Securities Law Prof Blog

J.P. Morgan Files Registration Statement for Bear Stearns Merger

J.P. Morgan Chase filed yesterday the Registration Statement on Form S-4 for the shares to be issued in the Bear Stearns merger.

Bear Stearns Reports on Liquidity Crisis

Bear Stearns filed an 8-K Report yesterday,

to provide disclosure regarding the liquidity crisis that the Company experienced during the end of the week of March 10, 2008 and related events in: (i) the historical consolidated statements of financial condition of the Company as of November 30, 2007 and 2006, and the related consolidated statements of income, comprehensive income, cash flows and changes in stockholders' equity for each of the three years in the period ended November 30, 2007 and the related management's discussion and analysis of financial condition and results of operations; and (ii) the historical condensed statement of financial condition of The Bear Stearns Companies Inc. (Parent Company Only) as of November 30, 2007 and 2006, and the related condensed statements of income and cash flows for each of the three years in the period ended November 30, 2007 prior to the incorporation of such financial statements and management's discussion and analysis of financial condition and results of operations into the Registration Statement.

ISS Recommends Against 4 Citigroup Directors

ISS recommends that Citigroup shareholders not vote for the reelection of four directors.  Three of the directors -- Alain J.P. Balda (Chair, Alcoa), Kenneth Derr (former Chair, Chevron), and Richard Parsons (Chair, Time Warner) are on the Compensation Committee, which approved a $9.5 million pay package to CFO Gary Crittenden and the exit package for departing CEO Charles Prince.  The fourth director, Anne Mulcahy serves on three corporate boards as well as her day job as Chair of Xerox.  CFO.com, ISS: Throw Them Citi Bums Out.

The U.S. Chamber of Commerce, meanwhile, has expressed concern that ISS policy-setting process furthers the agenda of "a minority of special-interest activist shareholders," according to BNA's Securities Law Daily, and calls on RiskMetrics for greater transparency.

Bear Stearns Notifies SEC It Cannot Timely File 10-Q

Bear Stearns notified the SEC today that it could not timely file its 10-Q Report because, as it explains:

The Company experienced a significant liquidity crisis during the end of the
week of March 10, 2008 that seriously jeopardized its financial viability. On
March 16, 2008, the Company and JPMorgan Chase & Co. ("JPMorgan Chase") entered
into an agreement and plan of merger, and on March 24, 2008, the Company and
JPMorgan Chase entered into an amendment to the agreement and plan of merger (as
amended, the "Merger Agreement"). The liquidity crisis, execution of the Merger
Agreement and the events and circumstances surrounding and following them have
precipitated some disruption and delay in the normal process of preparation and
completion of the Form 10-Q and the certification process attendant thereto.

The reasons causing the inability to file timely could not be eliminated by the
Company without unreasonable expense or effort. The Company intends to file the
Form 10-Q as promptly as practicable, and expects that such filing will be made
by the April 14, 2008 extended deadline.

SEC Charges Another U.K. Fund with Late Trading

For the second time in  a week, the SEC charged a U.K. fund group with late trading and market timing in U.S. mutual funds.  The SEC alleges that Headstart Advisers, its chief investment adviser, and Headstart Fund earned nearly $200 million in illicit profits from 1998 to 2003.  WSJ, SEC Files Late-Trading Claim Against Another U.K. Fund.

Lehman Borrows from Fed Creatively

Wall St. is taking advantage of its new ability to borrow from the Fed.  Lehman Brothers, for example, moved $8.2 billion in loans that it had trouble selling into a new investment vehicle "Freedom," so called because it gave the firm the freedom to tap into as much cash as it needed.  Freedom then issued debt securities backed by the loans, most of which received investment grade credit ratings.  Lehman then used the securities as collateral for a low interest short term loan from the Fed.  Was this strategy "shocking" or "brilliant?"  In any event, expect more of the same.  WSJ, How Lehman Opened the Fed's Spigot.

Bernanke Outlines Regulatory Reform

In a speech today, Addressing Weaknesses in the Global Financial Markets: The Report of the President's Working Group on Financial Markets, Ben S. Bernanke offered some preliminary conclusions about the causes of the current turmoil and identified some measures to strengthen the global financial system.  Although noting that many factors contributed to the current problems, he identified as a primary cause the implementation of the "originate-to-distribute" approach to credit extension.  This ultimately led to a variety of undesirable consequences, including the compromise of underwriting standards at the point of origination, the general erosion of market discipline, underpricing of risk, and insufficient attention by investors to the quality or riskiness of the investments they purchased (including overreliance on credit rating agencies).

His recommendations include: 

• Weaknesses in the origination stage must be corrected
• Better consumer protections and disclosures
• Greater supervisory scrutiny of the originators' processes and their incentives
• Improved methods and greater transparency from credit rating agencies
• Strengthening risk management practices

In addition, investors must take responsibility for developing independent views of the risks of these investments.

Reports about Possible Yahoo and Microsoft Deals

The news today is full of behind-the-scenes dealmaking involving Microsoft and Yahoo.  First, it is reported that News Corp. (Rupert Murdoch) and Microsoft are in talks about a joint bid for Yahoo that, if successful, would combine Yahoo, MSN, and MySpace.  Second, Yahoo reportedly is having talks with TimeWarner about combining AOL with Yahoo's internet operations.  The deal would include Yahoo buying back some of its shares at a price higher than Microsoft's bid.  (Previously, it was reported that Yahoo had talks with News Corp too.)  In addition, Yahoo announced it would test outsourcing some of its search advertising to Google, to see if it resulted in more revenues.  Microsoft blasted the partnership as anticompetitive.  NYTimes, News Corp. May Join Yahoo Bid With Microsoft; WSJ, News Corp., AOL Pursue Yahoo Deals.

SEC Advisory Committee on Improvements to Financial Reporting Notices Meeting

The SEC Advisory Committee on Improvements to Financial Reporting will hold a public meeting on Friday, May 2, 2008, in Rosemont, Illinois.  The agenda for the meeting includes hearing oral testimony from panel participants regarding the Advisory Committee’s developed proposals and conceptual approaches, as presented in the Advisory Committee’s progress report dated February 14, 2008, related to substantive complexity and the standards-setting process; consideration of comment letters received by the Advisory Committee; consideration of updates from subcommittees of the Advisory Committee; and discussion of next steps and planning for the next meeting.

Cox Addresses NASAA

Chairman Christopher Cox Addressed the North American Securities Administrators Association 2008 Public Policy Conference on April 1, 2008 and focused on SEC-NASAA initiatives against senior fraud and other enforcement actions against fraud.

Court Upholds Forfeiture of Gemstar-TV Guide Severance Payment

The SEC announced a court ruling that successfully concludes its effort to stop a $29.5 million severance package from being paid to the former CEO of Gemstar-TV Guide International, Henry C. Yuen, who committed securities fraud before leaving his position at the Pasadena, Calif.-based company. The funds were previously set aside in an escrow account that will now be dissolved so that the money remains with the company and its shareholders.  The SEC was able to stop the large payment to Yuen through a provision in the Sarbanes-Oxley Act - Section 1103 - that allows the Commission to seek a temporary order from a federal district court requiring the company to hold "extraordinary payments" likely to be made to any officer, director, or affiliate of the company who is charged with a violation of the securities laws. The SEC charged Yuen with various violations of the federal securities laws in 2003, and he was later found guilty on all claims and forced to pay more than $22 million in financial penalties. This forfeiture of his severance payment will bring the total financial cost to more than $51 million for Yuen in the wake of his securities fraud violations.

"The U.S. District Court for the Central District of California ordered on March 27, 2008, that the $29.5 million be returned to the company. The district court had granted the SEC's application for an order pursuant to Section 1103 of the Sarbanes-Oxley Act on May 13, 2003, requiring Gemstar-TV Guide to escrow the pending payment to Yuen.

After obtaining the temporary order, the SEC sued Yuen for various violations of the federal securities laws. Following a three-week trial in December 2005, the court ruled in favor of the SEC against Yuen on all claims. Yuen committed securities fraud by making misrepresentations and omissions of material fact about certain Gemstar revenues, aiding and abetting Gemstar's primary violations of the periodic reporting and record keeping control requirements, and lying to the auditors. On May 8, 2006, the court ordered Yuen to disgorge more than $10.5 million in ill-gotten gains, pay prejudgment interest of more than $1.1 million, and pay a civil penalty of more than $10.5 million. On April 1, 2008, the Ninth Circuit Court of Appeals affirmed the district court ruling that Yuen committed securities fraud, and found that the financial penalties against Yuen were appropriate.

FINRA Issues Guidance on Unauthorized Proprietary Trading

In the wake of several recent cases involving allegations of unauthorized or "rogue" trading resulting in substantial losses by firms both in the United States and abroad, many FINRA firms are undertaking comprehensive reviews of their internal controls and risk management systems designed to prevent such trading activity. FINRA is issuing a Notice to Members to highlight sound practices for firms to consider as they undergo that process and to remind firms that even profitable unauthorized trading can result in regulatory exposure if it involves falsification of the firm's books and records, failures in supervisory control systems, market manipulation or fraud. Therefore, internal control systems should be designed to address regulatory as well as business and reputational risk. Regulatory Notice 08-18, Sound Practices for Preventing and Detecting Unauthorized Proprietary Trading Executive Summary.

 

WaMu Turned Down JPM Before Taking Deal with TPG

JP Morgan Chase appears to have its finger in all the Wall St. pies.  Washington Mutual, which just got a $7 billion capital infusion from TPG, previously had been negotiating with JPM  about a stock tender offer that would have valued the WaMu stock at around $8, before turning it down.  Some WaMu shareholders think the JPM deal would have been better.  WSJ, WaMu's Hedge: CEO Called In Dimon & Co.

Apollo Management Files IPO

Private equity firm Apollo Management has filed an IPO with the SEC, according to the Wall St. Journal (although I couldn't find the filing on EDGAR this morning).  The offering is valued at about $418 million.   If the deal is successful, the main owners, including Leon Black, will make a lot of money and also maintain control, since they plan to seek a "controlled corporation" exception from the NYSE listing requirement of a majority of independent directors.  Mr. Black made his reputation selling junk bonds at Drexel Burnham.  WSJ, IPO for Apollo Management.

Bankruptcy Trustee Goes After Subprime Lender's Underwriters

Subprime lender American Business Financial Services (ABFS) went bankrupt three years ago, and purchasers of its high-yield notes, unsophisticated investors who purchased the notes through direct mailings and newspaper ads, lost millions.  Now the bankruptcy trustee is looking into the role the investment banks played in the company's overstatement of its assets on its books, and the FBI and SEC are investigating as well.  All the investment banks have denied wrongdoing.  After the banks stopped securitizing ABFS loans in 2003 (after an annonymous letter accusing the company of running a pyramid scheme), the company kept marketing its notes directly to the public, warning investors in the prospectus that they could lose their entire investment.  WSJ, Subprime Lender's Failure Sparks Lawsuit Against Wall Street Banks.

SEC Charges 5 Former San Diego Officials with Fraud

The SEC charged 5 former San Diego officials with fraud in connection with the City’s false and misleading financial statements in five 2002 and 2003 bond offerings.  According to the SEC’s complaint, these five former officials knew that the city had been intentionally under-funding its pension obligations so that it could increase pension benefits but defer the costs. They were aware that the city would face severe difficulty funding its future pension and retiree health care obligations unless new revenues were obtained, pension and health care benefits were reduced, or city services were cut. They specifically knew that the city’s unfunded liability to its pension plan was projected to dramatically increase, growing from $284 million at the beginning of fiscal year 2002 to an estimated $2 billion by 2009, and that the city’s liability for retiree health care was another estimated $1.1 billion. The complaint seeks a final judgment permanently enjoining the officials from further violations of the securities laws and ordering them to pay civil penalties. To settle the action, the city previously agreed to cease and desist from future securities fraud violations and to retain an independent consultant for three years to foster compliance with its disclosure obligations under the federal securities laws. The Commission also previously filed a settled civil injunctive action against the outside auditors for the City of San Diego and its pension system.

NYSE Firms Lost Over $7 Billion in 2007

New York Stock Exchange member firms that conduct business with the public reported a fourth-quarter 2007 after-tax loss of $10.64 billion and revenues of $88.18 billion, compared with $4.92 billion in after-tax profits on revenues of $93.38 billion in fourth quarter 2006. For 2007, the firms reported an after-tax loss of $7.35 billion on record revenues of $352.05 billion, compared with an after-tax profit of $13.58 billion on revenues of $331.34 billion in 2006. Comparative financial results are in the attached table.

Former Nymex Director Pleads Guity to Front-Running

Steven Karvellas, a former Director of the New York Mercantile Exchange, pleaded guilty to two felony counts of illegal trading in natural-gas markets.  The charges result from an investigation by the Exchange, the CFTC, and the Manhattan District Attorney into "front-running," or the practice of waiting to execute a customer's order until the broker determines how the market is moving.  WSJ, Ex-Nymex Official Pleads Guilty To 2 Counts in Gas-Trading Probe.

Greenspan Defends his Legacy

Alan Greenspan wants to set the record straight: the current financial mess is not his fault.  The Wall St. Journal contains excerpts from several interviews with him about his record, criticisms of his performance, and his recommendations for the future.  WSJ, 'The Impact Was Larger Than I Expected'.

Shareholders' Resolutions Reflect Shareholder Anger

Shareholders are upset about the credit collapse, and the shareholders' resolutions this proxy season reflect their anger.  CFO.com has a good article summarizing shareholder activists' efforts; For Shareholders, It's Subprime Time.

SEC Obtains Jury Verdict Against Stock Promoter

The SEC obtained a jury verdict against stock promoter Cort L. Poyner of Pompano Beach, Fla.  The SEC had alleged that Poyner defrauded investors in a California start-up company called The Children's Internet, falsely stating that the company's stock would be listed on a national stock exchange shortly and failing to disclose that he was receiving a 25% commission for selling the stock.

The Commission charged Poyner with fraud and the sale of unregistered securities. Following a three-day jury trial in Oakland, Calif., the jury found Poyner liable on all counts.

SEC Charges former CFO of United Rentals

The SEC filed securities fraud charges against John N. Milne, a former Vice Chairman, President, and Chief Financial Officer of United Rentals, Inc. ("URI"). Milne is the second URI officer, and the third CFO, charged in connection with the alleged violations. On December 12, 2007, the SEC filed settled financial fraud charges against Michael J. Nolan, another former CFO of URI. On December 27, 2001, the Commission charged Joseph F. Apuzzo, a former CFO of Terex Corporation, with aiding and abetting the fraudulent scheme.

The complaint, filed in the United States District Court for the District of Connecticut, alleges that, from 2000 through 2002, Milne engaged in a series of fraudulent transactions undertaken in order to meet URI's earnings forecasts and analyst expectations. The complaint alleges that Milne and Nolan carried out the fraud through a series of interlocking three-party transactions, structured as "minor sale-leasebacks," to allow URI to recognize revenue prematurely and to inflate profits generated from the sales. As a result of the fraud, URI materially overstated its financial results in its Forms 10-K for fiscal years 2000 and 2001, and its Forms 10-Q for the periods ended June 30, 2001 and March 31, 2002, as well as in other public releases.

The complaint further alleges that shortly after URI announced 2001 and 2002 year-end results, Milne sold approximately $38 million of URI stock that he owned, knowing that the company's announced financial results were materially overstated.

The Commission's complaint alleges that, as a result of his actions, Milne violated the securities laws and seeks a permanent injunction, an officer and director bar, disgorgement and prejudgment interest, civil penalties, and other equitable relief.

SEC Announces Mutual Fund Comparison Aid

The SEC announced the launch of a new Internet Web page that enables investors to more easily read, analyze, and compare the information provided by mutual funds related to fund cost, risk, and past performance.  The SEC approved rule amendments in June 2007 to enable mutual funds to submit risk/return summary information from their prospectuses using interactive data. To date, 20 mutual funds have voluntarily submitted their information in interactive data format since Aug. 20, 2007. Additional filers are expected to participate in the coming months.

Interactive data is powered by XBRL, a computer software language that labels companies’ financial and other data so that investors and analysts can more easily find what they’re looking for, and use the information for comparisons and analysis.

SEC Files Complaint Alleging Penny Stock Fraud

The SEC filed a civil injunctive action against fourteen defendants involved in the alleged illegal issuance and sale of unregistered stock of CMKM Diamonds, Inc., purportedly a diamond and gold mining company located in Las Vegas. CMKM allegedly fraudulently issued hundreds of billions of shares of purportedly unrestricted stock to John Edwards and his nominees, as well as to the nominees of Urban Casavant, the company's chief executive officer. The Commission alleges that as Casavant generated demand for CMKM stock through fraudulent promotion of the company, Edwards, Casavant, and their nominees sold their shares into the public markets for at least $64.2 million in profit.  The complaint, filed in U.S. District Court for the District of Nevada, alleges that, from January 2003 to May 2005, CMKM improperly issued up to 622 billion shares of purportedly unrestricted stock. According to the complaint, these issuances were based in large part on both written authorizations and attorney opinion letters prepared by Brian Dvorak, CMKM's lawyer, which were often facially inadequate, suspect, and inconsistent. Allegedly, based on these faulty documents, CMKM's transfer agent, 1st Global Stock Transfer LLC, and its owner, Helen Bagley, issued stacks of stock certificates without restrictive legends. Edwards, his nominees, Kathleen Tomasso and Anthony Tomasso, and Casavant's nominees, James Kinney and Ginger Gutierrez, then allegedly deposited the certificates with various broker-dealers and sold the shares into the market. NevWest Securities Corporation and its employees, Anthony Santos, Sergei Rumyantsev, and Daryl Anderson, are alleged to have sold more than 259 billion shares of CMKM stock for Edwards, despite numerous red flags indicating a massive unregistered distribution. Meanwhile, Casavant allegedly generated investor interest in CMKM by using false press releases, Internet chat boards, and "funny car" race events across the country. The complaint alleges that this promotion was extremely successful, and about 40,000 investors purchased CMKM stock during the period of the fraud without knowing that Casavant ran the company from his house in Las Vegas, and that CMKM's primary activity was to issue and promote its own stock.

The Commission charged defendants with violating Section 5 of the Securities Act of 1933 and seeks a permanent injunction against all defendants. The Commission also seeks an accounting, disgorgement with prejudgment interest, and civil penalties.

Yahoo Sends Response to Microsoft Letter

Yahoo CEO Jerry Yang and Chairman Roy Bostock responded to Microsoft CEO Steven Ballmer's weekend letter, stating that they continue to believe that Microsoft's bid undervalues the company, but saying that they remain open to a deal if it is superior to alternatives.  They also took issue with Ballmer's comment that Yahoo refused to negotiate with Microsoft and referred to two meetings that he had attended.  WSJ, Yahoo Rebuffs Microsoft Again, But Says Open to A Better Deal.

Motorola and Icahn Agree to Resolve Dispute

One of the longest ongoing corporate soap operas may end as Motorola agreed to back two of Carl Icahn's nominees for the Motorola board, in exchange for Icahn's dropping his proxy contest for four directors and a lawsuit he filed to seek corporate documents.  Motorola agreed to appoint Keith Meister, a manager of Icahn's investment funds, immediately to the Board.  WSJ, Motorola, Icahn Declare Truce.

New York Law Firm Can be Liable as Aider & Abettor of Securities Fraud under Oregon Statute

A disappointed investor in a hedge fund, residing in Oregon, can sue the New York law firm that drafted the offering documents for aiding and abetting the securities fraud of the principal, who had already pleaded guilty to securities fraud violations, under the Oregon securities statute.  The federal district court for the S.D.N.Y.  ruled against the defendant on a motion to dismiss and rejected its arguments that federal law preempted the statute statute and the state statute violated the dormant commerce clause.  The court did, however, agree with defendant that plaintiff failed to allege that the securities were not federally covered securities and dismissed the claim based on sale of unregistered securities.  The court noted that the U.S. Supreme Court, as recently as Stoneridge Investment Partners v. Scientific-Atlanta, Inc., recognized state authority to regulate and enforce its own fraud statutes in the securities area independent of federal law.  It also found nothing in National Securities Markets Improvement Act (NSMIA) that preempts state oversight of fraud or deceit in the securities area.  The Oregon Blue Sky Statute, modeled on the ALI's 1956 Uniform Securities Act, expressly provides a cause of action against aiders and abettors of securities fraud, and the Oregon Supreme Court has previously found that attorney preparation of legal materials for an offering qualifies as participating in or materially aiding under the statute.  The court noted that while the principal probably lied to the law firm, the statute requires the defendant to establish its due diligence as an affirmative defense.  Houston v. Seward & Kissel, LLP, 2008 WL 818745 (S.D.N.Y. Mar. 27, 2008).

Microsoft Puts Pressure on Yahoo

Over the weekend Microsoft send the Yahoo board a letter warning that it would begin a proxy solicitation to take control of the Yahoo board if the companies did not reach a negotiated deal in the next three weeks.  In that event, the letter went on to say, the price Microsoft offered might be lower than the price it offered in January, a combination of cash and stock worth at that time $31 per share and now valued at closer to $29.  Microsoft also noted that Yahoo's business appeared to have deteriorated in that time.  Yahoo is expected to reply today.  NYTimes, Yahoo Is Said to Rebuff Microsoft Threat Over Bid; WSJ, Microsoft Ratchets Up Deal Pressure on Yahoo.

$5 Billion Investment in Washington Mutual

Washington Mutual, the largest U.S. savings and loan association, is negotiating with U.S. private equity firm TPG and other investors for a $5 billion infusion of capital.  Washington Mutual has been hit hard by the mortgage crisis.  The deal would be in the form of common and convertible preferred stock, and TPG would become a substantial minority shareholder with one seat on the board.  JP Morgan Chase was doing due diligence for a deal, but those discussions broke down last week.  NYTimes, Report Says Washington Mutual to Get $5 Billion; WSJ, Washington Mutual to Get $5 Billion.

Karmel on Accredited Investor Definition

Regulation by Exemption: The Changing Definition of an Accredited Investor, by ROBERTA S. KARMEL,
Brooklyn Law School, was recently posted on SSRN.  Here is the abstract:

The Securities and Exchange Commission ("SEC") has preserved its jurisdictional grip and ideological purity with respect to the regulation of initial public offerings and the regulation of mutual funds by creating huge exemptions from its regulatory scheme. While these exemptions have been in response to push backs against a rigid and complex framework for the registration of public offerings and the governance of mutual funds, it has led to anomalies in the capital markets, arguably not in the interests of the retail investors the SEC endeavors to protect. The SEC exemptions have been achieved through the use of the "accredited investor" concept, injected into the Securities Act of 1933 ("Securities Act") in 1980.

The problem with regulating by exemption is that it does not incentivize the SEC to adjust regulations that discourage capital market participants from entering a regulated system. Instead of reforming the registration provisions of the Securities Act to make such registration more user friendly and less likely to result in after-the-fact lawsuits, the SEC fashioned private placement exemptions that have created a huge market for unregistered offerings. Instead of trying to reform the Investment Company Act and the Advisers Act to accommodate hedge funds and private equity funds, the SEC exempted them for many years, and then, becoming worried that a large part of the capital market had moved beyond its jurisdiction, unsuccessfully tried to recapture jurisdiction over these investment pools.

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. Traditional commentators continue to view class actions with suspicion; they see class suits as nonmeritorious byproducts of self-interest and the attorneys who bring them as rent-seekers. Their conventional approach has popularized securities class actions' negative effects. High-profile commissions capitalizing on this rhetoric, such as the Committee on Capital Markets Regulation, have recently recommended eliminating or severely curtailing securities class actions. But this approach misses the point: in the ongoing push and pull of securities regulation, corporations are winning the battle.

Thus, understanding the full picture and texture of securities class actions necessitates a positive pragmatic account. This Article provides that account and thus fills a significant gap in the benefit side of academic cost-benefit literature. To do so, however, it self-consciously begins from a controversial assumption: namely, that securities class actions provide a public good. Integrating both public and private actors into ex post enforcement diminishes collective action dilemmas, agency inaction, and private resolution of public law matters through arbitration. Moreover, by supplementing ex post enforcement, securities class actions produce positive externalities, spillover effects that confer public advantages such as: innovation, cost-reduction through information sharing, deterrence, transparent judicial process, and both corporate and enforcement accountability. So, while I harbor no illusion that the securities class action always functions optimally and have a number of lingering doctrinal and jurisprudential concerns about its operation, I also recognize its comparative institutional capability to make transparent an increasingly opaque process, craft decisional rules and interpretations that guide future behavior, cultivate innovation, deter fraud, and hold corporations, exchanges, and the SEC publicly accountable. This piece thus envisions the ramifications 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 neglecting nonprioritized misconduct, and one ignoring litigant preference for judicial process. In short, it is a world less preferable than our current system-flawed though it is.

Barrett on Audit Quality

Sarbanes-Oxley, Kermit the Frog, and Competition Regarding Audit Quality, by MATTHEW J. BARRETT, Notre Dame Law School, was recently posted on SSRN.  Here is the abstract:

The regulatory scheme after Sarbanes-Oxley has significantly improved public company audits in the United States, or at least has demonstrated the potential to do so, but the obligation to preserve client confidentially still prevents auditors from competing for new clients on the basis of audit quality. This paper suggests a simple way for the SEC to facilitate such competition within the existing regulatory framework. The SEC should require issuers and registrants to disclose whether their independent audits uncovered any financial fraud and, within specified ranges, the number and amount of all audit adjustments incorporated into the financial statements filed with the Commission. Auditing firms could use this then-public information, plus perhaps data about the infrequency of any restatements to financial statements on which the firm had expressed an unqualified opinion, to evidence the quality of the firm's audits relative to those of its competitors. The PCAOB might also incorporate such information in its inspection reports.

Although audit industry experts agree that we cannot directly observe audit quality, accountants have constructed and deployed empirical proxies for audit quality, such as abnormal accruals, to study aggregate behavior across samples of registrants, rather than to report individual behavior within a single registrant. As another proxy for audit quality, this proposal, which seeks to publicize the actual number and dollar amount of audit adjustments, measures directly what abnormal accruals measure indirectly.

With such data, investors, audit committees, and other participants in our capital markets, could better assess the quality and value of the independent audits that registered public accounting firms provide. Initially, auditing firms could better compete within tiers regarding audit quality. Eventually, the proposal might allow second-tier auditing firms to expand their audit practices and to enhance their reputations sufficiently to compete with the Big Four, potentially reducing concentration in the industry.

Fanto on Broker-Dealer Professionalism in IPOs

The Continuing Need for Broker-Dealer Professionalism in IPOs, by JAMES A. FANTO, Brooklyn Law School, was recently posted on SSRN.  Here is the abstract:

In this essay, I contend that the IPO process and its abuses of the late 1990s reveal a fundamental problem in the brokerage industry. The abuses show the culmination of a concerted training in business, business schools, and even law schools and, more generally, in society: the acceptance of self-interested profit maximization as the sole goal for business and financial activities. I first review the IPO abuses from the perspective of individual self-interest and the group enhancement of it to show the fundamental motivation of the abuses. I then examine the regulatory responses to these abuses in order to point out their incompleteness. I argue that the reforms were incomplete because they established limited broker-dealer professionalism, focusing only on research analysts, which perversely encouraged those not directly touched to continue to engage in self-interested conduct. I also contend that this absence of full broker-dealer professionalism can lead to reputational risk that threatens these financial institutions and even the stability of the securities markets. I thus suggest that the professional reform for broker-dealers must be wide-ranging and must reach into the training of future bankers and brokers in the business schools. However, I also offer a practical, stopgap reform suggestion that can help alleviate reputational risk.

Shadab on Hedge Funds

The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection, by HOUMAN B. SHADAB, George Mason University - Mercatus Center, was recently posted on SSRN.  Here is the abstract:

A persistent theme underlying contemporary debates about financial regulation is how to protect investors from the growing complexity of financial markets, new risks, and other changes brought about by financial innovation. Increasingly relevant to this debate are the leading innovators of complex investment strategies known as hedge funds. A hedge fund is a type of private investment pool that actively trades securities and is not subject to the full range of restrictions on investment activities and disclosure obligations imposed by the federal securities laws.

Hedge funds engage in financial innovation by pursuing novel investment strategies that lower market risk (beta) and increase returns attributable to manager skill (alpha). Despite the funds' unique costs and risk properties, the historical performance of hedge funds suggests that the ultimate result of hedge fund innovation is to help investors reduce economic losses during market downturns. Most recently, during the first nine months of the subprime mortgage-initiated credit crunch (from June 2007 to February 2008) hedge funds produced gains averaging an estimated 1.46% while banks and mutual funds suffered substantial losses and the U.S. stock market lost 13.02% of its value. By increasing investors' ability to maximize risk-adjusted returns, hedge funds advance the same goal that federal investor protection regulation seeks to advance.

This Article shows that the economic outcomes attained by hedge funds are in part attributable to the legal regime under which they operate. The hedge fund legal regime includes not only federal securities law but also the entity and contract law provisions governing the fund, its manager, and investors. Federal law applicable to hedge funds enables the funds to pursue innovative investment strategies employing the trifecta of leverage, short sales, and derivatives. The entity and contract law governance of hedge funds provides high-powered incentives for fund managers to engage in and capture the gains from financial innovation.

A general lesson from the law and economics of hedge funds is that when a legal regime permits financial intermediaries to be flexible in their investment strategies and aligns the incentives of investors and innovators through performance fees and co-investment by managers, financial innovation is likely to complement investor protection.