Securities Law Prof Blog

Galleon Group Founder Indicted on Insider Trading Charges

A Federal grand jury indicted Raj Rajaratnam, founder of Galleon Group, and Danielle Chiesi, a former Bear Stearns hedge fund manager, of operating a complex insider trading ring that has been described by the government as the largest insider trading case involving hedge funds.  Both are expected to plead not guilty.  NYTimes, Grand Jury Indicts Galleon Chief and Associate ; WSJ, Rajaratnam, Chiesi Charged in Insider Case.

House Bill Allows Broker-Dealers to Switch Hats

Investment News reports on a provision buried in the financial reform legislation passed by the House last year that would allow broker-dealers to switch hats.  The legislation would require the SEC to adopt rules that would establish a fiduciary duty for brokers who provide investment advice; however, the bill goes on to say that “Nothing in this section shall require a broker or dealer or registered representative to have a continuing duty of care or loyalty to the customer after providing personalized investment advice about securities.”  Purportedly added after lobbying by discount brokerage firms, the investment advisory community is up in arms.  InvNews, Adviser groups blow tops over House bill's ‘hat-switching' clause.

FiNRA Foundation Releases Survey on How People Manage Their Money

The FINRA Investor Education Foundation announced the release of the National Financial Capability Study today at a special event at the U.S. Department of the Treasury. The National Financial Capability Study established a baseline measure of the ability of Americans to manage their money, benchmarking four key indicators of financial capability and evaluating how these indicators vary with underlying demographic, behavioral, attitudinal and financial literacy characteristics. It consists of findings from three linked surveys: 

National Survey. A national, random-digit-dialed telephone survey of 1,488 respondents with over-sampling to enable segmentation by selected demographic variables (e.g., race, household income, education level) (released December 2009)
 

State-by-State Survey. A state-by-state online survey of approximately 25,000 respondents (roughly 500 per state, plus DC) (to be released in 2010)
 

Military Survey. An online survey of 800 military personnel and spouses (to be released in 2010).

According to the executive summary:

1. Making Ends Meet. Nearly half of survey respondents reported facing difficulties
in covering monthly expenses and paying bills.
2. Planning Ahead. The majority of Americans do not have “rainy day” funds set
aside for unanticipated financial emergencies and similarly do not plan for
predictable life events, such as their children’s college education or their own
retirement.
3. Managing Financial Products. More than one in five Americans reported engaging
in non-bank, alternative borrowing methods (such as payday loans, advances on
tax refunds or pawn shops). And few appear to be knowledgeable about the
financial products they own.
4. Financial Knowledge and Decision-Making. While many American adults believed
they were adept at dealing with day-to-day financial matters, they nevertheless
engaged in financial behaviors that generated expenses and fees and exhibited a
marked inability to do basic interest calculations and other math-oriented tasks.
In addition, few compared the terms of financial products or shopped around
before making financial decisions.
 

Wells Fargo Announces It Will Repay $25 Billion TARP Money

Wells Fargo joins the TARP exodus.  It announced yesterday that it will repay the $25 billion government investment in part through a $10.4 billion common stock offering.

Backdating Charges Dismissed Against Two Broadcom Executives

A federal district court dismissed fraud charges against Broadcom co-founder Henry T. Nicholas III and former CFO William J. Ruehle stemming from backdating stock options, on grounds of prosecutorial misconduct.  The judge also dismissed an SEC civil suit against four Broadcom executives.

The judge found that the prosecutors tried to prevent three key defense witnesses from testifyinng, improperly contacted lawyers for defense witnesses, and leaked information about grand jury proceedings to the media.  NYTimes, Charges Dismissed Against 2 Broadcom Executives.

Citigroup Will Repay $20 Billion to Treasury

Citigroup announced that it will repay $20 billion in TARP funds to the government by issuing common stock, thus ending the government's restrictions over compensation.  Citigroup is the last major financial services firm under TARP restrictions.  Treasury will also make a secondary offering of up to $5 billion of the common shares it owns and plans to sell off the remainder of its 34% stake in the next 6-12 months.  That's a lot of Citi shares hitting the market at once.

Vikram Pandit, Chief Executive Officer, said, "The TARP program was designed to provide assistance until banks were in a position to repay it prudently. We are pleased to be able to repay the U.S. government's trust preferred securities and to terminate the loss-sharing agreement. We owe the American taxpayers a debt of gratitude and recognize our obligation to support the economic recovery through lending and assistance to homeowners and other borrowers in need."

Treasury continues to own warrants for another 464 million shares.

SEC Enforcement Director Testifies on BofA -- Merrill Merger

Robert Khuzami, Director, SEC Division of Enforcement, testified today before the House Oversight and Government Reform Committee and Domestic Policy Subcommittee, on Events Surrounding Bank of America’s Acquisition of Merrill Lynch.  His prepared testimony defends the proposed settlement rejected by Judge Rakoff and discusses the Bank's assertion of attorney-client privilege. 

House Defeats Amendment Subjecting B-D Investment Advisers to FINRA Regulation

An amendment to the House financial regulation legislation that would have subjected investment advisers associated with broker-dealers to FINRA regulation was defeated by voice vote.  This is a battle of the titans among influential lobbyists, as the broker-dealer groups go against the investment advisory groups.  The broker-dealers might have expected more support since FINRA's former CEO, Mary Schapiro, is now SEC Chair, but that isn't how it played out.  InvNews,House scraps plan to place B-D advisers under Finra (UPDATED).  (hat tip:  Jill Gross)

House Passes Financial Regulation Overhaul

After three days of floor debate, the House voted, 223-202, to overhaul government regulation of the financial markets.  Among the bill's notable features:

• Heightened supervision of large financial institutions, including higher capital and liquidity requirements (through a newly created Financial Stability Council);
• New goverenment authority to break up institutions "too big to fail;"
• New government authority to handle failures of large financial services firms;
• Establishment of a Consumer Financial Protection Agency (despite a Democratic bid to kill it);
• Regulation of OTC derivatives;
• Shareholder advisory vote on executive compensation;
• Registration of hedge fund advisors.

No Republicans supported the legislation, and 27 Democrats voted against it. The focus now turns to the Senate and its consideration of parallel legislation.

The House Financial Services Committee press release describing the legislation is here.

For media coverage, see:

WSJ, House Passes Sweeping Financial Oversight Bill

NYTimes, House Passes Far-Reaching Bill Tightening Financial Rules

WPost, House approves sweeping regulatory reform package  

SEC Delays Effective Date of Rule 151A

In a court filing, the SEC stated that it would delay the effective date of Rule 151A, which makes indexed annuities securities, for two years.  The D.C. Circuit had previously upheld the SEC's legal analysis but remanded the Rule for consideration of the economic impact, which the court found deficient.  InvNews, Indexed annuities as securities? Not until 2013, says the SEC.

SEC Proposes Some Increased Recovery for Early Madoff Investors

The House Capital Markets Subcommittee, chaired by Rep.Kanjorski, held another hearing today on the Madoff fraud, specifically dealing with SIPC.  In honor of the occasion, the New York Times today ran an article featuring the head of SIPC, Stephen P. Harbeck, whom critics have charged with being too conservative in his interpretation of the statute.  Critics object to the failure of SIPC to recognize claims from investors whose withdrawals at least equaled their deposits and from investors through feeder funds.    NYTimes, Protection Chief Struggles With Madoff Claims.  At the hearing Michael Conley, an SEC official, proposed that the claims of early investors be adjusted to reflect inflation, a recommendation it will make to the bankrupty court.  Here are excerpts from his testimony on this point:

The Madoff case raises difficult issues. Based on an analysis of SIPA, its legislative history, and cases that have applied it, the Commission is recommending to the bankruptcy court that customer claims should be determined through the cash-in/cash-out method advocated by the Trustee and SIPC — with an additional adjustment to ensure that the investors' claims in this long-running scheme are valued most accurately and fairly.

The Commission is basing its recommendation on the conclusion that the claims of the Madoff investors cannot be valued based on the balance shown on their final account statements. Although this approach would allow most Madoff account holders to receive payments on their claims, those payments would be based on account balances reflecting amounts that Madoff himself concocted that bear no relation to reality. ... Neither SIPA nor any of the cases interpreting that statute can be read to support an approach that would value claims based on the fictitious investment returns of such a scheme.

.... Therefore, the Commission has concluded that the most reasonable way to measure the value of the Madoff customers' net equity is to look to the money those customers invested with Madoff as a proxy for the unspecified investments in securities (the split-strike conversion strategy) Madoff told them he would make for their accounts.

The Commission's recommendation resembles what would likely be the outcome in a private suit by a customer challenging the distribution of assets on the same facts. Although the customer could establish that the broker had committed fraud, and could recover her initial investment (less withdrawals), she would not be able to recover as damages the amounts shown on the final account statements because they were based on fraudulent backdating of trades through hindsight. The fraud did not cause the customer to lose actual proceeds that were (or could have been) the product of legitimate trading. The same principles are relevant in calculating the Madoff customers' net equity under SIPA. In this case, the only reliably determinable transactions are the cash deposits and withdrawals those customers made to and from their brokerage accounts....

In addition, it is important to note that basing customers' net equity on the fictitious balances on their final account statements would do nothing to increase the fund of customer property — it would simply reallocate it. It is clear that there will not be enough money in the fund of customer property to pay out the $65 billion that Madoff falsely reported was in customer accounts when the firm failed. The Trustee has estimated that he may be able to recover as much as $8 billion to distribute to claimants. Using the final account statement approach would have the effect of favoring early investors-many of whom withdrew all or more than the principal they invested with Madoff — over later investors — some of whom withdrew little or none of what they invested and will not receive a distribution equal even to their principal.

While the final account statement approach favors earlier customers at the expense of later customers, the SEC is also sensitive to the corresponding fairness concerns under the cash-in/cash-out method. That method of calculating net equity favors later customers at the expense of earlier customers by treating a dollar invested in 1987 as having the same value as a dollar invested in 2007. ...

In the SEC's view, to achieve a fair and economically accurate allocation among Madoff customers who invested and withdrew funds in different historical periods, it is appropriate to convert the dollars invested into "time-equivalent" or constant dollars. This constant-dollar approach is rooted in the classic economic concept of the time value of money and will result in greater fairness across different generations of Madoff investors — in effect, treating early investors and later investors alike in terms of the real economic value of their investments.

The issue of calculating net equity in constant dollars has not arisen before in SIPA cases, probably because many Ponzi-type schemes are of relatively short duration, and the inequity among those who invested at different points in time is less striking. But the Madoff fraud — which lasted for 20-plus years — puts this issue into stark relief. ... Under the facts of this case, the Commission believes that the use of constant dollars can be distinguished from the payment of interest discussed in that Sixth Circuit case and that the best reading of SIPA and the cases interpreting it is that net equity here should be calculated in constant dollars.

It also is the Commission's view that the constant-dollar method will have limited application to the calculation of net equity in other liquidations under SIPA. ...

Here is the prepared testimony of Mr. Harbeck that does not address this damages calculation issue.

Treasury Plans Offering of JPMorgan Chase Warrants

The U.S. Department of the Treasury today announced that it has commenced a secondary public offering of approximately 88,401,697 warrants to purchase the common stock of JPMorgan Chase & Co. (the "Company").  The offering is expected to price through a modified Dutch auction.  Deutsche Bank Securities Inc. is the sole book-running manager and Ramirez & Co., Inc., The Williams Capital Group, L.P. and Utendahl Capital Group, LLC are the co-managers for the offering.

Deutsche Bank Securities Inc., in its capacity as auction agent, has specified that the auction will commence at 8 a.m., Eastern Time, on December 10, 2009, and will close at 6:30 p.m., Eastern Time, on that same day  (the "submission deadline").  During the auction period, potential bidders will be able to place bids at any price (in increments of $0.25) at or above the minimum bid price of $8.00 per warrant. 

The auction procedures, and the strike price, expiration, and other terms of the warrants are described in the preliminary prospectus supplement.

Adviser Group Releases Survey of Financial Professionals' Views on Fiduciary Standard

The SEI Advisor Network and The Committee for the Fiduciary Standard recently conducted a survey of financial advisers and brokers to determine the level of support and understanding of the fiduciary standard.  The survey was completed by 890 RIAs, IARs and registered broker-dealers, who self-identified their compensation structures as follows:  commission (132), commission-fee (510) and fee-based and fee-only (242).  The findings include:

A majority of brokers (53%) believe that "all financial professionals who give investment and financial advice should be required to meet the fiduciary standard;"  twenty-seven percent disagree with the statement.  Among those who identified themselves as fee-based and fee-only advisers, 86% agreed with the statement.

Eighty percent of brokers stated that they understood the fiduciary standard either "fairly well" or "very well."  Nearly all (98%) of advisers stated they understand the standard "fairly well" or "very well."

Respondents were asked if they believed that they should be allowed to meet a fiduciary standard in providing advice and then revert to a suitability standard when recommending products.  Ninety-three percent of fee-based and fee-only advisers disagreed with that statement, as did fifty-five percent of commission-fee brokers.  In contrast, thirty-seven percent of commission-only brokers disagreed with that statement.

As to compensation, fifteen percent of advisers said that they believe investors do not care how they are compensated, in contrast to fifty-six percent of commission-fee brokers and sixty-three percent of commission-only brokers.

House Capital Markets Subcommittee Schedules Hearing on SIPC Issues Related to Madoff

Congressman Paul E. Kanjorski (D-PA), the Chairman of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, today announced that he will convene yet another proceeding looking into the Madoff Ponzi scheme.  The hearing will focus on a variety of policy issues involving the Securities Investor Protection Corporation (SIPC). The hearing will also occur during the week of the first anniversary of Mr. Madoff’s arrest.

House Financial Services Committee Passes Financial Reform Package

Yesterday the House Financial Services Committee completed its work on a comprehensive set of reforms intended to modernize America’s financial regulations. The Wall Street Reform and Consumer Protection Act (H.R. 4173), which will be considered on the House floor next week, includes the following provisions:

Consumer Protections: Creates the Consumer Financial Protection Agency (CFPA), a new, independent federal agency solely devoted to protecting Americans from unfair and abusive financial products and services. 

 
Financial Stability Council: Creates an inter-agency oversight council that will identify and regulate financial firms that are so large, interconnected, or risky that their collapse would put the entire financial system at risk. These systemically risky firms will be subject to heightened oversight, standards, and regulation. 

 
Dissolution Authority and Ending “Too Big to Fail”: Establishes an orderly process for dismantling large, failing financial institutions like AIG or Lehman Brothers in a way that ends bailouts, protects taxpayers, and prevents contagion to the rest of the financial system.

Executive Compensation: Gives shareholders a “say on pay” – an advisory vote on pay practices including executive compensation and golden parachutes. It also enables regulators to ban inappropriate or imprudently risky compensation practices, and it requires financial firms to disclose any compensation structures that include incentive-based elements.

Investor Protections: Strengthens the SEC’s powers so that it can better protect investors and regulate the nation’s securities markets.  It responds to the failures to detect the Madoff and Stanford Financial frauds by ordering a study of the entire securities industry that will identify needed reforms and force the SEC and other entities to further improve investor protection. 

Regulation of Derivatives:  Regulates, for the first time ever, the over-the-counter (OTC) derivatives marketplace. Under the bill, all standardized swap transactions between dealers and “major swap participants” would have to be cleared and traded on an exchange or electronic platform. The bill defines a major swap participant as anyone that maintains a substantial net position in swaps, exclusive of hedging for commercial risk, or whose positions create such significant exposure to others that it requires monitoring. 

Mortgage Reform and Anti-Predatory Lending: Would incorporate the tough mortgage reform and anti-predatory lending bill the House passed earlier this year. The legislation outlaws many of the egregious industry practices that marked the subprime lending boom, and it would ensure that mortgage lenders make loans that benefit the consumer.  It would establish a simple standard for all home loans: institutions must ensure that borrowers can repay the loans they are sold. 

Reform of Credit Rating Agencies: Addresses the role that credit rating agencies played in the economic crisis, and takes strong steps to reduce conflicts of interest, reduce market reliance on credit rating agencies, and impose a liability standard on the agencies.  

Hedge Fund, Private Equity and Private Pools of Capital Registration: Fills a regulatory hole that allows hedge funds and their advisors to escape any and all regulation.  This bill requires almost all advisers to private pools of capital to register with the SEC, and they will be subject to systemic risk regulation by the Financial Stability regulator.
 

Office of Insurance: Creates a Federal Insurance Office that will monitor all aspects of the insurance industry, including identifying issues or gaps in the regulation of insurers that could contribute to a systemic crisis and undermine the entire financial system.

House Financial Services Committee Passes Financial Stability Improvement Act

Today, the House Financial Services Committee approved legislation that, according to its press release,  will put an end to “too big to fail” financial firms, help prevent the failure of large institutions from becoming a systemwide crisis, and ensure that taxpayers are never again left on the hook for Wall Street’s reckless actions. The Financial Stability Improvement Act (H.R. 3996) passed by a vote of 31-27.

H.R. 3996 specifically targets the issue of systemic risk within the financial system and the potential harm that regulatory gaps and large, interconnected companies like AIG can pose to the economy. The legislation will:

• Identify and subject systemically risky firms to increased scrutiny and regulation: H.R. 3996 will create an inter-agency oversight council that will identify and monitor financial firms and activities that could potentially undermine the nation’s financial stability. Once identified, these firms and activities will be subject to stricter oversight, standards, and regulation.
   

• Ensure that the collapse of a large, interconnected financial institution does not lead to another taxpayer bailout or jeopardize the economy: Currently, there is no system in place to responsibly shut down a failing financial company like AIG or Lehman Brothers. This bill establishes an orderly process for the dismantling any large failing financial institution in a way that protects taxpayers and minimizes the impact to the financial system.
   

• Hold Wall Street accountable for its actions: If a large institution fails, the bill holds the financial industry and shareholders responsible for the cost of the company’s orderly wind down, not taxpayers. Under H.R. 3996, any costs for dismantling a failed financial company will be repaid first from the assets of the failed firm at the expense of shareholders and creditors. Any shortfall would then be covered by a “dissolution fund” pre-funded by large financial companies with assets of more than $50 billion and hedge funds with assets of more than $10 billion.

SEC Reportedly Investigating Insider Trading in Health Care Mergers

The Wall St. Journal reports today that the SEC has sent out "at least three dozen" subpoenas to hedge funds and brokerage firms looking into insider trading.  The focus appears to be on health care mergers in recent years and the role of Goldman Sachs.  WSJ, SEC Steps Up Insider-Trading Probes.

House Financial Services Committee Passes Amendment to Dismantle Firms "Too Large to Fail"

On Nov. 18 the House Financial Services Committee passed an amendment offered by Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, to the Financial Stability Improvement Act by a vote of 38-29.  The Kanjorski amendment would empower federal regulators to rein in and dismantle financial firms that are so large, inter-connected, or risky that their collapse would put at risk the entire American economic system, even if those firms currently appear to be well-capitalized and healthy.  Therefore, American taxpayers should no longer be on the hook for bailouts, as financial companies would not be able to become “too big to fail.” The Kanjorski amendment outlines clear and objective standards for regulators to examine financial companies and reduce the level of risk their activities pose to our financial stability and our economy.

The Kanjorski amendment expands on a segment of the Financial Stability Improvement Act, by enabling federal action to address financial companies that are deemed “too big to fail” before resolution authority is needed.  The amendment transfers such mitigatory action from the Federal Reserve to the Financial Services Oversight Council and establishes objective standards for the Council to effectively evaluate companies to determine whether they are systemically risky.  Additionally, the amendment provides clear checks and balances by requiring the Council to consult with the President before taking extraordinary mitigatory actions.  A financial company also has the right to appeal any actions.

Ohio AG Sues Rating Agencies

Ohio Attorney General Richard Cordray today filed a lawsuit against Standard & Poor’s, Moody’s and Fitch. The lawsuit, filed in United States District Court for the Southern District of Ohio on behalf of five Ohio public employee retirement and pension funds, charges the rating agencies with wreaking havoc on U.S. financial markets by providing unjustified and inflated ratings of mortgage-backed securities in exchange for lucrative fees from securities issuers.

The lawsuit alleges the rating agencies gave many of these exotic investments the highest investment-grade credit rating. This rating – often referred to as “AAA”– is consistent with the credit ratings given to the safest corporate bonds, and it assured institutional investors, including the Ohio funds, that the investments were extremely safe with a very low risk of default. According to preliminary estimates, the improper ratings cost the Ohio Funds losses in excess of $457 million.

(Hat tip:  Darrell Miller)

Davidoff on BofA-ML Merger Testimony

Great blog by NYTimes Deal Professor Steven Davidoff on the mysteries contained in former BofA GC Mayopoulos's testimony today before the House committee investigating the BofA-ML merger.  His bottom line -- to which I heartily concur -- move on to more serious issues.  Some Mysteries in the BofA-Merrill Deal