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From Securities Regulation Daily, October 1, 2013

Jury verdict against The Reserve Fund sustained, civil penalties imposed

By Amy Leisinger, J.D.

In an action following a jury verdict in the SEC’s case against The Reserve Primary Fund and certain of its control persons and affiliated entities, the U.S. District Court for the Southern District of New York denied Commission’s motion for judgment as a matter of law and for a new trial, as well as the defendants’ motion for judgment as a matter of law. The court did, however, grant the defendants’ motion to amend the judgment to correct a clerical error. The court imposed second tier civil penalties against the corporate defendants and one official for his role in the violations but declined to impose disgorgement and permanent injunctions (In re The Reserve Fund Securities and Derivative Litigation, September 30, 2013, Gardephe, P.).

Background. As of September 2008, Reserve Management Company, Inc. (RMCI) was a privately held corporation that provided investment advisory services to a number of mutual funds, collectively known as the Reserve Funds; Resrv Partners served as the broker-dealer for all of these funds. The Reserve Primary Fund (the Fund), a money market fund, was the “flagship” fund. Bruce Bent Sr. and his son, Bruce Bent II, served as chairmen and executive officers of RMCI and the Fund.

On September 14, 2008, the Fund held $785 million in Lehman Bros. commercial paper. The next day, Lehman filed a bankruptcy petition, and because of its substantial holdings, the Fund was besieged by redemption requests. At a board meeting to address the effects of the Lehman bankruptcy, the Bents told the board that RMCI intended to implement a credit support agreement for the Fund and to seek approval for such an agreement from the Commission. After the meeting, Bent II informed sales and marketing that would to protect the NAV of the Fund and stated that this could be communicated to clients. This resulted in a shareholder communication, which was reviewed before distribution by Bent II, Bent Sr., and RMCI sales and marketing personnel, stating that: (1) RMCI intended to enter into a credit support agreement to support the “integrity” of the Fund’s $1.00 NAV and was submitting documentation to the Commission; and (2) the Lehman holdings would not have a “material impact” on the Fund’s because the holdings would “mature at par value.” The communication was sent to numerous Fund investors, as well as to rating agencies, and was posted on RMCI’s website. Patrick Ledford, RMCI’s chief investment officer, told Moody’s that redemptions appeared to have “stopped” and that RMCI had been able to sell sufficient assets to fund outstanding redemption requests.

On September 16, Bent II informed the board that the Fund’s custodial bank had suspended the Fund’s overdraft privileges and redemption requests and that RMCI did not intend to enter into an agreement to support the Fund’s $1.00 NAV. Thereafter, RMCI issued a press release announcing that the Fund had reduced its valuation of its Lehman holdings to zero, which caused the Fund to “break the buck,” with its NAV dropping to $0.97 per share.

The alleged that, while the Fund was collapsing, the defendants “engaged in a systematic campaign to deceive the investing public into believing that the Primary Fund . . . was safe and secure despite its substantial Lehman holdings” and failed to give the Fund’s board accurate information, thereby violating the antifraud provisions of the federal securities laws.

The jury found that Bent II negligently violated Sections 17(a)(2) or (3) of the Securities Act and that RMCI and Resrv Partners knowingly or recklessly violated these provisions. It further found that RMCI negligently violated Advisers Act Section 206(2) and knowingly or recklessly violated Section 206(4) and Rule 206(4)-8. Neither the Commission nor the defendants made applications with respect to the verdict before the court discharged the jury.

Judgment as matter of law/new trial. The SEC moved for judgment as a matter of law, or, alternatively, a new trial, based on the jury’s conclusions. The defendants also moved for judgment as a matter of law. The court that noted that judgment as a matter of law is only appropriate if the evidence is wholly insufficient to permit a reasonable jury to find as it did and that it must give deference to jury determinations and inferences. A motion for a new trial, however, “may be granted even if there is substantial evidence supporting the jury’s verdict,” but a court must conclude that “‘the jury has reached a seriously erroneous result,’” the court stated.

The Commission argued that it is entitled to judgment as a matter of law on its Section 10(b) and Rule 10b-5 claims against RMCI and Resrv Partners because the jury found that they violated Sections 17(a)(2) or (3) with scienter and that the jury thus necessarily determined that the SEC had satisfied each element of a Section 10(b). The court rejected this argument, stating that an inconsistent jury verdict “is a possible ground for a new trial, but not for entry of judgment as a matter of law.” However, the court continued, the SEC’s motion for a new trial must also fail, as the Commission waived this argument by failing to object to the verdict after it was delivered but before the jury was discharged.

The defendants moved for judgment as a matter of law, arguing that no reasonable jury could have found that: (1) RMCI and Resrv Partners engaged in a scheme to defraud; (2) Ledford’s statements to Moody’s were attributable to Resrv Partners; or (3) Moody’s was defrauded., The court, however, found that the evidence went beyond mere misstatements and was sufficient to permit a reasonable jury to find a fraudulent scheme and that the fact that the jury chose not to make a scienter finding as to Bent II does not demonstrate insufficient evidence to make a such a finding as to RMCI and Resrv Partners. Further, the court stated, ample evidence supports the conclusions that Ledford was acting on behalf of Resrv Partners when he spoke with Moody’s and that his statements the Fund’s ability to sell assets to satisfy redemption requests was objectively material. As such, the defendants’ motion for judgment as a matter of law was also denied.

Amendment of judgment. The defendants also moved the court to amend the judgment to strike the jury’s findings that RMCI and Resrv Partners acted “intentionally or recklessly” as “surplusage.” Because liability under the charged provisions requires merely a finding of negligence, the defendants contended, the scienter finding should be struck. The court also erred in including in the verdict form a question asking whether the Commission had proven that they knowingly or recklessly violated the provisions, the defendants explained. The court found this argument unpersuasive, noting that the questions used in the form reflect well-established law and were acknowledged by the defendants at themselves as trial. The court concluded that the verdict could be based either on a finding of scienter or negligence and that jury’s mental-state findings are relevant to determination of remedies and refused to strike the jury’s finding.

The court did, however, agree to amend the judgment to correct a clerical error to reflect the jury’s finding that the defendants violated Section 17(a)(2) or (3) rather than Sections 17(a)(2) and (3) of the Securities Act.

Remedies. The Commission moved for disgorgement, penalties, and permanent injunctive relief. Arguing in favor of disgorgement, the SEC contended that but for the companies’ fraud, there would have been an orderly liquidation of Fund assets in a much shorter period of time. The court noted that “[t]he purpose of disgorgement is to force a defendant to relinquish the amount by which he was unjustly enriched” and stated that the Commission did not show that any amounts defendants possess are “causally connected” to the securities violations established. The court thus refused to order disgorgement.

The Commission moved to impose third tier penalties on the defendants, but the defendants countered that the court should impose no greater than first tier penalties. The court found that SEC was judicially estopped from seeking third tier penalties because it persuaded the court to deny the defendants discovery on the issue of investor loss by arguing that the position that investor loss was irrelevant and cannot now argue for third tier penalties that require proof of losses. Even if the Commission were not estopped, the court continued, it has failed to establish the requisite link between the fraud violation and a “risk of substantial losses” of for third tier penalties. The court determined that second tier penalties are appropriate where, as here, the SEC cannot prove losses or risk of losses, and the defendants’ actions were not egregious or repeated and imposed penalties of $325,000 on each RMCI and Resrv Partners and $100,000 on Bent II.

The court also concluded that permanent injunctions were not warranted against any of the defendants, as RMCI and Resrv Partners are now defunct and not likely to commit future violations, and Bent II engaged in what the jury determined to be only negligent conduct and did over a period of less than 36 hours with no history of misconduct.

The case is No. 09 MD. 2011 (PCG).

Attorneys: Daniel Brett Rehns (Cohen Milstein Sellers & Toll P.L.L.C.), Peter E. Borkon and Reed R Katherine (Hagens Berman Sobol Shapiro LLP) for Reserve Yield Plus Fund Investor Group. Gary Steven Graifman (Kantrowitz Goldhamer & Graifman, P.C.) for Leon Frenkel. John Dellaportas and Kevin F. Berry (Duane Morris, LLP) and Marc Jason Shanker (Morgan, Lewis & Bockius LLP) for Reserve Management Company Incorporated. John Dellaportas (Morgan Lewis & Bockius, LLP) for Resrv Partners Incorporated.

Companies: Reserve Management Company Inc.; Reserve Yield Plus Fund Investor Group; Resrv Partners Inc.

LitigationEnforcement: FraudManipulation InvestmentAdvisers InvestmentCompanies NewYorkNews

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