April 14, 2008
SEC Settles Discriplinary Proceedings Against Two Worldcom Auditors
The SEC settled actions against two former Arthur Andersen LLP (Andersen) partners, Melvin Dick (Dick) and Kenneth M. Avery (Avery), who served on the WorldCom, Inc. (WorldCom) audit for the fiscal year ended December 31, 2001. Dick, former lead engagement partner for the WorldCom audit, and Avery, an audit partner on the engagement, consented to settled administrative proceedings which found that they had engaged in improper professional conduct in connection with their work on the WorldCom audit. Dick and Avery each consented to the entry of an order pursuant to Rule 102(e) of the Commission's Rules of Practice denying them the privilege of appearing or practicing before the Commission as an accountant, with the right to apply for reinstatement after four years and three years, respectively. The respondents settled without admitting or denying the findings in the Commission's Orders.
The SEC found that during the 2001 audit, Andersen had designated WorldCom as a "Maximum Risk" client, and Dick and Avery were aware of several factors that increased the potential for fraud at WorldCom. Nevertheless, they failed to alter their planning and execution of the audit to take these risks into account as required under Generally Accepted Auditing Standards (GAAS). In addition, Dick and Avery failed to carry out certain audit procedures in critical audit areas, such as WorldCom's Property, Plant & Equipment (PP&E) and line cost accounts, where WorldCom's management posted its fraudulent accounting entries.
The SEC's Orders found that Dick's and Avery's failure to implement fundamental audit steps violated GAAS in that they failed to: exercise due professional care and professional skepticism in the planning and performance of the audit, obtain sufficient evidential matter to afford a reasonable basis for Andersen's opinion regarding WorldCom's financial statements; expand the extent of the audit procedures applied, apply procedures closer to or as of year end, particularly in critical audit areas, or modify the nature of procedures to obtain more persuasive evidence, in light of the significant risks of material misstatement that existed at WorldCom; plan and perform the audit to obtain reasonable assurance about whether the financial statements were free of material misstatement, whether caused by error or fraud; and issue an audit report that accurately stated that the audit was conducted in accordance with GAAS and that WorldCom's financial statements were presented in conformity with Generally Accepted Accounting Principles. Based on these findings, the Commission found that Dick and Avery engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii).
SEC Sustained Expulsion of PAZ Securities
On remand from the United States Court of Appeals for the District of Columbia Circuit, the SEC sustained the expulsion of PAZ Securities, Inc. from NASD membership and the bar of Joseph Mizrachi from associating with any NASD member firm in any capacity for completely failing to respond to NASD requests for information. The Court of Appeals had remanded for the Commission to determine whether the sanctions were excessive or oppressive in light of factors raised in mitigation and to consider whether the sanctions served a remedial purpose. On remand, the Commission found that members and associated persons who, without mitigation, fail to respond in any manner to NASD requests for information pose too great a risk to markets and investors to be permitted to remain in the securities industry and that their removal from the industry therefore served the remedial purpose of protecting public investors. The Commission also found that the failure to respond to the requests for information in this case until after NASD had expelled PAZ and barred Mizrachi was tantamount to a complete failure to respond. The Commission found further that no factors mitigated the misconduct and that the sanctions were thus not excessive or oppressive.
SEC Upholds in part NASD Disciplinary Proceedings Against Principals of Brokerage Firm
The SEC sustained in part and set aside in part NASD disciplinary action against Dennis Todd Lloyd Gordon, the chief executive officer of former NASD member firm Lloyd Scott and Valenti, Ltd. ("LSVL" or the "Firm"), and Sterling Scott Lee, LSVL's president. The SEC found that Gordon and Lee permitted Michael Guss, an unregistered individual, to function as a principal of the Firm and failed to maintain the accuracy of the Firm's membership application. It also found that Gordon and Lee caused the Firm to charge excessive markups in thirty-one retail sales, although the Commission set aside NASD's finding that the markups were fraudulent. In addition, the Commission sustained an NASD finding that Lee violated Section 10(b) of the Securities Exchange Act of 1934 and was responsible for the Firm's violations of Exchange Act Rule 10(b)(10) because he failed to ensure that markups on the Firm's riskless principal transactions were disclosed to customers, but it set aside NASD's finding that Gordon was liable for those violations; the Commission found that Lee was responsible for ensuring that the Firm's remuneration was disclosed on confirmations sent to customers, but that the record did not show that Gordon knew or should have known that Lee was not fulfilling his responsibility in that area.
The Commission sustained the bar in all capacities that NASD imposed on Gordon and Lee for the registration violations. The Commission found, however, that the bar imposed by NASD for the markup violations was excessive, and imposed instead a six-month suspension on both Gordon and Lee, with an additional thirty-day suspension (to run concurrently) on Lee based on the violations of Exchange Act Section 10(b) and Exchange Act Rule 10(b)(10). The Commission also affirmed NASD's order of restitution.
April 13, 2008
Fox on Mandatory Disclosure
Civil Liability and Mandatory Disclosure, by MERRITT B. FOX, Columbia University - Columbia Law School, was recently posted on SSRN. Here is the abstract:
This paper explores the appropriate system of civil liability for mandatory securities disclosure violations by established, publicly traded issuers. The U.S. system's design has become outmoded as the underlying mandatory disclosure regime that has moved from an emphasis on disclosure at the time that an issuer makes a public offering, to an emphasis on the issuer's ongoing periodic disclosures. An efficiency analysis shows that, unlike U.S. law today, the relevant actors should have equally great civil liability incentives to comply with the disclosure rules whether or not the issuer is offering securities at the time.
An issuer not making a public offering of securities should have no liability because the compensatory justification is weak. Deterrence will be achieved instead by imposing liability on other actors. An issuer's annual filings should be signed by an external certifier - an investment bank or other well capitalized entity with financial expertise. If the filing contains a material misstatement and the certifier fails to do due diligence, the certifier would face measured liability. Officers and directors would be subject to similar liability. Damages would be payable to the issuer. When an issuer is making a public offering, it would be liable to investors for its disclosure violations as an antidote to what otherwise would be an extra incentive not to comply.
This design would address two major complaints concerning the existing U.S. civil liability system: underwriter Section 11 liability for a lack of due diligence concerning disclosures that in modern offerings underwriters have no realistic ability to police, and litigation-expensive issuer class action fraud-on-market liability. The system suggested here would eliminate both sorts of liability. But unlike elimination reforms proposed by underwriters and issuers, it would retain deterrence by substituting in place of these liabilities more effective and efficient civil liability incentives for disclosure compliance.
Rose on Sovereign Shareholders
Sovereigns as Shareholders, by PAUL ROSE, Ohio State University - Michael E. Moritz College of Law, was recently posted on SSRN. Here is the abstract:
This paper considers the increasing impact of sovereign wealth funds as equity investors. Sovereign investment has been viewed with suspicion because sovereign wealth funds, as tools of sovereign entities, could be used for political rather than investment purposes. While this risk is considerable, much of the discussion surrounding sovereign investment ignores or minimizes the mitigating effect of a number of regulatory, economic and political factors. This paper argues that continued care, but not additional regulation, is necessary to ensure that U.S. interests are not jeopardized by sovereign investment in U.S. enterprises. However, while the U.S. is able to protect its interests within its markets, other countries may not have the regulatory structure or political power to adequately defend their interests. Additionally, U.S. interests could be harmed by politically-motivated sovereign investment in other countries. As a result, this paper argues in support of efforts to establish a code of conduct for sovereign investment.
Ware on Securities Arbitration
What Makes Securities Arbitration Different from Other Consumer and Employment Arbitration?, by STEPHEN J. WARE, University of Kansas - School of Law, was recently posted on SSRN. Here is the abstract:
This short piece emphasizes what makes consumer and employment arbitration in the securities industry different from consumer and employment arbitration generally. Securities law imposes non-contractual duties to arbitrate on both broker-dealers and securities employees. I believe these laws are bad policy because they restrict contractual freedom. I conclude that securities arbitration should be contractual, like other arbitration.
Cunningham on Gobal Accounting
The SEC's Global Accounting Vision: A Realistic Appraisal of a Quixotic Quest, by LAWRENCE A. CUNNINGHAM, George Washington University Law School, was recently posted on SSRN. Here is the abstract:
In the most revolutionary securities law development since the New Deal, the SEC is poised to jettison rules requiring companies to apply recognized US accounting standards by inviting use of a new set of international ones created by a private London-based organization. This radical shift follows decades of gradual movement towards international standards that has gained momentum since 2005 when all listed companies in the European Union were required to use them. For the US, the SEC could give companies the option to use either or establish a medium-term plan to move US companies to international standards within a decade.
Analysis of the SEC's vision for this quest reveals that it contains contradictions, paradoxes and ironies that suggest quixotic thinking. A contradiction: the SEC touts its vision as promoting comparability, yet proposes injecting choice and competition into accounting standards that would reduce it. A paradox: the SEC celebrates a single set of global standards while advocating changes that would create a double set within the US and overlooks factors that justify skepticism about the possibility of a single set of written standards translating into uniform application. An irony: the SEC acknowledges that pursuing global standards is "very complex" while its Chairman says the SEC has "declared a war on complexity" in accounting.
A more realistic vision of the quest appreciates that, under either an optional or mandatory route, the shift amounts to a leap of faith posing both large costs for the US and potentially large gains for it and the world. This realistic appraisal lowers expectations about actual comparability; highlights serious risks that competing standards would impair comparability; recognizes needs the SEC has scantly examined to render elaborate infrastructural changes; and, above all, faces the realization that the abrupt shift is less about the SEC's historical mandate to protect investors than about a newly undertaken mission to expand global capitalism.
Mitchell on the Innocent Shareholder in Securities Class Actions
The "Innocent Shareholder": An Essay on Compensation and Deterrence in Securities Class Actions, by LAWRENCE E. MITCHELL, George Washington University - Law School, was recently posted on SSRN. Here is the abstract:
One of the persistent tropes in the debate over the desirability of private securities class actions is that innocent shareholders pay the damages. The claim that shareholders are indeed innocent has rarely been examined. In this paper, I take the assertion seriously, tracing the use of the concept from its origins as a rhetorical anti-regulatory device from the 1890s through about 1920, its disappearance as the rising New Deal concern with corporate power led to a variety of academic, regulatory, and popular efforts to achieve shareholder empowerment, and its re-emergence in the 1970s as modern finance theory and its application separated the shareholder from the corporation and reconceptualized her as a passive diversified receptacle of profit. The dominant economic thinking has been so widely accepted that rejuvenated claims of shareholder innocence are made at least as often by those in favor of regulation as by those against it.
Following my presentation of this history, I argue that the contemporary innocent shareholder argument ignores both the reality and emerging theory of shareholder empowerment, and make some suggestions as to why and how shareholders can and should be expected to take a share of responsibility for market integrity. Damages awards in class actions help to create the proper incentives.
Fried on Backdating
Option Backdating and its Implications, by JESSE M. FRIED, University of California, Berkeley - School of Law, was recently posted on SSRN. Here is the abstract:
Thousands of US companies appear to have secretly backdated stock options. This paper analyzes three forms of secret option backdating: (1) the backdating of executives' option grants; (2) the backdating of non-executive employees' option grants; and (3) the backdating of executives' option exercises. It shows that each type of backdating less likely reflects arm's-length contracting than a desire to inflate and camouflage executive pay. Secret backdating thus provides further evidence that pay arrangements have been shaped by executives' influence over their boards. The fact that thousands of firms continued to secretly backdate after the Sarbanes Oxley Act, in blatant violation of its reporting requirements, suggests recent reforms may have failed to adequately curb such managerial power.