Cypen & Cypen
FEBRUARY 12, 2009
Stephen H. Cypen, Esq., Editor
The Securities and Exchange Commission charged Merrill Lynch, Pierce, Fenner & Smith, Inc. and two of its former investment adviser representatives with securities laws violations for misleading pension consulting clients about its money manager identification process and failing to disclose conflicts of interest when recommending them to use two of the firm’s affiliated services. In Release 2009-13, SEC said there has been tremendous growth in the pension consulting business in recent years. The subject case is an important reminder to firms and their investment adviser representatives that, whenever they sit across the table from their advisory clients, they need to make sure that all material conflicts of interest are disclosed. According to SEC's order, Merrill Lynch failed to disclose its conflicts of interest when recommending that clients use directed brokerage to pay hard dollar fees, whereby clients directed their money managers to execute trades through Merrill Lynch. These clients received credit for a portion of commissions generated by these trades against the hard dollar fee owed for advisory services provided by Merrill Lynch Consulting Services. Consequently, Merrill Lynch and its investment adviser representatives could and often did receive significantly higher revenue if clients chose to use Merrill Lynch directed brokerage services. SEC's order finds that Merrill Lynch also failed to disclose a similar conflict of interest in recommending that clients use Merrill Lynch's transition management desk. In addition, SEC found that Merrill Lynch made misleading statements to the clients served in its Florida office regarding the process used to identify new money managers to present to its clients. SEC also charged Michael Callaway and Jeffrey Swanson, who were formerly employed in Merrill Lynch's Florida office. In a settled enforcement action against Swanson, SEC found that he made misleading statements to some of the firm's pension consulting clients regarding the process by which Merrill Lynch assisted them in identifying new managers. As a result, SEC charged Swanson with aiding and abetting and causing Merrill Lynch's violation of the Investment Advisers Act of 1940. Without admitting or denying SEC's allegations, Swanson has agreed to a censure, and to cease and desist from committing or causing violations of Section 206(2) of the Advisers Act. In the contested enforcement action against Callaway, SEC's Division of Enforcement alleged that Callaway breached his fiduciary duty in making misrepresentations about the manager identification process used by the Florida office and his compensation in connection with transition management services. The Division of Enforcement further alleges that Callaway was a cause of Merrill Lynch's violation of the Advisers Act because he failed to ensure that Merrill Lynch disclosed to clients conflicts of interest in recommending that clients enter into a directed brokerage relationship with Merrill Lynch and in recommending that they use Merrill Lynch for transition management services. The Division of Enforcement charges that, by such conduct, Callaway willfully aided and abetted and caused Merrill Lynch's violations of Section 206(2) of the Advisers Act. SEC charged Merrill Lynch with violations of an anti-fraud provision of the Advisers Act, which does not require a showing of scienter (intent). SEC also charged Merrill Lynch with failing to maintain certain records and failing to supervise its investment adviser representatives in the Florida office. Without admitting or denying SEC's allegations, Merrill Lynch agreed to a censure, to cease and desist from committing or causing violations of Sections 204 and 206(2) of the Advisers Act and to pay a $1 Million penalty. Stay tuned for similar actions against other consulting firms.
2. CALLAWAY REPLIES:
In a February 2, 2009 letter addressed to “My Friends, Associates and Former Clients,” Michael Callaway responds to the above SEC charges. Reiterating that Merrill Lynch has settled with SEC and ended its 3 1/2 year investigation of the firm, Callaway writes to say why he has chosen not to settle with SEC. Callaway believes SEC’s claims against him are made without adequate consideration (or presentation) of all key facts, and are without merit. Callaway believes that contesting those claims is the right thing to do. Callaway notes that in delivering consulting services to Merrill Lynch clients, he acted at all times in the best interests of his clients. Further, he claims to have acted at all times in conformity with Merrill Lynch policies that were in effect at the time -- policies determined by Merrill Lynch management personnel, rather than by him. Merrill Lynch knew how Callaway was conducting business, and it never directed him to change any procedures. The crux of SEC’s charges is that Callaway had a personal obligation to make additional disclosures to firm clients beyond those disclosures prescribed by Merrill Lynch, its management, its compliance officers and its legal advisors. Callaway believes this position is both unreasonable and impractical: it would require each financial advisor effectively to hire his own personal compliance officer, something which no one has ever suggested. Contesting SEC’s claims is certainly “not the easiest or quickest course of action for me, but I believe it is the appropriate one.” Time will tell.
3. THE DISAPPEARING DB PLAN AND ITS POTENTIAL IMPACT ON BOOMERS:
The long-term shift in coverage from defined benefit pensions to defined contribution plans may accelerate rapidly as more large companies freeze their DB pensions and replace them with new or enhanced DC plans. A new Working Paper from Center for Retirement Research at Boston College simulates the impact of an accelerated transition from DB to DC pension on distribution of retirement income among boomers. A scenario in which employers freeze all remaining private sector DB plans and a third of all state and local plans over the next five years will, on balance, produce more losers than winners among boomers and reduce their average income through age 67. Income changes will be largest among higher-income boomers, who have the highest DB coverage rate and projected pension incomes. Furthermore, the number of winners and losers in net income changes are much greater for the last wave of boomers (born between 1961 and 1965) than for earlier boomers. Younger boomers are more likely to have their DB pensions frozen with relatively little job tenure and to lose their high accrual years for DB pension wealth, but also to have relatively more years to accumulate DC pension wealth before retirement. Key findings include the following:
4. STUDY PROVIDES INSIGHT INTO FUTURE OF PENSION RISK MANAGEMENT:
MetLife U.S. Pension Risk Behavior Index uncovers gaps between pension plan risk factors deemed important and reported success in managing those risks. Plan sponsors for the largest U.S. defined benefit pension plans, which account for $2.3 Trillion in assets and cover nearly 42 million plan participants, report that they are focused on only a few risk factors associated with their pension plans. Many also reported inconsistent success in addressing the risks they view as most important. These are two of the key findings from the index. The first of its kind study polled 168 corporate plan sponsors among the 1,000 largest U.S. defined benefit plans on eighteen different risk factors identified by a panel of industry experts and researchers. MetLife designed and fielded the study to encourage public dialogue around pension risk issues. The primary objective of the research is to help plan sponsors develop a new framework for understanding risks, and to explore solutions of mitigating risk exposure. On an aggregate basis, plan sponsors surveyed ranked “asset allocation,” “meeting return goals” and “underfunding of liabilities” as most important -- factors that are relatively easy to model and measure. Risks ranked least important by sponsors are slower to change, more difficult to model/measure and may be less well understood. Among them are “longevity risk,” “mortality risk” and “early retirement risk.” What is surprising about the ranking is not the order in which the risk factors appear, which is relatively consistent with the asset centric, “total rate of return” pension plan management model that has prevailed over the past fifteen years. Unexpected, however, is the range of importance among risk items. The top four risk factors received the vast majority of attention, while the bottom four received nearly negligible readings. Asset allocation (the most important attribute) was ranked “most important” 54% of the time, while thirteen of the remaining eighteen factors were picked as “most important” 30% of the time. Looking separately at the responses of individual plan sponsors, the gap between “most” and “least” important risk factors is even greater. Only 26% of individual respondents rated a majority of risk items (that is, more than half) as important. Every respondent did not consider at least five of the eighteen risk factors (assigning an importance rating of 0.00%).
5. HIGHER PENSION CONTRIBUTIONS FOR OLDER WORKERS NOT VIOLATIVE OF ADEA:
In an action brought under the Age Discrimination in Employment Act, the U.S. Equal Employment Opportunity Commission challenged an aspect of the Baltimore County Pension System that governs employees hired prior to July 1, 2007 (see Cypen & Cypen Newsletter for September 27, 2007, Item 8). Under that system the percentage of salary that new-hires pay into Baltimore County’s Pension Plan varies depending on the number of years to retirement eligibility. (For example, a 30-year-old new-hire contributes more than a 20-year-old new-hire.) In the suit, EEOC contended that such provision discriminates against older workers. Following discovery, the parties filed cross-motions for summary judgment. The United States District Court for the District of Maryland heard oral argument, and concluded that the plan does not violate ADEA because (1) Baltimore County was motivated by a permissible principle, the time value of money, rather than the age of new-hires and (2) retirement benefits of older new-hires accrue faster than do benefits of younger new-hires. Thus, the court denied EEOC’s motion for summary judgment and granted Baltimore County’s motion. While it may be axiomatic, it should be noticed that ADEA does not prohibit employer actions when the motivating factor is something other than the employee’s age. This case is controlled by a recent Supreme Court decision concerning defined benefit pension plan offered by the State of Kentucky (see Cypen & Cypen Special Supplement for June 19, 2008). U.S. Equal Employment Opportunity Commission v. Baltimore County, Case No. L07-2500 (U.S. D., Maryland, January 21, 2009).
6. GUIDANCE ON FIDUCIARY DUTIES IN RESPONSE TO MADOFF SITUATION:
The U.S. Department of Labor, Employee Benefits Security Administration, has issued a statement entitled “DUTIES OF FIDUCIARIES IN LIGHT OF RECENT EVENTS REGARDING BERNARD L. MADOFF INVESTMENT SECURITIES LLC.” Recent events regarding Bernard L. Madoff Investment Securities LLC have resulted in fiduciaries, investment managers and other investment service providers asking the Department of Labor about steps they should be taking in connection with employee benefit plans they believe may have exposure to losses as a result of plan assets being invested with Madoff entities. Fiduciaries of employee benefit plans covered by the Employee Retirement Income Security Act of 1974 should address these events in a manner consistent with their fiduciary duties of prudence and loyalty to the plan’s participants and beneficiaries. Where plan fiduciaries determine that plan assets were invested with Madoff entities and material losses are likely, appropriate steps should be taken to assess and protect interests of the plan and its participants and beneficiaries. Such steps may include (1) requesting disclosures from investment managers, fund managers and other investment intermediaries regarding the plan’s potential exposure to Madoff-related losses; (2) seeking advice regarding likelihood of losses due to investments that may be at risk; (3) making appropriate disclosures to other plan fiduciaries and plan participants and beneficiaries; and (4) considering whether the plan has claims that are reasonably likely to lead to recovery of Madoff-related losses that should be asserted against responsible fiduciaries or other intermediaries who placed plan assets with Madoff entities, as well as claims against the Madoff bankruptcy estate. Fiduciaries must ensure that claims are filed in accordance with applicable filing deadlines. The website of the court-appointed trustee for liquidation of Bernard L. Madoff Investment Securities LLC is http://www.madofftrustee.com. The website contains liquidation notice, claims forms, related claims information and deadlines for filing of claims with the trustee. Although public plans are generally not subject to ERISA, the foregoing is sound advice.
7. THE AMAZING WARREN BUFFETT:
Warren Buffett was recently interviewed on CNBC. Here are some interesting aspects of his life:
He advises young people to stay away from credit cards and bank loans, investing in themselves and always remembering:
And the best philosophy of all: “The happiest people do not necessarily have the best things. They simply appreciate the things they have.” Warren, you da man.
8. EX-ILL. GOV. (NOT BLAGO) CATCHES PENSION BREAK:
We have previously written about the forfeiture of former Illinois Governor George Ryan’s pension (see C&C Newsletter for April 20, 2006, Item 3; C&C Newsletter for November 22, 2006, Item 3; C&C Newsletter for December 7, 2006, Item 5; C&C Newsletter for January 11, 2007, Item 11 and C&C Newsletter for June 7, 2007, Item 9). Well, according to the Chicago Sun-Times, a state appellate court has ruled that Ryan can keep the part of his state pension accrued from his state legislative and lieutenant governor days, about $65,000 a year. State officials and the trial court had stripped him of his entire pension for the 34 years he served in state government, after his conviction in 2006 for corruption while he served as Secretary of State and Governor. But the appellate court ruled that Ryan should not be denied that portion of his pension acquired over 22 years in the state legislature and as lieutenant governor. He will only forfeit the portion for 12 years served as Secretary of State and Governor. Ryan is currently serving a 6 1/2-year prison term. Illinois Attorney General Lisa Madigan has indicated that she will appeal the ruling to the state supreme court. Note how this ruling differs from a recent Florida appellate court decision (see C&C Newsletter for September 4, 2008, Item 1). Boy, the State of Illinois has sure come up with some great governors.
9. PRICELESS OBSERVATIONS:
By the time a man is wise enough to watch his step, he's too old to go anywhere.- Billy Crystal
10. QUOTE OF THE WEEK:
“The pessimist sees difficulty in every opportunity; the optimist sees opportunity in every difficulty.” Winston Churchill
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Items in this Newsletter may be excerpts or summaries of original or secondary source material, and may have been reorganized for clarity and brevity. This Newsletter is general in nature and is not intended to provide specific legal or other advice.