October 10, 2007
Stoneridge Investments Argument
A study of the hearing transcript in the Supreme Court arguments on the Stoneridge Investments case on October 6th offers some interesting tidbits. 1) None of the eight Justices hearing the case (Justice Breyer recused himself) is willing to touch the core holding of the Central Bank of Denver case (that there is no private right of action under Rule 10b-5 for aiding and abetting). All Justices seemingly assented to the argument that Congress had accepted the opinion in the PSLRA of 1995 (Section 20(e))and Sarbanes Oxley of 2002 (Section 303). Justice Kennedy, the swing vote in Stoneridge wrote the majority opinion in Central Bank of Denver (he is not going to overrule his own opinion). 2) Those three (and perhaps four) Justices who appear desirous of finding liability for third parties must distinguish the Central Bank of Denver case and were searching for a rationale to do so. 3) The Justices were thoroughly conflicted and confused by the plaintiffs' lawyers attempt to distinguish the Central Bank of Denver case on the grounds that in that case there was no allegation of a "deceptive act" by the third party defendants. The plaintiffs' counsel argued that in the Stoneridge case the plaintiffs had alleged that the third party defendants committed a deceptive act by lying to Arthur Anderson, the primary violator's (Charter Communications) auditor. One of the Justices did not think the deceptive act was plead, another did not understand the difference between deceiving investors and deceiving Arthur Anderson, a third wondered whether the difference based on deceptive acts and just assisting another to deceive would ever exist in real life, and yet a fourth wondered whether in theory there was such a difference. It was a mess. The plaintiffs' have asked the court to split hairs to avoid overruling the old 1994 opinion using a distinction that is easy to misunderstand and hard to apply if properly understood. A case decided on such grounds would invite substantial disagreement in application in the lower courts. 4) Some of the Justices attempted to pursue a third tack. One asked whether there was a "middle ground" between primary violations and aiding and abetting, another asked whether tort law had any other doctrines that could apply, a third (with help from another) wondered whether there was an "overlap" in categories (one act could be both aiding and abetting and a primary violation. They each received no help from plaintiffs' counsel. The irony of the plaintiffs' counsel argument is that if everyone is in on the scam, there is no liability for assisting the primary violator's misleading statement; if, on the other hand, there is one innocent insider who assists, then all those who lied to the innocent party can be held liable. The distinction is nonsense and designed to create a huge opening (logic aside) in the otherwise tightly wrapped Central Bank of Denver case. 4) The defendants' lawyer insisted that primary violators had to make misleading statements to investors and this the defendants did not do. The government (the solicitor general) understood the problem (there cannot be multiple defendants???) with such an argument and, although supporting the defendants, impliedly disagreed with defendants' counsel. The government argued an absence of reliance doomed the complaint even if the plaintiffs' had plead a deceptive act by the defendants. One Justice noted that the reliance argument had not been briefed below and seeming was not part of the circuit court opinion. The circuit court had held, more obviously, that there was no deceptive act alleged. 5) Justice Kennedy, the swing vote (transforming a 4-4 into a 5-3 for the defendants) was pro-defendant and searching for a way to hold for the defendants and leave to a later day the liability of professionals (lawyers) who assisted primary violators who deceived their investors. This was, in my view, the central moment in the argument. He asked the defendants' counsel how he could find for his clients and still hold the outside lawyers who assisted in preparing the errant disclosure document liable. Defense counsel evaded the question with a stream of alternative hypothetical. All-in-all it was quite an exercise in mental gymnastics.
The Court made a mistake in 1994 (investors in an insolvent primary violator (a random event) now have no legal recourse in a private suit) and the Court will not fix it. The mistake puts pressure on the definition of "primary" violator and the Court could, in an effort to cut back on the damage, open up the definition but in so doing it will create severe application confusion. Some of the Justices are willing to suffer the cost to open the test but a majority of the Court hearing the case is likely not. Those who will not open up the test nor overruled Central Bank of Denver are willing to create an arbitrary result for investors based on their view that private securities litigation is out- of- control. But this is an artificial and arbitrary limit.
There is a fascinating debate going on in the country's B-School that foresees what law schools will soon also be debating. For some time the B-School ranking systems are heavily weighted towards post graduate employment. Professors bemoan the loss of an incentive to teach the "intangible qualities." B-School rankings are more market driven. The purveyors of rankings, and there are several that compete for the attention of potential students, have discovered that students pay primary attention to how employment opportunities enhanced by an MBA at a given school. The purveyors are just reflecting the market; they known they do not set or create the market. So B-School professors are upset with market forces in which they operate-- a common complaint of academics who want to "mold" things. I don't know about you but I'll throw my support in favor of the wisdom of the market.
SEC Compensation Report
The SEC has issued it first report on the compensation disclosure practices under the new rules. We should not be surprised; lawyers are doing what lawyers do. Lawyers by using traditional techniques are obscuring the data (too much technical information and too much general language, etc). The SEC is doing what it must -- pointing out that the disclosures are deficient. The consistently missing part of the package is apparently "analysis". Companies are supposed to discuss why and how they adopted the packages they did. Many of the disclosures are silent on the matter.
October 9, 2007
State Attorney General Securities Litigation
The State Attorney General, Marc Dann dumped his out-of-town lawyers in the state's lawsuit against Fannie Mae for securities fraud. He fired a Boston law firm and replaced it with a New York City law firm. No big news there. But wait. The Boston law firm (and an in-state Cincinnati law firm) was selected by his predecessor, Jim Petro, a Republican. Dann is a Democrat who ran a spirited successfully ran against another Republican. Both the Boston Law Firm and an affiliate of the New York City law firm contributed money to the candidates in the Ohio race. So did the Cincinnati law firm. Danna's office states that the campaign contributions had nothing to do with the choice, but the whole thing smells. Out of state law firms contributing to a local race for state attorney general while they are handling a case for the office or seeking to replace counsel in a pending case for the office? Oh good grief.
Regulation of OTC Derivatives
Stephen Cecchetti has written an op-ed in the Financial Times that argues for exchange traded derivatives (futures and options) over OTC derivatives (swaps)["A better Way to Organise Securities Markets"]. He concludes that government should create incentives (tax and regulatory) to drive those who like derivatives to the exchanges. This is a terrible ideal. The OTC is innovative and favors those who develop and use products the exchanges do not offer. Moreover, favoring the exchanges would make worse an already present problem of market concentration that gives the largest markets (the NYSE and the CME, for example) immense trading advantages. Concentrated trading in select markets is a recipe for mischievous behavior and for ossification of trading practices.
Stoneridge Arguments Today
One can infer from the oral arguments today on the Stoneridge Investments case that the defendants will prevail on a probable vote of 5-3 (Justice Breyer did not participate). In other words, the Court will limit secondary liability in private securities cases that otherwise could catch lawyers, accountants and auditors, and investment advisers who have aided those who engage in direct securities fraud. Six justices were on the Court when it heard the Central Bank of Denver case in 1994 and split 3-3 on that opinion. The comments of the six were consistent with their positions in that case. Two new Justices, Roberts and Alito, were active with questions that signaled a pro-defendant view. It will be up to Congress to repeal the Central Bank of Denver case, a case that was a mistake when decided and remains a mistake today.
What I find disturbing about the arguments in the business community swirling around this case is the exaggeration for potential defendants. Lawyers and accountants operated easily around an aiding and abetting standard before the 1994 opinion and will do so again if the opinion were to be repealed. Aiding and abetting requires an intent to aid the fraud ("recklessness in aiding the fraud" would be more of a threat but was never the standard), and lawyers and accountants are very able when it comes to papering a file with documents that demonstrate they do not have the requisite intent.
SEC and Environmental Disclosures
Environmental advocates have been pressuring the SEC for some time to force publicly traded companies in the United States to disclose completely their environmental impact, World Wide. The latest missive is from state officials who want the SEC to require that United States companies disclose potential material financial impact on company operations from "global climate change." The political agenda is obvious but there is something more fundamental going on here. Historically accounting rules were designed to monitor the flow of cash and assets, to make sure that those in management did not pocket the funds or otherwise divert the money. It was a very simple goal and easily accomplished with a liabilty system predicated on fixed, transactionally based accounting rules. We now are using accounting rules to provide data that forecasters can use to predict future values. This is a radically different philosophy for accounting rules and one that is much harder to enforce and design. Our liability system was predicted on the old philosophy, tracing the location of funds and assets, and does not easily accommodate the new philosophy. The liability system juxtaposed on the new function for accounting numbers could easily transpose into a system that penalizes legitimate risk taking to the disadvantage of the American business community. More and more we see the SEC parsing rules on accounting numbers to allow room for risk taking.
October 8, 2007
Our State Attorney General, Marc Dann, has made national headlines with his aggressive investigations into those in the financial industry. He is currently investigating players in the sub prime mortgage market. I would suggest that he focus on corrupt brokers and appraisers who were successful in passing off overpriced land to banks (and those who bought the paper from banks). Going after rating agencies and others in the securitization process makes less sense. At this point he may find that his efforts focus on negligence rather than intentional fraud and it is a stretch in expertise for a state official to deal with these folks. He may also find that the rating agencies surcharge Ohio borrowers in the future.
What to Expect From the Fed
History has shown that the Fed, subjected to intense pressure from the business community, is timely or even early when it eases interest rates (the federal funds rate) and, subjected to protestations from the business community, is tardy when it increases interest rates to combat increasing inflation. Look for more of the same.