March 13, 2010
The Short Story on Lehman and Repo 105
What is Repo 105 (from Examiner Report's executive summary, footnotes omitted):
Lehman employed off‐balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008. Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short‐term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction. By recharacterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.
Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet. ...
Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10‐K and 10‐Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet;” felt that “there was no substance to the transactions;” and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public. In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.
The Examiner's Report describes that no U.S. law firm would opine that the accounting treatment for Repo 105 was appropriate. Accordingly, Lehman moved these transactions abroad:
Lehman first introduced its Repo 105 program in approximately 2001. Unable to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo 105 program under the aegis of an opinion letter the Linklaters law firm in London wrote for LBIE, Lehman’s European broker‐dealer in London, under English law. Accordingly, if United States‐based Lehman entities such as LBI and LBSF wished to engage in a Repo 105 transaction, they transferred their securities inventory to LBIE in order for LBIE to conduct the transaction on their behalf.
Lehman increased its reliance on Repo 105 to improve its reported performance:
Lehman dramatically ramped up its use of Repo 105 transactions in late 2007 and early 2008 despite concerns about the practice expressed by Lehman officers and personnel. In an April 2008 e‐mail asking if he was familiar with the use of Repo 105 transactions to reduce net balance sheet, Bart McDade, Lehman’s former Head of Equities (2005–2008) and President and Chief Operating Officer (June–September 2008), replied: “I am very aware . . . it is another drug we r on.” A week earlier, McDade had recommended to Lehman’s Executive Committee that the firm set a cap on the use of Repo 105 transactions. A senior member of Lehman’s Finance Group considered Lehman’s Repo 105 program to be balance sheet “window‐dressing” that was “based on legal technicalities.”* Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.
* Why do lawyers get blamed for accounting technicalities? (editorial comment)
The Examiner concludes that:
a fact finder could find that Lehman’s failure to disclose its use of Repo 105 transactions to impact its balance sheet at a time when both the market and senior Lehman management were keenly focused on the reduction of Lehman’s firm‐wide net leverage and balance sheet, and particularly in light of the specific volumes at which Lehman undertook Repo 105 transactions at quarter‐end in fourth quarter 2007, first quarter 2008, and second quarter 2008, materially misrepresented Lehman’s true financial condition.
Examiner's Report: Colorable Claims Against Lehman Senior Management and Audit Firm
It cost $36 million and a year to produce, so the logical question is what will result from Examiner Anton Valukas' Report (2,200 pages) on the causes of the Lehman Brothers collapse and whether there are colorable claims against individuals and entities relating to the collapse. Jenner & Block posted the complete report on its webite, and I am working my way through parts of it. The bankruptcy judge was right -- it is a fascinating read, better than most journalists' books on business scandals.
Here are some highlights from the introduction and executive summary. I have omitted footnotes, but otherwise the text is verbatim.
From the Introduction:
There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate. Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet
manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome.
On the importance of the repo transactions ("Repo 105"):
Lehman did not disclose, however, that it had been using an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet – by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008. In an ordinary repo, Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehman’s balance sheet. In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet. With Repo 105 transactions, Lehman’s reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have to have been reported at 13.9.
On the nondisclosure of Repo 105:
Lehman did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors. Lehman’s auditors, Ernst & Young, were aware of but did not question Lehman’s use and nondisclosure of the Repo 105 accounting transactions.
From the executive summary on why Lehman failed:
Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. ...
As to whether there are colorable claims. First, the Examiner makes clear that by "colorable claim" he means more than simply an allegation that could survive a motion to dismiss. Instead, because of his extensive investigation, he means by "colorable claim" a higher standard -- sufficient credible evidence exists to support a finding of a trier of fact.
From the executive summary:
The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements – Lehman’s CEO Richard S. Fuld, Jr., and its CFOs Christopher O’Meara, Erin M. Callan and Ian T. Lowitt. There are colorable claims against Lehman’s external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.
Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. Lehman’s own accounting personnel described Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end.” Lehman used Repo 105 “to reduce balance sheet at the quarter‐end.”
Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman’s financial statements and who failed to disclose Lehman’s use and extent of Repo 105 transactions to manage its balance sheet.
And what about the independent auditors, Ernst & Young? Again from the executive summary:
In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end. The next day ‐ on June 13, 2008 ‐ Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee’s assertions, despite an express direction from the Committee to advise on all allegations raised by Lee. Ernst &
Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions. Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee’s allegations and in connection with its audit and review of Lehman’s financial statements.
The Examiner has done his job. Will the regulators and prosecutors do theirs?
March 11, 2010
Bankruptcy Examiner Reveals Accounting Tricks at Lehman
The examiner appointed by the bankruptcy court to examine the September 2008 collapse of Lehman Brothers reveals, in a 2,200 page report, new information about how Lehman used accounting tricks in efforts to conceal its deteriorating financial condition. For details and the report, see:
Wall St. J, Examiner: Lehman Torpedoed Lehman
Dodd Says Senate Bill on Monday
Today Senate Banking Committee Chairman Chris Dodd (D-CT) issued the following statement on financial reform.
“On Monday, I will present to my colleagues a substitute to the original financial reform package, unveiled last November.”
“Over the last few months, Banking Committee members have worked together to try and produce a consensus package. Together we have made significant progress and resolved a many of the items, but a few outstanding issues remain.”
“It has always been my goal to produce a consensus package. And we have reached a point where bringing the bill to the full committee is the best course of action to achieve that end. I plan to hold a full committee markup the week of March 22nd.”
“I have been fortunate to have a strong partner in Senator Corker, and my new proposal will reflect his input and the good work done by many of our colleagues as well.”
“Our talks will continue, and it is still our hope to come to agreement on a strong bill all of the Senate can be proud to support very soon.”
March 10, 2010
Connecticut AG Sues Moody's and S&P, Alleging Tainted Credit Ratings for Risky Investments
Connecticut Attorney General Richard Blumenthal today sued Moody’s and Standard & Poor’s, alleging that they knowingly assigned tainted credit ratings to risky investments backed by sub-prime loans. The lawsuits are sovereign enforcement actions brought under the Connecticut Unfair Trade Practices Act.
According to the press release, Moody’s and S&P’s lack of independence and objectivity, violating the Connecticut Unfair Trade Practices Act, manifested itself in several ways, including:
Moody’s and S&P modified rating methodologies to make more money: In short, in direct contrast to their public representations, and unbeknownst to investors and other market participants, Moody’s and S&P’s rating methodologies were directly influenced by a desire to please their clients and enhance their own revenue. Assessing actual credit risk was of secondary importance to revenue goals and winning new business.
Ratings shopping: Issuers unhappy with a credit rating agency’s initial analysis can attempt to influence the process by informing the rating agency of a more desirable rating that one of its competitors is willing to assign. As a result, the rating agency knows that it must meet its competitor’s rating or forgo the revenue altogether. Both Moody’s and S&P knuckled under to this pressure and allowed it to influence the ratings they assigned to structured finance securities.
Despite public representations of vigilant monitoring of conflicts of interest inherent to the Issuer Pays business model, Moody’s marginalized its own compliance departments and even punished employees who raised concerns about its lack of independence and objectivity. In some cases, compliance employees were given poor performance evaluations, less compensation and even demoted for interfering with Moody’s ability to please the large issuers of structured finance securities that paid the majority of Moody’s fees.
The Attorney General previously brought litigation against all three credit rating agencies -- Moody’s, S&P and Fitch -- that was filed in July 2008. The earlier lawsuits allege that the agencies knowingly gave state, municipal and other public entities lower credit ratings as compared to other forms of debt with similar or even worse rates of default. Those cases remain pending.
SEC Charges Broker with Diverting $3.3 Million of Customer's Funds to Another Customer
The SEC today charged Jose O. Vianna, Jr., a former registered representative at a New York based broker-dealer named Maxim Group LLC ("Maxim"), with a fraudulent scheme to divert millions of dollars in trading profits from a large institutional customer of the broker to another of the broker's customers. The complaint alleges that Vianna diverted profitable trades from the account of a large Spanish bank, referred to in the Complaint as Customer A, to the account of Creswell Equities, Inc. ("Creswell"), a British Virgin Islands company. The Commission's complaint alleges that over $3.3 million in trading profits were diverted from Customer A to Creswell.
The complaint alleges that 57 times between July 2007 and March 2008, Vianna simultaneously entered orders in the accounts of Customer A and Creswell to trade the same amounts of the same stock. Each time, he placed a buy order in one customer's account and a sell order in the other customer's account. When the market moved to make Customer A's trade profitable and Creswell's trade unprofitable, Vianna improperly misused his access to Maxim's order management system to divert Customer A's profitable trade to Creswell and Creswell's unprofitable trade to Customer A by changing Maxim's records to inaccurately reflect the account for which the orders were entered. However, when the market moved so that Creswell's trade was profitable and Customer A's unprofitable, Vianna let the trades remain as originally entered.
The Commission seeks permanent injunctive relief from Vianna, as well as disgorgement of ill-gotten gains plus prejudgment interest, and civil money penalties. The Commission's complaint also charges Creswell as a relief defendant, and seeks disgorgement of Creswell's illicit profits, plus prejudgment interest. On March 9, 2010, the Court entered an order temporarily freezing Creswell's assets pending a hearing on the Commission's application to freeze Creswell's assets for the duration of the action.
Former HBOC GC Settles Accounting Fraud Charges at McKesson HBOC
The SEC settled charges against Jay Lapine, the former GC of HBO & Company, a vendor of health care technology that merged with McKesson in 1999. Lapine was charged in a previously-filed action with securities fraud in connection with a financial reporting fraud at McKesson HBOC, Inc. (now, McKesson Corporation), a Fortune 100 company headquartered in San Francisco, California. Lapine consented to the entry of judgment without admitting or denying the allegations of the Commission's complaint except as to jurisdiction.
The Complaint, filed September 27, 2001, alleged that Lapine, together with other senior executives, participated in a long-running fraudulent scheme to inflate the revenue and net income of HBOC. As part of this scheme, Lapine took part in negotiating two large backdated transactions with side agreements containing cancellation contingencies that enabled the companies to recognize revenue in earlier reporting periods. Both of these practices failed to comply with Generally Accepted Accounting Principles. The fraud enabled HBOC and McKesson HBOC to report falsely in press releases and in periodic reports HBOC filed with the Commission that the companies were having an unbroken run of financial success and had continually exceeded analysts' expectations. However, when McKesson HBOC announced in April 1999 that the company was conducting an internal investigation into financial reporting irregularities, its shares tumbled from approximately $65 to $34, a drop that slashed its market value by more than $9 billion. The Commission also alleged that Lapine failed in his gatekeeper role during the multi-year long scheme.
The final judgment against Lapine permanently enjoins him from violating federal securities law, bars him from acting as an officer or director of a public company for a period of five years, and orders him to pay a civil penalty of $60,000. Lapine was acquitted on November 19, 2009 of criminal charges related to the fraud at HBOC and McKesson HBOC.
SEC Obtains Emergency Relief Against Ponzi Scheme Pitching Phony "Turkish Eurobonds"
On March 9, 2010, the SEC obtained an emergency court order to shut down a Ponzi scheme targeting retirees in California and Illinois by inviting them to estate planning seminars and later coaxing them to buy promissory notes for purported Turkish investments. According to the SEC's complaint, USA Retirement Management Services ("USARMS") and managing partners Francois E. Durmaz and Robert C. Pribilski mass-mailed promotional materials to prospective investors and invited them to estate planning seminars held at country clubs and banquet halls. They gained retirees' confidence in follow-up meetings and portrayed themselves as educated and experienced in foreign investments specifically tailored to the needs of seniors. Durmaz and Pribilski then pitched what they represented as safe, guaranteed investments in "Turkish Eurobonds" through the purchase of USARMS promissory notes that would earn annual returns between 8 and 11 percent.
The SEC alleges that USARMS raised at least $20 million from more than 120 investors, but did not actually invest the money in Turkish Eurobonds as promised. Instead, returns were paid to earlier investors with funds received from new investors in Ponzi-like fashion. Durmaz and Pribilski further misused investor funds to finance their other businesses and purchase such things as luxury automobiles, homes, vacations, and web-based pornography. They also wired investor money into bank accounts belonging to individuals living in Turkey who are named as relief defendants in the SEC's case.
The U.S. District Court for the Central District of California granted the SEC's request for emergency relief for investors, including an order temporarily enjoining defendants from future violations of the antifraud provisions and freezing their assets.
Former Chief Investment Officer of New York Pension Fund Pleads Guilty to Corruption Charges
New York Attorney General Andrew M. Cuomo today announced that David Loglisci, the former Chief Investment Officer at the Office of the New York State Comptroller (OSC), who was indicted last year along with co-defendant Henry “Hank” Morris, pled guilty to a Martin Act felony for his role in the corruption of the New York State Common Retirement Fund (CRF) and will cooperate in the ongoing investigation. Today’s plea is part of a more than two-year ongoing investigation into corruption involving the Office of the State Comptroller and the Common Retirement Fund. The charges to date allege a complex criminal scheme involving numerous individuals operating at the highest political and governmental levels under former Comptroller Alan Hevesi, in which the State pension fund was used as a piggy bank for the Comptroller’s chief political aide and a favor bank for political allies and other friends.
The State pension fund is the biggest pool of money in the state and the third largest pension fund in the country, most recently valued at approximately $129 billion. At the time of the events charged, it was valued at approximately $150 billion. The New York State Comptroller is the sole trustee of the fund, responsible for managing and investing the pension fund solely in the best interests of the over one million current and former public employees and their families.
FINRA CEO Speaks on Reforms in Fixed Income Markets
Rick Ketchum, Chairman and CEO, FINRA, spoke at the FINRA Fixed Income Conference on March 9, 2010. Here is an excerpt from his conclusion:
We as regulators must keep pace with the changes in fixed income markets—recognizing the differences across fixed income markets, and respecting those differences, while ensuring investor protection and market integrity. FINRA is committed to meeting these objectives as we move forward with our ambitious agenda for the fixed income markets, focused on transparency. And we will work to ensure these objectives are adhered to as we continue our cooperation with the Administration, Congress, U.S regulatory agencies, and our counterparts in other countries.
But we should keep in mind that new regulations can only achieve so much. For the reforms to trigger lasting market improvements, it is just as important for fixed income leaders to communicate to their industry colleagues that change is underway, and that there is a duty to comply with both the letter of the reforms, as well as the spirit underpinning them. I am hopeful that the industry will embrace the work regulators are doing to shape the future of the fixed income markets, because I believe it will lead to more robust markets. The lesson for both sides is: where there is doubt, err on the side of investors.
March 9, 2010
SIPC Warns About Bogus Website Aimed at Madoff Victims
The Securities Investor Protection Corporation (SIPC), which maintains a special reserve fund mandated by Congress to protect the customers of insolvent brokerage firms, said today that it is alerting international regulators about a "look-alike" Web site for a fictitious organization that is mimicking the SIPC Web site in an apparent attempt to target Madoff victims.
The so-called "International Securities Investor Protection Corporation (I-SIPC.com)" copies several aspects of the SIPC Web site artwork and structural design. It is soliciting Madoff victims to submit claims, which SIPC is warning could result in "phishing" or other identify theft problems. The phony group claims to be based in Geneva and also maintains that it has ties to the United Nations and the International Monetary Fund, among others.
In one section of the Web site, the group includes a supposed testimonial from a Madoff victim who is reported as having received funds from the organization. In a link from the homepage of the site that leads to a photo of a huge stack of U.S. currency, the group falsely claims to have collaborated with Interpol to recover $1.3 billion in Madoff money from a hideout in Malaysia.
SEC Brings Reg FD Charges Against Presstek and Former CEO
The SEC brought Regulation FD charges against Presstek, Inc. ("Presstek"), a Greenwich, Connecticut based manufacturer and distributor of high-technology digital imaging equipment, and its former chief executive officer, Edward J. Marino, of Boston, Massachusetts.
The Commission's complaint alleges that on September 28, 2006, while acting on behalf of Presstek, Marino selectively disclosed material non-public information regarding Presstek's financial performance during the third quarter of 2006 to a managing partner of a registered investment adviser. In addition, the complaint alleges that within minutes of receiving the information from Marino, the partner decided to sell all of the shares of Presstek stock managed by the investment adviser. The complaint also alleges that Presstek did not simultaneously disclose to the public the information provided by Marino to the partner.
Presstek has agreed to settle the Commission's charges, without admitting or denying the allegations in the complaint, by consenting to an order that enjoins Presstek from further violations of Regulation FD and Section 13(a) of the Exchange Act and directs it to pay a $400,000 civil penalty. The Commission took into account certain remedial measures taken by Presstek, including revising its corporate communications policies and corporate governance principles, replacing its management team and appointing new independent board members, and creating a whistleblower's hotline.
In the ongoing civil action against Marino, the Commission is seeking injunctive relief and the imposition of civil penalties.
SEC Charges Former Stock Loan Trader in Cash Kickback Scheme
The SEC filed charges against a former securities lending, or "stock loan," trader for participating in a long-running cash kickback scheme involving stock loan transactions at several major Wall Street brokerage firms. The Commission's complaint alleges that from March 2004 through December 2005, Salvatore Zangari ("Zangari"), a former stock loan trader at Morgan Stanley & Co., Inc. ("Morgan Stanley") and Banc of America Securities, LLC ("Banc of America"), received over $100,000 in cash kickbacks from a Brooklyn, New York stock loan finder in exchange for sending stock loan orders to brokerage firms that paid the finder for purportedly locating the stocks.
Zangari is charged with violating Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and, in the alternative, with aiding and abetting others' violations of certain of these provisions. The Commission's complaint seeks permanent injunctive relief, disgorgement with prejudgment interest, and civil penalties against Zangari. The Commission's investigation is ongoing.
CFTC Chairman Speaks out on Regulating OTC Derivatives
Two speeches today by CFTC Chairman Garny Gensler. First, delivering the Keynote Address on OTC Derivatives Reform, Markit’s Outlook for OTC Derivatives Markets Conference, he advocates:
We need broad regulatory reform of over-the-counter derivatives to best lower risk and promote transparency in the marketplace. While similar to other derivatives, credit default swaps have unique features that require additional consideration. Only with comprehensive reform can we be sure to fully protect the American public.
He also presented testimony before the Senate Committee on Energy and Natural Resources regarding the regulation of over-the-counter (OTC) derivatives, particularly with respect to energy markets.
March 8, 2010
Florida Jury Finds Canadian Citizen Liable for Pump-and-Dump Scheme
Following a five-day trial in U.S. District Court in Tampa, Florida, a jury found Darko S. Mrakuzic liable for violating the anti-fraud and registration provisions of the federal securities laws in connection with a scheme to illegally convert several million illegally issued shares of a small, Florida corporation into purportedly unrestricted shares that netted Mrakuzic more than $6 million in profits. The judge will determine remedies and sanctions at a later date.
Mrakuzic was the only one of the seven defendants whom the Commission sued in May 2008 to take the case to trial. The Commission's evidence at trial showed Mrakuzic and the other defendants engaged in a complex scheme from June through August 2005 to create and sell shares of Global Development and Environmental Resources Inc., a purported environmental remediation company that was based in Las Vegas, Nevada. The scheme involved creating a promissory note convertible into Global Development shares that were fraudulently backdated to avoid the holding requirements for restricted stock under Rule 144. The defendants then arranged a forged assignment of the note to three foreign entities, one of which was under Mrakuzic's control and two others where he secretly owned brokerage accounts. The third step in the scheme was to convert the note into unrestricted shares. The last step involved the defendants promoting the stock by arranging for Global to issue press releases that contained false and misleading information relating to the company's purported clients, pending contracts and revenue projections. The resulting inflated market allowed Mrakuzic to sell the shares through the foreign entities for profits in excess of $6 million.
The other defendants, Global Development, Carmine J. Bua, Anthony M. Cimini Sr., Philip Prichard, Pietro Cimino, and Dante M. Panella, all previously settled the Commission's anti-fraud and securities registration charges against them by consenting, without admitting or denying the Commission's allegations, to permanent injunctions. All the individuals consented to penny stock bars, and Cimini, Pritchard, and Cimino consented to officer-and-director bars. The Court previously ordered disgorgement and civil penalties against Bua and Panella, with monetary orders still to be decided against the others.
March 7, 2010
Okamoto & Edwards on Risk-Taking
Risk-Taking, by Karl S. Okamoto, Drexel University - Earle Mack School of Law, and Douglas O. Edwards, University of Colorado Law School, was recently posted on SSRN. Here is the abstract:
“First, kill all the bankers.”
With this phrase, the Wall Street Journal recently captured the sentiment driving the movement to regulate bankers’ pay. While we agree that financial industry executives made poor decisions, we take issue with the recent suggestion that, to prevent the excessive risk-taking that led to the recent financial crisis, we must only correct certain “perverse” compensation-related incentives. This logic, unfortunately, underpins a worldwide call to reform executive compensation in the finance industry. The precise prescriptions differ, but a common view has prevailed - if we can dampen the incentives to take risk, we can achieve greater financial stability.
We agree that prudent risk-taking is a necessary component of financial stability, but we reject, on two levels, the prevailing view’s myopic focus on compensation.On one level, we argue that compensation-related reforms simply miss their mark. In what we term the functional critique, even if excessive risk-taking is an appropriate regulatory target, we show that the proposed compensation-related reforms fail to speak to excessive risk-taking. Indeed, we find that attempts to de-leverage executive compensation may actually exacerbate risk-taking. Beyond this, however, we have an even greater concern. In what we term the completeness critique, we note that any regulatory attempt to curb excessive risk-taking would need to offer an account of optimal risk-taking. Without defining when risk-taking becomes excessive, schemes to prevent executives from taking “too much” risk remain fatally incoherent. Because the science for such a determination does not exist, proponents of this approach can only hope that government will get right what industry has failed to achieve.
Rather than paint risk-taking as an evil to be avoided, we advocate a regulatory response that is aimed at a particular failure in the private construction of incentives. We provide a description of the risk-taking process that depicts investment decisions as a hypothetical conversation between risk-seekers and risk-managers. Our purpose is to isolate when regulators can expect that conversation to produce imprudent risk-taking and how they can act to correct that failure. In doing so, we ask regulators to do what regulators can do well - facilitate the establishment of industry standards, examine past incidences of loss, and assess compliance with established standards of conduct. We find this approach superior to those that require government to micro-manage bankers’ pay.
Olazabal on False Forward-Looking Statements
False Forward-Looking Statements and the PSLRA's Safe Harbor, by Ann Morales Olazábal, University of Miami School of Business, Business Law Department, was recently posted on SSRN. Here is the abstract:
Voluntary public disclosure of soft information -- corporate projections and predictions and other forward-looking statements -- is now the norm, following a brief learning curve after the enactment of the PSLRA’s safe harbor for forward looking information in 1995. As a consequence, allegations of false forward-looking statements are also quite standard in today’s class action securities fraud pleading. This work addresses an emerging trend, spearheaded by a Seventh Circuit’s decision in Ashe v. Baxter Int’l, to improperly inject a subjective scienter or intent-like inquiry into consideration of the application of the PSRLA’s safe harbor. Numerous district courts have followed Asher’s lead, employing a variety of semantic maneuvers to circumvent the safe harbor’s straightforward, occasionally distasteful application. Bolstered by a 2009 opinion from the Fifth Circuit, this theoretical disagreement is destined for a circuit split. This manuscript provides a definitive analysis of the Asher-inspired jurisprudential detour, concluding that it is supported neither by the statute and its legislative history, nor any sound policy argument. With this premise established, the article then prescribes intellectually grounded ameliorating measures that can be taken by courts, which face increasingly imaginative and often appealing arguments for avoiding the prophylactic nature of the statutory safe harbor.
Erickson on Shareholder Derivative Suits in Federal Courts
Corporate Governance in the Courtroom: An Empirical Analysis, by Jessica Erickson, University of Richmond School of Law, was recently posted on SSRN. Here is the abstract:
Conventional wisdom is that shareholder derivative suits are dead. Yet this death knell is decidedly premature. The current conception of shareholder derivative suits is based on an empirical record limited to suits filed in Delaware or on behalf of Delaware corporations, leaving suits outside this sphere in the shadows of corporate law scholarship. This Article aims to fill this gap by presenting the first empirical examination of shareholder derivative suits in the federal courts. Using an original, hand-collected data set, my study reveals that shareholder derivative suits are far from dead. Shareholders file more shareholder derivative suits than securities class actions, the area of corporate litigation that has received nearly all of the scholarly attention. By writing off shareholder derivative suits, scholars have missed the distinct role that these suits play in corporate law, particularly in the area of corporate governance. Unlike traditional litigation, remarkably few of the suits in my study ended with monetary payments. Instead, these suits more commonly ended with corporations agreeing to reform their own corporate governance practices, from the number of independent directors on their boards to the method by which they compensate their top executives. These settlements reflect the rise of a new type of shareholder activism, one that has gone undocumented in the legal literature. Corporate governance has moved into the courtroom, and this development has important, and potentially troubling, implications for corporate law.
Heminway on Securities Regulation Scholarship in the Global Financial Crisis
The Best of Times, the Worst of Times: Securities Regulation Scholarship and Teaching in the Global Financial Crisis, by Joan MacLeod Heminway, University of Tennessee College of Law, was recently posted on SSRN. Here is the abstract:
This short piece is an annotated version of remarks that I gave to introduce a roundtable discussion on securities regulation scholarship at the University of Maryland School of Law program on “Corporate Governance and Securities Law Responses to the Financial Crisis” held on April 17, 2009. The piece represents my current thoughts about what it is like to teach, research, and write in the area of securities regulation. Ultimately, the message I deliver is a positive one; there is much opportunity for securities regulation teachers and scholars in an environment like the one we have been wrestling with since at least the fall of 2008. The text is quite short, but I have offered many citations in support of my ideas in the hope that they may be helpful to those exploring aspects of the areas I cover.