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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-