Saturday, March 19, 2011
Judges Who Settle, by Hillary A. Sale, Washington University School of Law in St. Louis, was recently posted on SSRN. Here is the abstract:
This Article develops a construct of judges as gatekeepers in corporate and securities litigation, focusing on the last-period, or settlement stage of the cases. Many accounts of corporate scandals have focused on gatekeepers and the roles they played or, in some cases, abdicated. Corporate gatekeepers, like investment bankers, accountants, and lawyers, function as enablers and monitors. They facilitate transactions and enable corporate actors to access the financial and securities markets. Without them the transactions would not happen. In class actions and derivative litigation, judges are the monitors and enablers. They are required to oversee the litigation arising from bad transactions and corporate scandals. Unlike other types of private law litigation, where the parties settle and have the case dismissed, judges must approve settlements of class actions and derivative litigation. They are actually charged with fiduciary responsibilities and control the exit stage, or settlement, of the litigation. As a result, the judges’ job is to be a gatekeeper.
The judges are not, however, doing their jobs. “Doing their jobs” requires actual scrutiny of the role of defense counsel and insurers, both of whom amplify agency costs. It also requires scrutiny of the settlement collusion between defendants and plaintiffs. Yet, traditionally both academics and the courts have failed to analyze those issues in the context of the costs of aggregate and derivative litigation. This Article provides a real cut at those issues. It then develops and explores principles for gate keeping judges, which, if implemented, will decrease the agency costs of this type of litigation and ensure that the judges are actually functioning as the fiduciaries they are required to be.
Deterring 'Double-Play' Manipulation in Financial Crisis: Increasing Transaction Cost as a Regulatory Tool, by Lynn Bai, University of Cincinnati - College of Law, was recently posted on SSRN. Here is the abstract:
The sub-prime mortgage crisis that originated in the United States has triggered a global credit crunch, threatening the solvency of emerging markets that have relied heavily on foreign debt, and resulting in the devaluation of their currencies. Currency market interventions by the central banks in countries with a currency board system lead to higher short-term interest rates and further declinations in the local stock market. This economic setting invites the double-play manipulation strategy that simultaneously attacks both the local currency and the stock market. History has shown that a central bank’s stock market intervention is costly and that sustaining the intervention over a meaningful period of time is a major challenge. In this paper, we examine the effect of a pan-market increase in transaction cost on double-play manipulators’ trading strategies when government intervention is limited to revenues generated by the transaction levy. We show that this regulatory change not only helps sustain equity market intervention but also reduces the short pressure in both the currency and the equity market.
Earlier this week the FDIC sued Kerry K. Killinger, former CEO of failed savings bank Washington Mutual, and two of the bank's executives, Stephen J. Rotella and David C. Schneider. In the suit, which is seeking $900 million in damages, the FDIC charges that the executives recklessly pursued short-term gains to increase their own compensation, in disregard of the bank's safety and soundness. This is the FDIC's first suit against executives at a major bank.
Killinger called the claims "baseless and unworthy of the government."
NYTimes, F.D.I.C. Sues Ex-Chief of Big Bank That Failed (Mar. 17, 2011)
The second week of the Raj Rajaratnam trial was mostly devoted to the testimony (both direct and cross) of Anil Kumar, the former McKinsey executive, who previously pleaded guilty to securities fraud charges. In addition, the prosecutors played more of those many taped phone conversations between RR and other individuals discussing various acquisitions. The most interesting tape may have been the conversation between RR and Rajat Gupta, the former Goldman director, involving Goldman board discussions about possible deals. (The SEC has sued Gupta in an administrative proceeding; Gupta, in turn, has sued the SEC in federal court.)
Kumar testified that he gave "super confidential information" about McKinsey client AMD and other companies to RR in exchange for $2 million, some of which was paid through an offshore account set up in the name of his housekeeper. RR's defense attorney aggressively cross-examined Kumar, accusing him of a "monstrous lie" in setting up the phony account and fraud on the IRS. RR's attorney also argued that the money paid by RR was for legitimate advice and that the information was not material nonpublic information.
After Kumar's testimony concluded, the prosecutor played still more taped conversations, this time RR's calls with former Intel employee Rajiv Goel (who also has pleaded guilty and is expected to testify). In one of them RR said he had received information about PeopleSupport "because one of our guys is on the board."
FINRA recently requested comment on a Concept Proposal to Identify and Manage Conflicts Involving the Preparation and Distribution of Debt Research Reports. According to the Executive Summary:
FINRA seeks comment on a concept proposal to apply objectivity safeguards
and disclosure requirements to the publication and distribution of debt
research reports. The proposal has a tiered approach that generally would
provide retail debt research recipients with most of the same protections
provided to recipients of equity research, while exempting debt research
provided solely to institutional investors from many of those provisions.
The comment period expires April 25, 2011.
The SEC settled charges with International Business Machines Corporation (“IBM”) that it violated the books and records and internal control provisions of the Foreign Corrupt Practices Act of 1977 (“FCPA”) as a result of the provision of improper cash payments, gifts, and travel and entertainment to government officials in South Korea and China.
As alleged in the SEC’s Complaint, from 1998 to 2003, employees of IBM Korea, Inc., an IBM subsidiary, and LG IBM PC Co., Ltd., a joint venture in which IBM held a majority interest, paid cash bribes and provided improper gifts and payments of travel and entertainment expenses to various government officials in South Korea in order to secure the sale of IBM products.
It was further alleged that, from at least 2004 to early 2009, employees of IBM (China) Investment Company Limited and IBM Global Services (China) Co., Ltd., both wholly-owned IBM subsidiaries, engaged in a widespread practice of providing overseas trips, entertainment, and improper gifts to Chinese government officials.
Without admitting or denying the SEC’s allegations, IBM consented to the entry of a final judgment that permanently enjoins the company from violating the books and records and internal control provisions of the FCPA, codified as Sections 13(b)(2)(A) and 13(b)(2)(B) of the Securities Exchange Act of 1934. IBM also agreed to pay disgorgement of $5,300,000, $2,700,000 in prejudgment interest, and a $2,000,000 civil penalty.
The SEC created a stir a few weeks ago when it brought an administrative enforcement action against Rajat Gupta, the former P&G and Goldman director, for tipping confidential inside information to Raj Rajaratnam. Many questioned why the SEC chose to exercise its new authority in Dodd-Frank to bring an administrative proceeding against Gupta and did not bring an action in federal district court and why the DOJ had not brought a criminal proceeding against Gupta. (The prosecutor in his opening statement at Rajaratnam's trial referred to the alleged tips from Gupta to Rajaratnam, and this week at the trial audio tapes were played of conversations between the two.)
Now Gupta has brought an action against the SEC, asserting that the SEC rushed to bring the administrative action against him and that his constitutional right to a trial by a jury has been violated. The law also questions whether the SEC can assert the Dodd-Frank provisions to conduct that allegedly took place before enactment of the statute.
Friday, March 18, 2011
The SEC proposed for public comment a rule on BENEFICIAL OWNERSHIP REPORTING REQUIREMENTS AND SECURITY BASED SWAPS. According to its summary, the rule is intended:
To preserve the application of our existing beneficial ownership rules to persons who purchase or sell security-based swaps after the effective date of new Section 13(o) of the Securities Exchange Act of 1934, we are proposing to readopt without change the relevant portions of Rules 13d-3 and 16a-1. The proposals are intended to clarify that following the July 16, 2011 statutory effective date of Section 13(o), which was added by Section 766 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), persons who purchase or sell security-based swaps will remain within the scope of these rules to the same extent as they are now.
Comments should be received on or before April 15, 2011.
The SEC charged four executives at Steel Technologies, a Louisville-based steel processing company, and four of their family and friends with illegal insider trading in advance of the company’s acquisition. The SEC alleges that Patrick Carroll, William “Tad” Carroll, David Mark Calcutt and David Stitt – who are vice presidents of sales at Steel Technologies – traded based on confidential information about their company’s acquisition by Mitsui & Co. (USA) Inc. Three of the four executives illegally tipped family members or friends. The ring of eight traders together purchased $578,000 of Steel Technologies stock in the month prior to the public announcement of the acquisition and made $320,000 in illegal profits.
According to the SEC’s complaint filed in U.S. District Court for the Western District of Kentucky, Patrick and Tad Carroll are brothers of Michael Carroll, who is the president and chief operating officer of Steel Technologies. Patrick traded after Michael introduced him to Mitsui representatives who were touring the Steel Technologies facility where Patrick worked. Patrick tipped his son James, who then purchased his own Steel Technologies stock shortly before the acquisition was publicly announced. Tad bought more than $84,000 of Steel Technologies stock approximately one week before the public announcement following his own communications with Michael.
The SEC alleges that before getting inside information about the forthcoming acquisition, Calcutt liquidated nearly all of his company stock. However after he went on a hunting trip with Michael Carroll, Calcutt soon started aggressively buying Steel Technologies stock at higher prices. He also tipped his brother Christopher Calcutt, who then sold all of his shares in another company for a loss and used that money to buy Steel Technologies stock on margin to increase his illicit gains.
According to the SEC’s complaint, Stitt, Monroe and Somers have known each other since childhood. Stitt learned about the forthcoming acquisition on the Friday before the public announcement and immediately purchased Steel Technologies stock that same day. Over the weekend, Stitt told Monroe about the forthcoming acquisition. On Monday, Monroe passed the inside information to Somers. That same day, Monroe told his broker to immediately open a new account so he could buy Steel Technologies stock. Somers also immediately traded based on the inside information. During the SEC’s investigation, Stitt and Monroe contradicted each other’s testimony about their communications and advance knowledge of the acquisition.
The SEC’s complaint charges the eight defendants with securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The Commission seeks permanent injunctive relief, disgorgement of illicit profits with prejudgment interest, and the imposition of monetary penalties against all defendants.
Sutherland Asbill & Brennan LLP recently announced the results of its 2011 Sutherland SEC/FINRA Litigation Study – an annual review of the litigated cases brought by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) against broker-dealers and associated persons. The study finds that at least in some cases it paid to fight SEC and FINRA charges, particularly in cases involving fraud.
Highlights from the study include:
• Of the 237 charges that were litigated by the SEC and FINRA and resulted in SEC Administrative Law Judge (ALJ) or FINRA Hearing Panel decisions during FY 2009 and FY 2010, respondents succeeded in getting approximately 13% of the charges dismissed.
• FINRA respondents with counsel are significantly more successful than pro se respondents.
• SEC staff failed to prove fraud charges approximately 57% of the time in FY 2009-2010.
• When SEC and FINRA respondents were found to have been liable for one or more charges, 33% of the time the ALJ or the Hearing Panel imposed monetary sanctions that were lower than the staff sought at the trial.
• When cases were appealed from SEC ALJs to the full Commission, 33% of SEC respondents were successful in getting reduced sanctions
The study is available at the firm's website.
Republicans on the House Financial Services Committee call on SEC Chair Schapiro to slow down on considering any rule to extend the investment adviser's fiduciary duty to broker-dealers. They call for more rigorous analysis and a cost-benefit analysis to justify any proposed rule. This was essentially the position taken by the two dissenting (Republican) Commissioners in the SEC's fiduciary duty study, released earlier this year. Bloomberg, Republicans Want More Study Before SEC Sets U.S. Fiduciary Rule
Wednesday, March 16, 2011
The Public Company Accounting Oversight Board (PCAOB) recently issued its first public Research Note which provides new data on the growth of reverse merger transactions involving companies from the China region.
The Research Note, entitled, "Activity Summary and Audit Implications for Reverse Mergers Involving Companies from the China Region (January 1, 2007 through March 31, 2010)," was prepared by the PCAOB Office of Research and Analysis (ORA) to provide further context to the issues discussed in Staff Audit Practice Alert No. 6 issued on July 12, 2010. That Alert was based on observations from the PCAOB inspection process that some U.S. registered accounting firms may not be conducting audits of companies with operations outside of the U.S. in accordance with PCAOB standards.
In the period from January 2007 to March 31, 2010, ORA staff found that out of the 603 reported reverse merger transactions, 159 of those involved companies from the China region; the remaining 444 transactions involved primarily U.S. companies. Overall, reported reverse merger transactions involving companies from the China region during that time represented 26 percent of all reverse merger transactions reported during that time period.
The number of reverse merger transactions in the study involving companies from the China region was almost triple the number of initial public offerings (IPOs) conducted in the U.S. by companies from the PRC during that time. There were 56 IPOs from such companies, representing 13 percent of the IPOs completed in the United States.
Additionally, following the reverse merger transaction, two-thirds of the Chinese reverse merger companies in the study had market capitalization below $75 million as of March 31, 2010, while more than three-quarters of the companies from the PRC that conducted IPOs had market capitalization above $75 million as of March 31, 2010.
As of March 31, 2010, the market capitalization of the 159 Chinese reverse merger companies identified by ORA staff was $12.8 billion, less than half the $27.2 billion market capitalization of the 56 companies from the PRC that conducted IPOs during the same period. As of that date, 59 percent of Chinese reverse merger companies reported less than $50 million in revenues or assets as of their most recent fiscal year.
PCAOB-registered accounting firms based in the United States audited 74 percent of the Chinese reverse merger companies, while China-based registered firms audited 24 percent. Due to the position taken by authorities in the PRC, the PCAOB is currently prevented from conducting inspections of the U.S.-related audit work of PCAOB-registered firms in the PRC and, to the extent their audit clients have operations in the PRC, PCAOB-registered firms in Hong Kong SAR.
The SEC today charged three senior executives at Akron, Ohio-based Fair Finance Company with orchestrating a $230 million fraudulent scheme involving at least 5,200 investors – many of them elderly. The SEC alleges that after purchasing Fair Finance Company, chief executive officer Timothy S. Durham, chairman James F. Cochran, and chief financial officer Rick D. Snow deceived investors while selling them interest-bearing certificates. Fair Finance had previously operated for decades as a privately-held consumer finance company. But under the guise of loans, Durham and Cochran schemed to divert investor proceeds to themselves and others as well as struggling and unprofitable entities that they controlled. Durham and Cochran further misused investor funds to buy classic cars and other luxury items to enhance their own lavish lifestyles.
In a parallel criminal proceeding, the U.S. Department of Justice today unsealed criminal charges against Durham, Cochran and Snow for the same alleged misconduct.
The SEC’s complaint seeks permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest, penalties and officer and director bars against each of the defendants.
The SEC today charged Teresa A. Kelly, the former operations supervisor of Colonial Bank’s mortgage warehouse lending division (MWLD), with participating in a $1.5 billion securities fraud scheme. According to the SEC, Kelly enabled the sale of fictitious and impaired mortgage loans and securities from the MWLD’s largest customer – Taylor, Bean & Whitaker Mortgage Corp. (TBW) – to Colonial Bank. She caused these securities to be falsely reported to the investing public as high-quality, liquid assets.
The SEC previously charged former TBW chairman and majority owner Lee B. Farkas in June 2010, charged TBW’s former treasurer Desiree E. Brown in February 2011, and charged the head of Colonial Bank’s MWLD Catherine L. Kissick earlier this month. According to the SEC’s complaint filed in U.S. District Court for the Eastern District of Virginia, Kelly along with Farkas, Kissick and Brown perpetrated the fraudulent scheme from March 2002 to August 2009, when Colonial Bank was seized by regulators and Colonial BancGroup and TBW each filed for bankruptcy. Because TBW generally did not have sufficient capital to internally fund the mortgage loans it originated, it relied on financing arrangements primarily through Colonial Bank’s mortgage warehouse lending division to fund such mortgage loans.
The SEC alleges that TBW began to experience liquidity problems and overdrew its then-limited warehouse line of credit with Colonial Bank by approximately $15 million each day. Kelly, Farkas, Kissick and Brown concealed the overdraws through a pattern of “kiting” in which certain debits were not entered until after credits due for the following day were entered. In order to conceal this initial fraudulent conduct, Kelly, Farkas, Kissick and Brown created and submitted fictitious loan information to Colonial Bank and created fictitious mortgage-backed securities assembled from the fraudulent loans. By the end of 2007, the scheme consisted of approximately $500 million in fake residential mortgage loans and approximately $1 billion in severely impaired residential mortgage loans and securities. These fictitious and impaired loans were misrepresented as high-quality assets on Colonial BancGroup’s financial statements.
The SEC’s complaint charges Kelly with violations of the antifraud, reporting, books and records and internal controls provisions of the federal securities laws.
Regulators Invite Comments on the CPSS-IOSCO Consultative Report on the Principles for Financial Market Infrastructures
The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commission (IOSCO) recently released for comment the consultative report on the Principles for Financial Market Infrastructures. The CPSS and IOSCO expect these principles to play an important role in the future regulation of financial market infrastructures around the world. The Board of Governors of the Federal Reserve System, a member of the CPSS, and the U.S. Commodity Futures Trading Commission and the U.S. Securities and Exchange Commission, members of the Technical Committee of IOSCO, encourage interested persons to review and comment on the consultative report. The deadline for submitting comments on the Principles for Financial Market Infrastructures is July 29, 2011.
The consultative report contains updated and new proposed international principles for systemically important payment systems, central securities depositories, securities settlement systems, central counterparties, and trade repositories. The 24 proposed principles would replace existing CPSS and CPSS-IOSCO standards for payment, clearing, and settlement systems previously published in the Core Principles for Systemically Important Payment Systems, Recommendations for Securities Settlement Systems, and Recommendations for Central Counterparties and introduce principles for trade repositories for the first time.
Tuesday, March 15, 2011
The SEC today charged a hedge fund investment advisory firm and its two founders with orchestrating a multi-faceted scheme to defraud clients and failing to comply with fiduciary obligations. According to the SEC, Eugenio Verzili and Arturo Rodriguez through their firm Juno Mother Earth Asset Management LLC misappropriated client assets, inflated assets under management, and filed false information with the SEC. Juno, Verzili and Rodriguez looted approximately $1.8 million of assets from a hedge fund they manage, misusing it to pay Juno’s operating costs related to payroll, rent, travel, meals, and entertainment. They issued promissory notes to conceal a substantial portion of their misappropriation. Juno, Verzili and Rodriguez also misrepresented the amount of capital that some Juno partners had invested in one of its funds, claiming they had invested millions of dollars when they actually had invested nothing in the funds.
According to the SEC’s complaint filed in the U.S. District Court for the Southern District of New York, Juno sold securities in client brokerage and commodity accounts and directed 41 separate transfers of cash to Juno’s bank account, claiming falsely that the transfers were reimbursements for expenses Juno had incurred on behalf of the client fund. Verzili and Rodriguez later fabricated and issued nine promissory notes to make it appear that the client fund had invested the money in Juno. But they concealed the so-called investment from the independent directors of the client fund.
The SEC seeks permanent injunctions, disgorgement of ill-gotten gains plus prejudgment interest, and monetary penalties.
State Regulators Urge Federal Court not to Enjoin State Administrative Proceedings Against Securities America
As I have previously blogged, a judge hearing a class action brought against Securities America granted plaintiffs' request for a TRO to restrain individual arbitration hearings brought against the firm, citing his power under the All Writs Act (Billitteri v. Securities America, Feb. 18, 2011, N.D. Tex.). NASAA and state regulators in Massachusetts and Montana filed briefs urging the court to deny a request for a preliminary injunction to halt administrative proceedings brought by state regulators against Securities America Inc. and Securities America Financial Corporation and other defendants.
A hearing has been scheduled for March 18 in the federal court in Dallas.
State securities regulators in Massachusetts and Montana have initiated investigations into allegations of wrongdoing by Securities America and others involving the offer and sale of securities.
In its brief, NASAA said: “The state regulators have dedicated significant resources and expended great effort in the course of these investigations and now face the potential of having this Court halt those proceedings.
"The request by the Plaintiffs to enjoin the state regulators will not only terminate the efforts of the Massachusetts and Montana regulators, but it will have a chilling effect on all state securities regulators in that, despite their clear statutory authority to take steps necessary to police illicit conduct in their states, they potentially face having that authority impaired by defendants who would run to federal courts to plead poverty. The Court should, therefore, refrain from interfering with the states’ proceedings as they seek to fulfill their critical function.”
Sunday, March 13, 2011
This past week the criminal trial of Raj Rajaratnam on fourteen counts of securities fraud and conspiracy began in Manhattan. RR is the founder of Galleon Group, a hedge fund, who was arrested in October 2009 and charged with running a vast network of corporate insiders, consultants, Wall Street bankers and traders to make profits through illegal insider trading. RR maintains his innocence, asserting that his profits were the result of diligent research, and is presenting an aggressive, spare-no-expense defense. In short, a spectacle worth following for those with an interest in securities fraud and enforcement. Throughout the trial, expected to last 10 weeks, I'll provide periodic summaries of what has transpired.
On March 8, both the government and the defense presented their opening statements to the jury. The prosecutor emphasized a network of "greed and corruption" to provide confidential inside information and specifically identified four of RR's associates: Anil Kumar, former Partner at McKinnsey & Co.; Rajil Goel, former Intel executive; Adam Smith, Galleon portfolio manager; and Rajat Gupta, former director of Goldman and P&G. The first three have pleaded guilty and are cooperating with the government. The prosecutor focussed, in particular, on Gupta's alleged tip that Goldman had just approved a $5 billion investment from Warren Buffett, an important transaction that took place during the financial crisis when banks were searching for additional capital.
The defense, in contrast, emphasized his client's research, diligence and hard work in achieving profits. The attorney made clear that the "mosaic theory" -- collecting bits of detailed, non-material information to form a mosaic on which investment decisions were based -- was an important part of the defense. (For a good summary of the first day, see NYTimes, It’s Greed vs. a Picture of Solid Research in Galleon Trial)
On March 11, the jury heard three taped telephone conversations between RR and three key figures: Adam Smith, Anil Kumar, Rajiv Goel. Much of the government's case is expected to be made on the basis of hundreds of secretly taped conversations, which are of high quality. (the WSJ has the audioi tapes.) These conversations took place in 2008 and, according to the government, show that RR was receiving tips on forthcoming deals. On cross-examination, the defense attempted to show that the conversations were taken out of context. (For a good summary of the second day, see NYTimes, Galleon Jurors Hear Tapes)
Stay tuned for next week's developments.
New York Stock Exchange Listing Standards and Corporate Social Responsibility, by Celia Taylor, University of Denver Sturm College of Law, was recently posted on SSRN. Here is the abstract:
Rules and regulations governing the disclosure of corporate social responsibility policies and practices in the US lag behind that of other countries. While countries such as Sweden, France, the UK and others have mandated the disclosure of corporate social responsibility data, efforts in the US are piecemeal and incomplete. To the extent that any CSR disclosure is required, it is often difficult to discern, assemble and interpret.
While many companies formed or operating in the US follow solid CSR practices, in the main they do so voluntarily as there are few, if any, rules that affirmatively require firms to make disclosures of non-financial social and environmental information. The limited attention paid to CSR under US law means that foreign companies seeking access to US markets generally will not face serious impediments in terms of regulations regarding CSR. This short work briefly describes the listing standards of the New York Stock Exchange-Euronext ("NYSE") to determine the impact of those standards on CSR disclosure applicable to foreign private issuers ("FPIs"). It is not a comprehensive review of all of the NYSE listing standard. It demonstrates that NYSE listing standards permit but do not require that companies follow any particular CSR practices or policies. Thus, FPIs that wish to list on the NYSE need not make any significant CSR disclosure although they are permitted to do so if they wish.
The Dodd-Frank Act: A New Deal for a New Age?, by Saule T. Omarova, University of North Carolina at Chapel Hill School of Law, was recently posted on SSRN. Here is the abstract:
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is widely regarded as the most comprehensive financial regulation reform in the United States since the Great Depression and, in many ways, the modern equivalent of the New Deal in the financial sector. Although it is difficult to assess the practical impact of the Dodd-Frank Act at this early stage in its implementation, this essay offers some reflections on whether the Act lives up to that historical comparison and whether it presents a qualitatively new approach to resolving regulatory challenges posed by today’s financial markets. The essay examines some of the overarching themes built into the foundation of the Act and identifies a few areas in which the Act continues to rely on the old, pre-crisis regulatory principles and assumptions. It concludes that, despite its expansive reach, the Dodd-Frank Act failed to deliver conceptually innovative solutions that could serve as the basis for the twenty-first-century version of the New Deal.