value" of several affiliated bond funds.

The major affiliated fund in question included structured products, specifically "mezzanine and subordinated tranches of structured securities" that included sub-prime mortgage-backed and asset-backed securities. In early 2007, the firm became aware that the fund's holdings were not stable and were subject to the volatility in the mortgage-backed securities market. The firm is alleged to have "failed to adequately disclose those risks in the sales materials or internal guidance" when in fact, over 50 percent of the fund's portfolio was invested in these problematic subprime products.

Noting the importance that firms "ensure that their marketing materials fully and accurately describe the products they sell, including the attendant risks and any relevant information about market conditions that may impact those products," Brad Bennett, FINRA Executive Vice President and Chief of Enforcement went on to say that the firm's failure to fully disclose these risks gave the impression that the fund was "a safer investment than it was."

The allegations against the firm included that it did not "adequately describe the nature, holdings and certain risks" of the fund and that when the market began adversely impacting the fund's holdings, the firm did not alter its sales and marketing materials to let investors know of those risks. The firm will now be required to ensure compliance with NASD rules regarding supervisory systems as well.

The New York securities regulation and enforcement attorneys at Gusrae Kaplan Nusbaum PLLC represent broker-dealers in regulatory and enforcement matters. We regularly advise clients and defend industry members involving a broad spectrum of issues, such as maintaining adequate supervision and providing marketing materials that properly disclose risks. Contact our law firm to consult with one of our attorneys.

The summer solstice is the longest day of the year and it happened yesterday. There was blue sky until well into the evening.

It was probably far too long a day for JP Morgan as the SEC announced its settlement with the firm for nearly $154 million saying that the firm "misled investors in a complex mortgage securities transaction just as the housing market was starting to plummet. Under the settlement, harmed investors will receive all of their money back." The firm has also agreed to make improvements to their review and approval of mortgage securities transactions.

The SEC has posted a PDF chart of these Collateralized Debt Obligation transactions for those who would like a visual representation to understand the way they were structured.

We have seen in previous enforcement proceedings against Goldman Sachs for example, that betting against your investors is not a strategy that works in the long run. In this case, the SEC claimed that the firm "structured and marketed a synthetic collateralized debt obligation (CDO) without informing investors that a hedge fund helped select the assets in the CDO portfolio and had a short position in more than half of those assets." This meant that if the CDO assets defaulted, the hedge fund would benefit.

In a separate action, the SEC also claims that Mr. Edward S. Steffelin acted negligently. Mr. Steffelin was at the head of the registered investment adviser group that was involved in the hedge fund's selection of the investment portfolio as well as in creating the marketing materials for the JP Morgan offering called Squared CDO 2007-1 (Squared). The SEC alleges that his involvement was in violation of Sections 17(a)(2) and (3) of the '33 Securities Act and Section 206(2) of the Investment Advisers Act of 1940.

In the SEC's press release on this matter, Robert Khuzami, Director of the Division of Enforcement stated that the firm "... marketed highly-complex CDO investments to investors with promises that the mortgage assets underlying the CDO would be selected by an independent manager looking out for investor interests," but did not disclose to investors "that a prominent hedge fund that would financially profit from the failure of CDO portfolio assets heavily influenced the CDO portfolio selection. With today's settlement, harmed investors receive a full return of the losses they suffered."

The settlement must be reviewed by Manhattan federal district court judge Richard Berman, who will determine whether or not to approve it. The action against Mr. Steffelin is not being settled and is assigned to Manhattan federal district court judge Miriam Cedarbaum.

The Wall Street law firm, Gusrae Kaplan Nusbaum PLLC has decades of experience in advising and representing members of the broker-dealer community. Please contact us at any time to consult with one of our lawyers.

A recent investor alert issued jointly by FINRA and the SEC's Office of Investor Education and Advocacy is directed at informing the public about the risks of structured notes -- even when they carry principal protection. In the investor alert that is entitled, Structured Notes with Principal Protection: Note the Terms of Your Investment, investors are warned that these investments are not as secure as they might seem given their "reassuring names."

Calling them "complex financial products," the SEC/FINRA alert states that these investments combine a zero-coupon bond that does not pay interest until maturity with either an option or other derivative product. One major concern is that the underlying asset value can vary and may be tied to assets, benchmarks or an index that could also carry a cap or limitation on the upside exposure.

If held to maturity, most investors will receive back some of their investment regardless of whether there is a reduction in value of the underlying asset, index or other benchmark. However, due to the fact that these products have varying levels of protection, the alert warns that "any guarantee is only as good as the financial strength of the company that makes that promise."

The concern about these complex investments is that the "payout structures" can be difficult for investors to fully understand. Lori J. Schock, Director of the SEC's Office of Investor Education and Advocacy, stated in the joint press release on this matter that the alert "... is a 'must read' for investors considering these products, especially those with the mistaken belief that these investments offer complete downside protection."

As investors look for higher yields, the concern is that investors might be drawn to these investments not knowing that in fact their investment could in fact be "expensive, risky, complex and illiquid investment," in the words of FINRA Senior Vice President for Investor Education John Gannon.

One of the major concerns for investors is that both the risk assessment and the growth potential are not easily assessed. It is important that investors review the alert before investing in these products.

Given the focus on these products by the SEC and FINRA, we suggest that broker-dealers carefully assess their current marketing materials and risk disclosures to their investors. When these entities jointly issue an investor alert, it is possible that these products will also be targeted for enforcement scrunity.

The New York securities regulation and enforcement attorneys at Gusrae Kaplan Nusbaum PLLC represent broker-dealers in regulatory and enforcement matters. Our lawyers advise clients and defend industry members in matters involving a broad spectrum of issues including compliance with regulatory requirements and rules. Contact our law firm to consult with one of our attorneys.

Northern Trust Securities, Inc. will pay a fine of $600,000 to FINRA for alleged lack of proper supervision in the areas of collateralized mortgage obligations (CMO's) and high-volume securities trades. FINRA claims that the firm did not monitor nearly 45% of their business over a year and one half time frame.

The allegations regarding lack of supervision and monitoring of customer accounts centered on a three-year period between 2006 and 2009. The claim is that due to the firm's alleged issues with monitoring, some accounts ended up with CMO's in concentrations that were not suitable for the account holders.

The underlying reason was stated to be because the firm "used an exception reporting system that failed to capture or analyze substantial portions of the firm's business, including all CMO transactions, certain trades of 10,000 equity shares or more, and certain trades of 250 or more of fixed-income bonds."

Without the appropriate systems in place to monitor equity trades at certain levels (10,000 shares, for example or large numbers of bonds in fixed income) the firm is alleged to have allowed trades to occur that were not monitored for suitability, concentration and other issues such as the rate of mark-ups and commissions.

Overall, FINRA pointed to a lack of monitoring that, according FINRA's Executive Vice President and Chief of Enforcement Brad Bennett, "allowed more than 40 percent of its transactions to proceed without review, which in turn left vulnerable investors exposed to the risk of losing all or a substantial portion of their principal through potential over-concentration in CMOs." The firm has consented to the settlement without an admission or denial of the charges.

Appropriate monitoring and supervision have been the subject of prior posts by the lawyers at the Securities Lawyer Blog. Compliance in this area continues to be important for broker-dealers.

Our New York securities litigation firm advises broker-dealers to ensure that they have proper systems in place to comply with industry rules and practices. We also represent industry members before all regulatory agencies. For more information on our law practice and representation, or to speak with one of our experienced securities litigators, please contact Wall Street's Gusrae Kaplan Nusbaum PLLC.

FINRA has just issued an investor alert on stock-based loan programs -- using their enforcement actions in this area as support for their caution to investors that these can be risky. The new alert, entitled "Stock-Based Loan Programs: What Investors Need to Know" is intended to ensure that investors are aware of both the risks and the rewards of these loan programs. But there is an enforcement issue brewing beneath the surface of this warning and the industry also needs to take note.

Warning that these loans can be "tempting" for investors who would like to hold investments while taking cash or value for other purposes, FINRA wants investors to consider the risks particularly when these loans are being offered by "unregistered, unregulated third-party lenders." They also caution investors that these programs can carry with them unintended tax consequences.

Before arranging for a loan of this type, FINRA wants investors to consider such issues as the costs and risks of the loan, possible taxable events, the source of the loan and whether the lender is registered either with banking regulators or with FINRA itself.

Those in the industry are aware that these programs provide investors an opportunity to pledge their fully paid stock as collateral -- but these loans when provided by unregistered third-party lenders can be very problematic for the investor. Noting that these programs are often offered by financial planners and insurance agents, FINRA states its concern that borrowing funds against an investment portfolio may not be wise for many investors lured by the possibility of holding their portfolios while using the funds from the loan program.

But the programs are fraught with risks. Once the stocks are pledged as collateral for the cash loan provided, the investor not only will owe the interest which can be at a high rate for the duration of the loan. Dividends are still paid and credited against the loan. At the end of the loan period, the investor can extend the loan or take back the stock.

FINRA's concern is that the investor might also have a big bill to pay at the end of the loan and not be aware of this, since it is possible that the Internal Revenue Service will view the transaction as a stock transfer which triggers a taxable event. This can include possible capital gains which might be based either on the loan proceeds receipt or the stock sale, if that occurs at the end of the loan period.

Recourse for investors concerned about a problem with a stock-based loan is available on FINRA's online Investor Complaint Center.

The New York securities regulation and enforcement attorneys at Gusrae Kaplan Nusbaum PLLC represent broker-dealers in regulatory and enforcement matters before FINRA and other regulatory agencies. Our lawyers advise and defend industry members in matters involving a broad spectrum of issues. Please contact our law firm to consult with one of our attorneys.