January 12, 2013
Black on Behavioral Economics and Investor Protection
Behavioral Economics and Investor Protection: Reasonable Investors, Efficient Markets, by Barbara Black, University of Cincinnati - College of Law, was recently posted on SSRN. Here is the abstract:
The judicial view of a “reasonable investor” plays an important role in federal securities regulation, and courts express great confidence in the reasonable investor’s cognitive abilities. Behavioral economists, by contrast, do not observe real people investing in today’s markets behaving as the reasonable investors that federal securities law expects them to be. Similarly, the efficient market hypothesis (EMH) has exerted a powerful influence in securities regulation, although empirical evidence calls into question some of the basic assumptions underlying EMH. Unfortunately, to date, courts have only acknowledged the discrepancy between legal theory and behavioral economics in one situation, class certification of federal securities class actions. It is time for courts to address the gap between judicial expectations about the behavior of reasonable investors and behavioral economists’ views of investors’ cognitive shortcomings, consistent with the central purpose of federal securities regulation: protect investors from fraud.
Booth on Materiality
The Two Faces of Materiality, by Richard A. Booth, Villanova University School of Law, was recently posted on SSRN. Here is the abstract:
To make out a claim for securities fraud under federal law, a plaintiff must plead and prove the misrepresentation of a material fact. The Supreme Court has repeatedly defined a material fact as one that would be important to a reasonable investor in deciding how to act in that it would change the total mix of information – although it need not necessarily change the ultimate decision of the investor as to how to vote or whether to trade. On the other hand, the courts have also defined a material fact as one that would affect market price – which clearly implies that it must have changed the decisions of some investors. Although these two definitions of materiality appear to conflict, they can be reconciled as alternative expressions of the same standard, the former referring to individual investors and the latter referring to investors in the aggregate. Indeed, the Supreme Court has held a fact cannot be material if it cannot matter to the ultimate outcome, suggesting that a fact cannot be material if it does not affect the behavior of a number of investors sufficient to move the market. Moreover, it is appropriate to consider price impact in connection with the decision to certify a securities fraud action as a class action since a class action involves the claims of investors in the aggregate and since price impact need not be dispositive as to the merits of the individual claim of the lead plaintiff who may be able to recover under the individual investor standard.
Rodrigues on Securities Law's Dirty Little Secret
Securities Law's Dirty Little Secret, by Usha Rodrigues, University of Georgia Law School, was recently posted on SSRN. Here is the abstract:
Securities law's dirty little secret is that rich investors have access to special kinds of investments — hedge funds, private equity, private companies — that everyone else does not. This disparity stems from the fact that from its inception federal securities law has jealously guarded the manner in which firms can sell shares to the general public. Perhaps paternalistically, the law assumes that the average investor needs the protection of the full panoply of securities regulation, and thus should be limited to buying public securities. In contrast, accredited — i.e., wealthy — investors, who it is presumed can fend for themselves, have the luxury of choosing between the public and private markets.
This Article uses the emergence of new secondary markets in the shares of private companies to illustrate the above disparity, which has long characterized the world of investment access. First, focusing narrowly on these markets reveals their troubling potential effects on the venture capital world, a vital source of startup funding. More broadly, these new secondary markets bring to light the stark contrasts in investing power and access that have always been securities law’s dirty little secret: by making it easier for accredited investors to wield their special privilege, the new markets just make the disparity of investment access more obvious. For example, after Facebook’s initial public offering (IPO), it was widely reported that accredited investors had been buying shares of the high-profile company in the three years before it rather disastrously went public — at which point the big money had already been made.
Thus, the increased transparency the secondary markets bring to the world of private investment makes our overall securities law newly vulnerable to a fundamental critique: Government intervention has created an investing climate that lets the rich get richer, while the poor get left behind. The Article acknowledges elements keeping the current system in place, explaining the current inequality of investor access by way of public choice theory: regulators and companies alike favor the status quo. Viewed from the perspective of the little guy, however, inequality in investment access may prove less defensible and ultimately less tenable. I suggest a modest fix: letting the general public participate in the private market via mutual fund investment, something it currently cannot do.
January 11, 2013
BATS Reports Numerous Bad Trades Over Four Years
BATS Exchange reported that in the past four years there have been numerous instances where trades were not executed at the best available price. The trades affected about 250 customers and cost about $420,000.
The Wall St. Journal reports on the impact on BATS and more generally on investor confidence in the trading markets and the regulators that regulate them. The SEC reportedly met on Thursday to discuss. WSJ, Now Up to BATS: Damage Control
January 10, 2013
FINRA Issues Voluntary Interim Form for Funding Portals
FINRA issued a voluntary Interim Form for Funding Portals designed for prospective crowdfunding portals under the JOBS Act. The Interim Form asks prospective funding portals to provide information including ownership; funding; management; and business model and relationships.
FINRA explains that:
Those intending to become a funding portal may voluntarily submit information regarding their business on the interim form. The information received will help FINRA develop rules specific to crowdfunding portals.
FINRA and the SEC are engaging in an open dialogue about the rules that should apply to funding portals. Once the SEC and FINRA have adopted funding portal rules, FINRA will issue a final funding portal application for FINRA regulation. In applying for membership, crowdfunding portals will not be bound by the responses provided on the Interim Form.
January 9, 2013
SEC Charges Commonwealth Bank Officers with Accounting FraudThe SEC today charged three former bank executives of Commonwealth Bank with understating millions of dollars in losses and masking the true health of the bank's loan portfolio at the height of the financial crisis. According to the SEC's complaint, defendants (Edward J. Woodard, Jr., the CEO, President and Chairman of the Board at Norfolk, Virginia-based Bank of the Commonwealth and its publicly-traded parent, Commonwealth Bankshares, along with Chief Financial Officer and Secretary Cynthia A. Sabol, a CPA, and Executive Vice President and Commercial Loan Officer Stephen G. Fields) understated the bank's loan-related losses as well as losses on real estate repossessed by the bank (other real estate owned or OREO) in Commonwealth's SEC filings from November 2008 through August 2010
SEC Charges KPMG Auditors with Unprofessional Conduct in Audit of Failed Bank
The SEC charged two auditors at KPMG for their roles in a failed audit of TierOne Bank, a Nebraska-based bank that hid millions of dollars in loan losses from investors during the financial crisis and eventually was forced to file for bankruptcy. The SEC previously charged three former TierOne Bank executives responsible for the scheme. Two executives agreed to settle the SEC’s charges, and the case continues against the other.
The new charges in the SEC’s case are against KPMG partner John J. Aesoph and senior manager Darren M. Bennett. According to the SEC’s order instituting administrative proceedings, the auditors failed to comply with professional auditing standards in their substantive audit procedures over the bank’s valuation of loan losses resulting from impaired loans. They relied principally on stale appraisals and management’s uncorroborated representations of current value despite evidence that management’s estimates were biased and inconsistent with independent market data. Aesoph and Bennett failed to exercise the appropriate professional skepticism and obtain sufficient evidence that management’s collateral value and loan loss estimates were reasonable. According to the SEC, the auditors engaged in improper professional conduct as defined in Section 4C of the Securities Exchange Act of 1934 and Rule 102(e)(1)(ii) of the Commission’s Rules of Practice.
A hearing will be scheduled before an administrative law judge to determine whether the allegations contained in the order are true and what, if any, remedial sanctions are appropriate pursuant to Rule 102(e).
Khuzami Announces Resignation as SEC Enforcement DirectorRobert Khuzami made it official today and announced that he is resigning as Director of Enforcement at the SEC to return to private practice. Mr. Khuzami was one of Mary Schapiro's first appointments when she became Chairman, brought in to strengthen and revitalize the enforcement division. Mr. Khuzami established a reputation as a tough regulator, but the SEC was frequently criticized for not bringing more enforcement actions against high-level officers at those financial firms involved in the financial crisis. The SEC's press release summarizes the accomplishments of the enforcement division under his leadership.
January 8, 2013
FINRA Year in Review
FINRA posted on its website a review of its 2012 activities. It identified
significant accomplishments in detecting fraudulent activity, implementing cross-market surveillance, increased transparency of securities markets and fulfilling its regulatory mandate to protect investors, assessing $68 million in fines, ordering a record $34 million in restitution to harmed customers and taking measures to ensure market integrity.
Richard Ketchum, FINRA's Chairman and CEO, said, "FINRA fulfilled its role as the first line of defense for investors through a comprehensive and aggressive enforcement program, supported by a realigned and more risk-based examination program and the provision, for the first time, of cross-market surveillance programs that more effectively detected electronic manipulative trading. Protecting investors and helping to ensure the integrity of the nation's financial markets is at the heart of what we do every day."
U.S. Supreme Court Hears Oral Argument in Gabelli v. SECThe U.S. Supreme Court heard oral argument today in Gabelli v. Securities and Exchange Commission (No. 11-1274). The issue in this case is when the federal statute of limitations begins to run when the government seeks civil penalties for claims based on fraud.
In April 2008 the SEC filed a complaint alleging that defendants concealed that they allowed market timing in a mutual fund contrary to the fund’s stated policy. The market timing took place from 1999 until 2002. The SEC did not discover the alleged fraud until late 2003. The applicable statute of limitations is 28 U.S.C. 2462, which states that the action must be commenced within five years “from the date when the claim first accrued.” The Second Circuit held that because the SEC’s complaint alleged that defendants aided and abetted the investment adviser’s fraud, the fraud discovery rule defined when the claim accrued and the SEC need not plead that the defendants took affirmative steps to conceal their fraud.
The Supreme Court must decide whether the government has additional time to bring an action when the complaint alleges fraud or a concealed wrong. Under the judicially created discovery rule for fraud actions, the limitations period does not begin to run until the plaintiff discovers, or in the exercise of reasonable diligence, should have discovered, the fraud. The SEC argued that the discovery rule is incorporated into § 2462 and the claim did not “accrue” until it first discovered the fraud in late 2003. The defendants, in contrast, argued that the discovery rule is not part of the statute and that the SEC’s suit is time-barred, because it was not brought within five years of when it had the right to file the suit.
In oral argument, Lewis Liman, arguing on behalf of the defendants, emphasized that Congress provided a clear and easily administered limitations period whenever the government sought a civil penalty (and was not acting on behalf of injured investors and was not seeking damages or equitable relief). Several Justices questioned whether the statute was so clear, since the SEC's action could also be characterized as a fraud action and the term "accrued" is not defined in the statute. They also questioned why, if the fraud discovery rule was available to private plaintiffs, it was not also available to the government.
Jeffrey Wall, arguing on behalf of the government, emphasized that the courts have long recognized the fraud discovery rule and that it should be read into the statute. The Justices, however, pressed Mr. Wall to identify a single case in which the discovery rule was applied in a criminal case with respect to a penalty or a criminal sanction. In particular, Justice Breyer asserted that "until 2004 I haven't found a single case in which the government ever tried to assert the discovery rule where what they were asserting was a civil penalty ... with one exception ... in the 19th century" [when the government lost and conceded the argument]. Justice Breyer also made clear that he was concerned about the consequences if the government could bring an action for "quasi-criminal" penalties and essentially abolish the statute of limitations by asserting fraud, in areas of law such as Social Security or Medicare. Several Justices also pressed Mr. Wall about the difficulties a defendant would have in attempting to show that the government could have discovered the fraud earlier with due diligence. Mr. Wall, in turn, stated that "I cannot imagine that the Congress, which allowed agencies to seek civil penalties ... would have thought that the only people who could get away without paying them are the ones who commit fraud or concealment and that remains hidden for five years." Justice Ginsburg also questioned why the SEC had delayed in bringing this suit, and Justice Kagan suggested that this was a decision about "enforcement priorities."
It is very difficult to "read" Justices' reactions based on a transcription of an oral argument. It seems clear, however, that the government encountered considerable skepticism because the government is asserting a power that it had not previously asserted for 200 years. The question posed by Justice Kagan was "why hasn't the government asserted this power previously?"