September 23, 2011
ARS Issuer Can Arbitrate Claims Against Broker-Dealer Related to Auction Services
The Second Circuit recently held that an issuer of auction rate securities (ARS) could arbitrate claims against the financial services firm that advised the issuer on the offerings and acted as the lead underwriter and the main broker-dealer responsible for facilitating the auctions that set the interest rates. UBS Financial Services, Inc. v. West Virginia University Hospitals (No. 11-235-cv, 9/22/11). There was no arbitration agreement between the parties, but a majority of the panel held that the issuer was a "customer" under the FINRA arbitration rules with respect to the services provided by the firm in its capacity as a broker-dealer and therefore could compel arbitration. While the district court had concluded that the issuer was a customer with respect to the underwriting services, the majority of judges declined to address that issue, although they made a point of stating that they disagreed with the dissenting judge's assertion that issuers can never be customers of underwriters.
This litigation thus offers another illustration of broker-dealers resisting arbitration when requested by the customer. Indeed, while the definition of "customer" is largely undefined at the borders and, in particular, whether the issuer is a customer of the underwriter that provides it underwriting services is unresolved, some of the arguments made by UBS's attorneys against arbitration were frivolous. Thus, they argued that FINRA rules do not contemplate arbitration for sophisticated parties, that FINRA has a narrow "investor-protection" mandate, and that a customer relationship requires a fiduciary relationship and cannot be founded on arm's length transactions. None of these arguments has ny basis in the FINRA rules, practice or policy.
Thus, we have another example of a situation where the securities industry believes that they will achieve a more favorable result in the law-oriented judicial forum than in the equity-based arbitration forum.
September 22, 2011
Becker on the Becker Case
Testimony of David M. Becker, Before the Subcommittee on Oversight and Investigations, Committee on Financial Services, and Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, Committee on Oversight and Government Reform, U.S. House of Representatives
(September 22, 2011)
SEC IG's Testimony on the Becker Case
Written Testimony of H. David Kotz, Inspector General of the Securities and Exchange Commission,
Before the Subcommittee on Oversight and Investigations, Committee on Financial Services, and Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, Committee on Oversight and Government Reform, U.S. House of Representatives (September 22, 2011)
Schapiro Testifies on Becker Case
Testimony Concerning “Potential Conflicts of Interest at the SEC: The Becker Case” by Chairman Mary L. Schapiro, U.S. Securities and Exchange Commission, Before the Subcommittee on Oversight and Investigations of the U.S. House of Representatives Committee on Financial Services and the Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs of the U.S. House of Representatives Committee on Oversight and Government Reform (September 22, 2011)
SEC & Quant Manager Settle Fraud Charges
The SEC settled charges of securities fraud against Barr M. Rosenberg, the co-founder of institutional money manager AXA Rosenberg, for concealing a significant error in the computer code of the quantitative investment model that he developed and provided to the firm's entities for use in managing client assets. According to the SEC's order instituting administrative proceedings, Rosenberg learned of the error in June 2009 but directed others to keep quiet about it and not fix it immediately. Rosenberg denied the existence of any significant errors in the model during an October 2009 board meeting discussion about its performance. AXA Rosenberg disclosed the error to SEC examination staff in late March 2010 after being informed of an impending SEC examination. The error was not disclosed to clients until April 2010, causing them $217 million in losses.
Rosenberg has agreed to settle the SEC's charges by paying a $2.5 million penalty and consenting to a lifetime securities industry bar. The SEC previously charged AXA Rosenberg and its affiliated investment advisers, and they agreed to pay $217 million to harmed clients plus a $25 million penalty.
Dysfunctional Boards: Hewlett-Packard Again!
Hewlett-Packard is in the news again, with reports that the board was meeting to fire its CEO Leo Apotheker only 11 months after firing Mark Hurd. If that isn't newsworthy enough, James Stewart, columnist of the New York Times, has a bombshell -- when the board's search committee narrowed the CEO candidates to three, no one else on the board was willing to interview the candidates! According to Stewart's sources, not one of the directors met Apotheker before he was hired! "I admit it was highly unusual. But we were just too exhausted from all the infighting," one of those directors told Mr. Stewart. (NYTimes, Voting to Hire a Chief Without Meeting Him)
Several years ago, I presented a Symposium on Dysfunctional Boards, and my inspiration was Hewlett-Packard. As you will recall, the scandal at that time involved allegations that the board authorized "pretexting" to obtain personal phone records as well as other unethical and possibly illegal methods of obtaining information about a possible leak within the board room. (In my introduction[Download INTRODUCTION - Publication Proof] to the Symposium, I discuss the allegations in greater detail.) At that time, I thought that H-P presented a "cautionary tale of the damage caused by distrust and dissension within the boardroom."
And sadly it appears that the H-P board learned nothing from its prior experience. Besides spying on fellow directors and failing to fulfill their responsibilities in appointing a CEO, the directors' conduct illustrates another serious symptom of dysfunctionality -- the apparent failure of these directors to understand the importance of confidentiality. The board's authorization of pretexting resulted from intense pressure to uncover the source of serious leaks to the press. The Wall St. Journal had reported details about a board retreat that could only have come from a participant. Similarly, Stewart says his information comes from interviews with several current and former directors and other people closely involved in the CEO search. What good do they think will come of blabbing? As I wrote previously about the H-P board:
All H-P directors and officers are subject to the company's Standards of Business Conduct that require prior approval before granting interviews or providing comments to the press. Moreover, even if a director sincerely believes that management's policies are misguided, the solution is not to leak confidential information to the press; instead, the director should work to change management's policies. What confluence of events caused at least one HP director to breach his obligation to maintain the confidentiality of corporate information?
September 21, 2011
DOJ Mulling Over Criminal Charges Against Former Goldman Director
The Wall S. Journal reports that DOJ is seriously considering criminal charges against Rajat Gupta, the former Goldman Sachs director whose wire tapped conversations were played at Raj Rajaratnam's insider trading trial. The SEC, whose administrative proceeding against Gupta was discontinued, reportedly is also considering filing civil charges in court. WSJ, Focus on Goldman Ex-Director
SEC Testimony on Small Business Capital Formation
Meredith B. Cross, Director, SEC Division of Corporation Finance, and Lona Nallengara, Deputy Director, Division of Corporation Finance, testified today on “Legislative Proposals to Facilitate Small Business Capital Formation and Job Creation” before the Subcommittee on Capital Markets and Government Sponsored Enterprises, U.S. House of Representatives, Committee on Financial Services.
Heath Abshure, Arkansas Securities Commissioner, also testified on behalf of NASAA.
SEC Charges Former Goldman Employee with Insider Trading involving ETFs
The SEC charged a former Goldman, Sachs & Co. employee and his father with insider trading on confidential information about Goldman’s trading strategies and intentions that the employee learned while working on the firm’s exchange-traded funds (ETF) desk. According to the SEC's complaint, Spencer D. Mindlin obtained non-public details about Goldman’s plans to purchase and sell large amounts of securities underlying the SPDR S&P Retail ETF (XRT). He tipped his father Alfred C. Mindlin, a certified public accountant. Father and son then illegally traded in four different securities underlying the XRT with knowledge of massive, market-moving trades in these securities that Goldman would later execute.
The case marks the SEC’s first insider trading enforcement action involving ETFs. According to the SEC's order instituting proceedings against the Mindlins, the insider trading occurred in December 2007 and March 2008.
September 20, 2011
SEC Inspector General Releases Report on Becker, Refers Matter to DOJ
The SEC website has a link to the SEC Inspector General's report investigating the circumstances surrounding former SEC General Counsel David Becker's involvement in the agency's consideration of Madoff issues (specifically, compensation to Madoff victims) despite having inherited from his mother an interest in a Madoff account. The IG has referred the matter to the DOJ to investigate whether Becker should face criminal charges and recommends that the SEC revisit some Madoff-related decisions. In the report, the IG finds that
Becker participated personally and substantially in particular matters in which he had a personal financial interest by virtue of his inheritance of the proceeds of his mother's estate's Madoff account and that the matters on which he advised could have directly impacted his financial position. We found that Becker played a significant and leading role in the determination of what recommendation the staff would make to the Commission regarding the position the SEC would advocate as to the determination ofa customer's net equity in the Madoff Liquidation.... Testimony obtained from SIPC officials and numerous SEC witnesses, as well as documentary evidence reviewed, demonstrated that there was a direct connection between the method used to determine customer net equity and clawback actions by the Trustee, including the overall amount of funds the Trustee would seek to clawback and the calculation of amounts sought in individual clawback suits. In addition to Becker's work on the net equity issue, we also found that Becker, in his role as SEC General Counsel and Senior Policy Director, provided comments on a proposed amendment to SIPA that would have severely curtailed the Trustee's power to bring clawback suits against individuals like him in the Madoff Liquidation.
Chair Schapiro has posted a response on the website. She stated:
“Last March, after learning about the Trustee’s suit against the Becker estate, I asked for the Inspector General to look into the matter.
I take his report, which was published today, very seriously.
It would be inappropriate for me to comment on the Inspector General’s referral to the Department of Justice.
I do want to state that I’ve known David for many years to be a talented, highly skilled lawyer and a dedicated civil servant who served under three Chairmen.
As the Inspector General recommends, we will seek another vote of the Commission on the question of the SEC’s position on the valuation of Madoff victim accounts.
I believe that the decision the Commission made on that issue was appropriate under the law and in the best interest of investors.
Moving forward, we plan to implement the other recommendations contained in the report as well.”
On Sept. 22, the House Financial Services Committee and the Committee on Oversight and Government Reform will hold a hearing on the Becker matter, where Schapiro, SEC IG Kotz and Becker are expected to testify.
September 19, 2011
Court Freezes Assets Linked to Suspicious Trading in Advance of Global-Technip Announcement
On September 16, 2011, the U.S. District Court for the Southern District of New York entered a Temporary Restraining Order freezing assets and trading proceeds of certain unknown purchasers of the securities of Global Industries, Ltd. (the “Unknown Purchasers”). The SEC filed a complaint alleging that the Unknown Purchasers engaged in illegal insider trading in the days preceding the September 12, 2011 public announcement that Technip SA (“Technip”), a French company, and Global Industries, Ltd. (“Global”) had entered into an agreement pursuant to which Technip would offer to acquire all of the outstanding common stock of Global for $8.00 per share, a 55% premium over the closing price of Global common stock on the trading day preceding the public announcement. The Commission’s complaint alleges that the Unknown Purchasers engaged in insider trading, thereby violating Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The complaint seeks permanent injunctive relief, the disgorgement of all illegal profits, and the imposition of civil money penalties.
SEC Announces Roundtable on Microcap Securities
The SEC announced that it will host a public roundtable on Oct. 17 to discuss "the unique regulatory issues" surrounding the execution, clearance, and settlement of microcap securities. It will feature in-depth discussions of key regulatory issues including Anti-Money Laundering monitoring, compliance challenges, and potential changes to the regulatory framework. Panelists will include representatives from The Deposit Trust Company, broker-dealers, the Financial Industry Regulatory Authority and others.
The roundtable is being sponsored by the SEC’s Microcap Fraud Working Group, a joint initiative of the Division of Enforcement and Office of Compliance Inspections and Examinations.
SEC Proposes to Prohibit Conflicts of Interest in ABS Transactions
The SEC voted to propose a rule intended to prohibit certain material conflicts of interest between those who package and sell asset-backed securities (ABS) and those who invest in them. The proposed rule would prohibit securitization participants of an ABS for a designated time period from engaging in certain transactions that would involve or result in any material conflict of interest. Two criteria to determine whether the transaction involves a material conflict of interest are set out in the rule proposal.
The proposal, which is not intended to prohibit traditional securitization practices, implements Section 621 of the Dodd-Frank Act.
SEC & DOL Back Off on Moving Forward in 2011 on Proposals for Fiduciary Duty
It appears that the SEC has responded to growing criticism that proposing a uniform fiduciary duty standard for securities professionals is "premature" until the agency has conducted more cost-benefit analysis to justify adoption of a rule. Many (including SEC Commissioner Paredes) have stated that the agency has not yet shown that different standards of care for securities professionals have resulted in harm to investors, even if it has resulted in investor confusion. Investment News reports that an SEC insider confirms the delay; Don't expect fiduciary proposal this year: SEC insider.
In addition, the U.S. Dept of Labor's EBSA released a statement today that it will re-propose its controversial definition of a fiduciary, in part in response to requests from the public and members of Congress that the agency allow additional time for imput. The release states that:
Specifically, the agency anticipates revising provisions of the rule including, but not restricted to, clarifying that fiduciary advice is limited to individualized advice directed to specific parties, responding to concerns about the application of the regulation to routine appraisals and clarifying the limits of the rule's application to arm's length commercial transactions, such as swap transactions.
Also anticipated are exemptions addressing concerns about the impact of the new regulation on the current fee practices of brokers and advisers, and clarifying the continued applicability of exemptions that have long been in existence that allow brokers to receive commissions in connection with mutual funds, stocks and insurance products. The agency will carefully craft new or amended exemptions that can best preserve beneficial fee practices, while at the same time protecting plan participants and individual retirement account owners from abusive practices and conflicted advice.
EBSA says it will continue to coordinate with the SEC and CFTC and expects to issue a new proposed rule in early 2012.
September 18, 2011
Omarova on Financial Services Regulation
Bankers, Bureaucrats, and Guardians: Toward Tripartism in Financial Services Regulation, by Saule T. Omarova, University of North Carolina at Chapel Hill School of Law, was recently posted on SSRN. Here is the abstract:
The recent financial crisis highlighted a fundamental but little-noticed paradox. The rising economic cost of financial market failure is disproportionately borne by the taxpaying general public. Yet, the public lacks an ability to participate meaningfully in the process of regulating increasingly complex financial markets. The crisis exposed pervasive market misconduct, regulatory incompetence, and conflict of interest in the U.S. financial sector. Yet, the post-crisis reform legislation continues to view financial services regulation as a process involving only two familiar principals: the industry and the regulators. Despite their dismal track record as guardians of public interest, bankers and bureaucrats effectively remain in charge of protecting the public from the next financial meltdown.
This Article challenges that concept by re-envisioning systemic risk regulation as a tripartite process. It proposes the creation of a Public Interest Council (the “Council”), an independent government instrumentality established and appointed by Congress and located outside of the executive branch. Its charge would be to participate in the regulatory process as the designated representative of the public interest in preserving long-term financial stability and minimizing systemic risk. The Council would comprise individuals who are (1) competent in issues of financial regulation, and (2) independent from both the industry and regulators. Although the Council would not have any legislative or executive powers, it would have broad statutory authority to collect information from government agencies and private market participants; to investigate specific issues and trends in financial markets; to publicize its findings; and to advise Congress and regulators to take action with respect to issues of public concern. In effect, the Council’s main function would be to counteract regulatory capture and to diffuse the financial industry’s power to control the regulatory agenda by putting both bankers and bureaucrats under constant and intense public scrutiny. Despite potential implementation challenges, this proposal takes an important step toward a more effective and public-minded model of systemic risk regulation.
Thompson on Market Makers
Market Makers and Vampire Squid: Regulating Securities Markets after the Financial Meltdown, by Robert B. Thompson, Georgetown University Law Center, was recently posted on SSRN. Here is the abstract:
Investment banks selling securities to their customers that the banks themselves were dumping crystallized the disconnect between Wall Street and Main Street during the recent financial crisis. Goldman Sachs asserted conflict was simply not relevant in the market maker relationship involving swaps and other innovative financial instruments since a dealer, by design, takes the opposite side of a transaction from the customer and does not typically disclose its mark-up or motives in entering into the transaction. Congress, not persuaded by the argument, reached out to move more dealer relationships from the space governed by markets to that governed by legal rules. The immediacy of the crisis has passed but the ongoing regulatory ambiguity over how much of market-making behavior should be regulated suggests continuing gaps in the law’s understanding of the role of intermediaries in securities regulation. This article seeks to fill some of those gaps and shape the learning as to the modern look of securities regulation in the aftermath of the financial crisis and subsequent law-making. First, the position of market-makers, long at the center of the debate over the role for markets and law, illustrates two distinct versions of private ordering that have not been clearly recognized. In one manifestation markets and express contracting will likely work fine, but the other is more like the agency and advisory relationships in which law has inserted fiduciary duties. When the dealer receives additional consideration for its effort on the selling side than the buying side, it destroys the neutral market-making that can be a predicate for leaving those relationships only to markets. Law imposed such obligations on underwriters and broker-dealers after the Depression; it is imposing such obligations on banks selling swaps after the meltdown of 2008. Second, the law’s tool kit in addressing securities markets is broader than disclosure that has occupied so much of our law school courses and thinking in the area. The recent federal response, in fact, has little in the way of disclosure and much more in the way of conflict management and market structuring to combat incentives that have not worked out as anticipated. The derivatives regulation in Dodd-Frank illustrates legal efforts to shape incentives of market participants in a broader way. Third, this spread of legal responses is not new but resembles more the approach of the New Deal legislation enacted during the 1930s that also was motivated by conflicts between investment banks and their customers and melded disclosure with a host of market structures to bring more social control over finance.
Coyle on Business Courts
Business Courts and Inter-State Competition, by John Coyle, University of North Carolina School of Law, was recently posted on SSRN. Here is the abstract:
Over the past two decades, nineteen states have established specialized trial courts that hear business disputes primarily or exclusively. To explain the recent surge of interest in these courts, policy-makers and scholars alike have cited the process of inter-jurisdictional competition. Specifically, these commentators have argued that business courts serve, among other purposes, to attract out-of-state companies to expand their business, re-incorporate, or litigate their disputes in the jurisdiction that created the business court.
This Article critically evaluates each of these theories. It argues, first, that business courts do not serve to attract companies from other states because business expansion decisions in the United States are rarely driven by the high quality of the courts in a particular jurisdiction. It next argues that business courts are unlikely to attract incorporation business because their core attributes are such that they are unlikely to compete successfully with the Delaware Court of Chancery. The Article goes on to argue that while the creation of a business court may in some cases serve to divert litigation business to local lawyers, the opportunities for diversion are relatively limited.
The Article then draws upon these insights to offer a number of suggestions as to how future business courts should be designed. It suggests that states should think twice before creating business and technology courts. It notes that major institutional reforms will be required if states wish to use business courts to attract incorporation business away from Delaware. It also identifies additional steps that states might take to more effectively attract litigation business. The Article concludes by briefly evaluating the viability of several non-competition-based rationales for establishing business courts.