SEC Put Writing and Swap Case Slogs To Federal Courts

July 12, 2016

In today's BrokeAndBroker.com Blog we wrestle with an ongoing Securities and Exchange Commission ("SEC") case. It is, in fact, a struggle to digest the various allegations and parse the misconduct among four different respondents. Ultimately, however, it seems that the SEC got it right and to the federal regulator's credit, there is ample content and context in its various decisions, orders, and opinions to allow readers to draw conclusions. That being said, we are also confronted with some interesting procedural disputes involving an attempt to stay the sanctions imposed. By way of brief introduction, during 2007 and 2008, Mohammed Riad was a Managing Director and Senior Portfolio Manager at Fiduciary Asset Management, LLC ("FAMCO") and Portfolio Manager of the closed-end investment company Fiduciary/Claymore Dynamic Equity Fund ("HCE"). Kevin Timothy Swanson was a FAMCO Portfolio Manager and a Co-Portfolio Manger of HCE with Riad.  FAMCO was the sub-adviser to HCE and received a 5% sub-advisory fee. And from here, we enter the fray.

The OIPs

On December 19, 2012, the SEC ordered the institution of administrative and cease-and-desist proceedings against Respondents Mohamed Riad and Kevin Timothy Swanson. (the "OIP"). In the Matter of Mohammed Riad and Kevin Timothy Swanson, Respondents (OIP;  '34 Act Rel. 68467; Invest. Adv. Act 3521; Invest. Co. Act 30310;  Admin. Proc. File 3-15141; / December 19, 2012). As asserted in the "Background" section of the OIP:

6. According to HCE's April 2005 registration statement, the Fund's primary investment strategy was to invest in equities and write call options on a substantial portion of those equities. This strategy is commonly referred to as a covered call strategy. Covered call strategies trade upside potential in the equities held in the portfolio for current income from option premiums received.

7. HCE informed investors in its periodic reports that this covered call strategy had the potential to protect the Fund in a downward trending market. The Fund also disclosed to investors that it had a goal of paying an annual dividend equal to an 8.5% yield on the Fund's initial public offering price.

8. Claymore provided advisory services to HCE pursuant to an investment advisory agreement, and delegated certain of its responsibilities to FAMCO through a sub-advisory agreement. Under the sub-advisory agreement, FAMCO acted as a fiduciary and was responsible for the management of HCE's portfolio.

9. FAMCO was required to manage the Fund in accordance with HCE's investment objective, policies, and restrictions as stated in the Fund's registration statement. FAMCO's engagement as sub-adviser was subject to annual review by HCE's Board of Directors. FAMCO initially designated Riad as HCE's portfolio manager and later in 2005 added Swanson as co-portfolio manager. Riad was the senior portfolio manager, and Swanson reported to him.

10. FAMCO was involved in HCE's periodic reporting. For each HCE annual and semi-annual report, Riad provided Claymore with a signed certification that: (1) he had reviewed the portfolio of investments contained in HCE's report and that, to the best of his knowledge, the portfolio of investments was complete and accurate; and (2) to the best of his knowledge, the securities in the portfolio were purchased in compliance with the investment parameters set forth in the prospectus.

11. Each HCE annual and semi-annual report also contained a Questions and Answers discussion with Riad and Swanson (also referred to as the portfolio manager commentary). A Claymore consultant interviewed Swanson for each periodic report and then, after the interview, drafted the Questions and Answers section based on Swanson's statements during the interview. Once the initial draft was completed, Riad, Swanson, and others at FAMCO and Claymore reviewed and edited the Questions and Answers before it was included in the report.

12. For each HCE annual and semi-annual report, Swanson provided Claymore with a signed certification that he had reviewed the portfolio manager commentary contained in the report and that, to the best of his knowledge, it did not contain any material misstatement or omission that would make the report inaccurate or misleading.

In the Matter of Claymore Advisors, LLC, Respondent (OIP; Invest. Adv. Act 3519; Invest. Co. Act 30308; Admin. Proc. File 3-15139 / December 19, 2012). As set forth in the "Summary" to the Claymore Advisors OIP:

1. These proceedings arise from the collapse of the Fiduciary/Claymore Dynamic Equity Fund ("HCE" or "the Fund"), a registered closed-end investment company. From April 2007 through October 2008, HCE engaged in derivative strategies to supplement the Fund's covered call investment strategy. Specifically, HCE wrote out-of-the-money S&P 500 put options and entered into short variance swaps, which exposed the Fund to substantial losses in the event of a steep market decline or spikes in market volatility. HCE failed to include adequate disclosure about the principal risks to the Fund arising from the Fund's use of written put options and variance swaps, either in its annual report or in an amended Fund registration statement. In September and October 2008, HCE realized an approximately $45.4 million loss, or 45% of the Fund's net assets as of the end of August 2008, on five written put options and variance swaps, contributing to a 72.4% two-month decline in the Fund's net asset value ("NAV"). In its role as HCE's investment adviser and fund administrator, Claymore failed reasonably to supervise the Fund's sub-adviser, Fiduciary Asset Management, LLC ("FAMCO"), which utilized strategies and exposed the Fund to risks that were not adequately disclosed.

In the Matter of Fiduciary Asset Management, LLC, Respondent (OIP; Invest. Adv. Act 3520; Invest. Co. Act 30309; Admin. Proc. File 3-15140/ December 19, 2012): As set forth in the "Summary" to the Fiduciary Asset Mgmt OIP:

1. These proceedings arise from FAMCO's conduct as a sub-adviser to the Fiduciary/Claymore Dynamic Equity Fund ("HCE" or "the Fund"). From April 2007 through October 2008, FAMCO implemented two new derivative strategies to supplement the Fund's existing covered call investment strategy. Specifically, HCE wrote out-of-themoney S&P 500 put options and entered into short variance swaps, both of which had a significant effect on HCE's performance, but which also exposed the Fund to substantial losses in the event of a steep market decline or spikes in market volatility. HCE failed to include adequate disclosure about the principal risks to the Fund arising from the Fund's use of written put options and variance swaps, either in its annual report or in an amended Fund registration statement. As a result, FAMCO managed HCE in a manner that was inconsistent with the Fund's registration statement. FAMCO also omitted any description of these strategies and their effect on HCE's return from its commentaries in the Fund's 2007 annual report and 2008 semi-annual report. In those same reports, FAMCO also claimed that it had used hedging strategies to protect the Fund from downside risk, when in fact HCE's use of written put options and short variance swaps exposed the Fund to substantial losses in periods of significant market decline or volatility. In September and October 2008, HCE realized an approximately $45.4 million loss, or 45% of the Fund's net assets as of the end of August 2008, on five written put options and variance swaps, contributing to a 72.4% two-month decline in the Fund's net asset value ("NAV").

Two Down But Two To Go

In the three OIPs filed on December 19, 2012, the SEC alleged that investment advisory firms Claymore Advisors and Fiduciary Asset Mgmt  and portfolio managers Riad and Swanson failed to inform investors of the use of purportedly risky derivative strategies (including writing out-of-the-money Puts and shorting variance swaps) that were among the factors resulting in the collapse of the closed-end fund HCE. The OIPs alleged that the non-disclosed strategies contributed to losses in excess of 45% of HCE's net assets or $45 million in September and October 2008 -- resulting in the fund's liquidation in 2009.

In announcing the OIPs on December 19th, the SEC noted that both Respondent Claymore Advisors and sub-adviser/manager Respondent FAMCO,had settled the charges without admitting or denying the findings and had agreed to a Censure and to a Cease-And-Desist from securities law violations. Additionally, Respondent Claymore agreed to distribute up to $45 million in compensation to investors, and Respondent FAMCO agreed to pay $644,951 disgorgement with $134,976 interest and a $1.3 million penalty.


The Initial Decision

Following 11 days of hearings, the SEC rendered an Initial Decision. In the Matter of Mohammed Riad and Kevin Timothy Swanson (Initial Decision; Init. Dec. Rel. 590; Admin. Proc. File 3-15141; / April 21, 2014). As set forth in the "Summary" of the Initial Decision:

This Initial Decision (ID) concludes that Mohammed Riad (Riad) and Kevin Timothy Swanson (Swanson) (collectively, Respondents) violated the antifraud provisions of the federal securities laws while employed at an investment adviser that managed the portfolio of a closed-end investment company. The ID orders them to cease and desist from further violations and bars them from the securities industry. Additionally, the ID orders Riad to disgorge ill-gotten gains of $188,948.52 plus prejudgment interest and orders each to pay a third-tier civil penalty of $130,000.

 The parameters of the Bars against Riad and Swanson covered their:

[a]ssociation with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization and IS PROHIBITED, permanently, from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter.

In imposing the Bars, the ALJ explained that:

[R]espondents' conduct was egregious. The underlying trading strategy at issue was recurrent without any public disclosure for approximately eighteen months, and Respondents made misrepresentations and omissions in two successive reports to shareholders. Respondents acted with a reckless degree of scienter. Both Respondents continue to deny any personal responsibility for the violations, contending that the responsibility for disclosure was Claymore's. Each Respondent's occupation, in light of his education and experience, presents opportunity for future misconduct as well. It is in the public interest to bar respondents from the securities industry, and is an appropriate deterrent.


SEC Opinion and Order

Following the issuance of the Initial Decision, the SEC essentially confirmed the ALJ's findings and sustained the Bars, Cease-And-Desists, and financial sanctions. In the Matter of Mohammed Riad and Kevin Timothy Swanson, Respondents (Corrected SEC Opinion / Order;  '34 Act Rel. 78049; Invest. Adv. Act 4420; Invest. Co. Act 32146; Admin. Proc. File 3-15141; / June 13, 2016). As explained in the introductory synopsis of the Corrected SEC Opinion:

Respondents, who were associated with registered investment adviser, made fraudulent misstatements and omitted material facts in a closed-end fund's shareholder reports regarding the fund's use of new derivative investments and their effect on the fund's performance and risk exposure. Held, it is in the public interest to bar respondents from associating with a broker, dealer, investment adviser, municipal securities dealer, or transfer agent; order respondents to cease and desist from committing or causing any violations or further violations of the provisions violated; order disgorgement; and assess civil penalties of $130,000 against each respondent.

Page 1 of the Corrected SEC Opinion

In imposing sanctions, the Corrected SEC Opinion explains that [Ed: Footnotes omitted]:

Respondents' principal argument against a bar is that they lacked the intent to deceive and were transparent about how they managed the Fund-assertions that are inconsistent with the record and our findings above. Respondents also argue that bars are appropriate only in the most egregious cases and cite two follow-on proceedings involving criminal convictions. But scienter-based antifraud violations by investment advisers often result in industry-wide, permanent bars, and we have barred advisers even for committing fraud without scienter. Respondents point to their previously unblemished disciplinary records. Yet their "lack of previous securities law violations does not outweigh the concern that, for the reasons discussed above, [they] will pose a continuing danger to investors

Given Riad's involvement in researching, evaluating, and ultimately implementing the derivative trades at issue, he plainly was aware they were not adequately disclosed. He hid these facts from the Fund's Board and its shareholders. Riad signed off on the Q&A section in the Fund's reports and shared responsibility with Swanson for their contents. Riad also took the lead on portfolio discussions at Board meetings and thus was responsible for keeping the Board in the dark. For these reasons, we have determined that it is the public interest to permanently bar him. But as to Swanson-who did not personally research the derivatives (although he was aware of their impact on the Fund's performance and their risky nature), decide to implement them, or receive any direct personal benefit-we have determined that a bar with a right to reapply after two years will provide sufficient protection of the public interest and investors.

Page 59 of the Corrected SEC Opinion

As a result of the Corrected SEC Opinion/Order, the Bars imposed upon Respondent Riad and Respondent Swanson are no longer the same. The difference between the two Bars are set forth in the SEC Order Imposing Remedial Sanctions [Ed: Yellow highlighting provided];

It is ORDERED that Mohammed Riad be barred from association with any broker, dealer, investment adviser, municipal securities dealer, or transfer agent and is prohibited, permanently, from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter.

It is further ORDERED that Kevin Timothy Swanson be barred,  with a right to reapply after two years, from association with any broker, dealer, investment adviser, municipal securities dealer, or transfer agent and is prohibited, with a right to reapply after two years, from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter.

Page 1 of the SEC Order Imposing Remedial Sanctions

Motion to Stay

On June 24, 2016, Respondents Riad and Swanson filed a Motion to Stay the SEC Order Imposing Remedial Sanctions pending judicial review. The SEC denied the motion but did grant a stay of the disgorgement and civil monetary penalties. In the Matter of Mohammed Riad and Kevin Timothy Swanson, Respondents (Partial Stay Order;  '34 Act Rel. 78272; Invest. Adv. Act 4446; Invest. Co. Act 32174; Admin. Proc. File 3-15141; / July 8, 2016).  In offering its rationale for its analysis of the motion, the SEC explained {Ed: Footnotes omitted]:

The party requesting a stay pending appeal has the burden of establishing that a stay is justified. The Commission's consideration of such requests is governed by the traditional, four-factor standard-namely, (1) whether the stay applicant has made a strong showing that he or she is likely to succeed on the merits; (2) whether the applicant will be irreparably injured absent a stay; (3) whether issuance of the stay will substantially injure the other parties interested in the proceeding; and (4) where the public interest lies. Because the first two factors are the most critical, an applicant's failure to demonstrate the requisite likelihood of success or irreparable harm ordinarily will be dispositive of the stay inquiry.

We conclude that respondents have not carried their burden on their request for a stay. Respondents have failed to demonstrate a likelihood that they will prevail on appeal. They urge the Commission to reflect upon the "gravity of the issues that will be considered by the appellate court on appeal." . . .

Given respondents' failure to show a strong likelihood of success, they must marshal a much more compelling showing of irreparable injury absent a stay. 7 This they have also failed to do. To be cognizable, an asserted irreparable "injury must be both certain and great; it must be actual and not theoretical." The Commission has consistently found that the kinds of harms asserted by respondents-e.g., financial detriment, the loss of employment prospects, and the potential for collateral proceedings initiated by third parties-do not amount to irreparable injury. So too here. For example, Swanson asserts that his reputation suffered when the CFA Institute, a professional organization, acted to summarily suspend his membership following the Commission's decision in this matter. Swanson identifies no concrete consequences flowing from loss of membership, let alone grave and irreparable ones. Moreover, as a general matter, a concern that the Commission's decision could be employed "against [the respondents] in collateral . . . litigation does not constitute irreparable harm because reversal of the decision on appeal . . . would vitiate its use in other proceedings." If respondents ultimately prevail, there is every reason to believe that the CFA Institute (and other third parties) will take note accordingly. Indeed, the CFA Institute's Rules of Procedure for Professional Conduct provide that a summary suspension of membership "may be rescinded . . . if the [affected member] provides reliable evidence demonstrating that the underlying . . . industry bar . . . has been reversed."

Furthermore, any harm that might be suffered by respondents is outweighed by the
danger posed by allowing them to continue to serve in the securities industry while their appeal is pending. . .


Although much of the rationale presented in the Partial Stay Order is coherent and compelling, in my opinion the SEC is on less firm ground when it attempts to address the thorny issue of so-called permanent and non-permanent Bars:

The Commission has recognized the "significant distinction[s] between a true time-limited bar and a bar that includes a right to reapply after a certain period of time."19 Unlike a suspension or a time-limited bar (whose duration is limited by its terms), a bar with the right to reapply does not create an entitlement to automatically rejoin the securities industry after a pre-determined period of time. Swanson is eligible to reapply after two years; if he submits an application at that time, the Commission would determine whether, "under all the facts and circumstances presented, it is consistent with the public interest and investor protection to permit [him] to function in the industry."20 Thus, in the event that Swanson ultimately prevails in court and the Commission's sanctions against him are vacated, he would enjoy a meaningful, tangible benefit-the ability to resume his advisory practice without seeking relief from the Commission-regardless of whether he prevailed before or after the two-year period had run. 21 In short, the considerations that motivated McCune, Electronic Transaction Clearing, and similar cases have no application to permanent bars (with or without the right to reapply) because the respondent is not in "jeopardy of losing the benefit of a successful appeal."

Nonetheless, the Commission "has at times stayed monetary sanctions pending appeal without reference to the applicant's likelihood of success on the merits" or the other components of the four-factor test.22 We have not been presented with a developed argument as to the continued application of this practice. Therefore, under the circumstances and in our discretion, we elect to stay the monetary components of the Order Imposing Remedial Sanctions.

= = = = =

19 Edgar R. Page, Advisers Act Release No. 4400, 2016 WL 3030845, at *9 n.45 (May 27, 2016); see also Rockies Fund, Inc., Exchange Act Release No. 56344, 2007 WL 2471612, at *4 n.21 (Aug. 31, 2007) ("[A]lthough Respondents characterize the sanction . . . as a 'one-year bar and no fine,' the sanction was in fact a permanent bar with the right to reapply after one year.").

20 See, e.g., Ciro Cozzolino, Exchange Act Release No. 49001, 2003 WL 23094746, at *3 (Dec. 29, 2003); see also Rule of Practice 193, 17 C.F.R. § 201.193 (governing applications by barred individuals for consent to associate). The Commission does not usually impose a "time-limited bar" in its administrative proceedings because a "bar with a right to reapply provides additional investor protection." Page, 2016 WL 3030845, at *9 n.45.

Page 5 - 6 of the Partial Stay Order

SIDE BAR: In my commonsense legal and regulatory lexicon, a "Suspension" starts on a date certain and ends on a date certain -- which means that once the suspension is served, you're "good to go." In contradistinction, a "Bar" should start on a date certain and extend to the ends of time. Although my definition of a Bar borders on the eternal, that does not preclude an opportunity to seek a waiver or exemption.  Unfortunately, in my simple and sensible world, various regulators insist upon intruding with such puzzling alternatives as two-year Bars or Suspensions predicated upon findings of willfullness that render those suspensions as statutory disqualifications tantamount to a Bar. Say what you mean versus mean what you say.

For some sense of the recurrent nature of this issue, see, for example: "BrokerCheck Dispute Says FINRA Wrongly Says SEC Bar Is Permanent" (BrokeAndBroker.com Blog, June 9, 2016). As noted in the June 9th BrokeAndBroker Blog:

Permanent Bar of Merely a Bar With The Right To Reapply?

Is Wanger's BrokerCheck disclosure correct? Before offering an opinion, re-read the applicable portion of the SEC's Order Making Findings and Imposing Sanctions:

A. Respondent Wanger shall cease and desist from committing or causing any violations and any future violations of Section 17(a) of the Securities Act, Sections 10(b) and 16(a) of the Exchange Act and Rules 10b-5 and 16a-3 thereunder, and Sections 206(1), 206(2), 206(3), and 206(4) of the Advisers Act and Rule 206(4)-8 thereunder.

B. Respondent Wanger be, and hereby is: barred from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization; and prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter. with the right to apply for reentry after one (1) year to the appropriate self-regulatory organization, or if there is none, to the Commission.

Okay, so, Wanger is ordered to Cease-And-Desist and is "barred" with the "right to apply for reentry after one (1) year . . ."  Is BrokerCheck correct that the SEC imposed a Permanent Bar?  If you ask Respondent Wanger, he would tell you that he is none too happy with FINRA's characterization of his SEC-imposed Bar as being permanent. In the Matter of the Application of Eric David Wanger. (Order Directing the Filing of Briefs, SEC, '34 Act Rel. No. 78019; Admin. Proc. File No. 3-17226 / June 8, 2016). As explained in pertinent part:

[W[anger claims that the BrokerCheck posting "alter[s] the SEC Bar Order and re-interpret[s] the words . . . that now perforce has permanently blocked Respondent[] of his right to seek employment . . . ."

At this time, the Commission requests the views of the parties as to the preliminary matter of whether the Commission has jurisdiction to review Wanger's application pursuant to Section 19 of the Securities Exchange Act of 1934 . . .

Off To The Courts

Respondents Riad and Swanson did not prevail at the SEC and have appealed to the federal courts. Among issues raised at the SEC and rejected by that body but likely to be presented on appeal are these two Constitutional claims:

Respondents argue that ALJ Carol Fox Foelak-who presided over this matter and issued the Initial Decision-was not appointed in a manner consistent with the Appointments Clause of the Constitution. We find that the appointment of Commission ALJs is not subject to the requirements of the Appointments Clause

Page 63 of the Corrected SEC Opinion

Respondents argue that they were denied equal protection because the Commission proceeded against them administratively rather than in federal district court. They do not allege that they have been singled out because of their membership in a protected class or group. Instead, respondents contend that the Commission's discretionary choice of an administrative forum disadvantages them given the "nearly unique size and complexity of this case." We reject this claim for three reasons.

Page 68 of the Corrected SEC Opinion

Bill Singer's Comment

Somewhat lost in the fascinating progress of the SEC's case against Respondents Riad and Swanson is the march of time. Keep in mind that the regulator's allegations against the two individuals asserts misconduct that largely occurred in 2007 and 2008, some 8 to 9 years ago -- nearly a decade. Moreover, the SEC's OIPs against the two respondents were filed in 2012, some four years ago; and the ALJ's Initial Decision was rendered in 2014. Is that inexorable churning of the wheels of Wall Street regulation a bad thing? Perhaps yes. Perhaps no. The delays in reaching a final adjudication demonstrate that there are layers of appeal, which offer some Due Process protection. On the other hand, what is exactly the point -- the merit or the value -- of barring someone when the sanction is imposed a decade after the misconduct at issue?  

For better or worse, this is the present-day system of regulation: persistent, plodding, hobbled, and bloated. Kafkaesque in all its dubious glory.

Waiting for the end to come
Wishing I had strength to stand
This is not what I had planned
It's out of my control

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