Securities Law Prof Blog

Breeden and Associate join Zale's Board

Former SEC Chair turned activist shareholder, Richard C. Breeden, increased his stake in troubled jeweller Zale Corp. to 18% and joined the board of directors, along with James Cotter, the senior managing director of Richard C. Breeden & Co.  WSJ, Breeden Joins Zale's Board.

SEC's Richards Speaks on Examinations

Lori Richards, Director, Office of Compliance Inspections and Examinations, SEC, spoke on Frequently-Asked Questions About SEC Examinations, at the SIFMA Compliance and Legal Division January General Luncheon Meeting, New York, N.Y., on January 17, 2008.  Her office is responsible for examining: 5800 broker-dealers (with more than 173,000 branch offices), 11,000 investment advisers; 950 mutual fund complexes with more than 8000 portfolios; and 450 transfer agents.  She set forth her office's two guiding principles:  Focus on areas where investors may be at greatest risk of harm and work on improving firm's compliance programs.  She also addresses issues of particular concern to her office.

NYSE, ASE Announce Merger

New York Stock Exchange Euronext announced a merger with American Stock Exchange for $260 million in stock and the proceeds from the sale of ASE headquarters.  The ASE business in recent years has focused on stock options and ETFs; it also has smaller listed companies.   The merger, which requires the approval of ASE members and regulators, is expected to close in the third quarter of this year.  NYSE says it will result in $100 million annual savings in two years.  NYTimes, NYSE Euronext in Deal for American Stock Exchange; WSJ, NYSE, Amex Finally Marrying.

Industry Losses Continue to Pile Up

Merrill Lynch reported a huge $9.8 billion loss for the fourth quarter and $16.7 billion write-downs in mortgage-related investments.  CEO John Thain said the firm's capital was adequate and that the majority of its businesses did "really, really well," except for the fixed-income trading desk.  Thain also emphasized Merrill's client focus.  NYTimes, Merrill Posts Huge Loss; Chief Says Firm’s Capital Is Adequate.   The Wall St. Journal adds up the numbers and calculates that, to date, the industry had reported more than $100 billion losses in subprime write-downs, turning this into a calamity to equal past financial crises.  WSJ,Hit Hard, Merrill and Others Pull Back From Riskier Businesses.

Seventh Circuit Adheres to Prior Decision in Tellabs

The Seventh Circuit (opinion by Judge Posner) issued its opinion on remand of Makor Issues & Rights, Ltd. v. Tellabs Inc. in which it considers whether the plaintiffs' allegations of securities fraud create the "strong inference" of scienter, as defined by the Supreme Court, required by PSLRA.  On remand, the Seventh Circuit adhered to its previous decision to reverse the judgment of the district court dismissing the suit. 

In Tellabs, the Supreme Court directed the appellate court to dismiss the complaint unless "a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."  The Seventh Circuit found that it was "exceedingly unlikely" that the allegedly false statements were the "result of merely careless mistakes at the management level based on false information fed it from below, rather than of an intent to deceive or a reckless indifference to whether the statements were misleading."  The court noted that the alleged misstatements involved the company's most important products, and it was "very hard to credit" that no member of senior management knew that they were false.  The court also noted that "it is possible to draw a strong inference of corporate scienter without being able to name the individuals who concocted and disseminated the fraud."  Finally, it also distinguished the use of annonymous sources in Higginbotham v. Baxter Int'l -- where it said that such allegations must be steeply discounted -- from  the Tellabs complaint's dependence on 26 "confidential sources."  Here the confidential sources are numerous, consist of persons who, from their job descriptions, are in a position to know the facts to which they are prepared to testify, and the information is set forth in convincing detail.  The absence of the names does not invalidate the drawing of a strong inference from the informants' assertions.

SEC Settles Insider Trading Charges Involving NBTY Stock

The federal district court for the Southern District of New York entered a final judgment against Morris Gad.  The SEC alleged that Nathan Rosenblatt, a former director of NBTY, Inc., and member of its three-person audit committee, tipped his close friend Gad with material, nonpublic information concerning the company's significant revenue and earnings shortfall for the third quarter of 2004, prior the company's public release of its financial results. With this information in hand, Gad sold his entire position of NBTY stock, sold the stock short, purchased put contracts, and sold call contracts through the custodial accounts of his three children prior to NBTY's release of its 2004 third quarter financial results. In so doing, Gad made approximately $400,000 in trading profits and losses avoided.  Gad consented to the entry of final judgment, without admitting or denying the allegations of the Commission's complaint, except as to jurisdiction.

Oceanographer Settles Insider Trading Charges involving Shipwreck

The SEC filed a complaint against Ernesto Tapanes in federal district court for the Southern District of Florida alleging that he engaged in unlawful trading on the basis of material, nonpublic information in the securities of Odyssey Marine Exploration, Inc. (Odyssey Marine) before Odyssey Marine's May 18, 2007 announcement of its discovery of the Black Swan shipwreck, a find valued at more than $500 million dollars.  The complaint alleges that on March 30, 2007, Tapanes, one of Odyssey Marine's oceanographic surveying consultants, discovered an anomaly on the ocean floor, while surveying off the coast of Gibraltar. Within days of the discovery, Odyssey Marine confirmed that the anomaly was an 18th century shipwreck, code-named the Black Swan, containing tons of silver and gold coins. Shortly thereafter, Tapanes and others signed a confidentiality agreement agreeing to keep the find confidential and not to trade in Odyssey Marine stock. In breach of his duty of trust and confidence, and while in possession of material, nonpublic information about that discovery, Tapanes purchased Odyssey Marine stock prior to Odyssey Marine's public announcement of the discovery. The complaint further alleges that soon after Odyssey Marine announced its discovery of the Black Swan on May 18, 2007, Tapanes sold his entire Odyssey Marine position for a profit of more than $107,000.

Tapanes has consented, without admitting or denying the allegations in the complaint, to a final judgment permanently enjoining him from violating Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and ordering him to pay disgorgement of $107,101.92, plus prejudgment interest of $2,151.56, and imposing a civil penalty of $107,101.92.

SEC Looks into How Money Market Funds Value Holdings

The SEC is looking into how mutual fund companies are valuing their money market fund holdings.  The SEC says it seeks to understand better how funds comply with Rule 2a-7, which guides money market fund operations.  There has been concern recently that some "enhanced" cash funds have had trouble maintaining the $1 net asset value per share because of securities issued by structured investment vehicles (SIVs).  More generally, the SEC is focusing on how funds value thinly-traded securities.  WSJ, SEC Requests Money-Market Data.

Dubai World and MGM Mirage Increase Terms for MGM Tender Offer

Dubai World and MGM Mirage said they would buy up to 15 million shares in their joint tender offer for MGM (an increase of 50%) at up to $80 per share.  The price for the casino operator will be set by a Dutch auction.  MGM's 52% shareholder Tracinda Corp. will not tender any shares.  Dubai World currently owns 4.9% of MGM.  WSJ, MGM, Dubai World to Raise Joint Tender Offer.

University of Phoenix Owner Commits Securities Fraud

A jury decided that the Apollo Group, the owner of the for-profit University of Phoenix, committed securities fraud when it failed to disclose that a Dept. of Education report found that its student recruitment policies violated federal regulations.  The jury awarded investors $280 million.  NYTimes, Fraud by University Owner Is Found.

SEC Charges Unauthorized Internet Access to Defraud Investors

The SEC filed a complaint in the United States District Court for the Southern District of New York against Anatoly Russ, a Russian citizen, alleging that Russ engaged in a fraudulent scheme to control the prices at which he purchased and sold options on an Exchange Traded Fund (ETF) by placing unauthorized orders in online brokerage accounts designed to match orders in his own account. The complaint alleges that between August 23, 2006, and September 19, 2006, Russ electronically stole and used usernames and passwords to gain unauthorized Internet access to online brokerage accounts for the sole purpose of entering purchase or sell orders that were executed opposite orders that he had placed in his own online accounts. Russ engaged in a pattern of purchasing four series of thinly traded options contracts on iShares Lehman Aggregate Bond Fund (AGG) and subsequently selling the contracts the same day at inflated prices that did not reflect the true economic value of the options contracts. According to the complaint, the AGG options were so thinly traded that Russ was able to control the prices at which he purchased and sold the options, allowing him to earn guaranteed profits - sometimes as high as sixteen-times the prices at which he had purchased the options contracts. As a result of his fraudulent scheme, Russ realized at least $88,465 in unlawful profits and caused losses of at least $339,929 in the intruded online accounts. The online brokers have made the intruded accountholders whole by taking the losses themselves.

Stoneridge -- More Perspectives

More viewpoints on Stoneridge:

“The Court missed an important opportunity to make clear that all of the principal actors in a fraudulent scheme -- not just those who disseminate falsehoods -- must answer to their victims. Far from burdening our markets, a decision for the plaintiffs in Stoneridge would have done much to protect the integrity of our markets to the benefit of investors and legitimate businesses alike,” said NASAA President and North Dakota Securities Commissioner Karen Tyler.  NASAA Responds to U.S. Supreme Court Decision in Stoneridge Case.

“The Supreme Court clearly made the right decision in this important case.  This decision ensures that over zealous litigation does not derail the U.S. economy,” said Ira Hammerman, senior managing director and general counsel at SIFMA.  “The wrong ruling would have unleashed a tsunami of damaging side effects, infecting the entire U.S. economy and harming investors.  In reaching its decision, the court clearly recognized that investors already receive substantial protections under the law, and the SEC and other securities regulators are already equipped with all the necessary regulatory tools to recoup lost money for investors.” Supreme Court Decision in Stoneridge Case Welcomed by SIFMA.

Former Brocade CEO Gets 21 Months in Backdating Conviction

The former CEO of Brocade Communications Systems, Gregory Reyes, the first executive convicted of backdating stock options, was sentenced to 21 months and a $15 million fine.  The Court said it took into account misleading statements made by Mr. Reyes in court filings.  WSJ, Reyes Gets 21 Months in Prison In Stock-Option Backdating Case.

Investors Sue Clearing Firm in Arbitration

At least 40 arbitration claims have been brought by investors against Brookstreet Securities Corp., a defunct brokerage firm, and National Financial Services, a unit of Fidelity Investments and the clearing firm for Brookstreet.  The investors allege that they should not have been permitted to go deeply into margin debt because the CMOs in their account were illiquid and therefore worthless.  Fidelity maintains that National Financial Services used reputable third-party valuations to price the securities.  Investors face two huge obstacles in these cases.  First, claims by investors that they should not have been allowed to borrow so much on margin have been viewed with disfavor by the courts.  Second, courts have not recognized a duty on the party of clearing firms to look out for the customers; that is the obligation of the introducing broker (defunct Brookstreet in this case).  Whether arbitration are required to follow the law is a much-debated question, and while a few arbitration panels have imposed liability on clearing firms, it is not, so far as I am aware, a common occurrence.  WSJ, Aggrieved Investors Sue a Clearing Firm.

Second-Day Thoughts on Stoneridge

Here is a sampling of the media coverage on Stoneridge: WPost, Corporate Fraud Lawsuits Restricted; NYTimes, Supreme Court Limits Lawsuits by Shareholders; WSJ, Top Court Limits Shareholder Fraud Suits.  Some analysts, who are more optimistic than I, find a silver lining in the majority's distinction between "ordinary" commercial transactions and capital-raising activities, a distinction that would still allow for imposition of liability on the investment banks in Enron (a case pending before the Court since last spring).  However, the strong message of the majority opinion is the need for reliance, which leaves no loophole for undisclosed, behind-the-scenes fraud (which, of course, is how fraudulent schemes are conducted).

After Stoneridge, the SEC's role in deterring fraud by third parties and obtaining compensation for investors from them under disgorgement and the Fair Funds provision of Sarbanes-Oxley becomes the only game in town.  Is it up to the task?  I have expressed my doubts elsewhere about the policy and the SEC's track record in bringing Fair Funds cases (in a forthcoming article in The Business Lawyer).  Meanwhile, what about filling those two vacancies on the Commission?  I think those two guys and one gal could use some help, what with the financial markets in such bad shape that "recession" and even "depression" are becoming buzz words.

Former UBS Broker Settles Hedge Fund Fraud Charges

The SEC filed a complaint charging a former broker with UBS Financial Services, Inc. for his role in a hedge fund fraud. The broker, Justin M. Paperny, of Studio City, California, agreed to settle the charges, without admitting or denying the allegations, by consenting to a permanent injunction and agreeing to pay disgorgement with prejudgment interest and a civil penalty in amounts to be determined.

The Commission's complaint alleges that, from 2002 through 2004, Paperny participated in a fraudulent offering of limited partnership interests in a hedge fund, the GLT Venture Fund, L.P., which raised $14.1 million from 42 investors. The complaint alleges that Paperny was GLT's broker and that he told GLT investors that GLT had access to highly sought after initial public offerings and achieved high average yearly returns. In reality, GLT had no access to hot IPOs and suffered substantial losses because of its hedge fund manager's poor trading and his misappropriation of investor funds. Specifically, the complaint alleges that Paperny arranged for new GLT investors to place their funds in GLT through UBS Financial and executed thousands of GLT's securities trades, using funds of GLT and its investors who, Paperny knew, were being defrauded by the fund manager. In exchange, Paperny received approximately $220,000 in commissions and in additional payments from the hedge fund manager.

Two Former PricewaterhouseCoopers Employees Settle Insider Trading Charges

A new year, and a new insider trading scandal -- the SEC  today charged two former San Francisco-area employees of PricewaterhouseCoopers LLP (PwC) with insider trading.  According to the Commission’s complaint, Gregory B. Raben, 30, a former PwC auditor, and William Patrick Borchard, 28, a former senior associate in PwC’s Transaction Services Group, used their access to sensitive information about PwC’s clients to allow Raben to buy stock ahead of a series of corporate takeovers. Without admitting or denying the allegations, Raben and Borchard agreed to a settlement including monetary penalties. The pair’s scheme was uncovered in October 2006 by PwC’s Office of General Counsel, which referred the matter to the Commission and cooperated with the SEC staff’s investigation.

Securities Arbitration Case Filings Down for 2007

FINRA has updated arbitration and mediation statistics on its website.  Arbitration case filings for 2007 were down 30% from 2006; the total (3238) was the lowest since at least 1992 (as far back as the website shows).  The number of cases closed in 2007 was also down 26% from 2006.  The overall turnaround time was up slightly (13.9 months in 2007, compared with 13.8 months in 2006), but the turnaround time in hearing decisions was down (16.0 in 2007, compared with 16.6 in 2006). 

Supreme Court Rules Against Scheme Liability in Stoneridge

The U.S. Supreme Court decided Stoneridge Investment Partners v. Scientific-Atlanta today, holding (5-3) that the plaintiff in a private securities fraud class action could not sue third parties who allegedly engaged in deceptive acts to further the corporation's securities fraud, because the plaintiff could not establish that it relied on the deceptive conduct.   Since it is a foregone conclusion that plaintiffs will lose in private securities fraud class actions, the only interesting question is how will the Court determine that they lost.  The majority opinion by Justice Kennedy (author of Central Bank)  is exactly the kind of result-oriented opinion we have come to expect. 

First, the Court rejects the actual holding of the Eighth Circuit opinion that there is no Rule 10b-5 liability without a misstatement or an omission where there is a duty to speak.  Affirming the decision on this ground would have done serious damage to SEC enforcement actions. 

Second, the Court does not rely on "plain meaning," its favorite tool of statutory construction in other private securities fraud cases, presumably because here the plain meaning actually supports the plaintiff's case -- it had good grounds to assert that the defendants engaged in a "deceptive act or contrivance" under Section 10(b).  Instead it focuses on the plaintiff's lack of reliance on the misconduct (because they did not know about it) and what it sees as the "remoteness" of the alleged misconduct from securities markets (never mind that plaintiff specifically alleged that the point of the scheme was to inflate the corporation's revenues so it could meet analysts' projections).  The Court thus announces that "reliance by the plaintiff upon the defendant's deceptive acts is an essential element" of the Rule 10b-5 cause of action.

Third, the Court believes that finding for the plaintiff here would revive "aiding and abetting" liability contrary to Congressional action.  "Were we to adopt this construction of section 10(b), it would revive in substance the implied cause of action against all aiders and abetters except those who committed no deceptive act in the process of facilitating the fraud; and we would undermine Congress' determination that this class of defendants should be pursued by the SEC and not by private litigants."

Fourth, the Court supports its result through its view of policy.  (1) Securities fraud liability should not attach to "commercial transactions" that are "the realm of ordinary business operations" and left to state law remedies; (2) Imposing liability would increase the costs of being a public company and encourage corporations to flee to foreign shores; and (3) Criminal and SEC enforcement provide adequate deterrence as well as compensation for investors.

Justice Stevens, in a dissent that Justices Souter and Ginsburg joined, criticizes the majority for its "overly broad reading" of Central Bank and its view that "reliance requires a kind of super-causation."  He also makes an heroic argument that "every wrong shall have a remedy" and protests against the majority's "continuing campaign to render the private cause of action under section 10(b) toothless."

Justice Breyer did not participate in the decision.

More Citi Bad News Expected

Citigroup is expected to announce the latest installment in its subprime and credit crisis debacle.  A fourth quarter writedown in the range of $20-24 billion has been predicted.  Citigroup is also expected to announce a 50% dividend cut, after assurances for weeks that it would not be touched, and more cash infusions, at least $10 billion, from investment arms of Singapore and Kuwait and Saudi Prince Alwaleed bin Talal.  WSJ, Citigroup Plans Big Dividend Cut.

Japanese Bank Will Invest in Merrill

Japan's megabank, Mizuho Financial Group, will invest $1.3 billion in Merrill Lynch in exchange for convertible preferred shares.  A Singapore SWF recently invested $5 billion in Merrill.  Other big banks have received cash infusions recently from SWFs in the mideast and China.  WSJ, Merrill to Get Cash Injection From Japanese Bank.

More Bad News for Citigroup

Citigroup may report a $24 Billion write-down in its 2007 fourth quarter, as a result of bad bets on subprime loans and other credit-related losses!  The announcement is expected tomorrow.  InvNews, Citigroup may face $24 billion write-down.  To add to its woes -- China will not permit its China Development Bank to invest $2 billion in the investment bank.  WSJ, Beijing Blocks Deal For Citigroup Stake.

In re Application of Wedbush Morgan Securities (SEC Jan. 14, 2008) involves an attempt by the brokerage firm to appeal a decision by an NASD Hearing Officer (the Decision) finding that Wedbush did not make full payment of all post-award interest due under an arbitration hearing against the firm.  The issue was the proper construction of NASD Rule 10330(h) with respect to the portion of the award and the number of days for which Wedbush owed post-award interest. [Under the new Code, the comparable provision is 12904(i).]  The SEC dismissed the appeal because it found no basis for jurisdiction under Section 19 of the Exchange Act; since the firm had paid the amount set forth in the Decision, its membership was not suspended.  The SEC, however, went on to express concern about aspects of the decision-making process; specifically, that the parties did not have an opportunity to develop evidence or legal arguments concerning the Decision's finding that Wedbush had not timely paid the award.  In addition, it noted that the Decision did not state a basis for its finding that the firm's attorney received the award on May 26, 2006 (and therefore payment was due by June 25) and did not address the discrepancy between the 30-day requirement in NASD Rule 10330(h) and the June 28 due date for paying the award that was stated in the NASD staff letter.  The SEC concludes by suggesting that "NASD may wish to consider these matters as part of its ongoing administration of its arbitration program."

SEC Inquiry on Possible Front-Running at Merrill

More trouble for Merrill Lynch?  The SEC is investigating whether employees at Merrill Lynch engaged in "front-running" -- the illegal practice of placing trades for the bank's own trading account ahead of customers' orders.  One investigation focuses on orders placed by Fidelity Investments between 2002-2005.  WSJ, SEC Looks at Merrill Trading, In Search of 'Front-Running'.

Academic Study on Pre-Deal Purchases by Investment Banks Gets Attention of Regulators

Is it coincidence or the next big scandal?  The Wall St. Journal reports on a recent academic study, The Dark Role of Investment Banks in the Market for Corporate Control, that has caught the attention of regulators.  According to the study, investment banks that serve as advisers to deals purchased shares in the corporations involved in the deals more often than coincidence would predict.  Representatives of the banks say the data is flawed, because the SEC filings the study relies on may not contain accurate current information.  The WSJ says it has identified many instances involving major investment banks where pre-deal purchases appeared to occur.  Banks are supposed to maintain "watch lists" and to monitor trading on the securities on the list, to prevent misuse of confidential information.  WSJ, Trading in Deal Stocks Triggers Look at Banks.

D.C. Circuit Affirms SEC Findings of Scienter Involving Underwriter of Municipal Bonds

The D.C. Circuit recently affirmed, in SEC v. Bradbury, 2008 WL 108728 (D.C. Cir. Jan. 11, 2008) an SEC order that held a broker-dealer that acted as an underwriter for a municipal bond offering was liable for securities fraud.  The only issue on appeal was whether the SEC established that defendants acted with scienter, which, in this case, was extreme recklessness.  The D.C. Circuit also discussed the role of the underwriter and noted, pithily, that the underwriter is supposed to be a "trail guide, not a mere hiking companion."

The Dauphin County General Authority issued the bonds to finance the purchase of an office building in Harrisburg, PA.  At the time of the offering, the Pennsylvania Dept. of Transportation (PennDOT) was the substantial tenant in the building; however, the lease was scheduled to expire well before the maturity date of the bonds, and, as the underwriter knew, PennDOT planned to vacate the premises when repairs to its own building were completed.  Although a state official had mentioned that the state would use the space for other purposes, it made no commitments to do so.

The disclosure document contained cautionary language (in boldface caps): The leases are scheduled to expire prior to the maturity of the bonds; there is no commitment, requirement or guarantee that the [state] will renew or extend any of the office leases."  The Court said this disclosure was deficient and materially misleading because the underwriter had actual knowledge that PennDOT planned to leave the premises.  In addition, the projections assumed that the PennDOT leases would continue on the same terms.

The Court notes that Congress directs it to apply a "substantial evidence" standard in reviewing SEC orders, which the court describes as an "extremely deferential" standard.  Otherwise, this would be a cery close case, since the scienter standard is very high.

Cox on International Business

SEC Chair Christopher Cox spoke on "International Business — An SEC Perspective" before the American Institute of Certified Public Accountants' International Issues Conference on Jan. 10, 2008.  Bottom line:  "IFRS is coming.  XBRL is coming.  And mutual recognition is coming."

Huang on Securities Laws and Affect, Happiness & Trust

How Do Securities Laws Influence Affect, Happiness, & Trust?, by PETER H. HUANG, Temple University - James E. Beasley School of Law, was recently posted on SSRN.  Here is the abstract:

This Article advocates that securities regulators promulgate rules based upon taking into consideration their impacts upon investors' and others' affect, happiness, and trust. Examples of these impacts are consumer optimism, financial stress, anxiety over how thoroughly securities regulators deliberate over proposed rules, investor confidence in securities disclosures, market exuberance, social moods, and subjective well-being. These variables affect and are affected by traditional financial variables, such as consumer debt, expenditures, and wealth; corporate investment; initial public offerings; and securities market demand, liquidity, prices, supply, and volume. This Article proposes that securities regulators can and should evaluate rules based upon measures of affect, happiness, and trust in addition to standard observable financial variables. This Article concludes that the organic statutes of the United States Securities and Exchange Commission are indeterminate despite mandating that federal securities laws consider efficiency among other goals. This Article illustrates analysis of affective impacts of these financial regulatory policies: mandatory securities disclosures; gun-jumping rules for publicly registered offerings; financial education or literacy campaigns; statutory or judicial default rules and menus; and continual reassessment and revision of rules. These regulatory policies impact and are impacted by investors' and other people's affect, happiness, and trust. Thus, securities regulators can and should evaluate such affective impacts to design effective legal policy.