Securities Law Prof Blog

Morgan Keegan Persuades Court That Written Disclosures of ARS Risks Trump Brokers' Oral Misstatements

A federal district court in Atlanta recently granted Morgan Keegan's motion for summary judgment in an SEC enforcement action involving auction rate securities (ARS).  In SEC v. Morgan Keegan & Co. (N.D. Ga. June 28, 2011), the court agreed with Morgan Keegan's argument that its written disclosures about liquidity risks trumped oral mistatements that MK brokers may have made to individual customers.  Among the written disclosures that the court highlighted were:

    (1) MK's ARS Manual (which tracked best practices set forth by SIFMA), which was sent to its ARS customers and posted on its website;

    (2) MK's annual newsletter to its customers that directed them to its website and ARS Manual;

    (3) its ARS Brochure available in its branch officers and upon request; and

    (4) Trade Confirmations that directed customers to its website and instructed them to contact MK within 10 days if the transaction was in error.

To counter the effect of the written disclosures, the SEC introduced the testimony of four customers who stated that their broker misrepresented the liquidity risks of ARS.  However, the court found such testimony from four customers insufficient:

Here, the SEC is attempting to bootstrap the investor-specific impact of the misrepresentations alleged by four individual investors as a grounds to seek relief for a whole class of investors without any evidence that the other investors received similar oral misrepresentations, without any evidence that Morgan Keegan encouraged or instructed its brokers generally to issue misleading statements, and without any evidence that other investors had not read the disclosures that were made in the variety of ways Morgan Keegan made them.

However, the court agreed with MK that:

that no reasonable juror could conclude that these four examples of alleged oral misrepresentations could conceivably “have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988).

The court emphasized that:

The SEC has not introduced any evidence to show that Morgan Keegan instituted a company-wide policy encouraging its brokers to misrepresent ARS liquidity risks.  The SEC also has not offered any evidence to show that Morgan Keegan was aware that its brokers were issuing misleading statements.

SEC Proposes Rules Imposing Business Conduct Standards on Security-Based Swap Dealers

The SEC voted to propose rules that would impose certain business conduct standards upon security-based swap dealers and major security-based swap participants when those parties engage in security-based swap transactions.  The SEC’s proposed rules stem from Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which authorizes the Commission to implement a comprehensive framework for regulating the over-the-counter swaps markets.

Public comments on the SEC’s proposal should be received by Aug. 29, 2011.

Raymond James Agrees to Buy Back ARS from Customers

Both the SEC and NASAA announced settlements with Raymond James requiring the firm to repurchase auction rate securities (ARS) bought before the 2008 financial collapse.  

According to the SEC’s administrative order, some registered representatives and financial advisers at Raymond James told customers that ARS were safe, liquid alternatives to money market funds and other cash-like investments. Among other things, representatives at Raymond James did not provide customers with adequate and complete disclosures regarding the complexity and risks of ARS, including their dependence on successful auctions for liquidity.

Without admitting or denying the SEC’s allegations, Raymond James consented to the SEC’s order and agreed to:

• Offer to purchase eligible ARS from its eligible current and former customers.
   
  Use its best efforts to provide liquidity solutions to customers who acted as institutional money managers who are not otherwise eligible customers.
   
  Reimburse excess interest costs to eligible ARS customers who took out loans from Raymond James after Feb. 13, 2008.
   
  Compensate eligible customers who sold their ARS below par by paying the difference between par and the sale price of the ARS, plus reasonable interest.
   
  At the customer’s election, participate in a special arbitration process with those eligible customers who claim additional damages.
   
  Establish a toll-free telephone assistance line and a public Internet page to respond to questions concerning the terms of the settlement.

SEC Proceeding Against Gupta is Postponed

The SEC's administrative proceeding against former McKinsey  executive Rajat Gupta, scheduled to begin on July 18, has been postponed without explanation for six months.  The SEC charges Gupta with tipping confidential inside information about Goldman Sachs and Procter & Gamble to Raj Rajaratnam when Gupta was on the boards of those companies.  The DOJ has not indicted Gupta on criminal charges.  Behind-the-scenes dickering between the DOJ and the SEC may be the reason.  NYTimes, S.E.C. Delays Rajat Gupta’s Trial for Six Months

BofA Announces $8.5 Billion Settlement of Countrywide RMBS Claims

Bank of America announced it reached agreement to settle nearly all of the claims related to Countrywide-issued first-lien residential mortgage-backed securities, representing 530 trusts with an original principal of $424 billion.  The agreement was entered into with The Bank of New York (Mellon), the trustee for the RMBS trusts covered by the settlement and is supported by a group of institutional investors.  BofA will pay $8.5 billion and will provide an additional $5.5 billion for representations and warranties exposure.

Silberman on Morrison

Morrison v. National Australia Bank: Implications for Global Securities Class Actions, by Linda Silberman, New York University School of Law, was recently posted on SSRN.  Here is the abstract:

The recent U.S. Supreme Court decision in Morrison v. National Australia Bank has had a significant impact on the extraterritorial reach of the U.S. Securities Laws as well as a limitating global class actions. Other countries have begun to fill a perceived gap with respect to such class actions, as the recent Converium case in the Netherlands and the Imax decision in Canada illustrate. In addition to thosse developments, the article discusses various post-Morrison developments in the United States, including the recent Dodd-Frank legislation, the possibility of bringing claims in the United States under foreign law, lower court interpretations of Morrison, including off-exchange case law. The author concludes with a call for increased regulatory cooperation as well as the need for an international treaty.

Jennings et alia on Deterrence Effects of SEC and Class Action Litigation

The Deterrence Effects of SEC Enforcement and Class Action Litigation, by Jared N. Jennings, University of Washington; Simi Kedia, Rutgers University, Newark - School of Business, Newark, Department of Finance & Economics; and Shivaram Rajgopal, Emory University - Goizueta Business School, was recently posted on SSRN.  Here is the abstract:

The United States’ (U.S.) Congress specifically requires the SEC to deter potential miscreants via its enforcement actions against firms that engage in fraudulent financial reporting. The U.S. is also unique in allowing private enforcement via class action lawsuits. In this paper, we investigate whether SEC enforcement actions and class action lawsuits, over the years 1996-2006, deter aggressive financial reporting behavior among the peers of fraudulent firms. We find significant deterrence associated with both SEC enforcement actions and class action lawsuits. The average peer firm, subject to SEC action and/ or litigation, reduces discretionary accruals equivalent to 14% to 22% of the median return on assets (ROA) in the aftermath of such enforcement. The results also inform target selection criteria associated with greater deterrence. Moreover, repeated and sustained enforcement in an industry, as opposed to isolated investigations, provides more effective deterrence.

Kaufman & Wunderlich on Fraud Created the Market

Fraud Created the Market, by Michael J. Kaufman, Loyola University Chicago School of Law, and John M. Wunderlich, was recently posted on SSRN.  Here is the abstract: 

Class actions are vital to protecting investors. Without class certification, individual damages may be de minimis, and investors would be unlikely to bring a securities fraud suit. This underenforcement allows those who defraud investors to skate liability and impugn the integrity of the marketplace. Presumptions of reliance facilitate classwide resolution of securities fraud claims. Under Rule 10b-5 for securities fraud the Supreme Court has presumed reliance to facilitate class actions where there is an omission in the face of a duty to disclose or where there is a fraud on the secondary market. The new frontier is whether federal courts should likewise presume reliance where fraud occurs on the primary market, giving rise to the fraud-created-the-market theory. Although some federal courts embraced the theory decades ago, a sharp conflict has arisen in the wake of the Court’s decision in Stoneridge Investment Partners v. Scientific-Atlanta, and the Third and Ninth Circuits have set the pace for rejecting the theory. In this Article, however, we show that the fraud-created-the-market theory is consistent with the fundamental bases for all presumptions in the law, comports with the Supreme Court’s interpretations of the federal securities laws as properly understood, and serves the investor-protection and market-integrity design of securities regulation.

We undertake a comprehensive definition and defense of the fraud-created-the-market theory and show why critics’ concerns regarding the presumption are unfounded. Properly understood, the fraud-created-the-market theory is about materiality and scienter - defendants should be held liable under the securities laws for committing fraud that is so material, without it, the securities never would have made it to market. In this regard, we show that a presumption of reliance for newly issued securities and the primary market is consistent with the Supreme Court’s collapsing the elements of securities fraud into a single inquiry whether the omission or misrepresentation was material. We build upon Professor Donald C. Langevoort’s fresh interpretation of the fraud-on-the-market presumption and his interpretation of Stoneridge, to show that the fraud-created-the-market presumption is grounded in the Court’s jurisprudence. We also find support for a judicially crafted presumption in the context of new issues in the securities laws themselves and in the common-law bases for presumptions. There is a pressing need for an answer to whether federal courts should adopt the fraud-created-the-market theory. The fraud-created-the-market theory will play an increasingly important role in actions against those involved in fraud relating to the issuance of subprime mortgage-backed securities.

CFPB Seeks Comment on Statutory Requirement to Define ‘Larger Participant’ in Certain Consumer Financial Markets

The Consumer Financial Protection Bureau (CFPB) announced the release of a Notice and Request for Comment seeking public input on a key element of the agency’s nonbank supervision program: the statutory requirement to define who is a “larger participant” in certain consumer financial markets.
 
Last year’s Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) charged the CFPB with ensuring that both banks and nonbanks comply with federal consumer financial laws. Historically, banks, thrifts, and credit unions have been subject to examinations by federal regulators, but other types of companies providing consumer financial services generally have not. Today, there are thousands of such companies that are not banks, and these nonbanks’ products form a significant portion of the consumer financial marketplace. 
 
The Dodd-Frank Act authorizes the CFPB to examine all sizes of nonbank mortgage companies, payday lenders, and private education lenders. Generally, before CFPB begins its nonbank supervision program in other markets, the Act requires that the agency first define by rule who is “a larger participant of a market for other consumer financial products or services.” The CFPB must issue an initial “larger participant” rule no later than July 21, 2012 -- one year after the designated transfer date.
 
To prepare for this eventual rulemaking, the CFPB is seeking public input through a Notice and Request for Comment, which identifies six markets for potential inclusion in an initial rule: debt collection; consumer reporting; consumer credit and related activities; money transmitting, check cashing, and related activities; prepaid cards; and debt relief services. The larger participant rule will not impose substantive consumer protection requirements.  Instead, the rule will enable CFPB to begin a supervision program for larger participants in certain markets.
 
The general issues discussed in the Notice include: 
 
·         What criteria to use to measure a market participant;
·         Where to set the thresholds for inclusion;
·         Whether to adopt a single test to define larger participants in all markets (measure the same criteria and use the same thresholds), or instead use tests tailored for specific markets;
·         What data are available to be used for these purposes;
·         What time period to use to measure the size of a market participant; 
·         How long a participant should remain subject to supervision after initially meeting the larger participant threshold, even if subsequently falling below the threshold; and
·         What consumer financial markets to include in the initial rule.  
 
The Notice and Request for Comment is available online, and contains information about how to submit responses. 
 

SEC Adopts Rules Implementing Amendments to Investment Advisers Act

The SEC adopted new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration by investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and require reporting by certain investment advisers that are exempt from registration. In addition, the SEC adopted rule amendments, including amendments to the Commission‘s pay to play rule, that address a number of other changes made by the Dodd-Frank Act.

SEC Adopts Final Rules on Exemptions for Advisers to Hedge Funds

The SEC adopted rules to implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to certain privately offered investment funds.  These exemptions were enacted as part of the Dodd-Frank Act. The new rules define "venture capital fund" and provide an exemption from registration for advisers with less than $150 million in private fund assets under management in the United States. The new rules also clarify the meaning of certain terms included in a new exemption from registration for "foreign private advisers."
DATES: Effective Date: July 21, 2011.

SEC Will Consider Proposing Rules on Business Conduct Standards for Security-Based Swap Dealers

The SEC's next Open Meeting will be held on June 29, 2011.  The subject matter of the Open Meeting will be:

The Commission will consider whether to propose rules under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act to establish business conduct standards for security-based swap dealers and major security-based swap participants.

 

SEC Adopts Rules Requiring Registration of Advisers to Hedge Funds

The SEC today adopted rules that require advisers to hedge funds and other private funds to register with the SEC, establish new exemptions from SEC registration and reporting requirements for certain advisers, and reallocate regulatory responsibility for advisers between the SEC and states.  These rules implement core provisions of the Dodd-Frank Wall Street Act regarding investment advisers, including those that advise hedge funds.

In addition, the Commission amended rules to expand disclosure by investment advisers, particularly about the private funds they manage, and revised the Commission’s pay-to-play rule.

The rules implement a transitional exemption period so that private advisers, including hedge fund and private equity fund advisers, newly required to register do not have to do so until March 30, 2012. The rules regarding exemptions for venture capital fund and certain private fund advisers are effective July 21, 2011.

SEC Adopts New "Family Offices" Rule under Advisers Act

The SEC adopted a rule to define “family offices” that will be excluded from the definition of an investment adviser under the Investment Advisers Act of 1940 (“Advisers Act”) and thus will not be subject to regulation under the Advisers Act. The scope of the rule 202(a)(11)(G)-1 is generally consistent with the conditions of exemptive orders that have been issued to family offices.

Former Taylor, Bean CEO Settles Charges of Aiding & Abetting TARP Fraud

On June 17, 2011 the SEC charged Paul R. Allen, the former chief-executive officer at Taylor, Bean and Whitaker Mortgage Corp. (TBW), which was once the nation's largest non-depository mortgage lender, with aiding-and-abetting the efforts of TBW’s former chairman, Lee B. Farkas, to defraud the U.S. Treasury's Troubled Asset Relief Program (TARP).  Without admitting or denying the SEC's allegations, Allen consented to the entry of a judgment permanently enjoining him from violation of Section 10(b) of the Exchange Act and Rules 10b-5.

According to the SEC's complaint, Farkas, with the substantial assistance of Allen, was responsible for a bogus equity investment that caused Colonial Bank to misrepresent that it had satisfied a prerequisite necessary to qualify for TARP funds. When Colonial Bank's parent company — The Colonial BancGroup, Inc. — issued a press release announcing it had obtained preliminary approval to receive $550 million in TARP funds, its stock price jumped 54 percent in the remaining two hours of trading, representing its largest one-day price increase since 1983.

The SEC's complaint alleges that Farkas falsely told BancGroup that a foreign-held investment bank had committed to financing TBW's equity investment in Colonial Bank. Farkas also issued a press release on behalf of TBW announcing that TBW had secured the necessary financing for BancGroup. Contrary to his representations to BancGroup and to the investing public, Farkas never secured financing or sufficient investors to fund the capital infusion. When BancGroup and TBW later mutually announced the termination of their stock purchase agreement, essentially signaling the end of Colonial Bank's pursuit of TARP funds, BancGroup's stock declined 20 percent. Allen substantially assisted Farkas in making these false statements.

Morgan Keegan Settles Charges Involving Bond Funds & Will Pay $200 Million to Customers

FINRA, the SEC and five state regulators from Alabama, Kentucky, Mississippi, South Carolina and Tennessee announced today that each has settled enforcement proceedings against Morgan Keegan & Company, Inc. Morgan Keegan will pay restitution of $200 million for customers who invested in seven affiliated bond funds, including the Regions Morgan Keegan Select Intermediate Bond Fund (Intermediate Fund). Morgan Keegan's affiliate, Morgan Asset Management, managed the funds.

According to the regulators, from the beginning of Jan. 2006 to the end of Sept. 2007, Morgan Keegan marketed and sold the Intermediate Fund to investors using sales materials that contained exaggerated claims, failed to provide a sound basis for evaluating the facts regarding the fund, were not fair and balanced, and did not adequately disclose the impact of market conditions in 2007 that caused substantial losses to the value of the Intermediate Fund. 

The Intermediate Fund invested predominantly in structured products, including mezzanine and subordinated tranches of structured securities including sub-prime products. Morgan Keegan marketed the Intermediate Fund as a relatively safe, investment-grade fixed income mutual fund investment when, in fact, the fund was exposed to risks associated with its investments in mortgage-backed and asset-backed securities, and subordinated tranches of structured products. By the beginning of 2007, Morgan Keegan was aware that the Intermediate Fund was experiencing difficulties related to the holdings in the fund impacted by turmoil in the mortgage-backed securities market yet failed to adequately disclose those risks in the sales materials or internal guidance. In March 2007, when adverse market conditions began to affect the fund, over 54 percent of the portfolio was invested in asset-backed and mortgage-backed securities, and 13.5 percent was invested in subprime products.

FINRA's settlement includes findings that Morgan Keegan failed to establish, maintain and enforce an adequate supervisory system, including written supervisory procedures reasonably designed to achieve compliance with NASD rules. Morgan Keegan's supervisory system and written procedures were not reasonably designed to ensure that its sales literature disclosed certain information as to risk and did not contain exaggerated claims. As a result, Morgan Keegan failed to adequately describe the nature, holdings and certain risks of the Intermediate Fund. In addition, beginning in 2007 when the particular risks associated with the Intermediate Fund's holdings began to impact negatively the holdings in the fund, Morgan Keegan failed to take steps reasonably designed to revise its advertising materials to inform customers of the specific risks of investing in the fund under the current market conditions.

In addition, the SEC announced that two Morgan Keegan employees also agreed to pay penalties for their alleged misconduct, including one who is now barred from the securities industry.  The Memphis-based firms, former portfolio manager James C. Kelsoe Jr., and comptroller Joseph Thompson Weller were accused in an administrative proceeding last year of causing the false valuation of subprime mortgage-backed securities in five funds managed by Morgan Asset Management from January 2007 to July 2007. The SEC’s order issued today in settling the charges also finds that Morgan Keegan failed to employ reasonable pricing procedures and consequently did not calculate accurate “net asset values” for the funds. Morgan Keegan nevertheless published the inaccurate daily NAVs and sold shares to investors based on the inflated prices.

The SEC’s order finds that Kelsoe instructed Morgan Keegan’s fund accounting department to make arbitrary “price adjustments” to the fair values of certain portfolio securities. The price adjustments ignored lower values for those same securities provided by outside broker-dealers as part of the pricing process, and often lacked a reasonable basis. In some instances, when price information was received that was substantially lower than current portfolio values, fund accounting personnel acted at the direction of Kelsoe and lowered values of bonds over a period of days in a series of pre-planned reductions to values at or closer to the price confirmations. As a result, during the interim days, the Morgan Keegan did not price those bonds at their current fair value.

The SEC’s order further finds that Kelsoe screened and influenced the price confirmations obtained from at least one broker-dealer. Among other things, the broker-dealer was induced to provide interim price confirmations that were lower than the values at which the funds were valuing certain bonds, but higher than the initial confirmations that the broker-dealer had intended to provide. The interim price confirmations enabled the funds to avoid marking down the value of securities to reflect current fair value. In some instances, Kelsoe induced the broker-dealer to withhold price confirmations, where those price confirmations would have been significantly lower than the funds’ current valuations of the relevant bonds.

According to the SEC’s order, through his actions Kelsoe fraudulently prevented a reduction in the NAVs of the funds that should otherwise have occurred as a result of the deterioration in the subprime securities market in 2007. His misconduct occurred in the context of a nearly complete failure by Morgan Keegan to employ the fair valuation policies and procedures adopted by the funds’ boards of directors to fair value the funds’ portfolio securities.

 

Court Permits Fund Investors to State Claim Based on Misrepresentations Inducing Them Not to Redeem Investments

A federal district court in Colorado, applying the Colorado Securities Act, recently held that limited partners stated a claim against a fund's administrator and its lender, based on their allegations that they made decisions not to redeem their investments, but to continue to reinvest their returns, because of defendants' misrepresentations about the fund's financial condition.  Agile Safety Variable Fund, L.P. v. Sky Bell, LP (D. Colo. May 31, 2011).  Ultimately, the fund turned out to be a Ponzi scheme.

The court did not view this as a pure "holder" case, because the plaintiffs increased their investment in the fund by reinvesting their returns.  In addition, the court noted that "the policy concerns underlying the holder doctrine" were inapplicable in this case, for two reasons.  First, unlike owners of common stock, plaintiffs could not trade in the securities in an open market, but could only redeem their investments directly with the fund.  Second, there were direct communications between the investors and the defendants.  Both these factors convinced the court that plaintiffs' theory was not too speculative to permit recovery.  Accordingly, the court held that plaintiffs were entitled to present their evidence to a jury.

 

SEC & JP Morgan Chase Settle Fraud Charges Involving CDO Sales

The SEC announced that J.P. Morgan Securities LLC will pay $153.6 million to settle SEC charges that it misled investors in a complex mortgage securities transaction just as the housing market was starting to plummet. In settling the SEC’s fraud charges against the firm, J.P. Morgan also agreed to improve the way it reviews and approves mortgage securities transactions.

The SEC alleges that J.P. Morgan structured and marketed a synthetic collateralized debt obligation (CDO) without informing investors that a hedge fund helped select the assets in the CDO portfolio and had a short position in more than half of those assets. As a result, the hedge fund was poised to benefit if the CDO assets it was selecting for the portfolio defaulted.

The SEC separately charged Edward S. Steffelin, who headed the team at an investment advisory firm that the deal’s marketing materials misleadingly represented had selected the CDO’s portfolio.

According to the SEC’s complaint, the CDO known as Squared CDO 2007-1 was structured primarily with credit default swaps referencing other CDO securities whose value was tied to the U.S. residential housing market. Marketing materials stated that the Squared CDO’s investment portfolio was selected by GSCP (NJ) L.P. – the investment advisory arm of GSC Capital Corp. (GSC) – which had experience analyzing CDO credit risk. Omitted from the marketing materials and unknown to investors was the fact that the Magnetar Capital LLC hedge fund played a significant role in selecting CDOs for the portfolio and stood to benefit if the CDOs defaulted.

The SEC alleges that by the time the deal closed in May 2007, Magnetar held a $600 million short position that dwarfed its $8.9 million long position. The SEC further alleges that in March and April 2007, J.P. Morgan knew it faced growing financial losses from the Squared deal as the housing market was showing signs of distress. The firm then launched a frantic global sales effort in March and April 2007 that went beyond its traditional customer base for mortgage securities.  By 10 months later, the securities had lost most or all of their value.

According to the SEC’s complaint, J.P. Morgan sold approximately $150 million of so-called “mezzanine” notes of the Squared CDO’s liabilities to more than a dozen institutional investors who lost nearly their entire investment.

Without admitting or denying the allegations, J.P. Morgan consented to a final judgment that provides for payment of $18.6 million in disgorgement, $2 million in prejudgment interest and a $133 million penalty. Of the $153.6 million total, $125.87 million will be returned to the mezzanine investors through a Fair Fund distribution, and $27.73 million will be paid to the U.S. Treasury. The settlement also requires J.P. Morgan to change how it reviews and approves offerings of certain mortgage securities. In addition, J.P. Morgan’s consent notes that it voluntarily paid $56,761,214 to certain investors in a transaction known as Tahoma CDO I. The settlement is subject to court approval.

 

Expert-Networks Consultant Found Guilty of Securities Fraud

The government continues its string of successes in insider-trading prosecutions.  A jury in S.D.N.Y. found Winifred Jiau, a former contract employee at NVIDIA, a California tech firm, and a consultant at an expert networks firm, guilty of selling confidential information to hedge fund employees.

WSJ, 'Guilty' for Expert Consultant

Credit Union Regulators Sue Underwriters of Mortgage-Backed Securities

The National Credit Union Administration (NCUA), as conservator for several failed wholesale credit unions, has, in separate actions, sued JP Morgan Chase and Royal Bank of Scotland in connection with their underwriting of morgage-backed securities sold to the credit unions.  Both actions were filed on June 20 in federal district court in Kansas.  In addition, NCUA stated it may bring actions against additional securities firms.

Brought under the Securities Act of 1933, both suits allege that the banks did not adhere to the underwriting standards set forth in the prospectuses and that the securities were "destined from inception to perform poorly."

WSJ, Feds Sue Bankers Over Fall in Bonds