Friday, September 18, 2009
The SEC has posted on its website the release proposing the amendment that would eliminate from Rule 602 of Reg NMS the exception for flash orders. Here is the introduction to the release:
The Securities and Exchange Commission (“Commission”) is concerned that the exception for flash orders from quoting requirements under the Securities Exchange Act of 1934 (“Exchange Act”), which originated in the context of manual trading floors for quotations that were considered “ephemeral,” is no longer necessary or appropriate in today’s highly automated trading environment. Accordingly, the Commission is proposing to amend Rule 602 of Regulation NMS under the Exchange Act to eliminate an exception for the use of flash orders by equity and options exchanges. In general, flash orders are communicated to certain market participants and either executed immediately or withdrawn immediately after communication. If the proposed amendment were adopted, the Commission would apply Rule 301(b) of Regulation ATS under the Exchange Act in a consistent manner with regard to the use of flash orders by alternative trading systems. The Commission also would apply the restrictions on locking or crossing quotations in Rule 610(d) of Regulation NMS in a consistent manner to prohibit the practice of displaying marketable flash orders.
Public comments are due 60 days after publication in the Federal Register.
The SEC unanimously proposed a rule amendment that would prohibit the practice of flashing marketable orders. A flash order enables a person who has not publicly displayed a quote to see orders less than a second before the public is given an opportunity to trade with those orders. Investors who have access only to information displayed as public quotes may be harmed if market participants are able to flash orders and avoid the need to make the order publicly available. If adopted, the proposed amendment would effectively prohibit all markets - including equity exchanges, options exchanges, and alternative trading systems - from displaying marketable flash orders.
Currently, flash orders are permitted as result of an exception to Rule 602 of Regulation NMS that exempts these orders from requirements that apply generally to other orders. The Commission is concerned that the Rule 602 exception may no longer be necessary or appropriate in today's highly automated trading environment.
In its proposal, the Commission is seeking public comment and data on a broad range of issues relating to flash orders, including the costs and benefits associated with the proposal. It also seeks comment on whether the use of flash orders in the options markets should be evaluated differently than their use in the equity markets. Public comments on today's proposal must be received by the Commission within 60 days after its publication in the Federal Register.
The SEC voted unanimously to take several rulemaking actions to bolster oversight of credit ratings agencies by enhancing disclosure and improving the quality of credit ratings, including:
Adopted rules to provide greater information concerning ratings histories - and to enable competing credit rating agencies to offer unsolicited ratings for structured finance products, by granting them access to the necessary underlying data for structured products.
Proposed amendments that would seek to strengthen compliance programs through requiring annual compliance reports and enhance disclosure of potential sources of revenue-related conflicts.
Adopted amendments to the Commission's rules and forms to remove certain references to credit ratings by nationally recognized statistical rating organizations.
Reopened the public comment period to allow further comment on Commission proposals to eliminate references to NRSRO credit ratings from certain other rules and forms.
Proposed new rules that would require disclosure of information including what a credit rating covers and any material limitations on the scope of the rating and whether any "preliminary ratings" were obtained from other rating agencies - in other words, whether there was "ratings shopping."
Voted to seek public comment on whether to amend Commission rules to subject NRSROs to liability when a rating is used in connection with a registered offering by eliminating a current provision that exempts NRSROs from being treated as experts when their ratings are used that way.
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Public comments on new rules or amendments proposed today must be received by the Commission within 60 days after their publication in the Federal Register.
Thursday, September 17, 2009
New York Attorney General Cuomo announced that four leading private equity firms, HM Capital Partners I (“HM Capital”), Levine Leichtman Capital Partners (“Levine Leichtman”), Access Capital Partners (“Access”), and Falconhead Capital (“Falconhead”) have adopted Cuomo’s Public Pension Fund Reform Code of Conduct to reform the public pension fund system and to end pay-to-play practices nationwide. Under the terms of the agreements announced today, the firms will return over $4.5 million associated with New York State Common Retirement Fund (“CRF”) investments. These funds will be returned to the CRF for the benefit of the pension holders.
Attorney General Cuomo’s Code of Conduct bans investment firms from hiring, utilizing, or compensating placement agents, lobbyists, or other third-party intermediaries to communicate or interact with public pension funds to obtain investments. To avoid pay-to-play schemes, the Code prohibits investment firms (and their principals, agents, employees and family members) from doing business with a public pension fund for two years after the firm makes a campaign contribution to an elected or appointed official who can influence the fund's investment decisions. This provision also bars all firms currently doing business with the pension fund from making such campaign contributions. Investment firms must also disclose any conflicts of interest to public pension fund officials or law enforcement authorities, to increase transparency and avoid abuse in the management of public pension funds.
The latest news today on the BofA-Merrill merger investigations is that the New York AG has issued subpoenas to 5 current or former directors of Bank of America, seeking to learn what they knew about Merrill's financial condition and the bonus payments before the deal was closed. NYTimes, Cuomo Is Said to Issue Subpoenas in Merrill Case; WSJ, Cuomo Calls In 5 BofA Directors. Mr. Cuomo is quoted as saying he wants to know whether the directors protected the shareholders' interests, whether they were misled, or were they rubber stamps?
For those of us teaching Corporations this fall, this is great stuff. Today in class, several students expressed skepticism about the priority given to independence, as opposed to expertise, as a value for directors. According to the New York Times article, the subpoenaed directors included a real estate executive, a venture capital investor, a retired 4-star general, a former college president, and the head of a utility company. Not a lot of banking, financial services, or audit expertise there. According again to the article, at least some of the directors were members of the audit committee.
The articles also state that it is "rare" to subpoena board members in a criminal case. This sounds a little surprising to me, given the Dept. of Justice's investigations in the aftermath of the Enron/Worldcom debacles. Can readers think of other examples?
Wednesday, September 16, 2009
The SEC and the UK Financial Services Authority (FSA) announced plans to explore common approaches to reporting and other regulatory requirements for key market participants such as hedge funds and their advisers. In particular, they agreed to identify a common, coherent set of data to collect from hedge fund advisers/managers to help the SEC and FSA identify risks to their regulatory objectives and mandates.
This announcement came out of a meeting of the SEC-FSA Strategic Dialogue, through which SEC and FSA leaders meet periodically to discuss areas of mutual interest. Other issues discussed at the meeting included over-the-counter derivatives markets and central clearing; accounting issues; regulatory reform; credit rating agency oversight; short selling; and corporate governance and compensation practices.
The SEC announced the creation of a new Division of Risk, Strategy, and Financial Innovation, and University of Texas School of Law Professor Henry T. C. Hu will be its first Director. The new division combines the Office of Economic Analysis, the Office of Risk Assessment, and other functions to provide the Commission with sophisticated analysis that integrates economic, financial, and legal disciplines. The division's responsibilities cover three broad areas: risk and economic analysis; strategic research; and financial innovation.
The new division will perform all of the functions previously performed by OEA and ORA, along with the following: (1) strategic and long-term analysis; (2) identifying new developments and trends in financial markets and systemic risk; (3) making recommendations as to how these new developments and trends affect the Commission's regulatory activities; (4) conducting research and analysis in furtherance and support of the functions of the Commission and its divisions and offices; and (5) providing training on new developments and trends and other matters.
With the creation of the Division of Risk, Strategy, and Financial Innovation, the SEC now has five divisions, including the Division of Corporation Finance, the Division of Enforcement, the Division of Investment Management, and the Division of Trading and Markets.
Tuesday, September 15, 2009
I continue to ponder Judge Rakoff's order refusing to approve the SEC-BofA consent judgment in connection with the alleged misstatements about the Merrill bonuses in the BofA proxy statement seeking approval of the merger. The judge acknowledges the deferential standard for reviewing consent judgments, but nevertheless finds this one is "neither fair, nor reasonable, nor adequate." Is the judge introducing a new standard for reviewing SEC consent judgments, or will this activism be confined to the particular facts of this case?
What really upsets the judge is that the corporation is paying $33 million in a penalty, but no chages were brought, or penalties sought, from the individuals responsible for the alleged misstatements. To the judge, this is victimizing innocent shareholders plain and simple. He rejects as "making no sense" the SEC's argument that a corporate penalty sends a strong signal to shareholders that corporate wrongdoing has taken place; implicitly, the SEC says that the shareholders should exercise responsibility for the quality of management. Yet corporate penalties are commonplace; does the judge mean to curtail their use, or does his sense of injustice result from the combination of a corporate penalty and the lack of individual sanctions?
The judge also finds the injunctive relief forbidding the Bank from issuing false or misleading statements in the future "too nebulous" to comply with the applicable Rule of Civil Procedure that requires describing in "reasonable detail" the restrained acts, particularly since the Bank is now asserting that it made no false or misleading material statements. Yet these kinds of broad injunctions have been standard practice, as is the practice of the defendants neither admitting or denying the allegations. Is the judge expecting a change in SEC practice?
Finally, the judge states that $33 million is a "trivial penalty" for a false statement that materially infected a multi-billion-dollar merger. (Although he also wonders why the Bank is paying so much money if the charges are, as it claims, bogus.) It's only post-SOX that the SEC began seeking penalties in excess of $10 million, and that resulted in a great deal of consternation on the part of the business community.
Again, we have to wait and see whether there is now a more heightened standard for reviewing consent judgments, or whether this is sui generis and reflects the judge's deep distaste for what he describes as the "cynical relationship" between the SEC and the Bank -- the SEC gets to claim a victory, and the Bank got the case to go away. This is not the first time this kind of deal has been struck; what will happen if the game is curtailed.
Will this case now go to trial? And what will the New York AG do? That office is also threatening to bring action against the Bank.
A FINRA Hearing Panel has barred John Edward Mullins, a former registered representative with Morgan Stanley DW, Inc., for misappropriating $11,156.47 from the charitable foundation of a 97-year old nursing home resident and widow who was his client for more that 20 years. The panel also sanctioned Mullins' wife, Kathleen Maria Mullins, also a former registered representative with Morgan Stanley — giving her a nine-month suspension and a $20,000 fine for borrowing $100,000 from the same client without the approval of her brokerage firm. Kathleen Mullins also made material misstatements on compliance questionnaires concerning her official role in the charitable foundation and receipt of the loan. The hearing panel is also requiring Kathleen Mullins to re-qualify by examination before she can be registered in any capacity in the securities industry.
The hearing panel noted that in early April 2006, just after the elderly widow fell ill and was under round-the-clock nursing care, John Mullins "embarked on his misuse and conversion of the foundation's funds." The hearing panel determined that within three months of the customer's illness, John Mullins misappropriated $4,000 to pay for his and his wife's vacation at the Four Seasons in London. The hearing panel also found that John Mullins misappropriated $5,500 to reduce his personal bill at Boyds of Philadelphia, an upscale Philadelphia clothing store, and $1,656.47 to buy 23 bottles of wine from Morton's Restaurant in Atlantic City, which he stored in his personal wine locker at the steakhouse.
Unless the matter is appealed to FINRA's National Adjudicatory Council (NAC), or is called for review by the NAC, the hearing panel's decision becomes final after 45 days.
Monday, September 14, 2009
On September 11, the SEC issued an Order Instituting Cease-and-Desist Proceedings Pursuant to Section 21C of the Securities Exchange Act of 1934, Making Findings, and Imposing a Cease-and-Desist Order against Dana Holding Corporation (as successor registrant to Dana Corporation). Dana Holding Corporation consented to the issuance of the Order without admitting or denying any of the findings in the Order. The Order finds that from 2004 through mid-2005, contrary to Generally Accepted Accounting Principles, Dana Corporation (Dana) improperly recognized revenue or income on several transactions and delayed recording expenses in the appropriate period. During this period, former Dana employees of Commercial Vehicle Systems (CVS), a subdivision of one of Dana's two main business units, the Heavy Vehicle Technologies and Systems Group (HVTSG), engaged in a fraudulent scheme with former Dana employees of HVTSG to inflate CVS's financial results. As a result, Dana's financial statements were misstated, in part because the company: (1) recognized income on transactions where assets were never transferred or risk of ownership never passed, (2) recognized revenue for price increases on parts sales without agreement from the customers, (3) improperly deferred the recognition of steel surcharge expenses, and (4) recorded other improper accounting entries, including decreasing debts owed to suppliers without any contractual support or agreement from the suppliers and recording entries that increased income without any basis or supporting documentation. Dana overstated its EBIT by $31.6 million due to the fraud.
In addition to the fraud, Dana's financial statements from 2004 through the first two quarters of 2005 contained accounting errors amounting to $56.4 million. Dana failed to maintain accurate books and records. Dana also had materially deficient internal accounting controls that significantly contributed to the accounting irregularities and errors. As a result, Dana filed materially false and misleading periodic filings with the Commission for fiscal year 2004 and the first two quarters of 2005. In total, Dana materially overstated its EBIT by $88 million, or 73.9% of restated EBIT. This is equivalent to an overstatement of $43 million or 39.8% of restated net income, as reported in Dana's Form 10-K/A and Forms 10-Q/A filed in December 2005. Dana Holding Corporation consented to the issuance of the Order without admitting or denying any of the findings in the Order. In the Matter of Dana Holding Corporation
In a separate action, the SEC filed a settled civil action against four former employees of Dana Holding, Bernard Cole, William Hennessy, Douglas Hodge and Robert Steimle, in connection with the financial accounting fraud scheme that occurred from 2004 through the first two quarters of 2005.
The Treasury Dept. issued a Status Report on Financial Stabilization Efforts and announced the "next phase:"
This next phase will focus on winding down those programs that were once necessary to prevent systemic failure. The use of those programs, by design, continues to decline as the financial system recovers, and the U.S. Government is being repaid for its investments. But this phase will also involve ensuring that those policies and programs that are still necessary for financial and economic recovery are maintained and well executed, making clear that the U.S. Government still stands ready to do whatever is needed to ensure a lasting recovery.
President Obama delivered his much-publicized speech to Wall St., in which he first asserted that the nation's financial situation has improved since the collapse of Lehman a year ago and that government intervention was effective in dealing with the crisis. Perhaps in response to many news reports about non-existence of regulatory reform in the past year, he then addressed the principal proposals in the Treasury's White Paper that was released some months ago. Specifically, he advocated;
1. new rules to protect consumers and a new Consumer Financial Protection Agency to enforce them (although the President did not mention it, the proposed agency has been the target of fierce opposition by the credit industry.)
2. close regulatory loopholes
3. the Federal Reserve as systemic risk regulator for the big banks, an oversight council and "resolution authority" to deal with failures that pose a risk to financial stability
4. coordinating international policies.
Will this jump-start regulatory reform? Let's hope so.
Judge Rakoff (SDNY) rejected the proposed settlement between the SEC and the Bank of America regarding misleading proxy disclosures over Merrill Lynch bonuses and set a Feb. 1 trial date. In his order, he emphasized the unfairness of making the Bank of America shareholders, in essence, pay the $33 million corporate penalty. The SEC did not seek penalties from any individuals, asserting that it could not do so because lawyers for the Bank and Merrill drafted the documents and made the relevant disclosure decisions. To the judge, that made no sense -- in that case, why not seek penalties from the lawyers? The judge goes on to say that the parties' submissions
"leave the distinct impression that the proposed Consent Judgment was a contrivance designed to provide the SEC with the facade of enforcement and the management of the Bank with a quick resolution of an embarrassing inquiry -- all at the expense of the sole alleged victim, the shareholders."
Sunday, September 13, 2009
Private Placements: A Regulatory Black Hole, by Jennifer J. Johnson, Lewis & Clark Law School, was recently posted on SSRN. Here is the abstract:
Many investors, including vulnerable senior citizens, are victimized each year in dubious securities offerings, yet governmental regulators can do little to intervene. Utilizing the Rule 506 private placement exemption, promoters today can escape regulatory review by both federal and state securities officials. While states at one time served as “local cops on the beat” to protect their citizens, in 1996, Congress preempted state authority thus creating a situation in which suspect investment schemes can proliferate below any governmental radar screen. This paper questions the continued wisdom of this regulatory vacuum, especially in light of recent financial events. This paper thoroughly reviews the legislative history of this preemptive statute known as NSMIA and concludes that the preemption of private placements either resulted from congressional misconceptions; back room politics resulting from the conservative deregulatory era of the decade; or both. After analyzing the regulations and private placement market in both as it existed in 1996 and as it operates today, the paper concludes that NSMIA’s poignant preemptive force primarily impacted state authority over the smaller, most risky private placements. Combined with the lack of federal oversight, this statutory preemption created a regulatory abyss that permits many questionable offerings to take place. In its zeal to deregulate, Congress left many investors with little if any governmental protection. The paper proposes returning to the states the supervision of designated private placements. This modest proposal would foster capital formation, protect investors, and provide for a more rational and efficient legislative framework to regulate private securities transactions.
Why Stock Options are the Best Form of Executive Compensation (And How to Make Them Even Better), by Richard A. Booth, Villanova University School of Law, was recently posted on SSRN. Here is the abstract:
Stock options are the primary form of compensation for CEOs because they are the best way to align the interests of CEOs with those of diversified stockholders. Nevertheless, critics argue that the use of stock options leads to excessive pay because there is no effective bargaining between the CEO and the board of directors about the number of options to award. They argue that the cost is underestimated by boards and hidden from stockholders and that options induce CEOs to undertake risky business strategies. None of these objections withstands scrutiny. First, there is little reason to believe that options have resulted in excessive CEO compensation. Although CEO pay has increased dramatically in absolute terms, data show that total executive pay as a percentage of corporate income – including gain from the exercise of options – has remained quite stable since 1982. This is true even though equity compensation grew from a negligible amount to as much as 75% of CEO pay by the year 2000. It would thus appear that equity compensation has been substituted for cash compensation and that a larger share of aggregate pay goes to those who succeed in increasing stock price. Second, options are subject to powerful market forces that effectively control their use. Using options as compensation effectively requires a corporation to repurchase shares to control for dilution. Because cash is scarce, there is a natural limit on the number of options that a corporation can grant. In addition, stock options confer significant benefits that are difficult to achieve with other forms of compensation. Aside from the fact that options induce corporations to distribute cash in the form of repurchases to control for dilution, options also convey significant information to the market about a company’s prospects, because the need to repurchase stock requires the company to estimate future cash flows in deciding how many options to grant. Finally, options provide an unbiased incentive for acquisitions when appropriate and for divestitures when appropriate. Thus, options make sense for both growing companies and mature companies. Although other forms of incentive compensation may provide some of the same benefits as stock options, they are ultimately inferior to options. For example, restricted stock rewards the CEO who increases stock price, but it may also induce the CEO to engage in conservative business strategies designed primarily to avoid losses rather than generate gains, contrary to the interests of diversified investors. And the traditional bonus based on earnings may induce CEOs to grow the business by retaining cash and investing it in new but suboptimal ventures. To be sure, stock options can be abused through such practices as timing and backdating. But these problems can be addressed by announcing option grants in advance of fixing the strike price. Moreover, it is quite easy to design an option that addresses the problem of overvalued equity and eliminates the incentive to maintain a stock price that is inappropriately high. By indexing exercise price downward, options can provide an incentive for CEOs to minimize losses in falling markets. In light of the numerous advantages of options as compared to other forms of incentive compensation, it appears that complaints about executive pay are based largely on ex post results. From an ex ante perspective, investors are not likely to object to options because with options the CEO gains only if and to the extent that stockholders gain. Indeed, as a result of the use of options as compensation, it is arguable that the model of the corporation as one owned by the stockholders has evolved into something more like a partnership between stockholders and officers in which the officers work for an ownership share of the business. Under this model, the board of directors may be seen primarily as an arbiter between these two groups for purposes of dividing up the gain rather than as an active manager of the business. But even under the prevailing stockholder ownership model, it is the supposed duty of the directors and officers to maximize stockholder value. In practice, there are few situations in which that duty is enforced as a matter of law. Options fill the gap.
Bailouts: An Essay on Conflicts of Interest and Ethics When Government Pays the Tab, by Richard W. Painter, University of Minnesota Law School, was recently posted on SSRN. Here is the abstract:
This essay, a precursor for a book project on the same topic, addresses ethics problems for government officials who orchestrate bailouts of private companies. These problems include excessive politicization of bailout decisions, the influence of campaign contributions, conflicts of interest when executives from the private sector move in and out of government positions, insider trading on government information about bailouts, and loose regulation of conflicts of interest within private companies that assist with bailouts as government contractors. This essay concludes that government ethics law in its current state is not up to the task and that the United States is not prepared to implement bailouts in a manner that will instill public confidence. Although these problems could be alleviated through stricter ethics rules or a more systematized approach to bailouts, most solutions would be more costly than the problems they attempt to solve. Bailouts thus impose a substantial burden on government ethics that may be impossible to remove, in addition to the economic cost bailouts impose on taxpayers. Designing a bailout free economy may be the only acceptable alternative. The author represented the Bush White House in drafting ethics agreements for Treasury Secretary Paulson and other Presidential nominees who were later responsible for implementing the massive bailout of the financial services industry in 2008.
Should the Sec Spin Off the Enforcement Division?, by Peter J. Henning, Wayne State University Law School, was recently posted on SSRN. Here is the abstract:
The current environment is highly supportive of increased government regulation, particularly in the financial field. One of the beneficiaries of this push for greater oversight of the markets appears to be the Securities & Exchange Commission, despite some recent high profile enforcement failures, most particularly the massive Ponzi scheme undertaken by Bernie Madoff. In this essay, I raise the question whether the SEC should retain its enforcement authority over fraud cases, or whether it would be better served if that function were shifted to the Department of Justice. The SEC’s recent push to take on a more prosecutorial air gives the clear impression that an adversarial approach to enforcement of the securities laws is in order. However, the Commission must continue to solicit the views of Wall Street to fulfill its regulatory function, much like Madoff was included in the SEC’s deliberations on rules related to the stock market. At some point in the future, the push for greater regulation is likely to pass from the scene as the pendulum swings back toward a less intrusive approach to oversight. Whether the Commission can resist renewed entreaties to go easier on enforcing the law to free the capital markets from strict regulation is an open question. To allow the SEC to regulate Wall Street properly, splitting off at least a portion of the enforcement function to an agency with expertise in prosecutions - the United States Department of Justice - is at least worthy of consideration as the government looks to increase regulation.
Identifying the Duty Prohibiting Outsider Trading on Material Non-Public Information, by Thomas Lee Hazen, University of North Carolina at Chapel Hill - School of Law, was recently posted on SSRN. Here is the abstract:
The federal securities laws do not contain a definition of insider trading. As a result, case law has developed in a common law fashion from the existing statutory broad anti-fraud prohibitions. The result has been a tortuous path in defining the reach of the prohibition against trading securities on the basis of non-public information. This article examines outsider trading which occurs when market participants who are not corporate insiders obtain material non-public information and whether they are permitted to enter into securities transactions on the basis of that information. SEC rulemaking adopted a relatively broad reading of the law’s reach to deal with outsider trading. In contrast, the trend in recent cases has been to question that breadth. This article examines recent developments and concludes that the SEC got it right. Namely, trading prohibitions properly extend 'outsider trading' to certain individuals even if they are not under a fiduciary duty to keep the information confidential. The article also explores the range of outsiders who should be covered by trading prohibitions. A final recommendation is that that the confusion in the cases demonstrates that Congress should recognize the need for a statutory definition of both insider and outsider trading.