Saturday, September 25, 2010
The law of insider trading under Rule 10b-5 is a law professor’s dream; it’s so much fun to come up with clever hypotheticals. For a doctrine that can result in loss of reputation and even criminal penalties, however, it is not a model of clarity and, indeed, presents difficult questions in application. The Supreme Court in U.S. v. Chiarella told us that a fiduciary relationship, or at least a relationship of trust and confidence, is required for “classic” insider liability, and, in U.S. v. O’Hagan, told us that “deception” is required to establish liability under the misappropriation theory. Meanwhile, the distinctions between the classic and misappropriation theories have become increasingly blurred; the SEC frequently alleges both theories in its complaints. While a legislative solution might seem the preferred method to clean up the law, Congress has not taken up the challenge, and the SEC has not advocated for Congressional action. Two recent decisions illustrate the difficulties.
In SEC v. Cuban (5th Cir. Sept. 21, 2010), the Fifth Circuit reversed the district court’s dismissal of the SEC’s action and held that the SEC had stated a claim. Cuban was a minority shareholder in Mamma.com when the company’s CEO called to ask if he would be interested in purchasing additional shares in a forthcoming PIPES offering. According to the SEC, the CEO began the conversation by telling Cuban he had confidential information for him, and Cuban agreed to keep the information confidential. Cuban became upset when the CEO told him about the PIPES offering and at the end of the conversation, Cuban told the CEO, “Well, now I’m screwed. I can’t sell.” Cuban asked for , and subsequently received, further information about the terms of the PIPES offering. Shortly thereafter, Cuban sold his holdings in Mamma.com. In dismissing the complaint, the district court acknowledged that Cuban’s “I’m screwed” statement appeared to express his belief that it would be illegal to sell his shares, but the statement could not be understood as a promise not to sell. Accordingly, the complaint alleged at best that the CEO intended to obtain an agreement to keep the information confidential and not an agreement to refrain from selling.
The Fifth Circuit agreed with the district court that the “I’m screwed” statement, read in isolation, did not express an agreement not to sell, but, emphasizing that it was reading the complaint in the light most favorable to the SEC, found that the additional allegations that Cuban obtained confidential information about the PIPES offering provide “more than a plausible basis” to find that the understanding between the CEO and Cuban was more than a confidentiality agreement. “It is at least plausible that each of the parties understood, if only implicitly, that Mamma.com would only provide the terms and conditions of the offering to Cuban for the purpose of evaluating whether he would participate in the offering, and that Cuban could not use the information for his own personal belief.” Had the SEC not alleged that Cuban asked for and received confidential information about the PIPES offering, the Fifth Circuit suggests it would have upheld the district court’s distinction between an agreement to keep information confidential and an agreement not to trade. Finally, the court expressly states it is taking no position on the merits of the SEC’s allegations, “given the paucity of jurisprudence on the question of what constitutes a relationship of ‘trust and confidence’ and the inherently fact-bound nature of determining whether such a duty exists.” In short, the Fifth Circuit’s reversal is not a robust showing of support for the SEC’s position.
A federal district in S.D.N.Y. recently granted summary judgment for defendants in SEC v. Obus (S.D.N.Y. Sept. 20, 2010). Strickland, an employee of GE Capital, was a member of the team that had discussions with SunSource about a financing in connection with an acquisition of the company by a third party. Strickland had at least one conversation about SunSource with a college friend, Black, an employee at Wynnefield Capital, which was a SunSource shareholder. Black, in turn, spoke with his boss, Obus, about SunSource. Shortly after that conversation, Obus spoke with SunSource’s CEO , saying that “a little birdie in Connecticut” told him that SunSource was going to be sold. Thereafter, Wynnefield’s trader received an unsolicited offer to purchase SunSource shares; after consulting with Obus, the trader purchased the SunSource shares. All this took place before any public announcement of the SunSource acquisition.
The SEC pursued both classic insider and misappropriation theories against Strickland, Black and Obus and also named Wynnefield entities as relief defendants. The district, however, dismissed all the counts.
As to the classic insider theory, the court rejected the argument that GE Capital, or its employee Strickland, became a temporary insider of SunSource when it held discussions with it about providing financing, for two reasons: (1) GE Capital did not sign a confidentiality agreement, and (2) the potential debtor-creditor relationship did not establish a relationship of trust and confidence.
As to the misappropriation theory, the court found insufficient evidence that Strickland breached a duty owed to his employer, GE Capital, despite the fact that GE Capital had reprimanded Strickland for violating its policies that preclude an employee from engaging in any tipping or trading on inside information. The court finds that Strickland’s conduct was not “deceitful,” noting GE Capital found only that Strickland made a “mistake.” It expressly rejected the SEC’s argument that “deception” could be established by the “breach, tip and trade” alone and did not require any additional deceptive conduct. The court also did not view Obus’s telling the SunShine CEO that he had information about a sale as the actions of someone acting deceptively.
These cases nicely illustrate the SEC’s difficulties in pleading and proving insider-trading cases under both the classic and misappropriation theories and perhaps reflect a judicial disinclination to extend these doctrines beyond the most obvious forms of insider trading. It might be time for the SEC to reconsider its longstanding disinclination to establish more certain guidelines in this very difficult area.
Friday, September 24, 2010
The SEC published interpretive guidance to clarify the application of certain Commission rules, regulations, releases, and staff bulletins in light of the authority granted to the Public Company Accounting Oversight Board in the Dodd-Frank Wall Street Reform and Consumer Protection Act to establish auditing, attestation, and related professional practice standards governing the preparation and issuance of audit reports to be included in broker and dealer filings with the Commission.
Section 982 of Dodd-Frank amended the Sarbanes-Oxley Act of 20022 to authorize PCAOB, among other things, to establish, subject to approval by the Commission, auditing and related attestation, quality control, ethics, and independence standards to be used by registered public accounting firms with respect to the preparation and issuance of audit reports to be included in broker and dealer filings with the Commission pursuant to Rule 17a-53 under the Exchange Act of 19344 (“Exchange Act”). The amendments directly impact certain Commission rules, regulations, releases, and staff bulletins related to brokers and dealers and certain provisions in the federal securities laws for brokers and dealers, which refer to Generally Accepted Auditing Standards (“GAAS”) and to specific standards under GAAS (including related professional practice standards). There may be confusion on the part of brokers, dealers, auditors, and investors with regard to the professional standards auditors should follow for reports filed and furnished by brokers and dealers pursuant to the federal securities laws and the rules of the Commission. The Commission is considering a rulemaking project to update the audit and related attestation requirements under the federal securities laws for brokers and dealers, particularly in light of the Dodd-Frank Act. In addition, the PCAOB has not yet revised its rules, which currently refer only to issuers, to require registered public accounting firms to comply with PCAOB standards for audits of non-issuer brokers and dealers.
As a result, the Commission is providing transitional guidance with respect to its existing rules regarding non-issuer brokers and dealers. Specifically, references in Commission rules and staff guidance and in the federal securities laws to GAAS or to specific standards under GAAS, as they relate to non-issuer brokers or dealers, should continue to be understood to mean auditing standards generally accepted in the United States of America, plus any applicable rules of the Commission. The Commission intends, however, to revisit this interpretation in connection with its rulemaking project referenced above.
Thursday, September 23, 2010
The Senate Banking Committee will hold a hearing on Implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act on September 30, 2010. Witnesses include Neal S. Wolin, Deputy Secretary, U.S. Department of the Treasury; Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System; Sheila Bair, Chairman, Federal Deposit Insurance Corporation; Mary Schapiro, Chairman, U.S. Securities and Exchange Commission; Gary Gensler, Chairman, Commodity Futures Trading Commission; and John Walsh, Acting Comptroller of the Currency, Office of the Comptroller of the Currency.
Treasury Secretary Tim Geithner, in his capacity as chairperson of the Financial Stability Oversight Council, announced that the Council will hold its first meeting on October 1, 2010.
The Dodd-Frank Wall Street Reform and Consumer Protection Act established the Financial Stability Oversight Council, to provide comprehensive oversight over the stability of our nation's financial system. It is charged with identifying threats to the financial stability of the United States; promoting market discipline by eliminating expectations on the part of shareholders, creditors, and counterparties that the government will shield them from losses in the event of failure; and responding to emerging risks to the stability of the United States financial system.
The members of the Financial Stability Oversight Council that are expected to attend the October 1 meeting include:
· Tim Geithner, Treasury Secretary (Chairperson of the Financial Stability Oversight Council)
· Ben Bernanke, Chairman of the Board of Governors of the Federal Reserve System
· John Walsh, Acting Comptroller of the Currency
· Mary Schapiro, Chairman of the U.S. Securities and Exchange Commission
· Sheila Bair, Chairman of the Federal Deposit Insurance Corporation
· Gary Gensler, Chairman of the Commodity Futures Trading Commission
· Edward J. DeMarco, Acting Director of the Federal Housing Finance Agency
· Debbie Matz, Chairman of the National Credit Union Administration
· John M. Huff, Director, Missouri Department of Insurance, Financial Institutions, and Professional Registration (non-voting member)
· William S. Haraf, Commissioner, California Department of Financial Institutions (non-voting member)
· David S. Massey, Deputy Securities Administrator, North Carolina Department of the Secretary of State, Securities Division (non-voting member
The SEC today charged Dallas-based hedge fund adviser Carlson Capital, L.P. with improperly participating in four public stock offerings after selling short those same stocks. Carlson agreed to pay more than $2.6 million to settle the SEC's charges.
The SEC's Rule 105 of Regulation M helps prevent short selling that can reduce proceeds received by companies and shareholders by artificially depressing the market price shortly before the company prices its public offering. Rule 105 ensures that offering prices are set by natural forces of supply and demand rather than manipulative activity by prohibiting the short sale of an equity security during a restricted period — generally five business days before a public offering — and the purchase of that same security through the offering. The rule applies regardless of the trader's intent in selling short the stock.
According to the SEC's order, Carlson violated Rule 105 on four occasions and had policies and procedures that were insufficient to prevent the firm from participating in the relevant offerings. For one of those occasions, the SEC found a Rule 105 violation even though the portfolio manager who sold short the stock and the portfolio manager who bought the offering shares were different. In its order, the SEC found that the "separate accounts" exception to Rule 105 did not apply to Carlson's participation in that offering. If certain conditions are met, this exception allows the purchase of an offered security in an account that is "separate" from the account through which the same security was sold short. The Commission found that the combined activities of Carlson's portfolio managers violated Rule 105 and did not qualify for the separate accounts exception because the firm's portfolio managers:
- Could access each others' trading positions and trade reports, and could consult with each other about companies of interest.
- Reported to a single chief investment officer who supervised the firm's portfolios and had authority over the firm's positions.
- Were not prohibited from coordinating with each other with respect to trading.
The SEC further found that the portfolio manager who sold short the particular stock during the restricted period received information — before the short sales were made — that indicated the other portfolio manager intended to buy offering shares.
Without admitting or denying the SEC's findings, Carlson agreed to pay a total of $2,653,234, which includes $2,256,386 in disgorgement of improper gains or avoided losses, a $260,000 penalty, and pre-judgment interest of $136,848. Carlson also consented to an order that imposes a censure and requires the firm to cease and desist from committing or causing any violations and any future violations of Rule 105. During the SEC's investigation, the adviser took remedial measures including implementation of an automated system that helps review the firm's prior short sales before it participates in offerings.
On November 12, 2010, Southwestern Law School in Los Angeles, California is hosting a symposium titled Beyond Borders: Extraterritoriality in American Law. This one-day symposium will bring together leading legal figures from throughout the country to analyze critical issues related to transnational litigation and extraterritorial regulation. Do U.S. law stop at the border? If not, when do they – or when should they – govern the conduct of people abroad? From the controversial extraterritorial application of U.S. domestic law, to the contentious uses of universal jurisdiction in the human rights context, to debates over the extent to which the U.S. Constitution applies outside U.S. territory, a flurry of recent scholarship has involved disputes over the geographic reach of domestic law.
The symposium will bring together leading scholars to discuss the history, doctrine, and current issues related to extraterritoriality. The proceedings will be published in the Southwestern Law Review and distributed widely. The following professors are participating in the symposium (listed alphabetically):
• Jeffery Atik, Professor of Law, Loyola Law School, Los Angeles
• Hannah Buxbaum, Professor of Law, Indiana Univ. Maurer School of Law
• Lea Brilmayer, Professor of Law, Yale Law School
• William Dodge, Professor of Law, University of California, Hastings College of the Law
• Stephen Gardbaum, Professor of Law, UCLA School of Law
• Andrew Guzman, Professor of Law, University of California, Berkeley School of Law
• Max Huffman, Associate Professor of Law, Indiana Univ. School of Law
• Chimene Keitner, Associate Professor of Law, University of California, Hastings College of the Law
• John Knox, Professor of Law, Wake Forest Univ. School of Law
• Caleb Mason, Professor of Law, Southwestern Law School
• Daniel Margolies, Professor of History, Virginia Wesleyan College
• Jeff Meyer, Professor of Law, Quinnipiac Univ. School of Law
• Trevor Morrison, Professor of Law, Columbia Law School
• Austen Parrish, Professor of Law, Southwestern Law School
• Tonya Putnam, Assistant Professor of Political Science, Columbia University
• Kal Raustiala, Professor of Law, UCLA School of Law
• Bartholomew Sparrow, Professor of Government, University of Texas at Austin
• Peter Spiro, Professor of Law, Temple Univ. Beasley School of Law
• Christopher Whytock, Acting Professor of Law, University of California, Irvine School of Law
The House Financial Services Subcommittee on Capital Markets held a hearing today on Assessing the Limitations of the Securities Investor Protection Act. Witnesses included:
Mr. Joseph Borg, Director, Alabama Securities Commission
The Honorable Orlan Johnson, Chairman of the Board, Securities Investor Protection Corporation
Mr. John Coffee, Adolf A. Berle Professor of Law, Columbia Law School
Mr. Ira Hammerman, Senior Managing Director and General Counsel, Securities Industry and Financial Markets Association
Mr. Steven Caruso, Partner, Maddox, Hargett, & Caruso
Here is some excerpts from Rep. Kanjorski's opening statement:
The victims of [Madoff's fraud] believe that SIPC has fallen short in meeting its responsibilities, and they want more change. I do, too.
We have many questions to explore today. For example, although SIPA’s protections do
not currently extend to the customers of investment advisers, we must explore the issue of
expanding SIPA’s coverage as investment advisers may also commit fraud.
In any serious efforts to reform SIPA, we must also consider what responsibility SIPC
has to honor the broker statements that customers receive. SIPC has denied the claims of
customers based on the seemingly legitimate paperwork provided to them by their brokers, yet
SIPC expects customers to use those very same statements to report unauthorized trading in their
accounts. This inconsistency is unacceptable, and we must work to resolve it.
Investor trust, for which SIPA was designed to preserve, has been seriously eroded by
SIPC’s narrow interpretations of its statutory mandate. While SIPC’s actions may follow the
letter of the law, many would argue that SIPC has ignored the spirit of the law. We therefore
must consider the best way to change the tone at SIPC and refocus this body on maintaining
confidence in the financial system and promoting investor protection. To the extent possible, we
ought to also explore how SIPC could learn from the success of the Federal Deposit Insurance
Corporation in maintaining the public’s trust.
The Senate unanimously passed S.3171 that would repeal a FOIA exemption for records obtained by the SEC during its surveillance, risk assessment, regulatory or other duties. A companion bill has been referred to the House Oversight and Financial Services Committee. The exemption was contained in Dodd-Frank 9291, but has been criticized for its breadth. SEC Chair warns that the legislation could weaken the effectiveness of the examinations process.
Meanwhile, the SEC was the subject of substantial criticism yesterday by Senators on the Banking Committee at a hearing on the SEC Inspector General's Report on the SEC's handling of the Stanford matter. Criticisms involved not only the agency's failure to uncover the alleged Stanford ponzi scheme sooner, but also more generally the failure of enforcement to hold individuals and firms accountable for the financial crisis. The SEC Inspector General also testified that the timing of the SEC's enforcement action against Goldman Sachs last spring was suspicious, as it coincided with the Inspector General's critical report on Stanford. WSJ, SEC Blasted on Goldman.
Wednesday, September 22, 2010
The GAO released a report on Action Needed to Improve Rating Agency Registration Program and Performance-Related Disclosures. According to the summary:
In 2006, Congress passed the Credit Rating Agency Reform Act (Act), which intended to improve credit ratings by fostering accountability, transparency, and competition. The Act established Securities and Exchange Commission (SEC) oversight over Nationally Recognized Statistical Rating Organizations (NRSRO), which are credit rating agencies that are registered with SEC. The Act requires GAO to review the implementation of the Act. This report (1) discusses the Act’s implementation; (2) evaluates NRSROs’ performance-related disclosures; (3) evaluates removing NRSRO references from certain SEC rules; (4) evaluates the impact of the Act on competition; and (5) provides a framework for evaluating alternative models for compensating NRSROs. To address the mandate, GAO reviewed SEC rules, examination guidance, completed examinations, and staff memoranda; analyzed required NRSRO disclosures and market share data; and interviewed SEC and NRSRO officials and market participants.
The Report's recommendations include:
SEC should identify the additional time frames and authorities it needs to review NRSRO applications, develop a plan to help ensure the NRSRO examination program is sufficiently staffed, improve NRSROs’ performance-related disclosure requirements, and develop a plan to approach the removal of NRSRO references from its rules. SEC generally agreed with these recommendations.
Tuesday, September 21, 2010
SEC Commissioner Elisse B. Walter chaired the SEC's first Field Hearing on the State of the Municipal Securities Market in San Francisco today. In her opening statement, she explained that:
The purpose of these hearings is to explore the issues relating to the municipal securities market that arise under the federal securities laws. At the conclusion of all of the hearings, the Commission staff will prepare a report concerning what we have learned, including their recommendations for further action that we should pursue, which may include legislation, rulemaking and changes in industry practice. These hearings will be instrumental in informing those recommendations. Thus, the Commission's standard disclaimer, which I make for myself and all other Commission participants, is particularly apt — that our remarks today represent our own views, and not necessarily those of the Commission, other Commissioners, or members of the staff. And, I would like to add that the views we express today may well change in light of the valuable input we will receive today and throughout the course of the field hearing process.
The SEC today charged a Minneapolis-based attorney and two San Francisco-area promoters with defrauding investors in a real estate lending fund by concealing the financial collapse of the fund's sole business partner. The SEC alleges that Todd A. Duckson, an attorney who resides in Prior Lake, Minn., and Michael W. Bozora and Timothy R. Redpath, who reside in Marin County, Calif., raised more than $21 million from investors in the Capital Solutions Monthly Income Fund after the fund's sole business partner defaulted on its obligations to the fund. The SEC alleges that after this May 2008 default, the fund - whose sole business was to make real estate loans to a single borrower - had no meaningful income and was using new investor funds to pay existing investors.
The SEC alleges that after the default, Duckson, Bozora, and Redpath told investors that the fund was poised to take advantage of attractive lending opportunities provided by the collapse in the U.S. credit and real estate markets, when in fact the fund' s business strategy had failed.
According to the SEC's complaint filed in federal court in Minneapolis, Bozora and Redpath launched the fund in 2004 and, through August 2009, raised approximately $74 million from approximately 450 investors from across the U.S. After the May 2008 default by the fund's sole borrower, the fund foreclosed on the borrower's real estate projects. The SEC alleges that in late 2008, Bozora and Redpath asked Duckson, who was acting as the fund's outside counsel, to take over managing the fund. The SEC alleges that Duckson then began managing the fund while Bozora and Redpath continued to raise money from new investors. The SEC alleges that Bozora, Redpath, and Duckson failed to disclose the default and foreclosure to investors for several months.
The SEC's complaint also charges True North Finance Corporation, a Minneapolis real estate lending company that merged with the fund in 2009, and True North's Chief Financial Officer Owen Mark Williams with accounting fraud. The SEC is seeking permanent injunctions, disgorgement, prejudgment interest and civil penalties against all of the defendants, and officer-director bars against Bozora, Redpath, Duckson, and Williams.
Monday, September 20, 2010
The U.K. Financial Services Authority (FSA) and FINRA have entered into a Memorandum of Understanding (MOU) to support more robust cooperation between the two regulators. The MOU establishes a framework for enhancing the ability of the FSA and FINRA to oversee the world's largest securities firms and markets. The agreement will facilitate the exchange of information on firms and individuals under common supervision, support collaboration on investigations and enforcement matters, and allow further sharing of regulatory techniques, including approaches to risk-based supervision of firms.
FINRA, in coordination with the Municipal Securities Rulemaking Board (MSRB), today issued a Regulatory Notice reminding municipal securities dealers of their sales practice, due diligence and fair pricing obligations when selling municipal securities in the secondary market. In particular, the regulators reminded dealers that they must obtain and disclose to their customers, at or before the time of trade, all material information about the bond that is either known to them or publically available through established industry sources, including, but not limited to, continuing disclosures and other information made available through the MSRB's Electronic Municipal Market Access System (EMMA). Dealers must also consider this information in assessing the suitability of a municipal security for their customer. The regulators also reminded dealers that while credit ratings and ratings changes are generally material information about a municipal security, they are only one factor to be considered, and dealers should not solely rely on credit ratings as a substitute for their own assessment of a bond.
FINRA has several ongoing sweeps involving municipal securities. While the results of the sweeps are still being evaluated, FINRA has concerns that firms may not completely understand their obligations with respect to the disclosure of material information to customers at the time of trade.
In addition, the SEC released an Investor Bulletin on Municipal Bonds today.
Accompanying the FINRA Regulatory Notice is a Checklist for Customer Disclosure that FINRA designed as a voluntary tool for dealers to use in connection with secondary market sales of municipal securities. Among other things, material information about a bond will include its terms and features, ongoing disclosures, ratings and ratings changes, the existence of bond insurance or credit or liquidity enhancements, the bond's price and yield, interest payments, tax implications, call provisions and other material risks, including risk of default.