May 6, 2011
Senate Banking Committee Schedules Oversight Hearing on Dodd-Frank Implementation
The Senate Banking Committee has scheduled a hearing on Oversight of Dodd-Frank Implementation: Monitoring Systemic Risk and Promoting Financial Stability for May 12, 2011. The witnesses will be: The Honorable Neal S. Wolin, Deputy Secretary, U.S. Department of the Treasury; The Honorable Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System; The Honorable Sheila Bair, Chairman, Federal Deposit Insurance Corporation; The Honorable Mary Schapiro, Chairman, U.S. Securities and Exchange Commission; The Honorable Gary Gensler, Chairman, Commodity Futures Trading Commission; and Mr. John Walsh, Acting Comptroller of the Currency, Office of the Comptroller of the Currency.
One Year After the Flash Crash
SEC Chairman Mary L. Schapiro, in her Remarks Before the Investment Company Institute's General Membership Meeting today, addressed the events of last May 6 (the "flash crash") and the SEC's responses to those events. She concluded by observing that:
We need to continue examining the effects of high speed trading on the markets and on buy-side and fundamental investors. The role of these traders, whose prominence in the markets seems only to increase, should be subject to further scrutiny. The possibility of imposing obligations during times of potential turmoil must remain on the table. And we need to pay attention to other potential flaws that could bring about equally disruptive events.
SIFMA released a statement on the One-Year Anniversary of the Flash Crash and stated, in part:
Over the past year, regulators, the exchanges, and market participants have worked together to fix what went wrong that day. In a unified effort, common sense workable solutions to curb volatility in equity markets have been put in place, including the implementation of a single stock circuit breaker, clarity on how to break erroneous trades and the treatment of so-called stub quotes.
Additionally, market participants will continue to work with regulators and the exchanges to implement the new limit-up, limit-down proposal recently announced by the Securities and Exchange Commission. We believe this is a positive step forward from the original single stock circuit breaker system.”
May 5, 2011
UBS Settles Fraud Charges in Municipal Bond Derivatives Transactions with Governments and Nonprofits
The New York AG announced a multimillion dollar settlement with UBS for fraudulent and anticompetitive conduct in its municipal bond derivative transactions with governments and nonprofits across the country. UBS will pay $90.8 million as part of a coordinated federal and state enforcement agency settlement. Of that amount, $63.3 million will go to a multistate restitution fund for governments and nonprofits that entered into municipal derivatives contracts with UBS, or used UBS as a broker on such deals, between 2001 and 2004.
The settlement follows an investigation led by the Attorneys General of New York and Connecticut, parallel with the U.S. Department of Justice and other enforcement agencies. Starting in 2008, the state authorities undertook a review of the municipal bond derivatives market, where tax exempt entities like governments and nonprofit organizations issue municipal bonds and reinvest the proceeds until the funds are needed or enter into contracts to hedge interest rate risk.
The investigation revealed conspiratorial and fraudulent conduct involving individuals at UBS, other financial institutions, and certain brokers with whom they had working relationships. Rather than establishing honest and fair terms of contract for the municipal derivative sales, certain UBS employees and their affiliates at other institutions rigged bids, submitted noncompetitive courtesy bids and fraudulent certificates of arms-length bidding to government agencies. The misconduct led local and state governments, municipalities, counties, government agencies and school districts, as well as nonprofits, to enter into municipal derivatives contracts on less advantageous terms than they would have otherwise.
The multistate settlement is the single largest component of coordinated settlements between UBS and the U.S. Department of Justice’s Antitrust Division, the Securities and Exchange Commission (SEC) and the Internal Revenue Service, as well as the states. UBS is the second of several financial institutions involved in the ongoing municipal bond derivatives investigation to resolve the claims against it. Bank of America entered into a settlement in December 2010.
Pursuant to the state agreement, UBS will pay a total of $90.8 million. Governmental and nonprofit entities nationwide that entered into municipal derivative agreements with UBS between 2001 and 2004 will be entitled to $63.3 million in restitution from the state settlement. The agreement also provides that UBS will pay the states $2.5 million in penalties and $5 million in fees and costs of the investigation. UBS will pay another $20 million directly to other governments and nonprofits as part of its resolution with the SEC.
Other states joining New York in the UBS settlement include: Alabama, California, Colorado, Connecticut, District of Columbia, Florida, Idaho, Illinois, Kansas, Maryland, Massachusetts, Michigan, Missouri, Montana, Nevada, New Jersey, North Carolina, Ohio, Oregon, Pennsylvania, South Carolina, Texas, Tennessee and Wisconsin.
FINRA Fines Wells Fargo $1 Million for Late Delivery of Mutual Fund Prospectuses
FINRA fined Wells Fargo Advisors, LLC of St. Louis, $1 million for its failure to deliver prospectuses in a timely manner to customers who purchased mutual funds in 2009, and for delays in reporting material information about its current and former representatives, including arbitrations and complaints involving its representatives. FINRA found that Wells Fargo failed to deliver prospectuses within three business days of the transaction, as required by federal securities laws, to approximately 934,000 customers who purchased mutual funds in 2009. The customers received their prospectuses from one to 153 days late. Wells Fargo had failed to take corrective measures to ensure timely delivery of the prospectuses after its third-party service provider provided the firm with regular reports indicating that a number of customers had not received the prospectuses on time.
FINRA also found that Wells Fargo did not promptly report required information to FINRA regarding its current or former representatives. Under FINRA rules, a securities firm must ensure that information on its representatives' applications for registration (Forms U4) is kept current in FINRA's Central Registration Depository (CRD). A firm must also ensure that it updates a representative's termination notice (Form U5) after the representative leaves the firm. These forms must be updated within 30 days of the firm learning that a significant event has occurred - including notification of a formal investigation, customer complaints or arbitrations filed against the representative. FINRA found that from July 1, 2008, to June 30, 2009, Wells Fargo failed to update 8.1 percent of their Forms U4 and 7.6 percent of the Forms U5 on time. In total, Wells Fargo filed nearly 190 late amendments to Forms U4 and U5.
In settling this matter, Wells Fargo neither admitted nor denied the charges, but consented to the entry of FINRA's findings.
EC Sues Allen E. Weintraub and Sterling Global Holdings for Securities Fraud
The SEC filed a Complaint alleging fraud and violations of a tender offer rule against AWMS Acquisition, Inc., d/b/a Sterling Global Holdings (Sterling Global), a shell company, and Allen E. Weintraub, Sterling Global’s sole owner, officer, director, and employee. The Complaint, which was filed in U.S. District Court for the Southern District of Florida, alleges that Weintraub and Sterling Global deceived the public by making false and misleading statements regarding Sterling Global’s ability to purchase and operate two public companies–Eastman Kodak Company (Kodak) and AMR (AMR), the parent company of American Airlines. Specifically, the Complaint alleges:
On March 19, 2011, Weintraub, on behalf of Sterling Global, emailed a written tender offer to Kodak for all its “outstanding stock” at a total price of approximately $1.3 billion in cash. On March 29, 2011, Weintraub emailed substantially the same letter to AMR offering to purchase all AMR’s “outstanding stock” for approximately $3.25 billion in cash. These offer prices represented almost a 50% premium over each company's then current stock price.
In an effort to generate publicity, Weintraub emailed the purported tender offers to media outlets and financial investment research firms. In published media interviews, Weintraub boasted that he has 15 years experience buying distressed companies, that banks had agreed to finance the acquisitions, and that letters of credit could be readily provided.
Weintraub was convicted in Florida for fraud and grand larceny in 1992, 1998, and 2008. Weintraub is on probation for his 2008 conviction.
The Commission requests that the court permanently enjoin Weintraub and Sterling Global from violating the antifraud and tender offer provisions of the federal securities laws, order them to pay disgorgement plus prejudgment interest, and impose a civil money penalty against them.
May 4, 2011
Walter Addresses SEC's Efforts in Municipal Securities Markets
SEC Commissioner Elisse B. Walter gave the Keynote Address at the National Federation of Municipal Analysts (NFMA) Twenty-Eighth Annual Conference on May 4, 2011 and spoke about about the SEC’s efforts with respect to the municipal securities market.
SEC Seeks Public Comments on Two Short-Selling Disclosure Regimes
The SEC published on its website a request for public comment on the feasibility, benefits, and costs of two short selling disclosure regimes as a part of a study mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Section 417 of the Dodd-Frank Act directs the SEC’s Division of Risk, Strategy and Financial Innovation to study two short sale disclosure regimes. A transactions reporting regime would add short sale-related marks to the consolidated tape in a voluntary pilot program. A position reporting regime would entail real time reporting of investors’ short positions either to the public or to regulators only. The Commission is required to submit a report on the study to Congress by July 21, 2011.
To better inform the study, the request seeks public comment on both the existing uses of short selling in securities markets and the adequacy or inadequacy of the information regarding short sales available today. The request also seeks public comment on the likely effect of these possible future reporting regimes on the securities markets, including their feasibility, benefits, and costs.
The public comment period will remain open for 45 days following publication of the request in the Federal Register.
Schapiro Testifies on SEC Budget Request
SEC Chairman Mary Schapiro presented Testimony on the President's FY 2012 Budget Request for the SEC before the United States Senate Subcommittee on Financial Services and General Government, Committee on Appropriations, on May 4, 2011. In her testimony, Ms. Schapiro provided an overview of the agency’s actions and initiatives over the past year and then discussed the FY 2012 budget request and the activities that these resources would make possible.
SEC Charges Six Executives With Financial Fraud at Brooke Corporation
The SEC charged six former leading executives affiliated with Brooke Corporation, a Kansas-based financial corporation, with hiding critical information from investors and conducting a financial fraud. The SEC alleges that senior executives at Brooke Corporation and two subsidiaries – whose line of business was insurance agency franchising and providing loans to franchisees – misrepresented their deteriorating financial condition in filings to investors and other public statements in 2007 and 2008. Meanwhile, behind the scenes they engaged in various undisclosed schemes to meet almost weekly liquidity crises, and falsified reports and made accounting maneuvers to conceal the rapid deterioration of the loan portfolio.
Five of the six executives have agreed to settle the SEC’s charges against them. The Brooke companies are no longer in business.
UBS Settles SEC Charges of Fraudulent Bidding Practices Involving Investment of Municipal Bond Proceeds
The SEC and UBS Financial Services Inc. (UBS) settled charges of fraudulently rigging at least 100 municipal bond reinvestment transactions in 36 states and generating millions of dollars in ill-gotten gains. UBS has agreed to pay $47.2 million that will be returned to the affected municipalities. UBS and its affiliates also agreed to pay $113 million to settle parallel cases brought by other federal and state authorities.
When investors purchase municipal securities, the municipalities generally temporarily invest the proceeds of the sales in reinvestment products before the money is used for the intended purposes. Under relevant IRS regulations, the proceeds of tax-exempt municipal securities must generally be invested at fair market value. The most common way of establishing fair market value is through a competitive bidding process in which bidding agents search for the appropriate investment vehicle for a municipality.
According to an SEC spokesperson: “Our complaint against UBS reads like a ‘how-to’ primer for bid-rigging and securities fraud. Specifically, the SEC alleges that during the 2000 to 2004 time period, UBS’s fraudulent practices and misrepresentations undermined the competitive bidding process and affected the prices that municipalities paid for the reinvestment products being bid on by the provider of the products. Its fraudulent conduct at the time also jeopardized the tax-exempt status of billions of dollars in municipal securities because the supposed competitive bidding process that establishes the fair market value of the investment was corrupted. The business unit involved in the misconduct closed in 2008 and its employees are no longer with the company.
According to the SEC’s complaint filed in U.S. District Court for the District of New Jersey, UBS played various roles in these tainted transactions. UBS illicitly won bids as a provider of reinvestment products, and also rigged bids for the benefit of other providers while acting as a bidding agent on behalf of municipalities. UBS at times additionally facilitated the payment of improper undisclosed amounts to other bidding agents. In each instance, UBS made fraudulent misrepresentations or omissions, thereby deceiving municipalities and their agents.
According to the SEC’s complaint, UBS as a bidding agent steered business through a variety of mechanisms to favored bidders acting as providers of reinvestment products. In some cases, UBS gave a favored provider information on competing bids in a practice known as “last looks.” In other instances, UBS deliberately obtained off-market ”courtesy” bids or arranged “set-ups” by obtaining purposefully non-competitive bids from others so that the favored provider would win the business. UBS also transmitted improper, undisclosed payments to favored bidding agents through interest rate swaps. In addition, UBS was favored to win bids with last looks and set-ups as a provider of reinvestment products.
Without admitting or denying the allegations in the SEC’s complaint, UBS has consented to the entry of a final judgment enjoining it from future violations of Section 15(c) of the Securities Exchange Act of 1934. UBS has agreed to pay a penalty of $32.5 million and disgorgement of $9,606,543 with prejudgment interest of $5,100,637. The settlement is subject to court approval.
This is the SEC’s second settlement with a major bank in an ongoing investigation into corruption in the municipal reinvestment industry. In December 2010, the SEC charged Banc of America Securities LLC (BAS) with securities fraud for similar conduct. In that matter, BAS agreed to pay more than $36 million in disgorgement and interest to settle the SEC’s charges, and paid an additional $101 million to other federal and state authorities for its misconduct.
Aguilar on Lack of Board Diversity
Statement by SEC Commissioner Luis A. Aguilar: The Abysmal Lack of Diversity in Corporate Boardrooms is Growing Worse (May 2, 2011):
Today, the Alliance for Board Diversity released a report, Missing Pieces: Women and Minorities on Fortune 500 Boards — 2010 Alliance for Board Diversity Census, that confirmed what many of us have known for some time. The abysmal statistics regarding the lack of diversity in Corporate America are growing worse. This report found that women and minorities lost ground in America’s corporate boardroom between 2004 and 2010.
Specifically, the report finds that in the Fortune 100, between 2004 and 2010, white men increased their share of board seats in corporate America from 71.2% to 72.9%. Minorities and women shared the remainder with very few seats occupied by Asian Pacific Islanders, Hispanics or minority women in particular.
Thus, even though there are more qualified diverse candidates for corporate board seats than ever before, fewer of these candidates are being chosen for corporate board seats. Even though our nation has grown more diverse, the corporate boardroom is proving resistant to change.
I find this status quo unacceptable and question why at a time when there are more qualified diverse board candidates, we have less diverse board members.
SEC Charges Kentucky Steel Company Executives With Insider Trading
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. According to the SEC, 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.
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.
Rockwell Settles FCPA Charges Involving China Subsidiary
The SEC, on May 3, settled charges against Rockwell Automation, Inc. (Rockwell) arising out of violations of the FCPA through a former subsidiary in China, Rockwell Automation Power Systems (Shanghai) Ltd. (RAPS-China). As described in the Commission’s Order, from 2003 to 2006, certain employees of RAPS-China paid approximately $615,000 to Design Institutes, which were typically state-owned enterprises that provided design engineering and technical integration services that can influence contract awards by end-user state-owned customers. The payments were made through third-party intermediaries at the request of Design Institute employees and at the direction of RAPS-China’s Marketing and Sales Director. RAPS-China’s Marketing and Sales Director intended that these funds be paid directly to the Design Institute employees, with the expectation that they would influence the ultimate state-owned customers to purchase RAPS products. Rockwell realized approximately $1.7 million in net profits on sales contracts with end-user Chinese government-owned companies that were associated with payments to the Design Institutes. During the same period, employees of RAPS-China paid approximately $450,000 to fund sightseeing and other non-business trips for employees of Design Institutes and other state-owned companies. As further described in the Commission’s Order, Rockwell voluntarily self-reported the Design Institute payments, provided relevant facts from its internal investigation and otherwise cooperated with the Commission staff’s investigation, and undertook numerous remedial measures.
Rockwell consented to the entry of the Order which orders it to pay disgorgement of $1,771,000, prejudgment interest of $590,091 and a civil money penalty of $400,000.
FINRA Bars Broker for Insider Trading
FINRA recently announced that a former registered representative, Michael Hendry, has been barred from the securities industry for engaging in insider trading and for failing to respond truthfully to questioning by investigators in FINRA's Office of Fraud Detection and Market Intelligence (OFDMI). Hendry was also fined nearly $70,000, which represents the unlawful profits he received from the transactions. Hendry, of Chicago, worked as a divisional vice president of Pacific Select Distributors, Inc. from November 2005 to September 2010. He was barred for buying shares of Boots & Coots, Inc. (WEL) while he was in possession of information, obtained from an insider at WEL, that another company was going to acquire WEL.
On February 25 and 26, and March 11 and 17, 2010, Hendry purchased 73,000 shares of WEL, paying between $1.73 and $2.16 per share. On April 9, 2010, the company announced that it had agreed to be acquired by Halliburton for $3 per share, at a total transaction value of approximately $204.4 million. By April 12, 2010, the next trading day, WEL's stock price increased $0.67, or 25 percent, to $2.95 per share. Following the announcement of WEL's acquisition, Hendry sold all of his WEL shares for between $2.94 and $3 per share, realizing a profit of $69,955.
In settling this matter, Hendry neither admitted nor denied the charges, but consented to the entry of FINRA's findings
May 1, 2011
Kaufman & Wunderlich on Halliburton
Regular readers are aware that the SecuritiesLawProf and friends at The Conglomerate have been analyzing the implications (i.e., reading the tea leaves) of the Supreme Court's oral argument in Erica P. John Fund v. Halliburton Co., which was argued on April 26. Dean Michael Kaufman (Chicago-Loyola) and John Wunderlich have prepared these thoughtful comments in response to my last post. I am delighted to share them and welcome additional commentary from readers.
Erica P. John Fund, Inc. v. Halliburton Co., could very well be the most significant securities law decision since Basic, Inc. v. Levinson. Initial thoughts from oral argument at Halliburton seem to be that the Court will not revisit Basic, but refine it. Many expect the Court to hold that plaintiffs need not prove loss causation on a motion for class certification, but that defendants must be given a chance to present evidence of a lack of market efficiency or any evidence that severs the link between the investment decision and the market price, including what respondents called price impact---that a corrective disclosure did not move the market price. In other words, many expect the Court to reject the Fifth Circuit’s approach in Oscar Private Equity Invs. v. Allegiance Telecom., Inc., 487 F.3d 261 (5th Cir. 2007), adopt the Second and Third’s approaches in In re Salomon Analyst Metromedia Litig., 544 F.3d 474 (2d Cir. 2008), and In re DVI, Inc. Sec. Litig., No. 08-8033, 2011 WL 1125926 (3d Cir. Mar. 29, 2011), respectively. Professor Black calls this a Pyrrhic victory for plaintiffs.
Five of the Justices may nevertheless recognize that allowing defendants a chance to rebut the presumption of reliance with proof of market impact is perverse on many levels, and thus preserve Basic. First, opportunity-for-rebuttal approach wrongly conflates reliance (the initial investment decision) with loss causation (the dissipation of inflation), as the Court has defined those terms. The presumption of reliance assumes that because the market was efficient at the time of the fraudulent statement, the fraud is impounded in the company’s stock price. Reliance is thus limited to evidence that the fraud was incorporated into the stock price at the time of purchase. But it is important to note here that at times, there is no market impact on the date of the fraud. Professor Frank Torchio of Forensic Economics, Inc., explains this very well in a paper on event studies and securities litigation available here: http://www.forensiceconomics.com/index.php?option=com_content&task=blogcategory&id=17&Itemid=54. Loss causation, as defined by Dura, asks whether the fraud caused investors to pay an artificially inflated price that they could not recover because that inflation in some way dissipated, i.e., the company issues a corrective disclosure and the stock price drops as a result. The lack of market impact at the back end when discussing corrective disclosures is at best very thin evidence of a lack of reliance---a lack of pre-transaction price impact. Indeed, to argue that months after the fraud the disclosure of the fraud had no impact on the market price and therefore did not influence the original investment decision is nonsensical. We make this point in a recent paper available here http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1825448, as well as argue that the focus on a corrective disclosure, creates an irrational access barrier at class certification for investors.
Second, requiring plaintiffs to prove reliance on class certification still smacks of a merits-based inquiry on class certification rather than the procedural inquiry whether the case is best handled as a class action. The named plaintiff is not asserting actual reliance or else there would be no need for the presumption at all. Rather, the claim rests on presumed reliance, and thus the class will win or lose together only if they prevail on the merits of their claim of reliance on the market price. Thus, proof of reliance on the market price is common to all class members and they may lose as a class if the defendants sever the link.
And if the decision at class certification is a merits-based decision, what about Chief Justice Robert’s question at oral argument whether the decision would become the law of the case, which is actually a pro-defendant concern, much like that originally expressed in Eisen. In Eisen v. Carlisle, the Supreme Court admonished district courts to refrain from deciding the merits at class certification because the Court was concerned that merits-based decisions would actually prejudice defendants. They would be forced to litigate their claims, the Court said, without the traditional protections afforded litigants at trial. Now, if the district court finds reliance or loss causation as part of the class certification process, then defendants are saddled with that decision on the merits later on. As a legal matter, defendants have more to lose than plaintiffs. For example, if the court finds no reliance on loss causation at class certification, the named plaintiff may be bound by that decision through the law-of-the-case doctrine or collateral estoppel, but every other individual plaintiff is not bound in any way because the class was never certified. These individual litigants then are free to pursue individual litigation anew. Practically, individual suits pose a problem for plaintiffs, but legally there is no impediment. By contrast, if the district court finds reliance or loss causation at class certification, then the defendant is bound by that finding as to the entire class. And if, as the parties suggested at oral argument, all discovery relevant to reliance and loss causation is introduced at class certification, then there is no need to relitigate the matter at trial. These issues are resolved the same as if the court decided the issues on summary judgment in favor of the plaintiffs before sending the case to trial on the remaining elements. These questions raised by the law-of-the-case doctrine thus suggest a practical explanation for Basic’s footnote that relegates rebuttal to trial. We might therefore expect that a truly shrewd pro-defendant Supreme Court Justice may actually be reluctant to allow a federal judge to even come close to reaching the merits of a reliance and loss causation at class certification.
Horwich on Materiality and Scienter in Rule 10b-5
An Inquiry into the Perception of Materiality as an Element of Scienter under SEC Rule 10b-5, by Allan Horwich, Northwestern University - School of Law; Schiff Hardin LLP, was recently posted on SSRN. Here is the abstract:
In any private action or enforcement proceeding based on SEC Rule 10b-5 the plaintiff, including the Securities and Exchange Commission, must prove that the defendant engaged in deception or manipulation with scienter, that is, an intent to deceive (which lower courts have held encompasses reckless conduct). Where the gravamen of the claim is deception, the deception must have been material. A fact, including forward-looking information, is material if there is a substantial likelihood that a reasonable shareholder would consider the fact important in making his investment decision. This Article demonstrates that in an appropriate case an assessment of whether the defendant acted with scienter should consider whether the defendant appreciated the materiality of an omitted or misrepresented fact. As one example, an insider who traded in the securities of his employer while he was aware of nonpublic information should not be found to have acted with scienter, if, before trading, he made a good faith evaluation of that information, including (but not necessarily) consulting with counsel, and concluded that the information was not material, even though a trier of fact later found that the information was material when the trade occurred.
Bratton & Wachter on Fraud on the Market
The Political Economy of Fraud on the Market, by William W. Bratton, University of Pennsyvlania Law School; European Corporate Governance Institute (ECGI), and Michael L. Wachter, University of Pennsylvania Law School, was recently posted on SSRN. Here is the abstract:
The fraud on the market class action no longer enjoys substantive academic support. The justifications traditionally advanced by its defenders - compensation for out-of-pocket loss and deterrence of fraud - are thought to have failed due to the action’s real world dependence on enterprise liability and issuer funding of settlements. The compensation justification collapses when considered from the point of view of different types of shareholders. Well-diversified shareholders’ receipts and payments of damages even out over time and amount to a wash before payment of litigation costs. The shareholders arguably in need of compensation, fundamental value investors who rely on published reports, are undercompensated due to pro rata distribution of settlement proceeds to all class members. The deterrence justification fails when enterprise liability is compared to alternative modes of enforcement. Actions against individual perpetrators would deter fraud more effectively than does enterprise liability. If, as the consensus view now has it, fraud on the market makes no policy sense, then its abolition would seem to be the next logical step. Yet most observers continue to accept it on the same ground cited by the Supreme Court in 1964 when it first implied a private right of action under the 1934 Act in J.I. Case v. Borak - a private enforcement supplement is needed in view of inadequate SEC resources. Restating, even a private enforcement supplement that makes no sense is better than no private enforcement supplement at all.
This Article questions this backstop policy conclusion, highlighting the sticking points retarding movement toward fraud on the market’s abolition and mapping a plausible route to a superior enforcement outcome. We recommend that private plaintiffs be required to meet an actual reliance standard. We look to the Securities and Exchange Commission (SEC), rather than Congress or the courts, to initiate the change - it is the lawmaking institution most responsible for the unsatisfactory status quo and best equipped to propose a corrective. Because an actual reliance requirement would substantially diminish the flow of private litigation, we also look to a compensating step up in public enforcement capability. More specifically, the SEC enforcement division needs enough funding to redirect its efforts away from the enterprise toward culpable individuals.
The Article addresses three barriers standing between here and there. First, there is a new justification of fraud on the market circulating in the wake of the failure of the original justifications - that fraud on the market litigation enhances the operation of the corporate governance system. We show that this line of reasoning, while well-suited to justify the federal mandatory disclosure system, does nothing for the case for fraud on the market, even detracting from it. Second, we turn to politics to explain why fraud on the market retains political legitimacy despite the failure of its policy justifications. Third, we look into the facts supporting the backstop justification - inadequate public enforcement resources. We show that circumstances have changed materially since the Supreme Court first invoked the justification in 1964. The SEC budget has grown 11-fold in real terms in the intervening 47 years, with much of the growth coming in the wake of Enron. The SEC’s enforcement resources, like those of the plaintiffs’ bar, ultimately are funded with dollars drawn from shareholder pockets, inviting direct comparison between the two. We show that, as between the public and private sector, public enforcement offers the shareholders more value than private enforcement. Private resources are tied to a low-deterrence, enterprise liability framework. Public enforcement even now yields the shareholders comparable damage returns per dollar invested in enforcement. It can be deployed more flexibly, and it can be refocused against individual wrongdoers so as to enhance deterrence.
We conclude that stepped up enforcement in public enforcement makes sense for shareholders even if it implies a diminished volume of private litigation. We accordingly propose a political trade-off for the SEC to moot to Congress - double the enforcement budget in exchange for an SEC rule-making replacing fraud on the market with an actual reliance requirement.