Saturday, August 28, 2010
Federal Misgovernance of Mutual Funds, by Larry E. Ribstein, University of Illinois College of Law, was recently posted on SSRN. Here is the abstract:
In Jones v. Harris Associates, the Supreme Court interpreted investment advisers’ fiduciary duty regarding compensation for services under Section 36(b) of the Investment Company Act of 1940. The Court endorsed an open-ended Second Circuit standard over a more determinate Seventh Circuit test calling only for full disclosure and no “tricks.” This paper shows that Congress created and must solve the fundamental problem the Court faced in Jones. At one level the problem stems from the existence of an investment adviser fiduciary duty as to compensation and the corporate structure from which it springs. At a deeper level lies the more basic problem of federal interference in firm governance, which lacks state corporate law’s safety valve of interstate competition and experimentation. This discussion is appropriate in light of the increasing federal role evident in the enactment of broad new financial regulation.
The Financial Reform Act: Will it Succeed in Reversing the Causes of the Subprime Crisis and Prevent Future Crises?, by Charles W. Murdock, Loyola University Chicago School of Law; Loyola University of Chicago, was recently posted on SSRN. Here is the abstract:
The current financial crisis, which could have plunged the world into a financial abyss similar to the Great Depression, is far from resolved. The financial institutions, which this article asserts caused the crisis, have returned to profitability and have paid billions of dollars in bonuses, while ordinary Americans have borne the brunt of the meltdown, with formal unemployment hanging around the 10% mark. This has caused some to comment that profits have been privatized and risk has been socialized. Two years after the economic meltdown, the impact continues as local governments turn off streetlights, cut back on police and fire departments, close down transit systems, return paved roads to gravel, and put schools on a four-day week.
Democrats in the House and Senate finally agreed on a financial regulation bill. Opposition to the bill in part was based on the belief that Fannie Mae and Freddie Mac were the cause of the subprime crisis. However, as this article demonstrates, it was the “big banks,” by funding the subprime lenders, buying their mortgages and securitizing them, slicing them to form CDOs and synthetic CDOs through derivatives, and leaning on the credit rating agencies to get AAA ratings for junk, there were the primary cause of the financial crisis.
Parts I and II are fairly dry: they deal with data. But, in a financial crisis, numbers are important. Part I deals with the incredible increase in assets under investment, which created the demand for the toxic mortgages, while Part II analyzes the changing characteristics of the subprime mortgages and their dramatic increase in volume and riskiness, a fact that was not recognized by the financial professionals.
In Part III, the roles of the borrowers, the mortgage brokers, the mortgage lenders, Fannie Mae and the investment banks, the credit rating agencies, and derivatives are explored, together with the incentives that drove each participant. The various titles of the Financial Reform Act are analyzed from the standpoint of the impact they will have on the foregoing players in order to prevent future crises.
The Conclusion asserts that the Financial Reform Act should prevent a future financial crisis that mirrors the past crisis. However, it does not adequately deal with the underlying issue that drives any financial crisis: management incentives that lead to excessive risk-taking. Nor does it deal with the ever increasing aggregation of financial power in large financial institutions.
Credit Default Swap Spreads as Viable Substitutes for Credit Ratings, by Frank Partnoy, University of San Diego School of Law, was recently posted on SSRN. Here is the abstract:
We evaluate the viability of credit default swaps (CDS) spreads as substitutes for credit ratings. We focus on CDS spreads based on the obligations of financial institutions, particularly fifteen large financial institutions that were prominently involved in the recent financial crisis. Our data, from 2006-09, show that CDS spreads incorporate new information about as quickly as equity prices, and significantly more quickly than credit ratings. Although CDS spreads did not identify accumulating risk exposures before 2007, they quickly reflected disclosures and developments beginning in summer 2007 at the latest. Thus, CDS spreads are a promising market-based tool for regulatory and private purposes, and they may serve as a viable substitute for credit ratings.
Friday, August 27, 2010
The Ongoing Milberg Weiss Controversy, by Lonny Sheinkopf Hoffman, University of Houston Law Center, and Alan F. Steinberg, Department Political Science, was recently posted on SSRN. Here is the abstract:
In this paper we revisit the ongoing controversy surrounding the Milberg Weiss prosecution. Our paper responds to an important, recent empirical study by Michael A. Perino that claims to have found evidence to support the government’s assertion (made without evidentiary support) that class members were in fact injured by the payments Milberg made to the named representatives. Notwithstanding the carefully constructed and rigorous study Perino has authored, we argue that the evidentiary proof of harm he claims to have found simply cannot withstand scrutiny. We raise several methodological critiques of the study. Although we did not have access to Perino’s full data, we were able to replicate some of it by using the same database of securities class action settlements on which he primarily relied. The replication data results validate some of our hypotheses. Most critically, the replication data strongly suggests that the reason why fees may have been higher in the indictment cases is that the almost all were filed before the Reform Act went into effect. By contrast, the vast majority of cases in the replication sample of Perino’s non-indictment cases were filed in a later period when fees have been lower. Additionally, the replication data we report is not consistent with some of the descriptive statistical findings Perino presents. Specifically, we find no difference either in mean or median fee awards between cases in which the government alleged Milberg paid a kickback and all other cases. Beyond the study’s methodological difficulties, we also show that there are equally substantial reasons to be concerned about the inferential conclusions Perino draws from the data. The big take away that Perino offers at the end of his study—that the evidence contradicts the claim that kickbacks paid to the named plaintiffs were a “victimless crime”—is not supported by the data he has collected and reported. Far from demonstrating that kickbacks allowed Milberg to obtain higher fees, his study fails to rule out the possibility that other, entirely benign reasons could explain the higher fees Milberg received, including that the fees were earned by the results obtained in settlements of the indictment cases.
Thursday, August 26, 2010
Since July 2010, FINRA arbitrators have ordered brokerage units of Raymond James Financial to buy back from customers auction rate securities (ARSs) totalling $3.5 million (3 separate proceedings). By way of contrast, ARS purchasers have not generally been successful in judicial proceedings. See, e.g., Defer LP v. Raymond James Financial, Inc.,654 F. Supp.2d 204 (S.D.N.Y. 2009).
Unlike many other firms, thus far securities regulators have not brought enforcement actions against Raymond James. When the market for ARSs froze in February 2008, Raymond James customers held $1.9 billion in ARSs; today that amount has been reduced to about $600 million, according to a Raymond James spokesperson. InvNews, Raymond James pays more auction rate claims.
Wednesday, August 25, 2010
Here is the SEC's Announcement about the new Directors' Nominations Rules (Proxy Access) that includes a Fact Sheet with a basic description of new rules (for those who don't have time to read the 400 page release):
The new rules require companies to include the nominees of significant, long-term shareholders in their proxy materials, alongside the nominees of management. This "proxy access" is designed to facilitate the ability of shareholders to exercise their traditional rights under state law to nominate and elect members to company boards of directors.
Under the rules, shareholders will be eligible to have their nominees included in the proxy materials if they own at least 3 percent of the company's shares continuously for at least the prior three years.
Under the new rules:
Shareholders who otherwise are provided the opportunity to nominate directors at a shareholder meeting under applicable state or foreign law would be able to have their nominees included in the company proxy materials sent to all shareholders.
Shareholders also have the ability to use the shareholder proposal process to establish procedures for the inclusion of shareholder director nominations in company proxy materials.
Application of the new access rules to the smallest public companies — those that are defined as "smaller reporting companies" under SEC rules — will be deferred for three years.
Generally, the new rules will become effective 60 days after their publication in the Federal Register.
FINRA fined Zions Direct, Inc. $225,000 for failing to disclose the potential conflict of interest created by the participation of its affiliate, Liquid Asset Management (LAM), in online CD auctions conducted by Zions involving certificates of deposit (CDs) issued by Zions-affiliated banks. Zions Direct, based in Salt Lake City, began auctioning CDs through its website in February 2007. Prior to November 2008, the firm failed to disclose LAM's participation in the auctions to retail investors bidding in the auctions. FINRA found that the closing yields in some auctions may have been higher had LAM not participated.
Beginning in November 2008, Zions Direct generally disclosed LAM's participation in the auctions, yet still failed to disclose the potential conflict of interest between the issuing banks affiliated with Zions and its customers who participated in the auctions.
FINRA also found that Zions Direct sent its current and prospective customers advertisements related to its CD auctions which contained misleading, unwarranted, and exaggerated statements and claims, and claims for which no reasonable basis had been provided. For example, some of the firm's communications contained the following statements:
"Where else can you bid with the big boys and win?"
"Crush The National Average For CD Yields."
"Higher yields on CDs."
In concluding this settlement, Zions Direct neither admitted nor denied the charges, but consented to the entry of FINRA's findings.
Just as night follows day, so the announcement of a big tender offer is followed by allegations of insider trading. The SEC charged two residents of Madrid, Spain with insider trading and obtained an emergency court order to freeze their assets after they allegedly made nearly $1.1 million in illegal profits by trading in advance of last week's public announcement of a multi-billion dollar cash tender offer by BHP Billiton Plc to acquire Potash Corp. of Saskatchewan Inc.
The SEC alleges that Juan Jose Fernandez Garcia and Luis Martin Caro Sanchez purchased — on the basis of material, non-public information about the impending tender offer — hundreds of "out-of-the-money" call option contracts for stock in Potash in the days leading up to the public announcement of BHP's bid on August 17. Garcia is the head of a research arm at Banco Santander, S.A. — a Spanish banking group advising BHP on its bid. Garcia and Sanchez jointly spent a little more than $61,000 to purchase the contracts in U.S. brokerage accounts. Immediately after BHP's offer was announced publicly on August 17, Garcia and Sanchez sold all of their options for illicit profits of nearly $1.1 million.
According to the SEC's complaint filed Friday in U.S. District Court for the Northern District of Illinois and unsealed by the court today, BHP made an unsolicited $38.6 billion offer to purchase all of the stock of Potash for $130 per share in cash. The acquisition share price represented a 16 percent premium above Potash's closing price of $112.15 on August 16. Potash, based in Saskatoon, Canada, is the world's largest producer of fertilizer minerals and its stock trades on the New York Stock Exchange. BHP, based in Melbourne, Australia, is the world's largest mining company.
The SEC alleges that Garcia was in possession of material, nonpublic information regarding BHP's offer to acquire Potash while he purchased approximately 282 call option contracts for Potash stock from August 12 to 16. The majority of the contracts were set to expire on August 21, and all but six of the call option contracts purchased by Garcia were out-of-the-money. Sanchez, while in possession of material, nonpublic information regarding BHP's offer to acquire Potash, purchased approximately 331 out-of-the-money call option contracts for Potash stock on August 12 and 13. He purchased the contracts in an account at Interactive Brokers LLC — the same U.S. brokerage firm through which Garcia traded his Potash call option contracts. Sanchez's contracts were set to expire within weeks of the purchase date. Neither individual had previously traded this year in Potash securities through his account at Interactive Brokers.
The emergency court order obtained late Friday by the SEC on an ex parte basis and unsealed by the court today freezes approximately $1.1 million in assets and, among other things, grants expedited discovery and prohibits Garcia and Sanchez from destroying evidence.
The SEC released today the much-anticipated final rules on proxy access and directors' nominations. I set forth below the release's introduction; I will analyze the new rules in a subsequent post.
We are adopting changes to the federal proxy rules to facilitate the effective exercise of shareholders’ traditional state law rights to nominate and elect directors to company boards of directors. The new rules will require, under certain circumstances, a company’s proxy materials to provide shareholders with information about, and the ability to vote for, a shareholder’s, or group of shareholders’, nominees for director. We believe that these rules will benefit shareholders by improving corporate suffrage, the disclosure provided in connection with corporate proxy solicitations, and communication between shareholders in the proxy process. The new rules apply only where, among other things, relevant state or foreign law does not prohibit shareholders from nominating directors. The new rules will require that specified disclosures be made concerning nominating shareholders or groups and their nominees. In addition, the new rules provide that companies must include in their proxy materials, under certain circumstances, shareholder proposals that seek to establish a procedure in the company’s governing documents for the inclusion of one or more shareholder director nominees in the company’s proxy materials. We also are adopting related changes to certain of our other rules and regulations, including the existing solicitation exemptions from our proxy rules and the beneficial ownership reporting requirements.
Tuesday, August 24, 2010
Monday, August 23, 2010
The Seventh Circuit, in an opinion authored by Judge Esterbrook, recently reaffirmed the fraud-on-the-market theory of reliance and disapproved of the Fifth Circuit's Oscar Private Equity opinion that held that proof of loss causation is essential at the class certification stage, Schleicher v. Wendt (Aug. 20, 2010) (Download SchleigervWendt). Stating that Oscar Private Equity would make class certification "impossible in many securities statutes," it rejected the Fifth Circuit's view that Basic "license[d] each court of appeals to set up its own criteria for certification of securities class actions or to 'tighten' Rule 23's requirements."
In this case, plaintiffs were both long and short sellers of Conseco common stock, a large corporation whose stock was actively traded on the NYSE; a financial expert had concluded that the market for Conseco's stock was efficient. Conseco's stock price was falling during the class period, and plaintiffs alleged that defendants made unduly optimistic statements to conceal the extent of its losses, until the company filed for bankruptcy. Defendants argued that before class certification the district judge must determine that the contested statements actually caused material changes in stock prices. In rejecting this, the Seventh Circuit refused to draw any distinctions between material misstatements that caused the stock price to rise and material misstatements that retarded the fall of the stock price and deemed defendants' invocation of "materialization-of-risk" irrelevant to the analysis. In addition, it deemed irrelevant the fact that the proposed class included short sellers, because both long and short sellers are affected by news that influences the stock prices for their transactions. Finally, the court reaffirmed the principle that under Rule 23, class certification is largely independent of the merits.
The Eighth Circuit recently held, in Lustgraf v. Behrens (Aug. 20, 2010)(Download LustgrafvBehrens), that investors stated controlling person claims under federal and state securities laws against a broker-dealer firm whose registered representative allegedly perpetrated a Ponzi scheme and misappropriated their investments. The court, however, found that the investors did not state controlling person claims against the insurance company that was the parent corporation of the brokerage firm.
In reversing the district court's dismissal of investors' controlling person claims against the brokerage firm, the court first discussed controlling person liability under Securities Exchange Act section 20(a) and reaffirmed its three-part test from previous caselaw. To hold a controlling person liable, plaintiff must prove that (1) a primary violator violated the federal securities laws, (2) the alleged controlling person actually exercised control over the general operations of the primary violator, and (3) the alleged control person possessed -- but did not necessarily exercise -- the power to determine the specific acts upon which the underlying violation was predicated. The court rejected the brokerage firm's argument that it could not be liable because the fraudulent transactions took place through another unaffilated firm and followed its precedent that "the involvement of a separate brokerage firm does not render inadequate an otherwise properly pleaded prima facie case for federal control person liability." Although the RR's fraud did not take place through defendant brokerage firm, it was the firm that effectively provided the RR access to the market and that had the duty to monitor the RR's activities. Questions of good faith and lack of knowledge, while potentially viable arguments at the summary judgment stage, are not relevant at the MTD stage. Finally, the Eighth Circuit rejected the argument that culpable participation by a defendant is required to establish control person liability.
In contrast, the Eighth Circuit held that investors did not state control person claims against the insurance company parent of the brokerage firm because they failed to allege that the company actually exercised control over the RR's general operations. The court stated that although it engaged in certain presumptions with respect to broker-dealers, it generally requires that a plaintiff allege facts demonstrating that the alleged control person "actually exercised" control over the primary violator's general operations. Allegations that (1) the brokerage firm and the insurance company operated from the same location, (2) many of the brokerage firm's RRs were also agents of the insurance company, and (3) the two companies shared directors and employees were insufficient to show actual control.
The Eighth Circuit also held that investors stated control person claims against the brokerage firm under Nebraska, Iowa, and Arizona securities laws, holding that the statutes did not require a plaintiff to allege material aid in order to state a control person claim against a broker-dealer. Rather, proof of direct or indirect control of the primary violator was sufficient. It also held that investors stated a claim against the broker-dealer firm (but not the insurance company) based on respondeat superior, but failed to state a claim based on apparent authority.
Sunday, August 22, 2010
The Pricing of Shares in Equity Markets with Securities Class Action Lawsuits, by Judson A. Caskey, University of California at Los Angeles - Anderson School of Management, was recently posted on SSRN. Here is the abstract:
This study develops an analytical model of a securities market in which investors can engage in securities class action lawsuits following a firm’s release of unfavorable news. Because all investors in the model have rational expectations, the model takes into account the fact that the buyers of the firm’s shares anticipate litigation, which reduces the price they are willing to pay and amplifies the price reaction to bad news. I derive the equilibrium prices in this model and apply it to the issues of manipulations of financial reports by the firm’s managers, litigation insurance and links between firm-specific information and cost of capital.
Trust and the Investment Adviser Industry: Congress’ Failure to Realize Finra’s Potential to Restore Investor Confidence, by James T. Koebel, Catholic University of America (CUA) - Columbus School of Law; Council, Baradel, Kosmerl & Nolan, P.A., was recently posted on SSRN. Here is the abstract
Congress’ passage of the Wall Street Reform and Consumer Protection Act was, among other things, supposed to be an effort to reform the financial services regulatory structure, including that of the investment adviser industry.
However, by preserving the SEC’s status as sole regulator of investment advisers, the Act fails to adequately address the importance of investor confidence and instead threatens to preserve the status quo in an industry that has time and again betrayed investors. The SEC’s recent missteps in the midst of the financial crisis necessitate organizational change in the regulation of investment advisers. Just as the SEC was born out of the market crash of 1929, this crisis of confidence calls for a response that actively culls a perception of a trustworthy and accountable infrastructure. By examining the role of trust in economic activity, the critical impact of self-regulatory organizations on investors’ trust in the securities industry becomes apparent: FINRA’s oversight authority must be extended to encompass the investment adviser industry so as to restore trust in the securities regulatory infrastructure, lest investors fail to regain the confidence needed for long-term financial recovery.