The SEC has changed its policies regarding anti-fraud consent injunctions.

The last few months have been nothing if not eventful for the investment advisory and mutual fund business. In the spring of 2003, the Securities and Exchange Commission (SEC) conducted a "sweep examination" of 43 broker-dealers, which revealed that many mutual fund investors are not receiving the benefit of available reductions in front-end loads, referred to as breakpoints, when purchasing mutual fund shares through a broker. It was further discovered that many of these brokers engaged in the practice of selling customers into a back-end loaded class of shares, the B class, when a reduced front-end share class may have been more appropriate.

No sooner had the smoke started to clear then New York Attorney General Eliot Spitzer alleged wrongdoing and brought enforcement action against two hedge funds and four different mutual fund organizations for illegal late trading or market-timing activities that were supposedly prohibited by the prospectuses of the fund companies. An embarrassed SEC quickly joined the investigation, sending out subpoenas and requests for information to every mutual fund and advisory group of any significant size and stature. Sandwiched between these two high-profile actions was a little-reported-on SEC investment advisory enforcement action in July, which may have far greater practical implications for registered investment advisors (and other securities professionals) than either the breakpoint study or the Spitzer splash.

Advisor Conduct And Initial SEC Enforcement

The history of the July action begins in 1998, when the SEC brought an enforcement action against Marshall E. Melton and Asset Management and Research, a registered investment advisor and broker-dealer. It alleged that Melton repeatedly misused client funds in a variety of mildly creative ways and generally lied to and abused the trust of clients. As is typical in such actions, Melton entered into a consent decree without admitting or denying the factual allegations and was enjoined from further violations of the anti-fraud provisions of the securities laws.

The law judge concluded that Melton should be barred from association with the securities industry and that Melton's advisory registration should be revoked. A subsequent proceeding was brought by the SEC to determine whether it was in the public interest to revoke Melton's advisory registration and to impose a personal bar against Melton from working in the securities business generally. The SEC found that the world would be a better place if Melton never worked in the securities business again. Certainly, one would be hard pressed to disagree with the SEC based on the "facts" in this case, but remember, Melton never admitted or denied the facts alleged.

SEC Refinement And Expansion Regarding Consent Injunctions

On July 25, 2003, when the SEC issued its opinion in this matter, it took the opportunity to "refine and expand" its policy regarding anti-fraud consent injunctions and their impact on respondents in future administrative disciplinary proceedings brought by the SEC. In particular, the SEC announced that for purposes of consent injunctions that are agreed to and entered by a court, the SEC "will construe the 'neither admit nor deny' language as precluding a person who has consented to an injunction in an SEC enforcement action from denying the factual allegations of the injunctive complaint in a follow-up proceeding before the SEC."

In the view of the SEC, after settling an injunctive action that, by its very nature, is predicated on conduct that would or does violate laws, rules or regulations, the SEC should not permit the defendant's denial of the allegations in the injunctive action in a later proceeding before the SEC. Accordingly, Melton was not able to contest the facts that were alleged against him by the SEC, even though he neither admitted nor denied the conduct.

What This Means To You

Obviously investment advisors, and other securities professionals subject to SEC examinations, who face enforcement action will want to think twice before they enter into a consent order and agree to an injunction with the SEC enforcement division. But the process of protecting yourself, against what could be viewed as a lack of due process, should begin long before the individual or company that is the subject of an examination is faced with the option of protracted, expensive litigation or an onerous consent order drafted by the SEC.

The most effective defense against any regulatory inquiry is to have been concerned long before the regulators come knocking, and to have in place a robust compliance program fully supported by executive management. Protecting oneself during an examination should start when the SEC Office of Compliance, Inspections and Examinations (OCIE) notifies an advisor that it intends to conduct an examination. Many advisors and other securities professionals believe that all requests by an OCIE examiner are non-negotiable, and that they are better off providing the examiner with all requested information rather than appear to be uncooperative.

SEC examiners, however, may request information to which they are not legally entitled and which may be damaging in the hands of an overzealous examiner. For example, this author is aware of an instance in which an SEC examiner asked for and received the billing statements from an advisor's outside law firm. OCIE could not have obtained a better roadmap to problems within the advisory organization without a wiretap. Billing statements are privileged and are not required to be provided to OCIE. In every advisory or broker-dealer examination, whether conducted by OCIE or, in the context of a broker-dealer examination, the National Association of Securities Dealers Regulation, the advisor or broker should have counsel, whether internal or external, to act as the point person to respond to requests for information from the examiners. Subsequent correspondence, whether a follow-up request for information for which a submission of information is necessary, or a response to a deficiency letter, should be drafted and submitted by counsel.

The understaffed and overworked SEC has a very difficult job trying to keep up with all of the registrants for which it has oversight responsibility. The SEC must use every weapon in its arsenal in an attempt to protect investors from the bad apples, and they have certainly come up with a good one in the Melton case. Advisors, broker-dealers and other securities professionals must be equally careful to not place themselves in the position of agreeing to a consent order from which there is no return.