Securities Law Prof Blog

SEC Staff Identifies Concerns at Credit Rating Agencies

SEC staff issued a report summarizing the staff's observations and concerns arising from the examinations of ten credit rating agencies registered with the SEC as Nationally Recognized Statistical Rating Organizations ("NRSROs") and subject to Commission oversight.  The report was required by the Dodd-Frank Act, which imposed new reporting, disclosure and examination requirements to enhance the regulation and oversight of NRSROs.

The report notes that despite changes by some of the examined credit rating agencies to improve their operations, Commission staff identified concerns at each of the NRSROs. These concerns included apparent failures in some instances to follow ratings methodologies and procedures, to make timely and accurate disclosures, to establish effective internal control structures for the rating process and to adequately manage conflicts of interest. The report notes that the staff made various recommendations to the NRSROs to address the staff’s concerns and that in some cases the NRSROs have already taken steps to address such concerns.

 

SEC Plans to Bring More Negligence Actions

The Wall St. Journal says that SEC enforcement attorneys may bring more enforcement actions against individuals alleging negligence instead of fraud and quote Ken Lench, the head of the SEC's structured and new-product enforcement unit to that effect.  The article cites as an example of the agency's change in strategy a complaint filed in June against Edward Steffelin, a former executive of GSC Capital Corp., charging negligence over allegedly inadequate disclosure in a mortgage bond deal.  Of course, negligence charges may not satisfy those who want to see heads roll, and defendants charged with negligence may be enboldened to fight the charges rather than settle.  WSJ, SEC Changes Tack on Enforcement Strategy

SIFMA Issues Best Practices on Expert Networks

SIFMA released a set of best practices for its member firms to provide guidance to broker-dealers on engaging and interacting with expert networks and their associated consultants.   SIFMA’s best practices include: 

• Core Assessment.  Firms that use expert networks should develop policies and implement procedures concerning the use of expert networks and the consultants identified by the expert networks.
• Training.  Firms should provide training for their employees and other affected individuals who interact with expert networks.
• Role of Firm Supervision.  Firms’ systems of supervisory oversight should be designed with a view of securing an understanding of a firm’s use of expert networks and their associated consultants.
• Firm Monitoring and Oversight. Firms should develop policies and procedures, or supplement existing politics and procedures that require firms to escalate for review and take appropriate action on “red flags” that become known to the firm.
• Agreement Between the Firm and Expert Network. Firms should favor written agreements with expert networks for repeating and/or substantial arrangements.
• Advising Consultants of Firm Policies. Firms should develop procedures, on a risk-assessed basis, for directly advising consultants associated with expert networks on firm’s policies regarding the use of material non-public information and confidential information, at the outset of any new engagement of a consultant.
• Additional Firm Policies and Controls. Firms should develop procedures obtaining from the expert network or a consultant, relevant and non-confidential information regarding any employment and/or other arrangements where the consultant may have access to material non-public information and confidential information.  

SIFMA also advises firms to consider whether the best practices may have applicability to situations where firms have direct relationships with consultants. 

SEC Charges Investment Adviser with Lying about "Soft Dollars"

The SEC charged Kurt Hovan, a San Francisco-area investment adviser, with fraud for lying to clients about how brokerage commission rebates were being used and producing phony documents to cover up the fraud during an SEC examination.  The SEC alleges that Hovan misappropriated more than $178,000 in “soft dollars” that he falsely claimed to be using to pay for legitimate investment research on his clients’ behalf. In reality, Hovan was secretly funneling the money for such undisclosed uses as office rent, computer hardware, and his brother’s salary. When SEC examination staff asked Hovan to provide documentation to back up his claims, he created phony research reports.

The SEC also charged his wife Lisa Hovan and his brother Edward Hovan for their roles in the fraudulent scheme at Hovan Capital Management (HCM).

SEC Settles Litigation With Former Execs of AOL Time Warner

The SEC announced that, on September 6, 2011, the United States District Court for the Southern District of New York entered a settled final judgment against J. Michael Kelly, the former Chief Financial Officer of AOL Time Warner Inc. and that on July 19, 2010, the district court entered a settled final judgment against Joseph A. Ripp, the former Chief Financial Officer of the AOL Division of AOL Time Warner, in SEC v. John Michael Kelly, Steven E. Rindner, Joseph A. Ripp, and Mark Wovsaniker, Civil Action No. 08 CV 4612 (CM)(GWG) (S.D.N.Y. filed May 19, 2008).

The final judgments resolve the Commission’s case against Kelly and Ripp. The Commission’s complaint alleges that, from at least mid-2000 to mid-2002, AOL Time Warner overstated the company’s online advertising revenue with a series of round-trip transactions. The complaint further alleges that the defendants participated in this effort and that their actions contributed to this overstatement. Online advertising revenue was a key measure by which analysts and investors evaluated the company.

Without admitting or denying the allegations in the complaint, Kelly consented to entry of a final judgment permanently enjoining him from future violations of Section 17(a)(2) and (3) of the Securities Act of 1933 and ordering him to pay disgorgement of $200,000 and a civil penalty of $60,000. Without admitting or denying the allegations in the complaint, Ripp consented to the entry of a final judgment permanently enjoining him from future violations of Rule 13b2-1 promulgated under the Securities Exchange Act of 1934 (Exchange Act) and from aiding and abetting violations of Exchange Act Section 13(b)(2)(A) and ordering him to pay disgorgement of $130,000 and a civil penalty of $20,000.

SEC Plans Roundtable on Conflict Minerals Reporting

The SEC announced that it will host a public roundtable on Oct. 18 to discuss the agency’s required rulemaking under Section 1502 of the Dodd-Frank Act, which relates to reporting requirements regarding conflict minerals originating in the Democratic Republic of the Congo and adjoining countries.  According to the SEC, the panel discussions will focus on key regulatory issues such as appropriate reporting approaches for the final rule, challenges in tracking conflict minerals through the supply chain, and workable due diligence and other requirements related to the rulemaking.

FINRA Fines Raymond James for Unreasonable Commissions

FINRA ordered Raymond James & Associates, Inc. (RJA) and Raymond James Financial Services, Inc. (RJFS) to pay restitution of $1.69 million to more than 15,500 investors who were charged unfair and unreasonable commissions on securities transactions. FINRA also fined RJA $225,000 and RJFS $200,000.  FINRA found that from Jan. 1, 2006 to Oct. 31, 2010, RJA and RJFS used automated commission schedules for equity transactions that charged more than15,500 customers nearly $1.69 million in excessive commissions on over 27,000 transactions involving, in most instances, low-priced securities. The firms' supervisory systems were inadequate because the firms established inflated schedules and rates without proper consideration of the factors necessary to determine the fairness of the commissions, including the type of security and the size of the transaction.

FINRA required the firms to revise their automated commission schedules to conform to the requirements of the Fair Prices and Commissions Rule.  In settling these matters, RJA and RJFS neither admitted nor denied the charges, but consented to the entry of FINRA's findings.

Judge Rakoff Reduces Madoff Trustee's Claims Against Net Winners

Judge Jed Rakoff significantly reduced the amount of money the Madoff trustee can potentially recover from "net winners."  In Picard v. Katz (S.D.N.Y. 09/27/11), the trustee sought to recover over a billion dollars from defendants  Saul Katz and Fred Wilpon on a variety of theories under federal bankruptcy law and New York Debtor and Creditor Law.  The court, however, dismissed all claims except those alleging actual fraud and equitable subordination and narrows the standard for recovery under the remaining claims.

First, because Madoff Securities was a registered broker-dealer, the liabilities of its customers are subject to the "safe harbor" of Bankruptcy Code section 546(e), under which a trustee cannot avoid settlement payments made by a stockbroker in connection with a securities contract except in cases of actual fraud.  The court relied on the plain language of the statute and rejected the trustee's argument that the policy behind the provision did not warrant its application to payments by Madoff Securities to its customers.  Accordingly, the court rejected all the trustee's claims based on principles of preference or constructive fraud.

Second, with respect to claims based on actual fraud, the court applied the bankruptcy code's avoidance provision permitting the trustee to clawback payments made by Madoff Securities to its customers within two years of the bankruptcy filing.  The bankruptcy code, however, provides that a transferee "that takes for value and in good faith" may retain its interest to the extent it gave value to the debtor in exchange for such transfer.  Accordingly, the trustee cannot recover the principal invested by a Madoff customer absent bad faith.  The trustee can recover a net winner's profits regardless of good faith.

Third, the court rejected the customers' argument that, so long as they acted in good faith, their profits, as reflected on their monthly statements, were legally binding obligations of Madoff Securities, so that payments of those profits were simply discharges of antecedent debts.  Rather, as to payments received in excess of their principal, customers would have to show that they took for value.

Fourth, the court leaves open whether the trustee can avoid as profits only what defendants received in excess of their investment during the two-year look back period or instead the excess they received over the course of their investment with Madoff.  According to the trustee's complaint, defendants' profits amounted to about $83 million in the two-year period and about $295 million over the course of their investment.

Fifth, the court discusses what lack of "good faith" means in this context.  Both sides agreed that actual knowledge (which the trustee did not allege) or willful blindness (which the trustee did allege and about which the court expresses skepticism) would constitute lack of good faith.  The trustee also argued that "inquiry notice" and failure to investigate constituted lack of good faith; the defendants, of course, disagreed.  The court rejected the latter in the context of a SIPA trusteeship, where bankruptcy law is informed by federal securities law.  Just as fraud, in the context of federal securities laws, requires scienter, so too "good faith" in a SIPA bankruptcy implies a lack of fraudulent intent.  In particular, an investor generally has no duty to investigate its broker in the absence of red flags that suggest a high probability of fraud.

Finally, the trustee can subordinate the defendants' own claims against the estate only by proving that the defendants invested with Madoff Securities with knowledge, or in reckless disregard, of its fraud.

SEC Charges Bay Area Investment Adviser for Defrauding Clients and Falsifying Documents During SEC Exam

The SEC charged a San Francisco-area investment adviser with fraud for lying to clients about how brokerage commission rebates were being used and producing phony documents to cover up the fraud during an SEC examination.  The SEC alleges that Kurt Hovan misappropriated more than $178,000 in “soft dollars” that he falsely claimed to be using to pay for legitimate investment research on his clients’ behalf. In reality, Hovan was secretly funneling the money for such undisclosed uses as office rent, computer hardware, and his brother’s salary. When SEC examination staff asked Hovan to provide documentation to back up his claims, he created phony research reports.

The SEC also charged his wife Lisa Hovan and his brother Edward Hovan for their roles in the fraudulent scheme at Hovan Capital Management (HCM).

The SEC’s complaint charges Kurt Hovan, Lisa Hovan, Edward Hovan, and HCM with violating the antifraud provisions of the federal securities laws, and asserts additional recordkeeping violations against Kurt Hovan and HCM. The complaint seeks injunctive relief, disgorgement with prejudgment interest, and financial penalties.

SEC Charges Long Island-Based Hedge Fund Manager With Fraud Involving PIPE Transactions

The SEC charged a Long Island-based investment adviser with defrauding investors in hedge funds investing in PIPE transactions and misappropriating more than $1 million in client assets for his personal use.  The SEC alleges that Corey Ribotsky and his firm The NIR Group LLC repeatedly lied to investors to hide the truth that his PIPE investment and trading strategy was failing during the financial crisis. For example, Ribotsky falsely told investors that despite the adverse market conditions he could liquidate all of the PIPE investments in 36 to 48 months – a practical impossibility given the size of the investments. Meanwhile, Ribotsky misused investor money by writing checks to pay for personal services and such luxury items as a Lexus, Mercedes, and Rolex watch.

According to the SEC’s complaint , NIR’s family of AJW Funds provided cash financing to distressed, emerging growth, and start-up microcap companies quoted on the Over-the-Counter Bulletin Board or the Pink Sheets. The AJW Funds were typically invested in 120 to 130 different companies at any given time.  The SEC alleges that beginning in July 2004, Ribotsky began siphoning assets from one of the AJW Funds he was managing through NIR. NIR’s strategy of investing in distressed and start-up companies began to show signs of failure by mid-to-late 2007. Many of the distressed companies to which the AJW Funds had made loans were by then essentially defunct or on the verge of filing for bankruptcy. The SEC alleges that Ribotsky made false and misleading statements to investors while his hedge funds were struggling to create the illusion of success.

The SEC’s complaint seeks a final judgment permanently enjoining Ribotsky and NIR from future violations of the above provisions of the federal securities laws and ordering them to disgorge any ill-gotten gains plus prejudgment interest and pay monetary penalties.

Updated Market-Wide Circuit Breaker Proposals to Address Extraordinary Market Volatility

The SEC announced that the national securities exchanges and the FINRA are filing proposals to revise existing market-wide circuit breakers that are designed to address extraordinary volatility across the securities markets. When triggered, these circuit breakers halt trading in all exchange-listed securities throughout the U.S. markets.  The proposals being filed today would update the market-wide circuit breakers by among other things reducing the market decline percentage thresholds necessary to trigger a circuit breaker, shortening the duration of the resulting trading halts, and changing the reference index used to measure a market decline.

If approved by the Commission, the new market-wide circuit breaker rules would replace the existing market-wide circuit breakers, which were originally adopted in October 1988.  The proposals would revise the existing market-wide circuit breakers by:

Reducing the market decline percentage thresholds necessary to trigger a circuit breaker from 10, 20, and 30 percent to 7, 13, and 20 percent from the prior day’s closing price.
 
Shortening the duration of the resulting trading halts that do not close the market for the day from 30, 60, or 120 minutes to 15 minutes.
 
Simplifying the structure of the circuit breakers so that rather than six there are only two relevant trigger time periods — those that occur before 3:25 p.m. and those that occur on or after 3:25 p.m.
 
Using the broader S&P 500 Index as the pricing reference to measure a market decline, rather than the Dow Jones Industrial Average.
 
Providing that the trigger thresholds are to be recalculated daily rather than quarterly.

SEC & RBC Settle Charges of Selling Unsuitable Investments to Wisconsin Schools

The SEC charged RBC Capital Markets LLC for misconduct in the sale of unsuitable investments to five Wisconsin school districts and its inadequate disclosures regarding the risks associated with those investments.  According to the SEC’s order instituting administrative proceedings, RBC Capital marketed and sold to trusts created by the school districts $200 million of credit-linked notes that were tied to the performance of synthetic collateralized debt obligations (CDOs). The school districts contributed $37.3 million of district funds to the investments with the remainder of the investment coming from funds borrowed by the trusts. The sales took place despite significant concerns within RBC Capital about the suitability of the product for municipalities like the school districts. Additionally, RBC Capital’s marketing materials failed to adequately explain the risks associated with the investments.

RBC Capital agreed to settle the SEC’s charges by paying a total of $30.4 million that will be distributed in varying amounts to the school districts through a Fair Fund.

Last month, the SEC separately charged St. Louis-based brokerage firm Stifel, Nicolaus & Co. and a former senior executive with fraudulent misconduct in connection with the same sale of the CDO investments to the school districts.

Court Dismisses Fraud Claims Against AOL Senior Managers Pursuant to Janus

A frequent question in the aftermath of the 2008 financial meltdown is: why aren't individual defendants being held accountable for their misdeeds?  Part of the difficulty is establishing securities fraud and the difficulty of pleading and proving scienter.  Another difficulty results from the definition of a "maker of a statement" the U.S. Supreme Court set forth in Janus Capital Group, Inc. v. First Derivative Traders.  In holding that a fund' investment adviser and administrator could not be held liable under Rule 10b-5 for misstatements in the Fund's prospectus, the Court defined a "maker of a statement" as "the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it....One who prepares or publishes a statement on behalf of another is not its maker."

In SEC v. Kelly (S.D.N.Y. Sept. 22, 2011), the court relied on that language to hold that two AOL senior managers could not be liable under Rule 10b-5 and 33Act section 17(a) for misstatements about advertising revenues.  As doubtful litigation strategy, the SEC conceded that Janus foreclosed a misstatement claim under Rule 10b-5(b), but argued that they could be liable under "scheme liability" based on Rule 10b-5(a) and (c) and section 17(a) of the 33 Act.  The court rejected both these arguments, because "this case is not about conduct that is itself deceptive -- it is about conduct that became deceptive only through AOL's misstatements in its public filings."  Moreover, since the elements of a 17(a) claim are essentially the same as those for Rule 10b-5 claims, the court also dismissed those claims.

Shareholder's Challenge to Executive Compensation Survives MTD Because of Negative Say-on-Pay Vote

A recent opinion suggests that a negative shareholder vote on a "say-on-pay" resolution will improve shareholders' chances in surviving a motion to dismiss a derivative suit alleging excessive executive compensation.  In NECA-IBEW Pension Fund v. Cox (S.D.Ohio  09/20/11), involving Cincinnati Bell, Judge Timothy Black framed the question:

Whether a shareholder of a public company may sue its directors for breach of the duty of loyalty when the directors grant $4 million dollars in bonuses, on top of $4.5 million dollars in salary and other compensation, to the chief executive officer in the same year the company incurs a $61.3 million dollar decline in net income, a drop in earnings per share from $0.37 to $0.09, a reduction in share price from $3.45 to $2.80, and a negative 18.8% annual shareholder return.

In answering that question in the affirmative, the judge emphasized that at the motion to dismiss stage, plaintiff only needs to state a plausible claim and that the business judgment rule imposes a burden of proof, not a burden of pleading.  The factual allegations raise a plausible claim that the bonuses approved by the directors in a time of the company's declining financial performance violated Cincinnati Bell's pay-for-performance compensation policy and thus constituted an abuse of discretion or bad faith.  In particular, the opinion references the fact that 66% of voting shares voted against the say-on-pay resolution; Cincinnati Bell was one of only 1.6% of public companies that received negative shareholder recommendations on their say-on-pay resolutions (as of the end of June 2011).

In addition, plaintiff was excused from the requirement of pre-suit demand because of futility, because it pled specific facts to give reason to doubt that the directors could make unbiased, independent business judgments about whether to sue:

Given that the director defendants devised the challenged compensation, approved the compensation, recommended shareholder approval of the compensation, and suffered a negative shareholder vote on the compensation, plaintiff has demonstrated suficient facts to show that there is reason to doubt these same directors could exercise the independent business judgment over whether to bring suit against themselves for breach of fiduciary duty....

Perhaps the nonbinding advisory vote will prove to have more teeth than anticipated!

S&P Gets Wells Notice About CDO Rating

The McGraw-Hill Companies, Inc., the parent company for Standard & Poor's, issued a press release stating that on September 22, 2011, it received a "Wells Notice" stating that the SEC staff is considering recommending that the Commission institute a civil injunctive action against S&P, alleging violations of federal securities laws with respect to S&P's ratings for a particular 2007 offering of collateralized debt obligations, known as "Delphinus CDO 2007-1." If the SEC does determine to bring an action, it will be the first against a rating company based on a faulty rating. ProPublica has the background on the Delphinus CDO; see In a First, SEC Warns Rating Agency It May Bring Financial Crisis Lawsuit.

Griffin et al. on Reg FD Enforcement

Enforcement and Disclosure under Regulation FD: An Empirical Analysis, by Paul A. Griffin, University of California, Davis - Graduate School of Management; David H. Lont, University of Otago - Department of Accountancy and Finance; and Benjamin Segal, INSEAD - Accounting & Control Area, was recently posted on SSRN.  Here is the abstract:

While Regulation FD was designed to benefit investors by curbing the selective disclosure of material non-public information to “covered” investors, such as analysts and institutional investors, it can also impose costs. This paper finds that FD levies three kinds of enforcement and disclosure costs. First, investors cannot recover as part of an SEC enforcement action the gains to covered investors from their alleged use of the non-public information. Second, investors lose because the market responds negatively to an SEC enforcement announcement. Third, investors suffer because some companies post their FD filings well after the due date, without earlier public disclosure.

SEC CHARGES THREE PRINCIPALS OF FORMERLY REGISTERED BROKER-DEALER FOR INVOLVEMENT IN MICROCAP STOCK FRAUD SCHEME AND STOCK SALES IN UNREGISTERED OFFERINGS

The SEC filed charges against the three former principals of Westcap Securities, Inc., a now-defunct broker-dealer – Thomas Rubin (“Rubin”), Westcap’s then Chief Executive Officer, Christopher Scott (“Scott”), Westcap’s then Chief Compliance Officer, and Jeff Greeney, Westcap’s then Chief Financial Officer, and their related entities. The Commission alleges that Rubin and Scott committed securities fraud by, among other things, engaging in market manipulation in a broader manipulative scheme, and also, through their respective related entities, BGLR Enterprises, LLC and E-Info Solutions, LLC, violated the registration provisions of Section 5(a) and (c) of the Securities Act of 1933 (“Securities Act”) by selling stock in unlawful unregistered offerings. The Commission separately alleged that Greeney, through his related entity, Big Baller Media Group, LLC, violated the registration provisions by selling stock in unlawful unregistered offerings.

The Commission alleges that Rubin and Scott participated in a broader market manipulation ring that involved bringing companies public through reverse mergers; using Westcap to raise funds for the newly-created companies through purported private placements; and manipulating the public markets for those newly-created public companies, which allowed Rubin and Scott, through their related entities, to sell their holdings of these companies at artificially inflated prices for total proceeds exceeding $1.5 million.

The Commission seeks injunctions, penny stock bars, disgorgement, and penalties from Rubin and Scott (and their related entities, BGLR Enterprises and E-Info Solutions), in addition to an officer and director bar against Scott because he was an officer of one of the microcap issuers.

With respect to Greeney, the Commission alleges that he, through his related entity, sold shares in unregistered offerings of two of the microcap issuers for unlawful profits of approximately $330,000, in violation of the registration provisions of the Securities Act. Greeney and his related entity, Big Baller Media Group, have offered to settle the Commission’s allegations.

ARS Issuer Can Arbitrate Claims Against Broker-Dealer Related to Auction Services

The Second Circuit recently held that an issuer of auction rate securities (ARS) could arbitrate claims against the financial services firm that advised the issuer on the offerings and acted as the lead underwriter and the main broker-dealer responsible for facilitating the auctions that set the interest rates.  UBS Financial Services, Inc. v. West Virginia University Hospitals (No. 11-235-cv, 9/22/11).  There was no arbitration agreement between the parties, but a majority of the panel held that the issuer was a "customer" under the FINRA arbitration rules with respect to the services provided by the firm in its capacity as a broker-dealer and therefore could compel arbitration.  While the district court had concluded that the issuer was a customer with respect to the underwriting services, the majority of judges declined to address that issue, although they made a point of stating that they disagreed with the dissenting judge's assertion that issuers can never be customers of underwriters.

This litigation thus offers another illustration of broker-dealers resisting arbitration when requested by the customer.  Indeed, while the definition of "customer" is largely undefined at the borders and, in particular, whether the issuer is a customer of the underwriter that provides it underwriting services is unresolved, some of the arguments made by UBS's attorneys against arbitration were frivolous.  Thus, they argued that FINRA rules do not contemplate arbitration for sophisticated parties, that FINRA has a narrow "investor-protection" mandate, and that a customer relationship requires a fiduciary relationship and cannot be founded on arm's length transactions.  None of these arguments has ny basis in the FINRA rules, practice or policy.

Thus, we have another example of a situation where the securities industry believes that they will achieve a more favorable result in the law-oriented judicial forum than in the equity-based arbitration forum.   

Becker on the Becker Case

Testimony of David M. Becker, Before the Subcommittee on Oversight and Investigations, Committee on Financial Services, and Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, Committee on Oversight and Government Reform, U.S. House of Representatives
(September 22, 2011)

SEC IG's Testimony on the Becker Case

Written Testimony of H. David Kotz, Inspector General of the Securities and Exchange Commission,
Before the Subcommittee on Oversight and Investigations, Committee on Financial Services, and Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, Committee on Oversight and Government Reform, U.S. House of Representatives (September 22, 2011)