Download SEC Hits Van Wagoner and Fund Director Over Private Placements

Investment Management Group
Update 2004-28
September 2004
Legal Update: SEC Hits Van Wagoner and Fund
Director Over Private Placements
If you have questions or would like
additional information on the material
presented herein, please contact:
Jay S. Neuman
412.288.7496
[email protected]
or
Frederick C. Leech
412.288.4178
[email protected]
Investment Management Group
C. Grant Anderson
G. Andrew Bonnewell
Byron F. Bowman
Andrew P. Cross
Gregory P. Dulski
John D. Johnson
Timothy S. Johnson
Gail C. Jones
George F. Magera
Lisa D. McAnany
Daniel M. Miller
Kary A. Moore
Donald J. Myers
Alicia G. Powell
Michael B. Richman
Leslie K. Ross
Victor R. Siclari
Nelson W. Winter
Todd P. Zerega
…or the Reed Smith attorney with
whom you regularly work.
This text is presented for informational
purposes and is not intended to constitute
legal advice.
On August 26, 2004, the SEC settled fraud charges against Van Wagoner
Capital Management, Inc. (VWCM), the investment adviser to the Van
Wagoner Funds, Inc. (the Funds), and Garrett Van Wagoner (the president
of VWCM) relating to their misstatement of the valuations of certain private
equity securities held by the Funds, and failure to observe the Funds'
investment restriction that limited "illiquid" investments to 15percent of net
assets. The settlement includes an $800,000 penalty from Van Wagoner
and VWCM, a seven-year prohibition on Van Wagoner serving as an officer
or director of a mutual fund, a seven-year restriction on certain of Van
Wagoner's activities with the investment adviser, and certain other remedial
measures. http://www.sec.gov/litigation/admin/ia-2281.htm
In a separate proceeding, the SEC announced on the same day actions
against and settlements with a former independent director of the Funds,
Robert Colman, who purchased private equity securities in transactions at
the same time as the Funds. The SEC found this to be an impermissible
"joint transaction." http://www.sec.gov/litigation/admin/ic-26581.htm
Van Wagoner and VWCM. The improper valuations at issue in this matter
are somewhat unusual, in that they involve the alleged intentional
undervaluation of the assets. According to the SEC's Order Instituting
Proceedings in this matter (in which Van Wagoner and VWCM neither
admit nor deny the allegations), Van Wagoner and VWCM misled the
Funds' shareholders about the size and value of the Funds' investments in
illiquid securities ("securities that were not publicly traded or could not be
sold readily"), which obscured the fact that the Funds' holdings in those
securities exceeded the limits stated in the Funds' disclosures. Van
Wagoner invested the Funds in illiquid securities issued by private
companies (with the hope that the investments would produce large returns
when the private companies went public). Because there were no market
quotations available for the private securities, they had to
LONDON
NEW YORK
be "fair valued," based on policies adopted by the Funds'
LOS ANGELES
board of directors. According to the SEC's Order, "Fair
SAN FRANCISCO
valuing these securities proved to be difficult and
WASHINGTON, D.C.
PHILADELPHIA
subjective." As described in the Funds' disclosures to
PITTSBURGH
shareholders, valuation was left to VWCM and carried
OAKLAND
out by Van Wagoner, subject to the oversight of the
PRINCETON
NORTHERN VA
Funds' board of directors. According to the SEC, VWCM
WILMINGTON
and Van Wagoner caused misleading representations to
NEWARK
MIDLANDS, U.K.
CENTURY CITY
RICHMOND
WESTLAKE VILLAGE
“Reed Smith” refers to Reed Smith LLP,
a limited liability partnership formed in the
state of Delaware.
© Reed Smith LLP 2004. All Rights Reserved.
r e e d s m i t h . c o m
be made about the Funds' investments in illiquid securities in two ways:
First, from mid-1999 through mid-2001, Van Wagoner understated the
amount of the Funds' investment in illiquid securities by treating all
publicly traded securities subject to "lock-up agreements" owned by the
Funds as liquid, and then continued to make new purchases of private
placement securities. Specifically, during 1999 and 2000, several private
companies in which the Funds had invested completed their initial public
offerings. After the IPOs, however, these companies' securities remained
illiquid because of "lock-up" agreements, which committed the Funds to
hold these securities for six months. Despite these obstacles to their sale,
Van Wagoner categorized all of these securities as liquid in reports to the
Funds' board and the Funds' shareholders. The SEC found that the
mischaracterization caused the Funds to significantly understate their
investments in illiquid securities, and Van Wagoner caused the Funds to
repeatedly purchase new illiquid private company securities (even when
holdings that were admittedly still private already exceeded the 15 percent
limit).
Second, in late 2000 and during 2001, the SEC found that Van Wagoner
reduced the valuations of groups of private securities without fair valuing
them in accordance with the Funds' policies, which caused the Funds to
understate their net asset values. According to the SEC, the Funds' fair
valuation policy established the original fair value of a private security as the
cost to the Funds in purchasing it. Thereafter, under the Funds' policy,
certain events at the company, such as another round of private financing, a
completed IPO, or a merger, could require a change in the fair value. The
policy also required VWCM to consider other factors on an ongoing basis,
such as "the operations of the issuer, change[s] in general market
conditions," or other information that affected the "fundamentals" of each
private investment.
Reed Smith, a leading global law
firm with nearly 1,000 lawyers
located in 15 U.S. and two U.K.
cities, represents Fortune 100 as
well as mid-market and emerging
companies. Clients include
technology companies and
entrepreneurs, financial services
firms, life sciences companies and
health care providers and insurers,
communications companies,
manufacturers, universities, nonprofit organizations, real estate
developers, and municipalities
throughout the United States and in
40 countries. For more information,
please visit reedsmith.com.
According to the SEC, beginning in late 2000, Van Wagoner reduced
valuations of private securities (including a number of across-the-board
reductions in the value of all private holdings, and taking the values of
certain holdings to zero) "in an effort to shrink the Funds' entire private
portfolio to avoid the 15 percent limitation." However, according to the
Order, information available at the time, and the records created at VWCM,
did not support the timing or level of the write-downs. For example, "Even
among the companies whose valuations were reduced to zero, most had
significant cash assets and had recently obtained, or were in the process of
obtaining, new private rounds of financing, which provided objective
evidence of fair values greater than zero."
The SEC concluded that, as a result of the conduct described above, VWCM
willfully violated the anti-fraud provisions of Sections 206(1) and 206(2) of
the Investment Advisers Act, and Van Wagoner willfully aided and abetted
and caused VWCM's violations; and that VWCM and Van Wagoner
willfully aided and abetted and caused the Funds' violations of Investment
Company Act Rule 22c-1 (requiring fund shares to be sold and redeemed at
their current net asset value).
Robert Colman. According to the SEC's Order Instituting Proceedings in
this matter (in which Colman neither admits nor denies the allegations),
"Before, during and after his service as a director of the Van Wagoner
Funds, Colman was an active investor in private placements of equity
-2-
securities," and between June 1998 and June 2000, Colman invested in
nine private placements of convertible, preferred securities offered by five
private companies. The Funds also invested in the same securities offered
by the same companies in the same rounds of private financing. Although
Colman independently identified the private equity investment
opportunities in question, and performed independent due diligence in
connection with his investment decision, in each such financing, both he
and Van Wagoner were aware that the other was making, or had made, an
investment in the same round of financing.
Without significant elaboration, the SEC found that Colman's series of
investments in the private companies at the same time as the Funds'
investments constituted "joint arrangements," and concluded that Colman
"willfully" violated Rule 17d-1(a) under the Investment Company Act
(which prohibits a registered investment company's director from
participating as a principal, or effecting transactions, in connection with
"joint enterprises" or other "joint arrangements" in which the registered
investment company is a participant, without having first filed with the SEC
an application, approved in an order, regarding such joint enterprise or
arrangement). To make matters worse, as a director of the Funds, Colman
was required to submit quarterly reports describing his own personal
investments pursuant to Investment Company Act Rule 17j-1(d). Although
he did submit quarterly reports, he did not describe any of his investments
in the nine private placements in the quarterly transaction reports he
submitted to the Funds during 1998, 1999 and 2000, thereby violating rule
17j-1 as well.
Colman, who resigned as a director of the Funds in July 2000, was ordered
to: "cease and desist" from committing or causing any further violations of
the reference provisions; disgorge the $13,500 in Fund directors' fees he
was paid during the period in question; and pay a $25,000 civil monetary
penalty.
Reed Smith, a leading global law
firm with nearly 1,000 lawyers
located in 15 U.S. and two U.K.
cities, represents Fortune 100 as
well as mid-market and emerging
companies. Clients include
technology companies and
entrepreneurs, financial services
firms, life sciences companies and
health care providers and insurers,
communications companies,
manufacturers, universities, nonprofit organizations, real estate
developers, and municipalities
throughout the United States and in
40 countries. For more information,
please visit reedsmith.com.
By Jay Neuman. Mr. Neuman is a partner with Reed Smith’s Investment
Management Group.
-3-