Securities Law Prof Blog

Seond Circuit Again Addresses "Customer" Definition in CDS Dispute

There has been considerable litigation in the Second Circuit over the issue of arbitrability in connection with credit default swap agreements.  Specifically, the issue presented is whether there is a customer/broker-dealer relationship that permits the disappointed party to require arbitration of claims against the financial services firm involved in the transaction.  In Wachovia Bank, N.A. v. VCG Special Opportunities Master Fund, Ltd. (No. 10-1648-cv, Oct. 28, 2011Download Wachovia.102811[1]), the Second Circuit, reversing the district court, held that the hedge fund was not a "customer" of the Wachovia broker-dealer within the scope of FINRA Rule 12200, even though employees of the broker-dealer negotiated part of the CDS agreement.  The court emphasized that all the agreements were between the hedge fund and Wachovia Bank, and the agreement contained a non-reliance clause in which the hedge fund acknowledged that the counter-party was not its broker or advisor in any respect.  In these circumstances, "there is no need to grapple with the precise boundaries of the FINRA meaning of 'customer.'"  The court distinguished the facts from those in two recently decided Second Circuit opinions where the broker-dealer provided brokerage services, Citigroup Global Markets, Inc. v. VCG, 598 F.3d 30 (2d Cir. 2010) and UBS Financial Services Inc. v. West Virginia University Hospitals, Inc. (2d Cir. Sept. 22, 2011).

Carney et al. on Dominance of Delaware Corporate Law

Lawyers, Ignorance, and the Dominance of Delaware Corporate Law, by William J. Carney, Emory University School of Law; George B. Shepherd, Emory University School of Law; and Joanna Shepherd, Emory University School of Law, was recently posted on SSRN.  Here is the abstract:

Why does Delaware continue to dominate the market for incorporations even though recent research has shown that the quality of Delaware corporate law has declined substantially? We focus on the rational ignorance of lawyers and investors. Using the results of our survey of lawyers involved in initial public offerings (IPOs) as well as our analysis of companies involved in IPOs, we conclude that lawyers recommend Delaware because they are ignorant about other states’ law. Because Delaware is so dominant, law schools focus on Delaware corporate law, and a lawyer rationally learns the corporate law only of Delaware and her home state. Regardless of the quality of the law of other states, lawyers will not recommend it because they are unfamiliar with it. Likewise, lawyers recommend only Delaware law because they believe that investors are ignorant of other states’ law.

Lo on Financial Crisis Literature

Reading About the Financial Crisis: A 21-Book Review, by Andrew W. Lo, MIT Sloan School of Management; MIT CSAIL; National Bureau of Economic Research (NBER), was recently posted on SSRN.  Here is the abstract:

The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of 21 books on the crisis, 11 written by academics, and 10 written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed.

Dick on Corporate Finance Jurisprudence

Confronting the Certainty Imperative in Corporate Finance Jurisprudence, by Diane Lourdes Dick, Seattle University School of Law, was recently posted on SSRN.  Here is the abstract:

Turbulent economic periods leave many enduring legacies. This Article examines a jurisprudential vestige of the economic instability and dominant intellectual theories of the 1970s and 1980s: what I call the "Certainty Imperative." The Imperative is a judicial decision-making paradigm that infuses the specific goal of stability in financial markets into the broader and more deeply entrenched normative theme of legal certainty. As it has evolved across decades of case law and legislative enactments, the Imperative has profoundly altered judicial decision-making in finance and lending by encouraging strict interpretive norms and rejecting more expansive analyses. Over time, the Imperative's methodological constraints have become a paralyzing force upon the judiciary, preventing it from engaging in law reform. In essence, the state of finance and lending jurisprudence can be summarized thusly: deference, in the very broadest sense, is shown to the legal status quo.

The methodological constraints imposed by the Imperative must be overcome. As modern corporate financing arrangements grow more complex, moral hazards arise when contractual language vests substantive rights and remedies in a manner that does not align with evolving economic interests. This Article suggests several possibilities for expanding the scope of judicial inquiries in the corporate financing realm so that the judiciary may resolve disputes through an interpretive methodology that considers economic substance over contractual form.

Myers on Say-on-Pay

The Perils of Shareholder Voting on Executive Compensation, by Minor Myers, Brooklyn Law School, was recently posted on SSRN.  Here is the abstract:

Giving shareholders more managerial power over corporate affairs—the goal of many recent corporate reform proposals—comes with costs that commentators have failed to recognize. In general, the more involved shareholders are in a firm's managerial decisions, the more difficult it is for directors to be held accountable for the outcome of those decisions. This can weaken directors' ex ante incentives to act in the interests of shareholders. This Article argues that this phenomenon may undermine the ambitions of the recent high-profile corporate reform requiring each public company to hold periodic, nonbinding shareholder votes on its executive compensation.

Supporters of the reform, known as "say on pay," predict that corporate directors will be fearful of shareholder "no" votes because they will attract embarrassing attention to directors and the firm. In other words, shareholder voting will amplify the "outrage constraint"— the threat of shame or embarrassment in the media that, according to the influential managerial power model of executive compensation, limits directors' ability to award pay packages that are too big and not sensitive enough to performance. To avoid the amplified outrage associated with a "no" vote, directors will be compelled to modify executive pay in ways amenable to shareholders.

Shareholder voting on executive compensation, however, could hurt shareholders in ways supporters of the reform have overlooked. Once shareholders have approved a firm's compensation arrangements, directors will no longer bear complete responsibility for them. If any negative attention—any outrage—is directed at the firm's pay practices in the future, directors can escape a portion of the blame that otherwise would have been theirs alone. This diffusion of responsibility willpartially insulate directors' reputations from future outrage, and because directors will no longer bear all of the future costs of taking risks in the CEO's favor, they may end up taking more of those risks.

By clouding the functioning of the outrage constraint, shareholder approval thus may liberate directors at some firms to offer executive pay packages that are larger and more insensitive to performance than if the board were acting alone. In view of this effect, giving shareholders a say on executive pay may injure as many firms as it helps. To eliminate this overbreadth problem, this Article proposes amending the legislation to allow firms to opt-out of the say on pay regime by shareholder vote. This preserves the benefits of say on pay for those firms where shareholders wish to retain it and allows other firms to exit the regime at little cost.

Johnson on Gatekeepers in State Court

Secondary Liability for Securities Fraud: Gatekeepers in State Court, by Jennifer J. Johnson, Lewis & Clark Law School, was recently posted on SSRN.  Here is the abstract:

The recent economic meltdown exposed numerous Ponzi schemes. When promoters of fraudulent ventures are unable to provide restitution to their victims, plaintiffs seek out other sources of repayment including professionals and other secondary participants in the transactions that precipitated their losses. Although most scholars agree that professionals can perform an important role in deterring securities fraud, scholarly opinions vary widely on the appropriate liability regime, if any, that these gatekeepers should face.

While civil liability for secondary participants in securities fraud was once well accepted in the federal courts, in 1994 the Supreme Court invalidated such claims as beyond the purview of Section 10(b) of the 1934 Securities Exchange Act and Rule 10b-5. In contrast, there is a robust tradition of aiding and abetting liability in most state blue sky statutes. Unlike the federal implied Rule 10b-5 cause of action, state blue sky laws contain express secondary liability statutes that do not have strict scienter standards or rigorous pleading requirements. Indeed, some state statutes are negligence based and contain burden-shifting provisions that require non-seller defendants to establish that they were not negligent in failing to discover the seller's fraud.

This Article traces the development of secondary liability under state securities laws and contrasts various state regimes and their federal counterparts. It also reviews federal efforts to restrict states from adjudicating securities related claims. Relying on available empirical evidence, the Article ultimately concludes that Congress should reverse its propensity of the last decade to preempt state securities actions and should recognize the valuable contribution of such actions in addressing fraud, particularly fraud committed upon retail investors.

Judge Rakoff Challenges SEC-Citigroup Settlement

Judge Jed Rakoff is, once again, asking tough questions about a proposed SEC settlement.  This time it's the agency's $285 settlement with Citigroup involving allegedly misleading CDOs.  Before he agrees to the settlement, he  again questions the common practice of allowing defendants charged with serious securities fraud to neither admit nor deny wrongdoing.  He also wants the SEC to explain why proposed penalty ($95 million of the settlement) is considerably less than the $535 million penalty imposed on Goldman Sachs last year in a settlement involving a complex financial instrument called Abacus, and why the penalty is being paid by the corporation (and its shareholders) and not the culpable individuals.  A hearing on the proposed settlement is set for Nov. 9.

WSJ, Judge Challenges SEC on Citi Settlement

SEC Adopts Rule on Confidential Private Fund Risk Reporting

Yesterday the SEC voted unanimously to adopt a new rule requiring certain advisers to hedge funds and other private funds to report information for use by the Financial Stability Oversight Council (FSOC) in monitoring risks to the U.S. financial system.  The rule, which implements Sections 404 and 406 of the Dodd-Frank Act, requires SEC-registered investment advisers with at least $150 million in private fund assets under management to periodically file a new reporting form (Form PF).

Information reported on Form PF will remain confidential.

Private fund advisers are divided by size into two broad groups – large advisers and smaller advisers. The amount of information reported and the frequency of reporting depends on the group to which the adviser belongs. The SEC anticipates that most private fund advisers will be regarded as smaller private fund advisers, but that the relatively limited number of large advisers providing more detailed information will represent a substantial portion of industry assets under management. As a result, these thresholds will allow FSOC to monitor a significant portion of private fund assets while reducing the reporting burden for private fund advisers.

There will be a two-stage phase-in period for compliance with Form PF filing requirements. Most private fund advisers will be required to begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after Dec. 15, 2012. Those with $5 billion or more in private fund assets must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after June 15, 2012.

SEC Orders FINRA to Improve Internal Compliance Procedures

The SEC ordered FINRA to hire an independent consultant and undertake other remedial measures to improve its policies, procedures, and training for producing documents during SEC inspections.  The SEC found that certain documents requested by the SEC’s Chicago Regional Office during a 2008 inspection were altered just hours before FINRA’s Kansas City District Office provided them. According to the SEC’s order, the production of the altered documents by the Kansas City District Office was the third instance during an eight-year period in which an employee of FINRA or its predecessor (National Association of Securities Dealers) provided altered or misleading documents to the SEC.

FINRA has consented to engage an independent consultant within 30 days that will:

• Conduct a one-time comprehensive review of FINRA’s policies and procedures and training relating to document integrity.
• Assess whether the policies and procedures and training are reasonably designed and implemented to ensure the integrity of documents provided to the SEC.
• Make recommendations for the enhancement of FINRA’s policies and procedures and training as may be necessary in light of the consultant’s review and assessment.

The Financial Industry Regulatory Authority (FINRA) today issued the following statement from Richard Ketchum, FINRA Chairman and Chief Executive Officer:

"As a regulator, FINRA must always hold itself to the highest standards. When we discover shortcomings, it is our obligation to take appropriate corrective action and make it clear that we have zero tolerance for actions that could compromise the integrity of our organization. We self-reported the Kansas City matter to the SEC and have fully cooperated with the agency's review. Following our own internal review we took decisive action, including appointing new leadership in our Kansas City office and instituting a number of changes that strengthened document-handling procedures across the organization. These strengthened procedures include additional online and live ethics training for all employees with an enhanced focus on document handling and integrity. An independent consultant will review these changes to determine if further improvements are warranted.

I am personally committed to taking all possible steps to ensure that this type of conduct does not reoccur. We have taken prompt action to report, investigate and discipline the behavior at issue in this matter. Under no circumstances will such conduct be tolerated at FINRA."

Investor in Madoff Feeder Fund Wins $7 Million Arbitration Award

An investor in a Madoff-feeder fund managed by J. Ezra Merkin recently won a $7 million arbitration award in a AAA proceeding (Straus v. Merkin, 13-148-Y-001800-10 Oct. 12, 2011DownloadARBITRAL AWARD V EZRA MERKIN) and seeks to confirm the award in New York Supreme Court.  In a reasoned award, the majority of the panel found that Merkin was liable for material misstatements and omissions under the New Jersey Securities Act.  Specifically, Merkin did not disclose to this investor (although he did to many others) that the fund was nothing more than a feeder fund for Madoff.  Instead, the documentation at the time of the investment represented that Merkin determined the investment strategy.  In addition, the panel found that, over their nine-year association,  Straus and Merkin had no discussions about the true nature of the investment and that Straus did not learn of other information that should have alerted him to the extent of Madoff's involvement.

What is particularly interesting about the award is that the majority addresses a Sept. 23, 2011 decision from the S.D.N.Y. (In Re Merkin and BDO Seidman Securities Litig.) that found no violation of Rule 10b-5 on similar allegations.  Judge Batts determined that there had been insufficient allegations of a material misstatement or omission in the context of the broad discretion in the agreement to use other fund managers.  "The answer to Respondent's assertion that Judge Batts' determination warrants a dismissal of the claim before this Panel is that the majority disagrees with Judge Batts' conclusions."  While the arbitration award was based on state securities law, "where [the issues] coincide, the majority respectfully disagrees with her conclusion."

Another good example where arbitration can result in a decision that is more pro-investor than would be achieved in court. 

Massachusetts Charges BNY Mellon with Forex Fraud

The Massachusetts Securities Division Charged BNY Mellon with Defrauding State Pension Funds of Millions in Foreign Exchange Transactions.

Eisinger on the SEC & the Citigroup Settlement

Well worth reading over at ProPublica:  Jesse Eisinger's Why the SEC Won’t Hunt Big Dogs , a blistering critique of the SEC's recent $285 million settlement with Citigroup over misleading investors by selling a CDO created out of mortgage securities junk.

SEC Adopts Form to Collect Systemic Risk Data about Private Funds

At its open meeting on Oct. 26, the Commission adopted a joint SEC/CFTC form (Form PF) to collect critical systemic risk data about hedge funds and other private funds.  This private fund data collection is mandated by Dodd-Frank and is intended to assist the Financial Stability Oversight Council.

See SEC Chairman Schapiro's Opening Statement.

SEC Charges "Money Managers" with Illegal Free-Riding

The SEC charged a pair of purported money managers with orchestrating an illegal “free-riding” scheme of selling stocks before they paid for them and netting $600,000 in illicit profits.  According to the SEC, Scott Kupersmith and Frederick Chelly portrayed themselves to broker-dealers as money managers for hedge funds or private investors, and they opened brokerage accounts in the names of purported investment funds they created. Kupersmith and Chelly then engaged in illegal free-riding by interchangeably buying and selling the same quantity of the same stock in different accounts – frequently on the same day – with the intention of profiting on swings up or down in the stock price. However, Kupersmith and Chelly did not have sufficient securities or cash on hand to cover the trades, and they instead used proceeds from stock sales in one brokerage account to pay for the purchase of the same stock in another brokerage account.

The SEC alleges that when trades were profitable, Kupersmith and Chelly took the profits. But when the trades threatened to result in substantial losses, Kupersmith and Chelly failed to cover their sales and left broker-dealers to settle the trades at a significant loss. In total, their brokers suffered more than $2 million in losing trades.

In parallel actions, the U.S. Attorney’s Office for the District of New Jersey and the Manhattan District Attorney’s Office today announced the unsealing of criminal charges against Kupersmith.

SEC Halts Fraud by Purported Quant Hedge Fund Manager

The SEC obtained an asset freeze against a Boston-area money manager and his investment advisory firm charged with misleading investors in a supposed quantitative hedge fund and diverting portions of investor money into his personal bank account.  According to the SEC, Andrey C. Hicks and Locust Offshore Management LLC made false representations to create an aura of legitimacy when soliciting individuals to invest in a purported billion dollar hedge fund that Hicks controlled called Locust Offshore Fund Ltd. Hicks raised at least $1.7 million from several investors for the hedge fund. Among the false claims made to investors were that Hicks obtained undergraduate and graduate degrees at Harvard University, and that he previously worked for Barclays Capital, and that the hedge fund held more than $1.2 billion in assets.

 

SEC & DOJ Charge Rajat Gupta with Passing Inside Information on Goldman & P&G to Rajaratnam

And the other shoe has dropped.  Both the DOJ and the SEC have brought insider trading charges against Rajat K. Gupta, a former director of Goldman Sachs and Procter & Gamble, who allegedly provided Raj Rajaratnam with confidential inside information about Goldman Sachs.  A federal grand jury charged Gupta with one count of conspiracy to commit securities fraud and five counts of securities fraud.  The SEC filed a civil complaint alleging an "extensive insider trading scheme" and  also filed new insider trading charges against Rajaratnam.  The allegations all relate to inside information involving both Goldman and P&G.

Gupta was named as an unindicted co-conspirator in the Rajaratnam case.  It is not clear how strong the government's case is, because, at least at the Rajaratnam trial, there were no tapes of phone conversations from Gupta, only phone calls between Rajaratnam and others that appear to refer to Gupta (i.e., hearsay).

The SEC previously brought an administrative proceeding against Gupta, which was dismissed because Judge Rakoff believed that the SEC's decision to bring an administrative proceeding against Gupta while bringing judicial proceedings against other Rajaratnam defendants was disciminatory.  The dismissal was without prejudice to bring a judicial proceeding.

NYTimes, Gupta Charged With Securities Fraud Related to Goldman Tips

SEC Press Release

 

FINRA Flags SAC's Trading Activities

The Wall St. Journal reports that FINRA has, over a period of nine years, made numerous reports to the SEC about its concerns over hedge fund SAC Capital Advisors' trading activities, detailing in confidential reports that the firm may have profited from inside information.  To date, the SEC has not taken any public action against SAC related to the referrals, although it has been previously reported that regulators are examining whether SAC improperly benefited from two takeovers.

To keep it in context, the WSJ points out that in the two years ended Sept. 2010, the SEC received 721 referrals about potential insider trading from SROs.  The SEC launched 90 insider-trading enforcement actions in the same time period.

WSJ, Regulator Flagged SAC Stock Trades .

NASAA Expresses Opposition to Congressional Crowdfunding Exemption

NASAA announced the formation of a committee to examine and propose steps that state securities regulators can take to help small and new businesses raise investment capital and went on record as opposed to a "crowdfunding" bill that has been introduced in Congress that would preempt state regulation.  NASAA President Herstein said the committee is expected to report specific recommendations to NASAA’s Board by early next year regarding crowdfunding and other small business capital formation initiatives.

The announcement of the new NASAA committee comes as the House Financial Services Committee is considering measures to stimulate the economy and promote job creation. On October 26, the Committee is scheduled to vote on one proposal, the Entrepreneur Access to Capital Act, H.R. 2930. This bill would deregulate crowdfunding by removing basic federal and state registration filing requirements and would allow businesses to raise up to $5 million from an unlimited number of investors through a crowdfunded offering.

“By prohibiting state securities regulators from being notified and reviewing investment opportunities before they are offered to the public, this bill will weaken investor protection,” Herstein said of H.R. 2930. “Con artists will undoubtedly flock to crowdfunding websites, lured both by the increased dollar amount of investments and the fact that a tough cop has been taken off the beat.”

In an October 21 letter, Herstein urged the Financial Services Committee’s leadership not to take a “rash and premature action” by enacting a blanket federal preemption of the authority of the states to protect their constituents by regulating crowdfunding.

“State securities administrators share the Committee’s goal of promoting small business capital formation and job-growth, including exploring the establishment of a framework that might facilitate the harnessing of investment capital online through techniques like crowdfunding,” Herstein wrote. “At the same time, NASAA believes it is vital that any such framework be crafted carefully and deliberately, as the potential for fraud in this area is real and potentially enormous.”

“Preempting state authority is a very serious step and not something that should ever be undertaken lightly or without careful consideration, including a thorough examination of all available alternatives,” Herstein said. “In the case of crowdfunding, state securities regulators are not only capable of acting, but indeed, are acting, and Congress should allow them the opportunity to continue to protect retail investors from the risks associated with smaller, speculative investments.”

FINRA Fines UBS $12 Million for Short-Sales Violations

FINRA announced that it fined UBS Securities LLC $12 million for violating Regulation SHO (Reg SHO) and failing to properly supervise short sales of securities. As a result of these violations, millions of short sale orders were mismarked and/or placed to the market without reasonable grounds to believe that the securities could be borrowed and delivered.  Reg SHO requires a broker-dealer to have reasonable grounds to believe that the security could be borrowed and available for delivery before accepting or effecting a short sale order.In addition, Reg SHO requires a broker-dealer to mark sales of equity securities as long or short.

 FINRA found that UBS' Reg SHO supervisory system regarding locates and the marking of sale orders was significantly flawed and resulted in a systemic supervisory failure that contributed to serious Reg SHO failures across its equities trading business. First, FINRA found that UBS placed millions of short sale orders to the market without locates, including in securities that were known to be hard to borrow. These locate violations extended to numerous trading systems, desks, accounts and strategies, and impacted UBS' technology, operations, and supervisory systems and procedures. Second, FINRA found that UBS mismarked millions of sale orders in its trading systems. Many of these mismarked orders were short sales that were mismarked as "long," resulting in additional significant violations of Reg SHO's locate requirement. Third, FINRA found that UBS had significant deficiencies related to its aggregation units that may have contributed to additional significant order-marking and locate violations.

As a result of its supervisory failures, many of UBS' violations were not detected or corrected until after FINRA's investigation caused UBS to conduct a substantive review of its systems and monitoring procedures for Reg SHO compliance. FINRA found that UBS' supervisory framework over its equities trading business was not reasonably designed to achieve compliance with the requirements of Reg SHO and other securities laws, rules and regulations until at least 2009.

 

Koss CEO Agrees to Return Incentive Compensation Because of Faulty Controls

The SEC announced a proposed settlement with Koss Corporation (“Koss”) and Michael J. Koss, its CEO and former CFO, based on Koss Corporation’s preparation of materially inaccurate financial statements, book and records, and lack of adequate internal controls from fiscal years 2005 through 2009. During this period, Sujata Sachdeva (“Sachdeva”), Koss’s former Principal Accounting Officer, Secretary, and Vice-President of Finance, and Julie Mulvaney (“Mulvaney”), Koss’s former Senior Accountant, engaged in a wide-ranging accounting fraud to cover up Sachdeva’s embezzlement of over $30 million from Koss.

Koss and Michael J. Koss have consented to the entry of an injunctive order without admitting or denying the allegations in the Commission’s complaint. The proposed order would order Michael J. Koss to reimburse Koss $242,419 in cash and 160,000 of options pursuant to Section 304 of the Sarbanes-Oxley Act. This bonus reimbursement, together with his previous voluntary reimbursement of $208,895 in bonuses to Koss Corporation represents his entire fiscal year 2008, 2009 and 2010 incentive bonuses.