The collapse of the Primary Reserve Fund in 2008 in the wake of the Lehman Brothers bankruptcy was one of the key events of the market crisis. Quickly the federal government stepped forward and guaranteed the money funds to which many had entrusted their savings, considering the investment vehicles as good as U.S. dollars. Later those events would spawn calls for reform of the industry in a debate which still continues.
Those events also resulted in one of the highest profile Commission enforcement actions arising out of the market crisis, SEC v. Reserve Management Company, Inc., Case No. 1:09 CV 4346 (S.D.N.Y. Filed May 5, 2009). Now after weeks in trial a New York jury rejected each critical charge brought by the Commission, handing the agency a resounding loss. The jury did give the regulator a conciliation prize – favorable verdicts on negligence based charges. While the SEC lost, the real looser may be the investing public.
The Reserve Management case was about intentional fraud, not the afterthought negligence charges the SEC won. The factual section of the complaint details an intentional fraud. It centers on the collapse of the Primary Reserve Fund as the market crisis unfolded. The Fund was the first to “break the buck.” That collapse precipitated wide spread panic in the already shaky financial markets.
The case named as defendants Reserve Management Company or RMC, a registered investment advisor owned by defendant Bruce Bent Sr. and his family; Resrv Partners, a registered broker dealer which is the distributor for the funds managed by RMC and which is also controlled by the Bent defendants; Bruce Bent Sr., the Chairman of RMC and president, treasurer and trustee of the Fund; and Bruce Bent II, also an owner of RMC and a vice chairman and the vice president and assistant treasurer of the Fund.
The Fund, one of the oldest and most respected in the country, held $785 million of Lehman Brothers bonds on September 15, 2008 when the investment banking firm collapsed into bankruptcy. By mid-morning on September 15 the Fund was overwhelmed with redemption demands. The Fund’s custodian bank halted redemptions. In an effort to reassure investors and others the defendants made a series of misrepresentations, the complaint claimed, regarding the financial resources available in an effort to prevent the Fund from breaking the buck. Later that day what the complaint described as a flawed process was used to strike the NAV. This was advantageous to some investors but not to others. By the end of next day the Fund was forced to admit it had broken the buck.
The charges in the complaint match the factual allegations: Intentional fraud in violation of Exchange Act Section 10(b), Securities Act Section 17(a) and Advisers Act Section 206(1). The back up charges were negligence under 17(a)(2) and (3) and Advisers Act Section 206(2).
Throughout years of hard fought discovery as the facts were painstakingly developed the central nature of the case did not change. Its focus was scienter based fraud. Through weeks of trial those charges did not change as the jury was presented with the evidence. The SEC maintained that the defendants had engaged in a intentional fraud.
The jury’s rejection of the SEC’s intentional fraud claims presents two fundamental issues. First, despite vast investigative powers to gather evidence, and years of discovery, it is evident that the Commission never saw what the jury did. To be sure, any case can be lost at trial. When, however, the jury rejects each intentional fraud theory proffered by the Commission it is more than a loss, its time to evaluate the reasons the prosecution went wrong to ensure that it does not happen again.
Facing accusations of fraud from a formidable prosecutor such as the SEC and the prospect of penalties that can result in huge fines and the loss of one’s profession and hard built reputation is no small thing. Before anyone is put through that grueling, years long and very costly gauntlet, it is critical that the evidence and charges be checked and double checked and checked again. The verdict here suggests that a better process than the one used in this case needs to be instituted.
Second, the verdict here will no doubt strengthen the view of those who oppose any industry reform. The claims of wrongful conduct alleged in the enforcement action clearly aided the cause of reformers. If reform was difficult before there can be no doubt that this loss by the Commission will only complicate matters.
In the end, however, the real loser is the investing public. To the extent that a public skeptical about the integrity of the markets relies on a watch dog SEC for protection, this verdict will renew the feeling that the dog is toothless. To the extent that industry reform is essential for the of the public and the markets, that protection seems much less likely now.