Business Law Prof Blog

Plaintiff's Securities Lawsuits

Plaintiffs lawyers who have filed class action securities suits relating to the sub-prime loan crisis face Congressionally mandated higher pleading standards.  The standards were a crude attempt by Congress to stop an acknowledge problem in the United States - an excess of securities class actions.  But plaintiffs lawyers are also complaining about a recent Supreme Court case that establishes clearly what was or should have been the law for some time, that plaintiffs must prove causation -- the acts complained of caused damage.  The press blames the Supreme Court for "higher" bars to recovery. In truth it is 1) a Congressional statute and 2) a long history of required causation that will test plaintiffs attorneys.  I suspect that the press, gearing up for a political fight over court nominees, will slant its coverage of business litigation.

Sarbanes-Oxley Compliance Costs Decline

A survey of 185 companies by Financial Executives International found that compliance costs for Sarbanes-Oxley's internal controls audit requirements, Section 404, had declined 5.4% last year.  Total audit costs were up 2%, however.  The data will give some solace to SOX supporters.  It does not affect the basic argument against Section 404 however:  1) The SEC vastly underestimated the costs of Section 404;  2) The current costs of Section 404 still hovers around $850,000 per firm -- nearly 25% of total audit fees; 3) The early costs of Section 404 were in the million per firm; 4) Small companies are still exempted by SEC order because they simply cannot afford to comply; and 5) Section 404 has not stopped the current sub-prime mortgage crisis or any other major financial crisis  (it does catch shortfalls in penny cash discretionary accounts, however). In short, the section is still a disaster and should be repealed.   

Arbitration: "Be Careful What You Wish For"

Not long ago arbitration was one of the darlings of the anti-court, anti-lawyer crowd.  Courts and lawyers cheated poor people and arbitration was a solution.  Now mandatory arbitration clauses are common in consumer industries and there is a bill pending in Congress to ban them.  Why?  Business likes them.  So much so that they are willing to collude, apparently, to make them industry wide.  The Second Circuit has reinstated a complaint against credit card issuing banks that claims they colluded to put mandatory arbitration clauses in all credit card agreements.  "Be Careful What You Wish For" [Hillary Clinton statement to a reporter when told conservative radio talk show host Rush Limbaugh was counseling his listeners to vote for her in the Democratic primaries so as to disrupt the Democratic nominee selection].

Private Equity Still Flush with Cash

Private equity funds are sitting on close to one trillion dollars, one trillion dollars, on uninvested cash.  Investors believe the funds will do better than alternative investments -- no matter what the academics say. 

Rating Agencies

The SEC is finally, finally, tackling the problem of rating agencies.  They are very, very late to the party on the matter.  Moreover, the SEC has found that its running up against Reg. FD and insider trading rule problems in the solutions in wants to propose -- that agencies demand more information when they rate securities.  I was introduced to the ratings agency mess as a consultant on a law suit that ended in a bizarre result.  A local municipality refused to pay all the agencies for ratings -- it would pay only one.  One of the other rating agencies then rated the bonds anyway and hammered them -- resulting in the municipality having to pay higher interest rates.  When the municipality sued for, in essence, economic extortion, the judge dismissed the suit on First Amendment grounds -- free speech!!  Extortion is free speech??  Unbelievable.  The real problem hear is one the SEC will not address -- the SEC has created a oligopoly in the industry.  The SEC does two things -- it requires ratings in many of its rules and it licenses the rating agencies.  Since few rating agencies are licensed the rating agencies that are can demand high prices and do shoddy work.  The SEC is throw this open to market forces by no longer requiring ratings (only the disclosure of any and all ratings that do exist) and by licensing many more rating agencies (a simple test and a character qualification should do it).  Let investors choose the rating agencies they trust and ask firms to us. 

States as Creditors in Bankruptcy: Ohio and Skybus

Ohio has found itself as a major creditor in the bankruptcy of Skybus Airlines and it will, as other creditors will, get nothing.  The Ohio Department of Development gave Skybus 1.5 million taxpayer dollars to locate in Columbus.  One year later, the money and the airline are gone.  Ohio has filed a claim in bankruptcy and will get nothing.  The head of development in Ohio, the Lt. Gov., has indicated that it will "keep an open mind" about forgiving the debt for potential purchasers of the airline.  In other words, he has learned little.  There will be no purchasers and he will have to pony up another big new grant to get a new airline in town -- he will be willing to double down with tax dollars.

National City's Woes Affect Ohio Pension Plans

It was an easy prediction to anticipate shareholder lawsuits over the National City buyout.  Shareholders have lost 84% from highs and the hedge fund buyout group is diluting existing shareholders by close to 70 percent at a below trading market price.  Not only are private shareholder the big losers -- employees who took company stock into 401(k) pension plans and sat on it and Ohio pension funds that try to invest in Ohio companies too baths as well.  It is another hard lesson for Ohio public pension plans that should invest for pure returns rather than out of local social obligation. 

Intrepid Potash IPO a Success

Agri-business in the United States is booming.  Note the success of the Intrepid Potash IPO in the United States yesterday. Shares of the pure-play agricultural nutrient producer, Intrepid Potash, Inc., began trading yesterday on the NYSE.  The 30 million-share IPO sold for $32 per share.  At $32 per-share, the IPO price was $3 above the top of the $27 to $29 anticipated pricing range. The offering was recently increased from 24 million shares and had an estimated price of $24 to $26 per share.  Intrepid stock rose over 50% or  $15, to $47 per-share, giving the company a $3.6 billion market cap.  There is money out there, waiting.

Hedge Funds to the Rescue: National City

In what has to be galling to the many hedge fund critics, the nation's hedge funds are rescuing the country's ailing financial system.  After the overblown hysteria directed at hedge funds in the past two years we have discovered that our main line banks, not our hedge funds, are the financial institutions that lost internal control over risk and are in distress.  The hedge funds, with capital, are riding to the rescue of the banks that are sorely in need of capital.  Without the hedge funds, the banks would either go under or suck up more government money in bailouts.  Unlike a government bailout, the hedge funds are providing need capital for profit -- they expect good returns.  The hedge fund returns come from the dilution of existing shareholders -- who should take a hit.  The National City cash infusion is a case in point.  Hedge funds put $7 billion in the bank, saving it from collapse.  The only issue is whether managers, who mismanaged the bank, sold to quickly and to the wrong bidder. Hedge funds are smart.  They show a paper profit after their weekend investment even though the stock dropped 28 percent yesterday (Monday) on the bank's announcement of first quarter losses.  The existing shareholders have lost big (84% from highs).  Where are the hedge fund critics now???

How Good People Have Come to Look Like "The Three Stooges"

We have three very talented and experienced people running our capital markets.  Chris Cox, a well-respected, capable member of Congress, is Chairman of the SEC; Henry Paulson, who ran the world's best investment bank -- Goldman, is Secretary of the Treasury; and Bob Bernanke, who is an intellectuals intellectual on market crisis, is Chairman of the Fed.  These are able, honest, capable folks.  Then why do they now look like the Three Stooges.  Cox and the SEC sat on the sidelines in the securitization mess (not to mention the mutual fund mess and the Wall Street analysts' mess).  Paulson is initiating study groups and and producing proposals that do not relate to the present crisis and that have no chance of passage anytime soon and has decided to broker investment bank buyouts with government money.  Bernanke is fighting with Paulson over buyout prices, late to the party on interest rate changes (calm too long and now too much in a panic), and has decided to regulate investment banks and brokerage houses as well as commercial banks.  It's the Three Stooges regulating our capital markets.  Permit me a bit of amateurish psycho-babble (move over Obama):  Good people get into government and just lose their focus -- they are scared that the history books will condemn them for a severe economic downturn -- so they do something, anything, to attempt to appear anyway as concerned, committed, and engaged.  They would rather go in the history books as well-intended and not effective than detached.  But sometimes detached is what they should be.  Markets correct themselves.  If they want to appear committed they should all focus on fraud prosecutions and condemnations.  Enforce the rules on the books.  Go after those who did not disclose the truth or who lied to people and extract appropriate penalties.  

New "Best Practices" Guidelines for Hedge Funds

A group of hedge fund managers, backed by treasury Secretary Hank Paulson, have just published a "Best Practices Guide" of hedge funds.  The Guide contains the expected -- more transparency and better internal valuation of assets.  Although the Guide is voluntary it could soon be part of the contractual obligations of the industry as hedge fund clients and counterparties may demand that the Guide's directors be included in their contracts.  One should not that the present economic crisis has hit the brokerage houses and investment banks much harder than hedge funds.  Given all the caterwauling about hedge fund risk taking in the past year or so, it should be well noted that it is not hedge funds that have proven to be the most vulnerable to the credit crunch. 

Questions on KPMG's Audit of New Century

The surprise failure of New Century Financial, one of the country's largest subprime mortgage lenders, has led to an all too familiar question -- how could the auditors have given the company a clean bill of health right up until the collapse?   KPMG has some explaining to do.  The Sarbanes Oxley Act of 2002 was largely pointed at auditors whose roles in the collapse of Enron and WorldCom drew the ire of Congress.  The Act increased auditor liability for inadequate performance, created a new auditor watchdog agency, and added procedural requirements intended to protect auditor independence and enhance auditor quality.  Yet -- the same old story -- a firm with a clean audit collapses and the auditor's for the firm disclaim any and all fault.  The audit industry mess reflects an inherent conflict of interest -- managers who select and pay auditors are those whom the auditor's audit.  We would not let football coaches pay game referees after each quarter, but we allow managers to pay auditors after each quarter.  Auditors should report to shareholder or investor groups not managers.  Until the basic conflict is cleaned up the salves, such as those in Sarbanes Oxley, will provide only temporary and partial relief.

The Uptick Rule

In July of this year the SEC finally overturned the "uptick" rule on short selling. The rule disables short sellers from shorting stock until after an uptick in the stock price.  Jim Cramer has called the SEC "morons'' for repealing the rule.  As usual, Cramer is wrong.  The market for years has had a vested interest in stock price appreciation and the law was slanted in that direction.  Penalties on short sellers are part of the legal bias.  The bias proves short term comfort at a long term price -- short term prices are artificially high and major asset re-valuations, when they come, are big and painful.  The same argument applies to artificially low interest rates -- we get short term asset bubbles that are very painful when they finally collapse.  Cramer, of course, is also pushing very low interest rates (to allow his buddies at the investment banks to print money).  Cramer is the moron. 

Sovereign Wealth Funds

When the sovereign wealth funds showed up to invest in United States financial institutions, my first response was great -- we enjoyed Japan's sucker money in the 1990s and now we will enjoy this sucker money as well.  Well, how are they doing.  The China Investment Corp has lost gobs on its $3 billion investment in Blackstone and the $5 billion it put in Morgan Stanley.  The Kuwait Investment Authority has lost big on investments in Merrill Lynch, Citigroup.  Bureaucrats care bureaucrats whatever country they come from; they are not astute investment managers.  Our bureaucrats do no better but it does ease the mind some to have other country's bureaucrats in our markets. 

James E. Cayne and the Bear Stearns Collapse

The chair of Bear Stearns, James E. Cayne, was a high flier -- brash and self-important.  He held 1$ billion in Bear Stearns stock.  After the collapse of Bear Stearns, his stock, which he sold, was worth $61 million.  Ordinary folks will not cry for him (he still has loads of money) but he did lose $940 million dollars in less than one year.  He also lost his false pride.  His brashness now does not play well on the street.  Recall the stories of how he refused to come off the golf course or the bridge table when problems were brewing. He has been humiliated and is ashamed and should be ashamed and others on Wall Street should note his example.  Rumor has it that he is turning to religion to help himself explain his predicament.  He does not need religion.  He should read Fitzgerald.

Two Items on Financial Restatements

The SEC's Advisory Committee on Improvements to Financial Reporting met last week in San Francisco, and discussed a February report from the Committee finding that companies are restating financials "for trivial reasons that have no bearing on their true financial situation," as BNA sums up the report.  Ultimately, the Committee report proposed that:

·       Prior period financial statements should only be restated for errors that are material to those prior periods.

·       The determination of how to correct a material error should be based on the needs of current investors. For example, a material error that has no relevance to a current investor’s assessment of the annual financial statements would not require restatement of the annual financial statements in which the error occurred, but would need to be disclosed in an appropriate document, and, to the extent that the error remains uncorrected in the current period, corrected in the current period.

Although this seems to me to be a sensible position, a number of concerns were raised by consumer and investor advocates and some institutional investors.  Most notably, a representative from the Capital Group, a very large fund manager, argued that a company should restate previously reported amounts for individual income and expense items on the income statement even though the previously reported net income number would not change as a result, stating that "[w]e are very interested in the corrected individual components of the income statement and use the changes in specific income and expense items over time as part of our trend analyses." 

The Capital Group’s position aside, I suppose that the real value in restatements for investor rights advocates is that a restatement is sometimes a prelude to a securities litigation claim—decreasing the number of restatements will probably decrease the number of securities fraud suits, which investor advocates promote as an important check on management. 

In related news, Plumlee (Utah) and Yohn (Indiana) recently posted on SSRN a study entitled An Analysis of the Underlying Causes of Restatements :

Abstract:      

The dramatic increase in the volume of restatements over the past years has been attributed to causes such as the complexity of the accounting standards, internal control reviews, changes in materiality thresholds, the overly conservative nature of auditors, earnings management, increased transaction complexity, and the second guessing of management judgments. While there are many explanations for the increased number of restatements, empirical evidence on the underlying causes of restatements has been lacking. This study provides such evidence by directly addressing the questions of what causes restatements, what characteristics of the accounting standards cause restatements, and whether the materiality threshold for restatements has fallen over the years. We analyze the disclosures related to each restatement filed during 2003 through 2006 and identify and categorize the underlying cause of each. Using these data, we analyze the relationship between the causes and various firm characteristics, including size and auditor type. We also consider the impact of contributing factors (including the clarity of standards and the use of judgment) on restatements caused by characteristics of the standards.

We find that, inconsistent with the notion that increased complexity has caused the rapid increase in the number of restatements, restatements are most often caused by basic internal company errors unrelated to the accounting standards themselves. We also find that for those restatements caused by some characteristic of the accounting standards, the primary contributing factor was the lack of clarity in applying the standards and/or the proliferation of the literature due to the lack of clarity in the original standard. Judgment and the use of bright lines are much less frequently cited as the contributing factors, and the proportion of restatements that they are related to has decreased across our sample period. Finally, we find some evidence that the materiality threshold applied in the decision to restate appears to have decreased over our four year sample period.

Posted by: Paul Rose

A Plug (Sort of) for XBRL

The SEC has expended a lot of effort in promoting XBRL (extensible business reporting language), which essentially codes data within electronic SEC filings so that the data can be searched and analyzed more easily.  The SEC even invites software engineers to download the source code.    Paul Schott Stevens, President and Chief Executive Officer of the Investment Company Institute, gushes that XBRL can "put investors in the driver’s seat by facilitating automated search, retrieval and analysis of tagged data.  By enabling investors and others to manipulate data, to perform analysis and comparisons, and to drill down deeper into layers of information, interactive data can truly increase the value of information made available to the public."

While I am skpetical that many investors will have the patience and economic justification to use XBRL regularly, it has the potential to be a useful tool for sophisticated institutional investors.  Ideally, investors concerned with executive compensation at a portfolio company, for example, could easily compare the company's pay packages with other companies of similar size within the same industry.  The problem is that while XBRL is useful, it is voluntary, and so there are limited comparables.  Let's say that you are worried about the pay of Tim and Gert Boyle at Columbia Sportswear.  A couple of selections from a drop-down menu (market cap: up to 9.5 billion; Industry: Apparel), and you'll see that Tim and Gert are paid significantly less than their equivalents at Jones New York and Liz Claibourne.  Of course, those companies both have market caps of $3.5 billion and revenues approaching $5 billion, while Columbia is a $600 million company, and has revenues of $1.2 billion.  Alas, there are as yet no other comparables. 

Posted by: Paul Rose

New Form D Requirements

The SEC continues to tinker with private equity offerings by proposing changes to Form D, the disclosure document for Reg D offerings.  All companies must file Form D electronically by March 16, 2009 (or voluntarily after September of this year).  The electronic filings will be easy for the public to access (the old ones required a trip to Washington).  The public nature of the filings has caused the SEC to eliminate the requirement that 10% or larger shareholder must be disclosed (venture capital funds will retain anonymity).  Moreover, there is no longer a requirement that the identity of limited partners be disclosed (encouraging start-ups to use partnership forms of financing once again). Once again the SEC has not gone far enough.  The Form was designed to notifiy the SEC of Reg D offerings (to stop fraud) not the public.  Now that the filings are on line they will become public disclosure documents more than SEC notices.  Why should the public know at all how a private company is financing itself?

Rule 144 and 145 Changes

Effective February 15th, new versions of SEC Rules 144 and 145 went into effect.  There are some major changes hidden here.  First,  Rule 144 reduces the required holding period to only six months for "restricted stock" of a reporting issuer.  Reporting issuers will be much encouraged to use private stock offerings.  More important perhaps is that investors of non-reporting issuers that are looking to become reporting issuers in IPOs will enjoy a 90 a scant required ninety day holding period after the IPO.  The investors no longer need to demand listing covenants (piggy-back or S8 offerings) in their investment contracts.  Second, Rule 145 eliminates the presumption underwriter doctrine for all target shareholders taking stock in a stock swap acquisition if there are no shell companies involved.  Stock swap acquisitions in strategic acquisitions, for example, allow recipients of stock to sell everything they get immediately (as long as they are not controlling shareholders after the deal).  The rule also favors strategic buyers over buyout buyers in an auction, as the recipient shareholder in the buyout still are subject to resale restrictions.  These are major changes.  Again the SEC is tinkering with the private equity markets (always a worry) but a reduction of requirements here makes sense.   

Visa's Public Offering

Visa has announced plans for the single largest intial public offering in American history.  It plans to sell $17.1 billion in stock in March.  The announcement is both good and bad news, in a way.  It is good news in that Visa, and its advisers, have given a strong vote of confidence on the condition of the stock markets.  It is bad news in a way because the ratio of stock to debt in capital raising is a negative indicator of overall market health.  When the market is sick, more companies have to raise money in stock offerings.

Club Deals in Private Equity Buyouts

There has long been a question about whether potentially competing private equity firms all after the same company could agree amongst themselves to make a joint offer, a club deal, rather than compete with each other on price.  Is the joint offer a version of "price fixing" or "auction rigging" in violation of state and federal antitrust style statutes?  A federal court in Seattle says no.  The court dismissed an antitrust action brought against Vector Capital and Francisco Partners for a club deal to buy Watch Guard Technologies for $151 million.  Several other similar actions are pending on other buyouts.  Until clear antitrust standards are developed for club deals, the threat of antitrust litigation may well discourage deals that otherwise could close.  These actions ought to be difficult to win because the public nature of any auction means than all buyout firms, as well as strategic acquirors, are potential bidders.  A club deal for a discount price should, in theory, tempt other bidder to ante up.  Strong evidence of a heavily constrained bidding market ought to be required to stop any given club deal.    

Theft and Insider Trading

Posted by:  Paul Rose

In Friday's New York Times, Floyd Norris discusses a case in which a hacker obtained material, non-public information and made $296,456 in trading profits.  Do insider trading laws require him to forfeit the gains?   

This situation exists because of a strange anomaly in American securities laws. A person who legally obtains insider information — as a corporate official or an investment banker, for example — will almost certainly break the securities law if he or she trades on the basis of that information before it is made public.

But it is far less clear that someone who illegally gets their hands on such information will have violated the securities laws by trading on it. The securities law used to bring insider trading charges — Section 10(b) of the 1934 Securities Exchange Act — talks of “a deceptive device or contrivance,” and it is not clear that there is any deception involved in simple theft.

It goes back to fiduciary duty.  Reminiscent of Chiarella, in this case District Court Judge Buchwald ruled that because there was no duty owed to the victims of the theft, there is no deception on which a 10b-5 claim could be based.  The SEC argued to no avail that the required element of deception was satisfied by hacking into the system, which was only for use by authorized persons.  Norris quotes Donald Langevoort, who has written extensively on insider trading (including a treatise) as asking: “Did he commit fraud? Yes.  Was it for the purpose of obtaining a trading advantage? Yes. Why should that not reach the level of the statute?”   From a policy perspective, I agree with Professor Langevoort.  However, the fiduciary duty requirement will likely continue to prevent such a result under U.S. law--as Norris notes, an act of Congress would seem necessary to ensure such activty falls under the insider trading laws. 

(hat tip: Justin Kilgore)

SEC Commissioner Atkins Speaks Out on SAB 99

Posted by:  Paul Rose

At last week's "SEC Speaks" conference, Commissioner Paul Atkins addressed, among other things, the "age-old" question: What does it mean to be material?  Of particular interest were his comments on Staff Accounting Bulletin No. 99, which gives the SEC staff's view that the use of percentages as a numerical threshold for determining materiality is not acceptable:

The SEC allowed the waters to be muddied on the issue of materiality in 1999 with Staff Accounting Bulletin 99. Anyone who has tried to apply SAB 99 is left with little certainty. . .. Would it surprise you to learn that SAB 99 does not necessarily represent the views of the Commission? As the title implies, it is a Staff Accounting Bulletin. The process of issuing Staff Accounting Bulletins is organized to avoid "complications" with the Administrative Procedure Act. Is that how a full-disclosure agency should operate? The Commission never voted on the views espoused within any SAB, so it does not and cannot represent the views of the SEC. Worse yet, SEC staff developed SAB 99 without public input. Substantive policy ought not to be made by the staff in private meetings, and ought not to be made based solely on the wisdom and experiences of SEC staff.

Moreover, since SAB 99 was released, a lot has changed. We now have Sarbanes-Oxley and new case law and regulations. Some persons are promoting new disclosure requirements on topics such as state sponsors of terrorism, climate change, and global warming. As the Advisory Committee on Improvements to Financial Reporting will discuss at its meeting next week, the issue of materiality may need to be revisited. I support the work of that committee and appreciate Bob Pozen's leadership. When the SEC takes up this issue, we must approach it by returning to "first principles" — that materiality is determined based upon the objective "reasonable investor" standard. The Commission itself — after proceeding with public notice and comment — should clear up this issue with the full input of the investor, legal, accounting, academic, and business communities.

The Report of the Advisory Committee referenced by Commisioner Atkins came out yesterday, and as expected addressed concerns with the materiality approach used in SAB No. 99.  First, the report notes that, in accord with SAB No. 99, surveyed investors stated that bright lines are not really useful in making materiality judgment.  Both qualitiative and quantitative factors should be considered in determining if an error is material.  Second, the report notes in practice, SAB No. 99 works in only one direction--to expand the scope of materiality.  As a result, disclosure often becomes cluttered as issuers attempt to respond to the demands of SAB No. 99.  The report offers a "sliding scale" approach that could help alleviate this problem:

Just as qualitative factors may lead to a conclusion that a quantitatively small error is material, qualitative factors also may lead to a conclusion that a quantitatively large error is not material. The evaluation of errors should be on a 'sliding scale.'  On this scale, the higher the quantitative significance of an error, the stronger the qualitative factors must be to result in a judgment that the error is not material. Conversely, the lower the quantitative significance of an error, the stronger the qualitative factors must be to result in a judgment that the error is material.

Plaintiff Lawyers and Subprime

This is a crisis made in heaven for plaintiff lawyers.  Solvent companies, banks, do not have the internal controls to protect themselves from fraud from within and from without the bank by those seeking closing fees at the expense of the bank holding bad obligations.  Moreover, others inside the bank in different capacities, i.e. those in the investing side of the bank, are valuing the same obligations at severe discounts when investing in SIVs and hedge funds.  Back up the truck for plaintiff lawyers fees. 

Sovereign Wealth Funds

The investment of Abu Dhabi in Citigroup raises anew concerns about sovereign wealth fund investments in United States companies. I believe our regulation on these investments if badly flawed.  The CFIUS system is front-ended loaded.  That is, it attempts to stop the initial investment.  It has no remedy for investments that have been made and are then misused.  The effect is that we over-prohibit or over-condition the initial investment, discouraging investment in this country that we sorely need.  The conditions for Abu Dhabi were heavy handed (they cannot vote their stock and cannot seek directorships).  I am also uncomfortable about the involvement of Congress and its protectionist sentiment in the approval process.  On the other hand, we under regulate investments that are misused once in place.  We need to be tolerant of sovereign wealth fund investments as long as they act like investors and when they do not, impose corrective conditions.  Designing triggers for corrective regulations after an investment is in place is tricky and itself can be overdone, also discouraging legitimate investment however.   If China, for example, invests in United States companies and begins to use the investments for foreign policy purposes, we ought to be able, on good provable grounds, to sterilize any stock owned or cap sales of stock. or bonds owned.

The Subprime Plan

Blogs are abuzz with speculation about whether SIVS affected by the Paulson subprime loan plan revealed today have violated their fiduciary duty to their investors.  The SIVs have voluntarily agreed to freeze teaser interest rates for five years for qualifying debtors on mortgage loans.  It appears that the SIVs have favored the debtors over their investors and in so doing have violated their fiduciary duty to their investors.  The plaintiff's lawyers are bound to be disappointed here.  First, it depends on what type of entity the SIVs are and in which jurisdiction, if they are corporations, are they incorporated.  Those SIVs incorporated in states with "constituency statutes" will not support a suit. Second, and more important, if the deal helps investors by producing more returns on the altered loans they can hardly complain.  The SIVs (and their service companies) can argue that the SIV will collect more money not less if the majority losses from loan defaults (30 to 60 of the value of the loan) are replaced with minor losses from rate foregiveness.  The stock market today pushed up the prices of firms that hold subprime debt, indicating that the market at least views the investors to be better off with the plan, not worse off.  This litigation, at present, is will not be the gold mine hoped for by plaintiff lawyers.

NYSE: Traditional Specialists On the Ropes

Two of the seven NYSE specialist operations are quitting, signaling an eventual end to the dominate position of floor trading in NYSE listed stocks.  Electronic trading is steaming ahead, dominating trading in listed stocks.  Specialists operations will survive, in electronic form; floor trading will not.  The new head of the NYSE is an electronic trading advocate.  He once said something to the effect of "I do not want my trades executed by several folks all named "Vinnie" on the floor."  It took a long time for this to happen -- too long.  [I wrote an article in 1991 suggesting that specialists should innovate and was savaged by NYSE flunkies for it.]  Vested interests delayed the move, all the the detriment of the US trading markets, which were slow to embrace electronic trading and lost their competitive edge, and US traders, who paid higher trading costs. 

Gisele and the Dollar

The press is giddly over the demand of supermodel Gisele to be paid in euros rather than dollars.  She does not trust the dollar to be stable and wants to eliminate currency risk in her huge salary payments.  Is this the beginning of the end for the dollar??  She realizes that, like it or not, she is a currency speculator.  She could always hedge her dollar bet (diversifying a bit) but she has chosed to beat on euros instead.  She, of course, would be better off to diversify. 

Old Mistakes?

A writer at the Wall Street Journal today asks "Why Street Bankers Get Away with Repeating Old Mistakes." He ask why banks lended long and borrower short without accurately assessing the risk. He misses two obvious explanations:  First, those inside banks get paid fees for placing exotic instruments who defects take time to show.  In other words, there is a short term incentive to produce sales with a long term instrument.  The optional strategy?  Take fees, move up the ladder before the crisis and blame those who are left in your old job.  Second, those outside banks who dream up exotic instruments sell them to those inside banks who do not fully understand them.  In other words, the drive to create exotic instruments is, in part, a drive to sell stuff to people who are dazzled and who are ignorant.  The two incentive, to take fees and to dupe, combing to make bank vulnerable to under appreciating risk.  This has been going on for centuries. 

A New Cause of Action for Mortgage Holders??

Democrats in the Houses are considering a bill to allow home owners to sue mortgage lenders, those who originate the loans and those who repackage the loans and sell them to other lenders, for loans in which the borrower does not have a "reasonable ability to repay."  So we will solve the sub-prime crisis by unleashing an army of plaintiffs' lawyers on our banks.  This of course will substantially deter any lending to those in the bottom half of the income curve in our population and otherwise blow up the securitization market in mortgage loans (you cannot price a package of loans with an overhang of unknown litigation potential).  The Democrats are disabling those less well off from buying homes at market driven - competitive rates, to help them of course.

Banks' Exposure to Subprime Mortgage Woes

Floyd Norris today in the New York Times (at C1) asks the question that has long troubled me.  Why are banks so heavily exposed to the problems of defaults on sub prime mortgages?  We are told that originators of sub prime mortgages, banks and brokers, offload the obligations to independent legal entities (SIVs or SPVs) and collect fees.  The SIVs fund their purchase with sales of securities (some rely on asset-backed commercial paper, other rely on tranches of debt (CDOs)).  If the sub prime market dries up banks will suffer a loss of origination fees, but we now learn that they are suffering losses on the defaults themselves.  How can this be?  Wall Street investment bank income is based on fees, not investments, is it not?  Apparently banks found a way to accept exposure to sub prime mortgages in a variety of ways -- through internally run investment (hedge) funds, thorough guarantees to and swaps with SIVs ("security enhancement devices") and through ownership of some of the securitization vehicles (conduits).  All the devices are racking up huge losses and many of the losses are difficult to value.  Their primary solution -- a new super SIV run by all the banks that will buy paper from the struggling SIVs -- will postpone accurate valuations and exacerbate our problems.   

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.         

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.

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.    

The Fed, The Market and The Consumer

Several years ago I wrote on this blog that I thought we were heading into a market correction of 10% or so.  That market correction has yet to come and I have taken some friendly and not so friendly advice to stay with legal analysis and stay away from future market predictions.  My projection ast the time was based on data that Americans, for the second year consecutive year, were spending more than they earned (in other words, that they were spending their savings or the equivalent, the equity in their house, for example).  They last time Americans had done this was some time in the 30s.  I thought the following -- the American consumer is holding up not only our stock market but the world's stock markets and he/she is running out of money.  Well, I underestimated the American consumer; he/she continues to spend more that he/she earns and has not run out of money nor has he/she decided to economize.  I can come up this three possible explanations:  First, the earnings numbers are low (the gray (or black) market or exchange economy is much larger than the numbers reflect); Second, Americans have more savings to burn than I anticipated; Or three, Americans will spend until someone says they cannot (they fall off the cliff).  In any event, do not follow any market advice I may offer, now or in the future. 

Auction IPOs Sag

The use of the auction IPO format, featured by W.R.Hambrecht & Co. for over eight years, continues to decline in frequency.  So far this year there have been only two.  In other world markets, in which their is also a choice between an auction and book building IPO, the auctions have all but been abandoned.  Is it a market based preference for book building or are the investment banks working together to kill a practice that reduces their fees?   

Securitization and the Rating Agencies

The bubble in the subprime residential mortgage market has caused many to take a hard look at securitization.  Securitization is the pooling of large asset pools, such as subprime mortgages, and the sale of securities backed by the pools.  The seller is often the securities division of a major investment or commercial bank.  The weak link seems to be the rating agencies that appraise and rate the securities. The rating agencies are hired and paid by the pooling agent, the seller.  Moreover, many of those working with the rating agencies are hoping to work eventually for the banks that hire them.  The conflicts are obvious and have led to the rating agencies being overly generous with their ratings.  The generous ratings led to a demand for assets, subprime mortgages, that could be securitized.  With the low interest rates adding another incentive, the makings of a financial bubble became inevitable. 

Quants and Stock Prices

Any doubts that individual "stock pickers" should stay away from short term trading strategies had to be dispelled last week.  The "quants,"  hedge funds with market neutral strategies dependent on the execution of historically based trading programs, rolled the market last week.  Companies with weak performance data had their stock prices increase and companies with strong performance data had their stock prices decrease.  Why?  The quants' programs were unwinding positions, automatically, to account for market situations that programs had heavily discounted as very rare occurrences.  Apparently the quants' programs were negatively affected by stock selloffs required by liquidity crunches.  These hedge fund trades dominate the market, accounting for up to 60% of the volume on any given day.  It is impossible for those on the outside, individual stock pickers, to make sense of such a market.  It is a recipe for huge losses for such folks.  Yet another example of why individuals should not try short term trading strategies.

BackDating Criminal Cases

On Tuesday, a jury convicted Gregory L. Reyes, the ex-CEO of Brocade Communications, of criminal securities act violations for backdating compensatory options.  He tried all the classic defenses: I did not know it was wrong; Everyone was doing it; I did not profit, my employees did; And, it was just a minor bookkeeping disclosure error with no victims.  He lost.  The interesting part of the case was the decision of not to call any witnesses from the Sonsini law firm to buttress the claim that Reyes thought it was legal.  I have blogged earlier about how law firms have to draft and file documents to make backdating work.  I suspect the law firm had in its firms enough CYA paper to give it "plausible denial" and not help the defense.  The Supreme Court opinion in the Charter Communications fraud will put all this in issue.  How much aid can professionals give a fraudulent scheme before they themselves are liable.  I hope that the Court uses a "red flag" test to catch those involved that will enable prosecutors to look behind the CYA documents in the file. 

London Regulating?

The FT reports here that the Financial Services Authority, the U.K.'s financial markets regulator, announced last week that it is going to study toughening up the requirements for foreign listings on the London Stock Exchange.  Currently, foreign issuers cross-listing on the LSE are subject to "light touch" regulation which principally requires maintenance of their primary listing and the furnishing of certain documents to the FSA.  The FT reports increasing fear in the City community that this light regulation will tarnish the LSE's reputation through scandal or generally perceived diminished quality.

The move is surprising on two levels.  First, the LSE had a spectacular year last year with respect to foreign issuers; of the £28 billion raised in IPOs on the LSE fully £10 billion was from foreign listings, the majority from the CIS states and India.  Second, London has been furiously marketing itself as an alternative market for Sarbanes-Oxley "refugees".  Why the FSA would act now to tighten regulation when things are going so well is uncertain and perhaps harmful to its own markets at a time of rising competitiveness.  But, I suspect part of the reason lies with the AIM, the LSE's similarly lightly regulated junior market.  It had a mixed year last year; attracting a large number of foreign IPOs itself but being criticized repeatedly for a number of scandals.  Moreover, the AIM was slightly down in 2006 and half of its largest IPOs were trading below their offering price by the end of last year.  The LSE has announced that it is considering raising regulatory standards for the AIM, and the concerns over light regulation have likely spilled over to the LSE.  But, London knows it has a good thing going in distinguishing itself from the United States.  The FSA may increase regulation of foreign issuers on the LSE at a later date, but they will be careful to set it apart from claimed "over-burdensome" U.S. regulation.  The bottom line is that any additional regulation will be measured.  Until the United States effects radical change, London is likely to continue to differentiate itself from the U.S. markets and better cater to its foreign issuers/customers by offering regulation more tailored to their needs. 

Steven M. Davidoff