January 26, 2013
Gilson & Gordon On Activist Investors
The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, by Ronald J. Gilson, Stanford Law School; Columbia Law School, and Jeffrey N. Gordon, Columbia Law School; European Corporate Governance Institute (ECGI), was recently posted on SSRN. Here is the abstract:
Equity ownership in the United States no longer reflects the dispersed share ownership of the canonical Berle-Means firm. Instead, we observe the reconcentration of ownership in the hands of institutional investment intermediaries, which gives rise to what we call “the agency costs of agency capitalism.” This ownership change has occurred because of (i) political decisions to privatize the provision of retirement savings and to require funding of such provision and (ii) capital market developments that favor investment intermediaries offering low cost diversified investment vehicles. A new set of agency costs arise because in addition to divergence between the interests of record owners and the firm’s managers, there is divergence between the interests of record owners – the institutional investors – and the beneficial owners of those institutional stakes. The business model of key investment intermediaries like mutual funds, which focus on increasing assets under management through superior relative performance, undermines their incentive and competence to engage in active monitoring of portfolio company performance. Such investors will be “rationally reticent” – willing to respond to governance proposals but not to propose them. We posit that shareholder activists should be seen as playing a specialized capital market role of setting up intervention proposals for resolution by institutional investors. The effect is to potentiate institutional investor voice, to increase the value of the vote, and thereby to reduce the agency costs we have identified. We therefore argue against recent proposed regulatory changes that would undercut shareholder activists’ economic incentives by making it harder to assemble a meaningful toe-hold position in a potential target.
January 25, 2013
Wrona on Standards of Conduct for Investment Advisers and Broker-DealersThe November 2012 issue of The Business Lawyer features an article entitled The Best of Both Worlds: A Fact-Based Analysis of the Legal Obligations of Investment Advisers and Broker-Dealers and a Framework for Enhanced Investor Protection by James S. Wrona, Vice President and Associate General Counsel at FINRA. The author provides an indepth analysis of the development of the standards of conduct for investment advisers and broker-dealers and the current debate that is usually referred to the dichotomy between the fiduciary standard required of investment advisers and the suitability standard applicable to broker-dealers. The article concludes with a framework for robust investor protection and recommends additional obligations on both financial advice providers "to achieve truly universal standards of conduct that are in investors' best interests." The citation is 68 Bus. Law. 1 (2012), and it is available in hard copy or at the ABA website.
Stanford Receiver Can Recover Interest Payments for Net Winners
The Texas federal district court that has exclusive jurisdiction over the receivership estate of R. Allen Stanford's Ponzi scheme recently held that the receiver could avoid interest payments made to those investors who received payments in excess of their principal investment ("Net Winners").
In Janvey v. Alguire (N.D. Tax. Jan. 22, 2013) (Download Janvey.012213), the court first held that, as a matter of law, Stanford operated a Ponzi scheme, based on the declarations of an expert. Next, the court addressed the issue of whether the Net Winners provided value for their interest payments. The court acknowledged that, although courts almost universally hold that the transfer of "false profits" from a Ponzi scheme is not made in exchange for value, courts are split where the investor receives payments in the form of interest on the principal. After reviewing the case law, the court sides with those courts that choose not to enforce investment contracts with a Ponzi scheme. Accordingly, the Net Winners failed to provide value in exchange for the interest they received. Noting that for victims of a Ponzi scheme, "everyone is a loser," the court decided that "avoiding the interest payments is the most equitable and just solution to a difficult problem."
The court found that the order "involves a controlling question as to which there is substantial ground for difference of opinion and that an immediate appeal from the order may materially advance the ultimate termination of the litigation." Therefore, he certified the order for interlocutory appeal.
January 24, 2013
Mary Jo White Nominated to Chair the SEC
It is now official -- President Obama has nominated Mary Jo White to chair the SEC. By picking a lawyer who made her reputation as an effective, aggressive prosecutor (former U.S. District Attorney for Southern District of New York), he clearly wants to send a message about the importance of tough enforcement. In his brief remarks, according to the Washington Post, the President said that while much has been done "we also need cops on the beat to enforce the law" and that "You don't mess with Mary Jo." If confirmed, she would be the first prosecutor to head up the agency.
The President also nominated Richard Cordray, a former attorney general of Ohio, to continue to head up the Consumer Financial Products Bureau. Mr. Cordray was a recess appointment in 2011, because Republicans made clear that they would not confirm him.
Securities Firms' Attempt to Avoid Arbitration Fails -- Again
The securities industry fought hard for the power to require brokerage customers to arbitrate all disputes with their firms. But some firms appear to think that arbitration is only a good dispute resolution mechanism when they want it and are challenging arbitration proceedings brought by dissatisfied users of their services. UBS Financial Services, Inc. v. Carilion Clinic (4th Cir. No. 12-2066, Jan. 23, 2013) is a recent example.(Download UBSFinancial.012313)
Carilion, a not-for-profit organization that operates hospitals and clinics in Virginia, decided in 2005 to issue municipal bonds and retained UBS and Citigroup Global Markets to advise it on the structure of the bond issues and to assist it in implementing the financing plan. UBS and Citigroup recommended the issuance of auction-rate bonds and acted as underwriters and lead broker-dealers in the $234 million offering. Unfortunately, in early 2008 the auction-rate bond market collapsed for the bonds, when UBS and Citigroup stopped submitting support bids. Carilion was forced to refinance and lost millions of dollars. Carilion filed an arbitration claim with FINRA, claiming that the firms misled it and asserting claims under both state and federal securities laws. UBS and Citigroup filed a declaratory judgment action and sought a preliminary injunction against the arbitration, asserting that Carilion was not a "customer" entitled to bring an arbitration under FINRA's rules. They further argued that Carilion had waived arbitration through the forum selection clause contained in one of the contracts among the parties. The district court rejected both arguments, and the Fourth Circuit affirmed.
FINRA Rule 12200 requires member firms to arbitrate disputes with customers when the customer requests arbitration and the dispute "arises in connection with the business activities of the member." UBS and Citigroup asserted that Carilion was not their "customer" because that term, as used in the FINRA rule, is limited to "investors." Carilion, in contrast, asserted that customer means anyone "who purchases some commodity or service." The Fourth Circuit agreed with Carilion, finding the broader interpretation is consistent with the purposes of FINRA arbitration and consistent with generally accepted meaning of customer. Thus, it held that "when FINRA uses 'customer' in Rule 12200, it refers to one, not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member's business activities insofar as those activities are covered by FINRA's regulation, namely the activities of investment banking and the securities business."
The Fourth Circuit also rejected the firms' argument that the forum selection clause, which provides that "all actions and proceedings arising out of this Agreement ... shall be brought in the United States District Court of the County of New York." This was "a straightforward issue of contract interpretation," said the Court. It found that the natural reading of the clause was to require any litigation to be brought in the designated court; "it would never cross a reader's mind that the clause provides that the right to FINRA arbitration was being superseded or waived," especially since the clause did not even use the word arbitration.
The Fourth Circuit relied on a previous opinion from the Second Circuit, UBS Financial Services, Inc. v. West Virginia Hospitals, 660 F.3d 643 (2d Cir. 2011), involving substantially similar facts.
January 23, 2013
FINRA Seeks Temporary Cease and Desist Order Against Westor Capital
FINRA announced that it has filed for a Temporary Cease-and-Desist Order against Westor Capital Group, Inc. and its President, Chief Compliance Officer and Financial and Operations Principal, Richard Hans Bach, to immediately stop the further misappropriation and misuse of customer funds and securities. In addition, FINRA issued a complaint against Westor and Bach, charging them with failing to allow customers to withdraw account balances and deliver securities, misusing customer securities, failing to maintain physical possession or control of securities, and for operating an unapproved self-clearing business.
According to FINRA, Westor's primary business is trading in microcap securities through its own accounts held at several different brokerage firms and has ineffective measures to track and reconcile its customers' stock positions, making it possible for Westor and Bach to conceal the improper use of securities, the complaint alleges.
Eisinger: Bad Behavior at Morgan StanleyNot to be missed -- ProPublica's Jesse Eisinger reviews Morgan Stanley documents made public last week in a lawsuit brought in Manhattan state court by a Taiwanese bank that purchased a CDO from the firm in 2006. According to the article, "the documents suggest a pattern of behavior larger than this one deal: people across the bank understood that the American housing market was in trouble. They took advantage of that knowledge to create and then bet against securities and then also to unload garbage investments on unsuspecting buyers." Morgan Stanley's defense, of course, is that the buyers were sophisticated investors that should have done their own due diligence. Read it and see what you think. NYTimes Dealbook, Financial Crisis Suit Suggests Bad Behavior at Morgan Stanley
January 22, 2013
Colorado Federal District Court Refuses to Approve SEC Settlement
A federal district court judge for the District of Colorado has refused to approve a proposed SEC settlement. In a terse order that does not describe the SEC's allegations against defendants Bridge Premium Finance LLC et al., Judge John L. Kane stated that he "refuse[d] to approve penalties against a defendant who remains defiantly mute as to the veracity of the allegations against him. A defendant's options in this regard are binary: he may admit the allegations or he may go to trial." In addition, the judge objected to the language in the consents and the proposed final judgments in which the defendants waived their rights to the entry of findings of fact and conclusions of law and their rights to appeal, because "[t]hese findings are important to inform the public and the appellate courts." SEC v. Bridge Premium Finance LLC (D. Col. Jan. 17, 2013, Case No. 1:12-cv-02131-JLK-BNB)
The Second Circuit will hear the SEC and Citigroup's appeal from Judge Rakoff's refusal to approve their proposed settlement on February 8.
FINRA Proposes Brokerage Firms Provide Link to BrokerCheck on Websites
FINRA has filed with the SEC a proposed rule change to amend FINRA Rule 2267 (Investor Education and Protection) to require that members include a prominent description of and link to FINRA BrokerCheck, as prescribed by FINRA, on their websites, social media pages and any comparable Internet presence and on websites, social media pages and any comparable Internet presence relating to a member’s investment banking or securities business maintained by or on behalf of any person associated with a member. (Download 34-68700)
This proposed change stems from FINRA's review of BrokerCheck, including ways to increase investor use of the information. Many participants in focus groups conducted by a market research consultant stated that they were unaware of the existence of BrokerCheck. Currently firms are required to notify customers annually in writing of the BrokerCheck hotline number.
Egan-Jones Rating Co. Settles SEC Charges by Agreeing to 18-Month Bar
The SEC announced that Egan-Jones Ratings Company (EJR) and its president Sean Egan have agreed to settle SEC charges that they made willful and material misstatements and omissions when registering with the SEC to become a Nationally Recognized Statistical Rating Organization (NRSRO) for asset-backed securities and government securities.
EJR and Egan consented to an SEC order that found EJR falsely stated in its registration application that the firm had been rating issuers of asset-backed and government securities since 1995 — when in truth the firm had not issued such ratings prior to filing its application. The SEC’s order also found that EJR violated conflict-of-interest provisions, and that Egan caused EJR's violations.
Under the settlement, EJR and Egan agreed to be barred for at least 18 months from rating asset-backed and government securities issuers as an NRSRO. EJR and Egan agreed to certain undertakings in the SEC’s order, including that they must conduct a comprehensive self-review and implement policies, procedures, practices, and internal controls that correct issues identified in the SEC’s order and in the 2012 examination of EJR conducted by the SEC’s Office of Credit Ratings. EJR and Egan consented to the entry of the order without admitting or denying the findings.
January 21, 2013
Will Mary Jo White be the Next SEC Chair?
The "buzz" is that President Obama will nominate Mary Jo White as the next SEC Chair. The nomination would send a message of the importance of SEC enforcement, as Ms. White would be the first prosecutor to serve as Chair. Ms. White served as U.S. Attorney in Manhattan from 1993-2002, where she made her reputation prosecuting terrorists and Mafia figures. Currently she represents corporate defendants as the head of the litigation department at Debevoise & Plimpton. Here is her bio from the firm's website:
When Mary Jo White left her post as US Attorney for the Southern District of New York in January, 2002, she was acclaimed for her nearly nine years as the leader of what is widely recognized as the premier US Attorney’s office in the nation. She had supervised over 200 Assistant US Attorneys in successfully prosecuting some of the most important national and international matters, including complex white collar and international terrorism cases. Ms. White rejoined Debevoise in 2002, and became Chair of the firm's over 225 lawyer Litigation Department. She is a Fellow in the American College of Trial Lawyers and the International College of Trial Lawyers. Ms. White is the recipient of numerous awards and is regularly ranked as a leading lawyer by directories that evaluate law firms. In addition, Ms. White has served as a Director of The Nasdaq Stock Exchange, and on its Executive, Audit and Policy Committee. She is also a member of the Council on Foreign Relations
January 20, 2013
Sjostrom on Private Placement Regulation
Rebalancing Private Placement Regulation, by William K. Sjostrom Jr., University of Arizona - James E. Rogers College of Law, was recently posted on SSRN. Here is the abstract:
The Article examines the investor protection/capital formation balance with respect to private placements of securities. Specifically, it details various rule changes that were implemented over the years to enhance capital formation and other events that have occurred over the same timeframe that have weakened investor protection. The Article submits that the latest round of capital formation enhancements has tilted the balance too far in favor of capital formation and away from investor protection, especially given the size of the private placement market today. Hence, the Article puts forth a proposal for strengthening private placement investor protection. The proposal is meant to serve as a starting point for debate if policy makers conclude rebalancing is needed.
Colesanti on Rajaratnam Conviction
Wall Street as Yossarian: The Other Effects of the Rajaratnam Insider Trading Conviction, by Scott Colesanti, Hofstra University - Maurice A. Deane School of Law, was recently posted on SSRN. Here is the abstract:
Without warning, the patient sat up in bed and shouted, ‘I see everything twice!’
And thus Yossarian, the war-weary bomber pilot of the masterful novel, Catch-22, was able to malinger in an Italian hospital even longer while nervous doctors attended to the strange malady of his neighbor.
The storied literary diversion may highlight the good fortune of those evading government prosecution of financial crimes in 2011, a year that fulfilled the promise that observers of hedge fund discipline would similarly see things twice. To wit, in May 2011, a Manhattan jury convicted billionaire hedge fund entrepreneur Raj Rajaratnam of fourteen counts of conspiracy and securities fraud. Chief among these convictions was the crime of insider trading. The case punctuated two years of criminal actions based upon insider trading allegations by the U.S. Attorney for the Southern District of New York, who had called Rajaratnam “the modern face of illegal insider trading.” Perhaps more significantly, five months later, Judge Richard J. Holwell sentenced Rajaratnam to eleven years in prison, in handing down the harshest sentence ever in such a case.
The Rajaratnam trial was the climax to a prolonged investigation that resulted in the conviction of over two dozen hedge fund workers and public company/financial firm employees for their roles in a $50 million scheme. The case also emphasized the unforgiving nature of securities fraud accusations where those who should know better (for example, attorneys) were concerned, as lawyers ensnared in the net cast at the fallen Galleon Management, LP (“Galleon”) received consistently glaring prison sentences. Further, the Rajaratnam conviction seemingly reverberated through the courts, leading to strict interpretations of procedural rules attending unrelated insider trading cases
But the celebrated conviction failed to end the parallel U.S. Securities and Exchange Commission (the “SEC” or the “Commission”) investigation, litigation, or its pursuit of both fine and disgorgement. Thus, while commentators accurately noted that the use of Department of Justice (“DOJ”) wiretaps changed the nature of both the game and the results for Wall Street’s illegal players, receiving less attention is the delaying effect the trial had — both on clarifying insider trading law and questioning the unchecked use of government resources. While no one could quibble with the efficiency of the DOJ’s results, this Article seeks to reveal their equally significant effects on the government’s ongoing crusade against insider trading. Born via an administrative decision, decades after the adoption of the securities laws themselves, the uniquely American insider trading prohibition (and the attendant efforts of its chief enforcer) became perhaps a little more unique and problematic with the U.S. Attorney’s 2011 conviction of Rajaratnam.
Strine et alia on Putting Stockholders First
Putting Stockholders First, Not the First-Filed Complaint, by Leo E. Strine Jr., Government of the State of Delaware - Court of Chancery; Lawrence A. Hamermesh, Widener University School of Law; Matthew Jennejohn, Shearman & Sterling LLP, was recently posted on SSRN. Here is the abstract:
The prevalence of settlements in class and derivative litigation challenging mergers and acquisitions in which the only payment is to plaintiffs’ attorneys suggests potential systemic dysfunction arising from the increased frequency of parallel litigation in multiple state courts. After examining possible explanations for that dysfunction, and the historical development of doctrines limiting parallel state court litigation — the doctrine of forum non conveniens and the “first-filed” doctrine — this article suggests that those doctrines should be revised to better address shareholder class and derivative litigation. Revisions to the doctrine of forum non conveniens should continue the historical trend, deemphasizing fortuitous and increasingly irrelevant geographic considerations, and should place greater emphasis on voluntary choice of law and the development of precedential guidance by the courts of the state responsible for supplying the chosen law. The “first-filed” rule should be replaced in shareholder representative litigation by meaningful consideration of affected parties’ interests and judicial efficiency.
Supreme Court Accepts Cert in Stanford Class Actions to Explore Scope of SLUSA Preclusion
The U.S. Supreme Court granted certiorari to decide another case involving the extent to which the Securities Litigation Uniform Standards Act (SLUSA) precludes investors from bringing class actions under state law. Chadbourne & Parke LLP v. Troice (No. 12-79) (consolidated with two other cases Willis of Colorado Inc. v. Troice (No. 12-86) and Proskauer Rose LLP v. Troice (No. 12-88)). The case comes from the Fifth Circuit, Roland v. Green, 675 F.3d 503 (5th Cir. 2012)
The plaintiffs in these cases are groups of investors who purchased the CDs offered in the alleged Ponzi scheme masterminded by R. Allen Stanford. The class actions assert a variety of claims under state law against a number of entities and individuals that were involved in Stanford's offering. Defendants assert that the class actions are precluded under SLUSA, which provides that "[n]o covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security" (emphasis added). Considerable post-Dabit litigation has focused on the necessary connection between the alleged fraud and a "covered security," and the Circuits have divided on the appropriate standard.
The Fifth Circuit reviewed the tests applied in other Circuits and held that the class actions were not precluded because the purchase or sale of securities (or representations about the purchase of sale of securities) was not more than "tangentially related" to the alleged fraudulent scheme. In its analysis the court followed the approach of the Ninth Circuit. The court also specifically distinguished the Stanford CDs from the Madoff "feeder funds," because the Stanford CDs were offered based on their own investment characteristics (debt instruments, fixed rate of return, safety), unlike the feeder funds, which existed for the purpose of funneling money into Madoff's investments.
The Question Presented is stated as follows:
Does the Securities Litigation Uniform Standards Act of 1998 ("SLUSA"), 15 U.S.C. §§
77p(b), 78bb(f)(1), prohibit private class actions based on state law only where the alleged purchase or sale of a covered security is "more than tangentially related" to the "heart, crux or gravamen" of the alleged fraud?