State-level Securites Enforcement

State securities regulators precede federal counterparts in identifying new gaps in investor protection by Charles Seavey Securities Enforcement Reporter http://www.enfrocementreporter.com In his testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs on March 26, 2009, NASAA President and Colorado Securities Commissioner Fred Joseph presented a list of 9 occasions between 1989 and 2008 when state securities regulators preceded their federal counterparts in identifying significant new gaps in investor protection. $2 billion/yr. Losses in Penny Stocks 1989: States determined penny stock offerings by newly formed shell companies to be per se fraudulent. These “blank check” companies had no business plan except a future merger with an unidentified company. National Response 1990: Congress passed Penny Stock Reform Act, which mandated SEC to adopt special rules governing sale of Penny Stocks (<$5.00 per share) and public offerings of shares in blank check companies (SEC Rule 419). $6 billion/yr. Losses in Micro-cap Stocks 1996-97: 33 States participated in sweep of 15 broker-dealer firms that specialized in aggressively retailing low priced securities to individual investors. States found massive fraud in firms’ manipulation of shares of start-up companies, most of which had no operating history. National Response 1997-98: Congress held hearings on fraud in the micro-cap securities markets (shares selling between $5-10). 2002: Congress passed Sarbanes-Oxley Act, which made certain state actions a basis for federal statutory disqualification from the securities industry. Risks of Securities offerings on the Internet 1996-97: States issued uniform interpretative guidance on use of Internet for legitimate securities offerings and dissemination of product information by licensed financial services professionals. National Response 1998: SEC issued interpretative guidance based on the States’ Model on the use of Internet for securities offerings and dissemination of services and product information by licensed financial services professionals. Risks of Online Trading 1999: In a report on trading of securities on the Internet, States found that investors did not

appreciate certain risks, including buying on margin and submitting market orders. National Response 2001: SEC approved a new NASD rule requiring brokers to provide individual investors with a written disclosure statement on the risks of buying securities on margin. Risks of Day Trading 1999: In a report on individuals engaged in day trading, States found that day trading firms failed to tell prospective investors that 70% of day traders would lose their investment while the firm earned large trading commissions. National Response 2000: SEC approved new NASD rules making day trading firms give written risk disclosure to individual investors. 2001: SEC approved new NASD and NYSE rules governing margin extended to day traders. Research Analyst Conflict of Interest 2002-03: States investigated and helped focus attention on conflicts of interest between investment analysts and major Wall Street firms. National Response 2002-03: The SEC, NASD, NYSE, and states reached a landmark $1.4 billion global settlement and firms agree to reform practices. Illegal Mutual Fund Trading Practices 2003: States uncovered illegal trading schemes that had become widespread in the mutual fund industry. National Response 2003-2004: SEC, NASD and NYSE launch investigations; reform legislation introduced in Congress but fails to gain support; SEC initiates wide-ranging effort to reform certain fund regulations. Senior Investment Fraud 2008: After calling attention to widespread fraud against senior investors, NASAA members approved a model rule prohibiting the misleading use of senior and retiree designations and numerous states have adopted the model through legislation or regulation. National Response 2008: Sen. Herb Kohl, chair of the U.S. Senate Special Committee on Aging, introduced legislation that would provide grants to states to enhance the protection of seniors from being misled by false designations. Auction Rate Securities 2008: Based on investor complaints, states launched a series of investigations into the frozen market for auction rate securities. The investigations led to settlements with 11 major Wall Street

firms to return $50 billion to ARS investors. National Response 2006: SEC looked into underwriting and sales practices of auction rate securities. While it did discover and try to remedy certain manipulative practices, the SEC failed to identify or correct fundamental conflicts of interest and self dealing that pervaded the auction rate market. This last item, auction rate securities, may seem curious insofar as date of the “National Response” is 2006 while the date of state action is 2008. These are not typos. Instead, they stem from a regulatory failure by the SEC that has been scantly reported and is surpassed only by the SEC’s reluctance to heed the detailed warnings of whistleblowers in the Madoff scandal. In 2006, having examined the ARS market as a whole, the SEC issued an Order that addressed only violations in the ARS market that related to “auction practices and procedures” of dealers that affected the clearing rate of the auctions, such as prioritizing certain orders. The 2006 SEC Order was limited, in other words, to addressing concerns regarding dealers or issuers in ARS auctions getting an upper hand over other dealers and issuers, or vice versa, while omitting to address fraud on the end-buyers of auction rate securities. Meanwhile, it has since fully come to light that broker-dealers were marketing the auction rate securities to end-buyers as “safe and liquid cash equivalents” and that broker-dealers were often listing the securities on end-buyers’ account statements as “Cash.” Notably, however, the SEC stated in its own press release regarding the 2006 Order that “investors may not have been aware of the liquidity and credit risks associated with certain securities.” In other words, the SEC’s investigation of the ARS market in 2006 appears to have raised such concerns about the representations that were being made to end investors, but the SEC’s resultant regulatory action, two years before the 2007-2008 investigations and actions of regulators in Massachusetts and other states, failed to address these concerns in any way. In his Senate testimony, Joseph pointed as a current issue to the National Securities Markets Improvement Act (NSMIA), which preempted states from prohibiting offerings made under Rule 506 of Regulation D, as an example of misguided legislation that has limited the states’ ability to address fraud in its earliest stages. “Since the passage of NSMIA, we have observed a steady and significant rise in the number of offerings made pursuant to Rule 506 that are later discovered to be fraudulent,” Joseph said. “NASAA believes the time has come for Congress to reinstate state regulatory oversight over Rule 506 offerings.” Indeed. Given the SEC’s failures in the ARS and Madoff matters, as well as the above areas where state action preceded a federal response, the idea of federal preemption of state securities regulators rings hollow.

Charley Seavey, Editor of Securities Enforcement Reporter, began his career in business, law and journalism by earning a BA in English at Stanford University and an MBA at the University of Chicago Booth School of Business, after which he was an analyst and portfolio manager at a few hedge funds, including Soros Fund Management, before spending the dot-com years advising and financing start-up companies. He subsequently became interested in investigative journalism and, through accounting analysis, discovered fraud at the Halliburton Company, which led to a New York Times article, an SEC investigation and class action suits. While working as a forensic accountant for plaintiffs attorneys on the Halliburton case, he became interested in the law and earned a JD at the University of California, Berkeley. He has since developed and authored numerous original securities class action complaints, served as CFO of a private company, and written on topics in international law and business, including The Anomalous Lack of an International Bankruptcy Court, which was published in the Berkeley Journal of International Law. In addition to editing the Securities Enforcement Reporter, he remains a valued consultant, known for his creative thinking and strategic insight, to investment advisers, the plaintiffs bar, and public and private companies.