Securities Law Prof Blog

FINRA Officer's Senate Testimony on Stanford Oversight

On August 17, 2009 Daniel M. Sibears, Executive Vice President, FINRA Market Regulation Programs, testified before the Senate Committee on Banking, Housing and Urban Affairs on FINRA's oversight over Stanford's broker-dealer operations.  Mr. Sibears stated that the broker-dealer operations have been subject to regular inspections every other year for the past ten years.  Since 2007 there have been 4 formal disciplinary actions, each resulting in a censure and modest fines.  In addition, FINRA received and reviewed 9 complaints and 7 regulatory tips since 2001.  In conclusion, he states:

Recent frauds, including Stanford, and the financial crisis of the last two years have made it painfully clear that the current regulatory structure is weakened by gaps, inconsistencies and, at times, jurisdictional limitations that should be remedied. In the Stanford case, while FINRA examined Stanford's broker-dealer, it did not examine the investment adviser, nor did it have the clear ability to compel information from Stanford's foreign bank affiliate. Such limitations are frustrating in practice and in the aftermath of this kind of fraud, no regulator can be happy with the status quo.

 Individual investors are the most important players in the financial markets, and we need to earn back the confidence of those investors by closing the gaps in our current U.S. regulatory system and strengthening oversight of all financial firms and professionals regardless of how they are registered. As FINRA's CEO, Rick Ketchum, testified before this committee earlier this year, we believe that one of the most important gaps to close in terms of investor protection is the disparity in oversight between broker-dealers and investment advisers. Between the SEC and self-regulatory organizations, more than half of the approximately 4,900 registered broker-dealer firms are examined each year. By contrast, the SEC projects that fewer than 10 percent of the more than 11,000 registered investment adviser firms will be examined during fiscal years 2009 and 2010. The authorization of an independent regulatory organization for investment advisers would augment the SEC's ability to oversee those financial firms with more frequent exams and expanded enforcement resources would enhance protections provided to all customers of investment advisers.

 As we have learned over the last two years, a system of fragmented regulation provides opportunities to those who would cynically game the system to do so at great harm to investors. FINRA is committed to working with other regulators and this Committee as you consider how best to restructure the U.S. financial regulatory system.

Black on Reputational Damages

Reputational Damages in Securities Litigation, by Barbara Black, University of Cincinnati - College of Law, was recently posted on SSRN.  Here is the abstract:

This short paper, originating in remarks made at the Institute for Law and Economic Policy's 15th Annual Conference on Compensation of Plaintiffs in Mass Securities Litigation, addresses an issue that has surfaced post-Dura Pharmaceuticals: can investors recover damages resulting from declines in stock price attributable to the market's reassessment of the integrity of management or the corporation's internal controls? Some finance scholars label these damages as non-recoverable 'collateral damage' that are not attributable to the original fraudulent disclosure. I argue that this position is based on a mischaracterization of the original fraudulent disclosure and that there is no basis in law or policy for denying plaintiffs recovery for what are properly considered as reputational damages.

Buxbaum on Personal Jurisdiction in Cross-Border Securities Litigation

Personal Jurisdiction Over Foreign Directors in Cross-Border Securities Litigation, by Hannah L. Buxbaum, Indiana University School of Law-Bloomington, was recently posted on SSRN.  Here is the abstract:

Securities litigation against non-U.S. companies – on the rise over the past decade – forces U.S. courts to address a variety of procedural and jurisdictional issues. This article considers one such issue: the circumstances under which the directors of foreign companies that engage in U.S. securities markets may be subject to the personal jurisdiction of U.S. courts. It argues that jurisdictional standards are sometimes applied in a way that undermines the effectiveness of private litigation in enforcing director accountability norms. This result is particularly problematic in cases based upon a director’s failure to meet an accountability obligation expressly imposed upon it by statute. The article considers possible ways of resolving this tension, and ultimately advocates that courts adopt a two-part presumption: (1) In a claim against a foreign director based upon a corporate filing with respect to which Congress has expressly created a director accountability requirement, there should be a strong presumption that the director is subject to the personal jurisdiction of the U.S. court; and (2) In a claim against a foreign director based only upon allegations that the director failed to meet his or her oversight responsibilities over management, there should be a strong presumption that the director is not subject to the personal jurisdiction of the U.S. court. The article argues that these presumptions will satisfy the due-process protections embodied in jurisdictional law while bringing that law into better alignment with regulatory expectations regarding the responsibility of corporate directors for an issuer’s securities activity.

Frankel on Fiduciary Duties of Securities Professionals

Fiduciary Duties of Brokers-Advisers-Financial Planners and Money Managers, by Tamar Frankel, Boston University School of Law, was recently posted on SSRN.  Here is the abstract:

Broker dealers and investment advisers form the lifeline of the financial markets. While in the past their functions were separate, and their regulation differed, throughout the years their functions were allowed to merge but their regulation remained separate. Advisers are their clients’ fiduciaries. Brokers are not, with some exceptions. It is recognized that the law has to change, and the question is how. In this Article I argue for imposing the fiduciary duty of loyalty and limiting conflict of interest all financial intermediaries, including broker dealers, and suggest a process for establishing the details of the law that should apply to them. Section One of the Article outlines the principles on which fiduciary law is based. Section Two offers a short overview of the past and current practice of broker dealers. Section Three highlights the fiduciary aspects of broker dealers and the risks posed to their clients from their conflicts of interest Section Four proposes changes in the current law and a process to achieve future changes. The law should impose principles; the financial intermediaries should seek the specificity.

Bainbridge on STOCK Act

The Stop Trading on Congressional Knowledge Act, by Stephen M. Bainbridge, University of California, Los Angeles - School of Law, was recently posted on SSRN.  Here is the abstract:

A 2004 study of the results of stock trading by United States Senators during the 1990s found that that senators on average beat the market by 12% a year. In sharp contrast, U.S. households on average underperformed the market by 1.4% a year and even corporate insiders on average beat the market by only about 6% a year during that period. A reasonable inference is that some Senators had access to - and were using - material nonpublic information about the companies in whose stock they trade.

Under current law, it is uncertain whether members of Congress can be held liable for insider trading. The proposed Stop Trading on Congressional Knowledge Act addresses that problem by instructing the Securities and Exchange Commission to adopt rules intended to prohibit such trading.

This article analyzes present law to determine whether members of Congress, Congressional employees, and other federal government employees can be held liable for trading on the basis of material nonpublic information. It argues that there is no public policy rationale for permitting such trading and that doing so creates perverse legislative incentives and opens the door to corruption. The article explains that the Speech and Debate Clause of the U.S. Constitution is no barrier to legislative and regulatory restrictions on Congressional insider trading. Finally, the article critiques the current version of the STOCK Act, proposing several improvements.

SEC Settles PIPE Offerings Insider Trading Case

On August 7, 2009, the United States District Court for the Southern District of New York entered a final judgment against Edwin "Bucky" Lyon, IV, Gryphon Master Fund, L.P., Gryphon Partners, L.P., Gryphon Partners (QP), L.P., Gryphon Offshore Fund, Ltd., Gryphon Management Partners, L.P., Gryphon Management Partners III, L.P., and Gryphon Advisors, L.L.C. (collectively, "Gryphon Partners") in SEC v. Edwin B. Lyon, IV, et al., 06 Civ. 14338 (S.D.N.Y.), an insider trading case the Commission filed on December 12, 2006. The Commission's complaint against Lyon and Gryphon Partners alleged that they violated the antifraud provisions of the federal securities laws in connection with four PIPE (an acronym for private investment in public equity) offerings.  Specifically, the complaint alleged that, in connection with four separate PIPE offerings, Lyon and Gryphon Partners, after being solicited to invest, engaged in illegal insider trading by selling short the PIPE issuers' securities prior to the public announcement. Lyon and Gryphon Partners engaged in this conduct notwithstanding their agreement to keep information about the PIPE confidential.

Without admitting or denying the allegations in the complaint, Lyon and each Gryphon Partners entity consented to the entry of a final judgment permanently enjoining them from future violations of the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 (specifically, Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and Exchange Act Rule 10b-5). The final judgment also orders Lyon and Gryphon Advisors, L.L.C. to pay, jointly and severally, disgorgement of $66,712, plus prejudgment interest of $33,850, and a civil penalty of $310,288, and further orders Gryphon Master Fund, L.P., Gryphon Partners, L.P., Gryphon Partners (QP), L.P., Gryphon Offshore Fund, Ltd., Gryphon Management Partners, L.P., and Gryphon Management Partners III, L.P. to pay, jointly and severally, disgorgement in the amount of $243,576, plus prejudgment interest of $123,590.

Florida Attorney Settles SEC Market Manipulation Charges

On July 31, 2009, the SEC filed a civil action in the United States District Court for the Southern District of Florida against L. Daniel Ferrer, a Florida attorney, alleging violations of the federal securities laws in connection with the manipulation of stock in Weida Communications, Inc.  According to the SEC’s complaint, from approximately June 2004 through April 2005, a group of promoters and brokers manipulated the market price for Weida common stock to approximately $5 per share in part to facilitate the sale of stock in private transactions for approximately $3 per share. The SEC alleges Ferrer used brokerage accounts opened in his name and that of his law firm to execute manipulative trades in Weida common stock. Ferrer was an attorney licensed to practice law in the State of Florida and outside counsel for Weida. The SEC further alleges that Ferrer falsely testified under oath when questioned by the staff about his trading activity during the investigation. The SEC charges Ferrer with violations of Section 10(b) Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder and seeks as relief a permanent injunction, disgorgement with prejudgment interest, a civil penalty and penny stock bar. Without admitting or denying the allegations against him, Ferrer consented to a permanent injunction and penny stock bar. Ferrer also consented to an administrative order permanently suspending his privilege of appearing or practicing before the SEC as an attorney.

On April 6, 2009, Ferrer was arrested on related criminal charges brought by the United States Attorney’s Office for the Southern District of Florida [United States of America v. L. Daniel Ferrer, Case No. 09-60069-CR (Cohen J/Seltzer MJ)]. On May 19, 2009, Ferrer pleaded guilty to misprision of a felony pursuant to 18 U.S.C. § 4. Ferrer’s sentencing is scheduled for August 27, 2009.

SEC and Terex Settle Accounting Fraud Charges

The SEC charged Terex Corporation, a heavy equipment manufacturer, with accounting fraud for making material misstatements in its own financial reports to investors, as well as aiding and abetting a fraudulent accounting scheme at United Rentals, Inc. (URI), another Connecticut-based public company. Terex has agreed to settle the SEC’s charges and pay a penalty of $8 million. The SEC previously charged URI with fraud as well as officers of URI and Terex.

The SEC’s complaint, filed in U.S. District Court for the District of Connecticut, alleges that Terex aided and abetted the fraudulent accounting by URI for two year-end transactions that were undertaken to allow URI to meet its earnings forecasts. These fraudulent transactions also allowed Terex to prematurely recognize revenue from its sales to URI. The fraud occurred through URI’s sales of used equipment to a financing company and its lease-back of that equipment for a short period. As part of the scheme, Terex agreed to sell the equipment at the end of the lease period and guarantee the financing company against any losses. URI separately guaranteed Terex against losses it might incur under the guarantee it had extended to the financing company.

The SEC’s complaint also alleges that from 2000 through June 2004, Terex’s accounting staff failed to resolve imbalances arising from certain intercompany transactions. Instead of investigating and correcting the imbalances, Terex offset the imbalances with unsupported and improper entries. As a result, costs were not recorded as expenses, and, on a consolidated basis, Terex appeared to be more profitable than it was.

Reviving the Debate on SEC Corporate Penalties

It seems like just yesterday that we were debating whether corporate penalties were too high and were unfair to the corporation's "innocent shareholders"; former SEC Commissioner Paul Atkins was the leading proponent of that view, shared by some academics.  Now a New York Times blog questions whether recent penalties are too low.  It makes a good argument -- $50 million paid by GE, $15 million by Hank Greenberg, and $33 million paid by Bank of America, each of them for allegations of pretty egregious fraud. NYTimes, S.E.C. Watchdog’s Bite Not Matching Its Bark?  The overarching issue here is that the SEC still has not articulated, much less enforced, a consistent policy on corporate penalties, so we really have no standards for determining what is fair and appropriate.  It's another task for the energized SEC.

Madoff Associate Pleads Guilty

Frank DiPascali Jr., longtime associate of Bernard Madoff, pleaded guilty today to 10 criminal charges, including securities fraud, investment adviser fraud, mail and wire fraud, and conspiracy.  He admitted that he helped Madoff to defraud his customers from 1990s-2008.  DiPascali reportedly is cooperating with prosecutors.  He will not be sentenced until next year.  WSJ, Madoff Aide Pleads Guilty.

The SEC also settled charges with DiPascali today. According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, DiPascali helped generate bogus annual returns of 10 to 17 percent by fabricating backdated and fictitious trades that never occurred. The SEC further alleges that DiPascali helped Madoff cover up the fraud by preparing fake trade blotters, stock records, customer confirmations, Depository Trust Corporation (DTC) reports and other phantom books and records to substantiate the non-existent trading.

Without admitting or denying the allegations of the SEC's complaint, DiPascali has consented to a proposed partial judgment, which if entered by the court would impose a permanent injunction against DiPascali and leave the issues of disgorgement and a financial penalty to be decided at a later time.

Administration Proposes Legislation to Regulate OTC Derivatives

The Administration delivered legislative language to Capitol Hill today focusing on the regulatory reform of over-the-counter (OTC) derivatives.  Under the Administration's legislation, the OTC derivative markets will be comprehensively regulated for the first time.  The Administration's announcement states that the legislation will provide for regulation and transparency for all OTC derivative transactions; strong prudential and business conduct regulation of all OTC derivative dealers and other major participants in the OTC derivative markets; and improved regulatory and enforcement tools to prevent manipulation, fraud, and other abuses in these markets.

Putting itself on the back, the Administration states that:

Today's delivery marks an important new milestone, as the Administration has now delivered a comprehensive package of financial regulatory reform legislation to Capitol Hill.  Less than two months since the release of its white paper, "Financial Regulatory Reform: A New Foundation," on June 17, the Administration has successfully translated all of its proposals into detailed legislative text – a remarkable effort in both speed and scope.  The Administration looks forward to working with Congress to pass a comprehensive regulatory reform bill by the end of the year.

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FINRA Tells SEC It's Premature to Mandate Elimination of Industry Arbitrator in Customer Disputes

One of the persistent criticisms of arbitration of customer-broker disputes before FINRA Dispute Resolution is the requirement that one of three arbitrators must come from the securities industry.  Many investors and their advocates are suspicious of an industry-sponsored mandatory dispute resolution system that mandates industry representation on the arbitration panel.  Defenders of the system argue that an industry arbitrator adds expertise and knowledge of industry practices to the panel. 

Beginning in October 2008 FINRA launched a two-year pilot program that allows investors to choose a panel consisting of three public arbitrators.  Eleven brokerage firms volunteered to participate in the pilot program, each contributing a set number of cases sto the pilot per year for two years. In June the Public Investors Arbitration Bar Association (PIABA) filed with the SEC a proposed rule change petition requesting the SEC require by rule that the parties in an arbitration have the power to select an all-public panel in any investor claim in which the amount in controversy exceeds $100,000.  In essence, PIABA seeks to make the key elements of the pilot program permanent before the pilot's expiration in October 2010.

FINRA filed a response to PIABA's petition, which the SEC has posted on its website.  As described by FINRA , PIABA's petition incorporates most aspects of the pilot, with one notable exception.  PIABA would mandate the pilot rules for all investor cases rather than providing investors with a choice in panel composition.  FINRA notes that investors and their counsel in many pilot-eligible cases have elected not to participate in the pilot, suggesting that choice is important to preserve.

FINRA's position is that the pilot program should continue for its two-year term, after which the SRO would study its results and assess its effectiveness.  It plans to survey participants in the pilot and seeks input on other ways to measure the results.  In short, FINRA argues that it is premature for the SEC to mandate elimination of the industry arbitrator.

(hat tip:  Jill Gross)

Judge Refuses to Approve SEC-BofA Settlement over Merrill Bonuses

A federal district court judge refused today to approve the settlement that the SEC and Bank of America had negotiated over the failure to disclose bonuses to Merrill Lynch executives in the proxy materials submitted to the bank's shareholders to approve the merger.  He said he lacked sufficient information to find the settlement fair.  Specifically, he asked who had made the decision not to disclose the promised bonuses.  NYTimes, Judge Refuses to Approve Settlement Over Merrill Bonuses.

FINRA Fines Credit Suisse for Violating Global Research Analyst Settlement

FINRA imposed a fine of $275,000 against Credit Suisse Securities (USA), LLC, for failing to comply fully with one of the key terms of the 2003 Global Research Analyst Settlement.  That settlement, which was between regulators and 13 leading financial services firms, required those firms to make independent research available to their customers.

 According to FINRA, beginning as early as 2004, Credit Suisse failed on a number of occasions to post all of the required, current independent research to its Web site. For instance, the firm posted independent research for companies not covered by Credit Suisse and was delayed in providing independent research in a timely manner after offerings. Following the discovery of these initial problems, the firm failed to implement effective measures to detect and prevent additional failures. As a result, the firm's lack of adequate safeguards, controls and oversight caused Credit Suisse to experience three significant failures to make independent research available to its customers.

 First, from April 2007 to September 2007, Credit Suisse failed to make available to its customers 32,500 required independent research reports, while some of the research reports that were posted were not the most currently available at the time. Separately, from December 2004 to October 2007, Credit Suisse failed to post independent research from certain research providers for 224 of its covered companies, although independent research coverage by other providers remained available for all but 45 of these companies. The firm failed to detect this deficiency for nearly three years. Finally, beginning at various points from September 2006 to July 2008, Credit Suisse failed to post required independent research for 35 additional covered companies because the firm neglected to deactivate a filtering system in its research database that excluded certain companies from its research website.

Stout on Trust Behavior

Trust Behavior: The Essential Foundation of Securities Markets, by Lynn A. Stout, University of California, Los Angeles - School of Law, was recently posted on SSRN.  Here is the abstract:

Evidence is accumulating that in making investment decisions, many investors do not employ a 'rational expectations' approach in which they anticipate others’ future behavior by analyzing their incentives and constraints. Rather, many investors rely on trust. Indeed, trust may be essential to a well-developed securities market. A growing empirical literature investigates why and when people trust, and this literature offers several useful lessons. In particular, most people seem surprisingly willing to trust other people, and even institutions like 'the market,' in novel situations. Trust behavior, however, is subject to history effects. When trust is not met by trustworthiness but instead is abused, trust tends to disappear. These lessons carry significant implications for our understanding of modern securities markets.

Free Enterprise Fund v. PCAOB Law Professors Amici Brief

Supreme Court Amici Brief of Law Professors in Support of Petitioners in Free Enterprise Fund V. Public Company Accounting Oversight Board, No. 08-861, by Donna M. Nagy, Indiana University School of Law-Bloomington, was recently posted on SSRN.  Here is the abstract:

A group of corporate and securities law professors submitted this brief as amici curiae to the United States Supreme Court in Free Enterprise Fund v. Public Company Accounting Oversight Board. Amici support Congress’s decision in the Sarbanes-Oxley Act to establish a new regulator to oversee the auditors of public companies. But amici express concern that the particular design chosen by Congress accords the PCAOB substantial discretion and autonomy without imposing constitutionally sufficient accountability. Specifically, the brief argues that the PCAOB's structure is unconstitutional because it violates the Appointments Clause and the doctrine of separation of powers. With a focus on statutory analysis, legislative history, and the securities industry’s self-regulatory organization (SRO) model on which the PCAOB was patterned, the brief challenges the D.C. Circuit’s conclusion that the PCAOB is merely 'a heavily controlled component' of the SEC. The brief argues instead that the PCAOB is an independent regulatory entity subject to oversight and enforcement by the SEC, another independent regulatory entity, and that this double-decker independence stretches the Constitution’s text and precedents too far.

Amici curiae: Stephen Bainbridge, Robert Bartlett, William Birdthistle, Timothy Canova, Lawrence Cunningham, James Fanto, Theresa Gabaldon, Lyman Johnson, Roberta Karmel, Donna Nagy, Lydie Pierre-Louis, Adam Pritchard, Margaret Sachs, Gordon Smith, Kellye Testy

Attorney Settles Charges in Pump and Dump Scheme

On July 31, 2009, the United States District Court for the Northern District of Georgia entered final judgments by consent against Albert J. Rasch, Jr., Kathleen R. Novinger, Sandra B. Masino and 144 Opinions, Inc. (144 Opinions) in a civil injunctive action charging them for their roles in issuing legal opinions in a pump-and-dump scheme. The final judgments enjoined all defendants from future antifraud and registration violations of the federal securities laws, imposed civil monetary penalties, and barred all defendants from participating in a penny stock offering for a period of five years.

The Commission filed its Complaint in this matter on May 5, 2009. The Complaint alleged that during 2007, the defendants collectively operated a legal "opinion mill" which issued fraudulent legal opinions used by promoters in a pump-and-dump scheme, and others, to sell securities in violation of the registration provisions of the federal securities laws. Masino and 144 Opinions drafted and Rasch or Novinger executed, at least 24 legal opinion letters concerning the removal of restrictive legends on certificates representing over 22 million shares of Mobile Ready Entertainment Corp. ("Mobile Ready"). The defendants cited to non-existent documents and misrepresented critical facts in executing the 24 legal opinions. The complaint alleges that the false and misleading statements drafted by Masino and 144 Opinions and thereafter executed by Rasch and Novinger fraudulently induced the transfer agent for Mobile Ready to remove the restrictive legends and permit the illegal sale of over 22 million shares of Mobile Ready in violation of the registration provision of the federal securities laws.

Without admitting or denying the allegations in the Commission's Complaint, Rasch, Novinger, Masino and 144 Opinions consented to judgments entered by the Court that permanently enjoin them from future violations of Sections 5 and 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder and bar them from participating in the offering of a penny stock for a period of five years. The judgments ordered Rasch and Masino each to pay a $20,000 civil monetary penalty, while Novinger was ordered to pay a $10,000 civil monetary penalty. Additionally, the final judgments ordered Rasch and Masino to disgorge all professional and service fees related to the Mobile Ready legal opinions.

Federal Judge Calls for Hearing on SEC-BofA Settlement

Earlier this week the SEC announced a settlement with Bank of America over allegations that the bank misled its shareholders by not disclosing promised Merrill Lynch bonuses when it solicited their proxies for the merger, but a federal judge in S.D.N.Y. has called a hearing for August 10 before he will decide whether to approve the settlement.  Judge Rakoff cited the public importance of the case and said unless a hearing is held the public will remain uncertain about the truth of the allegations.  He specifically questioned the basis for the $33 million penalty and whether it will be paid with bailout money.   WSJ, Judge Calls Hearing in SEC Case Against BofA.   

FINRA Fines Ameritas for Sales of Unsuitable VUL Policies

FINRA fined Ameritas Investment Corp.  $100,000 and suspended and fined one of its brokers for inducing customers to take on additional mortgage and/or home equity debt in order to purchase variable universal life insurance policies (VULs). Those policies were pitched to customers as mechanisms for funding college expenses and retirement.

 Ameritas was sanctioned for failing to adequately supervise broker Nancy Ziering, who was based in New Jersey, and for advertising violations related to her financial plans. FINRA found that the financial plans she created and were misleading and that her recommendations to customers to purchase VUL policies were unsuitable. Although the plans were marketed as a way to demonstrate how customers could save for college and retirement, in nearly every instance they recommended that the customer purchase a VUL policy issued by an affiliate of Ameritas, using money obtained from a mortgage refinancing or home equity loan.  Ziering was fined $60,000 and suspended for nine months. 

SEC Enforcement Statistics in 2009

Remarks to the New York City Bar Association, by Robert Khuzami, Director, Division of Enforcement, SEC, August 5, 2009:

Comparing the period from late January [2009] to the present to roughly the same period in 2008, the Division has opened 10% more investigations (approximately 525, compared to 475); have been granted 118% more formal orders (which grants us subpoena power) (275, compared to 126); have filed 147% more TROs (52, compared to 21); and have filed nearly 30% more actions (397, compared to 306).

Khuzami goes on to discuss organizational changes within Enforcement to improve its focus and efficiency as well as Enforcement's priorities.