Saturday, July 2, 2011
What is Securities Fraud?, by Samuel W. Buell, Duke University School of Law, was recently posted on SSRN. Here is the abstract:
As Rule 10b-5 approaches the age of 70, deep familiarity with this supremely potent and consequential provision of American administrative law obscures its lack of clear conceptual content. The rule, as written, interpreted, and enforced, is missing a straightforward connection to, of all things, fraud. Fraud is difficult to define. Several approaches are plausible. But the law of securities fraud, and much of the commentary about that body of law, have neither attempted such a definition nor acknowledged its necessity to the coherence and effectiveness of doctrine.
Securities fraud’s lack of mooring in the concept of fraud produces at least three costs: public and private actions are not brought on behalf of clearly specified regulatory objectives; the line between civil and criminal liability is not acceptably sharp; and the law provides an at best weak means of resolving vital public questions about wrongdoing in financial markets. The agenda of this article is to illuminate and clarify the relationship between securities fraud and fraud, and to structure a law reform discussion that promises to make more explicit the connection between securities fraud remedies and the purposes of a regime of securities regulation; brighten the line between civil and criminal liability; and produce better understanding of what is being asked when, as so often these days, we wonder whether to label an important matter of market failure, “fraud.”
In Whose Shoes? Third-Party Standing and 'Binding' Arbitration Clauses in Securities Fraud Receiverships, by Jared Aaron Wilkerson, William & Mary Law School, was recently posted on SSRN. Here is the abstract:
This article exposes a question that has recently opened a circuit split: in whose shoes do federal equity receivers stand when disentangling a Ponzi scheme or other securities fraud through litigation? This question has enormous implications for any investors, employees, and service providers of failed schemes who have arbitration agreements with the entities in receivership and are added as defendants by a receiver: if the supervising court allows the receiver to stand in place of creditors, with whom the defendants have no arbitration agreement, then the defendants will not be able to arbitrate their claims and will instead be subject to summary proceedings as a group—an outcome that ignores arbitration for efficiency’s sake. Notwithstanding efficiency, however, federal courts have generally answered the receiver standing question by holding that receivers stand exclusively in the receivership entities’ shoes. One recent diversion from this rule is the Fifth Circuit’s decision in Janvey v. Alguire, in which the court allowed a receiver to stand in third-party creditors’ shoes to avoid 331 binding arbitration clauses. This article argues, contrary to efficiency, that courts should follow both the Federal Arbitration Act and the Supreme Court’s prohibition against third-party standing by holding that receivers stand only in the place of receivership entities and so must arbitrate according to binding agreements made by those entities. In cases with a large number of arbitration agreement-wielding defendants, such as Alguire, this solution is terribly inefficient, but it is, at least until Congress or the Court says otherwise, the only solution that respects both Article III and the FAA.
Proceed at Your Peril: Crowdfunding and the Securities Act of 1933, by Joan MacLeod Heminway, University of Tennessee College of Law, and Shelden Ryan Hoffman , was recently posted on SSRN. Here is the abstract:
A promising Web-based funding model for small business firms has emerged over the past few years. Crowdfunding (as this model has come to be known) actually includes a variety of business models, all of which use the Internet to fund business ventures by connecting promoters of businesses or projects needing funding with potential funders. Most of these funders are not professional investors; instead, they are just members of the Internet “crowd” that like the business idea of a particular entrepreneur and want to help him or her out with a nominal amount of funding—even $10.
Some (but not all) manifestations of crowdfunding result in the offer and sale of interests that are securities under the Securities Act of 1933, as amended. Offers and sales of securities that are neither registered nor exempt from registration violate the Securities Act. The high cost of registration is prohibitive for small businesses that might benefit from crowdfunding. Accordingly, if crowdfunding is to achieve its optimal benefit (or even just survive or thrive), there must be some intervention. This dilemma has caught the attention of many, including the U.S. Securities and Exchange Commission (SEC).
This article first shows how crowdfunding interests may be securities under the Securities Act and describes key legal effects of that security status—including the requirement of registration (absent an exemption). The article then explains why the offer and sale of crowdfunding interests under certain conditions should not require registration and offers the principles, process, and substantive parameters of a possible solution in the form of a new registration exemption adopted by the SEC under Section 3(b) of the Securities Act.
Derivatives and the Legal Origin of the 2008 Credit Crisis, by Lynn A. Stout, University of California, Los Angeles (UCLA) - School of Law, was recently posted on SSRN. Here is the abstract:
Experts still debate what caused the credit crisis of 2008. This Article argues that dubious honor belongs, first and foremost, to a little-known statute called the Commodities Futures Modernization Act of 2000 (CFMA). Put simply, the credit crisis was not primarily due to changes in the markets; it was due to changes in the law. In particular, the crisis was the direct and foreseeable (and in fact foreseen by the author and others) consequence of the CFMA’s sudden and wholesale removal of centuries-old legal constraints on speculative trading in over-the-counter (OTC) derivatives.
Derivative contracts are probabilistic bets on future events. They can be used to hedge, which reduces risk, but they also provide attractive vehicles for disagreement-based speculation that increases risk. Thus, as an empirical matter, the social welfare consequences of derivatives trading depend on whether the market is dominated by hedging or speculative transactions. The common law recognized the differing welfare consequences of hedging and speculation through a doctrine called “the rule against difference contracts” that treated derivative contracts that did not serve a hedging purpose as unenforceable wagers. Speculators responded by shifting their derivatives trading onto organized exchanges that provided private enforcement through clearinghouses in which exchange members guaranteed contract performance. The clearinghouses effectively cabined and limited the social cost of derivatives risk. In the twentieth century, the Commodity Exchange Act (CEA) largely replaced the common law. Like the common law, the CEA confined speculative derivatives trading to the organized (and now-regulated) exchanges. For many decades, this regulatory system also kept derivatives speculation from posing significant problems for the larger economy.
These traditional legal restraints on OTC speculation were systematically dismantled during the 1980s and 1990s, culminating in 2000 with the enactment of the CFMA. That legislation set the stage for the 2008 crises by legalizing, for the first time in U.S. history, speculative OTC trading in derivatives. The result was an exponential increase in the size of the OTC market, culminating in 2008 with the spectacular failures of several systemically important financial institutions (and the near-failures of several others) due to bad derivatives bets. In the wake of the crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). Title VII of the Act is devoted to turning back the regulatory clock by restoring legal limits on speculative derivatives trading outside of a clearinghouse. However, Title VII is subject to a number of possible exemptions that may limit its effectiveness, leading to continuing concern over whether we will see more derivatives-fueled institutional collapses in the future.
The Dodd-Frank Extraterritorial Jurisdiction Provision: Was it Effective, Needed or Sufficient?, by Richard W. Painter, University of Minnesota Law School, was recently posted on SSRN. Here is the abstract:
In Morrison v. National Australia Bank, the U.S. Supreme Court ruled in June 2010 that securities fraud suits could not be brought under Section 10(b) of the Exchange Act against foreign defendants by foreign plaintiffs who bought their securities outside the United States (so called, “f-cubed,” securities litigation). The Court held that Section 10(b) reaches only fraud in connection with the, “purchase or sale of a security listed on an American stock exchange, and the
purchase or sale of any other security in the United States.” Congress responded to Morrison with Section 929P of the Dodd-Frank Act, which gives federal courts jurisdiction over some similar cases if they are brought by the SEC or the Department of Justice (DOJ).
This article discusses alternative explanations for why Congress used extraterritorial jurisdiction language in Section 929P instead of directly addressing the reach of Section 10(b) on the merits, and whether as a result Section 929P does nothing more than confer jurisdiction on federal courts that the Morrison opinion already recognized courts have over all Section 10(b) cases. This article also discusses whether Section 929P reinstates for SEC and DOJ suits some of the case law in the courts of appeals that was overturned by Morrison, and if so, how that case law is to be applied. This article discusses whether Section 929P is retroactive, and how Section 929P likely will be used by the SEC and DOJ in insider trading and other cases. Finally, this article discusses whether Section 929P was necessary given the SEC’s already expansive enforcement authority under Section 10(b) and whether Congress should have taken the opportunity to address other more pressing post-Morrison issues in Dodd Frank. These issues include the status under Morrison of securities listed both in the United States and outside the United States, and the status of off-exchange traded security-based swap agreements, as well as other private transactions where identifying a transaction location is not as easy as it is for exchange traded securities.
The SEC provided additional guidance to clarify which U.S. securities laws will apply to security-based swaps starting July 16 -- the effective date of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
That Act created a new regulatory framework for over-the-counter derivatives, authorizing the SEC to regulate security-based swaps and the Commodity Futures Trading Commission to regulate other swaps. Under the Dodd-Frank Act, starting July 16, 2011, security-based swaps are defined as “securities” subject to existing federal securities laws, including the Securities Act of 1933 and the Securities Exchange Act of 1934.
As one part of today’s action, the Commission approved an order granting temporary relief and interpretive guidance to make clear that a substantial number of the requirements of the Exchange Act applicable to securities will not apply to security-based swaps when the revised definition of “security” goes into effect on July 16. Nevertheless, federal securities laws prohibiting fraud and manipulation will continue to apply to security-based swaps after that date. To enhance legal certainty for market participants, the Commission also provided temporary relief from provisions of U.S. securities laws that allow the voiding of contracts made in violation of those laws.
In addition, the Commission approved an interim final rule providing exemptions from the Securities Act, Trust Indenture Act and other provisions of the federal securities laws to allow certain security-based swaps to continue to trade and be cleared as they have pre-Dodd-Frank. That interim relief will extend until the Commission adopts rules further defining “security-based swap” and “eligible contract participant.”
The Commission previously issued guidance in this area on June 15 and plans additional steps in coming days related to the July 16 effective date. Although these actions have been approved, the Commission is seeking input from the public on today’s actions.
The Wall St. Journal reports that the New York AG, as part of an investigation begun by former AG and current governor Andrew Cuomo, has issued subpoenas seeking testimony from Bank of America's current CEO and other executives. The investigation stems from BofA's 2008 acquisition of Merrill Lynch and questions about whether Bof A misled its shareholders about the extent of Merrill's losses. This is a significant development since there were questions about whether the current AG had an interest in the types of securities fraud investigations brought by his predecessor. WSJ, New York Attorney General Steps Up Probe Into BofA-Merrill Disclosures
Thursday, June 30, 2011
Morgan Keegan Persuades Court That Written Disclosures of ARS Risks Trump Brokers' Oral Misstatements
A federal district court in Atlanta recently granted Morgan Keegan's motion for summary judgment in an SEC enforcement action involving auction rate securities (ARS). In SEC v. Morgan Keegan & Co. (N.D. Ga. June 28, 2011), the court agreed with Morgan Keegan's argument that its written disclosures about liquidity risks trumped oral mistatements that MK brokers may have made to individual customers. Among the written disclosures that the court highlighted were:
(1) MK's ARS Manual (which tracked best practices set forth by SIFMA), which was sent to its ARS customers and posted on its website;
(2) MK's annual newsletter to its customers that directed them to its website and ARS Manual;
(3) its ARS Brochure available in its branch officers and upon request; and
(4) Trade Confirmations that directed customers to its website and instructed them to contact MK within 10 days if the transaction was in error.
To counter the effect of the written disclosures, the SEC introduced the testimony of four customers who stated that their broker misrepresented the liquidity risks of ARS. However, the court found such testimony from four customers insufficient:
Here, the SEC is attempting to bootstrap the investor-specific impact of the misrepresentations alleged by four individual investors as a grounds to seek relief for a whole class of investors without any evidence that the other investors received similar oral misrepresentations, without any evidence that Morgan Keegan encouraged or instructed its brokers generally to issue misleading statements, and without any evidence that other investors had not read the disclosures that were made in the variety of ways Morgan Keegan made them.
However, the court agreed with MK that:
that no reasonable juror could conclude that these four examples of alleged oral misrepresentations could conceivably “have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988).
The court emphasized that:
The SEC has not introduced any evidence to show that Morgan Keegan instituted a company-wide policy encouraging its brokers to misrepresent ARS liquidity risks. The SEC also has not offered any evidence to show that Morgan Keegan was aware that its brokers were issuing misleading statements.
The SEC voted to propose rules that would impose certain business conduct standards upon security-based swap dealers and major security-based swap participants when those parties engage in security-based swap transactions. The SEC’s proposed rules stem from Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which authorizes the Commission to implement a comprehensive framework for regulating the over-the-counter swaps markets.
Public comments on the SEC’s proposal should be received by Aug. 29, 2011.
According to the SEC’s administrative order, some registered representatives and financial advisers at Raymond James told customers that ARS were safe, liquid alternatives to money market funds and other cash-like investments. Among other things, representatives at Raymond James did not provide customers with adequate and complete disclosures regarding the complexity and risks of ARS, including their dependence on successful auctions for liquidity.
Without admitting or denying the SEC’s allegations, Raymond James consented to the SEC’s order and agreed to:
- Offer to purchase eligible ARS from its eligible current and former customers.
Use its best efforts to provide liquidity solutions to customers who acted as institutional money managers who are not otherwise eligible customers.
Reimburse excess interest costs to eligible ARS customers who took out loans from Raymond James after Feb. 13, 2008.
Compensate eligible customers who sold their ARS below par by paying the difference between par and the sale price of the ARS, plus reasonable interest.
At the customer’s election, participate in a special arbitration process with those eligible customers who claim additional damages.
Establish a toll-free telephone assistance line and a public Internet page to respond to questions concerning the terms of the settlement.
The SEC's administrative proceeding against former McKinsey executive Rajat Gupta, scheduled to begin on July 18, has been postponed without explanation for six months. The SEC charges Gupta with tipping confidential inside information about Goldman Sachs and Procter & Gamble to Raj Rajaratnam when Gupta was on the boards of those companies. The DOJ has not indicted Gupta on criminal charges. Behind-the-scenes dickering between the DOJ and the SEC may be the reason. NYTimes, S.E.C. Delays Rajat Gupta’s Trial for Six Months
Bank of America announced it reached agreement to settle nearly all of the claims related to Countrywide-issued first-lien residential mortgage-backed securities, representing 530 trusts with an original principal of $424 billion. The agreement was entered into with The Bank of New York (Mellon), the trustee for the RMBS trusts covered by the settlement and is supported by a group of institutional investors. BofA will pay $8.5 billion and will provide an additional $5.5 billion for representations and warranties exposure.
Sunday, June 26, 2011
Morrison v. National Australia Bank: Implications for Global Securities Class Actions, by Linda Silberman, New York University School of Law, was recently posted on SSRN. Here is the abstract:
The recent U.S. Supreme Court decision in Morrison v. National Australia Bank has had a significant impact on the extraterritorial reach of the U.S. Securities Laws as well as a limitating global class actions. Other countries have begun to fill a perceived gap with respect to such class actions, as the recent Converium case in the Netherlands and the Imax decision in Canada illustrate. In addition to thosse developments, the article discusses various post-Morrison developments in the United States, including the recent Dodd-Frank legislation, the possibility of bringing claims in the United States under foreign law, lower court interpretations of Morrison, including off-exchange case law. The author concludes with a call for increased regulatory cooperation as well as the need for an international treaty.
The Deterrence Effects of SEC Enforcement and Class Action Litigation, by Jared N. Jennings, University of Washington; Simi Kedia, Rutgers University, Newark - School of Business, Newark, Department of Finance & Economics; and Shivaram Rajgopal, Emory University - Goizueta Business School, was recently posted on SSRN. Here is the abstract:
The United States’ (U.S.) Congress specifically requires the SEC to deter potential miscreants via its enforcement actions against firms that engage in fraudulent financial reporting. The U.S. is also unique in allowing private enforcement via class action lawsuits. In this paper, we investigate whether SEC enforcement actions and class action lawsuits, over the years 1996-2006, deter aggressive financial reporting behavior among the peers of fraudulent firms. We find significant deterrence associated with both SEC enforcement actions and class action lawsuits. The average peer firm, subject to SEC action and/ or litigation, reduces discretionary accruals equivalent to 14% to 22% of the median return on assets (ROA) in the aftermath of such enforcement. The results also inform target selection criteria associated with greater deterrence. Moreover, repeated and sustained enforcement in an industry, as opposed to isolated investigations, provides more effective deterrence.
Fraud Created the Market, by Michael J. Kaufman, Loyola University Chicago School of Law, and John M. Wunderlich, was recently posted on SSRN. Here is the abstract:
Class actions are vital to protecting investors. Without class certification, individual damages may be de minimis, and investors would be unlikely to bring a securities fraud suit. This underenforcement allows those who defraud investors to skate liability and impugn the integrity of the marketplace. Presumptions of reliance facilitate classwide resolution of securities fraud claims. Under Rule 10b-5 for securities fraud the Supreme Court has presumed reliance to facilitate class actions where there is an omission in the face of a duty to disclose or where there is a fraud on the secondary market. The new frontier is whether federal courts should likewise presume reliance where fraud occurs on the primary market, giving rise to the fraud-created-the-market theory. Although some federal courts embraced the theory decades ago, a sharp conflict has arisen in the wake of the Court’s decision in Stoneridge Investment Partners v. Scientific-Atlanta, and the Third and Ninth Circuits have set the pace for rejecting the theory. In this Article, however, we show that the fraud-created-the-market theory is consistent with the fundamental bases for all presumptions in the law, comports with the Supreme Court’s interpretations of the federal securities laws as properly understood, and serves the investor-protection and market-integrity design of securities regulation.
We undertake a comprehensive definition and defense of the fraud-created-the-market theory and show why critics’ concerns regarding the presumption are unfounded. Properly understood, the fraud-created-the-market theory is about materiality and scienter - defendants should be held liable under the securities laws for committing fraud that is so material, without it, the securities never would have made it to market. In this regard, we show that a presumption of reliance for newly issued securities and the primary market is consistent with the Supreme Court’s collapsing the elements of securities fraud into a single inquiry whether the omission or misrepresentation was material. We build upon Professor Donald C. Langevoort’s fresh interpretation of the fraud-on-the-market presumption and his interpretation of Stoneridge, to show that the fraud-created-the-market presumption is grounded in the Court’s jurisprudence. We also find support for a judicially crafted presumption in the context of new issues in the securities laws themselves and in the common-law bases for presumptions. There is a pressing need for an answer to whether federal courts should adopt the fraud-created-the-market theory. The fraud-created-the-market theory will play an increasingly important role in actions against those involved in fraud relating to the issuance of subprime mortgage-backed securities.