Securities Law Prof Blog

Fuerman on Stock Option Backdating

Ross D. Fuerman has posted The Stock Option Backdating Litigation: An Empirical Investigation on SSRN with the following abstract:

This paper adds to the stock option backdating literature by examining the litigation it spawned. The stock option backdating litigation ("SOBL"), compared to the contemporaneous typical financial reporting litigation, is negatively associated with auditor defendants, bankruptcy, and the amount of the aggregate settlements paid directly to the shareholders. It is positively associated with the computer industry, stock option backdating restatements, and US companies. In comparing the derivative lawsuit-only SOBL to the SOBL with related securities class actions, it was found that the derivative lawsuit-only SOBL is negatively associated with auditor defendants, fraud, revenue restatements, and the forced departure of executives implicated in stock option backdating. In the final analysis – of the factors associated with the amount of the SOBL securities class action settlement with the shareholders – the forced departure of executives implicated in stock option backdating was positively associated with the settlement amount. The results suggest that securities class actions may be more effective than derivative lawsuits in deterring fraud, and that their effectiveness is positively associated with their successful prosecution.

Testimony of Chair White on “Oversight of the SEC’s Agenda, Operations and FY 2015 Budget Request”

Details available here.

NASAA Issues Investor Advisory on Virtual Currency

Details available here.

Shepro on the SEC

Mary McAllister Shepro has posted Old-Fashioned Deterrence: Why the SEC's New Policy Could Actually 'Bring the Swagger Back' to the Commission on SSRN with the following abstract:

This Paper sheds light on the potential ramifications of the new SEC enforcement policy requiring wrongdoers to admit guilt and assesses the deterrent capacity of the new policy. Overall, this Paper concludes that requiring certain wrongdoers to admit guilt is not as catastrophic for defendants or the SEC as some critics suggest. It further argues that the potential for deterring violations of the federal securities laws is great enough to support the SEC’s new policy.

Donelson, Kadous & McInnis on Auditor Litigation

Dain C. Donelson, Kathryn Kadous, and John M. McInnis have posted Litigation Against Auditors on SSRN with the following abstract:

Auditors are subject to litigation exposure under federal securities laws and under state law. Research into auditors’ liability under federal securities laws tends to make use of publicly available data from class action suits to examine factors associated with the incidence of litigation against auditors, the extent to which the legal merits of the case influence incidence and outcomes of those cases, and the impact of legal reform on litigation against auditors. State law does not generally allow class actions suits, so public data are not available. Research in this area focuses on understanding the process by which jurors and judges assess auditor blame for client misstatements. It considers similar issues, including the extent to which the merits of the case versus legally irrelevant factors impact the resolution of the case. Market-based experiments examine the effects of various legal regimes on auditor and social welfare. We summarize research results in these areas and identify important areas for future research, including examining the effects of potential decreases in auditor liability on social welfare, deepening our understanding of the conditions under which the merits of the case are appropriately reflected in case outcomes, and improving our understanding of how parties determine whether to settle and how juries set damage awards.

Brown on Proxies

J. Robert Brown Jr. has posted The Proxy Plumbing Release Revisited and the Need for Version 2.0 on SSRN with the following abstract:

Congress assigned the Securities and Exchange Commission (SEC or Commission) responsibility over the proxy process in the Securities Exchange Act of 1934. The Act gave little guidance but left the Commission with broad authority to adopt rules that were “necessary or appropriate in the public interest or for the protection of investors.” The Commission found itself thrown into the middle of a complex regulatory environment already inhabited by other decision makers. State law governed the substantive rights of shareholders, determining who could vote, the matters subject to their approval, and the percentages needed for adoption. Stock exchanges regulated the relationship between brokers and street name owners and the activities of listed companies.

The SEC for the most part focused on disclosure. Solicitations were to be accompanied or preceded by a proxy statement that provided shareholders with the information needed to make an informed voting decision. To ensure accuracy, the earliest version of the rules included a strong anti-fraud provision.

Beginning in a modest fashion, the proxy process ultimately assumed a disproportionate role in the system of corporate governance. The right of shareholders to nominate directors or make proposals was meaningless without the ability to solicit proxies. Aware of this, the proxy rules were designed to function as a “replacement” for the annual meeting and to give shareholders the same rights available under state law.

In fact, the rules amounted to more of a limit on, rather than a replacement of, the rights of shareholders. The costs associated with solicitations restricted shareholders communications and sharply curtailed the ability to nominate directors. Even where the Commission provided access to the proxy statement, the authority extended only to certain shareholders and allowed for the exclusion of proposals on grounds not sanctioned under state law. Proxy cards bore little resemblance to ballots used at the meetings, restricting shareholder choice in contests for control of the board.

Changes in the underlying dynamics, however, gradually challenged the system of regulation. Investors shifted from record to nominee ownership, facilitating trading activity but complicating the voting process. Institutional investors grew in importance and chaffed under the restrictions contained in the rules. The proxy process increasingly confronted the logistical problems that arose from the need to process billions of votes in thousands of meetings over a short period of time.

The proxy rules needed reform. Longstanding but antiquated provisions interfered with effective exercise of voting rights. The plethora of participants made accountability difficult. Hanging chads threatened to throw results into doubt. The process resulted in low participation rates for retail investors. Aware of these strains, the Commission initiated a comprehensive reexamination of the regulatory regime in 2010. Dubbed the Proxy Plumbing Release, or Concept Release, the SEC sought comments on a wide range of issues that potentially affected the integrity of the voting process. The Concept Release addressed, among other things, back office issues, the role of intermediaries, and the plight of retail investors.

Gross on Securities Arbitration Clinics

Jill Gross has posted The Improbable Birth and Conceivable Death of the Securities Arbitration Clinic on SSRN with the following abstract:

This article explores the birth. life and possible death of the securities arbitration clinic (SAC), a law school clinic in which students represent investors of modest means in arbitrable securities disputes with their broker-dealers. The article first describes the history of the SAC, how a SAC operates and how SAC students help investors. The article then reviews the pedagogical advantages and disadvantages of a SAC, and addresses the reluctance of many law schools to embrace this type of clinic. The article concludes by predicting whether these clinics have a future in lights of the modern challenges to legal education.

Niszczota on Religious Prohibitions on Investment

Paweł Niszczota has posted Religious Prohibitions and Investment: The Effect of the Islamic Moral Code on Investment in Foreign Debt Securities on SSRN with the following abstract:

The purpose of this study is to investigate whether religious prohibitions have a significant impact on the propensity to invest in foreign securities. We do this by exploring the effect of the Islamic prohibition of interest, which as we hypothesize, should impact the level of investment in foreign debt securities made from countries with a high Muslim population. We perform a panel regression analysis that gives support for this hypothesis, by demonstrating a negative relationship between the value of investments in foreign debt securities and the percentage of Muslims in the population of the investing country. Our results are robust to the inclusion of several other factors that could impact investment – including culture-related ones – and the use of different estimation procedures and dependent variables.

Maslo on National Securities Exchanges

Paul Brian Maslo has posted Immunocompromised: A Call for Courts to Redefine the Boundaries of the Application of Absolute Immunity to National Securities Exchanges on SSRN with the following abstract:

Because of their status as self-regulatory organizations (“SROs”), courts have granted national securities exchanges absolute immunity from suit for money damages when they act within the scope of their regulatory and general oversight functions. When securities exchanges were member-owned nonprofits, primarily focused on regulation, application of the absolute-immunity doctrine was clear-cut. The doctrine’s application now requires a more nuanced approach because exchanges have evolved into for-profit businesses that compete directly with broker-dealers and have offloaded a substantial portion of their regulatory functions to the Financial Industry Regulatory Authority (“FINRA”).

As for-profit entities, securities exchanges undertake numerous business activities that are completely divorced from or only tangentially related to their role as regulators. Though courts have begun to recognize that exchanges wear two hats (i.e., business and regulatory) and carve out an exception from the absolute-immunity doctrine for activities that lie well outside exchanges’ general oversight functions, courts have not yet applied the commercial exception to activities that have some regulatory hook but are undertaken primarily for business reasons. Thus, under the commercial exception as currently fashioned, exchanges have absolute immunity for business activities, so long as they have some ancillary connection to the exercise of their regulatory powers. To remedy that problem, this article advocates extending the commercial exception to cover actions primarily taken to further exchanges’ business interests, regardless of whether they have some regulatory connection. Exchanges should not have absolute immunity when they are acting as for-profit market participants executing self-interested business decisions, only because those decisions relate, in some indirect way, to a regulatory function. Instead, courts should grant immunity to shield exchanges only when they are acting under the aegis of their delegated authority as market regulators.

To aid courts in identifying whether an activity is primarily regulatory or primarily commercial, this article proposes that, when addressing the application of absolute immunity to securities exchanges, courts carve out an exception from the line of precedents rejecting the consideration of motive in the immunity analysis. Considering motive may be the best way for courts to ferret out those activities that are primarily commercial (and not deserving of protection) in situations involving some regulatory component.

Babis on European Short Selling Regulation

Valia S.G. Babis has posted The Power to Ban Short-Selling: The Beginning of a New Era for EU Agencies? on SSRN with the following abstract:

This case note discusses Case C-270/12 United Kingdom v European Parliament and Council [2014] (not yet reported), regarding certain powers of the European Securities and Markets Authority under the Short-Selling Regulation.

Markovic on Mortgage Backed Securities

Milan Markovic has posted Subprime Scriveners on SSRN with the following abstract:

Although mortgage-backed securities (“MBS”) and other financial products that nearly caused the collapse of the global financial system could not have been issued without attorneys, the legal profession’s role in the financial crisis has received relatively little scrutiny.

This Article focuses on lawyers’ preparation of MBS offering documents that misrepresented the lending practices of mortgage loan originators. While attorneys may not have known that many MBS would become toxic, they lacked incentives to inquire into the shoddy lending practices of prominent originators such as Washington Mutual Bank (“WaMu”) when they and their clients were reaping considerable profits from MBS offerings.

The subprime era illustrates that attorneys are unreliable gatekeepers of the financial markets because they will not necessarily acquire sufficient information to assess the legality of the transactions they are facilitating. The Article concludes by proposing that the Securities and Exchange Commission impose heightened investigative duties on attorneys who work on public offerings of securities.

Thel on Section 10(b)

Steven Thel has posted Taking Section 10(b) Seriously: Criminal Enforcement of SEC Rules on SSRN with the following abstract:

The Supreme Court has determined the scope of federal securities laws in a series of cases in which it has read section 10(b) of the Securities Exchange Act as either prohibiting certain misconduct or authorizing the SEC to regulate that conduct and only that conduct. Judging by the language, structure and history of the Exchange Act, the Court’s reading is wrong. Section 10(b) does not prohibit anything, and it neither grants the SEC rulemaking power nor limits the rulemaking power granted to the SEC elsewhere in the Exchange Act. Instead, section 10(b) simply triggers criminal sanctions for certain rule violations. This is an important function, but one very different from the one the Supreme Court has ascribed to section 10(b).

Contrary to conventional wisdom, not all SEC rules are subject to criminal enforcement. Instead, criminal sanctions apply to rules whose violation the statute makes “unlawful.” Section 10(b) triggers criminal sanctions by making it “unlawful” to use or employ manipulative or deceptive devices or contrivances in connection with a security trade in contravention of SEC rules. While this mechanism has long been ignored, it was well understood when the Exchange Act was enacted. By ignoring the language of section 10(b) and the history and structure of the Exchange Act, the Supreme Court has frustrated the will of Congress and needlessly complicated securities law. In the context of SEC enforcement actions, Congress has repeatedly rejected the Court’s approach to section 10(b), which cannot withstand extension to other well-established parts of the statutory regulatory scheme.

The Supreme Court should take responsibility for the private right of action for violations of rule 10b-5, and should consider substantially restricting the fraud on the market class action that it has itself created . On the other hand, inasmuch as section 10(b) has little to do with the SEC, the Court’s restrictive holdings in rule 10b-5 cases should not apply to enforcement actions brought by the Commission, but only to private and, sometimes, criminal actions. For the same reason, the Court’s consistent and insistent rejection of the SEC’s interpretation of section 10(b) turns out to be oddly principled.

Sunstein on Cost-Benefit Analyses

Cass R. Sunstein has posted Financial Regulation and Cost-Benefit Analysis: A Comment on SSRN with the following abstract:

Many regulators have concluded that cost-benefit analysis is the best available method for capturing the welfare effects of regulations. It is therefore understandable that in recent years, some people have been interested in requiring financial regulators to engage in careful cost-benefit analysis of their regulations, and to proceed only if the benefits justify the costs. Ideas of this sort have played a significant role in judicial review of agency action, especially in cases involving the Securities and Exchange Commission. But it is important to distinguish the question whether courts should require cost-benefit analyses, and review them for arbitrariness, from the separate question whether financial regulators should produce such analyses. It is also important to understand that in some cases, cost-benefit analysis presents serious challenges for financial regulators. When agencies lack relevant information, and cannot project benefits (or costs), they can invoke established techniques to discipline the question whether and how to proceed. In particular, breakeven analysis plays a valuable role. Of course it remains possible that in rare cases, agencies have so little information that they cannot even use breakeven analysis. In such cases, it is not helpful to refer to the precautionary principle or to “expert judgment.” In such rare cases, the best that agencies may be able to do is to rely on some version of maximin, while also seeking to fill informational gaps over time.

Klöhn on EU Insider Trading Regulation

Lars Klöhn has posted Inside Information Without an Incentive to Trade? What's at Stake in Lafonta v. AMF on SSRN with the following abstract:

The term “inside information” is key to both the EU insider trading prohibition and the European continuous disclosure requirement. Artt. 2-4 Market Abuse Directive (MAD) prevent market participants from trading on, disclosing, and making investment recommendations on the basis of inside information. Art. 6 MAD requires issuers to publicly disclose any inside information which directly concerns them unless such disclosure would prejudice the issuers’ legitimate interests. In both contexts, the term inside information has the same legal definition, found in Art. 1 no. 1 MAD and Art. 1(1) of Directive 2003/124/EC. Recently, the French Cour de cassation submitted an interesting question to the European Court of Justice (ECJ, the “Court”) for a preliminary ruling, asking, in essence: Can there be inside information if the information does not provide an incentive to trade, i.e. can information be regarded as inside information if it does not allow an unambiguous prediction as to whether the market price will go up or down if it is publicly disclosed? This article attempts to answer that question from comparative, economic and dogmatic perspectives. It seeks to show that the ECJ must limit the concept of “inside information” to such information that gives market participants an incentive to trade on it, as otherwise the Court would contravene the policy considerations of MAD’s principle of equal access, contradict its own ruling in “Spector Photo Group” and harm the efficiency of European capital markets.

This Week in Securities Litigation

The SEC Actions Blog has compiled This Week In Securities Litigation (Week ending April 25, 2014).

New in Print

The following law review articles relating to securities regulation are now available in paper format:

Tim Bakken, Dodd-Frank's Caveat Emptor: New Criminal Liability for Individuals and Corporations, 48 Wake Forest L. Rev. 1173 (2013).

M. Hampton Foushee, Comment. Eminent Domain, Mortgage Backed Securities, and the Limits of the Takings Clause, 8 N.Y.U. J.L. & Liberty 66 (2013).

Jeffrey D. Hochberg & Michael Ochowski., What Looks the Same May Not be the Same: The Tax Treatment of Securities Reopenings, 67 Tax Law. 143 (2013).

Tammy C. Hsu, Comment, Understanding Bondholders' Right to Sue: When a No-Action Clause Should Be Void, 48 Wake Forest L. Rev. 1367 (2013).

Kevin Levenberg, Comment, Read My Lipsky: Reliance on Consent Orders in Pleadings, 162 U. Pa. L. Rev. 421 (2014). 

Pinto on Securitization

João Pinto has posted The Economics of Securitization: Evidence from the European Markets on SSRN with the following abstract:

Securitization is the process whereby financial assets are pooled together, with their cash flows, and sold to a specially created third party that has borrowed money to finance the purchase. The borrowed funds are raised through the sale of securities, in the form of debt instruments, into the market. Securitization is thus a technique used to transform illiquid assets into securities.

Securitization creates value by increasing liquidity and funding, reducing the cost of funding, allowing originators to reach a funding sources diversification, improving originators’ risk management, increasing the segmentation between the origination and investment functions, and allowing originators to benefit from regulatory (and/or tax) arbitrage and to improve key financial ratios.

Although the economic advantages, securitization also has problems, especially when used inappropriately. Considering the important role played by securitization in the development and propagation of the 2007/2008 financial crisis, the most commonly referred problems of securitization are complexity, off-balance sheet treatment, asymmetric information problems, agency problems, and higher transaction costs.
Besides describing the economic motivations and problems of securitization, this paper provides details on asset securitization characteristics and players, presents the recent trends of securitization markets, describes the role played by securitization in the 2007/2008 financial crisis, and provides some statistics of asset securitization activity in Western Europe between 2000 and 2013.

Torres-Spelliscy, Fogel & El-Khatib on the SEC and the D.C. Circuit

Ciara Torres-Spelliscy, Kathy Fogel, and Rwan El-Khatib have posted Running the D.C. Circuit Gauntlet on Cost Benefit Analysis after Citizens United: Empirical Evidence from SOX and the JOBS Act on SSRN with the following abstract:

To require disclosure or not to require disclosure; that is the question faced by regulators, including the Securities and Exchange Commission (SEC), in light of the Supreme Court’s 2010 Citizens United decision, which allows anew free flow of corporate money into the political system.

Pending before the SEC since 2011 is a petition by 10 law professors asking for transparency of corporate political spending. We write this article in anticipation of the SEC’s eventual promulgation of rules requiring disclosure of corporate political spending. Many of the core questions about the market’s reaction to increased regulation of listed companies that we can study now are likely to be implicated in the debate about regulation within the narrower subset of corporate political spending.

Corporations who do not want to disclose their political spending are likely to challenge any rule that the SEC issues on the subject. Such a legal challenge is destined to be heard by the D.C. Circuit Court, which examines federal regulations with an increasingly jaundiced eye. One of the ground on which the D.C. Circuit can dispose of a new regulation is by finding that the SEC did not do a sufficiently rigorous cost-benefit analysis.

This article addresses the potential hostility that the D.C. Circuit may harbor against a new SEC rule requiring greater corporate transparency in election activities and provides some data that might assist the SEC in navigating this gauntlet.

In summary, our data showed that the market reacted positively to the new regulations in SOX and reacted negatively to the deregulations embodied in the JOBS Act. In short, and as discussed more fully below, the data demonstrate that the market values transparency and distrusts opaqueness. We hope that the D.C. Circuit will find these data useful in illuminating the larger debate over what securities regulations are allowable.

Couture on Materiality

Wendy Gerwick Couture has posted Materiality and a Theory of Legal Circularity on SSRN with the following abstract:

This Article argues that the materiality doctrine, which lies at the heart of securities fraud, has the potential to operate as a self-fulfilling prophecy. This Article labels this phenomenon "legal circularity." In order to place the potential legal circularity of materiality in context among the various other legal doctrines that share this potential, this Article proposes a two-part Theory of Legal Circularity. First, this Article proposes the following Legal Circularity Test to identify potentially circular doctrines: A legal doctrine is potentially circular if: (1) the legal doctrine incorporates the behavior or attitude of a population or person, either hypothetical or real; and (2) the subject population or person either would (if hypothetical) or does (if real) consider prior precedent interpreting the legal doctrine when choosing said behavior or when adopting said attitude. Materiality, among other legal doctrines, arguably satisfies this test because (1) the materiality standard focuses on whether there is a substantial likelihood that a hypothetical "reasonable investor" would consider information important when making an investment decision, and (2) a reasonable investor would arguably consider prior materiality precedent when assessing whether information is important to his or her investment decision. Second, this Article proposes a Framework to Assess Legal Circularity, with the goal of providing guidance about whether to embrace a doctrine’s potential legal circularity. Under this framework, which draws from the rich scholarship on the related but distinct concepts of stare decisis, substantive law heuristics, and precedential herding, courts and scholars should weigh (1) the risk of a "wrong" rule; (2) the effects of greater predictability; and (3) the import of reconceiving the courts’ role. Finally, this Article applies this framework to materiality, concluding that courts and scholars should explicitly embrace the legal circularity of materiality, coupled with increased investor education about materiality and absent any clarifying guidance from the Securities and Exchange Commission about the scope of the doctrine.

NASAA Survey Finds Inconsistent Broker-Dealer Fee Disclosure and Questionable Markups

Details available here.