PR OFILE


Controversy over SEC Tribunals The SEC's internal administrative tribunals, which use its own judges, are perceived to give the regulator an unfair advantage over legal forums (such as federal court trials) where the SEC has had a much lower success rate. Schiffman, who recently won a case against the SEC for a client, recalls with some delight how "the SEC had a rough go of it in federal court". There have even been allegations that SEC judges were improperly pressured into ruling in favour of the regulator, although its own review found no bias. There are now two categories of challenges to the SEC's judicial (or, some would say, quasi-judicial) process. The legal argument that the tribunals are unconstitutional, and therefore illegal, is currently being litigated but is not likely to prevail, Schiffman reckons. However, the equitable argument is already being listened to and there are several proposals – to give more rights to defendants, have more discovery and provide the ability to appeal. The SEC thinks this will be more costly and time-consuming, but Schiffman thinks these proposals are "a step in the right direction and further changes will be made as the process evolves".


Longer Lookbacks As if the SEC was not busy enough finding current violations, reformed transgressors continue to be seen as violators in the eyes of the SEC. They can be punished for past actions, and Daly has noticed "in examinations, the SEC is now asking for longer lookbacks to see amendments to policies such as expenses and client charges. This can be unfortunate as managers who have cleaned up their act and improved their procedures years before may still be held up by the SEC for what preceded that".


SELF REGULATORY ORGANISATIONS (SROs) – EXAMS AND FINES Registered Investment Advisers (RIAs) do not have SROs, but those financial market participants that do have SROs go through examinations, which entail different challenges and complications. National Futures Association (NFA) exams are a whole different ball game, Daly finds. "The NFA examiners are professionals with very different exam goals; the NFA examination process focuses on risk management and comes at fiduciary duties from that angle, which can be quite different from the SEC's approach", he says. The NFA can also act as a messenger for other regulators, referring funds to the Commodity Futures Trading Commission (CFTC) if it suspects a firm may have violated the commodity exchange act.


Futures exchanges are licensed by the CFTC as SROs, and they are reviewed annually by the government agencies. "This means that the exchanges must carry out their own enforcement function; several of the exchanges have made a number of litigation hires from the criminal bar (such as former district


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attorneys and public defenders) to create a real prosecutorial enforcement division", Daly points out. Violations pursued by the exchanges have included position limit breaches, and "market participants are often taken by surprise by the severity of the sanctions", he adds. A particularly complicated area is Exchanges for Related Positions (EFRPs), whereby over-the-counter (OTC) securities are exchanged for physical instruments or futures, often involving exchanges between listed futures, or options, and OTC swaps or options. "The rules are in a state of flux and are hard to understand for brokers, with many traps for the unwary, leading the CME Group to bring enforcement cases", Daly warns.


ACTIVISTS IN CONCERT? A new area of focus for the SEC is potential collusion between funds, including activist funds, particularly where they may appear to be acting together to put a company into play. If one fund puts a company into play, and other fund(s) subsequently invest, the SEC supposition may be that there was some form of collusion. "It is a very difficult area, and they have not done anything yet", notes Schiffman, whose colleague, Charles Clark, recently joined SRZ's Washington DC office. Prior to entering private practice, Clark spent nine years in the SEC's Division of Enforcement, investigating and prosecuting some of the SEC's most significant matters, and upon being named assistant director, supervised the SEC's investigation into Enron Corp.


Clearly, any casual analysis of 13F filings shows that many hedge funds, or other funds, can coincidentally hold the same positions, without there being any links between the managers. The SEC has not yet defined criteria for determining whether or not funds have any agreements to act in concert or in parallel, but the concern is only over any concerted action that has not been disclosed.


Failing to disclose acting in concert is serious enough in itself, and funds deemed to be acting in concert could also be caught in the net of other rules that apply to any investor above certain ownership thresholds.


Short Swing Profit Rule One example is the Section 16(b) short swing profit rule. Explains Swartz, "If the aggregate beneficial ownership of a single fund or group of funds exceeds 10 per cent, then any profits made by each fund or group member within a six-month time period must be disgorged and given to the investee company." The short swing profit rule can operate in perverse ways because 'profits' are calculated by subtracting the lowest purchase price from the highest sale price (including short sales - although most shorting by Section 16 insiders is prohibited) within any period of less than six months, whether or not the investor


has made any overall profit. Not only can funds be required to disgorge more than their actual profits; those who have lost money on an investment can also be liable so long as sufficient share price volatility has occurred for some sale prices to exceed some purchase prices.


A federal appeals court has stated that the rule is "arbitrary and sweeping", but it continues to apply. Naturally companies do not necessarily want to bring these claims against their investors, but shareholders have standing to bring them derivatively on the company's behalf, and plaintiffs' lawyers are well incentivised to monitor closely any potential claims as they may receive between 10 and 25 per cent of the disgorgements.


Plaintiffs' lawyers are becoming increasingly sophisticated at identifying these types of potential claims. Swartz adds, "There's a real danger of funds being improperly accused of being a group and therefore having their ownership aggregated for purposes of calculating whether the 10-percent threshold has been crossed."


According to Gussman,"funds have to be particularly careful to avoid acting as a group in distressed situations because the company itself might approach a group of funds with common economic interests to engage in discussions with the company". In that situation, plaintiffs' lawyers are likely to point to any communications between the funds as evidence of a group, and argue that the funds' holdings should be aggregated to determine whether they are subject to the 10 per cent threshold.


The essential distinction in these cases is between those investors who coincidentally have the same economic objectives but have not reached any agreement or understanding with each other, and those who have actually agreed to work together with regard to the company's securities. "Funds can find it surprisingly difficult to establish that they did not act as group" notes Swartz.


Antitrust Disclosure Implications Swartz goes on to say that funds acquiring or increasing a stake can also put them on the radar of federal antitrust laws, such as the Hart-Scott-Rodino (HSR) competition law which requires owners of more than $76.3 million of stock to file with the FTC and DOJ for antitrust approval. This is nothing new to activist funds but in August 2015 the FTC brought a complaint and entered a consent decree with Third Point, alleging that the manager improperly tried to make use of the 'investment only' exemption whilst contemplating running a proxy contest, as well as making statements intended to influence Yahoo's management. This case shows that the government interprets the scope of the 'investment only'


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