Securities Law Prof Blog

Florida Broker-Dealer Settles Charges It Sold Unsuitable Annuities to Seniors

The SEC today issued an administrative Order imposing sanctions on Prime Capital Services, Inc. and Gilman Ciocia, Inc. The Order finds that from approximately November 1999 through February 2007, Prime Capital Services, Inc. (PCS) sold unsuitable variable annuities to senior citizens in south Florida by means of material misrepresentations and omissions. It also finds that PCS's parent company, Gilman Ciocia, Inc. (G&C), aided and abetted the broker-dealer's fraud by arranging and marketing free-lunch seminars in the south Florida area at which PCS registered representatives recruited elderly customers whom they later induced to buy variable annuities.

Based on the above, the Commission has issued an Order that, among other things, orders PCS to disgorge $97,389.05 plus $46,873.53 in prejudgment interest and orders G&C to pay $1 in disgorgement and a civil monetary penalty of $450,000 to be paid in three installments. In addition, PCS and G&C have agreed to a number of undertakings, including hiring an independent compliance consultant to review and recommend changes to PCS's supervisory procedures; restricting certain associated persons from involvement in variable annuity sales until the independent compliance consultant has completed its review; refunding the variable annuity fees incurred by certain elderly customers of particular registered representatives; and giving notice of the settlement to elderly customers who bought variable annuities from particular registered representatives in the past five years. PCS and G&C consented to the issuance of the Order without admitting or denying any of the findings of the Order.

Dodd Punts on Harmonizing Regulation of Investment Advice Providers

An important issue in any financial reform package adopted by Congress is the so-called "harmonization" of regulatory treatment of broker-dealers and investment advisers that provide personalized investment advice to retail customers.  While "harmonization" can be subject to many interpretations, there is broad consensus among the broker-dealer and investment adviser industries that the standard of care applicable to those providing investment advice to retail customers should not turn on whether they are registered as broker-dealers, investment advisers or both.  However, this broad consensus has not translated into agreement about how to accomplish the harmonization.  Investment advisers have campaigned on the slogan that the fiduciary duty applicable to investment advisers is a higher standard than the "watered-down" suitability standard applicable to broker-dealers.  While this is a highly debatable assertion in my mind, a sensible legislative solution would be for Congress to adopt a broad principle of comparable regulation and leave to the SEC the appropriate, context-specific standards.  

Unfortunately, this is not the approach taken in Senator Dodd's legislative proposal.  Instead, his proposal calls for the SEC to conduct yet another study and prepare an exhaustive report.  Then,

"If the study . . . identifies any gaps or overlap in the legal or regulatory standards in the protection of retail customers relating to the standards of care for brokers, dealers, investment advisers, persons associated with brokers or dealers, and persons associated with investment advisers for providing personalized investment advice about securities to such retail customers, the Commission, not later than 2 years after the date of enactment of this Act, shall . . . commence a rulemaking, as necessary or appropriate in the public interest and for the protection of retail customers, to address such regulatory gaps and overlap that can be addressed by rule, using its authority under the Securities Exchange Act of 1934 . . . and the Investment Advisers Act of 1940 . . . and . . . consider and take into account the findings, conclusions, and recommendations of the study required under this section."

Section 913(f), Restoring American Financial Stability Act of 2010.

Frankly, it's hard for me to see this as another more than a stalling for more time.  RAND did a comprehensive report on the broker-dealer and investment adviser industries a few years ago, at the SEC's request, which provides unrefuted evidence of investor confusion about the differences among advice providers.  Industry representatives and academics have fully explored the legal and regulatory issues. We don't need another study, and the SEC has better uses for its time.  Most importantly, retail investors deserve prompt action.

Just as a reminder of how this issue has  played out to date --  In December 2009 the House passed legislation that requires the SEC to promulgate rules to provide that the standard of conduct for all brokers, dealers and investment advisers, "when providing personalized investment advice about securities to retail customers…, shall be to act in the best interest of the customer without regard to the financial or other interest of the [advice provider]."   The proposed legislation goes on to state that the "standard of conduct shall be no less stringent than the standard applicable to investment advisers under section 206(1) and (2) of the [IAA] when providing personalized investment advice about securities…."   The provision, however, specifically excepts broker-dealers from having a "continuing duty of care or loyalty to the customer after providing personalized investment advice about securities."   "Retail investor" is defined as a natural person who receives personalized investment advice about securities from an advice provider and who uses such advice "primarily for personal, family, or household purposes."
 
 In contrast, the earlier, pre-Dodd Senate version, which was never voted out of committee, took a more straightforward approach and simply eliminated the broker-dealer exclusion from the definition of "investment adviser" in the IAA.   The SEC would have the authority to exempt any person or transaction from the principal trades prohibition if it finds that the adviser protects investors against conflicts of interest or principal transactions that are not in the best interests of the interests of the investor.  Under both the House and Senate versions, the SEC is supposed to promulgate rules enhancing disclosure of conflicts of interest.

This issue is an important one affecting the interests of retail investors, but, given the broad consensus on its advisability, it should not be difficult to accomplish.  It does not bode well for significant financial reform if Congress cannot address this issue promptly and directly.

(Thanks to Michael Keefe, UCin '10, for his research assistance.)
  

 

SEC Commissioner Aguilar on Money Market Fund Reform

Excerpt from Speech by SEC Commissioner Luis Aguilar, Making Sure Investors Benefit from Money Market Fund Reform, Investment Company Institute and Federal Bar Association Mutual Funds and Investment Management Conference, Phoenix, AZ, March 15, 2010:

Potential Further Action
Notwithstanding the substantial reform recently made as to Rule 2a-7, more may be in the works. Besides what may be contained in the pending money market fund report by the President’s Working Group on Financial Markets, the Chairman as well as senior staff at the Commission have telegraphed a desire to see more fundamental structural change in the money market fund industry. In particular, the staff is examining the merits of a floating, mark-to-market NAV for money market funds, rather than the stable one-dollar price. Other ideas under consideration include real-time disclosure of the shadow price; mandatory redemptions-in-kind for large redemptions (such as by institutional investors); a private liquidity facility to provide liquidity to money market funds in times of stress; and a possible "two-tiered" system of money market funds, with a stable NAV only for money market funds subject to greater risk-limiting conditions and possible liquidity facility requirements, among others.

I believe that any consideration of future reforms should be careful not to jeopardize the tremendous value money market funds bring to investors. As the Commission considers further money market reform, I believe two fundamental priorities must be at the forefront of our consideration. The first priority should be to recognize that money market fund investments have historically worked well for all investors, particularly for retail investors. All contemplated proposals should take retail investors into account and make sure that they are able to continue to participate and benefit.

In addition, any further reform should not be so “transformational” that the money market fund is no longer an economically attractive product. Future proposals should be rigorously analyzed to determine the consequences that would result. One consequence no one wants to see is a flight of trillions of dollars to unregistered vehicles that have no regulatory oversight or accountability. As a second round of reform is contemplated, there needs to be serious consideration given to what other reforms should be made regarding unregistered vehicles to insure that there is no regulatory end-run

Former InfoUSA CEO Settles Charges of Fraudulent Compensation Scheme

The SEC oday charged three former senior executives and a former director of infoUSA Inc., an Omaha-based database compilation company, for their roles in a scheme in which the CEO funneled illegal compensation to himself in the form of perks worth millions of dollars.  According to the SEC, Vinod Gupta, the former CEO and Chairman of infoUSA Inc. and infoGROUP Inc. (Info), fraudulently used corporate funds to pay almost $9.5 million in personal expenses to support his lavish lifestyle. He additionally caused the company to enter into $9.3 million of undisclosed business transactions between Info and other companies in which he had a personal stake.  The SEC also charged the former chairman of Info's audit committee, Vasant H. Raval, and two of the company's former chief financial officers, Rajnish K. Das and Stormy L. Dean, for enabling Gupta to carry out the scheme.

The SEC's complaints, filed in federal district court in Nebraska, allege that from 2003 to 2007, Gupta improperly used corporate funds for more than $3 million worth of personal jet travel for himself, family, and friends to such destinations as South Africa, Italy, and Cancun. He also used investor money to pay $2.8 million in expenses related to his yacht; $1.3 million in personal credit card expenses; and other costs associated with 28 club memberships, 20 automobiles, homes around the country, and three personal life insurance policies. The SEC alleges that Raval, the Chairman of the Audit Committee, failed to respond appropriately to various red flags concerning Gupta's expenses and Info's related party transactions with Gupta's other entities. Two Info internal auditors raised concerns to Raval that Gupta was submitting requests for reimbursement of personal expenses, yet Raval failed to take meaningful action to further investigate the matter and he omitted critical facts in a report to the board concerning Gupta's expenses.

The SEC further alleges that Das and Dean allowed Gupta to support his lavish lifestyle by rubber-stamping hundreds of his expense reimbursement requests. Das and Dean approved Gupta's expense reimbursement requests despite the fact that the requests lacked sufficient explanation of business purpose and supporting documentation, even in the face of concerns raised by several Info employees. Das and Dean also signed management representation letters to Info's outside auditor falsely representing that all related party transactions with Gupta's entities had been properly recorded and disclosed in Info's financial statements.

Gupta, Raval, and Info agreed to settle the SEC's charges without admitting or denying the allegations against them.

Gupta agreed to pay disgorgement of $4,045,000, prejudgment interest of $1,145,400, and a penalty of $2,240,700. He consented to an order barring him from serving as an officer or director of a public company, and placing restrictions on the voting of his Info common stock.

Raval agreed to pay a $50,000 penalty and consented to an order barring him from serving as an officer or director of a public company for five years.

The SEC's case against Das and Dean is ongoing.

Senator Dodd's Financial Reform Bill

The complete text of Senator Dodd's Financial Reform bill is now posted at the Senate Banking Committee's website.

Dodd Releases The Democrats' Version of Regulatory Reform

Senator Chris Dodd, Chair of the Senate Banking Committee, just released the Senate Democrats' summary(Download FinancialReformSummary231510FINAL) of proposed federal financial reform.  (In case you've forgotten, the House passed a version last December.)  Here are some of the highlights, many of which were widely reported over the weekend:

1. The consumer protection "watchdog" will be housed in the Federal Reserve instead of being established as an independent agency.  The director will be appointed by the President and confirmed by the Senate, and it will have the authority to write and enforce consumer protection rules.

2. Creates a process for liquidating failed financial firms and imposes new capital and leverage requirements that make it undesirable to get too big.  It will require regulators to adopt the Volcker Rule, i.e., prohibit proprietary trading.

3. Creates a council to identify and address systemic risks before they threaten the economy's stability.  It will be composed of federal financial regulators and an independent member.

4. Eliminates loopholes for OTC derivatives, asset-backed securities, hedge funds, mortgage bankers, and payday lenders.  It will require central clearing and exchange trading for derivatives that can be cleared and will require margin for un-cleared trades.

5. Provides shareholders with a "Say on pay" nonbinding resolution on executive compensation and gives the SEC authority to grant shareholders proxy access to nominate directors. 

6. New rules on credit-rating agencies.  It will create an Office of Credit Ratings at the SEC and will require the SEC to examine NRSROs annually.  In addition, investors could bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source.

7. Strengthens oversight and empowers regulators to pursue financial fraud aggressively.  This includes requiring a study on whether broker dealers who give investment advice should be held to the same fiduciary standards as investment advisers.  It will also provide self-funding for the SEC.

There are many other provisions (including increased regulation of securitization and municipal securities, and increasing the accountability of the New York Federal Reserve Bank).  As always, the devil is in the details, and we can expect a lot of horse-trading in the weeks ahead.  Stay tuned!   

Scarlett on Shareholders in the Jury Box

Shareholders in the Jury Box: A Populist Check Against Corporate Mismanagement, by Ann M. Scarlett,  
Saint Louis University - School of Law, was recently posted on SSRN.  Here is the abstract:

The recent subprime mortgage disaster exposed corporate officers and directors who mismanaged their corporations, failed to exercise proper oversight, and acted in their self-interest. Two previous waves of corporate scandals in this decade revealed similar misconduct. After the initial scandals, Congress and the Securities and Exchange Commission attempted to prevent the next crisis in corporate governance through legislative and regulatory actions such as the Sarbanes-Oxley Act of 2002. Those attempts failed. Shareholder derivative litigation has also failed because judges accord corporate executives great deference and thus rarely impose liability for breaches of fiduciary duties.

To prevent the next crisis in corporate governance, the answer is not to enact more laws but to change the enforcer of the current laws. That enforcer already exists - the civil jury. Most states, however, deny any right to jury trial for shareholder derivative litigation. In these states, shareholders largely fail in their attempts to hold corporate executives liable for breaching their fiduciary duties. Extending a jury trial right to all states would reinvigorate shareholder derivative litigation and offer a populist check against corporate executives’ misconduct. This simple change would coerce corporate executives to properly oversee their companies and fulfill their fiduciary duties because they would know that their misconduct would be adjudicated by a jury of average Americans - similar to their shareholders. Empowering the civil jury would also help restore shareholders’ trust in corporate management, which could rebuild confidence in the stock markets.

Fleischer on Regulatory Arbitrage

Regulatory Arbitrage, by Victor Fleischer, University of Colorado Law School, was recently posted on SSRN.  Here is the abstract:

Most of us share a vague intuition that the rich, sophisticated, well-advised, and politically connected somehow game the system to avoid regulatory burdens the rest of us comply with. The intuition is correct; this Article explains how it’s done.

Regulatory gamesmanship typically relies on a planning technique known as regulatory arbitrage, which occurs when parties take advantage of a gap between the economics of a deal and its regulatory treatment, restructuring the deal to reduce or avoid regulatory costs without unduly altering the underlying economics of the deal. This Article provides the first comprehensive theory of regulatory arbitrage, identifying the conditions under which arbitrage takes place and the various legal, business, professional, ethical, and political constraints on arbitrage. This theoretical framework reveals how regulatory arbitrage distorts regulatory competition, shifts the incidence of regulatory costs, and fosters a lack of transparency and accountability that undermines the rule of law.

Schaefer on Zealous Advocacy

Harming Business Clients with Zealous Advocacy: Rethinking the Attorney Advisor's Touchstone, by Paula Schaefer, University of Tennessee College of Law, was recently posted on SSRN.  Here is the abstract:

Joseph Collins was a successful business lawyer, with a sophisticated practice at Mayer Brown LLP. In January 2010, Collins was sentenced to seven years in prison for his role in a massive fraud that cost investors millions and sent his client Refco, Inc. into bankruptcy. At sentencing, the judge reportedly stated, “I think this is a case of excessive loyalty to his client.” Collins’ own testimony reflects a lawyer who believed he was zealously representing his client's interests. But in reality, Collins’ conduct was not “loyal” to his client. He contributed to his client’s destruction.

With the Collins example and others, I argue that business lawyers act as zealous advocates to their own clients’ peril. I explain that professional conduct rules are central to the problem. The advisor’s duties are relegated to a single rule that provides scant direction about how to advise. In the absence of direction, lawyers fill in the gaps with zealous advocacy. After examining the problems of the zealous advocacy mantra, I suggest that “fiduciary duty” would be a preferable touchstone for attorney-advisors. While it is true lawyers are already fiduciaries, fiduciary duty is not the focus for most lawyers. I argue that it should be. Using fiduciary duty as a framework, I propose professional conduct rules that would provide direction to business lawyers that is more consistent with their clients’ interests.

Tung & Wang on Bank CEOs' Inside Debt Compensation

Bank CEOS, Inside Debt Compensation, and the Financial Crisis, by Frederick Tung, Emory University - School of Law, and Xue Wang, Emory University - Goizueta Business School, was recently posted on SSRN.  Here is the abstract:

Bank executives’ compensation has been widely identified as a culprit in the Financial Crisis. The structure of banker pay, equity-based compensation in particular, has been blamed for excessive short-term risk taking by banks, and policy makers and academics have proposed reforms. In a recent prominent paper, Fahlenbrach and Stulz (2009) show that no association exists between better bank CEO-shareholder alignment before the Crisis and bank performance during the Crisis. We extend Fahlenbrach and Stulz (2009) by offering a new approach to investigating the link between banker compensation and the Financial Crisis. We hypothesize that bank CEOs’ inside debt holdings reduce risk taking and agency costs of debt within banks. Consistent with our hypothesis, we find that bank CEOs’ inside debt holdings preceding the Financial Crisis are significantly positively associated with bank performance and significantly negatively associated with bank risk taking during the Crisis.

The Short Story on Lehman and Repo 105

What is Repo 105 (from Examiner Report's executive summary, footnotes omitted):

Lehman employed off‐balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008. Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short‐term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction.  By recharacterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.  ...

Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10‐K and 10‐Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet;” felt that “there was no substance to the transactions;” and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public.  In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.

The Examiner's Report describes that no U.S. law firm would opine that the accounting treatment for Repo 105 was appropriate.  Accordingly, Lehman moved these transactions abroad:

Lehman first introduced its Repo 105 program in approximately 2001. Unable to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo 105 program under the aegis of an opinion letter the Linklaters law firm in London wrote for LBIE, Lehman’s European broker‐dealer in London, under English law. Accordingly, if United States‐based Lehman entities such as LBI and LBSF wished to engage in a Repo 105 transaction, they transferred their securities inventory to LBIE in order for LBIE to conduct the transaction on their behalf.

Lehman increased its reliance on Repo 105 to improve its reported performance:

Lehman dramatically ramped up its use of Repo 105 transactions in late 2007 and early 2008 despite concerns about the practice expressed by Lehman officers and personnel. In an April 2008 e‐mail asking if he was familiar with the use of Repo 105 transactions to reduce net balance sheet, Bart McDade, Lehman’s former Head of Equities (2005–2008) and President and Chief Operating Officer (June–September 2008), replied: “I am very aware . . . it is another drug we r on.” A week earlier, McDade had recommended to Lehman’s Executive Committee that the firm set a cap on the use of Repo 105 transactions. A senior member of Lehman’s Finance Group considered Lehman’s Repo 105 program to be balance sheet “window‐dressing” that was “based on legal technicalities.”* Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.

* Why do lawyers get blamed for accounting technicalities? (editorial comment)

The Examiner concludes that:

a fact finder could find that Lehman’s failure to disclose its use of Repo 105 transactions to impact its balance sheet at a time when both the market and senior Lehman management were keenly focused on the reduction of Lehman’s firm‐wide net leverage and balance sheet, and particularly in light of the specific volumes at which Lehman undertook Repo 105 transactions at quarter‐end in fourth quarter 2007, first quarter 2008, and second quarter 2008, materially misrepresented Lehman’s true financial condition.

Examiner's Report: Colorable Claims Against Lehman Senior Management and Audit Firm

It cost $36 million and a year to produce, so the logical question is what will result from Examiner Anton Valukas' Report (2,200 pages) on the causes of the Lehman Brothers collapse and whether there are colorable claims against individuals and entities relating to the collapse.  Jenner & Block posted the complete report on its webite, and I am working my way through parts of it.  The bankruptcy judge was right -- it is a fascinating read, better than most journalists' books on business scandals.

Here are some highlights from the introduction and executive summary.  I have omitted footnotes, but otherwise the text is verbatim.

From the Introduction:

There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate.  Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet
manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome.

On the importance of the repo transactions ("Repo 105"):

Lehman did not disclose, however, that it had been using an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet – by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008. In an ordinary repo, Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehman’s balance sheet. In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet. With Repo 105 transactions, Lehman’s reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have to have been reported at 13.9.

On the nondisclosure of Repo 105:

Lehman did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors. Lehman’s auditors, Ernst & Young, were aware of but did not question Lehman’s use and nondisclosure of the Repo 105 accounting transactions.

From the executive summary on why Lehman failed:

Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. ...

As to whether there are colorable claims.  First, the Examiner makes clear that by "colorable claim" he means more than simply an allegation that could survive a motion to dismiss.  Instead, because of his extensive investigation, he means by "colorable claim" a higher standard -- sufficient credible evidence exists to support a finding of a trier of fact.

From the executive summary:

The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements – Lehman’s CEO Richard S. Fuld, Jr., and its CFOs Christopher O’Meara, Erin M. Callan and Ian T. Lowitt. There are colorable claims against Lehman’s external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.

Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. Lehman’s own accounting personnel described Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end.” Lehman used Repo 105 “to reduce balance sheet at the quarter‐end.”

Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman’s financial statements and who failed to disclose Lehman’s use and extent of Repo 105 transactions to manage its balance sheet.

And what about the independent auditors, Ernst & Young?  Again from the executive summary:

In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end. The next day ‐ on June 13, 2008 ‐ Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee’s assertions, despite an express direction from the Committee to advise on all allegations raised by Lee. Ernst &
Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions. Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee’s allegations and in connection with its audit and review of Lehman’s financial statements.

The Examiner has done his job.  Will the regulators and prosecutors do theirs?

Bankruptcy Examiner Reveals Accounting Tricks at Lehman

The examiner appointed by the bankruptcy court to examine the September 2008 collapse of Lehman Brothers reveals, in a 2,200 page report, new information about how Lehman used accounting tricks in efforts to conceal its deteriorating financial condition.  For details and the report, see:

NYTimes, Report Details How Lehman Hid Its Woes as It Collapsed

Wall St. J,  Examiner: Lehman Torpedoed Lehman

Dodd Says Senate Bill on Monday

Today Senate Banking Committee Chairman Chris Dodd (D-CT) issued the following statement on financial reform.
 
“On Monday, I will present to my colleagues a substitute to the original financial reform package, unveiled last November.”
 
“Over the last few months, Banking Committee members have worked together to try and produce a consensus package.  Together we have made significant progress and resolved a many of the items, but a few outstanding issues remain.”
 
“It has always been my goal to produce a consensus package.  And we have reached a point where bringing the bill to the full committee is the best course of action to achieve that end.  I plan to hold a full committee markup the week of March 22nd.”
 
“I have been fortunate to have a strong partner in Senator Corker, and my new proposal will reflect his input and the good work done by many of our colleagues as well.”
 
“Our talks will continue, and it is still our hope to come to agreement on a strong bill all of the Senate can be proud to support very soon.”

Connecticut AG Sues Moody's and S&P, Alleging Tainted Credit Ratings for Risky Investments

Connecticut Attorney General Richard Blumenthal today sued Moody’s and Standard & Poor’s, alleging that they knowingly assigned tainted credit ratings to risky investments backed by sub-prime loans.  The lawsuits are sovereign enforcement actions brought under the Connecticut Unfair Trade Practices Act.  

According to the press release, Moody’s and S&P’s lack of independence and objectivity, violating the Connecticut Unfair Trade Practices Act, manifested itself in several ways, including:

 Moody’s and S&P modified rating methodologies to make more money: In short, in direct contrast to their public representations, and unbeknownst to investors and other market participants, Moody’s and S&P’s rating methodologies were directly influenced by a desire to please their clients and enhance their own revenue. Assessing actual credit risk was of secondary importance to revenue goals and winning new business. 

Ratings shopping: Issuers unhappy with a credit rating agency’s initial analysis can attempt to influence the process by informing the rating agency of a more desirable rating that one of its competitors is willing to assign. As a result, the rating agency knows that it must meet its competitor’s rating or forgo the revenue altogether. Both Moody’s and S&P knuckled under to this pressure and allowed it to influence the ratings they assigned to structured finance securities. 

Despite public representations of vigilant monitoring of conflicts of interest inherent to the Issuer Pays business model, Moody’s marginalized its own compliance departments and even punished employees who raised concerns about its lack of independence and objectivity. In some cases, compliance employees were given poor performance evaluations, less compensation and even demoted for interfering with Moody’s ability to please the large issuers of structured finance securities that paid the majority of Moody’s fees.

The Attorney General previously brought litigation against all three credit rating agencies -- Moody’s, S&P and Fitch -- that was filed in July 2008. The earlier lawsuits allege that the agencies knowingly gave state, municipal and other public entities lower credit ratings as compared to other forms of debt with similar or even worse rates of default. Those cases remain pending.

SEC Charges Broker with Diverting $3.3 Million of Customer's Funds to Another Customer

The SEC today charged Jose O. Vianna, Jr., a former registered representative at a New York based broker-dealer named Maxim Group LLC ("Maxim"), with a fraudulent scheme to divert millions of dollars in trading profits from a large institutional customer of the broker to another of the broker's customers.  The complaint alleges that Vianna diverted profitable trades from the account of a large Spanish bank, referred to in the Complaint as Customer A, to the account of Creswell Equities, Inc. ("Creswell"), a British Virgin Islands company. The Commission's complaint alleges that over $3.3 million in trading profits were diverted from Customer A to Creswell.

The complaint alleges that 57 times between July 2007 and March 2008, Vianna simultaneously entered orders in the accounts of Customer A and Creswell to trade the same amounts of the same stock. Each time, he placed a buy order in one customer's account and a sell order in the other customer's account. When the market moved to make Customer A's trade profitable and Creswell's trade unprofitable, Vianna improperly misused his access to Maxim's order management system to divert Customer A's profitable trade to Creswell and Creswell's unprofitable trade to Customer A by changing Maxim's records to inaccurately reflect the account for which the orders were entered. However, when the market moved so that Creswell's trade was profitable and Customer A's unprofitable, Vianna let the trades remain as originally entered.

The Commission seeks permanent injunctive relief from Vianna, as well as disgorgement of ill-gotten gains plus prejudgment interest, and civil money penalties.  The Commission's complaint also charges Creswell as a relief defendant, and seeks disgorgement of Creswell's illicit profits, plus prejudgment interest. On March 9, 2010, the Court entered an order temporarily freezing Creswell's assets pending a hearing on the Commission's application to freeze Creswell's assets for the duration of the action.

Former HBOC GC Settles Accounting Fraud Charges at McKesson HBOC

The SEC settled charges against Jay Lapine, the former GC of HBO & Company, a vendor of health care technology that merged with McKesson in 1999. Lapine was charged in a previously-filed action with securities fraud in connection with a financial reporting fraud at McKesson HBOC, Inc. (now, McKesson Corporation), a Fortune 100 company headquartered in San Francisco, California. Lapine consented to the entry of judgment without admitting or denying the allegations of the Commission's complaint except as to jurisdiction.

The Complaint, filed September 27, 2001, alleged that Lapine, together with other senior executives, participated in a long-running fraudulent scheme to inflate the revenue and net income of HBOC. As part of this scheme, Lapine took part in negotiating two large backdated transactions with side agreements containing cancellation contingencies that enabled the companies to recognize revenue in earlier reporting periods. Both of these practices failed to comply with Generally Accepted Accounting Principles. The fraud enabled HBOC and McKesson HBOC to report falsely in press releases and in periodic reports HBOC filed with the Commission that the companies were having an unbroken run of financial success and had continually exceeded analysts' expectations. However, when McKesson HBOC announced in April 1999 that the company was conducting an internal investigation into financial reporting irregularities, its shares tumbled from approximately $65 to $34, a drop that slashed its market value by more than $9 billion. The Commission also alleged that Lapine failed in his gatekeeper role during the multi-year long scheme.

The final judgment against Lapine permanently enjoins him from violating federal securities law, bars him from acting as an officer or director of a public company for a period of five years, and orders him to pay a civil penalty of $60,000. Lapine was acquitted on November 19, 2009 of criminal charges related to the fraud at HBOC and McKesson HBOC.

SEC Obtains Emergency Relief Against Ponzi Scheme Pitching Phony "Turkish Eurobonds"

On March 9, 2010, the SEC obtained an emergency court order to shut down a Ponzi scheme targeting retirees in California and Illinois by inviting them to estate planning seminars and later coaxing them to buy promissory notes for purported Turkish investments.  According to the SEC's complaint, USA Retirement Management Services ("USARMS") and managing partners Francois E. Durmaz and Robert C. Pribilski mass-mailed promotional materials to prospective investors and invited them to estate planning seminars held at country clubs and banquet halls. They gained retirees' confidence in follow-up meetings and portrayed themselves as educated and experienced in foreign investments specifically tailored to the needs of seniors. Durmaz and Pribilski then pitched what they represented as safe, guaranteed investments in "Turkish Eurobonds" through the purchase of USARMS promissory notes that would earn annual returns between 8 and 11 percent.

The SEC alleges that USARMS raised at least $20 million from more than 120 investors, but did not actually invest the money in Turkish Eurobonds as promised. Instead, returns were paid to earlier investors with funds received from new investors in Ponzi-like fashion. Durmaz and Pribilski further misused investor funds to finance their other businesses and purchase such things as luxury automobiles, homes, vacations, and web-based pornography. They also wired investor money into bank accounts belonging to individuals living in Turkey who are named as relief defendants in the SEC's case.

The U.S. District Court for the Central District of California granted the SEC's request for emergency relief for investors, including an order temporarily enjoining defendants from future violations of the antifraud provisions and freezing their assets.

Former Chief Investment Officer of New York Pension Fund Pleads Guilty to Corruption Charges

New York Attorney General Andrew M. Cuomo today announced that David Loglisci, the former Chief Investment Officer at the Office of the New York State Comptroller (OSC), who was indicted last year along with co-defendant Henry “Hank” Morris, pled guilty to a Martin Act felony for his role in the corruption of the New York State Common Retirement Fund (CRF) and will cooperate in the ongoing investigation.  Today’s plea is part of a more than two-year ongoing investigation into corruption involving the Office of the State Comptroller and the Common Retirement Fund. The charges to date allege a complex criminal scheme involving numerous individuals operating at the highest political and governmental levels under former Comptroller Alan Hevesi, in which the State pension fund was used as a piggy bank for the Comptroller’s chief political aide and a favor bank for political allies and other friends.

The State pension fund is the biggest pool of money in the state and the third largest pension fund in the country, most recently valued at approximately $129 billion. At the time of the events charged, it was valued at approximately $150 billion. The New York State Comptroller is the sole trustee of the fund, responsible for managing and investing the pension fund solely in the best interests of the over one million current and former public employees and their families.

FINRA CEO Speaks on Reforms in Fixed Income Markets

Rick Ketchum, Chairman and CEO, FINRA, spoke at the FINRA Fixed Income Conference on March 9, 2010.  Here is an excerpt from his conclusion:

We as regulators must keep pace with the changes in fixed income markets—recognizing the differences across fixed income markets, and respecting those differences, while ensuring investor protection and market integrity. FINRA is committed to meeting these objectives as we move forward with our ambitious agenda for the fixed income markets, focused on transparency. And we will work to ensure these objectives are adhered to as we continue our cooperation with the Administration, Congress, U.S regulatory agencies, and our counterparts in other countries.

 But we should keep in mind that new regulations can only achieve so much. For the reforms to trigger lasting market improvements, it is just as important for fixed income leaders to communicate to their industry colleagues that change is underway, and that there is a duty to comply with both the letter of the reforms, as well as the spirit underpinning them. I am hopeful that the industry will embrace the work regulators are doing to shape the future of the fixed income markets, because I believe it will lead to more robust markets. The lesson for both sides is: where there is doubt, err on the side of investors.