Sunday, December 6, 2009
Is the PCAOB a 'Heavily Controlled Component' of the SEC?: An Essential Question in the Constitutional Controversy, by Donna M. Nagy, Indiana University School of Law-Bloomington, was recently posted on SSRN. Here is the abstract:
The U.S. Supreme Court will soon be hearing oral arguments in Free Enterprise Fund v. Public Company Accounting Oversight Board, described by D.C. Circuit Judge Brett Kavanaugh as “the most important separation-of-powers case regarding the President’s appointment and removal powers to reach the courts in the last 20 years.” Established by Congress as the cornerstone of the Sarbanes-Oxley Act of 2002, the PCAOB was structured as a strong, independent board in the private sector, to oversee the conduct of auditors of public companies.
This Article challenges the D.C. Circuit’s depiction of the PCAOB as “a heavily controlled component” of the SEC, and argues that this flawed premise was essential to the court’s 2-1 decision upholding the PCAOB’s constitutionality. With a focus on statutory analysis and legislative history, the Article seeks to show that Congress designed the PCAOB to operate with substantive independence from the SEC. It then argues that PCAOB members acting with significant discretion and autonomy outside the SEC’s control are “principal officers” who, pursuant to the Appointments Clause, must be appointed by the President with the advice and consent of the Senate. And as “principal officers” performing significant executive functions, PCAOB members must be removable for cause by the President.
The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008, by Lucian A. Bebchuk, Harvard University - Harvard Law School; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Alma Cohen, Tel Aviv University - Eitan Berglas School of Economics; Harvard Law School; National Bureau of Economic Research (NBER); and Holger Spamann, Harvard University - Harvard Law School, was recently posted on SSRN. Here is the abstract:
The standard narrative of the meltdown of Bear Stearns and Lehman Brothers assumes that the wealth of the top executives of these firms was largely wiped out along with their firms. In the ongoing debate about regulatory responses to the financial crisis, commentators have used this assumed fact as a basis for dismissing both the role of compensation structures in inducing risk-taking and the potential value of reforming such structures. This paper provides a case study of compensation at Bear Stearns and Lehman during 2000-2008 and concludes that this assumed fact is incorrect.
We find that the top-five executive teams of these firms cashed out large amounts of performance-based compensation during the 2000-2008 period. During this period, they were able to cash out large amounts of bonus compensation that was not clawed back when the firms collapsed, as well as to pocket large amounts from selling shares. Overall, we estimate that the top executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1 billion respectively from cash bonuses and equity sales during 2000-2008. These cash flows substantially exceeded the value of the executives’ initial holdings in the beginning of the period, and the executives’ net payoffs for the period were thus decidedly positive. The divergence between how the top executives and their shareholders fared implies that it is not possible to rule out, as standard narratives suggest, that the executives’ pay arrangements provided them with excessive risk-taking incentives. We discuss the implications of our analysis for understanding the possible role that pay arrangements have played in the run-up to the financial crisis and how they should be reformed going forward.
Separation of Powers, Independent Agencies, and Financial Regulation: The Case of the Sarbanes-Oxley Act, by Richard H. Pildes, New York University School of Law, was recently posted on SSRN. Here is the abstract:
The Supreme Court will hear in December one of the most important separation-of-powers case in many years involving the structure of administrative agencies. The case, Free Enterprise Fund v. The Public Company Accounting Oversight Board, and this article, addresses virtually every major constitutional issue regarding the design of administrative governance: the line between principal and inferior officers of the United States; the appointment power; the removal power; separation of powers; and the status of independent agencies, including whether they can be "Departments" under the Constitution.
The case is a challenge to the constitutionality of the Sarbanes-Oxley Act, which Congress enacted in 2002 to address the corporate auditing debacles in cases such as Enron, WorldCom, and others. The Act's centerpiece was a new regulatory body, located within the Securities and Exchange Commission, with the power to regulate and oversee the accounting industry in the United States, under the supervision of the SEC. Judicial resolution of this conflict will determine not only the constitutionality of regulatory oversight of the accounting industry that Sarbanes-Oxley sets up. That resolution will determine the kinds of options Congress has for designing politically-insulated administrative structures to deal with the current financial crisis and with other major regulatory needs in the coming years.
This article analyzes these central constitutional issues in the context of the larger system of financial regulation. The analysis argues that the Sarbanes-Oxley Act and the new agency it creates is constitutional. This article is a substantially revised version, which addresses a number of new issues, of an earlier posted draft.
The Fox and the Ostrich: Is GAAP a Game of Winks and Nods?, by Arthur Acevedo, The John Marshall Law School, was recently posted on SSRN. Here is the abstract:
The fox is frequently described as sly, cunning and calculating in world literature. It is often associated with behavior that seeks advantage through trickery and pretext. The ostrich on the other hand, has been portrayed as cowardly and irrational. Its character defect is epitomized when it sticks its head in the sand at the first sign of trouble. The Financial Accounting Standards Board (FASB) can be described as the fox; the Securities Exchange Commission (SEC), the ostrich. This article examines the creation of accounting principles by the fox and the failure to govern by the ostrich. History demonstrates that the SEC adopted a policy of relying heavily on FASB in establishing accounting standards commonly known as generally accepted accounting principles (GAAP). However, neither FASB nor any of its predecessor organizations bear a responsibility of a public trust, nor any liability in the event of a breach of that trust. The SEC’s failure to establish accounting principles and constant reliance on private standard setters has contributed to the manipulation and exploitation of GAAP by corporations and their auditors. This article challenges the SEC’s policy of relying on third party standard setters such as FASB and calls upon the SEC to stop relying on private standard setters and start taking an active role in creating accounting standards. Only then, can it be said that the SEC is no longer sticking its head in the sand.
Principles-Based Securities Regulation in the Wake of the Global Financial Crisis, by Cristie L. Ford, University of British Columbia Faculty of Law; Columbia Law School, was recently posted on SSRN. Here is the abstract:
This paper seeks to re-examine, and ultimately to restate the case for, principles-based securities regulation in light of the global financial crisis and related developments. Prior to the onset of the crisis, the concept of more principles-based financial regulation was gaining traction in regulatory practice and policy circles, particularly in the United Kingdom and Canada. The crisis of course cast financial regulatory systems internationally, including more principles-based approaches, into severe doubt. This paper argues that principles-based securities regulation as properly understood remains a viable and even necessary policy option, which offers solutions to the real-life and theoretical challenge that the GFC presents to contemporary financial markets regulation. That said, the global financial crisis illustrates how such outcome-oriented and devolved models can slide into self-regulation in the absence of meaningful regulatory oversight and engagement, and regulatory commitment to its publicly and systemically oriented role. Our response to the crisis should not be to re-embrace more rules-based regulatory approaches. Financial markets are too fast-moving and complex to be regulated in a command-and-control manner, and the risk of Enron-style “loophole behavior” associated with rules is too great. Instead, the paper draws on the lessons of the financial crisis to identify three critical success factors for effective principles-based securities regulation: considerable regulatory capacity (along four main parameters); an effective strategy for dealing with complexity (including the possibility of incorporating “prophlylactic rules” at strategic junctures); and adequate independence of mind and diversity of perspectives among regulators (meaning potentially a move away from an expertise-based, technocratic model toward a more broadly participatory one).
Insider Trading in Takeover Targets, by Anup Agrawal, University of Alabama - Culverhouse College of Commerce & Business Administration, and Tareque Nasser, University of Alabama, was recently posted on SSRN. Here is the abstract:
Takeover announcements typically result in large increases in stock prices of target firms, providing a tempting opportunity for insider trading. Surprisingly, no prior study has examined whether the level and pattern of profitable insider trading before takeover announcements is abnormal for a broad cross-section of targets of takeovers during modern times. This paper brings large-sample evidence on this issue in an attempt to fill this gap in the literature. We examine insider trading in about 3,700 targets of takeovers announced during 1988-2006. We analyze open-market purchases, sales and net purchases of five groups of corporate insiders during the one year pre-takeover period. Using cross-sectional and time-series control samples, the paper estimates difference-in-differences regressions of several measures of the level of insider trading that control for its other determinants. We find an interesting and subtle pattern in the average pre-takeover trading behavior of target insiders. While insiders reduce both their purchases and sales below normal levels, their sales reduce more than purchases, leading to an increase in net purchases. This pattern of ‘passive’ insider trading is confined to the six-month period before takeover announcement, holds for each insider group, for all three measures of net purchases examined, and in certain sub-samples with less uncertainty about takeover completion, such as deals with a single bidder, domestic acquirer, and less regulated target. Our findings suggest that while insiders are careful about trading before major corporate events, they try to get around the restrictions on their trading activities.
The SEC has created on its website a portal devoted to XBRL. The page provides links from the SEC website to sources of information about XBRL technology, as well as creating and submitting XBRL-tagged interactive data files in compliance with Commission rules.
The SEC charged a purported bio-diesel fuels company with making false statements regarding its purported emissions-free coal conversion technology and financial condition. The Commission's complaint names Nova Gen Company ("Nova Gen") of San Diego, Calif., its current CEO, Margaret Grey ("Grey"), and a sales agent, Paul Randall Fraley ("Fraley"). The complaint alleges that Grey, of San Diego, Calif. and widow of the company's founder, has continued in Nova Gen's unregistered fraudulent securities offering since she assumed control over the company in June 2009.
According to the complaint filed in U.S. District Court in San Diego, Nova Gen falsely claimed to have technology capable of converting coal into bio-diesel fuel, virtually emissions free, and even touted a plant that was up and running. The complaint further alleges Nova Gen disseminated financial statements to investors that depicted $27 million in a brokerage account and net operating income of $21 million. The complaint alleges that, in fact, Nova Gen's technology was not "ready to go," and that it did not have any plant, did not own any brokerage account, and had not generated revenue at any time. The complaint further alleges that Fraley, of Hewitt, W.Va., located potential investors and received sales commissions for his efforts, and falsely told investors that Nova Gen was about to become a publicly-traded company that would pay a guaranteed 11% dividend.
The Commission's complaint charges the defendants with violating the securities registration provisions, Sections 5(a) and 5(c) of the Securities Act of 1933 ("Securities Act"), the broker-dealer registration provisions, Section 15(a) of the Securities Exchange Act of 1934 ("Exchange Act"), and the antifraud provisions, Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, of the federal securities laws. The Commission's complaint seeks permanent injunctions, disgorgement, prejudgment interest, and financial penalties.
On December 3, 2009, the SEC obtained a temporary restraining order and emergency asset freeze against Joseph S. Blimline relating to his involvement in a $485 million offering fraud and Ponzi scheme. The scheme was orchestrated by Joseph S. Blimline, Paul R. Melbye, Brendan W. Coughlin and Henry D. Harrison through a company they owned and controlled, Provident Royalties LLC. The Commission had previously filed a complaint against Melbye, Coughlin and Harrison and on July 7, 2009, obtained a temporary restraining order, asset freeze and appointment of a receiver with respect to those defendants. In addition to the asset freeze against Blimline, the court has extended the authority of the receiver over the newly-frozen assets.
The Commission alleges in its amended complaint that Provident advanced approximately $93 million of investor funds to Blimline and entities he controlled. The funds were for the purported purchase of oil and gas interests, or loans, to which Provident often never received title or repayment. The amended complaint also alleges that in presentations to investors and representatives of broker-dealers marketing Provident securities, Blimline failed to disclose his receipt of such funds, his involvement in the management of Provident and a prior sanction imposed against him by the Michigan securities authorities for prior conduct.
The Commission's amended complaint charges the defendants with violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The amended complaint seeks a temporary restraining order and preliminary and permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest and financial penalties. Officer and director bars are sought against Blimline, Melbye, Harrison and Coughlin. An additional 36 affiliated entities that did not sell securities are named as relief defendants in the amended complaint for purposes of disgorgement.
The SEC's options backdating cases are not over yet. The agency announced that, on December 4, 2009, it filed a civil action in the United States District Court for the Western District of Pennsylvania against Black Box Corporation ("Black Box"), a Lawrence, PA technical services provider, its former Chief Executive Officer Frederick C. Young, 53, of Silver Point, Tennessee, and its former Chief Financial Officer Anna M. Baird, 52, of Bridgeville, PA, alleging violations related to stock-options backdating. Without admitting or denying the Commission's allegations, all three defendants agreed to settle the matter.
The Commission's complaint alleges that, in July and August 2007, as a result of a previously announced review of its stock options practices, Black Box filed quarterly and annual reports restating its net income for fiscal years 1994 through 2006 (the "Restatements") by identifying approximately $70.9 million of unrecorded expenses it had incurred as a result of mispriced stock option grants. Black Box was required to, but did not, record an expense for options issued at below-market prices ("in the money" options). More than one-half of the unrecorded expenses reported in the Restatements, approximately $38.1 million, stem from backdated options awarded at Young's direction.
The complaint alleges that, as Chief Executive Officer, Young had authority for the granting of stock options at Black Box. On six occasions, from 1998 through 2001, Young intentionally backdated stock option grants totaling millions of shares, to hundreds of recipients, including Black Box's officers, directors, and employees. Young chose dates for these grants from between two weeks to over a year prior to the actual dates such grants were awarded. By doing so, the options were "in-the-money" in amounts ranging from $3.19 to $43.86 per share on the dates they were actually granted (or 13% to 58% lower than the market price on the actual grant date).
The complaint further alleges that, in or about December 2000, Baird, then Black Box's Chief Financial Officer and a CPA, also participated in granting backdated options to Black Box's officers and employees. Baird personally exercised backdated options for $87,243 in excess profits. The complaint further alleges that Young and Baird engaged in their conduct despite knowing, or having reason to know, that the Company had improperly recorded compensation expenses for the options and violated the terms of its own stock option plans as disclosed in various filings with the Commission.