Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, December 23, 2008

SEC Approves Exemptions for Central Counterparty in CDS

The SEC today approved temporary exemptions allowing LCH.Clearnet Ltd. to operate as a central counterparty for credit default swaps with the expectation of stabilizing financial markets by reducing counterparty risk and helping to promote efficiency in the credit default swap market. The Commission developed these temporary exemptions in close consultation with the Board of Governors of the Federal Reserve System (FRB), the Federal Reserve Bank of New York, the Commodity Futures Trading Commission (CFTC), and the U.K. Financial Services Authority.

The President's Working Group on Financial Markets has stated that the implementation of central counterparty services for credit default swaps was a top priority. In furtherance of this goal, the Commission, the FRB and the CFTC signed a Memorandum of Understanding in November 2008 that establishes a framework for consultation and information sharing on issues related to central counterparties for credit default swaps.

The temporary exemptions will facilitate central counterparties such as LCH.Clearnet and certain of their participants to implement centralized clearing quickly, while providing the Commission time to review their operations and evaluate whether registrations or permanent exemptions should be granted in the future. The conditions that apply to the exemptions are designed to provide that key investor protections and important elements of Commission oversight apply, while taking into account that applying all the particulars of the securities laws could have the unintended consequence of deterring the prompt establishment and use of a central counterparty.

Well-regulated central counterparties should help promote stability in financial markets by reducing the counterparty risks posed by the default or financial distress of a major market participant. This, in turn, should reduce the potential for disruption in financial markets attributable to credit default swaps. They should also promote operational efficiencies and transparency, which are lacking currently in the over-the-counter market for credit default swaps.

The SEC is soliciting public comment on all aspects of these exemptions.

December 23, 2008 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Monday, December 22, 2008

SEC Settles Backdating Charges Against UnitedHealth Group and Its Former GC

The SEC today settled charges against UnitedHealth Group Inc. relating to the backdating of stock options. The SEC also settled charges against former UnitedHealth General Counsel David J. Lubben relating to his participation in the stock option backdating scheme. Lubben consented to, among other things, an antifraud injunction, a $575,000 penalty, and a five-year officer and director bar.

The Commission alleges that between 1994 and 2005, UnitedHealth concealed more than $1 billion in stock option compensation by providing senior executives and other employees with “in-the-money” options while secretly backdating the grants to avoid reporting the expenses to investors.

In December 2007, the SEC announced a record $468 million settled enforcement action against William W. McGuire, M.D., the former Chief Executive Officer and Chairman of the Board of UnitedHealth. The settlement, which is pending before U.S. District Judge James M. Rosenbaum, was the first to deprive corporate executives of their stock sale profits and bonuses earned while their companies were misleading investors pursuant to the “clawback” provision (Section 304) of the Sarbanes-Oxley Act. McGuire consented to anti-fraud and other injunctions; disgorgement plus prejudgment interest of approximately $12.7 million; a $7 million penalty (the largest penalty against an individual in a stock option backdating case); and reimbursement to UnitedHealth under Section 304 of the Sarbanes-Oxley Act of approximately $448 million in cash bonuses, profits from the exercise and sale of UnitedHealth stock and unexercised UnitedHealth options. McGuire also agreed to be barred from serving as an officer or director of a public company for ten years.

The Commission declined to charge the company with fraud or seek a monetary penalty, based on the company’s extraordinary cooperation in the Commission’s investigation, as well as its extensive remedial measures. UnitedHealth’s cooperation included an independent internal investigation, the company’s release in a Form 8-K of a report detailing the investigation’s findings and conclusions, and the sharing of the facts uncovered in the internal investigation with the government. The company also took significant remedial actions in response to the findings of its internal investigation, including the implementation of new controls designed to prevent the recurrence of fraudulent conduct, removal of certain senior executives and board members, and the recoupment of nearly $1.8 billion in cash, options value and other benefits from several former and current officers, through, among other things, derivative litigation and the voluntary re-pricing and cancellation of retroactively-priced options.

According to the Commission’s complaint, Lubben or others acting at his direction created false or misleading company records indicating that the grants had occurred on dates when the company’s stock price had been at a low. Lubben personally received numerous backdated grants of options, representing as many as 3.8 million shares of UnitedHealth stock on a split adjusted basis. He exercised approximately 1.8 million of those options for approximately $1.1 million in gains attributable to improper backdating.

Lubben consented to the entry of an order permanently enjoining him from violating or aiding and abetting violations of the antifraud, reporting, record-keeping, internal controls, proxy statement, and securities ownership reporting provisions of the federal securities laws, and barring him from serving as an officer or director of a public company for a period of five years. Lubben will disgorge ill-gotten gains of $1,403,310 with $347,211 in prejudgment interest and pay a $575,000 penalty.

Under the terms of the settlement, Lubben’s disgorgement and prejudgment interest would be deemed satisfied by his voluntary repricing of his UnitedHealth stock options, which reduced the value of those options by approximately $2.7 million, and his payment of approximately $630,000 in pending settlements to resolve derivative and shareholder lawsuits related to options backdating filed against Lubben in state and federal courts in Minnesota.

In addition, Lubben agreed to resolve a separate administrative proceeding against him by consenting to a Commission order that suspends him from appearing or practicing before the Commission as an attorney for three years.

The Commission’s settlements with UnitedHealth and Lubben in the civil actions are subject to the approval of the U.S. District Court for the District of Minnesota.

December 22, 2008 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Fiat Settles FCPA Charges Involving Iraq Oil for Food Program

The SEC today filed Foreign Corrupt Practices Act books and records and internal controls charges against Fiat S.p.A. and CNH Global N.V. in the U.S. District Court for the District of Columbia. Fiat S.p.A., an Italian company, provides automobiles, trucks and commercial vehicles. CNH Global N.V., a majority-owned subsidiary of Fiat, provides agricultural and construction equipment. The Commission's complaint alleges that from 2000 through 2003, certain Fiat and CNH Global subsidiaries made approximately $4.3 million in kickback payments in connection with their sales of humanitarian goods to Iraq under the United Nations Oil for Food Program (the "Program"). The kickbacks were characterized as "after sales service fees" ("ASSFs"), but no bona fide services were performed. The Program, intended to provide humanitarian relief for the Iraqi population, required the Iraqi government to purchase humanitarian goods through a U.N. escrow account. The kickbacks paid by Fiat's and CNH Global's subsidiaries diverted funds out of the escrow account and into Iraqi-controlled accounts at banks in countries such as Jordan.

Fiat and CNH Global failed to maintain adequate systems of internal controls to detect and prevent the payments and their accounting for these transactions failed properly to record the nature of the payments. Fiat and CNH Global, without admitting or denying the allegations in the Commission's complaint, consented to the entry of a final judgment permanently enjoining Fiat and CNH Global from future violations of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934 and ordering Fiat to disgorge $5,309,632 in profits plus $1,899,510 in pre-judgment interest plus a civil penalty of $3,600,000. Fiat will also pay a $7,000,000 penalty pursuant to a deferred prosecution agreement with the U.S. Department of Justice, Fraud Section. The Commission considered remedial acts promptly undertaken by Fiat and CNH Global and the cooperation the companies afforded the Commission staff in its investigation.

December 22, 2008 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Court Extends SEC Injunction Against Madoff

In a fine example of closing the barn door etc.:

The SEC announced that on December 18, 2008, the federal district court in the Southern District of New York entered a preliminary injunction order, by consent, against Bernard L. Madoff and Bernard L. Madoff Investment Securities LLC ("BMIS").  The judge also, by consent, ordered that assets remain frozen until further notice, continued the appointment of a receiver for two entities owned or controlled by Madoff in the United Kingdom (while defendant BMIS remains subject to oversight by a SIPC trustee), and granted other relief. The preliminary injunction order continues the relief originally obtained on December 12, 2008, in response to the Commission's application for emergency preliminary relief that sought a temporary restraining order, an order freezing assets, and other relief against Madoff and BMIS based on his alleged violations of the federal securities laws.

The Commission continues to seek, among other things, a permanent injunction, disgorgement of ill-gotten gains plus pre-judgment interest, and civil money penalties.

December 22, 2008 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Enjoins Participant in Universal Leases Fraud

On December 22, the SEC issued an administrative Order Imposing Remedial Sanctions (Order) against George L. Phelps (Phelps), finding that on December 2, 2008, an order of permanent injunction was entered by consent against Phelps, permanently enjoining him from future securities violations. The SEC alleged that Phelps participated in a massive fraud orchestrated by Michael E. Kelly that victimized thousands of investors across the United States by raising at least $428 million through the offer and sale of fraudulent and unregistered securities called Universal Leases. Universal Leases were timeshares in several hotels in Cancun, Mexico, coupled with pre-arranged servicing agreements with a purportedly independent leasing agent that promised investors a safe investment and guaranteed returns. Phelps agreed to the issuance of the Order without admitting or denying any of the factual findings.

December 22, 2008 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Sunday, December 21, 2008

Greabe on Gartenberg

Moving Beyond Gartenberg: A Process-Based and Comparative Approach to Section 36(b) of the Investment Company Act of 1940, by John Greabe, Vermont Law School; Michael Brickman; James C. Bradley; and Nina H. Fields, was recently posted on SSRN.  Here is the abstract:

Section 36(b) of the Investment Company Act of 1940 imposes on mutual fund advisers a fiduciary duty with respect to their receipt of compensation from fund assets for the advisory services they provide. For the past quarter century, courts adjudicating claims for breaches of this fiduciary duty have relied heavily on a rubric proposed in Gartenberg v. Merrill Lynch Asset Management Trust, 694 F.2d 923 (2d Cir. 1982). But in doing so, courts have tended to read Gartenberg to require them to serve as rate setters and to make substantive economic judgments about the fairness of mutual fund advisory fees. As a consequence, there has not been a single liability finding under section 36(b), even as the compensation paid to mutual fund advisers has skyrocketed. In this paper, the authors propose that courts enforce the fiduciary duty that section 36(b) creates through a process-based and comparative approach that is rooted in the common law of trusts and relies on judicially administrable guideposts. If section 36(b) is to serve the role Congress envisioned for it, it is imperative that courts move beyond the Gartenberg approach.

December 21, 2008 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Dickinson on Credit Default Swaps

Credit Default Swaps: So Dear to Us, So Dangerous, by Eric Dickinson, Fordham University - School of Law, was recently posted on SSRN.  Here is the abstract:

Credit-default swaps (CDS) are a valuable financial tool that has created system-wide benefits. At the same time, however, these derivative contracts have also created the potential for relatively few market participants to destabilize the entire economic system. This Paper will explore (1) how CDS could hypothetically create systemic risk, (2) how CDS have recently exacerbated the current financial crisis, and (3) how the U.S. legislature could best regulate CDS to minimize systemic risk in the future.

In theory, CDS could foster systemic crisis by means of (1) encouraging the growth of dangerous asset bubbles, (2) causing the collapse or failure of an institution that is systemically significant, and (3) creating perverse incentives that subvert policies underpinning business law on a system-wide scale. This Paper will question whether CDS helped support the growth of the sub-prime mortgaged-backed securities asset bubble that has been blamed for igniting the current financial crisis. Ultimately, there is evidence cutting both ways, thereby encouraging further research into the issue. The second of these theoretical risks has certainly come into realization within the last few months when the trillion-dollar company, AIG, destroyed itself by blundering in the CDS market and causing system-wide instability. As for the third theoretical risk, there is currently no empirical evidence that CDS has created perverse incentives on a system- wide scale.

How should the government regulate CDS to minimize systemic risk? After examining seven distinct proposals, this Paper recommends that legislators require CDS market participants to (1) maintain increased capital reserve requirements when involved in the purchase or sale of CDS tied to highly speculative debt; and (2) confidentially disclose their CDS positions to the Federal Reserve. Increasing the capital reserve requirements for companies that trade in junk-grade CDS is essential for two reasons. First, higher capital reserve requirements protect the solvency of systemically significant institutions that attempt to profit from the riskiest CDS. Second, specifically targeting CDS that are associated with the junk lending business will discourage banks from extending cheap credit to unworthy borrowers, thereby reducing the potential for markets to generate precarious asset bubbles. As a second regulatory measure, confidential disclosure of CDS positions to the Federal Reserve is an efficient but relatively non- intrusive way to greatly facilitate the monitoring of systemic risk going forward.

While the proposed legislative action would invariably impose costs on both market participants and society in general, the benefits of enhanced economic stability are incalculable.

December 21, 2008 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)