Securities Law Prof Blog

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

Friday, June 1, 2012

FINRA Suspends Provident Principals for Two Years for Role in Ponzi Scheme

Are $50,000 fines and two-year suspensions from the industry meaningful sanctions for two principals of Provident Asset Management, LLLC, which marketed and sold preferred stock interests in a series of 23 private placements offered by an affiliate?  The offerings, as many will recall, were in fact a big ponzi scheme that raised over $458 million from at least 7,700 investors.  The order of settlement between FINRA and Coughlin and Harrison, which is posted on the FINRA website, is criticized by some as a "slap on the wrist."  Others point out that as a practical matter the two men are barred from the industry, as neither has worked in the industry since 2009, when the fraud was discovered.  As an SRO, moreover, FINRA is not permitted to "punish" wrongdoers, but only impose remedial sanctions, although the distinction is unclear.  For more on this story, see InvNews, Finra's settlement with ex-Provident execs 'slap on the wrist,' says lawyer

June 1, 2012 in News Stories, Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

SEC Approves Plans to Address Extraordinary Stock Volatility

The SEC approved two proposals submitted by the national securities exchanges and FINRA that are designed to address extraordinary volatility in individual securities and the broader U.S. stock market.

One initiative establishes a “limit up-limit down” mechanism that prevents trades in individual exchange-listed stocks from occurring outside of a specified price band. When implemented, this new mechanism will replace the existing single-stock circuit breakers that the Commission approved on a pilot basis after the market events of May 6, 2010.

The second initiative updates existing market-wide circuit breakers that when triggered, halt trading in all exchange-listed securities throughout the U.S. markets. The existing market-wide circuit breakers were adopted in October 1988 and have been triggered only once, in 1997. The changes lower the percentage-decline threshold for triggering a market-wide trading halt and shorten the amount of time that trading is halted.

The exchanges and FINRA will implement these changes by February 4, 2013, for a one-year pilot period.   Additional information, including the approval orders, are posted on the SEC website.

June 1, 2012 in Other Regulatory Action, SEC Action | Permalink | Comments (0) | TrackBack (0)

Wednesday, May 30, 2012

GAO Reports on SEC's Oversight of FINRA

GAO released a report, Opportunities Exist to Improve SEC's Oversight of the Financial Industry Regulatory Authority (GAO-12-625, May 30, 2012).  Here is its summary:

What GAO Found
Historically, the Securities and Exchange Commission’s (SEC) oversight of the Financial Industry Regulatory Authority’s (FINRA) programs and operations varied, with some programs and operations receiving regular oversight and others receiving limited or no oversight. Through its inspection process, SEC conducted routine and special inspections of various aspects of FINRA regulatory programs, including examinations, surveillance, and enforcement programs. SEC has also conducted routine inspections of FINRA’s advertising and arbitration programs but not as frequently as it had planned. SEC has also regularly reviewed FINRA proposed rule changes that are subject to SEC approval to determine consistency with the Securities Exchange Act of 1934 and related rules and regulations. However, neither SEC nor FINRA conducts retrospective reviews of FINRA’s rules. GAO and others have reported on the usefulness of retrospective reviews as they allow agencies to assess the effectiveness of their rules, and some federal financial regulators, including SEC, have begun pursuing plans to conduct retrospective reviews of their rules in light of a recent executive order that encourages independent regulatory agencies to do so. By not conducting these reviews, FINRA may be missing an opportunity to systematically assess whether its rules are achieving their intended purpose and take appropriate action, such as maintaining rules that are effective and modifying or repealing rules that are ineffective or burdensome. Further, by not reviewing what steps FINRA takes in reviewing its existing rules, SEC may not capture sufficient information to form an opinion about FINRA’s efforts to review its rules. Further, SEC has conducted limited or no oversight of other aspects of FINRA’s operations, such as governance and executive compensation. According to SEC, these operations were not historically considered due to competing priorities and resource constraints. Specifically, SEC officials said that SEC focused its resources on FINRA’s regulatory departments, which were perceived as programs that have the greatest impact on investors.

SEC is in the process of enhancing and expanding its oversight of FINRA using a more risk-based approach. To assess the risks facing FINRA, SEC has collected a substantial amount of information on FINRA’s regulatory programs and operations, including for programs and operations of FINRA for which it has not previously conducted oversight. SEC has analyzed the information it collected, and, according to SEC staff, will use this information as it implements its enhanced risk-based oversight of FINRA later this year. SEC has followed some elements GAO has previously found to be important in a risk-management framework, but officials have not articulated or documented how they will implement all of the elements, such as considering alternative oversight approaches and monitoring the effectiveness of its oversight. Incorporating these other elements will better position SEC to prioritize evolving and varying risks, evaluate alternatives, and monitor its oversight efforts. Without such elements, SEC may be missing opportunities to take a more comprehensive, risk-based approach in overseeing FINRA.


May 30, 2012 in Other Regulatory Action, SEC Action | Permalink | Comments (0) | TrackBack (0)

Eleventh Circuit Says Misrepresentations Affecting Choice of Broker are not Material

SEC v. Goble (11th Cir. May 29, 2012) addresses the issue of what constitutes "securities fraud" under rule 10b-5 in the context of a clearing firm's fudging its books and records to meet regulatory reserve requirements.  To my astonishment, the appellate court decided that the principal of a clearing firm did not commit securities fraud when he caused the firm to enter on its records a sham transaction purporting to be a $5 million money market purchase because, according to the court, "a misrepresentation that would only influence an individual's choice of broker-dealers cannot form the basis for 10(b) securities fraud liability." ( Download SECv.Goble ) 

First, the facts: Richard Goble controlled North America Clearing, Inc., a clearing broker for about forty small brokerage firms.  In 2007-2008 the firm had financial difficulties and struggled to maintain at the appropriate level the cash reserve account required by SEC regulations.  Finally, in May 2008, Goble directed the CFO  to record a sham transaction -- $5 million money market purchase -- to make it appear that firm could withdraw $3.4 million from the reserve account.  FINRA examiners, who were on site, quickly discovered the sham transaction; within a few days, it was clear that the firm could not meet the reserve requirements, and the firm was wound down.  An SEC enforcement action followed, charging that the firm violated the customer protection rule and books and records requirements.  It also charged Goble with violating Rule 10b-5 (in addition to aiding and abetting the firm's violations).  The district found against Goble on both counts, enjoined him from future violatons of the securities laws and permanently restrained him from seeking a securities license or engaging in the securities business.  The appeals court reversed the district court's judgment on the 10(b) count, upheld the judgment on the aiding and abetting count and remanded for reconsideration of the injunctive relief and the bar.

Second, the appellate court's analysis of the 10(b) claim:  The SEC based its 10(b) claim on Goble's causing the CFO to record the fake money market fund purchase in the firm's books.  The appellate court first rejected the district court's finding that this was a material misrepresentation.  It "easily dispatch[ed] the ... theory that the sham transaction would have been material to an investor's choice of broker-dealers," because the materiality test focuses on the importance of the fact on an investment decision -- which the court believes does not include an investor's choice of broker-dealer.  The court categorically states that "a misrepresentation that would only influence an individual's choice of broker-dealers cannot form the basis for a 10(b) securities fraud liability."  The appellate court also found that the misrepresentation was not made "in connection with the purchase or sale of securities," even though it assumed, without deciding, that the money market fund was a security.  (The district court had found that a money market fund was not a security, another curious assertion.)  Since the only "purchase" was a sham transaction, it was neither a "purchase" nor the type of behavior that 10(b) forbids.  Indeed, another categorical assertion by the court:  "Section 10(b) was not intended to protect investors from a broker-dealer's inaccurate records or an inadequate reserve fund."

As noted, the count against Goble for aiding and abetting the customer protection rule and books and records regulations was upheld, although the district court was directed to reconsider the remedy and determine if a bar is an appropriate remedy.  Nonetheless, it is discouraging to read that information that would affect an investor's choice of broker-dealer is not material because it does not relate to an investment decision.  I just hope that the reach of this opinion is confined to its particular facts and the sweeping assertions do not come back to bite investors who rely to their detriment on brokers' assertions of their competence, expertise and probity.


May 30, 2012 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Tuesday, May 29, 2012

Second Circuit Interprets Disclosure Obligations under Item 303 of Reg S-K

The Second Circuit has issued several opinions interpreting the disclosure obligations created by Item 303 of Regulation S-K, which requires registrants to "describe any known trends or uncertainties ... that the registrant reasonably expects will have a material ... unfavorable impact on ... revenues or income from continuing operations."  Panther Partners Inc. v. Ikanos Communications, Inc. (decided May 25, 2012)(Download PantherPartners.052512[2]) is the latest in this line of cases.  Plaintiff appealed a federal district court order that dismissed its third complaint alleging violations of Securities Act 11, 12(a)(2) and 15 in connection with a March 2006 secondary offering of Ikanos Communications stock.  In contrast to the district court, the appeals courts held that the complaint stated a claim because it plausibly alleged that defects in the company's semiconductor chips constituted a known trend or uncertainty that the company reasonably expected would have a material unfavorable impact on revenues.

As alleged in the complaint, in 2005 Ikanos sold chips to Sumitomo and NEC, its two largest customers and the source of 72% of its 2005 revenues.  They in turn incorporated the chips into products that were sold to NTT and installed in its network.  In early 2006 Ikanos learned that the chips were defective and were causing the network to fail, with the complaints increasing in the weeks preceding the March 2006 offering.  Indeed the board of directors met and discussed the problem, and company representatives regularly traveled to Japan to meet with Sumitomo and NEC to discuss the problem.  Ultimately, the company had to replace at its expense all of the units sold, resulting in substantial losses.  

Plaintiff alleged that the company did not adequately disclose in its Registration Statement the magnitude of the problem and instead provided a generic cautionary warning that "highly complex products ... frequently contain defects and bugs..."  The district court had previously dismissed the complaint twice and denied plaintiff's motion to file another amended complaint because it failed to allege "additional facts that Ikanos knew the defect rate was above average before filing the registration statement."  In vacating the district court's judgment, the appeals court held that it construed the proposed complaint too narrowly:

We believe that, viewed in the context of Item 303's disclosure obligations, the defect rate, in a vacuum, is not what is at issue.  Rather, it is the manner in which uncertainty surrounding that defect rate, generated by an increasing flow of highly negative information from key customers, might reasonably be expected to have a material impact on future revenues.

The appeals court emphasized two allegations in the amended complaint that it considered critical: (1) Sumitomo andNEC accounted for 72% of revenues and (2) Ikanos knew when it was receiving the complaints that it would be unable to determine which chip sets contained defective chips. From these facts, two reasonable and plausible inference could be drawn: Ikanos would have to replace and write off a large volume of chip sets and it had jeopardized its relationship with the two customers that accounted for the vast majority of its revenues.

In light of these allegations, the Registration Statement's generic cautionary language did not fulfill the company's duty to inform the investing public of the particular, factually-based uncertainties of which it was aware in the weeks before the offering.  The court had "little difficulty concluding that Panther has adequately alleged that the disclosures concerning a problem of this magnitude were inadequate and failed to comply with Item 303."


May 29, 2012 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Monday, May 28, 2012

Moberly on Whistleblower Protection

Sarbanes-Oxley's Whistleblower Provisions - Ten Years Later, by Richard Moberly, University of Nebraska College of Law, was recently posted on SSRN.  Here is the abstract:

Whistleblower advocates and academics greeted the enactment of the Sarbanes-Oxley Act’s whistleblower provisions in 2002 with great acclaim. The Act appeared to provide the strongest encouragement and broadest protections then available for private-sector whistleblowers. It influenced whistleblower law by unleashing a decade of expansive legal protection and formal encouragement for whistleblowers, perhaps indicating societal acceptance of whistleblowers as part of its law enforcement strategy. Despite these successes, however, Sarbanes-Oxley’s greatest lesson derives from its two most prominent failings. First, over the last the decade, the Act simply did not protect whistleblowers who suffered retaliation. Second, despite the massive increase in legal protection available to them, whistleblowers did not play a significant role in uncovering the financial crisis that led to the Great Recession at the end of the decade. These related failures indicate that although whistleblowers had stronger and more prevalent protection than ever before, they had less reason to believe such protection works. This Article examines the developments in whistleblower law during the last decade and concludes that Sarbanes-Oxley’s most important lesson is that the usual approach to whistleblowing may not be sufficient. Encouragingly, the Article also evaluates recent developments in light of Sarbanes-Oxley’s successes and failures to demonstrate that policy makers may have learned from the Sarbanes-Oxley experience. During the last two years, regulators and legislators implemented new strategies that may encourage employees to blow the whistle more effectively.

May 28, 2012 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Block on Systemic Risk

Letting Go of Binary Thinking and Too-Big-To-Fail: Preserving a Continuum Approach to Systemic Risk, by Cheryl D. Block, Washington University in Saint Louis - School of Law, was recently posted on SSRN.  Here is the abstract:

This Article highlights differences between principle and practical implementation of prudential regulation and resolution rules pertaining to financial institutions. In principle, even though general prudential regulatory rules reflect a gradual risk-based continuum approach, their implementation with respect to large systemically important institutions has often been through regulatory forbearance. Particularly when confronted with lobbying pressure from very large banks, regulators have opted for inaction. In ironic contrast, statutory and regulatory resolution rules over time have increasingly restricted regulators’ options, often apparently leaving regulators to make a binary choice between letting the entity fail and providing a major government rescue or “bailout.” In reality, however, regulators have adopted a range of government strategic responses to imminent or actual large private business failures. Resolution authority is binary in principle, but actually implemented along a private-public continuum. Despite Dodd-Frank’s attempt to limit this “reality,” regulators are likely to continue to exercise their resolution authority in a more flexible manner along this continuum than might otherwise appear from formal and statutory rules.

Such a continuum-based approach is important for both regulation and resolution. On the regulation side, this approach suggests better implementation of the risk-based principles already in place and assurance that new enhanced prudential regulatory rules will be properly implemented. On the resolution side, it means understanding that resolution authority reflects government policy with respect to allocating large financial entity failure risks. Rather than pretend to rid the system of bailouts, regulators should acknowledge the range of existing and potential government responses to risk allocation, and work toward developing an equitable and transparent process and substantive criteria for making allocative choices in the case of systemically important financial institution failures.

May 28, 2012 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Bradford on Crowdfunding

The New Federal Crowdfunding Exemption: Promise Unfulfilled, by C. Steven Bradford, University of Nebraska College of Law, was recently posted on SSRN.  Here is the abstract:

On April 5, 2012, President Barack Obama signed into law a new federal securities law exemption for crowdfunded securities offerings. Crowdfunding — the use of the Internet to raise small amounts of money from a large number of contributors — has become incredibly popular outside the securities context. But the use of crowdfunding to sell securities has been stymied by federal securities regulation. Securities Act registration is simply too expensive for small, crowdfunded offerings, and, until now, none of the registration exemptions fit crowdfunding well. Moreover, the web sites that facilitate crowdfunding could be considered brokers if they hosted securities offerings, imposing additional regulatory costs.

The new crowdfunding exemption attempts to resolve both of those regulatory problems — by exempting crowdfunded offerings from the registration requirement of the Securities Act and by providing that crowdfunding sites that meet certain requirements will not be treated as brokers. However, the new exemption imposes substantial regulatory costs of its own and, therefore, will not be the panacea crowdfunding supporters hoped for. The regulatory cost of selling securities through crowdfunding may still be too high.

This article analyzes the requirements of the new crowdfunding exemption and discusses its flaws.

May 28, 2012 in Law Review Articles | Permalink | Comments (1) | TrackBack (0)

Cohn on Crowdfunding

The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, by Stuart R. Cohn, University of Florida - Fredric G. Levin College of Law, was recently posted on SSRN.  Here is the abstract:

Title III of the JOBS Act, signed by President Obama on April 5, 2012, sets forth a new exemption from federal and state securities registration for so-called "crowdfunding" promotions. Crowdfunding is an increasingly popular form of raising capital through broad-based internet solicitation of donors. Many promotions simply seek charitable or other donations. But the lure of raising funds through the internet has also led to promotions for potentially profitable ventures that offer an economic return to donors. These efforts invoke the federal and state securities laws, as there are no de minimis standards protecting even the smallest of offferings. Registration exemptions under the 1933 Securities Act and those created by the Securities & Exchange Comission have not been useful for such small offerings and certainly cannot be used for internet-based offerings. In the face of SEC inaction with regard to such small-scale promotions, Congress took it upon itself to create a new exemption. Unfortunately, as described in the article, despite good intentions, the newly-created exemption is fraught with regulatory requirements that go beyond even existing exemptions and raise transaction costs and liability concerns that may substantially reduce the exemption's utility for small capital-raising efforts,

May 28, 2012 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Rose & LeBlanc on State Securities Regulators

Policing Public Companies: An Empirical Examination of the Enforcement Landscape and the Role Played by State Securities Regulators, by Amanda M. Rose, Vanderbilt Law School, and Larry J. LeBlanc, Vanderbilt University - Owen Graduate School of Management, was recently posted on SSRN.  Here is the abstract:

U.S. public companies can be pursued by multiple different securities law enforcers for the same misconduct. These enforcers include a variety of federal agencies, class action attorneys, derivative litigation attorneys, as well as 50 separate state regulators. Scholars and policymakers have increasingly questioned whether the benefits of this multi-enforcer approach are worth the costs, or whether a more coordinated and streamlined enforcement regime might lead to efficiency gains. How serious are these concerns? And what role do state regulators play in the enforcement mix? Whereas SEC and class action enforcement of the securities laws has been well studied, almost no empirical research has been done on state enforcement.

This Article provides an empirical foundation for considering these questions. We reviewed the Item 3 “material litigation” disclosures in the FY2004-FY2006 Form 10-Ks filed by every domestic public company that listed common stock on the NYSE from 2000-2010 — a total of 5441 Form 10-Ks filed by 1977 distinct companies. Seventy-two percent of the companies in our unique dataset disclosed some form of material litigation over the span of the three-year period examined, and 27% disclosed some form of securities litigation. Remarkably, well over half of the companies disclosing securities litigation reported facing two or more different forms of securities litigation, and nearly 30% reported facing three or more.

The securities-related state matters disclosed in our dataset share some interesting characteristics. For example, they tended to target out-of-state firms (68%) and to involve scandals that beset the financial industry (85%). Overwhelmingly, they were accompanied by a related federal action or investigation (91%) and very often were accompanied by related private litigation (67%). Whereas only 34% of states have an elected (as opposed to appointed) securities regulator, these states were responsible for 80% of the state matters disclosed. We ran regressions controlling for other variables that might be expected to influence a state’s level of enforcement activity. Our statistically significant results indicate that states with elected enforcers brought matters at more than four times the rate of other states, and states with an elected Democrat serving as the securities regulator brought matters at nearly seven times the rate of other states.

Our findings bring into focus several important public policy questions concerning the use of multiple securities law enforcers in general, and the social value of state enforcement in particular, that are worthy of further exploration.

May 28, 2012 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)