Sunday, November 13, 2011
Do They Do It for The Money?, by Utpal Bhattacharya, Indiana University Bloomington - Department of Finance, and Cassandra D. Marshall, Indiana University Bloomington - Department of Finance, was recently posted on SSRN. Here is the abstract:
Using a sample of all top management who were indicted for illegal insider trading in the United States for trades during the period 1989-2002, we explore the economic rationality of this white-collar crime. If this crime is an economically rational activity in the sense of Becker (1968), where a crime is committed if its expected benefits exceed its expected costs, “poorer” top management should be doing the most illegal insider trading. This is because the “poor” have less to lose (present value of foregone future compensation if caught is lower for them.) We find in the data, however, that indictments are concentrated in the “richer” strata after we control for firm size, industry, firm growth opportunities, executive age, the opportunity to commit illegal insider trading, and the possibility that regulators target the “richer” strata. We thus rule out the economic motive for this white-collar crime, and leave open the possibility of other motives.
The SEC Commissioner Elisse B. Walter made an important speech on November 8, 2011 at the FINRA Institute at Wharton Certified Regulatory and Compliance Professional (CRCP) Program at the University of Pennsylvania, in which she explored the relationship between public and private enforcement of federal securities laws. After tracing first the development and then the contraction of the implied private right under Rule 10b-5, she stated:
Given these developments, what are the implications for the federal securities laws? I speak only for myself, but I believe strongly that the public, Congress, courts, and even the securities bar do not fully appreciate the interrelationship between public and private enforcement. The impact of changes in the parameters or existence of private actions on the enforceability of the federal securities laws is simply not well understood. And yet, it is critical to investors, our securities markets, and our economy overall that these laws remain fully enforceable.
The contraction of private rights means that their ability to supplement government enforcement is limited, and they become less sturdy support for the overall enforcement process. This means that Commission and other public enforcement of the federal securities laws must “take up the slack,” so to speak. Thus, the need for strong governmental and self-regulatory enforcement has never been greater.
In other words, I believe that the trend away from private rights of action under the securities laws has placed more and more pressure on the Commission and other regulators to be the sole guardians of the statutes. It is a vast understatement to say that the Commission has a big job to do. If private rights are cut back further, or further constrained, that puts an increasing burden on already scarce governmental resources.
Thursday, November 10, 2011
The SEC charged China-based Longtop Financial Technologies Limited with failing to file current and accurate financial reports with the SEC. The SEC’s Division of Enforcement alleges that Longtop failed to comply with its reporting obligations because it failed to file an annual report for its fiscal year that ended March 31, 2011. Furthermore, Longtop’s independent auditor stated in May 2011 that its prior audit reports on Longtop’s financial statements contained in annual reports for 2008, 2009 and 2010 should no longer be relied upon.
If the administrative law judge overseeing the proceeding revokes the registration of Longtop’s securities, no broker-dealer may execute any trades in those securities. Revocation also would abolish Longtop as a public shell company so that it could not be sold and used as a vehicle for future fraud.
According to the order instituting the administrative proceeding, Longtop’s American depositary shares were listed and traded on the New York Stock Exchange under the symbol LFT beginning in October 2007 after an initial public offering. On Aug. 29, 2011, the NYSE delisted LFT, finding that the American depositary shares were no longer suitable for continued listing and trading. Currently, Longtop’s American depositary shares trade in the over-the-counter market under the ticker symbol “LGFTY.”
The SEC previously filed a subpoena enforcement action against Deloitte Touche Tohmatsu CPA Ltd. in Shanghai for failing to produce documents related to the SEC’s investigation into possible fraud by Longtop, the audit firm’s longtime client.
The SEC charged UBS Securities LLC for inaccurate recording practices when providing and recording “locates” to customers seeking to execute short sales. The practices go back at least to 2007. UBS settled the enforcement action by agreeing to pay an $8 million penalty and retain an independent consultant.
Broker-dealers are routinely asked by customers to locate stock for short selling, and a “locate” represents a determination by a broker-dealer that it has borrowed, arranged to borrow, or reasonably believes it could borrow the security to settle the short sale. Broker-dealers are required under Regulation SHO to accurately record the basis upon which it has given out locates.
The SEC announced that three former directors of DHB Industries have agreed to more than $1.6 million in monetary sanctions to settle charges that they were involved in an accounting fraud at the major supplier of body armor to the U.S. military and law enforcement agencies. The settlements agreed to by Cary Chasin, Jerome Krantz and Gary Nadelman would impose permanent officer-and-director bars in addition to the monetary sanctions. The settlements are subject to court approval.
DHB Industries is now known as Point Blank Solutions.
FINRA announced today that it fined Morgan Stanley & Co. Inc. and Morgan Stanley Smith Barney LLC $1 million and ordered $371,000 in restitution and interest to customers for excessive markups and markdowns charged to customers on corporate and municipal bond transactions, and related supervision violations. FINRA found that Morgan Stanley charged markups and markdowns ranging from below 5 percent to 13.8 percent on corporate and municipal bond transactions, which were higher than warranted given factors including market conditions, the cost of executing the transactions and the value of the services rendered to the customers.
FINRA found that Morgan Stanley's supervisory system for corporate and municipal bond markups and markdowns was inadequate. The firm's supervisory reports were not designed to include markups and markdowns that were below 5 percent but nonetheless may have been excessive. And before August 2009, Morgan Stanley's policies and procedures considered only one of two charges that the firm added to the price of a bond when it determined whether a markup or markdown was fair and reasonable. Morgan Stanley was also ordered to revise its written supervisory procedures regarding supervisory review of markups and markdowns in fixed income transactions with its customers.
Wednesday, November 9, 2011
The SEC approved new rules of the three major U.S. listing markets that toughen the standards that companies going public through a reverse merger must meet to become listed on those exchanges.
In summer 2010, the SEC launched an initiative to determine whether certain companies with foreign operations – including those that were the product of reverse mergers – were accurately reporting their financial results, and to assess the quality of the audits being done by the auditors of these companies. The SEC and U.S. exchanges have in recent months suspended or halted trading in more than 35 companies based overseas citing a lack of current and accurate information about the firms and their finances. These included a number of companies that were formed by reverse mergers. In June, the SEC issued an investor bulletin warning investors about companies that engage in reverse mergers.
Under the new rules, Nasdaq, NYSE, and NYSE Amex will impose more stringent listing requirements for companies that become public through a reverse merger. Specifically, the new rules would prohibit a reverse merger company from applying to list until:
- The company has completed a one-year “seasoning period” by trading in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange following the reverse merger, and filed all required reports with the Commission, including audited financial statements.
- The company maintains the requisite minimum share price for a sustained period, and for at least 30 of the 60 trading days, immediately prior to its listing application and the exchange’s decision to list.
Under the rules, the reverse merger company generally would be exempt from these special requirements if it is listing in connection with a substantial firm commitment underwritten public offering, or the reverse merger occurred long ago so that at least four annual reports with audited financial information have been filed with the SEC.
The SEC charged two Minnesota-based hedge fund managers and their firm for facilitating a multi-billion dollar Ponzi scheme operated by Minnesota businessman Thomas Petters. The SEC alleges that James N. Fry, Michelle W. Palm, and Fry’s firm Arrowhead Capital Management LLC invested more than $600 million in hedge fund assets with Petters while collecting more than $42 million in fees. Fry, Palm, and Arrowhead falsely assured investors and potential investors that the flow of their money would be safeguarded by the operation of certain collateral accounts when, in fact, the process did not exist as described. When Petters was unable to make payments on investments held by the funds they managed, Fry, Palm, and Arrowhead concealed Petters’s inability to pay by entering into secret note extensions with Petters.
This is the fourth enforcement action that the SEC has brought against hedge fund managers that collectively fed billions of dollars into the Petters fraud. The SEC previously charged Petters and froze the assets of an Illinois-based hedge fund manager who was a $2 billion feeder to his scheme, charged two Florida-based fund managers who facilitated the scheme, and blocked an attempt by a Connecticut-based hedge fund manager to divert funds from victims of the scheme.
Both Fry and Palm have been charged criminally in connection with the same misconduct. Palm pleaded guilty to one count of securities fraud and one count of making false statements to SEC staff during investigative testimony. Fry pleaded not guilty to multiple counts of securities fraud, wire fraud, and making false statements to SEC staff during investigative testimony.
Tuesday, November 8, 2011
Judge Jed Rakoff imposed a $92.8 million civil monetary penalty on Raj Rajaratnam in the SEC's civil enforcement action against him, marking the largest penalty ever assessed against an individual in an SEC insider trading case. In the criminal proceeding, Rajaratnam was sentenced to 11 years in prison and was ordered to pay more than $53.8 million in forfeiture of illegal gains and a $10 million criminal fine. Thus, the grand total of monetary sanctions is more than $156.6 million.
In a per curiam opinion the U.S. Supreme Court vacated a judgment of a Florida appellate court that upheld a trial court's refusal to compel arbitration of investors' claims against an auditing firm that asserted an arbitration clause in its audit services contract with the fund manager. KKMG LLP v. Cocchi, 556 U.S. (Nov. 7, 2011) (Download KPMGv.Cocchi). The trial court refused to compel arbitration after it determined that two of the four claims asserted by the investors were direct claims (negligent misrepresentations, Florida Deceptive and Unfair Trade Practices Act violation) and were therefore not arbitrable. The trial court's opinion was silent, however, with respect to the two other claims (professional malpractice, aiding and abetting a breach of fiduciary duty), yet the trial court recognized that if the investors' claims were derivative, the arbitration clause could be enforced. Because state courts "have a prominent role to play as enforcers of agreements to arbitrate," the court could not issue a blanket refusal to compel arbitration merely because some of the claims were not arbitrable. The Supreme Court thus reaffirmed Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213 (1985): if a dispute presents multiple claims, some arbitrable and some not, the arbitrable claims must be sent to arbitration, even if this leads to piecemeal litigation.
While not relevant to the merits, the investors' claims arise out of investments in Bernard Madoff's Ponzi scheme.
Monday, November 7, 2011
In a speech today at the SIFMA Annual Meeting, SEC Chair Schapiro stated that additional money market fund reform is necessary, because money market funds have no committed source of stability to draw upon, except for the discretionary support of their sponsors. Accordingly:
the SEC – working with FSOC – is evaluating options to address the structural vulnerabilities posed by money market funds. We are focused in particular on a capital buffer option to serve as a cushion for money market funds in times of emergency and floating NAVs, which would eliminate the expectation of stability that accompanies the $1.00 stable NAV. Both of these reform options would ensure that investors who use money market funds realize the costs that might be imposed during rare market events.
Ms. Schapiro stated that proposal would be released in the coming months.
Sunday, November 6, 2011
There have been several interesting decisions recently about the relationship between arbitration proceedings and the courts, of which In re American Express Financial Advisors Securities Litigation (No. 10-3399, 2d Cir. Nov. 3, 2011) is the most recent. The opinion addresses several unsettled issues concerning the effect of a class action settlement on an individual class member's right to arbitrate certain claims. The Bolands brought various claims before the FINRA arbitration forum against Ameriprise Financial Services, based on Ameriprise's alleged failure to adhere to the Bolands' conservative investment strategy and its "steering" of the Bolands' assets into mutual funds that allowed Ameriprise to collect excessive fees. Unfortunately for the Bolands, they were members of a class that had settled claims against Ameriprise, and they had neither opted out nor submitted a claim to share in the settlement funds. After the arbitration panel denied Ameriprise's motion to stay the arbitration, the firm moved in federal district court to enforce the settlement agreement and enjoin the Bolands from pursuing the arbitration. The district court concluded that the class settlement barred all of the Bolands' claims, granted Ameriprise's motion and ordered the Bolands to dismiss their FINRA complaint with prejudice.
Fortunately, however, for the Bolands, the settlement agreement expressly excluded from the definition of "Released Claims" "suitability claims unless such claims are alleged to arise out of the common course of conduct that was alleged ... in the Action." On appeal, the Second Circuit determined that the FINRA claims and the Released Claims do not totally overlap; accordingly, the Bolands remained free to arbitrate some of their claims.
The Second Circuit also addressed the district court's power to enjoin arbitration, an unanswered question in the Second Circuit. It noted that the FAA did not explicitly confer on the judiciary the authority to enjoin a private arbitration. It acknowledged that previous decisions in the Circuit recognized the district court's power to enjoin arbitration in certain circumstances: (1) where the court has determined that the parties have not entered into a valid and binding arbitration agreement, and (2) where the court has determined that the initiation of judicial proceedings in a foreign country constituted a waiver of arbitration. The court confirmed and applied those principles to this situation:"it makes little sense to us to conclude that district courts lack the authority to order the cessation of an arbitration by parties within its jurisdiction where such authority appears necessary in order for a court to enforce the terms of the parties' own agreement, as reflected in a settlement agreement." The court also relied on the fact that the settlement agreement explicitly stated that the federal district court retained jurisdiction over the settlement agreement. The court did not decide whether the All Writs Act, which other federal courts had relied upon to stay arbitration, gave the district court the authority to enjoin arbitration to prevent relitigation of issues.
Inside-Out Corporate Governance, by David A. Skeel Jr., University of Pennsylvania Law School; European Corporate Governance Institute (ECGI), et alia, was recently posted on SSRN. Here is the abstract:
Until late in the twentieth century, internal corporate governance - that is, decision making by the principal constituencies of the firm - was clearly distinct from outside oversight by regulators, auditors and credit rating agencies, and markets. With the 1980s takeover wave and hedge funds’ and equity funds’ more recent involvement in corporate governance, the distinction between inside and outside governance has eroded. The tools of inside governance are now routinely employed by governance outsiders, intertwining the two traditional modes of governance. We argue in this Article that the shift has created a new governance paradigm, which we call inside-out corporate governance.
Using the inside-out model as our lens, and drawing on comparisons to Italian and E.U. governance, we explore three areas of corporate governance that have been pervasively restructured by the Dodd-Frank Act and subsequent regulation: proxy access, credit rating agencies, and derivatives. We begin, in Part I, with proxy access, arguing that the new scheme for minority shareholder access excludes the very outsiders it ostensibly integrates into corporate governance. In Part II, which focuses on auditing and credit rating agencies, we argue that the inside-out relationship - in which the corporation itself chooses its gatekeeper - is deeply problematic but cannot be “cured.” The most realistic strategy is to create more flexibility in the audit relationship, and diminish the importance of credit ratings. Part III analyzes the new derivatives regulation. Here, we argue that Congress’s effort to sharply separate the inside and outside uses of derivatives is incoherent from a corporate governance perspective. We conclude by briefly speculating about the future implications of inside-out governance.
On the Regulation of Investment Advisory Services: Where Do We Go from Here?, by James Angel, Georgetown University - Department of Finance, was recently posted on SSRN. Here is the abstract:
A controversy has arisen over the regulation of investment advisers in the United States. Traditionally, larger registered investment advisers (RIAs) have been regulated by the SEC and smaller ones by the states. The Investment Advisers Act of 1940 severely restricts the ability of RIAs to engage in principal trades with their customers. Brokers, on the other hand, are regulated by a self-regulatory organization, FINRA, as well as by the SEC. Brokers may engage in principal trades with their customers as long as the advice is merely “incidental” to their other activities. In recent years, the boundaries between RIAs and brokers have become blurred as brokers offer more advisory services, and there is substantial confusion among consumers as to the differences between brokers and RIAs.
In a study mandated under §914 of Dodd-Frank, the SEC documented that it is examining RIAs at a rate of approximately once every eleven years, and recommended the study of additional means to increase the frequency of examinations including user fees to fund more examinations by the SEC, or requiring RIAs to become part of an SRO. It should be noted that the SEC has assigned fewer employees to its Office of Compliance, Inspections, and Enforcement (OCIE) in 2010 than in 2004, despite an increase in overall FTE over this period. This SEC diversion of resources presumably reflects its belief that RIA examinations are less important than other SEC activities.
This study examines several alternatives for increasing the frequency of examinations. It is unlikely in the current political environment that the SEC will be able to charge users fees to RIAs or to get the budgetary resources it needs. Moving more RIAs from federal to underfunded state regulatory agencies is likewise unsatisfactory.
SROs do much more than just examine their members; they also create and enforce rules and other activities. As RIAs who are not also brokers lack the same degree of conflict of interest as brokers trading opposite their own customers, they do not need the same regulation. However, institutional dynamics at the SEC would result in a new adviser SRO acting just like FINRA.
The problem is that RIAs are not being examined frequently enough. No other serious deficiencies in RIA regulation have been documented. Exam frequency can be increased by requiring RIAs to engage independent auditors such as accounting or consulting firms or an SRO to examine their regulatory compliance on a more frequent basis. Precedents for this include the SEC’s requiring corporate issuers to provide audited financial statements, and the SEC’ s proposal to require broker-dealers to submitted independently audited compliance reviews. This would free up scarce SEC resources for more important activities, and provide the benefits of competition in the provision of examination services.
Crowdfunding, Social Networks, and the Securities Laws – The Inadvisability of a Specially Tailored Exemption Without Imposing Affirmative Disclosure Requirements, by Thomas Lee Hazen, University of North Carolina (UNC) at Chapel Hill - School of Law, was recently posted on SSRN. Here is the abstract:
Social networks have been used as a medium for financing films and other performing arts, as well as for charitable solicitations. These and similar fundraising endeavors are known as crowdfunding. Social networks have the potential for using crowdfunding to reach large numbers of people. Since crowdfunding is designed to reach a large number of people, limiting the fund-raising request to a small amount from each donor can provide meaningful funding. The solicitation of funds as gifts or donations is a substantially unregulated activity. Crowdfunding can also be used to finance small business enterprises, which in contrast is a highly regulated activity by virtue of the securities laws.
Securities laws are designed to provide investor protection by requiring disclosure and in many instances registration. The securities laws come into play when social networks are used to make a widespread solicitation of funds for business enterprises, regardless of the amount being sought from each investor. For the most part, the exemptions from the more burdensome securities law disclosures do not apply when there is a general solicitation as is the case with crowdfunding efforts. There are a few exemptions permitting a general solicitation exist but those exemptions are conditioned on the use of an offering circular or other mandated disclosure to potential investors. There has been some discussion of providing a less onerous exemption from the securities laws to facilitate crowdfunding of business ventures. In fact, there have been a number of proposals to the SEC urging the adoption of an exemption for crowdfunding efforts.
The difficulty here is trying to balance the policy of encouraging small business formation against the investor protection goals of the securities laws. Unless new exemptions are formally adopted, crowdfunding may not provide a viable capital raising method in light of the costs of complying with securities registration or disclosure requirements. This article provides an overview of the applicable securities laws and evaluates the various proposals which their proponents argue would provide a workable exemption that would not unduly compromise investor protection. The article concludes, however, that the proposals to date do not adequately justify an exemption.
Excess-Pay Clawbacks, by Jesse M. Fried, Harvard Law School, Harvard Law & Economics Submitter
Harvard University - John M. Olin Center for Law, Economics, and Business, Nitzan Shilon, Harvard Law School, was recently posted on SSRN. Here is the abstract:
We explain why firms should have a clawback policy requiring directors to recover “excess pay”—extra payouts to executives resulting from errors in performance measures (such as reported earnings). We then analyze the compensation arrangements of S&P 500 firms and find that very few have voluntarily adopted such a policy. Our findings suggest that the Dodd–Frank Act, which requires firms to adopt a policy for clawing back certain types of excess pay, will improve compensation arrangements at most firms. We also suggest how firms should address the types of excess pay not reached by Dodd–Frank
Wednesday, November 2, 2011
Judge McMahon (S.D.N.Y.) ruled on November 1 that Madoff Trustee Picard did not have standing to pursue common law claims against JPMorganChase andd UBS to recover on behalf of the defrauded customers, based on allegations that the banks knew, should have known or consciously avoided discovering, that Madoff' was illegally misappropriating customers' funds. Picard v. JPMorgan Chase & Co., Picard v. UBS AG (No. 11 civ. 913 (CM)Download Picard.JP Morgan. ( She thus joins Judge Rakoff (also S.D.N.Y.), who recently ruled similarly in Picard v. HSBC Bank PLC, 454 B.R. 25, in holding that the Trustee's authority under the Bankruptcy Code and SIPA extends only to recovering funds on behalf of the brokerage firm. Accordingly, the amount of money the Trustee can recover from the banks is significantly reduced.
Judge McMahon held that:
- There was no doubt that the common law causes of action belong to the creditors, not the brokerage firm; and
- The Trustee cannot pursue the common law causes of action on behalf of the brokerage firm as a consequence of the equitable doctrine of in pari delicto.
Tuesday, November 1, 2011
On Oct. 24, 2011, a New York State Supreme Court (County of New York) Justice dismissed the New York Attorney General's complaint against Charles Schwab & Co. involving the firm's sale of auction rate securities (ARS).(Download Schwaborder ) Filed in 2009, the AG charged that Schwab failed to disclose to investorsthe risks involved in ARS, but instead repeatedly described the investments as "liquid," while knowing that major underwriter broker-dealers in the ARS market were supporting the market with proprietary bids to keep the auctions from failing and that the market would collapse if they stopped maintaining it. The AG further alleged that Schwab failed to ensure that its sales force was knowledgeable about the features and risks of ARS. Bringing claims under the Martin Act as well as consumer fraud, the AG sought to compel Schwab to buy back the ARS at par and other equitable remedies and penalties.
The court found, however, found that the complaint did not allege any representations that the ARS were liquid at a time when they were illiquid and accordingly dismissed all claims. Further, "despite having conducted an investigation for over a year prior to the filing of the complaint during which time the AG demanded and obtained more than 4,000 documents, received audio and call recordings involving more than 200 ARS transactions and deposed eleven witnesses, the complaint is devoid of any allegations of representations made that were untrue when made." Emphasizing that this was a misrepresentations and not an omissions case, the court held that the AG's allegations were essentially "fraud by hindsight."