I'm so glad that Lisa educated us about the California IOUs!  I had not even thought of the securities angle, so now I'm intrigued.  I looked at Lisa's links, and the SEC investor alert reminds us that the California IOUs are exempt from registration as municipal bonds (Section 3(2) of the Securities Act), but those trading them must comply with the Municipal Securities Rulemaking Board.  The alert specifically points out that holders selling and those buying might need to register as broker-dealers and comply with suitability rules.  Wow. 

So, the first thing I was interested in was this suitability rule (Rule G-19).  Here's a 2007 MSRB release about two rules that brokers of municipal securities need to heed:  anti-fraud protections (Rule G-17) and suitability.  The more I looked, the more I think suitability might not be an issue, even thought the IOUs are being handed out to all kinds of Californians.  Although rumors of a credit downgrade have been swirling for two weeks, Moody's is still holding the State of California's general (taxable, senior) obligations at A2.  A downgrade would be to Baa or Baa2.  Most municipal bonds are rated one of those two ratings, and the default rate for municipal bonds in those ratings classes is nonzero, but only barely so.  I understand that these are special times and anything can happen (remember auction rate bonds?), but U.S. state obligations are among the safest instruments available.  So, to bring a suitability claim, someone would really have to be unsuitable for a CD. 

But another MSRB rule may be even more important:  price fairness.  In this notice dated today, the MSRB explains how the MSRB rules apply to the California IOUs:

The MSRB notes in particular its Rule G-30, which requires dealers to effect purchases and sales of municipal securities at fair and reasonable prices based on the dealer’s best judgment of their fair market value, and also requires dealers to charge fair and reasonable commissions in connection with brokered transactions. Dealers must deal fairly with customers and must not take advantage of a customer’s need for cash by offering to purchase registered warrants at deeply discounted prices that are below what could reasonably be viewed as their fair market value. More details on a dealer’s fair pricing obligations are included in a January 26, 2004 MSRB notice.[2] Published quotations regarding offers to buy or sell registered warrants must be bona fide and must be based on the dealer’s best judgment of fair market value under MSRB Rule G-13, and advertisements regarding registered warrants are subject to MSRB Rule G-21.

I would think that offering someone half of face value for an IOU doesn't reflect the fair value (value at maturity plus low default risk, etc.) but instead reflects buyers' knowledge that some recipients will have stark liquidity problems by being paid in IOUs that banks won't honor.  I'm not familiar with the MSRB, and I don't know how much teeth the rules have, or how strictly the SEC and the MSRB are going to police individual buyers and sellers of the IOUs, but on paper, Rule G-30 looks pretty important.

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Wednesday the SEC Staff announced its view that California’s IOUs are “securities” for federal securities law purposes.  California’s IOUs, which the state began issuing on July 2, pay an interest rate of 3.75% and are to be redeemed on October 2 or earlier if California manages to reach a budget deal.  On the one hand, classifying these IOUs as securities seems like a good move.  AS the SEC announcement noted, the purpose of characterizing the IOUs as securities is to ensure that those who purchase and sell the IOUs will have the protection of the federal securities law, especially the antifraud protections.  This protection seems necessary.  Indeed, several major banks have stated that after today they will no longer accept California’s IOUs.  The banks insist that they have taken such an action to force California to deal with its budget crisis.  Apparently the last time the state issued IOUs in 1992, it was only after several banks stopped accepting them that the state eventually reached a budget deal.  Hence, the banks believe that their acceptance of the IOUs may prolong the process of the state resolving its budget problems.  But with banks indicating their refusal to accept IOUs, those holding them must look elsewhere to turn them into cash.  And as their options narrow, apparently ads have begun popping up on sites like Craigslist offering to buy the IOUs at a discount from face value.  If a secondary market develops in these IOUs, there certainly seems to be some potential for abusive practices both on the buying and selling side.  And hence the need for some regulation and oversight. 

And yet, as some have noted, the regulation may pose problems for those trying to convert their IOUs to cash.  Indeed, as the SEC Staff Statement notes, trading in these IOUs means being subject to the federal securities laws and may even require people to register as brokers or dealers.  Thus, given the extra hurdles involved with trading in these IOUs, the characterization could make it more difficult for people to redeem their IOUs, even if that difficulty is warranted.  To be sure, banks have said that they are willing to work with individuals and businesses, and credit unions have indicated that they will continue to redeem the IOUs.  Hence there may be other options.  And the SEC has issued an investor alert urging both buyers and sellers to be careful, and among other things, consider if they are getting a fair price and ascertain that the IOUs are accompanied with appropriate documentation so that they can be presented for payment.  However, apparently by Wednesday California had sent out 91,213 IOUs totaling over $354 million and by the end of the month the amount is expected to reach nearly $3.4 billion.  These figures suggest that there are a lot of people and entities in California that may be looking to convert their IOUs into cash.  And if people and businesses need the cash badly enough, it is hard to imagine that they will be particularly prudent.  In that kind of environment, it is not clear whether and to what our securities laws will be able to protect investors.   

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As a follow-up to my post below on the surplus of funds earmarked for investor restitution from the 2003 $1.5M Global Settlement on Analyst Conflicts, I wanted to circle back to the amounts that were earmarked for "investor education."  Three years ago, it had become clear that this huge fund was not being used particularly well by the states or at all by the federal government.  Around that time, the  SEC successfully petitioned the court to allow it to give it to the NASD (now FINRA) for use by its foundation.  However, according to Judge Pauley's rebuke this week, FINRA has done no better, using only a pitiful fraction of its $55M investor education fund ($6.5M in substantive uses, $800k for administrative uses in past 3 years). 

One of the proposed uses of the $80M surplus of investor restitution funds was to give it to FINRA to be used for investor education.  Judge Pauley's response to this proposal was very negative, noting that the average grant from FINRA was $200,000 but cost $21,000 to process:  "To put it mildly, the FINRA Foundation's performance has been disappointing."

Perhaps more interestingly, several law school clinics focusing on aid to harmed investors proposed that the surplus money be donated to law school investor aid clinics.  However, Judge Pauley explained that he could not do so because none of the parties to the consent decree would consent to that plan, however attractive.  In fact, Pauley went on to say:

The history of this case suggests that those clinics might have been better shepherds of an investor education program than the SEC or the FINRA Foundation. One of the clinics [Bluhm Legal Clinic at Northwestern University School of Law] advises the Court that its grant request was denied by the FINRA Foundation because the Foundation is apparently barred from "funding ongoing clinical activities." (citation omitted) The FINRA Foundation appears to be having difficulty identifying investor education programs deserving support. If such a restriction exists, perhaps the SEC can prevail on the FINRA Foundation to amend its guidelines to fund grants to qualified law school clinics. Moreover, this Court invites the SEC and the FINRA Foundation to collaborate on proposals with realistic time lines to administer investor education projects so that the funds in these cases will be disbursed by the 10th anniversary of the September 2, 2005 Order.

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Back before most people never thought about mortgage-backed securities, troubled assets or credit default swaps, we weathered a technology bust in 2001, peppered with various scandals from accounting to analyst conflicts.  A guy we don't hear from much now, Eliot Spitzer, was the AG of New York, and he went after 10 entities we used to call investment banks for issuing research telling the public to "buy" the stocks of their investment bank clients, even though those clients were tanking.  Spitzer also accused some of the banks of spinning shares of hot IPOs (something else we haven't seen in awhile) to their investment banking clients.  The result was a Global Settlement of Analyst Conflicts in which the banks neither confirmed nor denied issuing improper research or spinning hot IPO shares but agreed to settle with Spitzer, the DOJ and the SEC and cough up $1.5 billion collectively to be used for a variety of purposes, including restitution ($432.75M) and investor research ($80M).  The year was 2003.  Now, six years later, federal district judge William Pauley has issued a scathing rebuke of the SEC as he returns unused portions of funds that were to be used for restitution to the federal treasury.

I have blogged about the disgraceful nonuse of the investor education funds before (three years ago!), and will update that with a different post.  However, the $432.75M for restitution is the main target of Judge Pauley's concern, and it deserves its own post. 

According to Judge Pauley's intutition, the SEC basically came up with a settlement number for the banks to pay as penalties and for disgorgement without any consideration or analysis of the investor losses.  Here, the court was charged with identifying a plan of disbursement without any input from the SEC, who had not done the work, the defendants, who had no incentive to identify investor losses as they had not admitted to any, or the adversarial process.  Without anyone advocating for investors who felt they were aggrieved, it fell to the court to come up with a workable solution.  Because no investors were in front of the court, the court attempted to send claim forms to investors twice, receiving return rates of less than half each time, and granting more than half of those claim forms some relief.  The court only had broad criteria to go from that the SEC had provided.  As a result, monies provided by some banks were inadequate to compensate investors who tied their losses to those banks, but monies provided by other banks were barely touched (including Bear Stearns, J.P. Morgan, and Merrill Lynch/Henry Blodget, who was barred from the securities industry).  The court now declares that it has met its limits of reaching investor losses and will return the surplus (almost $80M) to the federal treasury.  One highlight:

This Court believed the SEC had brought its expertise to bear on the issue at the time the settlements were submitted for approval in October 2003. But three years elapsed before the SEC acknowledged that the amounts the Defendant paid, representing both disgorgement and penalties, were not necessarily connected to any measure of investor losses. (citation omitted). Had the SEC realized that earlier, several exercises in futility could have been obviated and the current predicament -- $75 million accumulating interest at the Federal Reserve Bank of New York with no payees -- avoided.

And finally,

In the final analysis, this Court does not question the SEC's interest in bringing to an end improper conduct. Nor does it question the SEC's interest in recompensing investor victims and deterring future violations. However, whether the SEC has the institutional resolve and commits adequate resources to reach these goals is an open question.

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Following up on Christine's post, I note that Larry Ribstein has an excellent post on Judge Sotomayor's opinion in Dabit v. Merrill Lynch, which was overturned by the Supreme Court 8-0. Larry thinks Sotomayor got it right and the Supreme Court was wrong. More or less. I don't have strong feelings on this case, but Larry's post is worth reading if you care about the federalization of corporate law.

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As you would expect, Lucian Bebchuk is in favor of the SEC's new proxy access proposal. In an editorial in today's W$J, he focuses on the issue of whether "one size fits all" in proxy access:

Opponents of the SEC's proposal argue that the SEC shouldn't impose a blanket rule about proxy access, but rather should leave the provision of proxy access arrangement to company-by-company choices. One size does not fit all, the argument goes, and the SEC's proposal would prevent variation and experimentation.

It is ironic that opponents of proxy access now raise the banner of company-by-company choices. In 2007, the SEC examined whether to let shareholders propose bylaw amendments that would establish proxy access for shareholders seeking to nominate directors. At that time, opponents of proxy access persuaded the SEC to prohibit the inclusion of such proposals on the ballot. This prohibition made it rather difficult for shareholders to adopt proxy access arrangements on a company-by-company basis. For many opponents of proxy access, then, uniformity seems to be quite acceptable when it doesn't involve shareholder access but becomes unacceptable when it does.

In fact, the proposed SEC rule would allow some meaningful variation. The proposal would establish some mandatory requirements as to shareholders nominations that would have to be included, but would allow companies to adopt arrangements providing shareholders with more expansive access to the company's proxy.

On the issue of federalism:

Opponents also argue that establishing any minimum requirements for inclusion of director candidates on the company's proxy card departs from the SEC's traditional role into an area best left for state corporate law. However, the SEC's proxy rules already mandate the inclusion of some information, including certain shareholder proposals, on the corporate ballot and accompanying proxy materials. The SEC's proposal would merely expand the current mandatory requirements, and wouldn't enter any new territory.

I am reserving judgment on the details of the new proposal until I have more time to study it, but I side with Lucian on the need for election reform. And this new proposal is sparking a healthy debate.

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First, the basics.  Shareholders will be able to include a nominee in the company's proxy materials under the following guidelines: For companies with a market value of $700 million or more, only shareholders with at least 1% of the voting securities will be eligible to nominate.  That percentage threshold requirement increases to 3% for companies with between $75 million and $750 million in market value, and 5% for companies with a market value lower than $75 million.  This rule also applies to mutual fund trustees as well as public company directors.

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The SEC is proposing amendments to the proxy rules to allow for shareholder nominations of directors. Mary Shapiro's announcement speech is here. (text) NYT story here.

A broad description from Shapiro:

I haven't seen the proposal, yet, but a Bloomberg story offers some intriguing details:

I was not a fan of the previous proxy access proposal, but this one sounds more promising. I will follow up with some detailed analysis in later posts.

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For the past couple of years, I have tried to carve out a piece of the "overcriminalization of corporate law" debate by pointing out that the same set of facts that leads to a corporate conviction leads to a dismissal of a civil lawsuit under securities fraud doctrines.  I explored this theory in The Undercivilization of Corporate Law, but regretted that this theory rarely plays itself out.  When there are parallel prosecutions and civil lawsuits, the plaintiffs usually wait for the conviction, and then use the conviction as leverage, a la Enron.  However, for some reason, this theory is playing itself out now in the Refco drama involving Joseph Collins, a partner at the law firm of Mayer Brown, which represented Refco before and during its 2004 LBO by Thomas H. Lee Partners and its 2005 IPO. 

The Refco scandal is even more brazen than more celebrated ones of this decade:  CEO of company hides massive losses with round-trip loans to affiliates, then sells 57 percent of shares in an LBO.  LBO firm, quickly after LBO decides to sell in fast-track IPO, even though it denies ever finding out about the fraud while running the company with its own officers.  Weeks after IPO, the fraud is discovered, CEO is arrested, company files bankruptcy.  CEO is serving 16 years in jail, and other insiders are cooperating.  Collins, outside counsel to Refco for 10 years, is indicted.  Collins is the only outside attorney indicted in any of this decade's scandals.  Lucky guy.  (Full story here, in the American Lawyer.)  And, not surprisingly, Collins and Mayer Brown were added to the shareholder lawsuit against Refco.

I cannot say that I am happy to find a case that fits in with my article's theory, but here is one.  In March, Collins and Mayer Brown were dismissed form the shareholder lawsuit for securities fraud in the Southern District of New York.  This week, Collins' criminal trial began in the Southern District.  If there is enough evidence to proceed against Collins for a criminal trial, then why isn't he subject to a shareholder suit?  Given the ordinary paradigm of evidentiary burdens being less in a civil trial and higher in a criminal trial (remember O.J.?), how can this be?

The easy answer is Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994), the Private Securities Litigation Reform Act of 1995 (15 U.S.C. s. 78u-4(b)) and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. __, 128 S. Ct. 761 (2008).  After Central Bank, only primary actors may be defendants in an action under Section 10(b) of the Securities Exchange Act of 1934.  The PSLRA then increased the pleading requirements for primary actors, so not only must an actor be a primary participant in the fraud, but the plaintiffs must be able to allege with particularity the elements of the crime as they relate to the participant, i.e., scienter.  Then, Stoneridge went on to hold (in a case where scienter as to the "third-party" participants could be inferred easily) that the plaintiffs did not "rely" on the statements of the third-party participants, which were detailed in documents that formed financial statements but were not themselves disclosed.  So, third parties that knowingly helped an issuer pump up financials by artificially inflating revenues, complete with documents from the contract parties meant to dupe the auditors, could not be held liable in a 10b-5 action because the plaintiffs didn't see those documents.  Thus, these counterparties were mere aiders and abetters, and not subject to private civil lawsuits.

In his opinion and order granting the motion to dismiss of Mayer Brown and Collins, Judge Lynch acknowledges that there was no way that Collins and the other attorneys could have drafted either the LBO offering memorandum, the registration statement for the related bond offering, or the registration statement for the IPO offering without knowing them to be false, given their involvement in 17 rounds of affiliate loan documentation.  Here, these false statements were made to the public, in publicly disseminated documents.  However, Judge Lynch ordered that because these statements were not attributed directly to Collins and Mayer Brown, these defendants were as remote to the investors as the defendants in Stoneridge.  Even though these documents identified Mayer Brown as issuer counsel, their name appearing once does not create an inference that investors knew that the firm was involved in making the false statements in the documents.  Attorneys everywhere should breathe a sigh of relief; under this analysis, securities attorneys that aren't otherwise directors or officers are fairly well insulated from civil suit.

But not from criminal prosecution, which brings us back to Mr. Collins, whose indictment is here.  This disconnect between civil and criminal prosecutions could signal either a Type I error, in which Collins may be falsely found to be guilty of securities fraud, or a Type II error, in which Collins may be falsely found to be not civilly liable for securities fraud.  I don't know enough about the facts to say which is happening.  Or, it could be that regulators have made a decision that there are certain types of fraud that we will pursue criminally or civilly only in an SEC prosecution, but we do not want private litigation in that area.  I think then we need to have a longer conversation on why we want to protect certain defendants from the vagaries of private litigation but not from the all-out hell of criminal prosecution.

As my criminal law professor Michael Tigar once said (to paraphrase):  Corporal punishment is unconstitutional because its cruel and unusual, but capital punishment is not.  Most criminals, however, would choose the former over the latter.

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The financial meltdown has many narratives, and many of them revolve around investors in mortgage-backed securities not knowing the risks of their investments and the borrowers in the underlying mortgages not knowing the risks of their investments.  My own brief experience with the mortgage industry this quarter has driven this latter point home.

In January, inspired by others we knew refinancing their mortgages, we contacted our mortgage holder and inquired about refinancing.  We bought our house in 2006 at 5.625%, so we knew that the pros and cons would be close, depending on the rate, fees, etc.  But, since our money wasn't making a positive return on any of our investments, we figured that paying a higher rate of return wasn't that palatable, either.  Our mortgage holder promptly emailed us five spreadsheets that were completely indecipherable to us.  When we asked questions, the answers made no sense to us.  Luckily, my colleague who officed next to me was the director of our Transactions and Economic Development Clinic, and she had mentioned that she recently had helped a neighbor determine whether refinancing was economically smart.  My corporate finance tail between my legs, I asked her if she could make heads or tails out of the spreadsheet.  She had to spend thirty minutes reviewing it to understand where all the numbers were coming from and what the bottom line was.  The bottom line, she said, was that the refinancing was going to cost $5000, or somewhat less than 2.5% of the loan.  Plus, the $5000 was tacked on to the loan, adding cost in interest and fees.  She encouraged us to "shop around" when our original mortgage holder would not negotiate on the fees.

So, we finally went with a local bank, who presented us our costs in more of a term sheet fashion, outlining a handful of fees that amounted to around $1000 for the same principal amount and interest rate.  The bank did warn us that although we were locked in at that rate (4.5%), the backlog of refinancing applications would take awhile to work through.  They weren't joking!  We signed the closing papers Wednesday on the refinancing we were approved for in January.  Although there were a few hiccups (because of the backlog, the payoff amount the bank received did not include the April payment, etc.), the documents were much easier to understand.  The local bank also explained that they kept their mortgages.

So, what was interesting to me about all of this?

I am quite willing to believe that many who sign mortgages and particularly refinance documents have no idea what the costs are or what their ending principal balance is.  If a corporate finance attorney could not figure out the loan documents and had to ask someone who is an expert in consumer finance documents, then we should not expect those with other types of work/life experiences to be able to do a better job.  If it wouldn't scandalize my co-borrower to show your our private finance life, I would post the spreadsheets so that you could get a flavor for the dizziness.

When people are faced with financial documents they don't understand, a first instinct is to say "Just tell me where to sign."  I'm ashamed to say that I gave up very easily when I couldn't make heads or tails out of the document and the answers to my questions were even more confusing.  I could feel myself think, "It's probably fine.  I should just go with it."  If I hadn't had a trusted friend to turn to, we might either have overpaid for the refi or just gave up on it altogether. 

When borrowers don't understand the loan documents, they don't have a lot of options.  No one likes to ask for help, especially with financial questions, but you also need someone to ask.  I wasn't really sure I wanted my friend to know how much my house was worth (sort of silly in Champaign where all the houses in our subdivision cost the same amount!) or how much equity we had in it.  I also didn't want her to know that I couldn't figure out what all the line items were or what the bottom line was.  But I feel very lucky to have had her available to me as long as I swallowed my pride.  For someone applying for a refinancing without friends in the finance world, who would she turn to?  Unless the borrower has a neighbor who is the director of a clinic that helps people with consumer finance, then she may not be able to find anyone better able than she is to make a rational refinancing decision.

With all the laws to make consumer lending more transparent, why is it so opaque?  In my practice, I often created or reviewed term sheets for commercial loans and corporate bonds.  Those term sheets were in English and made sense.  Why would documents in a consumer financing be so hard to understand?  At our closing, the "Uniform" documents the bank had to use were the most confusing.  The documents that were generated in-house, including a two-page letter telling us what the principal amount was, the interest rate, the term, and the fees, was the simplest.

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The civil litigation associated with Bernard Madoff's Ponzi scheme may go on for years -- both investors suing Madoff and investors suing their financial advisors who invested their monies in Madoff's investment funds without doing any due diligence at all.  And on top of this, investors want to know what about the other Madoff relatives?  The wife?  The sons?  The brother?

Today the NYT reports that one of the state law lawsuits brought against an advisor investing client funds in Madoff Investment Securities is against Peter Madoff, the brother of Bernie.  Brought in New York state by a Brooklyn Law School student, this suit alleges that Peter, the trustee of a trust settled for the plaintiff by his grandfather, invested the entire corpus of the trust in Madoff Investment Securities.  Well, that's gone now -- almost $500,000.  Talk about everything going bad -- law students everywhere are bemoaning the market, and one law student was able to say, "Well, at least I have my trust fund to fall back on. . . .hey, what's going on?"

So, in connection with this lawsuit, a NY state judge froze the assets of Peter Madoff, which seemed to surprise federal authorities whose investigation is continuing.

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I've already posted twice about the article I've been working on the past few months.  Quick recap: an overlap of securities requirements allows us to see whether companies are actually complying with the law.

Answer: it looks like not always.  We found 30 instances in our 200 company sample where companies disclose related-party transactions with CEOs, CAOs, and CFOs in their proxies but failed to disclose them when they occurred as ethics waivers in 8-Ks or on the website, as required by SOX Section 406.  You may think, "no harm, no foul"--at least the market is learning about these transactions somehow.  But proxy disclosure (like Christmas) comes but once a year, and contains a whole lot of stuff.  So companies who avoid Section 406 "bury" these ethically questionable transactions at the end of the year, rather than disclosing them as they occur, all by themselves.

We also found 74 cases we term "in spirit" violations, where companies appear not to be disclosing because their codes of ethics don't prohibit related party transactions.  No waiver needed!  But Section 406 defines a waiver as "such standards as are reasonably designed to promote—(1) Honest and ethical conduct, including the ethical handling of actual or apparent conflicts of interest between personal and professional relationships", so it's a bit of a stretch to call something a "code of ethics" if it doesn't prohibit related party transactions.

This last point gets to our larger story, the limits of transparency.  Section 406 was a direct response to Enron.  You'll remember that Enron granted a waiver to its code of ethics to allow related-party transactions with CFO Andy Fastow, facilitating the deals with special purpose entities that helped perpetrate fraud on the market.  The regulatory response was to require Section 406 disclosure, but that doesn't seem to be working.  A lesson for today?

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I've been under a vow of blogging silence these past few weeks, working feverishly to get a draft done. It went out Tuesday, and I'm happy to be back in the blogosphere. I'll use the next few posts to talk about what I've been working on.

My new piece looks at a basic question: do public companies comply with our securities laws? When you think about it, our whole securities system is based on voluntary compliance. Companies are supposed to disclose facts about executive compensation, material agreements, related party transactions, etc. And we generally presume that they do. But we really have no way of knowing. Most securities lawyers or scholars have at some point run across an annoying instance of non-disclosure. They're looking for a big agreement they know the company entered into, but they can't find it. They think: "Shouldn't the company have dislosed this agreement to the SEC? Why isn't it here?" But it's hard to study what isn't disclosed because...it isn't disclosed.

My co-author, Mike Stegemoller, and I think we've found a way around this problem, at least for a narrow slice of the securities disclosure world. Tune it tomorrow to learn more...or, if the suspense is too much for you, download the article here.

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