Securities Law Prof Blog

District Court Will Decide Dispute between SEC and SIPC in Summary Proceeding

The federal district court for the D.C. Circuit moved a step closer to resolving the unprecedented dispute between the SEC and the Securities Investor Protection Corp. (SIPC) over whether the customers of the Stanford Group Company (SGC), the defunct broker-dealer that was part of Robert Allen Stanford's ponzi scheme, are entitled to the protection from SIPC.  SIPC takes the position that the SGC customers are not covered by the statute because SGC did not perform a custody function for the customers who purchased the CDs issued by the Stanford International Bank.  The SEC originally held this position, but changed its mind in mid-2011, when it delivered to SIPC an analysis that the SGC customers were in need of protection and that SIPC should seek to commence a liquidation proceeding under SIPA.  

On Feb. 9, the court held that the statute authorizes the SEC to bring a summary proceeding for a protective decree and that the full, formal procedures of the Federal Rules of Civil Procedure are not required.  The court asked the parties to brief fully what procedures should apply in the summary proceeding.  SEC v. SIPC (D.D.C. Cir. Feb. 9, 2012)

The district court did address the SEC's contention that its "preliminary determination that SGC has failed or in danger of failing to meet its obligations to customers is not subject to judicial review by this Court."  The court found the SEC's contention "untenable:" "the plain meaning [of the statute] makes the relief available to the SEC contingent upon an affirmative determination that SIPC has refused to commit funds or otherwise protect customers."

SEC Charges California Hedge Fund Manager with Insider Trading

The SEC charged Douglas F. Whitman, a hedge fund manager, and his Menlo Park, Calif.-based firm for their involvement in the insider trading ring connected to Raj Rajaratnam and hedge fund advisory firm Galleon Management.  The SEC alleges that Whitman and Whitman Capital illegally traded based on material nonpublic information obtained from Rajaratnam associate Roomy Khan, who was Whitman's friend and neighbor. Khan tipped Whitman with confidential details about Polycom Inc.'s fourth quarter 2005 earnings and Google Inc.'s second quarter 2007 earnings prior to the public announcements of those financial results by the companies. Whitman Capital reaped nearly $1 million in ill-gotten gains by trading on Khan's illegal tips, according to the SEC's complaint.

According to the SEC's complaint, filed in federal court in Manhattan, the inside information about Polycom and Google used by Whitman is the same information that the SEC has previously alleged Khan provided to many of her hedge fund contacts, including Rajaratnam as well as Robert Feinblatt and Jeffrey Yokuty at Trivium Capital.

The SEC has charged 30 defendants in its Galleon-related enforcement actions

Ethics Office Investigates Bachus for Trading on Nonpublic Information

The Washington Post reports that the Office of Congressional Ethics has notified Rep. Spencer Bachus, chairman of the House Financial Services Committee, that it has found probable cause that he violated the ethics rules because of trading on nonpublic information.  Rep. Bachus said in a statement that he welcomes the opportunity to present facts and set the record straight.  The ethics investigation reportedly began last year.  Rep. Bachus is a frequent trader, especially making short-term trades in stock options.  WPost, Rep. Spencer Bachus faces insider-trading investigation  

SEC Charges Former Pharma Employee with Insider Trading

The SEC charged a former employee of Takeda Pharmaceuticals International, Inc. with trading on inside information about the Japanese firm’s business alliances and corporate acquisitions.  Brent Bankosky, a former Senior Director in Takeda’s U.S.-based business development group, agreed to pay more than $136,000 to settle the SEC’s charges.

The SEC’s complaint alleges that Bankosky reaped more than $63,000 of profits, achieving a 169% rate of return, by trading on non-public information about two business transactions in 2008. Takeda’s business development group worked on the transactions, a strategic alliance with Cell Genesys, Inc., and the acquisition of Millennium Pharmaceuticals, Inc., which were referred to internally by their code names, Project Ceres and Project Mercury. Bankosky’s trading violated U.S. securities laws and Takeda’s policies, which forbade employees from disclosing or trading based on inside information.

According to the SEC’s complaint, almost immediately after Bankosky joined Takeda in January 2008 as a Director in its business development group, he began to misuse confidential corporate information for his personal benefit.

Ernst & Young Settles PCAOB Disciplinary Order for Audit Failures

The Public Company Accounting Oversight Board announced a settled disciplinary order censuring Ernst & Young LLP, imposing a $2 million civil money penalty against the firm, and sanctioning four of its current and former partners for violating PCAOB rules and standards.  The $2 million civil money penalty is the Board's largest civil money penalty to date. The respondents agreed to settle without admitting or denying the Board's findings.

The order related to three E&Y audits of Medicis Pharmaceutical Corporation, and a consultation stemming from an internal E&Y audit quality review of one of the audits.  James R. Doty, PCAOB Chairman, summarized E&Y's failings:

These audit partners and Ernst & Young — the company's outside auditor for more than 20 years — failed to fulfill their bedrock responsibility. The auditor's job is to exercise professional skepticism in evaluating a public company's accounting and in conducting its audit to ensure that investors receive reliable information, which did not happen in this case.

Cantor Releases His Version of STOCK Act

House Majority Leader Eric Cantor released his version of the STOCK Act.  It expands the prohibition on trading on nonpublic information to the executive branch (which is already prohibited).  It also  deletes the provision added by Senator Grassley that would require political intelligence consultants to disclose their activities and instead calls for a study of the issue.  See Seung Min Kim, Eric Cantor under fire for STOCK Act tweaks, Politico.  While Democrats are dismayed about this deletion, in fact, registration of political intelligence consultants is the wrong way to address the problem of inequal access to government information, as Professor Richard Painter argues in a blog on the Legal Ethics Forum, Senate Adds Flawed Political Intelligence Amendment to Insider Trading Bill.  Professor Painter argues that the right approach is to restrain officials from leaking nonpublic information through an approach similar to Regulation FD.

The House passed its version on Thursday.  NYTimes, House Passes Bill Banning Insider Trading by Members of Congress

SEC Settles Foreign Bribery Charges Against Smith & Nephew

The SEC announced a settlement with Smith & Nephew PLC to resolve SEC charges that the global medical device company violated the Foreign Corrupt Practices Act (FCPA) when its subsidiaries bribed public doctors in Greece for more than a decade. Smith & Nephew PLC, headquartered in London, England, is a global medical device company with operations around the world.

The SEC alleges that, from 1997 to June 2008, two of Smith &Nephew PLC’s subsidiaries, including its U.S. subsidiary, Smith & Nephew Inc., used a distributor to create a slush fund to make illicit payments to public doctors employed by government hospitals or agencies in Greece. Smith &Nephew PLC agreed to settle the SEC’s charges by paying more than $5.4 million in disgorgement and prejudgment interest. In addition, Smith &Nephew PLC agreed to retain an independent compliance monitor for a period of eighteen months to review its FCPA compliance program.

Smith &Nephew PLC’s U.S. subsidiary, Smith & Nephew Inc., agreed to pay a $16.8 million fine to settle parallel criminal charges announced by the U.S. Department of Justice today.

Posner & Weyl on Limiting Speculation on Derivatives

A Proposal for Limiting Speculation on Derivatives: An FDA for Financial Innovation, by Eric A. Posner, University of Chicago - Law School, and E. Glen Weyl, University of Chicago; 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 sophisticated 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. Most discussions center on enhanced disclosure and the use of exchanges and clearinghouses. However, we argue that disclosure rules do not address the real problem, which is that financial firms invest enormous resources to develop financial products that facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities. We propose that when investors invent new financial products, they be forbidden to market 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 and only if they satisfy a test for social utility. The test centers around a simple market analysis: is the product likely to be used more often for hedging or 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.

Velasco on Aspiration and Corporate Fiduciary Duties

The Role of Aspiration in Corporate Fiduciary Duties, by Julian Velasco, University of Notre Dame, was recently posted on SSRN.  Here is the abstract:

Corporate law is characterized by a pervasive divergence between standards of conduct and standards of review. Courts often opine on the relatively-demanding standard of conduct, but their verdicts must be based on the more forgiving standard of review. Commentators defend this state of affairs by insisting that it provides guidance to directors without imposing ruinous liability. However, the dichotomy can lead many, especially those who focus on the bottom line, to call into question the meaningfulness of standards of conduct. Of particular concern is the increasing popularity, in legal and scholarly circles, of the notion that fiduciary duty standards of conduct are aspirational and unenforceable. This theory, which I will call the “aspirational view”, is misguided. The use of the term "aspirational" is especially problematic. Whatever else aspirational may mean, it does not mean obligatory or mandatory. Whether by design or only by effect, this has the potential to undermine fiduciary duties significantly. In this article, I will argue that fiduciary duty standards of conduct are duties — fully binding on actors even when they are not enforced. I will also argue that the unenforced duty is a meaningful concept because people obey the law for many different reasons, and not simply out of fear of punishment.

Lipson on Defining Securitization

Re: Defining Securitization, by Jonathan C. Lipson, University of Wisconsin Law School, was recently posted on SSRN.  Here is the abstract:

This Article fills a gap in commercial finance law. Despite the fact that “securitization” has become enormously important to capital markets — and is sometimes blamed for the credit crisis — we have no agreed understanding of the term. Various regulators and commentators have generated a wide range of definitions, but many are vague or omit crucial elements. Perhaps most surprising, the Dodd-Frank financial services reform — the most aggressive attempt yet to regulate securitization — does not define it at all. How can we regulate something without a shared conception of what it is?

This Article assesses data on the performance and function of securitizations to develop a normative definition of the term based on its essential elements (its inputs, structure, and outputs) and its legitimate social and economic functions, namely providing a more effective means of connecting buyers and sellers of capital than traditional methods of financing, such as bank lending or issuing shares of stock.

The definition offered here distinguishes “true” securitizations from other transactions, such as collateralized debt obligations and Enron’s structured financings, which may satisfy current legal definitions of a securitization, but which in fact lack one or more essential elements, and which therefore fail to perform the important social and economic functions captured by the normative definition advanced here.

The Article concludes by summarizing the benefits of a better definition of securitization.

Schwarcz on Defining Securitization

What is Securitization? And for What Purpose?, by Steven L. Schwarcz, Duke University - School of Law, was recently posted on SSRN.  Here is the abstract:

In Re: Defining Securitization, Professor Jonathan Lipson attempts to define a “true” securitization transaction. My article engages Lipson’s, exploring how securitization should be legally defined. As a starting point, even a normative approach to defining a financial concept should be pragmatic, taking into account how the concept is used in the real world. The definition also should take into account dynamically changing financial markets and, in what I call an audience-adaptive approach, the different perspectives of policymakers and lawmakers, market participants and their lawyers, regulators and judges, and other members of the “audience” affected by the definition.

Carlyle Drops Arbitration Clause in IPO Filings

Good news!  The Carlyle Group announced today that it was dropping the controversial mandatory arbitration (and no class actions) clause from its IPO documents.  Apparently it decided it was a bad idea after consultations with the SEC, investors and other interested individuals.  Three Democratic Senators (Blumenthal, Franken and Menendez) also wrote to SEC Chair Schapiro expressing their concerns. 

 

Schwab Sues FINRA, Seeks Declaratory Judgment It Can Prohibit Class and Consolidated Claims

In a blog yesterday, I reported that Charles Schwab has filed a declaratory judgment action against FINRA in federal district court in Northern California in response to FINRA's institution of a disciplinary action against the firm.  The issue is whether Schwab's amending its customer agreements to bar class actions in court and to prevent arbitrators from consolidating individual claims is legal and enforceable.  FINRA asserts the changes violate its rules; Schwab disputes this, but says that in any event the recent U.S. Supreme Court opinions in Concepcion and Compucredit override FINRA's rules.

I will have more to say about the litigation later, but in the meantime here is the Schwab complaint (Download Schwab Complaint).

Senate Passes STOCK Act by 96-3 vote

The Senate passed, by a vote of 96-3, the STOCK Act, which prohibits members of Congress and their aides from trading on inside information and also requires public officials to disclose their financial transactions within 30 days.

The legislation also contains a number of other provisions, including requiring members of the political intelligence community to disclose their activities.  The House is expected to vote on legislation next week.  WPost, Minor Senate bill transformed into broad reform package

NYSE & Deutsche Boerse Call It Off

It's official -- the NYSE and Deutsche Boerse merger is over:

NYSE Euronext (NYSE: NYX) announced today that in light of the decision by the European Commission to block the proposed merger agreement,  both companies have agreed to a mutual termination of the business combination agreement originally signed by the Companies on February 15, 2011.

It will be interesting to see what is Plan B for the Exchange.  This is a big setback on its plans to dominate the global markets.

Schwab Goes to Court to Uphold its Class Action Waiver

Recently I wrote an article in which I explored the question of why no brokerage firm seeks to attract retail investors by advertising that it does not require its customers to enter into mandatory predispute arbitration agreements.  Barbara Black, Can Behavioral Economics Inform Our Understanding of Securities Arbitration?, 12 Transactions: The Tennessee Journal of Business Law 107 (2011).  Charles Schwab, apparently, has chosen a different strategy.  In fall 2011 the firm amended its customer agreements to include a provision requiring customers to waive their rights to bring or participate in class actions against the firm and also states that arbitrators do not have the authority to consolidate claims.  In a blog yesterday, I described FINRA's enforcement proceeding against Schwab, which charges that both these provisions violate FINRA rules.

Schwab has responded to the FINRA action by filing a declaratory judgment action in federal district court in Northern California, seeking a determination that the agreements are enforceable under recent U.S. Supreme Court opinions, AT&T Mobility v. Concepcion and Compucredit Corp. v. Greenwood.  As reported in BNA Securities Daily, the company stated that class actions are "unduly expensive and time-consuming, and too often result in little benefit to class members" and that class action waivers are "in the best interests of both its customers and its shareholders."

We now have the Carlyle Group, in its IPO, seeking to bar investors' class claims and Schwab seeking, in its brokerage agreement, to bar customers' class claims.  Both are directly attributable to Concepcion.  If these provisions are legal and enforceable, securities class claims will soon be a thing of the past; the Supreme Court will have accomplished what millions of lobbyists' dollars could not.  Where does the Securities and Exchange Commmission, the self-proclaimed investors' advocate, stand on these developments?

Second Circuit Again Rules that Class Action Waiver In American Express Merchants Agreements is Unenforceable

In a victory for consumer and investor advocates, the Second Circuit reaffirmed its decision in In re American Express Merchants' Litigation, 634 F.3d 187 (2d Cir. 2011) (Amex II) that the class action waiver provision contained in the contracts between American Express and merchants is unenforceable under the Federal Arbitration Act (FAA), because enforcement of the clause would as a practical matter preclude any action seeking to vindicate the statutory rights asserted by the plaintiffs.  The Second Circuit ruled that the U.S. Supreme Court's recent opinion in AT&T Mobility v. Concepcion did not alter its analysis.  In re American Express Merchants' Litigation (Amex III) (2d Cir. Feb. 1, 2012) Download AmericanExpress.020112[2]

The Second Circuit has now issued three opinons on this question, necessitated by recent Supreme Court pronouncements.  In Amex I, 554 F.3d 300 (2d Cir. 2009), the court considered the enforcement of a mandatory arbitration clause in a commercial contract that also contained a class action waiver and determined that it was unenforceable.  The court reasoned that the high costs of litigating an antitrust claim ruled out individual claims and meant that without a class action plaintiffs would have no remedy.  The Supreme Court granted Amex's petition for certiorari and vacated and remanded in light of its decision in Stolt-Nielsen S.A. v. AnimalFeeds Int'l Corp., 130 S. Ct. 1758 (2010), which held that parties could not be compelled to submit to class arbitration unless they agreed to it.  In Amex II, the Second Circuit found that Stolt-Nielsen did not affect its original analysis, since the court acknowledged that it could not, and thus were not, ordering the parties to participate in class arbitration.  After Amex II, the court placed a hold on its mandate in order for Amex to file a petition for certiorari.  While the mandate was on hold, the Supreme issued Concepcion, which held that the FAA preempted a California law barring enforcement of class action waivers in consumer contracts.  The Second Circuit then sua sponte considered rehearing in light of Concepcion, and parties submitted supplemental briefing on the question.

In Amex III, the Second Circuit, in response to Amex's argument that Concepcion applies a fortiorari and requires reversal, observes that

[I]t is tempting to give both Concepcion and Stolt-Nielsen such a facile reading, and find that the cases render class arbitration waivers per se enforceable. But a careful reading of the cases demonstrates that neither one addresses the issue presented here: whether a class-action arbitration waiver clause is enforceable even if the plaintiffs are able to demonstrate that the practical effect of enforcement would be to preclude their ability to vindicate their federal statutory rights.

*    *    *    *

Concepcion plainly offers a path for analyzing whether a state contract law is preempted by the FAA.  Here, however, our holding rests squarely on a "vindication of statutory rights analysis, which is part of the federal substantive law of arbitrability."

Accordingly, since Concepcion and Stolt-Nielsen do not answer the question, the Second Circuit looked for guidance in other Supreme Court decisions addressing the issue of vindicating federal statutory rights in arbitration.  The court begins its analysis with precedent acknowledging the importance of class actions in vindicating statutory rights and then proceeds to a discussion of arbitration, also recognized as an effective vehicle for vindicating statutory rights, so long as the litigant can effectively vindicate its statutory cause of action in arbitration (citing Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc.)  Most recently, in Green Tree Financial Corp.-Alabama v. Randolph, 531 U.S. 79 (2000), the Supreme Court acknowledged in dicta "that the existence of large arbitration costs could preclude a litigant ... from effectively vindicating her federal statutory rights in the arbitral forum."

Because neither Stolt-Nielsen nor Concepcion overrules Mitsubishi and neither even mentions Green Tree, the Second Circut, in Amex III, reaffirms its earlier analysis in Amex II:  because plaintiffs' expert evidence establishes as a matter of law that the cost of plaintiffs' individually arbitrating their disputes with Amex would be prohibitive, the effect of enforcing the class-action waiver is to ensure that the merchants could not challenge Amex's tying arrangements under the antitrust laws.  Accordingly, the clause is unenforceable under the FAA.  The court made clear that each class-action waiver must be considered on its own merits, based on its own record and "governed with a healthy regard for the fact that the FAA 'is a congressional declaration of a liberal federal policy favoring arbitration agreements ....'"

We can expect that Amex will again seek a petition for certiorari.  Stay tuned!  In the meantime, kudos to the Second Circuit for a well-reasoned and eloquent opinion on the importance of class actions in enforcing federal statutory rights.

DOJ & SEC Charge Former Credit Suisse Traders with Subprime Bond Pricing Scheme

The DOJ and the SEC brought criminal and civil charges against former Credit Suisse bankers alleging misstatements about the bank's valuations of $3 billion in subprime mortgage-backed securities during the financial crisis.  A former trader, Salmaan Siddiqui, and his supervisor, David Higgs, pleaded guilty to a criminal conspiracy charge.  The former global head of the Structured Credit Trading unit, Kareem Serageldin, was also charged; he is believed to be in the UK.  Credit Suisse was not charged.

According to the SEC, the employees deliberately ignored specific market information showing a sharp decline in the price of subprime bonds under the control of their group. They instead priced them in a way that allowed Credit Suisse to achieve fictional profits. Serageldin and Higgs periodically directed the traders to change the bond prices in order to hit daily and monthly profit targets, cover up losses in other trading books, and send a message to senior management about their group’s profitability. The SEC alleges that the mispricing scheme was driven in part by these investment bankers’ desire for lavish year-end bonuses and, in the case of Serageldin, a promotion into the senior-most echelon of Credit Suisse’s investment banking unit.

The SEC alleges that the scheme reached its peak at the end of 2007, when the group recorded falsely overstated year-end prices for the subprime bonds. Just days later in a recorded call, Serageldin and Higgs acknowledged that the year-end prices were too high and expressed a concern that risk personnel at Credit Suisse would “spot” their mispricing. Despite acknowledging that the subprime bonds were mispriced, Serageldin approved his group’s year-end results without making any effort to correct the prices. When the mispricing was eventually detected in February 2008, Credit Suisse disclosed $2.65 billion in additional subprime-related losses related to the investment bankers’ misconduct.

The SEC explained that its decision not to charge Credit Suisse was influenced by several factors, including the isolated nature of the wrongdoing and Credit Suisse’s immediate self-reporting to the SEC and other law enforcement agencies as well as prompt public disclosure of corrected financial results. Credit Suisse voluntarily terminated the four investment bankers and implemented enhanced internal controls to prevent a recurrence of the misconduct. Credit Suisse also cooperated vigorously with the SEC’s investigation of this matter.

WSJ, Ex-Credit Suisse Employees Face Charges in Mortgage-Bond Probe .

FINRA: Schwab Improperly Requires Customers to Waive Class Actions

Will Charles Schwab get away with including a class action waiver in its customer agreements?

FINRA announced today that it has filed a complaint against Charles Schwab & Company charging the firm with violating FINRA rules by requiring its customers to waive their rights to bring class actions against the firm.  FINRA's complaint charges that in October 2011, Schwab amended its customer account agreement to include a provision requiring customers to waive their rights to bring or participate in class actions against the firm. Schwab sent the amended agreements to nearly 7 million customers.  The agreement also included a provision requiring customers to agree that arbitrators in arbitration proceedings would not have the authority to consolidate more than one party's claims. FINRA's complaint charges that both provisions violate FINRA rules concerning language or conditions that firms may place in customer agreements. 

Specifically, the class action waiver violates NASD Rule 3110(f)(4)(C) and FINRA Rule 2268(d)(3), both of which prohibit member firms from including any condition in a predispute arbitration agreement that "limits the ability of a party to file any claim in court permitted to be filed in court under the rules of the forums in which a claim may be filed under the agreement."  The class action waiver also violates NASD Rule 3110(f)(4)(A) and FINRA Rule 2268(d)(1), which prohibit member firms from including any condition in the agreement that limits or contradicts the rules of any self-regulatory organization," because Rule 12204(d) provides that customers can bring and participate in class actions in the manner provided in the rule.  Similarly, the provision that purports to limit the ability of arbitrators to consolidate claims of more than one party violates NASD Rule 3110(f)(4)(A) and FINRA Rule 2268(d)(1) because it contradicts Rule 12312(a) and (b) that provide that arbitrators have the authority to consolidate claims under certain curcumstances.

FINRA's complaint seeks an expedited hearing because Schwab's conduct is ongoing, as the firm has continued to use account agreements containing these provisions in opening more than 50,000 new customer accounts since October 2011.

Download FINRA.SchwabComplaint