November 2, 2011
Another Court Significantly Reduces Madoff Trustee's Claims Against Banks
Judge McMahon (S.D.N.Y.) ruled on November 1 that Madoff Trustee Picard did not have standing to pursue common law claims against JPMorganChase andd UBS to recover on behalf of the defrauded customers, based on allegations that the banks knew, should have known or consciously avoided discovering, that Madoff' was illegally misappropriating customers' funds. Picard v. JPMorgan Chase & Co., Picard v. UBS AG (No. 11 civ. 913 (CM)Download Picard.JP Morgan. ( She thus joins Judge Rakoff (also S.D.N.Y.), who recently ruled similarly in Picard v. HSBC Bank PLC, 454 B.R. 25, in holding that the Trustee's authority under the Bankruptcy Code and SIPA extends only to recovering funds on behalf of the brokerage firm. Accordingly, the amount of money the Trustee can recover from the banks is significantly reduced.
Judge McMahon held that:
- There was no doubt that the common law causes of action belong to the creditors, not the brokerage firm; and
- The Trustee cannot pursue the common law causes of action on behalf of the brokerage firm as a consequence of the equitable doctrine of in pari delicto.
November 1, 2011
New York State Court Throws Out AG's Case Against Schwab Involving ARS Sales
On Oct. 24, 2011, a New York State Supreme Court (County of New York) Justice dismissed the New York Attorney General's complaint against Charles Schwab & Co. involving the firm's sale of auction rate securities (ARS).(Download Schwaborder ) Filed in 2009, the AG charged that Schwab failed to disclose to investorsthe risks involved in ARS, but instead repeatedly described the investments as "liquid," while knowing that major underwriter broker-dealers in the ARS market were supporting the market with proprietary bids to keep the auctions from failing and that the market would collapse if they stopped maintaining it. The AG further alleged that Schwab failed to ensure that its sales force was knowledgeable about the features and risks of ARS. Bringing claims under the Martin Act as well as consumer fraud, the AG sought to compel Schwab to buy back the ARS at par and other equitable remedies and penalties.
The court found, however, found that the complaint did not allege any representations that the ARS were liquid at a time when they were illiquid and accordingly dismissed all claims. Further, "despite having conducted an investigation for over a year prior to the filing of the complaint during which time the AG demanded and obtained more than 4,000 documents, received audio and call recordings involving more than 200 ARS transactions and deposed eleven witnesses, the complaint is devoid of any allegations of representations made that were untrue when made." Emphasizing that this was a misrepresentations and not an omissions case, the court held that the AG's allegations were essentially "fraud by hindsight."
MF Global Admits it Diverted Customers' Funds
According to a WSJ article, MF Global admitted to federal regulators that it diverted money out of customers' funds. The NYSE moved to delist the company because of its bankruptcy filing.
SIPA Trustee Appointed for MF Global Liquidation
The big news of the week (at least so far) is the bankruptcy filing and SIPA liquidation of MF Global, Inc., which the press reports is one of the largest ever, and the issue of missing customers' funds (reportedly hundreds of millions of dollars). The SEC posted on its website information for investors, and the court-appointed trustee for the liquidation has established a website.
See also NYTimes, Regulators Investigating MF Global for Missing Money
Ninth Circuit Confirms Debt Award Against Challenge to Arbitrability
In an opinion marked "not for publication," Wang v. Bear Stearns & Co. (Oct. 31, 2011)Download Wang.103111, the Ninth Circuit rejected a customer's efforts to resist confirmation of an adverse arbitration award by claiming that the claim was not arbitrable because her claim was encompassed by a putative class action.
Bear Stearns had brought the FINRA arbitration proceeding to collect payment for completed stock purchases pursuant to the customer's agreement. Wang asserted that a pending class action alleging that the broker-dealer committed fraud in the sale of the stock meant that she did not have to submit to arbitration. The court, however, rejected her argument because "the essential elements of the claims are distinct and bear little relation to each other....It is axiomatic that Bear Stearns cannot assert a counterclaim for monetary damages in the pending class action where Wang is not a named party." Accordingly, the appellate court affirmed the trial court's confirmation of the award in favor of Bear Stearns.
SEC ALJ Dismisses Fraud Charges Against 2 Former State Bank and Trust officials
An SEC administrative law judge dismissed charges that two former Street State Bank and Trust Co. employees misled investors about their exposure to subprime mortgage-backed securities in an unregistered fund, In re John P. Flannery and James D. Hopkins (File No. 3-14081 10/28/11Download InreFlannery). The fund at issue was the Limited Duration Bond Fund (LDBF), an actively managed "enhanced cash" fund whose objective was to match or exceed the return of the J.P. Morgan one-month U.S. Dollar LIBOR Index by 50-75 basis points over an interest-rate cycle. LDBF's clients consisted of sophisticated investors such as public funds, pension funds, endowments and foundations.
The ALJ emphasized that she found both respondents to be credible witnesses and that "testaments of their honesty, good character, hard work, and concern for clients were delivered enthusiastically" by every witness on their behalf.
The 58-page opinion thoroughly reviews the facts and testimony. In her legal analysis, the ALJ determined that the Janus test was the appropriate standard to apply in evaluating the extent of the respondets' conduct and that, therefore, with respect to allegations involving documentary evidence, the Division must establish that the respondents had ultimate authority and control over the documents.
Ultimately, the ALJ concluded that
neither Flannery nor Hopkins was responsible for, or had ultimate authority over, the allegedly false and materially misleading documents at issue in this proceeding.... Moreover, I find that these documents, as well as Hopkins’ representation to Hammerstein on April 9, 2007, and Flannery’s August 14 letter, did not contain materially false or misleading statements or material omissions. Because I find there were no materially false or misleading statements or omissions, there can also be no fraudulent “course of conduct” or “scheme liability.”
October 31, 2011
Seond Circuit Again Addresses "Customer" Definition in CDS Dispute
There has been considerable litigation in the Second Circuit over the issue of arbitrability in connection with credit default swap agreements. Specifically, the issue presented is whether there is a customer/broker-dealer relationship that permits the disappointed party to require arbitration of claims against the financial services firm involved in the transaction. In Wachovia Bank, N.A. v. VCG Special Opportunities Master Fund, Ltd. (No. 10-1648-cv, Oct. 28, 2011Download Wachovia.102811), the Second Circuit, reversing the district court, held that the hedge fund was not a "customer" of the Wachovia broker-dealer within the scope of FINRA Rule 12200, even though employees of the broker-dealer negotiated part of the CDS agreement. The court emphasized that all the agreements were between the hedge fund and Wachovia Bank, and the agreement contained a non-reliance clause in which the hedge fund acknowledged that the counter-party was not its broker or advisor in any respect. In these circumstances, "there is no need to grapple with the precise boundaries of the FINRA meaning of 'customer.'" The court distinguished the facts from those in two recently decided Second Circuit opinions where the broker-dealer provided brokerage services, Citigroup Global Markets, Inc. v. VCG, 598 F.3d 30 (2d Cir. 2010) and UBS Financial Services Inc. v. West Virginia University Hospitals, Inc. (2d Cir. Sept. 22, 2011).
October 30, 2011
Carney et al. on Dominance of Delaware Corporate Law
Lawyers, Ignorance, and the Dominance of Delaware Corporate Law, by William J. Carney, Emory University School of Law; George B. Shepherd, Emory University School of Law; and Joanna Shepherd, Emory University School of Law, was recently posted on SSRN. Here is the abstract:
Why does Delaware continue to dominate the market for incorporations even though recent research has shown that the quality of Delaware corporate law has declined substantially? We focus on the rational ignorance of lawyers and investors. Using the results of our survey of lawyers involved in initial public offerings (IPOs) as well as our analysis of companies involved in IPOs, we conclude that lawyers recommend Delaware because they are ignorant about other states’ law. Because Delaware is so dominant, law schools focus on Delaware corporate law, and a lawyer rationally learns the corporate law only of Delaware and her home state. Regardless of the quality of the law of other states, lawyers will not recommend it because they are unfamiliar with it. Likewise, lawyers recommend only Delaware law because they believe that investors are ignorant of other states’ law.
Lo on Financial Crisis Literature
Reading About the Financial Crisis: A 21-Book Review, by Andrew W. Lo, MIT Sloan School of Management; MIT CSAIL; National Bureau of Economic Research (NBER), was recently posted on SSRN. Here is the abstract:
The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of 21 books on the crisis, 11 written by academics, and 10 written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed.
Dick on Corporate Finance Jurisprudence
Confronting the Certainty Imperative in Corporate Finance Jurisprudence, by Diane Lourdes Dick, Seattle University School of Law, was recently posted on SSRN. Here is the abstract:
Turbulent economic periods leave many enduring legacies. This Article examines a jurisprudential vestige of the economic instability and dominant intellectual theories of the 1970s and 1980s: what I call the "Certainty Imperative." The Imperative is a judicial decision-making paradigm that infuses the specific goal of stability in financial markets into the broader and more deeply entrenched normative theme of legal certainty. As it has evolved across decades of case law and legislative enactments, the Imperative has profoundly altered judicial decision-making in finance and lending by encouraging strict interpretive norms and rejecting more expansive analyses. Over time, the Imperative's methodological constraints have become a paralyzing force upon the judiciary, preventing it from engaging in law reform. In essence, the state of finance and lending jurisprudence can be summarized thusly: deference, in the very broadest sense, is shown to the legal status quo.
The methodological constraints imposed by the Imperative must be overcome. As modern corporate financing arrangements grow more complex, moral hazards arise when contractual language vests substantive rights and remedies in a manner that does not align with evolving economic interests. This Article suggests several possibilities for expanding the scope of judicial inquiries in the corporate financing realm so that the judiciary may resolve disputes through an interpretive methodology that considers economic substance over contractual form.
Myers on Say-on-Pay
The Perils of Shareholder Voting on Executive Compensation, by Minor Myers, Brooklyn Law School, was recently posted on SSRN. Here is the abstract:
Giving shareholders more managerial power over corporate affairs—the goal of many recent corporate reform proposals—comes with costs that commentators have failed to recognize. In general, the more involved shareholders are in a firm's managerial decisions, the more difficult it is for directors to be held accountable for the outcome of those decisions. This can weaken directors' ex ante incentives to act in the interests of shareholders. This Article argues that this phenomenon may undermine the ambitions of the recent high-profile corporate reform requiring each public company to hold periodic, nonbinding shareholder votes on its executive compensation.
Supporters of the reform, known as "say on pay," predict that corporate directors will be fearful of shareholder "no" votes because they will attract embarrassing attention to directors and the firm. In other words, shareholder voting will amplify the "outrage constraint"— the threat of shame or embarrassment in the media that, according to the influential managerial power model of executive compensation, limits directors' ability to award pay packages that are too big and not sensitive enough to performance. To avoid the amplified outrage associated with a "no" vote, directors will be compelled to modify executive pay in ways amenable to shareholders.
Shareholder voting on executive compensation, however, could hurt shareholders in ways supporters of the reform have overlooked. Once shareholders have approved a firm's compensation arrangements, directors will no longer bear complete responsibility for them. If any negative attention—any outrage—is directed at the firm's pay practices in the future, directors can escape a portion of the blame that otherwise would have been theirs alone. This diffusion of responsibility willpartially insulate directors' reputations from future outrage, and because directors will no longer bear all of the future costs of taking risks in the CEO's favor, they may end up taking more of those risks.
By clouding the functioning of the outrage constraint, shareholder approval thus may liberate directors at some firms to offer executive pay packages that are larger and more insensitive to performance than if the board were acting alone. In view of this effect, giving shareholders a say on executive pay may injure as many firms as it helps. To eliminate this overbreadth problem, this Article proposes amending the legislation to allow firms to opt-out of the say on pay regime by shareholder vote. This preserves the benefits of say on pay for those firms where shareholders wish to retain it and allows other firms to exit the regime at little cost.
Johnson on Gatekeepers in State Court
Secondary Liability for Securities Fraud: Gatekeepers in State Court, by Jennifer J. Johnson, Lewis & Clark Law School, was recently posted on SSRN. Here is the abstract:
The recent economic meltdown exposed numerous Ponzi schemes. When promoters of fraudulent ventures are unable to provide restitution to their victims, plaintiffs seek out other sources of repayment including professionals and other secondary participants in the transactions that precipitated their losses. Although most scholars agree that professionals can perform an important role in deterring securities fraud, scholarly opinions vary widely on the appropriate liability regime, if any, that these gatekeepers should face.
While civil liability for secondary participants in securities fraud was once well accepted in the federal courts, in 1994 the Supreme Court invalidated such claims as beyond the purview of Section 10(b) of the 1934 Securities Exchange Act and Rule 10b-5. In contrast, there is a robust tradition of aiding and abetting liability in most state blue sky statutes. Unlike the federal implied Rule 10b-5 cause of action, state blue sky laws contain express secondary liability statutes that do not have strict scienter standards or rigorous pleading requirements. Indeed, some state statutes are negligence based and contain burden-shifting provisions that require non-seller defendants to establish that they were not negligent in failing to discover the seller's fraud.
This Article traces the development of secondary liability under state securities laws and contrasts various state regimes and their federal counterparts. It also reviews federal efforts to restrict states from adjudicating securities related claims. Relying on available empirical evidence, the Article ultimately concludes that Congress should reverse its propensity of the last decade to preempt state securities actions and should recognize the valuable contribution of such actions in addressing fraud, particularly fraud committed upon retail investors.