Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Saturday, January 15, 2011

SEC Adopts New Rules of Practice for Disapproving SRO Proposed Rule Changes

The SEC adopted rules setting forth the procedural requirements of proceedings to determine whether a proposed rule change filed by a SRO should be disapproved.  These rules are required by Section 916 of the Dodd-Frank Act. The new Rules of Practice will formalize the process it will use when conducting proceedings to determine whether an SRO’s proposed rule change should be disapproved under Section 19(b)(2) of the Exchange Act. The new rules are intended to add transparency to the Commission’s conduct of those proceedings.

January 15, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Proposes Rule on Acknowledgement & Verification of SBSs

The SEC is proposing a rule governing the way in which certain security-based swap transactions are acknowledged and verified by the parties who enter into them.

Under the proposed rule, security-based swap dealers and major security-based swap participants, collectively known as SBS entities, would have to provide to their counterparties a trade acknowledgement detailing information specific to the transaction.  The new rule, Rule 15Fi-1, is being proposed under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act which generally authorizes the SEC to regulate security-based swaps. Among other things, the new law gives the SEC the authority to establish standards for the confirmation and documentation of security-based swap transactions entered into by SBS entities.

The proposed rule would require SBS entities to provide their counterparties with an electronic record containing information specific to the security-based swap transaction.  In particular, it would require an SBS entity to:

  • Provide a trade acknowledgment to its counterparty in a security-based swap transaction within 15 minutes, 30 minutes or 24 hours of execution, depending on whether the transaction is executed or processed electronically.
  • Electronically process security-based swap transactions if the SBS Entity has the ability to do so.
  • Have written policies and procedures in place that are reasonably designed to obtain verification of the terms outlined in the trade acknowledgment.

In addition, the proposed rule would:

  • Specify which SBS entity is responsible for providing the trade acknowledgment.
  • Permit an SBS entity to satisfy the requirements of the proposed rule by processing the transaction through the facilities of a registered clearing agency.
  • Identify the transaction details that must be included in the trade acknowledgement.
  • Provide a limited exemption from the requirements of Rule 10b-10 under the Exchange Act for SBS Entities that are also brokers.

January 15, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Considers ABS Regulation this Week

The SEC's next Open Meeting is January 20, 2011.  The subject matter of the Open Meeting will be:

The Commission will consider whether to adopt new rules to implement Section 943 of the Dodd-Frank Wall Street Reform and Consumer Protection Act relating to the use of representations and warranties in the market for asset-backed securities.
The Commission will consider whether to adopt rules to implement Section 945 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires an issuer of asset-backed securities (ABS) to perform a review of the assets underlying the ABS and disclose information relating to the review.

January 15, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Profile of New York's New Attorney General

What can the financial industry expect from Eric Schneiderman, the new AG of New York?  Unlike his predecessors Eliot Spitzer and Andrew Cuomo, he is unlikely to focus on financial reform; his agenda is likely to be civil rights and the environment.  The Wall St. Journal profiles the new AG this morning.  WSJ, Top Cop Cut From a Different Cloth

January 15, 2011 in News Stories | Permalink | Comments (0) | TrackBack (0)

Friday, January 14, 2011

SEC Charges Penny Stock Promoter with Pump and Dump Fraud

The SEC charged Christopher Wheeler, an upstate New York-based penny stock promoter, and his affiliated website with fraud for failing to disclose that he was paid by certain issuers to promote their stock while simultaneously liquidating millions of his own shares for profits of at least $2.95 million.

The SEC alleges that Wheeler received compensation at various times in 2007 and 2008 to promote several thinly-traded penny stocks on his website, Wheeler's website claimed to "have compiled a long list of successful stock picks" and to afford investors the opportunity to "make a fortune."

According to the SEC, Wheeler, after receiving millions of shares in undisclosed compensation from the issuers, featured the issuers' stock on, recommended that investors purchase the securities, and posted lofty price predictions for the stock without any reasonable basis for those projections. Wheeler's and's promotional efforts often resulted in dramatic, but temporary, increases in the volume of shares traded and the price of the issuers' securities. Once the prices were pumped in this manner, Wheeler simultaneously dumped shares from his personal brokerage account onto the market.  

The SEC's complaint seeks a final judgment permanently enjoining Wheeler and from future violations of the federal securities laws, and an order permanently barring Wheeler from participating in any offering of penny stock, requiring the defendants to pay financial penalties, and requiring the defendants and North Coast to disgorge all ill-gotten gains plus prejudgment interest.

January 14, 2011 in SEC Action | Permalink | Comments (1) | TrackBack (0)

Thursday, January 13, 2011

SEC Charges Former Chairman of Home Diagnostics with Illegal Tipping

The SEC charged George H. Holley, the co-founder and former Chairman of the Board at Home Diagnostics Inc., with illegally tipping friends and business associates with inside information about an impending acquisition of the company.  The SEC alleges that Holley provided his personal accountant Steven Dudas and his friend and business associate Phairot Iamnaita with confidential information about the company's upcoming acquisition by Nipro Corporation. Holley then gave Dudas $121,500, which Dudas and Iamnaita used to purchase Home Diagnostics stock in a joint brokerage account. After the acquisition was publicly announced, Dudas and Iamnaita tendered their shares for an illicit profit of approximately $90,120. Dudas and Iamnaita are charged along with Holley in the SEC's complaint filed today in federal district court in Trenton, N.J.

The SEC alleges that in addition to tipping Dudas and Iamnaita between December 2009 and Jan. 13, 2010, Holley illegally provided two other friends, a relative, and a business associate with inside information about Home Diagnostics's imminent acquisition. Holley provided at least two of these individuals with a cover story, giving them copies of analyst reports and telling them that they should use the reports to justify their illicit trading. All four of these individuals purchased Home Diagnostics stock on the basis of Holley's tips for combined profits of more than $170,000.

The Commission seeks permanent injunctive relief, disgorgement of illicit profits with prejudgment interest, and the imposition of monetary penalties against all defendants. The SEC also seeks to permanently prohibit Holley from acting as an officer or director of a public company pursuant to Section 21(d)(2) of the Exchange Act.

January 13, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SIFMA Supports Comparable Regulatory Oversight of Brokers, Investment Advisers

SIFMA submitted a comment letter (Download 2011-SIFMA-commentletter-DFsection914study[1]) to the SEC urging that the SEC recommend to Congress a regulatory structure that would provide comparable oversight and examination of both brokers and investment advisers when providing personalized investment advice to retail customers. 

In the letter, SIFMA noted that Section 913 of the Dodd-Frank Act emphasized that all intermediaries (brokers and investment advisers) providing personalized investment advice to retail customers should be held to a comparable standard of care, whether they are registered investment advisers (RIAs) or broker-dealers and that an important component of holding these intermediaries to a comparable standard of care is ensuring effective oversight of these activities.   According to SIFMA,

Most retail RIAs that are not affiliated with a broker-dealer are small independent advisers that, apart from their RIA status, are not otherwise subject to Commission enforcement.  Due to the small size of these RIAs, many do not have substantial legal and compliance departments to monitor for compliance with applicable regulatory standards.  Additionally, these RIAs are not regularly examined by the Commission today.  Limited government resources for examining and monitoring independent RIAs also warrants an SRO with jurisdiction over independent RIAs and which would be able to devote sufficient examination and enforcement resources to protect investors.  

SIFMA also believes that any SRO examination program should be carefully tailored to investment adviser practices so to recognized and accommodate the divergent business models and historical regulatory regimes of RIAs and their associations with broker-dealers or other persons.  In addition, SIFMA believes that if more than one SRO is ultimately developed that could examine RIAs, business entities that have both broker-dealer and investment advisers in their corporate structure should have the option to select a single SRO to serve as their regulator.

January 13, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC and Canadian Attorney Settle Insider Trading Charges

On Jaunuary 11, 2011, the U.S. District Court for the Southern District of New York entered a settled Final Judgment as to Canadian attorney Phillip Macdonald.  The SEC charged that Macdonald engaged in insider trading in the securities of certain companies ahead of public announcements of business combinations. The Complaint alleges that between January and June 2005, the wife of Macdonald's co-defendant, Michael Goodman, learned the identities of those companies in the course of her employment as an administrative assistant with Merrill Lynch Canada, Inc. Goodman's wife sometimes mentioned the information to Goodman, expecting that he would keep it confidential. Goodman instead misappropriated the information by, among other things, recommending stocks to his business associate, Macdonald. On the basis of the information, Macdonald then purchased securities ahead of business combination announcements. (Goodman and Gollan previously consented to the entry of Final Judgments against them in the Commission's action.)

Macdonald consented to the entry of the Final Judgment against him, without admitting or denying the allegations in the Commission's Complaint, except as to jurisdiction. The Final Judgment against Macdonald permanently enjoins him from further violations of Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 and Rules 10b 5 and 14e-3 thereunder and orders him to pay disgorgement of $810,000.

January 13, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Website Company Settles SEC Charges It Failed to Disclose Perks to Former CEO

The SEC settled charges that NIC Inc., a company that manages government websites, and four current or former company executives failed to disclose to investors more than $1.18 million in perks paid to the former CEO over a six-year period.  According to the SEC, the company footed the bill for wide-ranging perks enjoyed by former CEO Jeffrey Fraser, his girlfriend, and his family — including vacations, computers, and day-to-day personal living expenses. NIC failed to disclose that it paid thousands of dollars per month for Fraser to live in a Wyoming ski lodge and commute by private aircraft to his office at NIC's Kansas headquarters. Meanwhile, NIC and its executives falsely represented to investors that Fraser worked virtually for free from 2002 to 2005, and then continued to materially understate the perks that Fraser received in 2006 and 2007. NIC's related party disclosures for 2002 through 2005 also were misleading.

NIC, Fraser, current CEO Harry Herington and former CFO Eric Bur agreed to pay a combined $2.8 million to settle the SEC's charges against them without admitting or denying the allegations. The SEC's litigation continues against NIC's current CFO Stephen Kovzan.

Among the alleged undisclosed perks for Fraser outlined in the SEC's complaints filed in federal court in the District of Kansas:

  • More than $4,000 per month to live in a ski lodge in Wyoming.
  • Costs for Fraser to commute by private aircraft from his home in Wyoming to his office at NIC's Kansas headquarters.
  • Monthly cash payments for purported rent for a Kansas house owned by an entity Fraser set up and controlled.
  • Vacations for Fraser, his girlfriend and his family.
  • Fraser's flight training, hunting, skiing, spa and health club expenses.
  • Computers and electronics for Fraser and his family.
  • A leased Lexus SUV.
  • Other day-to-day living expenses for Fraser such as groceries, liquor, tobacco, nutritional supplements, and clothing.

 NIC agreed to settle the SEC's charges by paying a $500,000 penalty and hiring an independent consultant to recommend, if appropriate, improvements to policies, procedures, controls, and training relating to payment of expenses, handling of whistleblower complaints, and related party transactions. Fraser agreed to pay $1,184,246 in disgorgement, $358,844 in prejudgment interest, and a $500,000 penalty, and consented to an order barring him from serving as an officer or director of a public company. Herington agreed to pay a $200,000 penalty; Bur agreed to pay a $75,000 penalty and agreed to resolve an anticipated administrative proceeding by consenting to an SEC order prohibiting him from appearing or practicing before the SEC as an accountant with a right to reapply after one year.


January 13, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Wednesday, January 12, 2011

FINRA Files Amendment to Proposed Rule Change Giving Customers Option of All-Public Arbitration Panel

FINRA recently filed with the SEC an amendment to its proposed rule change to allow customers the option of selecting an arbitration panel consisting entirely of public arbitrators.  Comments filed in response to date have been overwhelmingly in support of the proposal.

The modifications principally address concerns raised by some commenters that customers could inadvertently lose the important right of selecting an all-public panel if they failed to select that option within 35 days.  FINRA rejected suggestions to make the all-public panel the default option.  Instead, it proposes that it will notify customers in writing of the option and the 35-day deadline as well as publicizing it on its website and in other informational materials.  It will also permit customers to make the election when filing its Statement of Claim.

January 12, 2011 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

Tuesday, January 11, 2011

FINRA and Charles Schwab Settle Charges Related to Marketing of YieldPlus Fund

FINRA announced that it has ordered Charles Schwab & Company, Inc., to pay $18 million into a Fair Fund to be established by the Securities and Exchange Commission (SEC) to repay investors in YieldPlus, an ultra short-term bond fund managed by Schwab's affiliate, Charles Schwab Investment Management. The $18 million consists of the $17.5 million in fees that Schwab collected for sales of the fund, plus a fine of $500,000, both of which will have been designated as restitution to customers.

FINRA's investigation found that despite changes in YieldPlus' portfolio that caused the fund to be disproportionately affected by the turmoil in the mortgage-backed securities market, Schwab failed to change its marketing of the fund. In written materials and in conversations with customers, some Schwab representatives omitted or provided incomplete or inaccurate material information relating to the fund's characteristics, risk and diversification, and continued to represent YieldPlus as a relatively low-risk alternative to money market funds and other cash alternative investments that had minimal fluctuations in net asset value (NAV).

 Between Sept. 1, 2006, and Feb. 29, 2008, Schwab sold over $13.75 billion in shares of YieldPlus to customers, which accounted for approximately 98 percent of the amount Schwab customers invested in ultra short-term bond funds. During this time period, Schwab's solicited sales of YieldPlus totaled approximately $3.36 billion, approximately 40 percent of which were to customers 65 years of age or older. Schwab collected approximately $17.5 million in fees from sales of the fund.

In concluding this settlement, Schwab neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

The SEC also announced a settlement with Charles Swab entities and a complaint filed against two executives, both related to the YieldPlus Fund.

January 11, 2011 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

Charles Schwab Entities Settle SEC Charges Relating to YieldPlus Fund for $118 Million

The SEC charged Charles Schwab Investment Management (CSIM) and Charles Schwab & Co., Inc. (CS&Co.) with making misleading statements regarding the Schwab YieldPlus Fund and failing to establish, maintain and enforce policies and procedures to prevent the misuse of material, nonpublic information. The SEC also charged CSIM and Schwab Investments with deviating from the YieldPlus fund's concentration policy without obtaining the required shareholder approval.  CSIM and CS&Co. agreed to pay more than $118 million to settle the SEC's charges.  SEC Order; SEC complaint

The SEC also filed a complaint in federal court against CSIM's former chief investment officer for fixed income Kimon Daifotis as well as Schwab official Randall Merk, who is an executive vice president at CS&Co. and was president of CSIM and a trustee of the YieldPlus and other Schwab funds. The SEC alleges that Daifotis and Merk committed fraud and other securities law violations in connection with the offer, sale and management of the YieldPlus Fund.  The SEC's case continues against the executives.  SEC Complaint

The YieldPlus Fund is an ultra-short bond fund that, at its peak in 2007, had $13.5 billion in assets and more than 200,000 accounts, making it the largest ultra-short bond fund in the category. The fund suffered a significant decline during the credit crisis of 2007 and 2008. Its assets fell from $13.5 billion to $1.8 billion during an eight-month period due to redemptions and declining asset values.

According to an administrative order issued by the SEC against the Schwab entities and the SEC's related complaints against the entities and the two executives filed in federal court in San Francisco, they failed to inform investors adequately about the risks of investing in the YieldPlus Fund. For example, they described the fund as a cash alternative that had only slightly higher risk than a money market fund. The statements were misleading because the fund was more than slightly riskier than money market funds, and the Schwab entities and Merk and Daifotis did not adequately inform investors about the differences between YieldPlus and money market funds.

The SEC found that the YieldPlus Fund deviated from its concentration policy when it invested more than 25 percent of fund assets in private-issuer mortgage-backed securities (MBS). Mutual funds and other registered investment companies are required to state certain investment policies in their SEC filings, including a policy regarding concentration of investments. Once established, a fund may not deviate from its concentration policy without shareholder approval. Schwab's bond funds, including the YieldPlus Fund and the Total Bond Market Fund, had a policy of not concentrating more than 25 percent of assets in any one industry, including private-issuer MBS. The funds violated this policy, and the Investment Company Act, by investing approximately 50 percent of the assets of the YieldPlus Fund and more than 25 percent of the Total Bond Fund's assets in private-issuer MBS without obtaining shareholder approval.

According to the SEC's order and complaints, the YieldPlus Fund's NAV began to decline and many investors redeemed their holdings as the credit crisis unfolded in mid-2007. Unlike a money market fund, few of the fund's assets were scheduled to mature within the next several months. As a result, the fund had to sell assets in a depressed market to raise cash. While the YieldPlus Fund's NAV declined, CSIM, CS&Co., Merk, and Daifotis held conference calls, issued written materials, and had other communications with investors that contained a number of material misstatements and omissions concerning the fund. For example, in two conference calls, Daifotis made false and misleading statements that the fund was experiencing "very, very, very slight" and "minimal" investor redemptions. In fact, Daifotis knew that YieldPlus had experienced more than $1.2 billion in redemptions during the two weeks prior to the calls, which caused YieldPlus to sell more than $2.1 billion of its securities. Similarly, Merk authored, reviewed and approved misleading statements about the fund, such as a false claim that the fund had a "short maturity structure" that "mitigated much of the price erosion" experienced by its peers.

The SEC also found that CSIM and CS&Co. did not have policies and procedures reasonably designed — given the nature of their businesses — to prevent the misuse of material, nonpublic information about the fund. For example, they did not have specific policies and procedures governing redemptions by portfolio managers who advised Schwab funds of funds, and did not have appropriate information barriers concerning nonpublic and potentially material information about the fund. As a result, several Schwab-related funds and individuals were free to redeem their own investments in YieldPlus during the fund's decline.

Without admitting or denying the findings in the SEC's order or the allegations in the SEC's complaint, CSIM and CS&Co. agreed to pay a total of $118,944,996, including $52,327,149 in disgorgement of fees by CSIM, a $52,327,149 penalty against CSIM, a $5 million penalty against CS&Co., and pre-judgment interest of $9,290,698. Some of CSIM's disgorgement may be deemed satisfied up to a maximum of $26,944,996 for payments made within the next 60 days to settle related investigations by FINRA or state securities regulators.

The SEC seeks to have payments placed in a Fair Fund for distribution to harmed investors, and the related recoveries by other regulators, such as FINRA, may be contributed to the Fair Fund. The payments and any Fair Fund are subject to approval by the U.S. District Court for the Northern District of California.

January 11, 2011 in SEC Action | Permalink | Comments (1) | TrackBack (0)

FCPAProfessor Reviews SEC Enforcement Actions

Mike Koehler has an interesting and informative year-end perspective on SEC enforcement actions involving the Foreign Corrupt Practices Act at his website; see SEC Enforcement of the FCPA - 2010 Year in Review.

January 11, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

U.S. Supreme Court Hears Oral Argument in Matrixx Initiatives v. Siracusano

On January 10 the U.S. Supreme Court heard oral argument ( Download MatrixxOralArgument09-1156) in Matrixx Initiatives, Inc. v. Siracusano, 585 F.3d 1167 (9th Cir. 2009), where investors brought a class action against a pharmaceutical company and three of its executives, alleging that defendants violated federal securities laws by failing to disclose material information regarding one of the company's products. Reversing the district court, the 9th Circuit held that investors adequately pled materiality and scienter under the Private Securities Litigation Reform Act (PSLRA).  Defendants sought Supreme Court review and framed the question as "whether plaintiffs could state a Rule 10b-5 claim based on nondisclosure of adverse events reports even though the reports were not alleged to be statistically significant."

The justices expressed little enthusiasm for the defendants' argument that there should be a bright-line "statistically significant" materiality test.  Justice Breyer expressed his skepticism most forcefully when defendants' counsel stated "we think the answer is statistical significance," and he interjected "oh no, it can't be."  Justice Kagan made the point that the FDA itself did not use a statistically significant test in making decisions about what it should regulate. Justice Sotomayor reminded defendants' counsel that cert was granted on a limited question of "whether in a complaint that alleges only adverse reports can you prove materialilty and scienter without proving statistical importance" and that "many of the amici here have done a wonderful job of explaining why statistical importance can't be a measure because it depends on the nature of the study at issue."  She also noted that defendants had backed away from an absolute rule in their brief, "so you've already answered the question presented."

Assuming that Supreme Court will not adopt a "statistically significant" requirement, what illumination, if any, will the Court supply to the Northway/Basic materiality test?  The Justices expressed concern about potential overbreadth in an extended colloquy with plaintiff's counsel over the materiality of allegations about a Satanic connection to a product.  Plaintiff's counsel suggested the importance of "credible medical professionals describing the harms based on credible scientific theories" and the effect on a "predominant product line" in shaping a disclosure duty.  In questioning the DOJ attorney arguing on behalf of the U.S. (in support of defendant), Chief Justice Roberts  asked if there was any way that consideration of many Basic factors would support a summary judgment in favor of the defendants.  In response, the government attorney pointed to PSLRA's safe harbor provision for forward looking statements and a scenario where the product at issue was such a small percentage of the company's income that a reasonable investor would not care if it failed.  While expressing concern, the justices did not offer much guidance on whether or how they would refine the Northway/Basic test.


January 11, 2011 in Judicial Opinions | Permalink | Comments (1) | TrackBack (0)

Monday, January 10, 2011

SEC Reports on Credit Rating Agencies

The SEC released its annual report on credit rating agencies required under Section 6 of the Credit Rating Agency Reform Act of 2006, which requires the Commission to submit an annual report that

 • Identifies applicants for registration as nationally recognized statistical
rating organizations (“NRSROs”) under Section 15E of the Securities
Exchange Act of 1934 (“Exchange Act”);
• Specifies the number of and actions taken on such applications; and
• Specifies the views of the Commission on the state of competition,
transparency, and conflicts of interest among NRSROs.

This report provides an overview of the rules and rule amendments that the Commission proposed and adopted during the period from June 26, 2009 to June 25,2010, and addresses each of the items specified in Section 6 of the Rating Agency Act.

January 10, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Advisers and Brokers Await SEC's Study on Standards of Care

The SEC's report (required under Dodd-Frank section 913) on the effectiveness of existing standards of care for investment advisers and broker-dealers is due January 21.  The consensus is that the SEC will propose a uniform  standard of care, but no one has a clear idea of the specifics of what that means.  According to Investment News, "efforts to influence the conclusions of the report are said to be continuing non-stop."  InvNews, Disclosure is at center of fiduciary tug of war

January 10, 2011 in News Stories | Permalink | Comments (0) | TrackBack (0)

SEC Expands Insider Trading Allegations Relating to Galleon

Today the SEC filed a civil injunctive action in the United States District Court for the Southern District of New York alleging that Robert Feinblatt – a co-founder and principal of New York-based hedge fund investment adviser Trivium Capital Management LLC – and Trivium analyst Jeffrey Yokuty engaged in insider trading in the securities of Polycom, Hilton, Google and Kronos. The complaint charges Trivium with insider trading as well. The SEC further alleges that Polycom senior executive Sunil Bhalla and Shammara Hussain, an employee at investor relations consulting firm Market Street Partners that did work for Google, tipped the inside information that enabled the insider trading by Feinblatt and Yokuty on behalf of Trivium’s hedge funds for illicit profits of more than $15 million. The complaint filed today relates to pending enforcement actions, SEC v. Galleon Management, LP, et al., 09-CV-8811 (S.D.N.Y.) (JSR) and SEC v. Hardin, 10-CV-8600 (S.D.N.Y.) (JSR).

The SEC has now charged 27 defendants in its Galleon-related enforcement actions that have alleged widespread and repeated insider trading at numerous hedge funds including Galleon – a multi-billion dollar New York hedge fund complex founded and controlled by Raj Rajaratnam – and by other professional traders and corporate insiders in the securities of 14 companies generating illicit profits totaling approximately $69 million.

January 10, 2011 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Supreme Court Accepts Cert to Address Loss Causation Standard

Since the U.S. Supreme Court's opinion in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), the lower federal courts have wrestled with the issue of loss causation, particularly as what it requires at the class-certification stage.  The Fifth Circuit has adopted the most rigorous standard, requiring plaintiffs, at the class certification stage, to prove loss causation by a preponderance of all admissible evidence, Oscar Private Equity Investments v. Allegiance Telecom, Inc., 487 F.3d 261 (5th Cir. 2007).  The Supreme Court has now accepted certiorari to address this issue in Erica P. John Fund Inc. v.  Halliburton Co. (09-1403).  The 5th Circuit's opinion is reported, under the name of Archdiocese of Milwaukee Supporting Fund, Inc. v. Halliburton Co., 597 F.3d 330 (5th Cir. 2010).  In that opinion the 5th Circuit affirmed the district court's denial of class certification for failure to prove the requisite causal relationship, i.e., that the corrected truth of the former falsehoods actually caused the stock price to fall and resulted in the losses.  Accordingly, plaintiff has to show "(1) that an allegedly corrective disclosure causing the decrease in price is related to the false, non-confirmatory positive statement made earlier, and (2) that it is more probable than not that it was this related corrective disclosure, and not any other unrelated negative statement, that caused the stock price decline."

January 10, 2011 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Sunday, January 9, 2011

Macey on Money Market Funds

Reducing Systemic Risk: The Role of Money Market Mutual Funds as Substitutes for Federally Insured Bank Deposits, by Jonathan R. Macey, Yale Law School, was recently posted on SSRN.  Here is the abstract:

In the wake of the events of September 2008, money market mutual funds have made significant changes to the way they invest. Those changes have been driven by business and investment needs as well as by substantial revisions to the regulatory framework in which funds operate. Yet, some policymakers and market participants are calling for additional regulatory or legislative action. This paper lays out the important role that money market mutual funds play in the short-term capital markets, traces the successful regulatory history of money market mutual funds and argues that more reforms could create, rather than reduce, systemic risk.

The first phase of these changes involved a number of amendments to Rule 2a-7, which governs the operation of mutual funds. The final rule changes released by the SEC in February 2010 included, among other things, tightened limits on portfolio maturity, greater disclosure obligations and heightened responsibilities for boards of money market funds.

When announcing the new rules in January 2010, SEC Chairman Schapiro indicated a possible second phase of reform that could include other “more fundamental” changes that the SEC would examine: a floating net asset value (or NAV), more frequent disclosure of mark-to-market NAVs, mandatory redemptions-in-kind for large redemptions, a private liquidity facility and a two-tiered system of money market funds in which the NAVs for some funds would float and the NAVs for others would not.

The Obama administration is also examining possible changes to money market funds. In June 2009, the administration instructed the President’s Working Group on Financial Markets to study whether fundamental changes are needed to reduce the susceptibility of money market funds to runs, including possibly prohibiting money market funds from relying on a stable NAV.

These reforms are being considered at a time when others, such as former Federal Reserve Board Chairman Paul Volcker, have called for money market funds to be regulated like banks.

Missing from the debate so far has been an acknowledgment of the enormous benefits that money market funds have provided over the last 40 years, both to investors and to the financial system as a whole. For both individual and institutional investors, money market mutual funds provide a commercially attractive alternative to bank deposits. Money market funds offer greater investment diversification, are less susceptible to collapse than banks and offer investors greater disclosure on the nature of their investments and the underlying assets than traditional bank deposits. For the financial system generally, money market mutual funds reduce pressure on the FDIC, reduce systemic risk and provide essential liquidity to capital markets because of the funds’ investments in commercial paper, municipal securities and repurchase agreements.

Despite these benefits, the changes under consideration, particularly a floating NAV, likely would curtail significantly, or potentially eliminate altogether, the money market fund industry as we know it. In this paper, I explore the advantages that funds have offered and the risks to the financial system from destabilizing the money market fund industry through these so-called reforms.

After a brief introduction explaining the operations of money market funds and a summary of the history of the industry, I describe the experiences of money market funds during the financial crisis. While much attention rightfully has been paid to the problems of the Reserve Primary Fund, the money market fund industry as a whole weathered the crisis quite well. Except for remaining shareholders in the Reserve Primary Fund, who in the end received more than 98 cents on each dollar invested, no money market fund investor suffered a loss of principal during the financial crisis. That said, money market funds did come under pressure and the federal government responded with its Temporary Guarantee Program. Prior to that program, some general purpose institutional money market funds experienced significant redemptions as investors looked to other investments such as Treasury bills and government money market funds.

In section IV of the paper, I describe in detail some of the advantages of money market funds, which I believed have been overlooked in the current policy debate. In particular, I discuss the following: •Money market funds reduce pressure on the FDIC: Banks suffer from a fundamental mismatch between their liabilities (which are deposits that can be withdrawn at any time) and their assets (which normally are in the form of much longer-term and illiquid commitments such as mortgages or commercial loans). Because of this mismatch, banks are susceptible to runs in the absence of deposit insurance. The FDIC has served as a back stop to protect depositors and, thus, has decreased the propensity for runs on banks. Still, the less pressure that is placed on the FDIC’s limited resources the better, particularly in light of the alarming rate at which banks continue to fail. Money market funds provide an alternative to bank deposits without the need for FDIC insurance. The $2.9 trillion that investors have placed in money market mutual funds would likely be deposited at banks if money market mutual funds did not exist. A stable $1.00 NAV and features such as check writing and no limits on the number of withdrawals make money market funds an attractive investment for short-term cash management. At the same time, money market funds do not suffer from the same structural mismatch between their assets and liabilities because of the liquidity and maturity requirements of Rule 2a-7. •Money market funds reduce systemic regulatory risk: Having all short-term savings subject to one regulatory regime creates systemic risk. The different regulation of banks and money market funds serves as an important method to diversify the regulatory risks involved in protecting short-term savings. Some have called for money market funds to be regulated like banks, citing functional similarities such as check-writing services. Doing so would be a mistake. Imposing the bank regulatory scheme on money market funds would increase, rather than decrease, systemic risk. Homogenous regulatory practices create the possibility that the oversight practices miss the next potential financial crisis. •Money market funds provide valuable liquidity by investing in commercial paper, municipal securities and repurchase agreements: Money market funds are significant participants in the commercial paper, municipal securities and repurchase agreement (or repo) markets. Money market funds hold almost 40% of all outstanding commercial paper, which is now the primary source for short-term funding for corporations, who issue commercial paper as a lower-cost alternative to short-term bank loans. The repo market is an important means by which the Federal Reserve conducts monetary policy and provides daily liquidity to global financial institutions.

In light of the many benefits that money markets funds provide, policymakers should be careful not to disrupt the operations of the money market industry by making more fundamental changes. These “reforms” are being discussed in the context of a regulatory structure that is already robust. In sections V and VI of the paper, I explain a number of the requirements in Rule 2a-7 and caution against making additional fundamental changes. The strength of Rule 2a-7 is underscored by the success and reliability of money market funds to investors over the last 40 years.

Like all regulatory regimes, policymakers should evaluate periodically whether improvements can be made. In the case of money market funds, those improvements should come within the context of Rule 2a-7, should not alter the basic structure of the funds and should not seek to impose arbitrarily a regulatory regime designed for a fundamentally different type of entity.

The proponents of more fundamental changes claim that they would reduce systemic risk. However, changes such as abandoning the stable $1.00 NAV could end the money market fund industry by causing a massive inflow of money to banks, which would increase the overall risk of the financial system.

January 9, 2011 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Wilkerson on Relief Defendants in Investment Fraud Receiverships

Investors and Employees as Relief Defendants in Investment Fraud Receiverships: Promoting Efficiency by Following the Plain Meaning of 'Legitimate Claim or Ownership Interest', by Jared Aaron Wilkerson, William & Mary Law School, was recently posted on SSRN.  Here is the abstract:

Relief defendants are nominal, innocent parties who hold funds traceable to the receivership but have no legitimate claim or ownership interest in them. These nominal parties, as opposed to full or primary defendants, have no cause of action asserted against them, and if they show no legitimate claim to the funds traced to the receivership, the funds are disgorged - generally at summary judgment. This seemingly simple relief defendant tool is used by receivers and regulatory agencies to quickly recover receivership funds for ultimate distribution to creditors. Recently, however, conflict has arisen in federal courts concerning the meaning of “legitimate claim or ownership interest.” Where courts fail to uphold the plain meaning of those words, confusion and unpredictability ensue, leading to enormous costs for creditors as receivers, on the receivership’s dime, attempt to claw back funds from relief defendants. I illustrate these costs using the recent case of Janvey v. Adams, an ancillary suit to SEC v. Stanford International Bank. To prevent such unnecessary costs in the future, the plain meaning of “legitimate claim or ownership interest” must be reinforced to protect, at minimum, the amount of investors’ returned principal and the amount of employees’ reasonable compensation.

January 9, 2011 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)