December 20, 2011
New York's Highest Court Holds that Investors Can Bring Common Law Claims for Breach of Fiduciary Duty and Gross Neglience
In a short and sweet opinion, the New York Court of Appeals significantly improved investor protection in New York state law today by holding that the state's Martin Act does not preempt an investor's common law claims for breach of fiduciary duty and gross negligence. Assured Guar. (UK) Ltd. v. J.P. Morgan Inv. Management Inc., 2011 NY Slip Opinion 09162 (Dec. 20, 2011). The lower state courts had split on this question, and the federal district court in S.D.N.Y., in particular, had asserted preemption.
Plaintiff, Morgan Investment Management, alleged that J.P. Morgan had mismanaged the investment portfolio of an entity (Orkney Re II) whose obligations MOM guaranteed. As an express third-party beneficiary of an investment management agreement between J.P. Morgan and Orkney, MOM alleged that J.P. Morgan invested Orkney's assets heavily in high-risk securities and failed to diversify the portfolio or advise Orkney of the risks. In addition, it alleged that J.P. Morgan improperly made investment decisions in favor of another Orkney investor that was a J.P. Morgan client.
The Supreme Court granted J.P. Morgan's motion to dismiss the complaint in its entirety on grounds of preemption. The Appellate Division, however, modified by reinstating the breach of fiduciary duty and gross negligence claims, thus setting up the appeal to the Court of Appeals.
The Court of Appeals rejected J.P. Morgan's argument that the common law breach of fiduciary duty and gross negligence claims must be dismissed because they are preempted by the Martin Act in short order. The Court stated that "[legislative intent is integral to the question of whether the Martin Act was intended to supplant nonfraud common-law claims." Moreover, it was "well settled that 'when the common law gives a remedy, and another remedy is provided by statute, the latter is cumulative, unless made exclusive by the statute'....We have emphasized that 'a clear and specific legislative intent is required to override the common law' and that such a prerogative must be 'unambiguous'...." The Court found no evidence in the plain text of the Martin Act that the legislature contemplated the elimination of common-law claims.
True, we have held that the Martin Act did not "create" a private right of action to enforce its provisions ....But the fact that "no new per se action was contemplated by the Legislature does not ... require us to conclude that the traditional...forms of action are no longer available to redress injury...."
Accordingly, an investor may bring a common-law claim that is not entirely dependent on the Martin Act for its viability, and "[m]ere overlap between the common law and the Martin Act is not enough to extinguish common-law remedies."
Finally, the Court recognized that policy concerns supported its conclusion because private actions further the goal of combating fraud and deception in securities transactions. Quoting Judge Marrero from the S.D.N.Y. (whose scholarly opinion in Anwar v. Fairfield Greenwich Ltd., 728 F. Supp. 2d 354, was instrumental in rethinking the analysis in the lower courts' preemption decisions), the Court concluded that to hold otherwise would leave the marketplace "less protected than it was before the Martin Act's passage, which can hardly have been the goal of its drafters...'"
November 28, 2011
Judge Rakoff Rejects SEC-Citigroup Settlement
In a decision that probably surprises no one, Judge Jed Rakoff refused to approve the proposed $285 million settlement between the SEC and Citigroup resolving charges that the bank failed to disclose to investors its role in selecting investments in a $1 billion mortgage-bond deal and taking a short position in those assets.(Download SECCITI11282011) The judge stated that the settlement did not provide the Court with a sufficient evidentiary basis to know whether the requested relief was justified, and, as he has done previously, he criticized the agency's policy of allowing defendants to enter into consent judgments without admitting or denying the allegations.
[W]hen a public agency asks a court to become its partner in enforcement by imposing wide-ranging injunctive remedies on a defendant, enforced by the formidable judicial power of contempt, the court, and the public, need some knowledge of what the underlying facts are: for otherwise, the court becomes a mere handmaiden to a settlement privately negotiated on the basis of unknown facts, while the public is deprived of ever knowing the truth in a matter of obvious public importance.
The judge goes on to say that "[i]t is harder to discern from the limited information before the Court what the S.E.C. is getting from this settlement other than a quick headline."
The court concludes by directing the parties to be ready to try the case on July 16, 2012.
November 17, 2011
Second Circuit Refuses to Reconsider Calculation of Madoff Damages
The Second Circuit denied the petition from some Madoff investors for an en banc rehearing of the panel's decision upholding the bankruptcy trustee's method of calculating damages that excludes recovery for net winners. In re Bernard L. Madoff Investment Securities LLC (2d Cir. Nov. 8, 2011).
November 08, 2011
U.S. Supreme Court Criticizes Blanket Refusal to Compel Arbitration Without Scrutinizing All Claims
In a per curiam opinion the U.S. Supreme Court vacated a judgment of a Florida appellate court that upheld a trial court's refusal to compel arbitration of investors' claims against an auditing firm that asserted an arbitration clause in its audit services contract with the fund manager. KKMG LLP v. Cocchi, 556 U.S. (Nov. 7, 2011) (Download KPMGv.Cocchi). The trial court refused to compel arbitration after it determined that two of the four claims asserted by the investors were direct claims (negligent misrepresentations, Florida Deceptive and Unfair Trade Practices Act violation) and were therefore not arbitrable. The trial court's opinion was silent, however, with respect to the two other claims (professional malpractice, aiding and abetting a breach of fiduciary duty), yet the trial court recognized that if the investors' claims were derivative, the arbitration clause could be enforced. Because state courts "have a prominent role to play as enforcers of agreements to arbitrate," the court could not issue a blanket refusal to compel arbitration merely because some of the claims were not arbitrable. The Supreme Court thus reaffirmed Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213 (1985): if a dispute presents multiple claims, some arbitrable and some not, the arbitrable claims must be sent to arbitration, even if this leads to piecemeal litigation.
While not relevant to the merits, the investors' claims arise out of investments in Bernard Madoff's Ponzi scheme.
November 06, 2011
Second Circuit Addresses District Court's Authority to Enjoin Arbitration
There have been several interesting decisions recently about the relationship between arbitration proceedings and the courts, of which In re American Express Financial Advisors Securities Litigation (No. 10-3399, 2d Cir. Nov. 3, 2011) is the most recent. The opinion addresses several unsettled issues concerning the effect of a class action settlement on an individual class member's right to arbitrate certain claims. The Bolands brought various claims before the FINRA arbitration forum against Ameriprise Financial Services, based on Ameriprise's alleged failure to adhere to the Bolands' conservative investment strategy and its "steering" of the Bolands' assets into mutual funds that allowed Ameriprise to collect excessive fees. Unfortunately for the Bolands, they were members of a class that had settled claims against Ameriprise, and they had neither opted out nor submitted a claim to share in the settlement funds. After the arbitration panel denied Ameriprise's motion to stay the arbitration, the firm moved in federal district court to enforce the settlement agreement and enjoin the Bolands from pursuing the arbitration. The district court concluded that the class settlement barred all of the Bolands' claims, granted Ameriprise's motion and ordered the Bolands to dismiss their FINRA complaint with prejudice.
Fortunately, however, for the Bolands, the settlement agreement expressly excluded from the definition of "Released Claims" "suitability claims unless such claims are alleged to arise out of the common course of conduct that was alleged ... in the Action." On appeal, the Second Circuit determined that the FINRA claims and the Released Claims do not totally overlap; accordingly, the Bolands remained free to arbitrate some of their claims.
The Second Circuit also addressed the district court's power to enjoin arbitration, an unanswered question in the Second Circuit. It noted that the FAA did not explicitly confer on the judiciary the authority to enjoin a private arbitration. It acknowledged that previous decisions in the Circuit recognized the district court's power to enjoin arbitration in certain circumstances: (1) where the court has determined that the parties have not entered into a valid and binding arbitration agreement, and (2) where the court has determined that the initiation of judicial proceedings in a foreign country constituted a waiver of arbitration. The court confirmed and applied those principles to this situation:"it makes little sense to us to conclude that district courts lack the authority to order the cessation of an arbitration by parties within its jurisdiction where such authority appears necessary in order for a court to enforce the terms of the parties' own agreement, as reflected in a settlement agreement." The court also relied on the fact that the settlement agreement explicitly stated that the federal district court retained jurisdiction over the settlement agreement. The court did not decide whether the All Writs Act, which other federal courts had relied upon to stay arbitration, gave the district court the authority to enjoin arbitration to prevent relitigation of issues.
November 02, 2011
Another Court Significantly Reduces Madoff Trustee's Claims Against Banks
Judge McMahon (S.D.N.Y.) ruled on November 1 that Madoff Trustee Picard did not have standing to pursue common law claims against JPMorganChase andd UBS to recover on behalf of the defrauded customers, based on allegations that the banks knew, should have known or consciously avoided discovering, that Madoff' was illegally misappropriating customers' funds. Picard v. JPMorgan Chase & Co., Picard v. UBS AG (No. 11 civ. 913 (CM)Download Picard.JP Morgan. ( She thus joins Judge Rakoff (also S.D.N.Y.), who recently ruled similarly in Picard v. HSBC Bank PLC, 454 B.R. 25, in holding that the Trustee's authority under the Bankruptcy Code and SIPA extends only to recovering funds on behalf of the brokerage firm. Accordingly, the amount of money the Trustee can recover from the banks is significantly reduced.
Judge McMahon held that:
- There was no doubt that the common law causes of action belong to the creditors, not the brokerage firm; and
- The Trustee cannot pursue the common law causes of action on behalf of the brokerage firm as a consequence of the equitable doctrine of in pari delicto.
November 01, 2011
New York State Court Throws Out AG's Case Against Schwab Involving ARS Sales
On Oct. 24, 2011, a New York State Supreme Court (County of New York) Justice dismissed the New York Attorney General's complaint against Charles Schwab & Co. involving the firm's sale of auction rate securities (ARS).(Download Schwaborder ) Filed in 2009, the AG charged that Schwab failed to disclose to investorsthe risks involved in ARS, but instead repeatedly described the investments as "liquid," while knowing that major underwriter broker-dealers in the ARS market were supporting the market with proprietary bids to keep the auctions from failing and that the market would collapse if they stopped maintaining it. The AG further alleged that Schwab failed to ensure that its sales force was knowledgeable about the features and risks of ARS. Bringing claims under the Martin Act as well as consumer fraud, the AG sought to compel Schwab to buy back the ARS at par and other equitable remedies and penalties.
The court found, however, found that the complaint did not allege any representations that the ARS were liquid at a time when they were illiquid and accordingly dismissed all claims. Further, "despite having conducted an investigation for over a year prior to the filing of the complaint during which time the AG demanded and obtained more than 4,000 documents, received audio and call recordings involving more than 200 ARS transactions and deposed eleven witnesses, the complaint is devoid of any allegations of representations made that were untrue when made." Emphasizing that this was a misrepresentations and not an omissions case, the court held that the AG's allegations were essentially "fraud by hindsight."
October 31, 2011
Seond Circuit Again Addresses "Customer" Definition in CDS Dispute
There has been considerable litigation in the Second Circuit over the issue of arbitrability in connection with credit default swap agreements. Specifically, the issue presented is whether there is a customer/broker-dealer relationship that permits the disappointed party to require arbitration of claims against the financial services firm involved in the transaction. In Wachovia Bank, N.A. v. VCG Special Opportunities Master Fund, Ltd. (No. 10-1648-cv, Oct. 28, 2011Download Wachovia.102811), the Second Circuit, reversing the district court, held that the hedge fund was not a "customer" of the Wachovia broker-dealer within the scope of FINRA Rule 12200, even though employees of the broker-dealer negotiated part of the CDS agreement. The court emphasized that all the agreements were between the hedge fund and Wachovia Bank, and the agreement contained a non-reliance clause in which the hedge fund acknowledged that the counter-party was not its broker or advisor in any respect. In these circumstances, "there is no need to grapple with the precise boundaries of the FINRA meaning of 'customer.'" The court distinguished the facts from those in two recently decided Second Circuit opinions where the broker-dealer provided brokerage services, Citigroup Global Markets, Inc. v. VCG, 598 F.3d 30 (2d Cir. 2010) and UBS Financial Services Inc. v. West Virginia University Hospitals, Inc. (2d Cir. Sept. 22, 2011).
October 24, 2011
New York's Highest Court Will Address Investors' Claims for Breach of Fiduciary Duty and Gross Neligence
An important, unresolved question in New York state investor protection law is whether common-law causes of action for breach of fiduciary duty and gross negligence are preempted by the state's Martin Act, which authorizes the Attorney General to investigate and enjoin fraudulent practices in the marketing of stocks, bonds and other securities within or from New York State. The New York Court of Appeals will hear oral argument on this question on November 15 in Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., 915 N.Y.S.2d 7 (App. Div. 1st Dept. 2010). This post provides background on the issue.
A majority of the federal courts in the Southern District of New York have, in recent years, held that, except for fraud, the Martin Act forecloses any private common-law causes of action. In 2010, however, Judge Victor Marrero, in a scholarly analysis of the history of the Martin Act and the preemption doctrine, held that the Martin Act did not preclude any private common law causes of action, in Anwar v. Fairfield Greenwich Limited, 728 F. Supp.2d 354 (S.D.N.Y. 2010). Although the judge acknowledged that a significant body of case law (much of it from the S.D.N.Y.) found a preemptive reading of the Martin Act, in his opinion, better reasoned and more persuasive authority, including the New York Attorney General, rejected that view.
Since then, New York's Supreme Court, Appellate Division, First Dept. addressed the issue in Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc. and also concluded that common-law causes of action for breach of fiduciary duty and gross negligence are not preempted by the Martin Act, In reaching this conclusion, the First Department quoted Judge Marrero's "cogent and forceful" argument that to find Martin Act preemption would "leave [ ] the marketplace arguably less protected than it was before the Martin Act's passage, which can hardly have been the goal of its drafters." The court also relied on the New York Attorney General's amicus brief that argued that "the purpose or design of the Martin Act is in no way impaired by private common-law claims that exist independently of the statute, since statutory actions by the Attorney General and private common-law actions both further the same goal, namely, combating fraud and deception in securities transactions."
The First Department now joins the Second Department and the Fourth Department in rejecting the argument that the Martin Act preempts properly pleaded common-law causes of action.
We will report further on the case after the November 15 oral argument.
October 23, 2011
Ohio Supreme Court Will Consider Scope of Securities Division's Power to Protect Investors
On November 1, the Ohio Supreme Court will hear oral argument in an important case that deals with the power of the Ohio Division of Securities to recover ill-gotten gains on behalf of defrauded investors. The lower court's opinion is Zurz v. Mayhew (2d Dist. Ct. App. Oct. 29, 2010).
Roy Dillabaugh ran a Ponzi scheme that bilked about 150 investors in Ohio and Indiana out of over $12 million. He purchased at least 34 life insurance policies that named his wife, son and secretary as beneficiaries. Before committing suicide, he left instructions to the beneficiaries telling them to use the insurance proceeds to repay his victims. They chose not to do so, however, and his wife was recipient of over $6.5 million. The Securities Division sued the beneficiaries in order to freeze the funds until a receiver could be appointed. The trial court ultimately held that the Division could compel the beneficiaries to return only the amount of the premiums and not the proceeds of the policies.
Upon appeal, the appellate court dealt a harder blow to the Division and held that it could not sue the beneficiaries at all, ruling that the state statute RC 1707.26 allows the Division only to sue those enumerated in the statute, i.e., the alleged violators of the statute and their "agents, employees, partners, officers, directors and shareholders." The court rejected the Division's reliance on the last clause in the statute, which allows it to seek "such other equitable relief as the facts warrant," stating that the clause did not expand the range of defendants.
On appeal, the Division makes two arguments. First, the appellate court erroneously reached an issue that was not before the court, since the defendants had not challenged the grant of temporary injunctive relief. Second, and most important, the appellate court's restrictive reading of the statute, if allowed to stand, creates a significant obstacle in the Division's power to act quickly to protect investors.
October 06, 2011
2d Circuit: FINRA Can't Sue to Collect Fines
On Oct. 5, 2011 the Second Circuit held that FINRA does not have the authority to bring judicial actions to collect disciplinary fines. Fiero v. FINRA (09-1556-cv (L))(Download Fireo v FINRA). Because I currently sit on the National Appellate Council of FINRA, I am not commenting on the opinion.
October 04, 2011
S.D.N.Y. Judge Blasts SEC for Lack of Oversight over Distribution of Funds to Investors
The SEC just can't catch a break in the courts. To cite just two recent examples: Judge Rakoff's begrudging approval of the agency's settlement with Bank of America over the Merrill Lynch merger, calling it "half-baked justice;" the D.C. Circuit's vacating of the proxy access rule because of inadequate analysis of its competitive impact. And now Judge Pauley, in the S.D.N.Y., refuses to sign off on a bill submitted by a claims administrator in an SEC settlement, because the administrator failed to justify its requested fees and the SEC appeared to conduct no meaningful oversight. SEC v. Zurich Financial Services (S.D.N.Y. Sept. 30, 2011).
As Judge Pauley explains, the SEC nominated Garden City Group (GCG) as claims administrator to distribute a $25 million in an SEC action against Zurich Financial Services, because GCG was the claims administrator in a $84.6 million private securities class action settlement against the same defendant involving the same misconduct. GCF charged a total of approximately $360,000 to administer the private class action fund; it submitted a bill of approximately $1.1 million to settle the SEC action. The only support for the charges was an invoice that provided no description of the services rendered or the rates charged. Worse, the invoice totalled only $870,000; the balance was not supported by any documentation. The judge had, in a previous litigation, warned the SEC about its responsibility to review and audit fees submitted by its nominees, and he is clearly very displeased about the agency's continued laissez-faire attitude. In particular, the judge questions the expenditure of about $529,000 in publication costs without any assessment of whether such an expensive notice program was necessary or effective.
Clearly, what bothers the court, at least in part, is the agency's cavalier disregard for the court throughout the process: the court had to prod the SEC to propose a distribution fund, and the agency did not keep the court informed throughout the distribution process. The fee application was the final straw: "In ostrich-like fashion, the SEC does not even bother to submit a single piece of paper on GCG's cumulative motions for payment of fees and expenses totalling $1,083,911.88."
So I wonder: has the agency's performance become so bad, or have judges become more demanding or less forgiving about the agency's performance? Has the SEC become the punching bag for the judiciary as well as for Congress (which seems to hold oversight hearings on a continuous basis).
September 29, 2011
Judge Rakoff Reduces Madoff Trustee's Claims Against Net Winners
Judge Jed Rakoff significantly reduced the amount of money the Madoff trustee can potentially recover from "net winners." In Picard v. Katz (S.D.N.Y. 09/27/11), the trustee sought to recover over a billion dollars from defendants Saul Katz and Fred Wilpon on a variety of theories under federal bankruptcy law and New York Debtor and Creditor Law. The court, however, dismissed all claims except those alleging actual fraud and equitable subordination and narrows the standard for recovery under the remaining claims.
First, because Madoff Securities was a registered broker-dealer, the liabilities of its customers are subject to the "safe harbor" of Bankruptcy Code section 546(e), under which a trustee cannot avoid settlement payments made by a stockbroker in connection with a securities contract except in cases of actual fraud. The court relied on the plain language of the statute and rejected the trustee's argument that the policy behind the provision did not warrant its application to payments by Madoff Securities to its customers. Accordingly, the court rejected all the trustee's claims based on principles of preference or constructive fraud.
Second, with respect to claims based on actual fraud, the court applied the bankruptcy code's avoidance provision permitting the trustee to clawback payments made by Madoff Securities to its customers within two years of the bankruptcy filing. The bankruptcy code, however, provides that a transferee "that takes for value and in good faith" may retain its interest to the extent it gave value to the debtor in exchange for such transfer. Accordingly, the trustee cannot recover the principal invested by a Madoff customer absent bad faith. The trustee can recover a net winner's profits regardless of good faith.
Third, the court rejected the customers' argument that, so long as they acted in good faith, their profits, as reflected on their monthly statements, were legally binding obligations of Madoff Securities, so that payments of those profits were simply discharges of antecedent debts. Rather, as to payments received in excess of their principal, customers would have to show that they took for value.
Fourth, the court leaves open whether the trustee can avoid as profits only what defendants received in excess of their investment during the two-year look back period or instead the excess they received over the course of their investment with Madoff. According to the trustee's complaint, defendants' profits amounted to about $83 million in the two-year period and about $295 million over the course of their investment.
Fifth, the court discusses what lack of "good faith" means in this context. Both sides agreed that actual knowledge (which the trustee did not allege) or willful blindness (which the trustee did allege and about which the court expresses skepticism) would constitute lack of good faith. The trustee also argued that "inquiry notice" and failure to investigate constituted lack of good faith; the defendants, of course, disagreed. The court rejected the latter in the context of a SIPA trusteeship, where bankruptcy law is informed by federal securities law. Just as fraud, in the context of federal securities laws, requires scienter, so too "good faith" in a SIPA bankruptcy implies a lack of fraudulent intent. In particular, an investor generally has no duty to investigate its broker in the absence of red flags that suggest a high probability of fraud.
Finally, the trustee can subordinate the defendants' own claims against the estate only by proving that the defendants invested with Madoff Securities with knowledge, or in reckless disregard, of its fraud.
September 27, 2011
Court Dismisses Fraud Claims Against AOL Senior Managers Pursuant to Janus
A frequent question in the aftermath of the 2008 financial meltdown is: why aren't individual defendants being held accountable for their misdeeds? Part of the difficulty is establishing securities fraud and the difficulty of pleading and proving scienter. Another difficulty results from the definition of a "maker of a statement" the U.S. Supreme Court set forth in Janus Capital Group, Inc. v. First Derivative Traders. In holding that a fund' investment adviser and administrator could not be held liable under Rule 10b-5 for misstatements in the Fund's prospectus, the Court defined a "maker of a statement" as "the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it....One who prepares or publishes a statement on behalf of another is not its maker."
In SEC v. Kelly (S.D.N.Y. Sept. 22, 2011), the court relied on that language to hold that two AOL senior managers could not be liable under Rule 10b-5 and 33Act section 17(a) for misstatements about advertising revenues. As doubtful litigation strategy, the SEC conceded that Janus foreclosed a misstatement claim under Rule 10b-5(b), but argued that they could be liable under "scheme liability" based on Rule 10b-5(a) and (c) and section 17(a) of the 33 Act. The court rejected both these arguments, because "this case is not about conduct that is itself deceptive -- it is about conduct that became deceptive only through AOL's misstatements in its public filings." Moreover, since the elements of a 17(a) claim are essentially the same as those for Rule 10b-5 claims, the court also dismissed those claims.
Shareholder's Challenge to Executive Compensation Survives MTD Because of Negative Say-on-Pay Vote
A recent opinion suggests that a negative shareholder vote on a "say-on-pay" resolution will improve shareholders' chances in surviving a motion to dismiss a derivative suit alleging excessive executive compensation. In NECA-IBEW Pension Fund v. Cox (S.D.Ohio 09/20/11), involving Cincinnati Bell, Judge Timothy Black framed the question:
Whether a shareholder of a public company may sue its directors for breach of the duty of loyalty when the directors grant $4 million dollars in bonuses, on top of $4.5 million dollars in salary and other compensation, to the chief executive officer in the same year the company incurs a $61.3 million dollar decline in net income, a drop in earnings per share from $0.37 to $0.09, a reduction in share price from $3.45 to $2.80, and a negative 18.8% annual shareholder return.
In answering that question in the affirmative, the judge emphasized that at the motion to dismiss stage, plaintiff only needs to state a plausible claim and that the business judgment rule imposes a burden of proof, not a burden of pleading. The factual allegations raise a plausible claim that the bonuses approved by the directors in a time of the company's declining financial performance violated Cincinnati Bell's pay-for-performance compensation policy and thus constituted an abuse of discretion or bad faith. In particular, the opinion references the fact that 66% of voting shares voted against the say-on-pay resolution; Cincinnati Bell was one of only 1.6% of public companies that received negative shareholder recommendations on their say-on-pay resolutions (as of the end of June 2011).
In addition, plaintiff was excused from the requirement of pre-suit demand because of futility, because it pled specific facts to give reason to doubt that the directors could make unbiased, independent business judgments about whether to sue:
Given that the director defendants devised the challenged compensation, approved the compensation, recommended shareholder approval of the compensation, and suffered a negative shareholder vote on the compensation, plaintiff has demonstrated suficient facts to show that there is reason to doubt these same directors could exercise the independent business judgment over whether to bring suit against themselves for breach of fiduciary duty....
Perhaps the nonbinding advisory vote will prove to have more teeth than anticipated!
September 23, 2011
ARS Issuer Can Arbitrate Claims Against Broker-Dealer Related to Auction Services
The Second Circuit recently held that an issuer of auction rate securities (ARS) could arbitrate claims against the financial services firm that advised the issuer on the offerings and acted as the lead underwriter and the main broker-dealer responsible for facilitating the auctions that set the interest rates. UBS Financial Services, Inc. v. West Virginia University Hospitals (No. 11-235-cv, 9/22/11). There was no arbitration agreement between the parties, but a majority of the panel held that the issuer was a "customer" under the FINRA arbitration rules with respect to the services provided by the firm in its capacity as a broker-dealer and therefore could compel arbitration. While the district court had concluded that the issuer was a customer with respect to the underwriting services, the majority of judges declined to address that issue, although they made a point of stating that they disagreed with the dissenting judge's assertion that issuers can never be customers of underwriters.
This litigation thus offers another illustration of broker-dealers resisting arbitration when requested by the customer. Indeed, while the definition of "customer" is largely undefined at the borders and, in particular, whether the issuer is a customer of the underwriter that provides it underwriting services is unresolved, some of the arguments made by UBS's attorneys against arbitration were frivolous. Thus, they argued that FINRA rules do not contemplate arbitration for sophisticated parties, that FINRA has a narrow "investor-protection" mandate, and that a customer relationship requires a fiduciary relationship and cannot be founded on arm's length transactions. None of these arguments has ny basis in the FINRA rules, practice or policy.
Thus, we have another example of a situation where the securities industry believes that they will achieve a more favorable result in the law-oriented judicial forum than in the equity-based arbitration forum.
August 30, 2011
SEC Seeks Judicial Review of the Definition of a Broker
The Eleventh Circuit will have an opportunity to weigh in on the elusive distinction between a "broker" and a "finder" if the SEC is successful in persuading a Florida federal district court to certify the issue in SEC v. Sky Way Global LLC (No. 8:09-cv-455-T-23TBM, Decided Apr. 1, 2011). In this case, according to the district court, the SEC failed to meet its burden to show that the defendant Kramer "engaged in the business of effecting transactions in securities in the accounts of others."
The SEC's allegations involve efforts on the part of Kramer to solicit sales of stock in Skyway Aircraft. Pursuant to a "cooperative" agreement between Kramer andd another defendant Baker (through his company Affiliated Holdings) to share with each other business opportunities and split fees, Kramer introduced Talib, a registered broker, to Baker and Skyway. Talib ultimately sold $14 million of Skyway shares to investors, for which Kramer received between $189,000 and $200,000. This transaction, however, according to the court, did not make Kramer a broker because his only involvement was to bring the two parties together. Specifically, Kramer did not participate in negotiations or in any way promote an investment in Skyway to Talib or his investors.
Kramer also told "a small but close group" about Skyway, directed them to Skyway's website, opined that Skyway was a "good investment" and received from Baker Skyway shares when he reported the number of Skyway shares members of this group purchased through registered brokers (20% of reported shares). The court thought this activity was "odd, but not 'broker' activity." The court concludes that Kramer's conduct was similar to the activity of an "associated person" of an unregistered broker, who, in this case, was Baker or his company Affiliated Holdings. Kramer did not contact a broker to encourage the broker to sell Skyway shares, did not field investor inquiries, and did not counsel investors to purchase Skyway shares.
According to an BNA Securities Law Daily Report, the federal district court preliminarily agreed to certify as final the judgment to permit the agency to appeal the judgment. Defendant Kramer has until August 31 to show cause wny the motion should not be granted.
The definition of a "broker" is an important one, and further judicial explication would be welcome.
August 18, 2011
Judge Denies Rajaratnam's Motion for Acquittal
In a 48-page opinion(Download USvRajaratnam) reviewing the law and the evidence, the judge in Raj Rajaratnam's insider trading case denied in its entirety his motion to set aside the jury verdict and enter a judgment of acquittal.
August 16, 2011
Second Circuit Agrees with Madoff Trustee on Limiting Recovery of Net Winners
The Second Circuit today affirmed the order of the bankruptcy court in the Madoff liquidation proceeding, which in turn affirmed the decision of the the Trustee, Irving Picard, that investors' "net equity" should be calculated based on the Net Investment Method (amount of cash deposited in account less any withdrawals)and not the Last Statement Method (market value of securities reflected on last customer statement) as a number of "net winners" had argued.
The Court noted that, although both the Trustee and objecting claimants had argued that the plain meaning of the statutory definition supported their position, in fact the statutory language did not prescribe a single means of calculating "net equity" that would apply under all circumstances. Instead, different fact patterns would call for differing approaches to determine the fairest method of calculating "net equity." Under the circumstances of this case (i.e. the entirely fictitious nature of Madoff's account statements), the Trustee's approach, approved by SIPC and the SEC, was consistent with the purpose and design of SIPA. Moreover,
use of the Last Statement Method in this case would have the absurd effect of treating fictitious and arbitrarily assigned paper profits as real and would give legal effect to Madoff's machinations.
In re Bernard L. Madoff Inv. Sec. LLC (2d Cir. Aug. 16, 2011)Download InreMadoff10-2378_opn
August 01, 2011
Ashland Loses Two ARS Cases
As we have reported in previous postings, purchasers of auction rate securities (ARS) have fared poorly in their Rule 10b-5 litigation against the investment banks that recommended the securities to them. Ashland Inc. recently had the dismissals of their complaints against two different investment firms affirmed by two Circuits (2d and 6th). The opinions provide good examples of the legal grounds successfully used by defendants to defeat these claims: lack of reasonable reliance on the part of the investor and failure to plead scienter with the requisite particularity required by PSLRA.
The Second Circuit, in particular, has frequently invoked the duty of sophisticated investors to conduct due diligence to bar Rule 10b-5 fraud claims, and Ashland Inc. v. Morgan Stanley & Co., Inc. (10-1549-cv, July 28, 2011) gives the court another opportunity to apply that doctrine. Ashland contended that Morgan Stanley, in both oral and email communications, repeatedly misrepresented the the liquidity of certain ARS, thus inducing them to purchase and hold these securities at a time when Morgan Stanley knew the market for ARS was collapsing. The Second Circuit, however, affirmed the district court's dismissal of the complaint because Ashland, concededly a sophisticated investor, could not plead reasonable reliance on the alleged misrepresentations because Morgan Stanley had,pursuant to an SEC order, previously posted on its website statements that explicitly disclosed the liquidity risks. The Second Circuit also affirmed the district court's dismissal of the claims under New York common law, also because of plaintiffs' lack of reasonable reliance, thus ducking the Martin Act preemption issue that has been the subject of conflicting rulings by the state and federal courts and is currently before the New York Court of Appeals.
The Sixth Circuit based its affirmance of Ashland's dismissal on that other common ground for dismissal -- failure to plead scienter with the requisite particularity. In Ashland Inc. v. Oppenheimer & Co., Inc. (No. 10-5305, July 28, 2011), the court, following the "entirely collective assessment" of Tellabs and Matrixx, concluded that Ashland's factual allegations, when considered together, did not give rise to a strong inference that Oppenheimer acted with scienter. "Simply put, apart from conclusory allegations, Ashland fails to provide any facts explaining why or how Oppenheimer possessed advance, non-public knowledge that underwriters would jointly exit the ARS market and cause its collapse..." The court also affirmed dismissal of the state law claims for failure to plead scienter or (in the case of the non-fraud claims) lack of justifiable reliance.