Securities Law Prof Blog

Former Qwest CFO Settles Securities Fraud Charges

The SEC announced that it settled charges against Robert S. Woodruff, the former chief financial officer of Qwest Communications International Inc., a Denver-based telecommunications company. According to the SEC’s complaint, from at least April 1, 1999 through March, 2001, Woodruff and others at Qwest engaged in a large-scale financial fraud that hid from the investing public the true source and nature of the company’s revenue and earnings growth. The complaint alleged that, although Qwest publicly touted its purported growth in services contracts which would provide a continuing revenue stream, in fact, the company fraudulently and repeatedly relied on revenue recognition from one-time sales of assets known as “IRUs” and certain equipment without making required disclosures. The complaint also alleged that Woodruff and others fraudulently and materially misrepresented Qwest’s performance and growth to the investing public. The complaint further alleged that Woodruff sold Qwest stock in violation of the insider trading prohibition of the securities laws.

Woodruff agreed to a Final Judgment that finds that he is liable for disgorgement of $1,731,048, plus prejudgment interest of $640,427, imposes a civil penalty of $300,000; and prohibits  him from acting as an officer or director of a public company for a period of five years. It is anticipated that the Commission will ask the Court to add the disgorgement, interest and penalty to a Fair Fund which was established in SEC v. Qwest Communications, Inc., Civ No. 04-cv-1267 (D. Colorado).

SEC & CFTC Propose Rule to Deter Identity Theft

The SEC announced a rule proposal to help protect investors from identity theft by ensuring that broker-dealers, mutual funds, and other SEC-regulated entities create programs to detect and respond appropriately to red flags.  The SEC issued the proposal jointly with the Commodity Futures Trading Commission (CFTC). (Download Identity.Theft.ic-29969[1])

The rule proposal would require SEC-regulated entities to adopt a written identity theft program that would include reasonable policies and procedures to:

Identify relevant red flags.
Detect the occurrence of red flags.
Respond appropriately to the detected red flags.
Periodically update the program.

The proposed rule would include guidelines and examples of red flags to help firms administer their programs.

Section 1088 of the Dodd-Frank Act transferred authority over certain parts of the Fair Credit Reporting Act from the Federal Trade Commission (FTC) to the SEC and CFTC for entities they regulate. The proposed rules are substantially similar to rules adopted in 2007 by the FTC and other federal financial regulatory agencies that were previously required to adopt such rules.

 

 

Michael Douglas Speaks Out Against Insider Trading!

The government has a public service announcement announcement against insider trading by none other than Michael Douglas, who played that infamously greedy Wall St. villain Gordon Gekko.  He warns us that if a deal sounds too good to be true it probably is and urges those with knowledge of insider trading to contact the FBI.  Watch it on Youtube.

Meanwhile, DOJ says it is building insider-trading cases against approximately 120 individuals, including hedge fund traders and company insiders, in its ever-expanding criminal investigation.  WSJ, Insider Targets Expanding

Wells Fargo Gets Wells Notice About Mortgage-Backed Securities Offerings

Wells Fargo & Co. has received a Wells notice from the SEC regarding disclosures in its mortgage-backed securities offering documents, including whether it adequately disclosed risks associated with mortgage-backed securities.  According the Wall St. Journal, the SEC is conducting similar investigations at a number of Wall St. firms, including Bank of America, Citigroup, Deutsche Bank and Goldman Sachs.  WSJ, Wells Fargo Discloses SEC Wells Notice

ProPublica Compares Versions of the STOCK Act

ProPublica's Lena Groeger provides a side-by-side comparison of the House and Senate versons of the STOCK Act, along with real-life scenarios that illustrate activities that the bill targets.  It's well worth checking out.  Taking Stock of the Stock Act: A Side-by-Side Comparison

Black on the SEC and the FCPA

I recently posted on SSRN my paper, The SEC and the Foreign Corrupt Practices Act: Fighting Global Corruption is Not Part of the SEC's Mission.  Here is the abstract:

In recent years, as both the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) have stepped up their enforcement efforts, the Foreign Corrupt Practices Act (FCPA) has been the subject of harsh criticism. Although critics have identified a variety of flaws in both the law and its enforcement, no one has seriously questioned a basic policy choice: why an agency whose mission is to protect investors is charged with civil enforcement of the FCPA’s anti-bribery provisions. Congress conferred this authority on the SEC in 1977 despite the agency’s statements that it did not fit within its mission. For over twenty years the SEC brought few actions involving allegations of foreign bribery and supported Congressional efforts to consolidate enforcement in the DOJ. By contrast, the SEC began to enforce the FCPA in the early 2000s with increasing enthusiasm. It has set up a specialized unit and publicized its large settlements, without ever providing an explanation of how enforcing the foreign bribery provision relates to the agency’s mission “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

I first review the legislative history, the “quiet” years prior to the early 2000s, and the SEC’s aggressive enforcement since then. I then make two arguments. First, since combating global corruption is not part of the agency’s mission, enforcement of the FCPA should be consolidated in the DOJ. Second, while “agency creep” is often described as resulting from agencies’ self-aggrandizing efforts to expand their power, the history of the FCPA illustrates a different problem: Congress giving an agency a power that it does not want and that diverts scarce resources from its core mission.

This paper is prepared for the Ohio State Law Journal's March 16 symposium on "The FCPA at Thirty Five and its Impact on Global Business."  For more information about the symposium, see the OSU website.  My paper is a work-in-progress, and I would be grateful for comments.

 

Frankel on Universal Fiduciary Principles

Towards Universal Fiduciary Principles, by Tamar Frankel, Boston University School of Law, was recently posted on SSRN.  Here is the abstract:

This Article focuses on unifying fiduciary law in Civil Law and the Common Law systems. The problems that fiduciary law addresses are similar throughout history and in all societies. However, the legal systems which address these problems differ. While in the Common Law fiduciary law is founded on property law, in the Civil Law similar fiduciary principles are found in the category of contract. However, the reach and basis of contract law in each system differ. Common Law judges tend to strictly enforce the parties’ contract terms while Civil Law allows for far more judicial discretion to impose fairness principles on the parties’ contract terms. This Article offers a number of ways in which the two systems of law can coincide and concludes and suggests by-passing the differences between the two systems by focusing on the results reached in each and at the same time following the models of dual systems.

Posner & Weyl on Financial Innovation

An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets, by Eric A. Posner, University of Chicago - Law School, and E. Glen Weyl, University of Chicago; University of Toulouse 1 - Toulouse School of Economics, was recently posted on SSRN.  Here is the abstract:

The financial crisis of 2008 was caused in part by speculative investment in complex derivatives. In enacting the Dodd-Frank Act, Congress sought to address the problem of speculative investment, but merely transferred that authority to various agencies, which have not yet found a solution. We propose that when firms invent new financial products, they be forbidden to sell them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if they satisfy a test for social utility that focuses on whether the product will likely be used more often for hedging than for speculation. Other factors may be addressed if the answer is ambiguous. This approach would revive and make quantitatively precise the common-law insurable interest doctrine, which helped control financial speculation before deregulation in the 1990s.

SEC Charges Three Oil Services Execs with Violating the FCPA

The SEC charged three oil services executives with violating the Foreign Corrupt Practices Act (FCPA) by participating in a bribery scheme to obtain illicit permits for oil rigs in Nigeria in order to retain business under lucrative drilling contracts.  According to the SEC's complaint, former Noble Corporation CEO Mark A. Jackson, along with James J. Ruehlen, who is the current Director and Division Manager of Noble’s subsidiary in Nigeria, bribed customs officials to process false paperwork purporting to show the export and re-import of oil rigs, when in fact the rigs never moved. The scheme was designed to save Noble Corporation from losing business and incurring significant costs associated with exporting rigs from Nigeria and then re-importing them under new permits. Bribes were paid through a customs agent for Noble’s Nigerian subsidiary with Jackson and Ruehlen’s approval.

The SEC separately charged Thomas F. O’Rourke, who was a former controller and head of internal audit at Noble. The SEC alleges that O’Rourke helped approve the bribe payments and allowed the bribes to be booked improperly as legitimate operating expenses for the company. O’Rourke agreed to settle the SEC’s charges and pay a penalty.Without admitting or denying the SEC’s allegations, O’Rourke consented to entry of a court order requiring him to pay a $35,000 penalty and permanently enjoining him from further violations of Sections 13(b)(2)(A), 13(b)(2)(B), 13(b)(5) and 30A of the Exchange Act and Rule 13b2-1.

Noble Corporation was charged with FCPA violations as part of a sweep of the oil services industry in late 2010. The company cooperated with investigators and agreed to pay more than $8 million to settle civil and criminal cases.

FINRA Proposes Raising Limit for Simplified Arbitration from $25,000 to $50,000

FINRA has filed with the SEC a proposed rule change to amend FINRA Arbitration Rules to raise the limit for simplified arbitration from $25,000 to $50,000. In its release FINRA explains that it currently offers streamlined arbitration procedures for claimants seeking damages of $25,000 or less. Under the simplified arbitration rules, one chair-qualified arbitrator decides a claim and issues an award based on the written submissions of the parties, unless, in a customer case, the customer requests a hearing, or, in an industry case, the claimant requests a hearing. FINRA also streamlines discovery for these cases.

The $25,000 threshold has been in place since 19983 and, at that time, captured 21 percent of all cases filed with the forum. Currently, the $25,000 threshold captures ten percent of FINRA’s caseload. Statistics for 2011 indicate that raising the threshold to $50,000 would increase the percentage of claims administered under simplified arbitration to 17 percent of the claims filed with the forum.

FINRA states a number of advantages to raising the threshold for simplified arbitration to $50,000:

Forum fees for simplified arbitration claims would be reduced.

Parties would save the time and expense of preparing for, scheduling, and traveling to the hearing.

Customers who are not able to retain an attorney to handle their case because of the small amount in dispute, and who are not comfortable appearing at an evidentiary hearing without representation, would have the flexibility to choose whether to request a hearing.

Raising the limit for cases decided on the papers would reduce the time to process the cases because the arbitrator and parties would not need to coordinate their calendars to schedule a hearing.

FINRA Seeks to Dismiss Schwab's Lawsuit Contesting its Rule Prohibiting Class Action Waivers

We previously blogged that Charles Schwab has filed a declaratory judgment action against FINRA, in response to FINRA's institution of a disciplinary proceeding against the firm for requiring its customers to accept a class action waiver in its customers' agreements. Schwab asserts that (1) FINRA Rule 2268(d)(3) does not prohibit the firm from including a class action waiver in its customer agreements, and (2) even if it does, the FAA and the recent Supreme Court decision in AT&T Mobility v. Concepcion preempt FINRA's prohibition. Schwab fails to acknowlege (much less address) the argument that the Securities Exchange Act and its anti-waiver clause preempt the FAA. On Feb. 21, 2012 Schwab filed a motion for preliminary injunction, reasserting its arguments.

On Feb. 22, FINRA in turn filed a Motion to Dismiss for lack of subject matter jurisdiction, asserting as its principal argument that Schwab failed to exhaust its administrative remedies under the Exchange Act. The Exchange Act establishes a comprehensive system of regulating broker-dealers, including judicial review of FINRA disciplinary proceedings. Noting the Schwab instituted this judicial proceeding within hours after the disciplinary complaint was served, FINRA argues that Schwab failed to meet the prerequisite for filing a federal law suit -- exhaustion of its administrative remedies.  Moreover, Schwab does not assert valid reasons for bypassing the disciplinary proceeding -- either that the disciplinary proceeding is too time-consuming or that the FINRA and SEC adjudicators lack the expertise to address issues outside of securities law or FINRA rules.

A hearing is scheduled for April 3.

SEC Charges Chinese Execs with Stealing Company's Primary Asset

The SEC filed securities fraud charges today against the Chairman of Puda Coal, Inc. (“Puda”) and the former CEO of Puda for the undisclosed theft of the primary asset of the U.S. public company they controlled. The Commission’s complaint alleges that defendants Ming Zhao, the Chairman of Puda, and Liping Zhu, Puda’s former CEO, perpetrated a massive fraud on Puda’s public shareholders by effectively stealing and selling Puda’s operating subsidiary.

Before the defendants’ fraud, Puda held an indirect 90% ownership stake in Shanxi Puda Coal Group Co., Ltd (“Shanxi Coal”), a coal mining company located in the Shanxi Province of the People’s Republic of China (“PRC”). In September 2009, just weeks before Puda announced that Shanxi Coal had received a highly lucrative mandate from the provincial government authorities to become a consolidator of smaller coal mining companies, Zhao, with Zhu’s knowledge and complicity, transferred Puda’s 90% stake in Shanxi Coal to himself. In July 2010, Zhao transferred a 49% equity interest in Shanxi Coal to CITIC Trust Co. Ltd. (“CITIC Trust”), a Chinese private equity fund controlled by CITIC Group, which is reported to be the largest state-owned investment firm in the PRC. CITIC Trust placed its 49% stake in Shanxi Coal in a trust and then sold interests in the trust to Chinese investors. In addition, Zhao caused Shanxi Coal to pledge 51% of its assets to CITIC Trust as collateral for a loan of RMB 3.5 billion ($516 million) from the trust to Shanxi Coal. In exchange, CITIC Trust gave Zhao 1.212 billion preferred shares in the trust. None of these asset transfers were approved by Puda’s board or its shareholders or disclosed in Puda’s various SEC filings.

Puda also conducted two public offerings in 2010 in the U.S. without disclosing that it no longer had any ownership stake in the coal company, Puda’s sole source of revenue. Thus, at the same time that CITIC Trust was effectively selling interests in the coal company to Chinese investors, Zhao and Zhu were still telling U.S. investors that Puda owned a 90% stake in that company. As a result of the defendants’ fraud, Puda is now little more than a shell company, with no ongoing business operations.

 

FINRA Seeks Comment on BrokerCheck

FINRA Requests Comment on Ways to Facilitate and Increase Investor Use of BrokerCheck Information

Comment Period Expires: April 6, 2012

FINRA requests comment on ways to facilitate and increase investor use of BrokerCheck information. Specifically, FINRA requests comment on potential changes to the information disclosed through BrokerCheck, the format in which the information is presented and strategies to increase investor awareness of BrokerCheck

District Court Emphasizes Differences Between Late Trading and Market Timing in SEC Action

On Feb. 14, Judge Sweet (S.D.N.Y.) handed down a 128 page opinion finding that Pentagon Capital Management PLC (PCM) and Lewis Chester violated federal securities laws by orchestrating a scheme to defraud mutual funds through late trading. He rejected the SEC's contentions that the defendants also violated the securities laws through their market timing, because the SEC did not establish that at the time of the trades market timing rules were sufficiently clear to permit liability. He granted the SEC injunctive relief, as well as $38.4 million in disgorgement and $38.4 million as a civil penalty. The SEC Release contains a link to the opinion.

The opinion followed a bench trial that lasted 17 days and heard from 18 witnesses. The opinion provides a thorough recital of the facts and the applicable law. With respect to the market timing charges, the Judge notes that liability turns on the "often blurry line between outwitting another in the marketplace and defrauding him." In contrast to the uncertainty about market timing, SEC regulation and uniform industry practice required a hard 4 p.m. cutoff for placing trades, so that the line is "startlingly bright" -- late trading is per se frauduluent.

SEC Charges Expert Consultant with Insider Trading

On Friday the SEC charged John Kinnucan and his expert consulting firm Broadband Research Corporation with insider trading. The charges stem from the SEC’s ongoing investigation of insider trading involving expert networks. The SEC alleges that Kinnucan and Broadband claimed to be in the business of providing clients with legitimate research about publicly-traded technology companies, but instead typically tipped clients with material nonpublic information that Kinnucan obtained from prohibited sources inside the companies. Clients then traded on the inside information. Portfolio managers and analysts at prominent hedge funds and investment advisers paid Kinnucan and Broadband significant consulting fees for the information they provided. Kinnucan in turn compensated his sources with cash, meals, ski trips and other vacations, and even befriended some sources to gain access to confidential information.

In a parallel criminal case, Kinnucan has been arrested and charged with one count of conspiracy to commit securities fraud, one count of conspiracy to commit wire fraud, and two counts of securities fraud.

The Kinnucan story has had colorful twists and turns. Last year Kinnucan achieved notoriety for loudly challenging federal authorities and their efforts to use him as an informant. NYTimes Dealbook, Tech Analyst Arrested in Insider Trading Crackdown. After his arrest, prosecutors urged a judge to detain Kinnucan because of a "pattern of threats and intimidation" against a witness and federal authorities. Bloomberg, Kinnucan’s Phone Threats Should Bar His Release, U.S. Says

The SEC has charged 22 defendants in enforcement actions arising out of its expert networks investigation. The allegations involve insider trading in the securities of 12 technology companies — including Apple, Dell, Fairchild Semiconductor, Marvell Technology, and Western Digital — for illicit gains totaling nearly $110 million. According to the SEC’s complaint filed in federal court in Manhattan, Kinnucan’s misconduct occurred from at least 2009 to 2010.

Gerding on Credit Derivatives and Leverage

Credit Derivatives, Leverage, and Financial Regulation’s Missing Macroeconomic Dimension, by Erik F. Gerding, University of Colorado Law School, was recently posted on SSRN. Here is the abstract:

Of all OTC derivatives, credit derivatives pose particular concerns because of their ability to generate leverage that can increase liquidity - or the effective money supply - throughout the financial system. Credit derivatives and the leverage they create thus do much more than increase the fragility of financial institutions and increase counterparty risk. By increasing leverage and liquidity, credit derivatives can fuel rises in asset prices and even asset price bubbles. Rising asset prices can then mask mistakes in the pricing of credit derivatives and in assessments of overall leverage in the financial system. Furthermore, the use of credit derivatives by financial institutions can contribute to a cycle of leveraging and deleveraging in the economy.

This Article argues for viewing many of the policy responses to credit derivatives, such as requirements that these derivatives be exchange traded, centrally cleared, or otherwise subject to collateral or 'margin' requirements, in a second, macroeconomic dimension. These rules have the potential to change – or at least better measure – the amount of liquidity and the supply of credit in financial markets and in the 'real' economy. By examining credit derivatives, this Article illustrates the need to see a wide array of financial regulations in a macroeconomic context.

Understanding credit derivatives’ macroeconomic effects has implications for macroprudential regulatory design. First, regulations that address financial institution leverage offer central bankers new tools to dampen inflation in asset markets and to fight potential asset price bubbles. Second, even if these regulations are not used primarily as monetary or macroeconomic levers, changes in these regulations, including changes in the effectiveness of these regulations due to regulatory arbitrage, can have profound macroeconomic effects. Third, the macroeconomic dimension of credit derivative regulation and other financial regulation argues for greater coordination between prudential regulation and macroeconomic policy.

Dallas on Short-Termism and the Financial Crisis

Short-Termism, the Financial Crisis, and Corporate Governance, by Lynne Dallas, University of San Diego School of Law, was recently posted on SSRN. Here is the abstract:

This article is a comprehensive exploration of why financial and nonfinancial firms engage in short-termism with particular attention given to the financial crisis of 2007-2009. Short-termism, which is also referred to as earnings management (or, alternatively, managerial myopia), consists of the excessive focus of corporate managers, asset managers, investors and analysts on short-term results, whether quarterly earnings or short-term portfolio returns, and a repudiation of concern for long-term value creation and the fundamental value of firms. This article examines market and internal firm dynamics that contribute to short-termism, which requires an examination of various structural, informational, behavioral and incentive problems operating within firms and markets. This article also discusses various regulatory responses to mitigate short-termism, including provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. It is the objective of this article to seek changes that would improve our financial system and prevent a financial meltdown in the future, such as the financial crisis of 2007-2009 that has had such a devastating impact on the U.S. and global economies.

Yadav on Clearinghouses

The Problematic Case of Clearinghouses in Complex Markets, by Yesha Yadav, Vanderbilt Law School, was recently posted on SSRN. Here is the abstract:

This Article challenges the academic and policy consensus that clearinghouses adequately mitigate the risks of trading credit derivatives. The Article advances two arguments. First, scholars have devoted little attention to the risks posed by underlying assets (e.g. a mortgage loan) that the credit derivative references and the impact that these have on the clearinghouse. Credit derivatives enable the economic risk of debt to be separated from the legal rights attaching to that debt. This separation impacts the clearinghouse profoundly. As a contract party to each trade it processes, the clearinghouse can be saddled with economic risk of underlying debt without the legal rights necessary to mitigate its exposure. If a clearinghouse cannot manage its risks, the consequences are invariably systemic and enormously costly to the taxpayer. Second, the Article shows that clearinghouse members are subject to complex incentives that: (i) actually encourage risk-taking by subsidizing its cost; (ii) allow parties to shift the private costs of monitoring to the clearinghouse and themselves under-invest in due diligence; and (iii) create undue reliance on information that is impressed by the strategic motives of parties providing it.

This Article, finally, proposes a new paradigm for the clearinghouse. This model seeks to repair the consequences of the separation between economic risks and legal rights enabled by the credit derivative – as well as control the perverse incentives affecting clearinghouse members. With the clearinghouse having better powers to police its exposures, the Article proposes that reform can make the clearinghouse a more robust institution and control lax underwriting standards more broadly.

SEC Says Adviser Stole from Clients to Pay SEC Settlement

If the SEC's allegations against Robert Pinkas are true, the investment adviser has a lot of chutzpah. According to its order instituting an administrative proceeding (In Re Pinkas, IA Rel. 3371),

Pinkas misappropriated $173,000 from a fund client to pay the costs of defending himself in an unrelated Commission investigation. Pinkas subsequently made material misrepresentations to the fund’s investors about the misappropriation, telling them that multiple law firms had reviewed the fund’s indemnification provisions and concluded that his use of fund assets to cover his attorney’s fees in the other matter was appropriate. Pinkas then misappropriated $632,000 from the same client to cover the disgorgement he agreed to pay as part of a settlement in the other matter with the Commission. After misappropriating these funds, Pinkas violated an investment adviser bar imposed in the other matter by continuing to associate with an investment adviser.

Pinkas agreed to a settlement in a previous SEC enforcement action, SEC v. Brantley Capital Management, which ordered him to pay a $325,000 civil penalty and $632,729 in disgorgement and interest, and barred him from associating with any investment adviser with a right to reapply after one year.

SEC Tightens Rules on Advisory Performance Fee Charges

The SEC tightened its rule on investment advisory performance fees to raise the net worth requirement for investors who pay performance fees, by excluding the value of the investor’s home from the net worth calculation.

Under the SEC’s rule, registered investment advisers may charge clients performance fees if the client’s net worth or assets under management by the adviser meet certain dollar thresholds. Investors who meet the net worth or asset threshold are deemed to be “qualified clients,” able to bear the risks associated with performance fee arrangements.

The revised rule will require “qualified clients” to have at least $1 million of assets under management with the adviser, up from $750,000, or a net worth of at least $2 million, up from $1.5 million. These rule changes conform the rule’s dollar thresholds to the levels set by a Commission order in July 2011. The Commission-ordered increase in the thresholds was required by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. In addition, the revised rule will exclude the value of a client’s primary residence and certain property-related debts from the net worth calculation; the change was not required by the Dodd-Frank Act, but is consistent with changes the Commission approved in December to net worth calculations for determining who is an “accredited investor” eligible to invest in certain unregistered securities offerings.

A new grandfather provision to the performance fee rule will permit registered investment advisers to continue to charge clients performance fees if the clients were considered “qualified clients” before the rule changes. In addition, the grandfather provision will permit newly registering investment advisers to continue charging performance fees to those clients they were already charging performance fees.

Finally, the revised rule provides that every five years, the Commission will issue an order making inflation adjustments to the dollar thresholds used to determine whether an individual or company is a qualified client, as required by the Dodd-Frank Act.