Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Saturday, November 10, 2007

Nicholson on SOX

Sarbanes-Oxley's Purported Over-Criminalization of Corporate Offenders, by LISA H. NICHOLSON, University of Louisville - Louis D. Brandeis School of Law, was recently posted on SSRN.  Here is the abstract:

The Sarbanes-Oxley Act of 2002 and its enhanced criminal penalties, which increase both the monetary fines and terms of imprisonment, were enacted at least in part to aid the SEC and to fill the perceived enforcement gap in combating corporate fraud. Congress, in so legislating, enlisted a criminal law behavioral model to induce law-abiding corporate behavior. In other words, Congress presumes that people will comply with the law after a conscious evaluation of the risks associated with disobeying the law. Deterrent-based punishments, however, may yield less effective outcomes for corporate fraudsters since some actors do not engage in the requisite cost-benefit assessments before acting. Moreover, even if everyone undertook such an assessment, their subjective beliefs will vary the outcomes. Indeed, a corporate offender's attitude toward risk will differ according to the type of criminal penalties that could be imposed, thereby implicating differing levels of marginal disutility.

This Article analyzes whether this tactic — that of enacting increasingly lengthier prison sentences and imposing higher fines alone — will have the desired effect of deterring potential offenders, and punishing wrongdoers. As will be demonstrated below, reliance on the Act's enhanced criminal penalties to deter wrongdoing may not yield the desired result in light of the many uncontrollable factors that may undermine both the imposition of lengthy sentences and higher fines, and the impact of such penalties on convicted wrongdoers. Consequently, the punishment prong of the costs-benefits analysis must fully extinguish all benefits of the unlawful act in order to fill in the gaps that arise from a sole reliance on deterrent-based punishment. The asset forfeiture sanction effectively removes the economic motive for the criminal conduct from the potential offender's “benefits” calculation. Any purported benefit from the criminal scheme will be wiped out if the offender is caught. This sanction which removes the economic incentive for the fraudulent scheme also punishes those individuals who either engage in a faulty cost-benefit analysis, or who fail to engage in such an analysis altogether.

November 10, 2007 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Cox, Thomas & Bai on Securities Class Action Settlements

There are Plaintiffs and... There are Plaintiffs: An Empirical Analysis of Securities Class Action Settlements, by JAMES D. COX, Duke University School of Law; RANDALL S. THOMAS, Vanderbilt University - School of Law; Vanderbilt University - Owen Graduate School of Management; and LYNN BAI, University of Cincinnati - College of Law, was recently posted on SSRN.  Here is the abstract:

In this paper, we examine the impact of the PSLRA and more particularly the impact the type of lead plaintiff on the size of settlements in securities fraud class actions. We thus provide insight into whether the type of plaintiff that heads the class action impacts the overall outcome of the case. Furthermore, we explore possible indicia that may explain why some suits settle for extremely small sums – small relative to the “provable losses” suffered by the class, small relative to the asset size of the defendant-company, and small relative to other settlements in our sample. This evidence bears heavily on the debate over “strike suits.” Part I of this paper sets forth the contemporary debate surrounding the need for further reforms of securities class actions. In this section, we set forth the insights advanced in three prominent reports focused on the competitiveness of U.S. capital markets. In Part II we first provide descriptive statistics of our extensive data set, and then use multivariate regression analysis to explore the underlying relationships. In Part III, we closely examine small settlements for clues to whether they reflect evidence of strike suits. We conclude in Part IV with a set of policy recommendations based on our analysis of the data.

November 10, 2007 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Booth on Securities Fraud Class Action Certification

Taking Certification Seriously - Why There Is No Such Thing as an Adequate Representative in a Securities Fraud Class Action, by RICHARD A. BOOTH, Villanova University School of Law, was recently posted on SSRN.  Here is the abstract:

Securities fraud class actions (SFCAs) arising under Rule 10b-5 are well established as a feature of the legal landscape, but they are a vestige of a largely outdated view of investor behavior and preferences. In the 1960s, most investors were undiversified stock pickers. Today, most investors hold stock through well diversified institutions. As a result, most investors are net losers from SFCAs. Moreover, it is arguable that it is irrational for most investors not to be diversified. A passive investor who fails to diversify assumes unnecessary risk for the same expected return that diversified investors enjoy. Given that federal securities law is intended to protect reasonable investors, it follows that it should be interpreted and applied consistent with the interests of diversified investors where the interests of diversified and undiversified investors diverge. For a diversified investor, gains and losses from securities fraud net out over time. But they lose to the extent of attorney fees and they lose when they are holders (which is most of the time) to the extent that defendant companies must compensate purchasers. In short, diversified investors would prefer that SFCAs be abolished. The one exception arises when insiders gain from the fraud such as by selling their shares before the release of bad news. But the appropriate remedy in such a case is a derivative action by which the company recovers from the wrongdoers.

The thesis here is that the courts should decline to certify securities fraud actions as class actions under FRCP 23 because of the conflicting interests of class members. Undiversified stock pickers - usually a minority of the plaintiff class - may favor SFCAs. But many diversified investors - particularly those who follow a portfolio balancing strategy - would prefer that the courts refuse to certify such actions as class actions because such investors usually lose more on stock they hold than they gain on stock they bought during the class period. To be sure, many diversified investors (including institutional investors) engage in some stock picking (although some such as index funds eschew it altogether). Such an investor might favor certification of actions in which he has bought a large amount of the subject stock during the class period relative to preexisting holdings even though the same investor would favor the abolition of SFCAs generally. Moreover, not even a strict portfolio balancing investor who would oppose certification because she loses more on stock she holds than she gains on stock she bought would dare to opt out of the SFCA if it is certified. Thus, it does no good for the courts to rely on investors to vote with their feet. Investors who opt out of the action effectively pay those who stay in by forgoing compensation for their losses. The bottom line is that the courts should refuse to certify securities fraud actions as class actions unless it is shown that the plaintiff class is composed wholly of undiversified investors. If the action involves allegations that insiders have somehow gained from the fraud or that the corporation itself has been damaged by the fraud, the action should proceed as a derivative action. And given that a derivative action is a form of class action, it is quite clear that the courts have the power under FRCP 23 (and FRCP 23.1) to recast any purported SFCA in such terms.

This is not to say that individual investors should not continue to have standing to sue under Rule 10b-5. Indeed, an investor who seeks to gain control or influence over a target company is likely to be undiversified. If such an investor suffers a fraud in connection with his purchase of target stock, he has standing to sue the wrongdoers if he can make out a claim. Nor does the argument here imply that there is a fundamental problem with remedies under the 1933 Act. In essence, the 1933 Act provides for disgorgement by issuers in cases in which they have effectively misappropriated capital from the market by false pretenses. Similarly, in the context of an SFCA under Rule 10b-5 in which insiders have gained from misappropriation (such as insider trading) during the fraud period or have visited loss on the issuer by damage to reputation or otherwise, the appropriate remedy if for the issuer to seek compensation. In other words, the approach advocated here is wholly consistent with the general scheme of federal securities law.

November 10, 2007 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Burch on Securities Class Actions

Securities Class Actions as Pragmatic Ex Post Regulation, by ELIZABETH CHAMBLEE BURCH, Samford University - Cumberland School of Law, was recently posted on SSRN.  Here is the abstract:

Securities class actions are on the chopping block again. And blue-ribbon commissions are claiming that increasing globalization requires a fresh hard look at the relationship between the markets, the Securities Exchange Commission, and private rights of action. Change is inevitable. But it may be disproportionate and ill conceived, ignoring private securities class actions' comparative institutional capability as a check against agency capture, selective enforcement, and secret settlements. For instance, these commissions recommend banning parallel private and SEC fair funds actions, increasing arbitration's use, restricting private securities class actions to insider trading cases, and allowing only the SEC to pursue Rule 10b-5 violations. But these reforms miss the point: in the ongoing regulatory push and pull, corporations are winning the battle.

It is true that the securities class action is not always a perfect regulator. But it is equally true that its role in consequence-based regulation allows the United States to maintain its central attraction as a relatively deregulated market with relaxed ex ante barriers and low entry costs. Moreover, marginalizing the securities class action's function reflects the ongoing trend toward winnowing public adjudication. Arbitration, mediation, and administrative proceedings have replaced judicial hearings, trials, and open records. Transparency and accountability for public law matters has been lost in the shift.

This public function of traditional litigation is so familiar as to be under-theorized: transparent adjudication through securities class actions holds the government and corporations publicly accountable. But securities class actions do more than this. Their pursuit has spillover effects - positive externalities - including innovation, deterrence, information sharing, accountability, and transparency. These spillovers benefit more than parties to a lawsuit; they benefit the public.

Still, most commentators view class actions with suspicion; they see class suits as nonmeritorious byproducts of self-interest and the attorneys who bring them as rent-seekers. But the full picture and texture of securities class actions also necessitates a pragmatic positive account. This Article provides that account. Naturally, I harbor no illusion that the securities class action always functions optimally. It doesn't. For instance, as litigation becomes the primary enforcement method, the responsibility for setting and implementing securities policies blurs between Congress, the judiciary, and private actors. Even from a policy standpoint, however, there is a need to appreciate the respective institutional capabilities of private and public actors. In short, even in their imperfect state, securities class actions can bestow benefits that are lost in pure government-centric enforcement.

The Article thus begins by explaining America's response to the challenge of institutional design. Using ex post regulation - consequence-based regulation - as opposed to heavy ex ante constraints on entry barriers attracts new businesses, fosters competition, and supports economic growth. Integrating both public and private actors into ex post enforcement avoids collective action dilemmas, agency inaction, and private resolution of public law matters through arbitration. But backdoor regulation through litigation, particularly class litigation, has its share of critics. Consequently, within this larger regulatory framework, I reconsider ingrained criticisms, criticisms perpetuating standard rhetoric about both class actions as a species of aggregate litigation and as a tool in securities enforcement.

After addressing those concerns and finding many less problematic than tradition would have us believe, the Article then assesses what is, for many, a counterfactual assertion: securities class actions can do more good than harm. In fact, they are a public good. By supplementing ex post enforcement, securities class actions produce positive externalities, spillover effects that confer public benefits. These benefits include innovation, cost-reduction through information sharing, deterrence, transparent process, and accountability. Because any attempt to assign numerical values to these benefits is inherently artificial, I opt instead to weigh benefits in terms of social objectives, educational goals, and accountability schemes. Their import is perhaps best gauged through indignation over their absence and the consequences that follow. Therefore, I envision the consequences of eliminating securities class actions by imagining a world with government-centric securities enforcement. That world, I contend, is one steeped in bureaucracy, one failing to produce behavior-guiding precedent, one filled with closed-door arbitrations, one overlooking nonprioritized misconduct, and one ignoring litigant preference for judicial process. That world is one severe enough to outweigh my lingering doctrinal and jurisprudential concerns about securities class actions. In short, it is a world less preferable than our current system - flawed though it may be.

November 10, 2007 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Friday, November 9, 2007

SEC Settles Rule 105 Charges with Two Offshore Firms

The SEC announced that it filed a settled civil action two offshore companies, Armstrong Capital Ltd. and Bay Capital Investment Ltd., and their owner and principal trader Timothy M. Bliss, charging them with violating Rule 105 of Regulation M. Rule 105, as in effect at the time of the conduct alleged in the complaint, prohibited covering a short sale with securities obtained in certain public offerings when the short sale occurred during a specific period (usually five business days) before the pricing of the offering. The complaint alleges that, from January 2004 through June 2006, Armstrong Capital, Bay Capital, and Bliss violated Rule 105 in connection with 57 public offerings by using shares purchased in those offerings to cover short sales made during the restricted period set by Rule 105. The complaint further alleges that in the offerings, the offering price was usually set at a discount to the last reported sale price of the stock before the pricing of the offering. As alleged in the complaint, by short selling just prior to pricing, Armstrong Capital and Bay Capital often sold shares short at prices higher than the price they would later pay for the shares in the offering.

Armstrong Capital, Bay Capital and Bliss agreed to settle the enforcement action and disgorge $1.47 million in trading profits and prejudgment interest, and to pay a $325,000 civil penalty.

November 9, 2007 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Cox Discusses Interactive Data Initiatives with International Regulators

SEC Chair Christopher Cox, while at meetings of the International Organization of Securities Commissions, concluded a week of bilateral discussions with securities regulators from Japan, China, Korea, Canada and Australia focused, among other things, on timetables for implementation of interactive data initiatives for financial reporting.

November 9, 2007 in SEC Action | Permalink | Comments (0) | TrackBack (0)

FINRA's Schapiro Speaks at SIFMA Annual Meeting

Mary L. Schapiro, Chief Executive Officer, FINRA, spoke at the SIFMA Annual Meeting, Boca Raton, FL on November 9, 200, principally about the consolidation of the regulatory arms of NASD and NYSE and the future of self-regulation.

November 9, 2007 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

SEC Approves New Rule on Fairness Opinions

FINRA issued Regulatory Notice 7-54, announcing that effective December 8, 2007, new NASD Rule 2290 (Fairness Opinions) requires specific disclosures and procedures addressing conflicts of interest when member firms provide fairness opinions in change of control transactions, such as a merger or sale or purchase of assets.

November 9, 2007 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

More About the Troubles at Merrill and Citigroup

The Wall St. Journal's front page has a well-written, in depth story about the last two weeks in the tenures of Merrill's Stan O'Neal and Citigroup's Charles Prince, with a day by day account of the events that led to each being forced out of the executive suite.  I found the description of how Citigroup uncovered the huge losses in its CDO portfolio, which had previously been thought to be low-risk, particularly revealing. According to the article, Citigroup executives met on a Saturday and began by reviewing Merrill's third quarter earnings report to figure out how it had valued its portfolio.  As the extent of Citigroup's losses became apparent, Gary Crittenden, Citigroup's CFO, reportedly said:

"How in the world could we have been so exposed and how could we not have been properly hedged?"

Good question.  WSJ, Two Weeks That Shook The Titans of Wall Street. Meanwhile, Charles Prince leaves with about $29.5 million in accumulated benefits and no severance pay.  He will receive a prorated 2007 bonus.  WSJ, No Severance Pay for Prince.

November 9, 2007 in News Stories | Permalink | Comments (0) | TrackBack (0)

Former Safety Kleen CFO Sentenced in Securities Fraud Case

The judge said she wanted to send a message -- that "concealing a company's financial position is always wrong."  The former CFO of Safety-Kleen, Paul Humphreys, was sentenced to nearly 6 years in prison after admitting to securities and bank fraud charges.  He was accused of artificially inflating earnings from 1998-2000.  NYTimes, Prison Term in Fraud Case.

November 9, 2007 in News Stories | Permalink | Comments (0) | TrackBack (0)

Thursday, November 8, 2007

SEC's Donohue Talks to Fund Directors

Andrew J. Donohue, Director, Division of Investment Management, SEC, gave the Keynote Address at the Investment Company Directors Conference in Washington, D.C. on November 6, 2007.  Topics included fair valuation of portfolio holdings, 12b-1 fees, and soft dollars.  He also described his Director Outreach Initiative, in which he has been meeting with fund boards and asking them how the SEC can assist fund directors in performing their jobs.

A recent study, meanwhile, reports that fund directors are not having fun and feel underappreciated.  Two-thirds of fund-board directors report that the job is tougher than a few years ago and 44% says the burdens outweigh the compensation.  WSJ, Directors Feel Burden of New Regulations.

November 8, 2007 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Full Agenda for SEC's Nov. 15 Open Meeting

The SEC has a number of significant matters on its agenda for its next open meeting on Nov. 15, including:

  • the perennial topic of better mutual fund disclosure;
  • whether to accept financial statements prepared in accordance with International Financial Reporting Standards without reconciliation to generally accepted accounting principles in filings of foreign private issuers;
  • whether to expand the number of companies that qualify for scaled disclosure requirements for smaller reporting companies;
  • whether to adopt amendments to Rule 144 to shorten the holding period for the resale of restricted securities if the issuer of the securities is subject to the Exchange Act reporting requirements and to relax on restrictions on resales of restricted securities by non-affiliates.

November 8, 2007 in SEC Action | Permalink | Comments (0) | TrackBack (0)

More Bad News About Subprime Mortgages

Morgan Stanley announced it would write down at least $3.7 billion due to proprietary trading positions related to subprime mortgage investments (unlike Merrill and Citigroup, whose losses related largely to its underwriting activities). AIG, the world's largest insurance company, said it would write down $2 billion in the third quarter.  Analysts had expected a much larger write-down, so the bad news may not yet be over.  NYTimes, A.I.G. Takes a Hit of $1.95 Billion on Housing Investments. WSJ, AIG, Morgan Stanley Show Subprime Losses Aren't Quite Over Yet.

Meanwhile, Merrill Lynch confirmed that the SEC was looking into how the firm valued its subprime portfolio.  NYTimes, Morgan Stanley Takes a Hit on Mortgages;

November 8, 2007 in News Stories | Permalink | Comments (0) | TrackBack (0)

Wednesday, November 7, 2007

SEC Obtains Consent Judgment in Ponzi Scheme

I have to confess -- Ponzi schemes fascinate me, and here's another outrageous one -- The  SEC  announced today  that  a federal district court for  the  Northern District  of  Georgia,  entered  judgments  as to defendants Bryant E. Behrmann (Behrmann) and Larry "Buck" E. Hunter (Hunter),  enjoining  them  from  future  securities law violations.  The  SEC charged  that, since  at least October 2005, Global, Behrmann  and  Hunter  have  orchestrated  a  massive Ponzi scheme and conducted     an   unregistered   offering   of   securities   through Global's   SPIP.  Global,  Behrmann  and  Hunter  solicited  investors to "loan" Global funds for a term of one year in exchange for promised daily  interest  payments.  Depending  on  the amount invested, Global promised   effective  annual  returns  of  more  than  1,800%.  Global purported  to  generate  revenue  sufficient  to  pay investors  their promised   returns   by   pooling   investor   proceeds   to  purchase distressed inventory,  which  Global  then  claimed to resell through various   online   auction   websites,   including   Ebay   and Yahoo!Auctions,  as  well  as  through flea markets, street sales and retail storefronts.  From  October  2005  through  March  2007, Global raised approximately  $45 million from more than 9,000 investors. The  defendants  consented to  the  entries  of the judgments without admitting  or  denying  any  of  the  allegations  of the Commission's Amended    Complaint. 

November 7, 2007 in SEC Action | Permalink | Comments (0) | TrackBack (0)

International Regulators Issue Statement on International Accounting Standards Process

The European Commission, the Financial Services Agency of Japan, the International Organization of Securities Commissions (IOSCO) and the US Securities and Exchange Commission issued a Combined Statement proposing changes to strengthen the institutional framework of the International Accounting Standards Committee (IASC) Foundation and encourage the Foundation's related efforts, while emphasizing the continued importance of an independent standard-setting process.  The statement explained:

"International Financial Reporting Standards (IFRS) are becoming more widely used throughout the world. We have a common interest of ensuring continuing user confidence in the institutions responsible for the development of global accounting standards. A natural step in the institutional development of the IASB and the IASC Foundation would be to establish a means of accountability to those governmental authorities charged with protecting investors and regulating capital markets. We will work together to achieve these objectives."

November 7, 2007 in SEC Action | Permalink | Comments (0) | TrackBack (0)

FINRA Releases Results of Study of Automatic Enrollment in 401(k) Plans

FINRA announced that a new study of employer-sponsored retirement plans shows that employees are nearly unanimous in their support of being automatically enrolled in their companies' 401(k) plans.  The study was conducted by Harris Interactive® on behalf of Retirement Made Simpler (RMS), a coalition formed by AARP, the Financial Industry Regulatory Authority (FINRA), and the Retirement Security Project (RSP) to improve the way Americans save for retirement.

The Retirement Made Simpler study found that 98 percent of U.S. adults currently enrolled in an automatic 401(k) plan agree they are glad their companies offer this savings vehicle, with nearly four in five (79 percent) of them expressing strong agreement. In addition, of those who were automatically enrolled, only seven percent opted-out of the plan. The study also found that 95 percent of adults in automatic 401(k) plans agree that automatic enrollment has made saving for retirement easy and 85 percent agree that it has helped them start saving for retirement earlier than they had planned.

November 7, 2007 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

FINRA Issues Guidance on New Rule on DVAs

FINRA issued both Regulatory Notice 07-53, including the text of new NASD Rule 2821, and a press release summarizing broker-dealers' compliance and supervisory responsibilities for deferred variable annuities.  The Rule, which becomes effective May 5, 2008, requires that, when recommending a deferred annuity transaction, a registered representative must:

Make a reasonable effort to obtain and consider various types of customer-specific information, including age, income, financial situation and needs, investment experience and objectives, intended use of the deferred variable annuity, investment time horizon, existing assets, liquidity needs, liquid net worth, risk tolerance and tax status.

Have a reasonable basis to believe the customer has been informed of the material features of a deferred variable annuity, such as a surrender charge, potential tax penalty, various fees and costs, and market risk.

Have a reasonable basis to believe that the customer would benefit from certain features of deferred variable annuities, such as tax-deferred growth, annuitization or death or living benefits.

Make a customer suitability determination as to the investment in the deferred variable annuity, the investments in the underlying sub-accounts at the time of purchase or exchange, and all riders and other product enhancements and features contained in the annuity contract.

Have a reasonable basis to believe that a deferred annuity exchange transaction is suitable for the particular customer, considering, among other factors, whether the customer would incur a surrender charge, be subject to a new surrender period, lose existing benefits, be subject to increased fees or charges, and has had another exchange within the preceding 36 months.

November 7, 2007 in Other Regulatory Action | Permalink | Comments (1) | TrackBack (0)

Whole Foods Board Bars Online Postings by CEO

The board of directors of Whole Foods Market amended its code of conduct to prohibit its executives and directors from posting messages about the company or the food industry on Internet forums not sponsored by the company.   The SEC is still investigating CEO John Mackey's online musings from 1999-2006 that caused embarassment for the company when they were publicized last summer.  WSJ, Whole Foods Bars Executives From Web Forums.

November 7, 2007 in News Stories | Permalink | Comments (0) | TrackBack (0)

Bancroft Family's Fiasco in Appointing Board Representative

The Bancroft family's representative on the News Corp. board of directors will be (subject to approval by the other directors) Natalie Bancroft, a 27 year old opera singer with little experience in business or journalism.  The Bancroft family missed a deadline to select their representative on the board, thus relinquishing the choice to Rupert Murdoch.  "I don't think we've distinguished ourselves in how we've handled this," said the Bancroft family lawyer, Michael Elefante.  WSJ, Bancrofts Bicker, Miss a Deadline, Lose Board Choice.

November 7, 2007 in News Stories | Permalink | Comments (0) | TrackBack (0)

Morgan Stanley and other Casualties of Credit Collapse

Waiting for another shoe to drop?  Analysts predict that Morgan Stanley may take $3-6 billion write-downs in the fourth quarter.  While the firm's participation in underwriting CDOs was small, it may have been involved in transactions with other firms that exposed it to CDO risks.  WSJ, Storm May Hit
Morgan Stanley After Its Calm

Meanwhile, the next "victims" of the subprime mortgage collapse may be Wall St. professionals whose year-end bonuses may be down as much as 15%.  NYTimes, Bonuses Likely to Shrink for Many on Wall Street.

November 7, 2007 in News Stories | Permalink | Comments (0) | TrackBack (0)