April 7, 2008
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.
April 6, 2008
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.