Tuesday, January 8, 2013
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?"
Wednesday, January 2, 2013
U.S. Supreme Court Will Hear Oral Argument in Case Deciding Limitations Period for Civil Penalty Actions
On Jan. 8, the U.S. Supreme Court will hear oral argument in Gabelli v. SEC, an appeal from the Second Circuit, that addresses the statute of limitations for civil penalty actions. In April 2008, the SEC filed a complaint alleging that defendants concealed the fact 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 Supreme Court must decide whether the SEC's fraud action for civil penalties is time-barred because it was not brought within five years "from the date when the claim first accrued," the language from the relevant statute (28 U.S.C. 2462). The Second Circuit, reversing the district court, held that the judicially-created discovery rule was read into the statute and delays the accrual of a fraud claim until the plaintiff discovers, or in the exercise of reasonable care should have discovered, the fraud. Defendants, in contrast, assert that the statute sets forth a clear rule whenever the government seeks to impose a penalty: the suit must be brought within five years from the date when the claim "first accrued," which means when the government's right to sue first arises.
The ABA's Preview has all the briefs filed with the Supreme Court.
Monday, December 17, 2012
Friday, November 30, 2012
In Goldman Sachs & Co. v. City of Reno (D. Nv. Nov. 26, 2012)( Download GSvReno) the investment banker sought to preliminarily enjoin a FINRA arbitration brought against it by the City of Reno, in connection with the city's issuance of auction rate securities. Goldman acted as underwriter and also as broker-dealer in the offerings. Neither the underwriting nor the broker-dealer agreement contained an arbitration clause, and the broker-dealer agreement contained a forum selection clause that all proceedings would be brought in the federal district court in Nevada. Goldman argued, therefore, that FINRA arbitration could not be maintained. The court refused to issue a preliminary injunction, finding that the City was a "customer" of Goldman because of the broker-dealer agreement and therefore could bring an arbitration under FINRA Rule 12200, requiring arbitration if requested by a customer.
The court's analysis largely adopts the analysis of the Second Circuit in UBS Financial Services, Inc. v. W. Va. Univ. Hosps., Inc., 660 F.3d 643 (2d Cir. 2011). The forum selection clause, it held, was not a waiver of arbitration, but only controlled the forum of a court action apart from, or in review of, arbitration. It recognized that the investment banker may have an argument that the alleged wrongdoing in this case was not directly related to its broker-dealer functions, but this was an issue of arbitrability that Goldman, as a FINRA member, agreed to arbitrate.
A recent 7th Circuit opinion authored by Judge Posner, SEC v. Huber (No. 12-1285, Nov. 29, 2012)Download SECvHuber.112912, explores two alternative methods for allocating recovered assets to investors in a Ponzi scheme, the net loss method generally used in bankruptcy and the rising tide method which the SEC-appointed receiver used in this case. Judge Posner explains the differences clearly and concisely (using graphs!).
Assume three investors lose money in a Ponzi scheme. Each invested $150,000. A withdrew $60,000 before the scheme collapsed; B withdrew $30,000; C made no withdrawals, for total losses of $360,000. Assume receiver has $60,000 to distribute. Under the net loss method, each investor would receive one-sixth of his losses: A gets $15,000; B gets $20,000; C gets $25,000. As a result, A recovered a total of $75,000; B recovered a total of $50,000; and C recovered $25,000.
In contrast, under the rising tide method, withdrawals are considered part of the distribution received by an investor and so are subtracted from the amount of receivership assets to which he would be entitled if there had been no withdrawals. In this example, then, for the "tide" to raise B and C as close to A as possible, B has to recover $15,000 in receiver assets, and C has to recover the remaining $45,000, so that the division among the three investors is 60-45-45 under this method. (See the charts for a more complete explanation.) Rising tide appears to be the method most commonly used in receiverships.
Judge Posner goes on to discuss whether rising tide discourages or encourages withdrawals from Ponzi scheme and finds that the public policy in bringing about the swift collapse of Ponzi schemes does not support one method over the other. He notes that the net loss approach may be attractive when under rising tide a large number of investors would receive nothing, but finds that is not the case before him. He also notes possible inconsistencies between approaches in receiverships and bankruptcy proceedings, before concluding that the investors had not shown that the district court abused its discretion in approving the reciever's use of rising tide.
Monday, November 12, 2012
On Nov. 9 the Supreme Court granted certiorari to a case many have been following for years. It raises the issue of whether class action waivers can be invalidated on federal grounds because plaintiffs have no effective individual remedy to vindicate a federal statutory right. Last term the Court rejected a challenge to a class action waiver on state law unconscionability grounds in AT&T Mobility LLC v. Concepcion.
• American Express Co. v. Italian Colors Restaurant, No. 12-133. Does the Federal Arbitration Act permit courts invoking the "federal substantive law of arbitrability" to invalidate arbitration agreements on the ground that they do not permit class arbitration of a federal law claim? The Second Circuit held that because the class action waiver in the contract between a group of plaintiff merchants and the defendant charge card service provider precluded the plaintiffs from enforcing their federal statutory right to bring antitrust claims, the arbitration provision was unenforceable.
By way of background, in its 2000 opinion, Green Tree Financial Corp. v. Randolph, 531 U.S. 79 (2000),the Supreme Court stated that “it may well be that the existence of large arbitration costs could preclude a litigant . . . from effectively vindicating her federal statutory rights in the arbitral forum.” The Second Circuit has been hostile toward class action waivers for this very reason. In its first opinion in In re American Express Merchants’ Litigation, 554 F.3d 300 (2d Cir. 2009), the Second Circuit held that a class action waiver was unenforceable because it would effectively preclude individual plaintiffs from vindicating their statutory rights under federal antitrust law, because of the high litigation costs and the small potential recovery. The court agreed with the plaintiffs that the class action waiver “flatly ensures that no small merchant may challenge American Express’s tying arrangements,” a troubling outcome because “private suits provide a significant supplement to the limited resources available to the Department of Justice for enforcing the antitrust laws and deterring violations.” Defendants sought certiorari before the Supreme Court, which granted the petition, vacated the decision, and remanded for reconsideration in light of Stolt-Nielsen S.A. v. AnimalFeeds International Corp., 130 S. Ct. 1758 (2010), in which the Court held that arbitrators exceeded their power under the FAA because they construed an arbitration clause in a shipping charter to permit class arbitration as a matter of public policy. In its opinion on remand, which was decided prior to Concepcion, the Second Circuit affirmed its earlier decision, essentially finding that Stolt- Nielsen was not relevant:
While Stolt-Nielsen plainly rejects using public policy as a means for divining the parties’ intent, nothing in Stolt-Nielsen bars a court from using public policy to find contractual language void. We agree with plaintiffs that “[t]o infer from Stolt-Nielsen's narrow ruling on contractual construction that the Supreme Court meant to imply that an arbitration is valid and enforceable where, as a demonstrated factual matter, it prevents the effective vindication of federal rights would be to presume that the Stolt-Nielsen court meant to overrule or drastically limit its prior precedent.”
634 F.3d 187 (2d Cir. 2011).
After the Court's decision in Concepcion, the Second Circuit again considered the issue and determined that Concepcion did not alter its analysis, 667 F.3d 204 (2d Cir. 2012), which rests squarely on "a vindication of statutory rights analysis, which is part of the federal substantive law of arbitrability." Nothing in either Concepcion nor Stolt-Nielsen, asserted the Second Circuit, requires that all class-action waivers be deemed per se enforceable. The Second Circuit declined to reconsider the case en banc, 681 F.3d 139, setting the stage for the showdown before the Supreme Court.
Monday, November 5, 2012
The Supreme Court heard oral argument today in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, in which the parties debate whether in a securities fraud class action courts must require proof of materiality before certifying a class based on the fraud-on-the-market (FOTM) theory and the related question of whether defendants must be allowed to present evidence rebutting the applicability of the FOTM theory at the class certification stage.
Seth Waxman, arguing on behalf of the petitioners/defendants, argued that each of the four predicates to the FOTM theory is common: market efficiency, public nature of statement, transactions in the stock during the period of market distortion, and materiality. Therefore, they should be treated similarly; each must be established at the class certification stage and again at trial. He drew a distinction between a judicial determination of materiality at the class certification stage and at a subsequent summary judgment stage, which elicited some questioning and requests for clarification from the Justices. He then addressed the purpose of Fed. R. Civ. Pro. 23, which he asserted was for the court to determine whether all of the preconditions for “forcing everyone into a class action” are present before certification.
David C. Frederick, arguing on behalf of respondent/plaintiff, started his argument with Basic and asserted that the Court indicated that materiality did not have to be proved at the class certification stage. With respect to Rule 23(b)(3), because materiality always generates a common answer for all class members, it is the quintessential common issue that does not cause the class to be noncohesive for purposes of deciding predominance. He emphasized that in a FOTM case, the only theory of reliance that is being advanced is indirect reliance on the integrity of the market; efficiency and publicity serve gate-keeping functions at the class certification stage, while materiality does not. This led to questioning about the distinctions he was making. Mr. Frederick also argued that Congress already addressed the concerns about securities fraud class actions in the PSLRA.
Melissa Arbus Sherry argued on behalf of the United States, as amicus curiae supporting the respondent. She focused on Rule 23 and the predominance requirement and also argued that materiality was different from efficiency and publicity, which again drew questioning from the Justices. She also argued Congressional intent.
It is difficult to “read” the Justices’ reactions to the counsel’s arguments from the written transcript. Nevertheless, nearly all the Justices questioned why materiality should be treated differently from the other predicates to FOTM. In addition, at least two Justices appeared to be thinking about policy implications. Justice Scalia suggested that perhaps the FOTM theory should be overruled as based on bad theory, and Justice Kennedy noted that post-Basic economic scholarship has shown that the efficient market theory is “really an overgeneralization.”
Friday, November 2, 2012
On Nov. 5, 2012, the U.S. Supreme Court will hear oral argument in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds (No. 11-1085), a case that raises important questions about the “fraud on the market” theory (FOTM) established in Basic Inc. v. Levinson, 485 U.S. 224 (1988), and class certification under Fed. R. Civ. Pro. 23. Currently, there is a split in the Circuits over the necessity of establishing materiality at the class certification stage of a federal securities class action.
The lead plaintiff, Connecticut Retirement Plans and Trust Funds, brought a typical Rule 10b-5 class action alleging material misstatements about the safety, efficacy and marketing of two of Amgen’s products and invoked FOTM in order to show that reliance can be established on a class-wide basis. The district court granted plaintiff’s motion for class certification, and the appellate court affirmed, in an opinion reported at 660 F.3d 1170 (9th Cir. 2011). The defendants did not contest that Amgen stock traded in an efficient market and that the statements at issue were publicly disseminated. They argued, however, that at the class certification stage, plaintiff must also establish the materiality of the statements and defendants must have an opportunity to establish “truth-on-the-market” to rebut FOTM. The Ninth Circuit rejected defendants’ arguments. The court held that in order to invoke FOTM in aid of class certification, the plaintiff need only (1) show that the securities were traded in an efficient market; (2) show that the alleged misrepresentations were public; and (3) plausibly allege that the alleged misrepresentations were material. Similarly, the court rejected defendants’ argument that they must be afforded an opportunity to rebut FOTM at the class certification stage by introducing evidence to establish a “truth-on-the-market” defense.
The questions presented in the petition for certiorari are stated as follows:
1. Whether, in a misrepresentation case under SEC Rule 10b-5, the district court must require proof of materiality before certifying a plaintiff class based on the fraud-on-the-market theory.
2. Whether, in such a case, the district court must allow the defendant to present evidence rebutting the applicability of the fraud-on-the-market theory before certifying a plaintiff class based on that theory.
In asserting that the answer to both questions is “yes,” defendants make a number of arguments. First, materiality, in addition to being an element of a securities fraud claim, is a predicate to FOTM and is therefore necessary to establish reliance on a class-wide basis. Second, because reliance is an essential predicate of FOTM, Fed R. Civ. Pro. 23 requires that it be proved before class certification. Third, if materiality is not determined at the class certification stage, it frequently will not be considered at all, because class certification creates enormous pressure to settle even frivolous claims. To defer judicial inquiry would be unfair to defendants, who should not have to face the pressures of class litigation in order to establish that a class action was not warranted. Finally, defendants refer to modern economic research to demonstrate that proof that a market is generally efficient does not make it appropriate to apply FOTM in every case involving a security in that market.
Connecticut Retirement Plans and Trust Funds assert a number of arguments to the contrary. First, proof of materiality is not required to certify a class under Rule 23, because materiality is a common question not susceptible to different answers for individual class members. Second, FOTM does not require proof of materiality for class certification. Third, requiring proof of materiality for class certification will have adverse effects on courts’ ability to administer securities fraud class actions. Fourth, rebuttal evidence regarding materiality is not appropriate at the class certification stage because it would not demonstrate a lack of predominance under Rule 23(b)(3); Amgen’s “truth-on-the-market” defense is irrelevant at the class certification stage. Finally, plaintiff argues that defendants are making “naked public policy arguments” to alter the rules for certification of federal securities class actions, contrary to Congressional intent expressed in the PSLRA and SLUSA.
The Solicitor General filed an amicus brief in support of the plaintiff and urged the Court to affirm the Ninth Circuit’s opinion. The Solicitor General stated that the United States has a “substantial interest” in the court’s resolution of the questions presented, because “meritorious private securities-fraud actions, including class actions, are an essential supplement to criminal prosecutions and SEC enforcement actions.” The Solicitor General will also participate in the oral argument.
As an indication of the case’s importance, a number of amicus briefs have been filed. Amicus briefs in support of defendants include the U.S. Chamber of Commerce, the Securities Industry and Financial Markets Association (SIFMA) and the Washington Legal Foundation. Amicus briefs in support of the plaintiff include CalPERS, AARP, and National Association of Shareholder and Consumer Attorneys. Needless to say, there are amicus briefs filed by law professors on both sides. In the interests of full disclosure, I am a signatory on an amicus brief filed by law professors in support of lead plaintiff Connecticut Retirement Plan.
Thursday, October 25, 2012
The National Association of Manufacturers, the U.S. Chamber of Commerce and the Business Roundtable recently brought suit challenging the SEC's adoption of the conflict minerals rule. Although Dodd-Frank requires the SEC to adopt a rule on corporate disclosure of information about conflict minerals, the petitioners assert that the rule should be modified or set aside in whole or in part. ( Download NAM v. SEC)
The petitioners filed their petition in both the D.C. Circuit and the D.C. district because of confusion over which court has jurisdiction. The SEC agrees with petitioners that the D.C. Circuit has jurisdiction over the case under Exchange Act 25(a).
Tuesday, October 2, 2012
There have been a number of recent cases addressing the issue of who is a "customer" for purposes of FINRA securities arbitration. Typically, investors assert they are "customers" in order to pursue an arbitation against a securities firm, which the firm resists. The applicable FINRA Rule 12200 allows a "customer" to bring arbitration proceedings against a FINRA member or an associated person if the dispute arises in connection with the business activities of the member or associated person. A FINRA rule defines "customer" as "not includ[ing] a broker or dealer."
In a recent case, Berthel Fisher & Co. v. Larmon (8th Cir. Oct. 1, 2012)( Download BerthelFisher.100112), unhappy purchasers of securities issued in private placements sought to arbitrate claims against Berthel Fisher, which served as the managing broker-dealer for the offering. As managing broker-dealer Berthel reviewed and suggested changes to at least two private placement memoranda. It also was required, along with the selling brokers, to determine each investor's eligibility to participate in the offering and maintained customer files for this purpose. The purchasers alleged that Berthel performed insufficient due diligence on the offering. Although the investors had no contact with Berthel, they argued that they were "customers" because Berthel provided "investment or brokerage services" to them in three ways: It was responsible for conducting due diligence on the offering, it was obligated to conduct a reasonable basis suitability analysis on the securities, and it maintained customer files on the investors.
The court, however, held that the investors were not "customers" of Berthel, because there was no "relationship" between the firm and the investors. Assuming that the firm's services were "investment or brokerage," the firm did not provide them to the customer either directly or through its associated persons. Its contractual obligations were with the issuer and the selling brokers, not with the customers.
The Second Circuit recently rejected a 10% shareholder's constitutional challenge to a suit for disgorgement of short-swing trading profits under section 16(b) of the Securities Exchange Act. The defendant argued that because the trading caused no injury to the corporation, there was no genuine case or controversy, and therefore the plaintiff, suing derivatively on behalf of the corporation, did not have standing. Donoghue v. Bulldog Investors General Partnership (2d Cir. Oct. 1, 2012) (Download Donoghue.100112)
Although it was undisputed that the complaint adequately alleged a section 16(b) claim against the defendant and that the plaintiff, as a shareholder, was a person statutorily authorized to bring the claim, the defendant asserted that the court did not have jurisdiction to hear the claim because it presented no live case or controversy affording plaintiff standing to sue. As the opinion states,
Bulldog argues that plaintiff cannot demonstrate any injury to the issuer from the alleged 16(b) violation because Invesco "was a non-party to the trades at issue, and no issue of 'corporate opportunity,' fiduciary duty, breach of contract or misappropriation is on the table."...Indeed, Bulldog insists that it is a "consummate 'outsider,'" lacking any "fiduciary, contractual or confidential relationship with Invesco."
In affirming the district court's judgment awarding short-swing profits, the Court rejected defendant's argument as without merit, because Congress, in enacting 16(b), established a rule of strict liability that effectively makes 10% beneficial owners fiduciaries to the extent of making their short-swing trading transactions "breaches of trust." Thus, defendant could not argue that it owed no fiduciary duty to the issuer. Moreover, since the statute conferred upon the issuer (and in appropriate circumstances, a shareholder of the issuer) an enforceable legal right to expect the defendant not to engage in any short-swing trading in its stock, the issuer is not a bounty hunter, but a person with a cognizable claim to compensation for the invasion of a legal right.
Sunday, September 30, 2012
On November 5, 2012, the U.S. Supreme Court will hear oral argument in Amgen, Inc. v. Connecticut Retirement Plans and Trust Funds (No. 11-1085), in which plaintiff brought a Rule 10b-5 class action alleging material misstatements about the safety of two products used to treat anemia. In this appeal from the 9th Circuit, the defendants assert that at the class certification stage plaintiff must prove materiality and defendants must be allowed to present evidence rebutting the applicability of the fraud on the market theory. The courts of appeals have split on this issue.
This week an amicus brief in support of plaintiff was filed by a group of law professors who teach civil procedure or securities regulation. The brief agrees with the plaintiff that proof of materiality is neither required nor appropriate at the class certification stage, either to assure that common questions predominate under F.R.C.P. 23(b)(3) or to invoke the fraud on the market presumption under Basic. The brief sets forth the history of Rule 23(b)(3) to show that the drafters had securities fraud class actions in mind. It also sets forth the underlying principles of market manipulation that were familar to the drafters of section 10(b). (Download No. 11-1085 bsac Civil Procedure and Securities Law Professors)
Thursday, September 27, 2012
The U.S. Supreme Court granted certiorari in Gabelli v. SEC (11-1274) to address the following question:
Section 2462 of Title 28 of the United States Code provides that "except as
otherwise provided by Act of Congress" any penalty action brought by the
government must be "commenced within five years from the date when the
claims first accrued." (emphasis added). This Court has explained that "[i]n
common parlance a right accrues when it comes into existence." United States v.
Lindsay, 346 U.S. 568, 569 (1954).
Where Congress has not enacted a separate controlling provision, does the
government's claim first accrue for purposes of applying the five-year limitations
period under 28 U.S.C. § 2462 when the government can first bring an action for a
The case comes from the Second Circuit, SEC v. Gabelli, No. 10-3581-cv(L) (decided Aug. 1, 2011).(Download Gabelli.080111) In that case the SEC alleged that Gabelli, the portfolio manager of a mutual fund, and Alpert, the chief operating officer for the fund's adviser, failed to disclose that the adviser, while prohibiting most fund investors from engaging in market-timing, secretly permitted one investor to market time in exchange for an investment in a hedge fund managed by Gabelli. The alleged conduct took place from 1999 until 2002. The SEC alleged that after the market timing stopped, the defendants continued to mislead the fund's board of directors and fund investors about these activities and that, because of this deception, the SEC did not discover the activity until late 2003.
The SEC filed its complaint in April 2008. The district court dismissed the claims in substantial part, some on the merits, others on statute of limitations grounds. The Second Circuit, however, applied the discovery rule to hold that the statute of limitations did not accrue until the claim was discovered or could have been discovered with reasonable diligence, by the plaintiff: "since fraud claims by their very nature involve self-concealing conduct, it has been long established that the discovery rule applies where, as here, a claim sounds in fraud" (citing the Supreme Court's opinion in Merck & Co. v. Reynolds). The court contrasted the discovery rule with the equitable tolling doctrine of fraudulent concealment, where a plaintiff may benefit from equitable tolling, even when a claim has already accrued, if the defendant took specific steps to conceal the activities from plaintiff, and is available for non-fraud claims.
Accordingly, the Court held that since the SEC alleged fraud claims under the Advisers Act, the discovery rule defines when the claim accrues and that the SEC need not plead that the defendants took affirmative steps to conceal their fraud. The court dismissed the defendants' argument that Section 2462 did not expressly state a discovery rule, citing previous decisions that for claims in fraud a discovery rule is read into the statute. Finally, the court ruled as premature the defendants' assertion that the SEC's claims could have been discovered, with reasonable diligence, within the five-year limitations period, because the lapse of a limitations period is an affirmative defense that defendants must plead and prove.
Friday, August 31, 2012
A California appellate court recently held that a registered representative could invoke the court's equitable and inherent powers to do justice and pursue an action to expunge his public securities brokerage records from FINRA's central registration depository database (CRD). FINRA had maintained that there were no grounds for expungement apart from the very narrow criteria set forth in FINRA Rule 2080(b), which were not applicable here. Lickiss v. FINRA (Cal. 1st Appel. Dist. Aug. 23, 2012) (Download Lickiss.082312)
The broker, Edwin Lickiss, sought expungement of 17 customer complaints and a regulatory action filed between 1991-1996 because those records were old and because 13 of the 17 customer complaints related to sales of one specific stock, whose failure was outside his control. Asserting that he had a clean record since then, he sought expungement because he suffers professional and financial hardship because current and potential clients use the internet to obtain his BrokerCheck history.
The appellate court found that the trial court erred by relying exclusively on FINRA Rule 2080 as the grounds for expungment, since the broker had invoked the equitable powers of the court. "The choice of a very narrow, rigid legal rule to assess the legal sufficiency of Lickiss's petition -- a choice that closed off all avenues to the court's conscience in formulating a decree and disregarded basic principles of equity -- was nothing short of an end run around equity."
As a result of this decision, commentators predict that more brokers will seek expungement of CRD records, in an effort to rewrite history and clean up their records.
Tuesday, August 21, 2012
Last week I filed, on behalf of a group of securities law scholars, an amicus brief in SEC v. Citigroup Global Markets Inc., in support of the district court's order that refused to approve the proposed settlement between the parties. In the brief we express our concern about the SEC's settlement practices and the constraints on judicial discretion in approving consent settlements advocated by the parties, which, if adopted by the Second Circuit, will reduce the effectiveness of judicial review as an independent check on agency action. (Download Citigroup AmicusBrief Aug 15)
In addition, yesterday Harvey Pitt, who has served both as SEC Chairman and as its General Counsel, filed an amicus brief in support of Judge Rakoff's order. Mr. Pitt asserts that the Commmission applies exacting standards before it approves the filing or settlement of an enforcement action and therefore its attorneys should have no difficulty supplying the court with the information it needs in order to review the proposed consent judgment. The questions posed by the district court, if answered, would have enabled the court to approve the settlement. (Download Pitt.AmicusBrief)
Friday, August 3, 2012
It has not been a good week for government enforcement of securities laws. On Tuesday, a jury in a federal district court in Manhattan rejected the SEC’s allegations of wrongdoing against Brian Stoker, a former mid-level executive at Citigroup. On Thursday, a federal appeals court in Washington D.C. threw out convictions of traders in the “squawk box” prosecution.(Download Usvmahaffy) Many commentators lament the failure of government to clean up the mess of the financial crisis and bring wrongdoers to justice. ProPublica’s Jesse Eisinger sums it up, “As every frustrated American knows, no major banking executive has gone to prison or has been fined any significant amount in the aftermath of the financial crisis.” So what went wrong this week?
First, SEC v. Brian Stoker (S.D.N.Y.). In this case, a companion to the SEC’s enforcement action against Citigroup Global Markets (in which Judge Rakoff rejected the parties’ proposed settlement; that case is now on appeal to the Second Circuit), the SEC charged Stoker with negligence in connection with his role in creating CDOs that Citigroup sold to investors. According to the SEC, Stoker knew, or at least should have known, that he was misleading investors by not disclosing that Citigroup helped select the underlying securities in the CDO and then bet against it. The jury refused to find Stoker liable and also issued an unusual statement that the judge read aloud in the courtroom:
“This verdict should not deter the S.E.C. from investigating the financial industry, to review current regulations and modify existing regulations as necessary.”
So what does this mean? Was the jury saying that the agency went after the wrong guy? Stoker, the only individual defendant in the case, was portrayed by his attorney as a “scapegoat,” a relatively junior executive (albeit one who made $2.4 million at Citigroup in 2007, the year before he left) at Citigroup. In contrast, the SEC’s attorney, in his closing to the jury, argued that “Citigroup stacked the deck and Brain Stoker dealt the cards.”
Alternatively, was the jury saying that it had no sympathy for the sophisticated investors who purchased the CDOs? The defense presented evidence that Citigroup’s marketing materials contained warnings about the riskiness of the investment and should have alerted the purchasers that Citigroup might bet against the security. Maybe the jury thought that the agency should use its scarce resources to protect unsophisticated investors from fraud?
In any event, to this jury, this was the wrong case for the agency to pursue.
Second, U.S. v. Mahaffy (2d Cir.) The convictions of these defendants stems from charges that in the early 2000s traders at several brokerage firms allowed employees of A.B. Watley, a day trading firm, to listen in on live feeds from “squawk boxes” to obtain information on clients’ pending block orders, so they could engage in “front running.” This litigation has a long and tortuous past. The first trial in 2007 resulted in acquittal on 38 counts, but the jury deadlocked on one count of conspiracy to commit securities fraud. The government determined to retry the defendants on this count and ultimately obtained convictions based on conspiring to misappropriate confidential information.
Now, as securities law specialists know, a violation of securities law based on the misappropriation theory requires the government to establish that the misappropriated information was confidential. The squawk boxes blared throughout the firm; hence, the key issue was proving that the firms treated information about block orders transmitted via the squawk boxes as confidential. The government called representatives from each firm who testified that client order information was confidential and they did not permit employees to allow outsiders to listen to squawks. On cross-examination, defense aggressively challenged the assertions that the information was treated as confidential.
After defendants were convicted and sentenced following the second trial, the SEC initiated an administrative proceeding against one of the defendants, in the course of which it disclosed thirty transcripts of depositions taken as early as December 2004. Defendants argued that information contained in twelve of the transcripts was exculpatory and should have been turned over to them in the criminal proceedings pursuant to Brady v. Maryland. Specifically, they argued that the information undermined testimony from government witnesses that the squawked information was treated as confidential. The district court, while it criticized the government’s conduct, refused to set aside the conviction.
The Second Circuit, however, reached a different outcome and determined that the Brady violations undermined confidence in the jury verdict. (It also found that the district court did not adequately instruct the jury on the scope of honest services fraud and also vacated that component as well.) It found that, because of the centrality of the issue of confidentiality, the defendants should have been provided with the transcripts: “The withheld SEC testimony strongly suggests that the brokerage firms did not treat squawked block order information as confidential and that senior employees and management at the respective firms did not bar the transmission of squawks or take steps to maintain exclusive control of pending block order information.” The court also found that there was no doubt that the government knew, at the time of the first trial, that at least one transcript contained possible Brady material, because the SEC attorney who conducted the depositions was designated as special AUSA for this case, sat at the counsel table during the trial, and even called the Brady issue to the attention of the DOJ attorneys.
The court concludes its discussion of the Brady issue with a pointed question:
“In light of the government's mishandling of material exculpatory and impeaching material, we wonder whether the government will choose to subject the defendants to yet a third trial.”
Unfortunately, Mahaffy is not the first case where prosecutors fail to live up to their professional responsibilities in their zeal to obtain convictions, either because they are convinced of the guilt of the defendants or because they can’t bear the thought of losing.
So a bad week for the government. And we continue to wait for government actions that will seek to identify and hold accountable the movers and shakers that caused the financial crisis.
Saturday, July 28, 2012
Nine years ago, the SEC announced, with great fanfare, the Global Research Analyst Settlement with ten leading investment banks. The resulting consent judgments had laudable purposes: to compensate aggrieved investors, untangle investment banking and research, and establish an investor education fund. Judge William H. Pauley III is the judge with oversight responsibility over the consent judgment, and he has over the years expressed his frustration over the SEC’s lack of diligence in implementing the Settlement. In a recent memorandum and order, SEC v. Bear Stearns (S.D.N.Y. July 25, 2012), he reviews the settlement’s troubled history and reminds us of the importance of judicial supervision. (Download SECvBearStearns)
Three years ago, the judge reluctantly transferred more than $79 million of disgorgement funds to Treasury because the parties were not able to identify harmed investors that were the intended beneficiaries of the fund.
More than two years ago, the judge refused to approve the parties' request to permit "research personnel and investment banking personnel to communicate with each other ... regarding market or industry trends, conditions, or developments." The court concluded that the parties' proposal ''would deconstruct the firewall between research analysts and investment bankers[,] ... be inconsistent with the Final Judgments[,] and contrary to the public interest."
In the July 25, 2012 memorandum and order, the court addresses once again the Settlement’s commitment to establish a $55 million foundation for investor education, intended “to finance efficient, cost-effective programs designed to educate the investing public.” The judge has devoted considerable attention to the investor education aspect of the consent judgment, and, as the court notes, “resolution of this aspect of the parties' consent decrees remains elusive.” Originally the SEC planned for the creation of a grant-making investor education entity. When that plan fizzled because of “agency torpor,” the consent judgment was modified in 2005 to transfer those funds to the NASD Investor Education Foundation (now the FINRA Foundation). In 2009 the court criticized the Foundation's ratio of administrative expenses to grant disbursements over the prior three year period. During that period, the Foundation paid $800,000 in administrative expenses while disbursing only $6.5 million to grantees, and paid administrative expenses of more than $21,800 per grant, with an average grant totaling $200,000. The court sought to prod the SEC into action and posed two rhetorical questions: "Is this the efficient and cost-effective program the SEC had in mind when it urged this Court to adopt it? When will the SEC exercise its responsibility to ensure that these substantial sums are expended to educate the investing public?"
In its recent opinion the court acknowledges that “over the last three years, a majority of the corpus has been disbursed,” but continues to have concerns about “whether the Foundation's management of the funds measures up to the SEC's promise of a cost-efficient and expeditious disbursement…. The Foundation's operational expenses, opaque project expenditures, internal audits, and the SEC's lack of oversight all contribute to this Court's skepticism.” The court directs both the SEC and the Foundation to comply with the court's September 2, 2005 Order requiring "an accounting of receipts and expenses in reasonable detail."
The court’s concerns related to the following areas:
1. Operational expenses. The Foundation’s 2011 audit showed expenditures of $16 million, of which $4.2 million were for “operational expenses” (of which $3.6 million were services provided by FINRA to the Foundation for free). The court observes that “Had the Foundation been responsible for its own costs in these areas, it would have distributed roughly seventy-three cents of each dollar directly on its mission programs. Neither the Foundation nor the SEC provides any guideposts to evaluate the efficacy of these expenditures.”
2. Opaque Project Expenditures. The court observes that generally “the amount of money the Foundation spends on a project often seems disproportionately high compared to the nature and scope of the activities undertaken” and provides some specific examples. For example, $683,000 (of which $500,000 came from the investor education fund) was spent on the “Investor Protection Campaign” in 2011 that consisted of “a press release, an e-newsletter, five one-to-two-hour events presenting existing programming, various ad campaigns, distributing copies of its DVDs, a strategy session, and possibly sixty-three partner events.” The court has similar concerns about the $775,000 (of which $542,000 came from the investor education funds) spend on the Investor Protection Campaign in 2010. In particular, the court questions “how Alabama, Colorado, Florida, Maine, North Carolina, Vermont, Washington, and West Virginia evolved to be the "eight primary states" in the campaign.
With respect to a third initiative, the Foundation's "Smart investing@your library" program, the court observes that of the seventeen new grants, “many of these libraries do not appear to be in major population areas or places evidencing the greatest need for investor education, and the grants they received could be significant additions to their budgets. Moreover, a random review by this Court of several participating libraries' online event calendars reveals little evidence of any investor education initiatives. And to the extent that some libraries appear to be scheduling investor education events, the disparities in apparent progress among various libraries suggest that the Foundation's and the SEC's oversight of these grants is far from uniform.”
3. Internal audits. The court details some troubling inadequacies in the Foundation's reporting structure.
Finally, the court makes clear its displeasure with the SEC’s continual lack of oversight over the Foundation’s activities:
The SEC has let fall to this Court the task of raising questions about the Foundation's reports, its disbursements, and the results of its funded grants and projects. The SEC appears to place its imprimatur reflexively on each and every quarterly report, no matter the content. This Court once again directs the agency to perform its duty (emphasis added).
ADDENDUM: After publication of the above post, George Smaragdis, spokesman for FINRA, sent me the following statement:
We strongly disagree with many of the Court’s statements and will provide the Court with the additional detailed information it requests. We are confident that the Investor Education funds from the Global Research Analyst Settlement are being used for maximum public good. We are proud of the FINRA Foundation’s work and look forward to addressing the Court’s concerns.
Thursday, July 19, 2012
The New York Court of Appeals will hear an appeal by former AIG executives Hank Greenberg and Howard Smith asserting that the state attorney general's action against them for violating the state's Martin Act is preempted by federal legislation --PSLRA, NSMIA and SLUSA -- that establishes a uniform federal standard for securities litigation. In State of New York v. Greenberg, the state charged the executives with violating the statute because of their role in fraudulent transactions designed to portray an unduly positive picture of AIG's loss reserves and underwriting performance. The trial court denied defendants' motion for summary judgment, and the Appellate Division affirmed, 95 A.3d 474 (Ist Dept. 2012(one justice dissenting). David Boies is representing Greenberg.
Sunday, July 8, 2012
Proprietary Trading: Of Scourges, Scapegoats, and Scofflaws, by Onnig H. Dombalagian, Tulane Law School, was recently posted on SSRN. Here is the abstract:
The Volcker Rule was designed to strike a compromise between reestablishing the firewall between investment and commercial banking activities under the Glass-Steagall Act and retaining the synergistic benefits of bundling such services championed by the Gramm-Leach-Bliley Act. This paper will approach the topic from the perspective of regulators who must grapple with the Rule’s implementation. On the one hand, the financial community can be expected squarely to resist any aggressive implementation of the Rule; on the other, failure to adopt a set of rules and an associated supervisory program would almost surely result in regulators taking significant heat if the Rule does not at least have some impact on the configuration of Wall Street’s activities. Moreover, such efforts must be implemented in a manner that complements other initiatives mandated by Dodd-Frank.
The regulators have staked out a three-pronged approach in their proposed rulemaking: (i) formalizing the classification of trading activities, (ii) adopting quantitative measures, and (iii) mandating a system of internal controls that provides a roadmap for regulatory compliance, supervision, and enforcement. This paper considers the arguments made for and against the Rule’s restrictions on proprietary trading, analyzes the public debate over the proposed implementation of the Rule, and offers some remarks on how regulators might advance the Rule’s moral imperative.
Thursday, July 5, 2012
The Second Circuit summarily affirmed a district court's confirmation of a $20.5 million arbitration award against Goldman Sachs Execution & Clearing L.P. The claimants, the unsecured creditors committee of Bayou Group, LLC, asserted that the clearing firm had "red flags" to alert them that Bayou was in fact a Ponzi scheme. Goldman Sachs unsuccessfully argued that the award was "in manifest disregard of the law." The Second Circuit, noting that the manifest disregard standard is, by design, exceedingly difficult to satisfy, agreed with district court that Goldman had not satisfied it. Goldman Sachs Execution & Clearing, L.P. v. Official Unsecured Creditors' Committee of Bayou Group LLC (2d Cir. July 3, 2012).