Securities Law Prof Blog

SEC Director of Investment Management Outlines Agenda

Andrew J. Donohue, Director, Division of Investment Management, SEC, outlined the following agenda for the Division at an April 24, 2008, Keynote Address at the Practicing Law Institute, Investment Management Institute 2008:

I expect the remainder of 2008 to be an exciting time for those of us at the Commission and, similarly, those of you who practice in the investment management area. I am hopeful that the Commission and its staff will be addressing three fundamental issues of critical importance to America’s investors. They are the structure of the mutual fund disclosure regime, the payment of distribution-related fees from fund assets as permitted by rule 12b-1 under the Investment Company Act, and the appropriate regulatory framework that should govern relationships between financial professionals and retail investors as discussed in the recent report issued by the RAND Corporation.

None of these is a new issue.  Let's hope that the SEC can finally accomplish some meaningful reform in the mutual fund area to provide better protection for retail investors.

H&R Block Financial Advisors Exonerated in Enron Sales Proceeding

A FINRA hearing panel dismissed a November 2004 complaint against H&R Block Financial Advisors alleging sales practices and supervisory violations relating to sales of Enron Corporation bonds during the one-month period immediately preceding Enron's filing for bankruptcy protection on Dec. 2, 2001.  The panel ruled that FINRA's Department of Enforcement failed to show by a preponderance of evidence that H&R Block registered representatives misrepresented or omitted material facts in connection with sales of Enron bonds, or that the firm failed to implement adequate supervisory systems and procedures.

Countrywide's CEO Does Well

Countrywide Financial's CEO Angelo Mazilo made $121.5 million in 2007 from exercising stock options under a Rule 10b5-1 plan.  He also received $22.1 million in compensation -- $1.9 million in salary, $20 million in stock and option awards, no bonus.  Countrywide, in contrast, lost $704 million, and its shares declined 79%.  NYTimes, A Losing Year at Countrywide, but Not for Chief.

SEC Institutes Market Timing Suit Against Former Portfolio Manager of A Gabelli Fund

The SEC filed a civil fraud action in the United States District Court for the Southern District of New York against Marc J. Gabelli, the former portfolio manager of the Gabelli Global Growth Fund (GGGF), currently known as GAMCO Global Growth Fund, and Bruce Alpert, Chief Operating Officer of GGGF's adviser, Gabelli Funds LLC (Gabelli Funds), in connection with an undisclosed market timing arrangement with Folkes Asset Management, currently known as Headstart Advisers Ltd. (Headstart). The complaint alleges that from September 1999 until August 2002, Marc Gabelli authorized Headstart to place market timing trades in GGGF while Gabelli Funds was rejecting other market timers. In return, Headstart maintained its investment in other affiliated funds.
 
Over a two-year period, Headstart's internal rates of return on its three accounts were 185 percent, 160 percent, and 73 percent, respectively, while the rate of return for other GGGF shareholders was at most negative 24.1 percent. Gabelli Funds financially benefited from the market timing in that it earned advisory fees from both the market timing and Headstart's investment in the affiliated hedge fund.
 
In a related administrative proceeding, the SEC settled administrative proceedings against Gabelli Funds, a registered investment adviser, in connection with the undisclosed market timing by Headstart. Gabelli Funds was censured, ordered to cease and desist its securities law violations, and ordered to pay $9.7 million in disgorgement, $1.3 million in prejudgment interest, and a penalty of $5 million, for a total payment of $16 million. As described in the Order, Gabelli Funds' payment will be distributed to shareholders harmed by the market timing activity during the relevant period.

SEC Settles Market Timing Charges Against Pritchard Capital

The SEC settled market-timing and late-trading charges against Pritchard Capital Partners, LLC, Thomas Pritchard and Elizabeth McMahon.  Pritchard Capital is a registered broker-dealer headquartered in Mandeville, Louisiana, and Thomas Pritchard is the firm's managing director. McMahon was formerly associated with Pritchard Capital in its New York office from approximately March 2001 through January 2004.  The SEC's order finds that from November 2001 through approximately July 2003, Pritchard Capital allowed some of its market timing customers, who provided 25% of the firm's revenue in 2003, to late trade mutual fund shares through its New York office.

FINRA Issues Alert on Event-Linked Securities

FINRA issued an alert to inform investors about event-linked securities—financial instruments that allow investors to speculate on a variety of events, including catastrophes such as hurricanes, earthquakes, and pandemics ("cat bonds").

The market for event-linked securities has grown substantially since they were first developed in the mid-1990s. At present, these products are not offered directly to individual investors. But various funds, including mutual funds and closed-end funds, have purchased or are authorized to purchase them on behalf of individual investors. While not widespread, holdings of event—linked securities in these funds—especially high income funds-are also not unusual.

Event-linked securities currently offer higher interest rates than similarly rated corporate bonds. But, if a triggering catastrophic event occurs, holders can lose most or all of their principal and unpaid interest payments.

The Alert advises investors to to find out whether any funds they own invest in cat bonds or other similar event-linked instruments and to consider whether the fund manager has adequate resources and expertise to evaluate the risks of event-linked securities and whether they are a sound investment.

FINRA Proposes Rule Change Regarding Complaints of Brokers'Sales Practices

FINRA is seeking comment on proposed rule amendments that would require registered firms - for the first time - to report allegations of sales practice violations against an individual broker made in arbitration claims that do not name the broker as a respondent.  Under current practice, firms are required to report customer allegations against a broker in an arbitration claim only if the legal document specifically names the broker as a respondent. A settlement or ruling resolving the allegations also need not be reported if the broker is not named as a respondent. Increasingly in recent years, claimants and their lawyers have been naming only the firm in arbitrations; as a result, neither the allegations of sales practice violations made against the unnamed brokers nor the dispositions of those proceedings are reported to CRD.

Currently, customer complaints and settlements involving an amount of $10,000 or more are reportable to CRD, a threshold that has been in place for years without being adjusted for inflation. FINRA is proposing raising that threshold to $15,000 to more accurately reflect today's business conditions.

FINRA will be accepting public comments on the proposals for 30 days, or until May 27.

SEC Settles False Rumors and Short-Selling Charges

The SEC charged Paul S. Berliner, a Wall Street trader formerly associated with Schottenfeld Group LLC, with securities fraud and market manipulation for intentionally spreading false rumors about The Blackstone Group's acquisition of Alliance Data Systems (ADS) while selling ADS short.The SEC alleged that five months ago, Berliner disseminated the false rumor through instant messages to numerous individuals, including traders at brokerage firms and hedge funds. The false rumor also was picked up by the media.  Heavy trading in ADS stock ensued, and within 30 minutes the false rumor had caused the price of ADS stock, trading at approximately $77 per share, to plummet to an intraday low of $63.65 per share - a 17 percent decline. In response to the unusual trading activity, the New York Stock Exchange temporarily halted trading in ADS stock. Later in the day, ADS issued a press release announcing that the rumor was false. By the close of trading, the price of ADS stock recovered to its pre-rumor price of approximately $77 per share. Berliner profited by short selling ADS stock during its precipitous decline.

Without admitting or denying the allegations in the SEC's complaint, Berliner agreed to settle the charges against him by consenting to the entry of a final judgment enjoining him from future violations of the antifraud and anti-manipulation provisions of the federal securities laws, and requiring him to disgorge $26,129 in profits and interest, pay a maximum third-tier penalty of $130,000, and consent to the entry of a Commission Order barring him from association with any broker or dealer.

Is Microsoft-Yahoo Merger Dead?

Maybe the Microsoft-Yahoo merger is over.  Microsoft reportedly has a list of nominees for the Yahoo board in the event it decides to go forward with a hostile takeover, and this Saturday is the date Microsoft previously gave Yahoo to decide whether to enter into friendly negotiations or face a hostile bid.  However, CEO Steve Ballmer suggested that Microsoft might give up the fight in the face of  skepticism from Microsoft employees about the deal.  WSJ, CEO Says Microsoft Could Forgo Yahoo.

Estate of James Brown Sues Morgan Stanely

The estate of singer James Brown brought a lawsuit charging that Morgan Stanley failed to prevent the late singer's manager from stealing money from his investment account.  The lawyers for the estate say there is no mandatory arbitration agreement.  Morgan Stanley said that the suit was without merit.  NYTimes, Stewards of James Brown Estate Sue Morgan Stanley.

Warren Buffett on Corporate America

Larry Cunningham (GW) has edited a second edition of Warren Buffett's legendary essays.  Among the "hot topics" touched upon in this edition are stock options, excessive CEO pay, derivatives, foreign currency trading, and management succession.  You can preorder the book in time for Berkshire Hathaway's annual meeting.

SEC Refuses to Respond to Congressional Inquiry on Bear Stearns

The SEC refused to respond to a congressional request for information about why it dropped two investigations begun in 2005 into Bear Stearns' methods of valuing complex debt securities.  The agency cited its confidentiality policy.  WSJ, SEC Rebuffs Lawmakers Over Bear.

EBay Brings Shareholders Suit against Craigslist

EBay, which owns almost 25% of Craiglist (that it acquired from a disgruntled ex-employee or from Craigslist itself, depending on whom you ask), filed a shareholders' derivative suit in Delaware against Craigslist, saying that undisclosed actions unfairly diluted its interest.  EBay said the complaint was under seal because of confidentiality restrictions.  NYTimes, EBay Files a Stockholder Lawsuit Against Craigslist.

CFTC Puts on Hold Changes in Face of Agriculture Industry Concerns

The CFTC placed on hold proposals that would have raised the amount that financial speculators could hold and would have exempted commodity index funds from those limits.  At a hearing representatives from the agricultural industry, who use commodity futures as a hedge against declines in crop prices, blamed speculators for the increased volatility in agricultural futures.  NYTimes, Regulators Back Away From Changes to Commodity Hedging.

Former Mercury Interactive CFO Indicted on Backdating Charges

The former CFO of Mercury Interactive Corp., Sharlene P. Abrams, was indicted on charges stemming from backdating stock options.  According to the indictment, Abrams orchestrated the backdating for herself and both the former CEO and COO.  She was charged with one count of income tax evasion and two counts of aiding and assisting the preparation of false returns.  CFO.com, Mercury Interactive Ex-CFO Is Indicted.

Virginia Law Review on SEC at 75

On Friday, September 26th, 2008, the Virginia Law Review will host a symposium marking the 75th anniversary of the Securities and Exchange Commission. The Virginia Law Review is pleased to announce that the following securities law scholars will present at the symposium:

John C. Coffee, Jr.
James D. Cox
Donald C. Langevoort
A.C. Pritchard
Hillary A. Sale
Joel Seligman
Robert S. Thompson
More details on commentators and special speakers will be announced on the Law Review's website as they become available.

Cox Testifies on Credit Rating Agencies

Chair Cox testified on Oversight of Nationally Recognized Statistical Rating Organizations before the U.S. Senate Committee on Banking, Housing and Urban Affairs on April 22, 2008.  He reported on the SEC's examination of the credit rating agencies on "the adequacy of their public disclosures, their recordkeeping, and their procedures to prevent the misuse of material nonpublic information" as well as "how the firms manage their conflicts of interest, as well as their approaches to preventing unfair, abusive, or coercive practices."

While stating that it was premature to describe the results, he went on to say:

that it appears the volume of the structured finance deals that were brought to the credit rating agencies increased substantially from 2004 to 2006. In addition, during the period of time under examination, the structured products that the rating agencies were being asked to evaluate were becoming increasingly complex, with many employing derivatives such as credit default swaps to replicate the performance of mortgage backed securities. At the same time, the loan assets underlying these securities shifted from primarily plain vanilla 30-year mortgages to a range of more difficult-to-assess products, such as adjustable rate and second lien loans.

We are evaluating whether credit rating agencies adapted their rating approaches in this environment. The staff is observing that the ratings process used to rate these products may have been less quantitatively developed, particularly as the products became more complicated and involved different types of loans, than was generally believed. ... The staff is currently working to assess whether, and if so the extent to which, these factors contributed to the volume of eventual downgrades, and whether other factors — such as the desire to maintain or increase market share — may have caused the credit rating agencies to be less conservative than their disclosed methodologies otherwise would have indicated.

We expect the results of these staff examinations will provide significant and useful new information that will help not only the SEC, but also issuers and users of credit ratings in this country and around the world, to address the problems we have seen with ratings of subprime-related products.

SEC and Broadcom Settle Backdating Charges

The SEC settled charges against Broadcom Corporation for falsifying its reported income by backdating stock option grants over a five-year period.  As a result of the fraud, Broadcom restated its financial results in January 2007 and reported more than $2 billion in additional compensation expenses. The Irvine, Calif.-based semiconductor maker has agreed to settle the charges and consented to pay a $12 million penalty.  Linda Chatman Thomsen, Director of the SEC's Division of Enforcement, said that "The scope and magnitude of the fraud warrants the significant penalty imposed on the company."

In a complaint filed in the U.S. District Court for the Central District of California, the SEC alleges that from June 1998 to May 2003, Broadcom misrepresented the dates on which stock options were granted to executives and employees. Broadcom's Chairman and Chief Technology Officer along with its former CEO sat on the two-member option committee with authority to approve options to employees and all but the most senior executives, whose grants were to be decided by two independent directors comprising Broadcom's compensation committee.

The SEC alleges that the option committee approved as many as 88 grants during the relevant period, but for many of these grants there was no meeting or decision made by the committee on the dates the grants were supposedly approved. Instead, Broadcom's former CFO allegedly selected many of the grant dates retroactively based on a comparison of Broadcom's historical stock prices, and the two option committee members allegedly concealed the backdating by signing false committee written consents stating that the grant had been approved "as of" the retroactive date. According to the complaint, Broadcom's General Counsel directed the preparation of false board and compensation committee written consents to conceal some of these grants.

The SEC further alleges that, as a result of the backdating scheme, Broadcom avoided reporting $2.22 billion in compensation expenses during the relevant period. Broadcom overstated its income by between 15 percent and 422 percent, and understated its loss by between 16 percent and 38 percent. Without admitting or denying the SEC's allegations, Broadcom agreed to settle the charges by consenting to a permanent injunction against further violations of the antifraud, record-keeping, financial reporting, internal controls, and proxy provisions of the federal securities laws, and payment of the $12 million penalty. The settlement is subject to approval by the court.

Wanted: Cash for Banks

Is there enough SWF and private equity money out there to bail out every financial institution that needs capital?  It is reported that as many as 42 firms may need a capital infusion before the crisis is over.   The final figure for bank writedowns could exceed $750 billion. WSJ, So Far, So Good on Bailouts, but How Long Will They Last?, NYTimes, Banks Hunting for More Cash.
 

Ofheo Issues Warning About FAS 159

Deja vu all over again?   The Office of Federal Housing Enterprise Oversight (Ofheo) warned Fannie Mae and Freddie Mac about strict compliance with the new fair use accounting rule FAS 159 that permits companies to make quarterly adjustments to reflect changes in the value of certain assets and liabilities.  Ofheo said changes sholuld be documented to prevent retroactive changes and promote transparency.  WPost, Fannie Mae, Freddie Mac Warned on Accounting.

Gross & Black on Perceptions of Fairness in SRO Securities Arbitration

When Perception Changes Reality: An Empirical Study of Investors' Views of the Fairness of Securities Arbitration, by JILL GROSS, Pace Law School, and BARBARA BLACK, University of Cincinnati - College of Law, was recently posted on SSRN.  Here is the abstract:

Arbitration in securities industry-sponsored forums is the primary mechanism to resolve disputes between investors and their brokerage firms. Because it is mandatory, participants debate its fairness, and Congress has introduced legislation to ban pre-dispute arbitration clauses in customer agreements. Missing from the debate has been empirical research of perceptions of fairness by the participants, especially investors. To fill that gap, we mailed 25,000 surveys to participants in recent securities arbitrations involving customers to learn their views of the process. The article first details the survey's background, explains the importance of surveying perceptions of fairness, and describes our methodologies, procedures, and survey error structure. We then present our findings, including our primary conclusions that (1) investors have a far more negative perception of securities arbitration than all other participants, (2) investors have a strong negative perception of the bias of arbitrators, and (3) investors lack knowledge of the securities arbitration process. We also offer several explanations for these negative perceptions. We conclude that customers' negative perceptions transform the reality faced by policy-makers and mandate reform of the process, including the elimination of the industry arbitrator requirement and further public deliberation on the value of the explained award.

Ahdieh on Rule 14a-8

The Dialectical Regulation of Rule 14a-8: Intersystemic Governance in Corporate Law, by ROBERT B. AHDIEH, Emory University School of Law; Program in Law and Public Affairs, was recently posted on SSRN.  Here is the abstract:

In recent years, Rule 14a-8 of the Securities Exchange Act - first adopted more than sixty years ago to increase shareholder participation in corporate governance - has been the subject of a flurry of litigation, scholarly analysis, and SEC rulemaking. Most recently, following several years of debate, the SEC issued a significant clarification of the rule, reversing the Second Circuit's hotly contested interpretation of it in AFSCME v. AIG. For the most part, the debates surrounding Rule 14a-8 - including in the latter case - have focused on the scope of the rule's exceptions. This paper, selected for reprinting in the Securities Law Review's forthcoming volume of the year's top securities law articles, attempts to go beyond those exceptions, to suggest a fundamental rethinking of the nature and operation of the rule.

Specifically, the paper explores Rule 14a-8 as an occasion for what I have termed "intersystemic governance" - an embrace of cross-jurisdictional overlap and engagement in regulatory design and function. In its very structure, thus, Rule 14a-8 calls on the SEC to interpret and apply state law. Properly utilized, this scheme offers an opportunity for the development of regulatory norms that meaningfully integrate both federal and state values of corporate governance and shareholder participation. To this end, among other reforms, I propose a shift in the SEC presumptions applicable to no-action letters, praise Delaware's recent constitutional amendment to permit SEC certification of questions to the Delaware courts, and highlight various opportunities for heightened discourse. By means such as these, a more integrated - and ultimately more efficient - regime of shareholder participation may begin to emerge.

Schwarcz on Principles-Based Regulation

The 'Principles' Paradox, by STEVEN L. SCHWARCZ, Duke University - School of Law, was recently posted on SSRN.  Here is the abstract:

Although principles-based regulation is thought to more closely achieve normative goals than rules, the extent to which that occurs can depend on the enforcement regime. A person who is subject to unpredictable liability is likely to hew to the most conservative interpretation of the principle, especially where that person would be a potential deep pocket in litigation. This creates a paradox: Unless protected by a regime enabling one in good faith to exercise judgment without fear of liability, such a person will effectively act as if subject to a rule and, even worse, an unintended rule.

Miller on Tellabs

Pleading After Tellabs, by GEOFFREY P. MILLER, New York University - School of Law, was recently posted on SSRN.  Here is the abstract:

In Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Supreme Court held that a securities fraud complaint will survive a motion to dismiss only if a reasonable person would deem the inference of [culpable state of mind] cogent and at least as compelling as any opposing inference one could draw from the facts alleged. This paper analyzes how the Tellabs test may be applied, identifies questions left open under the decision, and discusses broader implications of the opinion and the PSLRA. Among other things, the paper suggests that the PSLRA's heightened pleading rules have deformed the motion to dismiss to the point where it now operates in securities fraud cases as a hybrid falling somewhere in between the traditional Rule 12(b)(6) and Rule 56 summary judgment procedures.