Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Tuesday, August 31, 2010

Treasury Releases Data on U.S. Holdings of Foreign Securities

Treasury released preliminary data from an annual survey of U.S. portfolio holdings of foreign securities at year-end 2009.  Final survey results, which will include additional detail as well as revisions to the data, will be reported on October 29, 2010.  The survey was undertaken jointly by the U.S. Department of the Treasury, the Federal Reserve Bank of New York and the Board of Governors of the Federal Reserve System. 

A complementary survey measuring foreign holdings of U.S. securities also is conducted annually.  Data from the most recent such survey, which reports on securities held on June 30, 2010, are currently being processed. Preliminary results are expected to be reported on February 28, 2011.

The survey measured U.S. holdings at year-end 2009 of approximately $6.0 trillion, with $4.0 trillion held in foreign equities, $1.6 trillion in foreign long-term debt securities (original term-to-maturity in excess of one year), and $0.4 trillion held in foreign short-term debt securities.  The previous such survey, conducted as of year-end 2008, measured U.S. holdings of $4.3 trillion, with $2.7 trillion held in foreign equities, $1.3 trillion in foreign long-term debt securities and $0.3 trillion held in foreign short-term debt securities.

August 31, 2010 in News Stories | Permalink | Comments (0) | TrackBack (0)

SEC Cautions Rating Agencies about Deceptive Ratings Conduct and Internal Controls

The SEC today issued a report cautioning credit rating agencies about deceptive ratings conduct and the importance of sufficient internal controls over the policies, procedures, and methodologies the firms use to determine credit ratings.  The SEC's Report of Investigation stems from an Enforcement Division inquiry into whether Moody's Investors Service, Inc. (MIS) — the credit rating business segment of Moody's Corporation — violated the registration provisions or the antifraud provisions of the federal securities laws.

The Report says that because of uncertainty regarding a jurisdictional nexus between the United States and the relevant ratings conduct, the Commission declined to pursue a fraud enforcement action in this matter. The Report notes that the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act provided expressly that federal district courts have jurisdiction over SEC enforcement actions alleging violations of the antifraud provisions of the securities laws when conduct includes significant steps, or a foreseeable substantial effect, within the United States. The Report also notes that the Dodd-Frank Act amended the securities laws to require nationally recognized statistical rating organizations (NRSROs) to "establish, maintain, enforce, and document an effective internal control structure governing the implementation of and adherence to policies, procedures, and methodologies for determining credit ratings."

According to the Report, an MIS analyst discovered in early 2007 that a computer coding error had upwardly impacted by 1.5 to 3.5 notches the model output used to determine MIS credit ratings for certain constant proportion debt obligation notes. Nevertheless, shortly thereafter during a meeting in Europe, an MIS rating committee voted against taking responsive rating action, in part because of concerns that doing so would negatively impact MIS's business reputation.

MIS applied in June 2007 to be registered with the Commission as an NRSRO. The Report notes that the European rating committee's self-serving consideration of non-credit related factors in support of the decision to maintain the credit ratings constituted conduct that was contrary to the MIS procedures used to determine credit ratings as described in the MIS application to the SEC.

In the Report of Investigation, the Commission makes clear that credit rating agencies registered with the SEC must implement and follow appropriate internal controls and procedures governing their determination of credit ratings, and must also take reasonable steps to ensure the accuracy of statements in applications or reports submitted to the SEC.

The Report cautions NRSROs that, when appropriate, the Commission will pursue antifraud enforcement actions against deceptive ratings conduct, including actions pursuant to the Dodd-Frank Act provisions regarding conduct that physically occurs outside the United States but involves significant steps or foreseeable effects within the U.S.

Under Section 21(a) of the Securities Exchange Act of 1934, the Commission may investigate violations of the federal securities laws and at its discretion "publish information concerning any such violations."

August 31, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Monday, August 30, 2010

SEC Approves Rule Change on RR's Outside Business Activities

The SEC granted approval to FINRA Rule 3270 (Outside Business Activities of Registered Persons).  As part of the process of developing a new consolidated rulebook, FINRA proposed to adopt NASD Rule 3030 (Outside Business Activities of an Associated Person) as FINRA Rule 3270 (Outside Business Activities of Registered Persons) in the Consolidated FINRA Rulebook with moderate changes.  Proposed FINRA Rule 3270 would prohibit any registered person from being an employee, independent contractor, sole proprietor, officer, director or partner of another person, or being compensated, or having the reasonable expectation of compensation, from another person as a result of any business activity outside the scope of the relationship with his or her member firm, unless he or she has provided prior written notice to the member. The proposed rule change would expand the obligations imposed under NASD Rule 3030, which prohibits any registered person from being employed by or accepting any compensation from any person as a result of any outside business activity, other than passive investment, unless he has provided prompt written notice to his member firm.  The rule change implements additional protections such as the need for registered persons to provide prior written notice to its member firms of proposed outside business activities and for firms to implement a system to assess the risk that these outside business activities may cause. 

August 30, 2010 in Other Regulatory Action, SEC Action | Permalink | Comments (0) | TrackBack (0)

Former Dell Chief Accounting Officer Settles Accounting Fraud Charges

The SEC today charged former Dell Inc. ("Dell") Chief Accounting Officer Robert W. Davis for his role in the company's accounting fraud. Last month, the SEC charged Dell with fraud for materially misstating its operating results from fiscal year 2002 to fiscal year 2005. The SEC's complaint against Davis alleges that he materially misrepresented Dell's financial results by using various "cookie jar" reserves to cover shortfalls in operating results and engaged in other reserve manipulations from FY2002 to FY2005. Davis agreed to pay a $175,000 penalty and to pay disgorgement and pre-judgment interest to settle the SEC's charges.

The SEC separately charged today former Dell Assistant Controller Randall D. Imhoff with aiding and abetting Dell's improper accounting. Imhoff agreed to pay a $25,000 penalty and to pay disgorgement and pre-judgment interest to settle the SEC's charges.

The SEC's complaint against Davis, filed in federal district court in Washington, D.C., alleges that he directed the use of "cookie jar" reserves to cover shortfalls in operating results over three years. This fraudulent accounting made it appear that Dell was consistently meeting Wall Street earnings targets through the company's management and operations. The SEC's complaint further alleges that the reserve manipulations allowed Dell to materially misstate its operating expenses as a percentage of revenue - an important financial metric that Dell highlighted to investors. The manipulations also enabled Dell to materially misstate the operating income of its Europe, Middle East and Africa ("EMEA") segment.

In a separate complaint also filed in federal district court in Washington, D.C., the SEC alleges that Imhoff aided and abetted Dell's improper use of "cookie jar" reserves and other reserve manipulations to cover shortfalls in Dell's operating results from FY2002 to FY2004. The SEC's complaint alleges that Imhoff, acting under his supervisors' general direction, planned and issued instructions regarding Dell's build-up and use of cookie jar reserves. In an example of his involvement in Dell's other improper reserve manipulations, the SEC's complaint alleges that Imhoff failed to ensure that Dell increased its reserves, as required by GAAP, after learning that an accrual to cover the costs of closing a Dell facility in Texas was inadequate.

August 30, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Saturday, August 28, 2010

Ribstein on Jones v. Harris Associates

Federal Misgovernance of Mutual Funds, by Larry E. Ribstein, University of Illinois College of Law, was recently posted on SSRN.  Here is the abstract:

In Jones v. Harris Associates, the Supreme Court interpreted investment advisers’ fiduciary duty regarding compensation for services under Section 36(b) of the Investment Company Act of 1940. The Court endorsed an open-ended Second Circuit standard over a more determinate Seventh Circuit test calling only for full disclosure and no “tricks.” This paper shows that Congress created and must solve the fundamental problem the Court faced in Jones. At one level the problem stems from the existence of an investment adviser fiduciary duty as to compensation and the corporate structure from which it springs. At a deeper level lies the more basic problem of federal interference in firm governance, which lacks state corporate law’s safety valve of interstate competition and experimentation. This discussion is appropriate in light of the increasing federal role evident in the enactment of broad new financial regulation.

August 28, 2010 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Murdock on The Financial Reform Act

The Financial Reform Act: Will it Succeed in Reversing the Causes of the Subprime Crisis and Prevent Future Crises?, by Charles W. Murdock, Loyola University Chicago School of Law; Loyola University of Chicago, was recently posted on SSRN.  Here is the abstract:

The current financial crisis, which could have plunged the world into a financial abyss similar to the Great Depression, is far from resolved. The financial institutions, which this article asserts caused the crisis, have returned to profitability and have paid billions of dollars in bonuses, while ordinary Americans have borne the brunt of the meltdown, with formal unemployment hanging around the 10% mark. This has caused some to comment that profits have been privatized and risk has been socialized. Two years after the economic meltdown, the impact continues as local governments turn off streetlights, cut back on police and fire departments, close down transit systems, return paved roads to gravel, and put schools on a four-day week.

Democrats in the House and Senate finally agreed on a financial regulation bill. Opposition to the bill in part was based on the belief that Fannie Mae and Freddie Mac were the cause of the subprime crisis. However, as this article demonstrates, it was the “big banks,” by funding the subprime lenders, buying their mortgages and securitizing them, slicing them to form CDOs and synthetic CDOs through derivatives, and leaning on the credit rating agencies to get AAA ratings for junk, there were the primary cause of the financial crisis.

Parts I and II are fairly dry: they deal with data. But, in a financial crisis, numbers are important. Part I deals with the incredible increase in assets under investment, which created the demand for the toxic mortgages, while Part II analyzes the changing characteristics of the subprime mortgages and their dramatic increase in volume and riskiness, a fact that was not recognized by the financial professionals.

In Part III, the roles of the borrowers, the mortgage brokers, the mortgage lenders, Fannie Mae and the investment banks, the credit rating agencies, and derivatives are explored, together with the incentives that drove each participant. The various titles of the Financial Reform Act are analyzed from the standpoint of the impact they will have on the foregoing players in order to prevent future crises.

The Conclusion asserts that the Financial Reform Act should prevent a future financial crisis that mirrors the past crisis. However, it does not adequately deal with the underlying issue that drives any financial crisis: management incentives that lead to excessive risk-taking. Nor does it deal with the ever increasing aggregation of financial power in large financial institutions.

August 28, 2010 in Law Review Articles | Permalink | Comments (1) | TrackBack (0)

Partnoy on Credit Default Swaps As Substitutes for Credit Ratings

Credit Default Swap Spreads as Viable Substitutes for Credit Ratings, by Frank Partnoy, University of San Diego School of Law, was recently posted on SSRN.  Here is the abstract:

We evaluate the viability of credit default swaps (CDS) spreads as substitutes for credit ratings. We focus on CDS spreads based on the obligations of financial institutions, particularly fifteen large financial institutions that were prominently involved in the recent financial crisis. Our data, from 2006-09, show that CDS spreads incorporate new information about as quickly as equity prices, and significantly more quickly than credit ratings. Although CDS spreads did not identify accumulating risk exposures before 2007, they quickly reflected disclosures and developments beginning in summer 2007 at the latest. Thus, CDS spreads are a promising market-based tool for regulatory and private purposes, and they may serve as a viable substitute for credit ratings.

August 28, 2010 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Friday, August 27, 2010

Hoffman & Steinberg on Milberg Weiss

The Ongoing Milberg Weiss Controversy, by Lonny Sheinkopf Hoffman, University of Houston Law Center, and Alan F. Steinberg, Department Political Science, was recently posted on SSRN.  Here is the abstract:

In this paper we revisit the ongoing controversy surrounding the Milberg Weiss prosecution. Our paper responds to an important, recent empirical study by Michael A. Perino that claims to have found evidence to support the government’s assertion (made without evidentiary support) that class members were in fact injured by the payments Milberg made to the named representatives. Notwithstanding the carefully constructed and rigorous study Perino has authored, we argue that the evidentiary proof of harm he claims to have found simply cannot withstand scrutiny. We raise several methodological critiques of the study. Although we did not have access to Perino’s full data, we were able to replicate some of it by using the same database of securities class action settlements on which he primarily relied. The replication data results validate some of our hypotheses. Most critically, the replication data strongly suggests that the reason why fees may have been higher in the indictment cases is that the almost all were filed before the Reform Act went into effect. By contrast, the vast majority of cases in the replication sample of Perino’s non-indictment cases were filed in a later period when fees have been lower. Additionally, the replication data we report is not consistent with some of the descriptive statistical findings Perino presents. Specifically, we find no difference either in mean or median fee awards between cases in which the government alleged Milberg paid a kickback and all other cases. Beyond the study’s methodological difficulties, we also show that there are equally substantial reasons to be concerned about the inferential conclusions Perino draws from the data. The big take away that Perino offers at the end of his study—that the evidence contradicts the claim that kickbacks paid to the named plaintiffs were a “victimless crime”—is not supported by the data he has collected and reported. Far from demonstrating that kickbacks allowed Milberg to obtain higher fees, his study fails to rule out the possibility that other, entirely benign reasons could explain the higher fees Milberg received, including that the fees were earned by the results obtained in settlements of the indictment cases.

August 27, 2010 in Law Review Articles | Permalink | Comments (0) | TrackBack (0)

Thursday, August 26, 2010

Raymond James Pays $3.5 Million to ARS Purchasers in Arbitrations

Since July 2010, FINRA arbitrators have ordered brokerage units of Raymond James Financial to buy back from customers auction rate securities (ARSs) totalling $3.5 million (3 separate proceedings).  By way of contrast, ARS purchasers have not generally been successful in judicial proceedings.  See, e.g., Defer LP v. Raymond James Financial, Inc.,654 F. Supp.2d 204 (S.D.N.Y. 2009).

Unlike many other firms, thus far securities regulators have not brought enforcement actions against Raymond James.  When the market for ARSs froze in February 2008, Raymond James customers held $1.9 billion in ARSs; today that amount has been reduced to about $600 million, according to a Raymond James spokesperson.  InvNews, Raymond James pays more auction rate claims.

August 26, 2010 in Securities Arbitration | Permalink | Comments (0) | TrackBack (0)

Wednesday, August 25, 2010

The Cheat Sheet on the New Directors' Nominations Proxy Rules

Here is the SEC's Announcement about the new Directors' Nominations Rules (Proxy Access) that includes a Fact Sheet with a basic description of new rules (for those who don't have time to read the 400 page release):

The new rules require companies to include the nominees of significant, long-term shareholders in their proxy materials, alongside the nominees of management. This "proxy access" is designed to facilitate the ability of shareholders to exercise their traditional rights under state law to nominate and elect members to company boards of directors.

Under the rules, shareholders will be eligible to have their nominees included in the proxy materials if they own at least 3 percent of the company's shares continuously for at least the prior three years.

Under the new rules:

Shareholders who otherwise are provided the opportunity to nominate directors at a shareholder meeting under applicable state or foreign law would be able to have their nominees included in the company proxy materials sent to all shareholders.

Shareholders also have the ability to use the shareholder proposal process to establish procedures for the inclusion of shareholder director nominations in company proxy materials.

Application of the new access rules to the smallest public companies — those that are defined as "smaller reporting companies" under SEC rules — will be deferred for three years.

Generally, the new rules will become effective 60 days after their publication in the Federal Register.

August 25, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

FINRA Fines Zions Direct for Not Disclosing Conflicts in Online CD Auctions

FINRA fined Zions Direct, Inc. $225,000 for failing to disclose the potential conflict of interest created by the participation of its affiliate, Liquid Asset Management (LAM), in online CD auctions conducted by Zions involving certificates of deposit (CDs) issued by Zions-affiliated banks.  Zions Direct, based in Salt Lake City, began auctioning CDs through its website in February 2007. Prior to November 2008, the firm failed to disclose LAM's participation in the auctions to retail investors bidding in the auctions. FINRA found that the closing yields in some auctions may have been higher had LAM not participated.

 Beginning in November 2008, Zions Direct generally disclosed LAM's participation in the auctions, yet still failed to disclose the potential conflict of interest between the issuing banks affiliated with Zions and its customers who participated in the auctions.

FINRA also found that Zions Direct sent its current and prospective customers advertisements related to its CD auctions which contained misleading, unwarranted, and exaggerated statements and claims, and claims for which no reasonable basis had been provided. For example, some of the firm's communications contained the following statements:

 "Where else can you bid with the big boys and win?"
"Crush The National Average For CD Yields."
"Higher yields on CDs."

In concluding this settlement, Zions Direct neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

August 25, 2010 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

SEC Alleges Insider Trading in Advance of BHP Tender Offer for Potash

Just as night follows day, so the announcement of a big tender offer is followed by allegations of insider trading.  The SEC charged two residents of Madrid, Spain with insider trading and obtained an emergency court order to freeze their assets after they allegedly made nearly $1.1 million in illegal profits by trading in advance of last week's public announcement of a multi-billion dollar cash tender offer by BHP Billiton Plc to acquire Potash Corp. of Saskatchewan Inc.

The SEC alleges that Juan Jose Fernandez Garcia and Luis Martin Caro Sanchez purchased — on the basis of material, non-public information about the impending tender offer — hundreds of "out-of-the-money" call option contracts for stock in Potash in the days leading up to the public announcement of BHP's bid on August 17. Garcia is the head of a research arm at Banco Santander, S.A. — a Spanish banking group advising BHP on its bid. Garcia and Sanchez jointly spent a little more than $61,000 to purchase the contracts in U.S. brokerage accounts. Immediately after BHP's offer was announced publicly on August 17, Garcia and Sanchez sold all of their options for illicit profits of nearly $1.1 million.

According to the SEC's complaint filed Friday in U.S. District Court for the Northern District of Illinois and unsealed by the court today, BHP made an unsolicited $38.6 billion offer to purchase all of the stock of Potash for $130 per share in cash. The acquisition share price represented a 16 percent premium above Potash's closing price of $112.15 on August 16. Potash, based in Saskatoon, Canada, is the world's largest producer of fertilizer minerals and its stock trades on the New York Stock Exchange. BHP, based in Melbourne, Australia, is the world's largest mining company.

The SEC alleges that Garcia was in possession of material, nonpublic information regarding BHP's offer to acquire Potash while he purchased approximately 282 call option contracts for Potash stock from August 12 to 16. The majority of the contracts were set to expire on August 21, and all but six of the call option contracts purchased by Garcia were out-of-the-money. Sanchez, while in possession of material, nonpublic information regarding BHP's offer to acquire Potash, purchased approximately 331 out-of-the-money call option contracts for Potash stock on August 12 and 13. He purchased the contracts in an account at Interactive Brokers LLC — the same U.S. brokerage firm through which Garcia traded his Potash call option contracts. Sanchez's contracts were set to expire within weeks of the purchase date. Neither individual had previously traded this year in Potash securities through his account at Interactive Brokers.

The emergency court order obtained late Friday by the SEC on an ex parte basis and unsealed by the court today freezes approximately $1.1 million in assets and, among other things, grants expedited discovery and prohibits Garcia and Sanchez from destroying evidence.

August 25, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

SEC Releases Final Rules on Proxy Access

The SEC released today the much-anticipated final rules on proxy access and directors' nominations.  I set forth below the release's introduction; I will analyze the new rules in a subsequent post.

We are adopting changes to the federal proxy rules to facilitate the effective exercise of shareholders’ traditional state law rights to nominate and elect directors to company boards of directors. The new rules will require, under certain circumstances, a company’s proxy materials to provide shareholders with information about, and the ability to vote for, a shareholder’s, or group of shareholders’, nominees for director. We believe that these rules will benefit shareholders by improving corporate suffrage, the disclosure provided in connection with corporate proxy solicitations, and communication between shareholders in the proxy process. The new rules apply only where, among other things, relevant state or foreign law does not prohibit shareholders from nominating directors. The new rules will require that specified disclosures be made concerning nominating shareholders or groups and their nominees. In addition, the new rules provide that companies must include in their proxy materials, under certain circumstances, shareholder proposals that seek to establish a procedure in the company’s governing documents for the inclusion of one or more shareholder director nominees in the company’s proxy materials. We also are adopting related changes to certain of our other rules and regulations, including the existing solicitation exemptions from our proxy rules and the beneficial ownership reporting requirements.

August 25, 2010 in SEC Action | Permalink | Comments (1) | TrackBack (0)

Tuesday, August 24, 2010

SEC Charges Former Countrywide CEO with Approving Special Loans

The SEC has already charged Angelo Mozilo, the former CEO of Countrywide, with fraud and insider trading.  Now it charges, in a filing opposing the motions to dismiss by Mozilo and other executives, that Mozilo personally approved mortgages for favored borrowers that violated the company's lending policies and ethical standards.  WPost, SEC: Ex-Countrywide chief approved special loans.

August 24, 2010 in News Stories | Permalink | Comments (0) | TrackBack (0)

Will SEC Issue Proxy Access Rules Tomorrow?

SEC's Open Meeting Agenda for August 25, 2010:

Item 1: Proxy Access Adoption

The Commission will consider whether to adopt changes to the federal proxy and other rules to facilitate director nominations by shareholders.

August 24, 2010 in SEC Action | Permalink | Comments (0) | TrackBack (0)

Monday, August 23, 2010

Boyfriend of Former Disney Employee Pleads Guilty to Attempt to Sell Earnings Information

The boyfriend of a former Walt Disney administrative assistant settled federal criminal charges that he offered to sell hedge funds early access to Disney's earnings reports.  Yonni Sebbag pleaded guilty to conspiracy to commit securities and wire fraud and one count of wire fraud in federal court in Manhattan and faces 27-33 months in prison.  Bonnie Hoxie, the former Disney employee, was not a party to the settlement, and the settlement does not affect pending SEC civil charges.  WSJ, Boyfriend of Ex-Disney Assistant Pleads Guilty in Insider Case.

August 23, 2010 in News Stories | Permalink | Comments (0) | TrackBack (0)

SEC Republishes FINRA Rule Proposal on Suitability, Know Your Customer

On August 13, 2010, the SEC sent to the Federal Register for publication Release No. 34-62718 - a Notice that the Financial Industry Regulatory Authority, Inc. (“FINRA”) had proposed rule changes to adopt FINRA Rules 2090 (Know Your Customer) and 2111 (Suitability).  On August 18, 2010, Commission staff discovered that several footnote cross-references in the August 13 Notice were inaccurate. Accordingly, today the SEC issued a corrected notice that does not substantively amend the August 13 Notice, but whose sole purpose is to rectify the footnote errors and alleviate any resulting confusion. As the number of footnotes affected is significant, the entire August 13 Notice is being republished with corrected footnotes.

August 23, 2010 in Other Regulatory Action | Permalink | Comments (0) | TrackBack (0)

Seventh Circuit Rejects Tightening of Class Certification Requirements in FOM Class Actions

The Seventh Circuit, in an opinion authored by Judge Esterbrook, recently reaffirmed the fraud-on-the-market theory of reliance and disapproved of the Fifth Circuit's Oscar Private Equity opinion that held that proof of loss causation is essential at the class certification stage, Schleicher v. Wendt (Aug. 20, 2010) (Download SchleigervWendt).  Stating that Oscar Private Equity would make class certification "impossible in many securities statutes," it rejected the Fifth Circuit's view that Basic "license[d] each court of appeals to set up its own criteria for certification of securities class actions or to 'tighten' Rule 23's requirements." 

In this case, plaintiffs were both long and short sellers of Conseco common stock, a large corporation whose stock was actively traded on the NYSE; a financial expert had concluded that the market for Conseco's stock was efficient.  Conseco's stock price was falling during the class period, and plaintiffs alleged that defendants made unduly optimistic statements to conceal the extent of its losses, until the company filed for bankruptcy.  Defendants argued that before class certification the district judge must determine that the contested statements actually caused material changes in stock prices.  In rejecting this, the Seventh Circuit refused to draw any distinctions between material misstatements that caused the stock price to rise and material misstatements that retarded the fall of the stock price and deemed defendants' invocation of "materialization-of-risk" irrelevant to the analysis.  In addition, it deemed irrelevant the fact that the proposed class included short sellers, because both long and short sellers are affected by news that influences the stock prices for their transactions.  Finally, the court reaffirmed the principle that under Rule 23, class certification is largely independent of the merits.

August 23, 2010 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Eighth Circuit Holds that Brokerage Firm can be Liable for RR's Ponzi Scheme

The Eighth Circuit recently held, in Lustgraf v. Behrens (Aug. 20, 2010)(Download LustgrafvBehrens), that investors stated controlling person claims under federal and state securities laws against a broker-dealer firm whose registered representative allegedly perpetrated a Ponzi scheme and misappropriated their investments.  The court, however, found that the investors did not state controlling person claims against the insurance company that was the parent corporation of the brokerage firm. 

In reversing the district court's dismissal of investors' controlling person claims against the brokerage firm, the court first discussed controlling person liability under Securities Exchange Act section 20(a) and reaffirmed its three-part test from previous caselaw.  To hold a controlling person liable, plaintiff must prove that (1) a primary violator violated the federal securities laws, (2) the alleged controlling person actually exercised control over the general operations of the primary violator, and (3) the alleged control person possessed -- but did not necessarily exercise -- the power to determine the specific acts upon which the underlying violation was predicated.  The court rejected the brokerage firm's argument that it could not be liable because the fraudulent transactions took place through another unaffilated firm and followed its precedent that "the involvement of a separate brokerage firm does not render inadequate an otherwise properly pleaded prima facie case for federal control person liability."  Although the RR's fraud did not take place through defendant brokerage firm, it was the firm that effectively provided the RR access to the market and that had the duty to monitor the RR's activities.  Questions of good faith and lack of knowledge, while potentially viable arguments at the summary judgment stage, are not relevant at the MTD stage.  Finally, the Eighth Circuit rejected the argument that culpable participation by a defendant is required to establish control person liability.

In contrast, the Eighth Circuit held that investors did not state control person claims against the insurance company parent of the brokerage firm because they failed to allege that the company actually exercised control over the RR's general operations.  The court stated that although it engaged in certain presumptions with respect to broker-dealers, it generally requires that a plaintiff allege facts demonstrating that the alleged control person "actually exercised" control over the primary violator's general operations.  Allegations that (1) the brokerage firm and the insurance company operated from the same location, (2) many of the brokerage firm's RRs were also agents of the insurance company, and (3) the two companies shared directors and employees were insufficient to show actual control.

The Eighth Circuit also held that investors stated control person claims against the brokerage firm under Nebraska, Iowa, and Arizona securities laws, holding that the statutes did not require a plaintiff to allege material aid in order to state a control person claim against a broker-dealer.  Rather, proof of direct or indirect control of the primary violator was sufficient.  It also held that investors stated a claim against the broker-dealer firm (but not the insurance company) based on respondeat superior, but failed to state a claim based on apparent authority.


August 23, 2010 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)

Sunday, August 22, 2010

Caskey on Pricing of Shares with Securities Class Actions

The Pricing of Shares in Equity Markets with Securities Class Action Lawsuits, by Judson A. Caskey, University of California at Los Angeles - Anderson School of Management, was recently posted on SSRN.  Here is the abstract:

This study develops an analytical model of a securities market in which investors can engage in securities class action lawsuits following a firm’s release of unfavorable news. Because all investors in the model have rational expectations, the model takes into account the fact that the buyers of the firm’s shares anticipate litigation, which reduces the price they are willing to pay and amplifies the price reaction to bad news. I derive the equilibrium prices in this model and apply it to the issues of manipulations of financial reports by the firm’s managers, litigation insurance and links between firm-specific information and cost of capital.

August 22, 2010 in Judicial Opinions | Permalink | Comments (0) | TrackBack (0)