Saturday, September 13, 2008
The SEC announces a Cybersecurities Fraud Conference, co-sponsored by the Litigation Section of the ABA, on Sept. 23 in Washington D.C. Here is the description:
What is the "state of the union" in the world of Internet securities regulation? Where do we stand? What are the prevailing trends and where are the next big threats coming from? Once, not so long ago, online trading seemed like something out of science fiction. Now, it is a firmly-established way of doing business, and online account security is a cornerstone of every brokerage's compliance practice. The hacker, once an anomaly like something from a cyberpunk novel, is now as omnipresent an actor on the scene as the old bucket-shop phone salesman.
In 2008, volatility is the norm and triple-digit swings in the Dow are the rule, not the exception. So how can the Internet be used for good or ill in this environment? Stealing data, funneling money across borders in the blink of an eye, and working a manipulation with stolen identities are just a few of the tools available to today’s financial criminals. What can be done? How much should be done? And how do we let investors know the signs that they are being used as pawns in schemes?
Explore these themes with us at the 2008 CyberSecurities Fraud Symposium, where we will examine these and other questions with staff from the Securities and Exchange Commission, the Financial Industry Regulatory Authority, the Federal Bureau of Investigation and other key law enforcement and regulatory agencies. All of the day's panels feature time for questions and answers, and it is sure to be a thought-provoking, challenging and, maybe even a little bit contentious program.
The SEC filed securities fraud charges in the United States District Court for the Western District of Pennsylvania against Mark D. Lay and MDL Capital Management, Inc. ("MDL Capital"), an investment adviser. Lay was the Chairman, CEO and Chief Investment Strategist of MDL Capital and part-owner of MDL Capital. The complaint alleges that, between February 2004 and November 2004, Lay and MDL Capital defrauded the Ohio Bureau of Workers' Compensation in connection with the Bureau's investment of public money in the MDL Active Duration Fund, Ltd., a hedge fund affiliated with and managed by Lay and MDL Capital. The Bureau transferred approximately $200 million from its advisory account managed by MDL Capital and Lay to the hedge fund pursuant to an agreement that those assets would be conservatively leveraged.
The Complaint further alleges that MDL Capital and Lay exposed Bureau funds to unauthorized and undisclosed risk by substantially exceeding a 150% leverage guideline, at one point using leverage of over 21,000% in the hedge fund. As a result, the Bureau incurred losses of approximately $160 million. During the course of the fraud, Lay repeatedly lied to and misled the Bureau as to the reasons for and amount of the losses as well as the excessive leverage Lay was using.
In October 2007, based on these same facts, Lay was convicted in the Northern District of Ohio of criminal mail fraud, wire fraud and investment adviser fraud. Lay is currently serving a 12 year prison sentence. Without admitting or denying the allegations of the Complaint, Lay and MDL Capital have consented to the entry of a final judgment permanently enjoining them from engaging in the violations set forth below, and ordering other relief.
From the SEC Website:
Senior representatives of major financial institutions are meeting at the Federal Reserve Bank of New York Friday evening to discuss recent market conditions. Also participating in the meeting are Treasury Secretary Henry M. Paulson, Jr., U.S. Securities and Exchange Commission Chairman Christopher Cox, and Federal Reserve Bank of New York President Timothy F. Geithner.
The Wall St. Journal reports that the meeting was called to discuss the fate of Lehman Brothers and is expected to continue throughout the weekend. WSJ, New York Fed Holds Emergency Meeting .On Lehman's Future
Thursday, September 11, 2008
The SEC instituted an enforcement action against LPL Financial Corporation for failing to adopt policies and procedures to safeguard their customers' personal information, leaving at least 10,000 customers vulnerable to identity theft following a series of hacking incidents involving LPL's online trading platform. Under the Safeguards Rule of Regulation S-P of the federal securities laws, broker-dealers and SEC-registered investment advisers like LPL are required to adopt policies and procedures reasonably designed to safeguard customer information. The firm agreed to pay a $275,000 penalty to settle the SEC's enforcement action without admitting or denying the findings.
The SEC's administrative order against LPL finds that the firm conducted an internal audit in mid-2006 that identified inadequate security controls to safeguard customer information at its branch offices. LPL's audit specifically identified the risk from hacking. The SEC's order finds that LPL failed to take timely corrective action because, by the time that hacking incidents began in July 2007, the firm had not implemented increased security measures in response to the identified weaknesses. According to the SEC's order, LPL experienced multiple hacking incidents between July 2007 and early 2008, and unauthorized persons gained access to the online trading platform LPL provided for its registered representatives. Once logged onto LPL's trading platform, the perpetrators placed or attempted to place 209 unauthorized securities trades worth more than $700,000 combined in 68 customer accounts.
Wednesday, September 10, 2008
Bank of America becomes the latest to settle with regulators, in this case the Massachusetts Securities Division, about its auction rate securities (ARS) sales practices. It announced an agreement in principle with the Massachusetts Securities Division under which it will offer to purchase at par ARS held by its retail customers. The offer will cover approximately $4.5 billion in ARS held by an estimated 5,500 Bank of America customers. Bank of America has informed the SEC and the New York State Attorney General's Office of the agreement and, according to its press release, continues to cooperate fully with the SEC's and the NYAG's ongoing investigations.
The terms of the agreement in principle include the following:
The offer to purchase applies to individual investors and trusts for the benefit of individuals which purchased auction rate securities before February 11, 2008. It also applies to businesses with account values up to $10 million and charities with account values up to $25 million. It does not apply to auction rate securities where auctions are clearing.
Bank of America will compensate eligible customers who purchased ARS through the company prior to February 11, 2008, and sold such securities at a loss between that date and the date of this announcement.
To the extent that eligible customers believe they have a claim for consequential damages beyond the loss of liquidity in the individual customer's holdings of ARS or loss based on a sale at less than par, Bank of America will participate in a special arbitration process. The special arbitration process is available at the customer's election and will be overseen by FINRA with Bank of America paying FINRA's forum and filing fees.
Bank of America's repurchase program will remain open for three months beginning the later of October 1, 2008, or as soon as practicable after the SEC provides definitive guidance on the mechanics of the program.
Bank of America will endeavor to work with issuers and other interested parties, including regulatory and government entities, to expeditiously and on a best efforts basis provide liquidity solutions for institutional customers.
Bank of America will refund refinancing fees it received from all municipal issuers that issued ARS in the primary market through Bank of America between August 1, 2007, and February 11, 2008, and refinanced those securities through the company after February 11, 2008.
The company neither admits nor denies allegations of wrongdoing.
Tuesday, September 9, 2008
On September 9, 2008, the federal district court in Nebraska sentenced Thirugnanam Ramanathan, a native of Chennai, India, and legal resident of Malaysia, to serve two years in prison, followed by 3 years of supervised release, and ordered him to pay restitution in the amount of $362,247. Ramanthan was arrested in Hong Kong and extradited to the United States on May 25, 2007. On July 2, 2008, Ramanathan pleaded guilty to one count of conspiracy to commit wire fraud, securities fraud, computer fraud and aggravated identity theft.
In January 2007, Ramanthan was indicted by a federal grand jury in Omaha along with his brother Chockalingam Ramanathan and Jaisankar Marimuthu, also residents of Chennai. Marimuthu and Chockalingham Ramanathan were charged with one count of conspiracy, eight counts of computer fraud, six counts of wire fraud, two counts of securities fraud and six counts of aggravated identity theft. Marimuthu is currently being detained in a Hong Kong prison awaiting extradition to the U.S. following his conviction there on similar offenses but related instead to the Hong Kong stock market. Chockalingam Ramanathan remains at large.
On March 12, 2007, the SEC filed a complaint in the United States District Court for the District of Nebraska charging all three Indian nationals with participating in a fraudulent scheme to manipulate the prices of at least fourteen securities through the unauthorized use of other people’s online brokerage accounts. The Commission’s complaint alleges that, between July and November 2006, Jaisankar Marimuthu, Chockalingam Ramanathan and Thirugnanam Ramanathan hijacked the online brokerage accounts of unwitting investors using stolen usernames and passwords. Prior to intruding into these accounts, the Defendants acquired positions in the securities of at least thirteen issuers and options on shares of another issuer. Then, without the account holders’ knowledge, and using the victims’ own accounts and funds, the Defendants placed scores of unauthorized buy orders at above-market prices. After these unauthorized buy orders were placed, the Defendants sold the positions held in their own accounts at the artificially inflated prices netting unlawful trading profits of at least $121,500. These transactions created the appearance of legitimate trading activity and pumped up the share price of the fourteen securities.
FINRA continues its investor education efforts by announcing a new series of Investor Podcasts. FINRA's press release states that the podcasts "are designed to help investors better understand often complex financial issues and investment products and protect themselves from potential pitfalls." New podcasts will be added to the series every month. The first three are:
Protect Your Online Brokerage Account outlines specific steps investors can take to prevent the theft of their personal financial information when investing online.
Reverse Mortgages: Avoiding a Reversal of Fortune helps homeowners carefully weigh all of their options before tapping into their home equity
Putting too Much Stock in your Company - a 401(k) Problem spells out the difficulties employees may face if they put too much of their retirement savings in their company's stock.
The SEC filed a civil complaint in the Southern District of New York charging James C. Dawson with securities fraud and investment adviser fraud. Dawson is the investment adviser to a hedge fund, Victoria Investors, LP, and to individual clients. The SEC alleges that from April 2003 through October 2005, Dawson cherry-picked profitable trades for his own account by purchasing securities throughout the day in one single account, and delaying the allocation of the purchases until later in the day, after he saw whether the securities appreciated in value. Between April 2003 and October 2005, Dawson allocated approximately 400 trades to his personal account, approximately 393 of which were profitable on the first day, for a success rate of approximately 98%. In contrast, of the 2,880 trades Dawson allocated to his clients during the same time, only 1,489 were profitable on the first day for a success rate of approximately 52%. The Commission's complaint also alleges that Dawson used Victoria Investors' funds to pay for personal and family expenses.
In its lawsuit, the Commission seeks an order permanently enjoining Dawson from violations of the above provisions of the federal securities laws. The Commission also seeks disgorgement, plus prejudgment interest, and civil penalties against Dawson.
On August 18, 2008, the United States District Court for the Northern District of Illinois entered an order permanently enjoining William K. Boston, Jr. (Boston) from violating certain of the antifraud and registration provisions of the federal securities laws. The SEC alleged that Michael E. Kelly and 25 other defendants, including Boston and his former business, Century Estate Planning, Inc. (Century Estate Planning), participated in a massive fraud on U.S. investors that involved the offer and sale of securities in the form of Universal Lease investments. Universal Leases were structured as timeshares in several hotels in Cancun, Mexico, coupled with a pre-arranged rental agreement that promised investors a high, fixed rate of return. The SEC's complaint alleges that from 1999 until 2005, Kelly and others, including Boston and Century Estate Planning, raised at least $428 million through the Universal Lease scheme from investors throughout the United States, with more than $136 million of the funds invested coming from IRA accounts. The SEC further alleges that a nationwide network of unregistered salespeople who sold the Universal Leases, including Boston and Century Estate Planning, collected undisclosed commissions totaling more than $72 million. According to the SEC's complaint, Kelly and others told investors that Universal Leases would generate guaranteed income through the leasing of investor timeshares by a large, independent leasing agent. In fact, the complaint alleges the leasing agent was a small Panamanian travel agency controlled by Kelly and for most of the scheme its payments to investors came from accounts funded by money raised from new investors. Further, the complaint alleges that Kelly and others, including Boston and Century Estate Planning, failed to disclose key facts about the Universal Lease investments, including the risks of the investments and that more than $72 million in investor funds were used to pay commissions as high as 27% to the selling brokers. The SEC continues to pursue its claims against Boston for disgorgement and civil penalties. The SEC's action against the remaining defendants is also pending.
The SEC charged three former senior executives of Embarcadero Technologies, Inc., alleging that they fraudulently backdated stock option grants to employees at the San Francisco business software company and reported false financial information to shareholders. The Commission alleges that the former CEO, President and Chairman, Stephen R. Wong, the former CFO, Raj P. Sabhlok, and the former Controller, Michael C. Pattison, concealed millions of dollars in compensation expenses associated with valuable, “in-the-money” options secretly granted to company employees.
The Commission’s complaints, filed in federal district court in San Francisco, allege that Embarcadero routinely provided valuable options priced at below market prices to its employees. The Commission alleges that the three executives allowed Embarcadero to avoid reporting expenses for these options by backdating paperwork to make it appear as if the options had been granted on an earlier date, when the stock was trading at a lower price. According to the Commission’s complaints, Embarcadero made hundreds of backdated stock option grants during 16 consecutive quarters. As a result, the company significantly overstated its net income (or understated its net loss) from 2000 through 2005. In the year with the largest percentage impact, Embarcadero understated its net losses by more than 500 percent. The SEC also alleges that all three executives participated in backdating grants and that Sabhlok and Pattison used false documents to support large option awards to themselves that were collectively “in-the-money” by almost $1.5 million.
Wong, without admitting or denying the Commission’s allegations, consented to a permanent injunction and also agreed to pay a $250,000 civil penalty.
The Commission seeks permanent injunctions, civil monetary penalties, and disgorgement against both Sabhlok and Pattison, and forfeiture of bonuses and stock sales pursuant to Section 304 of the Sarbanes-Oxley Act and an order barring against acting as an officer or director of a public company against Sabhlok.
Monday, September 8, 2008
On September 5, 2008, a federal jury returned a verdict in the SEC's favor on securities fraud and other charges against John P. Miller, the former Chief Executive Officer, President, and Chairman of the Board of Master Graphics, Inc., a printing company based in Memphis, Tennessee that was publicly traded on the NASDAQ national market system, but is now defunct. The Commission's Complaint, filed June 8, 2004, alleged that Miller, in the spring of 1999, devised and implemented a scheme to fraudulently overstate the company's net income to meet analyst expectations. Pursuant to the plan, the company fraudulently reclassified rent and salary expenses that Master Graphics had already paid to its division presidents in the first quarter as assets on the company's balance sheet. This misstatement caused Master Graphics to materially overstate its earnings for the first quarter of 1999, and materially understate its losses for the second and third quarters of 1999.
The jury found that Miller violated: (1) the antifraud provisions of both the Securities Act of 1933 (Section 17(a)) and the Securities Exchange Act of 1934 (Section 10(b) and Rule 10b-5); and (2) the internal controls and books and records provisions of the Exchange Act (Section 13(b)(5) and Exchange Act Rule 13b2-1). Additionally, the jury found that Miller aided and abetted violations of the issuer reporting, books and records, and internal control provisions of the Exchange Act (Sections 13(a) and 13(b)(2)(A), and Exchange Act Rules 12b-20 and 13a-13).
The SEC filed a complaint on September 3, 2008, in the United States District Court for the Northern District of Illinois, against Rick J. Boros, a/k/a Vincent Kwiatkowski ("Boros"), and North American Mining Ventures, Inc. The Complaint alleges that between May 2005 and June 2007, Boros and North American Mining sold interests in limited partnerships that purportedly operated "low-risk, high-return" gold and silver mines in Durango, Mexico. Boros told investors that investor funds would be used to develop and expand the alleged gold and silver mines. As a result of the offering, the Complaint alleges that Boros obtained at least $1.2 million from approximately 17 investors, a number of whom are elderly and retired. The Complaint further alleges, however, that Boros then misappropriated virtually all of these funds to pay his personal credit card debt, to lease and maintain three BMW automobiles, and to pay for his household expenses and his daughter's college tuition. The Complaint alleges that, as a result of their conduct, the Defendants violated Sections 5 and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission seeks injunctive relief, disgorgement and civil penalties.
United Rentals, Inc. (URI) settled SEC charges alleging that URI engaged in financial fraud and in a broad range of other improper accounting practices and agreed to pay a $14 million penalty. URI is one of the largest equipment rental companies in the world.
The Commission's complaint, filed in the United States District Court for the District of Connecticut, alleged that, from late 2000 through 2002, URI engaged in a series of fraudulent transactions undertaken in order to meet URI's earnings forecasts and analyst expectations. The fraud was accomplished primarily through a series of interlocking three-party sale-leaseback transactions orchestrated by URI's then- Chief Financial Officer, Michael Nolan, and its then- Chief Acquisitions Officer, John Milne. Nolan and Milne were previously charged by the SEC for individual wrongdoing. The SEC's complaint also alleges that in another effort to improve its earnings, URI engaged in a series of fraudulent "trade packages" with suppliers. The company sold blocks of used equipment for amounts in excess of fair value, in exchange for certain undisclosed financial inducements offered to those suppliers.
In addition, the SEC alleges that from 1997 to 2000, during a period of enormous growth through acquisitions, URI engaged in other improper accounting practices involving its valuations of acquired assets, use of acquisition reserves, and accounting for customer relationships as well as improperly accounting for other items that overstated net income, including its estimation and recording of self-insurance reserves, its recognition of equipment rental revenues, and its income tax accounting.
In addition to the financial penalty, URI consented to a permanent injunction against further violations.
Treasury Secretary Paulson announced on Sunday that Fannie Mae and Freddie Mac are being placed in conservatorships. According to the press statement this action is necessary "to protect the financial system, to support the housing market, and to protect the taxpayers." New CEOs supported by new non-executive Chairmen have taken over management of the enterprises. While conservatorships do not eliminate the existing preferred and common stocks, they place common shareholders last, and the preferred shareholders next to last, in terms of claims on the assets of the enterprises.
Depository institutions are encouraged to contact their primary federal regulator if they believe that losses on their holdings of Fannie Mae or Freddie Mac common or preferred shares, whether realized or unrealized, are likely to reduce their regulatory capital below "well capitalized." The banking agencies are prepared to work with the affected institutions to develop capital restoration plans consistent with the capital regulations.
The primary mission of these enterprises now will be to work to increase the availability of mortgage finance, including by examining the guaranty fee structure with an eye toward mortgage affordability. To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size.
Treasury has taken three additional steps: First, Treasury and FHFA have established Preferred Stock Purchase Agreements between the Treasury and the conserved entities. Under these agreements, Treasury will ensure that each company maintains a positive net worth through its purchase of senior preferred equity shares and warrants. According to the press statement, these investments were necessary because of "the ambiguities in the GSE Congressional charters" that led to investors' perceptions that the securities were "virtually risk-free."
Second, Treasury is establishing a new secured lending credit facility which will be available to Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. This facility is intended to serve as an "ultimate liquidity backstop," implementing the temporary liquidity backstop authority granted by Congress in July, and will be available until those authorities expire in December 2009.
Third, Treasury is initiating a temporary program to purchase GSE MBS so that mortgages will become more affordable. Treasury will begin this new program later this month, investing in new GSE MBS, and additional purchases will be made as deemed appropriate. This program will also expire with the Treasury's temporary authorities in December 2009.
Additional information about the government's actions is posted on the Treasury website.
Sunday, September 7, 2008
The SEC, Retail Investors, and the Institutionalization of the Securities Markets, by Donald C. Langevoort, Georgetown University Law Center, was recently posted on SSRN. Here is the abstract:
The last thirty years or so have brought a rapid shift toward institutionalization in the financial markets in the U.S., i.e., investment by mutual funds, pension funds, insurance companies, bank trust departments and the like. This paper focuses on the institutional role of the SEC as a seventy-five year old agency in a capital marketplace far different from that of the 1930's. A baseline question about the future of financial regulation in the U.S. is whether the SEC, with such a long and weighty legacy of law-making from a time when public markets were retail markets, is competitively fit to act as a regulator in a capital marketplace that is now so institutional and global. Part I asks whether there is a coherent theory or approach to retail investor protection in today's marketplace, either in terms of enforcement intensity or rule-making. This Part considers two very different contemporary challenges to SEC's orthodoxy: the emergence of the British "light touch" to securities industry regulation, which favors informal suasion to heavy-handed enforcement, and the expansion of knowledge about consumer and investor behavior from research in behavioral economics. Neither, it argues, maps well onto the SEC's mission. Part II then moves to the institutional marketplace for issuer securities and engages in a thought experiment about whether, as many assume, markets that have no appreciable retail participation should properly be governed as "antifraud only." This Part considers what antifraud-only means, and again expresses some skepticism about whether we can expect to see the development of private markets, largely free of regulation, that substitute for the public ones we observe today. Finally Part III takes up whether the SEC's regulatory orthodoxy is stable enough as markets become not only institutional but global. It suggests, contrary to what many believe, that globalization leads to increasingly territorial (rather than listings) based exercise of regulatory jurisdiction over issuer disclosure. It also places the SEC's recent initiatives toward mutual recognition in this context. The unifying theme in all three Parts stems from a long-standing interest in studying the behavior of the SEC: why it acts as and when it does and (often more importantly) what limits it imposes on itself or has imposed from outside.
Female Investors and Securities Fraud: Is the Reasonable Investor a Woman?, by Joan Macleod Heminway, University of Tennessee College of Law, was recently posted on SSRN. Here is the abstract:
This paper extends existing scholarship that questions the existing materiality standard used under Rule 10b-5 (and elsewhere in U.S. securities regulation) and its touchstone notion of the reasonable investor. Specifically, the paper asks and answers a seemingly straightforward, yet provocative, question: Is the reasonable investor a woman? The paper then preliminarily explores the potential significance of its key findings - that women and men exhibit different investment behaviors and achieve different investment outcomes, and that the resulting female investor profile is closer to existing conceptions of the reasonable investor than the resulting male investor profile.
As women become larger players in the securities markets, it may be comforting to know that they are relatively well protected by existing conceptions of the reasonable investor. However, the knowledge that women are not completely protected by these existing conceptions and that men are less well protected than women under the current reasonable investor paradigm gives us pause and forces us to reconsider inaction. To that end, this paper continues an ongoing academic and practical conversation about when changes in investor protection should be undertaken and how those changes can best be made if they are to be undertaken - not just for the benefit of women or men, but for the benefit of all underprotected investors.
Subprime Crisis Confirms Wisdom of Separating Banking and Commerce, by Arthur E. Wilmarth Jr., George Washington University Law School, was recently posted on SSRN. Here is the abstract:
During the past three years, a highly-publicized controversy has raged over the question of whether Congress should prohibit acquisitions of industrial loan companies (ILCs) by commercial organizations. The controversy began when Wal-Mart and Home Depot filed applications to acquire ILCs. Those applications triggered strong opposition from a broad coalition that included the Federal Reserve Board (FRB), members of Congress, community banks, labor unions, retail stores, and community activists. From July 2006 to January 2008, the Federal Deposit Insurance Corporation (FDIC) imposed a moratorium on the processing of applications by commercial firms to acquire ILCs. In May 2007, the House of Representatives passed a bill (H.R. 698) that would prohibit further acquisitions of ILCs by commercial firms.
The Senate has not yet acted on legislation similar to H.R. 698 and is not likely to do so during 2008. Wal-Mart and Home Depot have withdrawn their applications, thereby removing the stimulus for much of the public opposition to commercially-owned ILCs. Senator Robert Bennett of Utah, the state with the largest number of ILCs, has strongly opposed any legislation restricting commercial ownership of ILCs. Congress' attention has also been diverted by the subprime lending crisis.
Despite the current legislative impasse, there are three important reasons why Congress should prohibit commercial firms from acquiring ILCs. First, commercial ownership of ILCs conflicts with the well-established U.S. policy of separating banking and commerce. Second, widespread commercial ownership of ILCs will create serious risks for the U.S. financial system and cause significant distortions in the broader economy. As indicated by the FRB's recent rescue of Bear Stearns, large commercial owners of ILCs are likely to receive significant federal subsidies by gaining access to the federal safety net for financial institutions. Such subsidies will encourage other commercial firms to acquire ILCs, thereby promoting extensive commercial-banking links that will increase the U.S. economy's vulnerability to systemic financial crises.
Third, no federal regulator currently has authority to exercise consolidated supervision over corporate owners of ILCs. The Bear Stearns rescue has shown that the FRB must be given consolidated supervisory powers over the parent company of any financial institution that has access to the FRB's liquidity support facilities. However, it would not be desirable to authorize either the FRB or the FDIC to supervise commercial firms that own ILCs. Consolidated supervision of commercial parent companies of ILCs would significantly increase the amount of governmental intrusion in the commercial sector of our economy, and it would cause financial markets to expect federal support for large commercial owners of ILCs. The subprime crisis confirms the need for Congress to close the ILC loophole in order to forestall even greater threats to the stability of our financial system and the broader economy.
Gatekeeper Incentive Compensation, by Sharon Hannes, Tel Aviv University - Buchmann Faculty of Law; Northwestern University - School of Law, was recently posted on SSRN. Here is the abstract:
A massive wave of corporate fraud at the beginning of the twenty first century exposed the failure of corporate gatekeepers. The Sarbanes-Oxley legislation accordingly targeted gatekeepers, primarily auditors, by imposing strict regulation and enhanced independence guidelines. This legislative remedy is of disputable benefit while its costs have been huge. This paper maintains that a certain type of auditor incentive compensation could work better than regulation. Under such an alternative scheme, auditors would defer a portion of the payment they receive from the client firm, which would be used to purchase shares in the client after their tenure as auditor has ended. Instead of making them simply independent, this compensation structure would cause auditors to fend against inflated share prices. This type of auditor compensation could, therefore, serve to counterbalance recent trends in executive compensation that cause managers to overstate earnings. Modern accounting standards that augment management's scope of discretion make the suggested type of auditor compensation even more beneficial. Thus, the paper advocates calls for the Securities and Exchange Commission to promulgate a safe harbor that would facilitate such compensation schemes, which current independence guidelines do not allow.