Securities Law Prof Blog

Ferrell and Saha on Loss Causation

The Loss Causation Requirement for Rule 10b-5 Causes-of-Action: The Implication of Dura Pharmaceuticals v. Broudo, by ALLEN FERRELL, Harvard Law School; European Corporate Governance Institute (ECGI), and ATANU SAHA, Alix Partners , was recently posted on SSRN.  Here is the abstract:

In order to have recoverable damages in a Rule 10b-5 action, plaintiffs must establish loss causation, i.e. that the actionable misconduct was the cause of economic losses to the plaintiffs. The requirement of loss causation has come to the fore as the result of the Supreme Court's landmark decision in Dura Pharmaceuticals v. Broudo. We address in this paper a number of loss causation issues in light of the Dura decision, including issues surrounding the proper use of event studies to establish recoverable damages, the requirement that there be a corrective disclosure, what types of disclosure should count as a corrective disclosure, post-corrective disclosure stock price movements, the distinction between the class period and the damage period, collateral damage caused by a corrective disclosure, and forward-casting estimates of recoverable damages.

Walker on Backdating

Unpacking Backdating: Economic Analysis and Observations on the Stock Option Scandal, by DAVID I. WALKER, Boston University School of Law, was recently posted on SSRN.  Here is the abstract:

The corporate stock option backdating scandal has dominated business page headlines since the summer of 2006. The SEC has launched investigations of more than one hundred companies with respect to the timing and pricing of stock options granted during the boom years of the late 1990s and early 2000s, and the number of firms caught up in the scandal continues to increase. This Article contributes to our understanding of the backdating phenomenon by analyzing the economics of backdating and the characteristics of the firms under investigation. Its main points are the following: First, given the high volatilities of the stocks of the technology companies that dominate the list of firms under investigation and the fact that options granted to executives and employees typically may not be exercised for several years, press reports that focus on the size of the strike price “discounts” achieved by backdating significantly overstate the impact on the value per share of backdated options. In some cases, reducing the strike price by a dollar per share by backdating increased the Black-Scholes value of the option by less than twenty cents per share. Second, backdating dramatically reduced the apparent value of options, which reduced the total level of executive compensation reported to shareholders. However, because the size of executive stock option grants often is determined by first establishing the value to be delivered and then “backing into” the number of shares to be covered by the option, reducing the apparent value of option shares may have substantially increased the size and economic value of some backdated executive option grants. Third, comparison of semiconductor firms under investigation for backdating with peer companies that are not suggests an association between backdating and the use of options in compensating non-executive employees. This Article considers the effects of and several possible explanations for backdating non-executive options, including reducing apparent rank and file compensation. Finally, this Article argues that the backdating phenomenon is not an accounting scandal. Backdating has accounting consequences, but it is unlikely to have been accounting driven.

Reviewing the Amicus Briefs in Stoneridge

I have been reading some of the amicus briefs filed in Stoneridge Investment Partners v. Scientific-Atlantic, which will be argued before the U.S. Supreme Court this fall.  The complaint alleges that defendants, equipment vendors, knowingly participated in a scheme by Charter Communications to inflate its operating cash flow through sham transactions.  Plaintiff argues that defendants were primary violators, and not simply aiders and abetters, because they participated in a scheme under Rule 10b-5(b) -- rather than the typical case involving misstatements under subparagraphs (a) and (c) of the Rule.  The Eighth Circuit rejected plaintiff's argument.

The Government's brief in support of affirmance (where President Bush broke the "tie" between Treasury Secretary Paulson, who supported the defendants, and the SEC, who supported the plaintiff) carefully makes its argument to maintain the SEC's authority to bring aiding and abetting actions.  Thus, it begins by criticizing the 8th Circuit's conclusion that section 10(b) reaches only misstatements, omissions made when under a duty to disclose, or manipulative trading practices.  To the contrary, the Government argues, the plain meaning of the statute makes it clear that it reaches all conduct that is manipulative or deceptive, including non-verbal decptive conduct.  Thus, while the alleged conduct of the defendants may have constituted a violation, plaintiff could not recover because it could not establish reliance, since it does not even allege that it was aware of the transactions that defendants entered into with Charter.  In addition, plaintiff cannot show loss causation. Accordingly, allowing plaintiff to recover would be a sweeping expansion of the Rule 10b-5 implied remedy.

An interesting amicus brief was filed by a group of former SEC Commissioners and Officials and Law and Finance Professors, also in favor of affirmance.  In essence, the brief argues that plaintiff's "scheme liability" theory is simply a "semantic ploy" to recast secondary conduct as a primary violation and that the alleged conduct in this case is indistinguishable from that in Central Bank.  The brief also addresses policy considerations made by plaintiff and concludes that they do not warrant deviation from the statute.  To the contrary, they assert, considerations of legal and economic policy cast "considerable doubt" on the wisdom of allowing private suits like plaintiff's.  As would be expected in a brief signed by law professors, lots of law review articles are cited.

SEC Files Fraud Charges Against Former Brocade CFO

The SEC filed fraud charges against Michael J. Byrd, a former Chief Financial Officer and Chief Operating Officer of Brocade Communications Systems, Inc., alleging that he disregarded indications that other senior corporate executives were improperly backdating stock option grants at the company. The Commission alleges that Byrd learned of instances in which Brocade's then-CEO and others were backdating options for certain individuals, yet failed to ensure that the company properly accounted for the option expenses and disclosed them to investors.  The Commission's complaint further alleges that Byrd himself received a backdated option grant after becoming the company's Chief Operating Officer in 2001, and filed a disclosure statement with the Commission falsely stating that the options had been granted on an earlier date.

EU Investigates Rating Agencies

The European Union plans to investigate whether U.S. ratings agencies adequately alert investors to risks in the securities markets.  This perennial concern was raised in the wake of the deterioration of the market for securities backed by subprime mortgages.  The EU cited the conflict of interest created by the agencies being paid by the issuers whose securities they rank.  NYTimes, Europeans Plan to Investigate Ratings Agencies and Their Warnings.

Market's Too Risky for Arbs

The Wall St. Journal's "Heard on the Street" column reports that even the merger arbitragers are losing their appetite for risk and selling some of their holdings, in many cases because of fears that private equity deals will not close because of the increased costs of debt financings.  For example, while Sallie Mae shareholders approved the LBO this week, the buyers have stated that they may walk away.  See WSJ, Flight of the Merger 'Arbs':Risk-Takers Fear Dead Deals.

Dubai Exchange and Nasdaq Compete for OMX

Borse Dubai made a competing offer for Nordic exchange OMX, topping Nasdaq's accepted bid.  Borse Dubai's offer is for the equivalent of $32.81 per share.  WSJ, Borse Dubai Launches Bid for OMX.

Dell Announces Manipulation of Books

Dell announced that it will have to restate its financial results dating back to fiscal 2003 after an internal investigation found numerous accounting violations.  In a press release, Dell said it uncovered evidence that "account balances were reviewed, sometimes at the request or with the knowledge of senior executives, with the goal of seeking adjustments so that quarterly performance objectives could be met."  The internal investigation was triggered by a SEC investigation into Dell's accounting.  WSJ, Dell to Restate Financial Results After Audit Finds Manipulation.

White Speaks on Corporation Finance

John W. White, Director, Division of Corporation Finance, at the SEC, reports on recent developments at Corporation Finance, before the American Bar Association, Section of Business Law Committee on Federal Regulation of Securities in San Francisco, California, on August 14, 2007.

SEC Files Fraud Claims Against InterGlobal Technologies

The SEC filed a complaint in the United States District Court for the Northern District of Texas, Dallas Division, charging Inter Global Technologies, Inc. ("IGT") and Michael E. Tomayko with selling unregistered securities and misleading investors in connection with the offer and sale of IGT securities. According to the complaint, from about January 2004 until at least Fall 2006, Tomayko raised at least $14.5 million from over 900 domestic and international investors through a fraudulent, unregistered offering of preferred stock and joint venture interests in IGT.  The SEC's complaint alleges that Tomayko and IGT lured new investors and induced additional investment from existing ones by claiming to own three valuable licenses to construct Indonesian oil refineries and promising huge returns once the refineries were financed and built. Tomayko repeatedly told investors that IGT would imminently receive funding for construction of the refineries from sources such as letters of credit or other bank instruments provided by a wealthy contact in Indonesia; a hidden vault filled with gold bullion controlled by Indonesian tribal elders; and investments by the Saudi royal family. Defendants represented that investor funds would be used to maintain IGT's Indonesian refinery licenses and procure financing to build the refineries.  In reality, the Commission alleges, Defendants' claims were baseless. Tomayko's schemes to finance the Indonesian refinery were based on dubious and unverified information, and the promised financing has never materialized. Indeed, Tomayko used false bank and other documents to bolster his claims to investors that financing for the refineries was imminent. Contrary to Defendants' representation, Tomayko used millions of dollars of investor funds to pay his personal expenses and support his lavish international lifestyle, and he squandered millions more, without due diligence, chasing financing in Indonesia.

Former Officer Settles Charges in McKesson HBOC Fraud

On August 7, a consent and final judgment against Michael G.  Smeraski was entered by the United  States  District  Court  for  the  Northern District of California. Smeraski was  charged  in  a  previously-filed action with securities fraud in connection with  a  massive  financial reporting  fraud  at  McKesson   HBOC   Corporation   (now,   McKesson Corporation), a Fortune 100 company headquartered  in  San  Francisco, Calif. The complaint, filed Sept. 27, 2001, alleged that Smeraski,  a  senior sales  vice  president,  together   with   other   senior   executives participated in  a  long-running  fraudulent  scheme  to  inflate  the revenue and net income of HBO & Company, an Atlanta, Ga.-based  vendor of health care software that merged with McKesson  in  1999.  Smeraski and others routinely approved software sales contracts with associated side letters containing unsatisfied contingencies  precluding  revenue recognition and  backdated  contracts  and  other  documents  for  the purpose of recognizing revenue in an earlier reporting period, in violation of GAAP.  The fraud enabled HBO & Company to report falsely in press releases and in periodic reports filed with the  Commission  that  the company was having an unbroken run of financial success and that HBO & Company had continually exceeded analysts' expectations. However, when McKesson HBOC announced in April 1999 that the company was  conducting an internal investigation into financial reporting irregularities, its shares tumbled from approximately $65 to $34, a drop that slashed  its market value by more than $9 billion.

It's not clear why it took so long to conclude this pre-SOX enforcement action.

Former U.S. Bancorp Asset Management Portfolio Manager Settles Insider Trading Charges

The SEC  announced  a settlement imposing Remedial Sanctions against Joseph A.  Frohna, a former portfolio  manager with U.S. Bancorp Asset Management, Inc.  The SEC's complaint alleged that Frohna engaged in insider  trading by having the mutual fund that he managed sell all of  its  shares  of XOMA, Ltd. on the basis of material,  nonpublic  information  that  he obtained from his brother, who was leading a joint drug study for XOMA and another pharmaceutical company. As a result  of  Frohna's  insider trading, the mutual fund that he managed avoided a loss of $954,776.  Based on the above, the Order suspends Frohna  from  association  with any investment adviser for a period of twelve months. Frohna consented to the issuance of the Order without admitting or denying the findings in the Order, except he admitted the entry of  the  injunction.

Sallie Mae Shareholders Approve Buyout

Shareholders of Sallie Mae voted to approve the $25 billion buyout of the company by a consortium of buyers led by private equity firm J.C. Flowers, amid serious doubts that the deal will close, at least at the original $60 per share price.  The buyers have stated that federal legislation cutting back on government subsidies of student lending is grounds for backing out of the deal.  In addition, the costs of borrowing money have increased since the deal was struck.   Sallie Mae's management, however, insists the deal will go through.  WPost, Shareholders Agree to Buyout Of Sallie Mae.

Reporters Sue Hewlett Packard in Pretexting Case

Three reporters for CNET Networks and their families sued Hewlett-Packard in California state court accusing it of violating their privacy.  The lawsuit arises out of last year's revelations that the company used illegal methods to obtain phone records in an attempt to discover the source of a board leak.  Hewlett Packard said that it has already apologized to the reporters and offered them a substantial settlement offer.  NYTimes, 3 Reporters Sue H.P. in Spying Case; WSJ, Reporters Sue H-P, Ex-Executives Over Surveillance.

U.S. Files Amicus Brief on Defendants' Side in Scheme Liability Case

The U.S. Solicitor General filed an amicus brief in favor of defendants in the "scheme liability" case before the U.S. Supreme Court, Charter Communications, arguing that allowing investors to sue third parties that did not themselves make public misstatements would be a "sweeping expansion" of the law.  President Bush determined that the U.S. would not follow the SEC's recommendation to file a brief in favor of the investors, but it was not clear until yesterday whether it would file a brief at all.  Oral argument is set for October 9.  WPost, In High Court Filing, It's U.S. vs. Investors; WSJ, Bush Sides With Business Over Lawsuits.

Nestle Announces Share Buyback

Nestle announced a $21 billion share buyback, the latest in a series of buybacks from major corporations.  Nestle's will take place over three years and could buy back as much as 15% of the outstanding shares.  CFO.com, Huge Nestle Buyback Is Sweet to Investors.

SEC Sends Wells Notice to Broadcom GC

The SEC has notified David Dull, general counsel of Broadcom Corp., that it may bring charges against him relating to its investigation of the company's backdating of stock options from 1998-2005.  The SEC previously sent similar notices to the company and its co-founder Henry Samueli.  In January the company took a $2.26 billion charge because of the backdating.  It blames three former executives for the practices.  CFO.com, Another Broadcom Exec Receives Wells Notice.

The Role of Ratings Firms in the Subprime Market

Does this sound familiar?  The Wall St. Journal reports on the role of the credit-rating firms in the subprime mortgage book by giving top ratings to many securities comprised of risky loans.  In addition, the credit-rating firms actively worked with underwriters to design mortgage-backed securities that would receive high-enough ratings to be marketable.  The rating firms, of course, were severely criticized when Enron/Worldcom imploded, for their failure to downgrade their bonds even as the companies were on the verge of bankruptcy.  WSJ, How Rating Firms' Calls Fueled Subprime Mess .

Criminal Charges Likely in Stock Lending Investigation

Yesterday NYSE Regulation censured and fined Janney Montgomery Scott $2.5 million for illegal practices involving the stock-lending market.  The firm's troubles may not be over.  The Wall St. Journal reports that federal criminal charges may be brought against a number of individuals at Janney and other financial institutions involving the same practices.  Charges include the use of finders or intermediaries as a means of channeling payments to favored individuals.  WSJ, Criminal Charges Near
In Stock-Lending Cases.

Former CA CEO Kumar Begins Prison Sentence

Former CA Inc. CEO Sanjay Kumar is off to prison, after being given time to sell off assets to satisfy  $50 million in restitution.  Kumar was sentenced to twelve years and fined $8 million for his role in a $2.2 billion accounting fraud at CA.  CFO.com, CA’s Kumar Reporting to Prison.