Business Law Prof Blog

The Stoneridge Case

Since everyone, and I mean everyone (including an ex-Chancellor of the Exchequer writing an op-ed in the Wall Street Journal), has weighed in on the merits of the Stoneridge Investments v Scientific-Atlanta case  (to be argued in the Supreme Court on October 9th), these comments may be pointlessly futile.  Never stops other bloggers, so here is my two cents.  The case is the most important private securities litigation case in two decades.  At stake is the number of potential defendants in such cases.  The case pits the SEC against the Department of Justice and the Treasury Department.  The SEC voted 3-2 to support the plaintiffs (Chairman Cox voted with the two Democratic seat holders against the two Republican seat holders).  Sec. Paulson of the Dept. of Treasury came out in favor of the defendants and the Dept. of Justice brief supports his position. 

In the case a cable company, Charter Communications, cooked its books, inflating revenues.  The scheme involved contracts with two suppliers of set-top boxes, who may or may not have known of the alleged fraudulent disclosures by Charter.  The plaintiffs sued Charter and the two suppliers, arguing "scheme liability."  The business community recognized immediately that at stake is not only supplier liability but liability of professional advisers (lawyers, accountants, underwriters and financial consultants) and of lenders.  These groups do not want to be caught in private suits.  In short, Goldman Sachs and the corporate law firms of New York do not want to be sued (have I mentioned that the present Sec. of the Treasury is an ex-Goldman Sachs CEO?).  They have riled up foreign companies as well with arguments that foreign corporations, supplying United States companies, will be sued in United States courts.  This caught the attention of the ex-Chancellor of the Exchequer in England who made a veiled threat that English companies would not longer do business with United States companies if the case went against the defendants.

Most agree that we have too much private securities class action litigation in the United States. Over the past fifteen years the Supreme Court and Congress have be chipping away at the cause of action. That is the problem -- the chipping away-- there has been no systematic definition of the cause of action.  The Court has required scienter, actual trading by the plaintiff, and limited secondary liability.  Congress has enhanced pleading requirements (recently affirmed by the Court) and recast the priority of named plaintiffs.  I agree that "scheme liability" may be too broad, but only if it does not require that the secondarily liable parties have intent to aid the fraud.  In short I like the old aiding and abetting (and conspiracy) standards for secondary liability and believer the Court made a mistake in the old Central Bank of Denver case (the Court disabled private litigants from making an aiding and abetting claim). Those who intentionally aid someone else make a fraudulent disclosure should be liable under a centuries old notion of secondary liability for aiding and abetting or conspiracy.  At present only the SEC can sue under an aiding and abetting allegation (this is want some academics favor, power in the SEC, a public agency, and less power in the hands of private litigants).  This case is about protecting Goldman Sachs, Price Waterhouse and Cleary, from private suits not about English suppliers.  I do not see why they should be protected from damage claims if they intentionally aided and abetted a fraud, espectially if the primary wrongdoer is involvent.

Real Estate Flipping

I am still perplexed at how easily real estate flippers got away with false appraisals on overvalued land.  The banks loaned too much based on the true value of the underlying collateral and the seller's walked with the excess cash (often repeating the process as buyer then seller in the next cycle).  In the simple case the lending bank has a strong interest in checking the accuracy of the appraisal (or hiring its own reliable appraiser) before loaning money on a land purchase and taking back a mortgage.  Some argue that structured finance dilutes everyones incentive to check for fraud. The argument notes that the bank sells the paper to a special purpose vehicle (SPV) and the SPV sell securities to investors.  The risk of fraud is borne by the investors who do not or cannot check on the validity of any appraisals.  The investors rely on rating agencies to rate the default risk and the rating agencies are operating under conflicts because they are paid by the SPV and get consulting fees from the SPV.   The bank (and the originating broker) and the SPV no longer care because they take fees and pass on the risk.  The investors end up holding the bag.  The argument seems overly simplistic.  Most SPVs sell tranches and the lowest tranche, the so-called equity tranche, is not rated and very risky.  Those who buy the equity, usually hedge funds, have an increased risk of loan defaults and should therefore have an increased incentive to monitor the quality of the loans.  Indeed, one could argue that the equity buyers and a stronger incentive than a bank that does not sell the paper to check on the default risk in the loans because the hedge funds took more risk with each default. There were long time rumors in the market of real estate flipping. Why did the hedge funds not check out the rumors, or at least price the equity to account for the rumors?  Moreover, many of the same banks that passed on the risk to the SPV then bought SPV securities in their own hedge funds (and those funds are now in distress).  Why did the banks not have the proper incentive, when purchasing back the paper, to make sure the paper that went to the SPVs they invested in was sound?  In short, I continue to be baffled by stories of easy money (made even by gangs of thugs) on real estate flipping that overvalued land in the appraisals. 

Sallie Mae Deal Heads to Court

The private equity group that has signed a buyout deal with Sallie Mae has offered a lower price and Sallie Mae has refused.  Sallie Mae wants the original price.  The buyer will allege that new legislation limiting government subsidies for student loans is a "material adverse change." Sallie Mae will counter that the buyer is using the new act as a pretext to bail because the buyer's financing has become more expensive since the deal was inked.  I have come to believe that the negotiators of buyouts and other major market events such as IPOs spend most of their time on the upside potential of the deals and little time on legal provisions limiting downside risk.  The downside stuff is left to "form agreement" debates among lawyers and resolved by "street" standards.  Only when the market goes sour do the documents matter.  Those who understand the documents, the M&A hedge fund arbs, can make a buck betting on court outcomes.   

Hedge Fund Investors: How Wealth Should They Be?

The Securities and Exchange Commission is proposing to increase the net asset requirement for individuals seeking to invest in hedge funds to $2.5 million from $1 million.  The increase represents more than just a number that attempts to correlate wealth to the ability to bear losses.  It is a shift in regulatory philosophy.  The $1 million number comes from the accredited investor exception in the private offering rules (investors who are worth over $1million are not counted towards the minimum 35 in Reg. D Rule 505 and Rule 506 private offerings.  The increase will be tucked in another exemption in another act, the Investment Company Act.  Hedge funds then will not be able to do private offerings that other types of operating companies will still be able to do.  There is little justification for the division as investors can loss money in high risk operating companies as easily as they can in hedge funds.  Indeed, hedge funds are diversified and individual privately held operating companies are not -- the risk might be greater in the privately held individual companies.  Whenever the SEC focuses on individual industry rule-making it often just shuffles investors and their risk choices off to somewhere else.

Derivatives and Banks

There is a worldwide explosion in the use of off-exchange (OTC) derivatives by asset managers (such as university endowment offices) and pension funds.  This means, of course, that there is a similar explosion in the writing of such derivatives by counter parties, investment banks.  As numbers and variety of the complex instruments proliferate there are two problems -- a short term back office processing problem and  longer term valuation problems.  Both problems increase the risk of mistakes and any major trading mistake, given the inherent leverage of these instruments, can have huge consequences.  It is likely that we will see, with some increasing frequency, some spectacular losses as investment managers or bank agents miscalculate risk and valuation on some of these exotic instruments.  The quality of internal controls over investment decisions make by fund traders will be sorely tested and some will be shown to have been wanting.    

Tax and Hedge Funds

Congress has figured out why over 80% of our nation's hedge funds are located offshore -- tax avoidance.  The funds use financial derivatives (swaps) to minimize dividend taxes and use other systems to minimize compensation taxes and unrelated business taxes.  Congress has scheduled hearings and will not doubt pass legislation to close today's shelter systems.  Behind the shelter is, of course, our basic double tax system (tax corporate earnings and then tax dividends) that should be eliminated, eliminating most of the tax planning devices in place today.  With no tax on dividends (and no capital gains tax on the sale of stock), funds would a minimal incentive to locate offshore.  Revenue lost could be gained back through the adjustment of remaining personal rates.