Kevin LaCroix has all the information on the first securities fraud lawsuit to be filed against Alibaba regarding its sale of ADS on the NYSE in September. For securities regulation professors, there are a few nice issues here.
Materiality. The complaint cites two separate "revelations" that appeared in the U.S. in the WSJ on the same day (January 29). One article reports that the company announced that it had come to an agreement with China's State Administration for Industry and Commerce to strengthen its websites ability to monitor unlawful activity. In addition, the article noted that the SAIC had met with Alibaba for the first time in July, two months prior to the IPO. This meeting was not mentioned in the registration materials. The other article reported disappointing revenue numbers and a decline in profits. That day, the share price drops about 7%. Which revelation caused the drop if we believe that a "market test" determines materiality? What about the "total mix" test? Would investors have wanted to know about the sit-down meeting? Aren't the disappointing numbers most likely non-actionable under a forward-looking safe harbor for any contrary statements in the registration materials?
The Difference Between Section 11 and 12 of the Securities Act and Section 10 of the Securities Exchange Act. The plaintiffs have only brought suit under Section 10, even though the false statements would be in the registration statement. Kevin hypothesizes that the plaintiffs can't meet the tracing requirements of the Securities Act, but a commenter also points out that those who purchased at the IPO or shortly thereafter bought at a purchase price lower than the market price now, even with the January 29 price drop, so no damages.
Fee-Shifting Provision. Alibaba has a fee-shifting provision in its (Grand Caymans) charter. Will the fee-shifting provision hold up in federal court under the Securities Exchange Act? Does federal securities law (specifically the PSLRA) pre-empt this provision? We shall see.
When I practiced in the mid-1990s, I occasionally worked on projects we called "asset securitizations." We didn't talk about it to our friends or families, because their eyes would glaze over and then they would pass out from boredom. Because of our client base, our asset securitizations were generally either used car loans from the finance side of large auto companies or franchise loan securitizations from oil and gas companies. Only when the financial crisis hit did everyone seem to become conversant in asset-backed securities, and the process of wide-spread securitization of mortgages seemed to be at the root of all the mortgage troubles.
The hypothesis is this, and it has some support: If lenders held their loans, particularly their mortgages, then they would only make good loans. By having a market to dump loans into, lenders loosen criteria to make more mortgages. Ignorant bond holders can't buy enough MBS, so lenders loosen criteria even more to meet demand. Lenders may even engage in fraud or encourage borrowers to engage in fraud. The Dodd-Frank Act tries to remedy these ills by having regulation at the lender end and the MBS end. We'll see if it works.
But the NYT this week tells us the securitization evil has spread to used car loans. Because I'm pretty sure used car loans have been securitized since at least 1993, I don't see this as news. However, the article suggests that because of less fun in MBS, those investors now have poured their money into used car loan-backed securities (let's say UCBS). The article doesn't state it's hypothesis, but suggests this is bad because (1) car buyers are defaulting and losing their vehicles and (2) financial players who package UCBS are getting rich. But, the article doesn't go so far as to provide evidence that (1) car buyers are defaulting more than usual or (2) that the demand for UCBS has caused lenders to be more unscrupulous than they have been in the past.
In addition, problems in the MBS market, particularly mortgage defaults, have pretty big negative externalities: foreclosures, neighborhoods with empty houses, dislocation of families, home prices, etc. When car borrowers default, the lender takes the car back. The borrower is out the car payments that were made (the NYT focuses on car buyers who never made any payments, so not particularly left worse off), but the car lot now can resell the car again. Cars are more liquid than houses, and repossession is quicker and cheaper than foreclosure.
So, I'm not getting very worried about the used car loan bubble just yet. If we think that used car loan rates are too high, then that's another concern. If we think that used car sales people are pressuring or misleading customers, that's another concern. But I don't think securitization is the problem.
While defendants are gearing up to make arguments against the constitutionality of the SEC's increasing inclination to use its ALJs, rather than the courts, to serve as the venue for fraud cases, it looks like it has already flipped that way for foreign corrupt practices cases. Mike Koehler did the counting:
More recently, the SEC has been keen on resolving corporate FCPA enforcement actions in the absence of any judicial scrutiny. As highlighted in this 2013 SEC Year in Review post, a notable statistic from 2013 is that 50% of SEC corporate enforcement actions were not subjected to one ounce of judicial scrutiny either because the action was resolved via a NPA or through an administrative order. In 2014, as highlighted in this prior year in review post, of the 7 corporate enforcement actions from 2014, 6 enforcement actions (86%) were administrative actions. In other words, there was no judicial scrutiny of 86% of SEC FCPA enforcement actions from 2014.
It is interesting to note that the SEC has used administrative actions to resolve 9 corporate enforcement actions since 2013 and in none of these actions have there been related SEC enforcement actions against company employees.
Maybe we are seeing an agency decision to prefer administrative adjudication to, you know, adjudicative adjudication.
Peter Henning has a nice overview of recent claims made against the SEC's growing inclination to take fraud cases before its handful of agency-judges (ALJs), instead of to court. Why should that be okay?
From a policy perspective, there's reason to worry. I did some litigation before an administrative tribunal, and it's not that different from in court litigation, with the exception of evidence admissability and objections. But it could be really quite different. Hearsay is in theory fine, there's no requirement that you be able to present evidence in person, and the judge works for the agency that is suing you. It's fair to say that defendants get less process from an ALJ than they would from a federal judge.
But not that much less. ALJs are required to hold hearings, permit the introduction of rebuttal evidence, the statute that governs them makes what they do ("formal adjudication" in the verbiage of administrative law) pretty similar to a trial.
That matters for the equities, as does the almost absolute discretion that agencies have to prosecute in the way they see fit. The SEC can drop claims, send scoldy letters, use ALJs, take you to court, or refer you to the criminal lawyers at DOJ with the recommendation that imprisonment could be sought. Because we wouldn't want judges second guessing the decisions to, say, emphasize insider trading prosecutions over accounting fraud claims, we leave those policy calls to the agency.
Which then begs the question: why now with the constitutional case against the ALJ, a thing that has existed since the end of WWII?
Well, the SEC hasn't used its ALJs for high profile cases very often, at least until recently. But the claims against the turn to administrative tribunals aren't getting a lot of love, and I predict that will continue to happen. Judge Lewis Kaplan, who isn't afraid to savage a government case alleging financial wrongdoing, concluded that he didn't have the power to judge whether an ALJ proceeding violated due process or equal protection standards, given that other, similar cases had been brought in court. The SEC recently ignored a declaratory relief case filed by an S&P executive when it brought an administrative complaint against her.
Some well-heeled defendants may have been emboldened to bring these cases by the Free Enterprise Fund decision in the Supreme Court, which constrained the number levels of tenured officials that could separate the president from policymakers. But administrative adjudication is simply too resource intensive and carefully done to be rendered illegal because of its insulation. The alternative would be to replace ALJs with political hacks, and no one wants that. So I'm not predicting a lot of luck for the defendants in these cases.
The government’s response to the financial crisis was dramatic, enormous, and unprecedented, and nothing about it has been overseen by the courts. In our federal system, the courts are supposed to put the policies of presidents and congresses to the test of judicial review, to evaluate decisions by the executive to sanction individuals for wrongdoing, and to resolve disputes between private parties. But during and after the financial crisis, there has been almost none of that sort of judicial review of government, few sanctions on the private sector for conduct during the crisis, especially criminal ones, for the courts to scrutinize, and a private dispute process that, while increasingly active, has resulted in settlements, rather than trials or verdicts. This Article tells the story of the marginal role of courts in the financial crisis, evaluates the costs of that role, and provides suggestions to ensure a real, if not all-encompassing, judicial role during the next economic emergency.
Do give it a download, and let me know what you think. And thanks in advance for supporting us around here - we do like downloads!
Glass-Steagall may have lasted only 65 years, but the actual life of the Volcker Rule may be measured in months, if at all. Several pieces of legislation entitled "A bill to repeal the Dodd-Frank Act" have been introduced in Congress, but one bill has passed the House that seeks to dampen a handful of its provisions, including the rule requiring banks to get rid of its collateralized debt obligation businesses. (The Promoting Job Creation and Reducing Small Business Burdens Act, H.R. 37). However, one legislation tracking site gives the bill a 7% chance of passage. Also, Elizabeth Warren is on the case.
For us boring Securities Regulation professors, the bill also would give the SEC more marching orders (as if they had finished their original Dodd-Frank marching orders). Specifically, the Bill requires that the SEC:
Not later than the end of the 180-day period beginning on the date of the enactment of this Act, the Securities and Exchange Commission shall take all such actions to revise regulation S–K (17 CFR 229.10 et seq.)—
(1) to further scale or eliminate requirements of regulation S–K, in order to reduce the burden on emerging growth companies, accelerated filers, smaller reporting companies, and other smaller issuers, while still providing all material information to investors;
(2) to eliminate provisions of regulation S–K, 2 required for all issuers, that are duplicative, overlapping, outdated, or unnecessary; and
(3) for which the Commission determines that no further study under section 1003 is necessary to determine the efficacy of such revisions to regulation S–K.
STUDY ON MODERNIZATION AND SIMPLIFICATION OF REGULATION S–K. (a) STUDY.—The Securities and Exchange Commission shall carry out a study of the requirements contained in regulation S–K (17 CFR 229.10 et seq.). Such study shall
(1) determine how best to modernize and simplify such requirements in a manner that reduces the costs and burdens on issuers while still providing all material information;
(2) emphasize a company by company approach that allows relevant and material information to be disseminated to investors without boilerplate language or static requirements while preserving completeness and comparability of information across registrants; and
(3) evaluate methods of information delivery and presentation and explore methods for discouraging repetition and the disclosure of immaterial information.
REPORT.—Not later than the end of the 360-day period beginning on the date of enactment of this Act, theCommission shall issue a report to the Congress containing—
(1) all findings and determinations made in carrying out the study required under subsection (a)
(2) specific and detailed recommendations on modernizing and simplifying the requirements in regulation S–K in a manner that reduces the costs and burdens on companies while still providing all material information; and (3) specific and detailed recommendations on ways to improve the readability and navigability of disclosure documents and to discourage repetition and the disclosure of immaterial information.
RULEMAKING.—Not later than the end of the 360-day period beginning on the date that the report is issued to the Congress under subsection (c), the Commission shall issue a proposed rule to implement the recommendations of the report issued under subsection (c).
Wouldn't that be awesome? Why hasn't Congress done that before -- told the SEC to make Regulation S-K easier, clearer, shorter, but still as effective? I can't wait to see what happens.
So, I suppose the Glom should mention one of the weirder but more interesting securities fraud issues around these days. Joseph Grundfest (Stanford) and SEC Commissioner Daniel Gallagher posted a paper on SSRN entitled "Did Harvard Violate Federal Securities Law? The Campaign Against Classified Boards of Directors." One could presume that the authors believe the answer to be "yes," or they would not have taken the time to ask the question. Here is Jonathan Macey's reply to the question and the paper, and his reply is "no." There has been more volleying back and forth, so here is the summing up of links at Bainbridge (as of today). Here is a letter from 34 senior law professors at Top 17 law schools in support of Harvard's Shareholder Rights Project. I was not asked to sign it, but I would have if asked.
Interestingly, many of us who teach Securities Regulation begin with "Materiality." If so, then this case fits right in. The thrust of the argument is that the Shareholder Rights Project (SRP) wrote shareholder's proposals for over 100 firms, proposing that each firm declassify its staggered board of directors. In this proposals, which must not be over 500 words long, the authors of the proposal cite studies that show that staggered boards depress firm value and only one study that supports an opposite conclusion (staggered boards are good). And, the proposals fail to cite a recent study supporting staggered boards. This omission constitutes securities fraud. The counterargument (besides "what the heck?") is that the exclusion of all relevant studies on either side is immaterial, particularly a very recent study that may not have been posted publicly yet or for a short time. The proposals may have been subject to counter-argument, but that is not the same thing as false or misleading.
So, if you say "see, e.g." is that better?
The Times reports that S&P will soon be paying a billion dollar fine - or roughly one year's annual profits - to make a case that it commited fraud in relation to a financial institution go away. What should we make of this decision to settle?
- The government is using FIRREA to go after S&P, the obscure statute that combines harsh penalties with a civil burden of proof. To apply, FIRREA has to be about fraud "affecting a federally insured financial institution," and that has been conceptually challenging when applied to banks who have defrauded themselves by overstating the quality of various financial products to their counterparties and in their quarterly statements (you see? doesn't that sound like the opposite of defrauding yourself? It sounds like fraud affecting someone doing business with an FI?), but is more easily fit into a case against S&P's allegedly fraudulent ratings of banks.
- S&P hired Floyd Abrams, who has in the past successfully invoked the First Amendment to defend credit ratings agency rights to offer opinions about securities. I've never really understood why this works, as no one has a First Amendment right to defraud someone. A one billion dollar settlement doesn't suggest that the free speech at stake here is something that, you know, the Reporters' Committee for Freedom of the Press is really willing to get behind.
- This is something of a "first principles" observation, but fraud. Doesn't that sound like a bad word? Fraud! S&P is a fraud! Intentionally deceiving someone? Or omitting information you had a fiduciary duty to disclose? I don't think fraud means "fraud," anymore. I think it means something more like reckless wrongheadedness, at least in the financial markets.
- Why settle? The Times has a nice blurb on this:
Most Wall Street institutions, when faced with the threat of a Justice Department lawsuit, eventually cut a check rather than go to court: JPMorgan agreed to pay $13 billion to settle a crisis case;Bank of America more than $16 billion.
That settle-at-all-costs mentality stems from fears that a courtroom fight might antagonize the government and unnerve shareholders. It also spares a company the embarrassment of paying the same or even more after a trial, where an anti-Wall Street sentiment might sour the jury pool.
Financial institutions still manage to wring concessions from the government, often persuading prosecutors to water down a statement of facts that accompanies a settlement or provide immunity from other charges. And for all the leverage the government possesses, its approach has not translated into criminal charges against a single top Wall Street executive.
The Times reports:
The billionaire investor, who managed to fend off a criminal insider trading investigation of himself, if not of his former hedge fund, is looking for a former prosecutor and several agents from the Federal Bureau of Investigation to join his new $10 billion investment firm, Point72 Asset Management, said several people briefed on the matter, who spoke on the condition of anonymity.
Look, one of the reasons to feel good about the revolving door is that it salts financial institutions with people who expect law compliance. So maybe that explains this development, and we should celebrate Cohen's search for g-men. Or maybe it is, as the Times reports, that he was heartened by the insider trading ruling of the Second Circuit requiring the trader to know both that he was trading on inside information and that the information was obtained in exchange for a benefit, and just wants to grow the enterprise on a number of different fronts.
I'm not sure he should be too heartened by that ruling. It only may free one of his convicted lieutenants, and certainly wouldn't do anything about Matthew Martoma, who both paid for and traded on information provided by a pharma insider.
Not to pile on, but there's the slightly unsettling trned of CEOs talking, or not, about their health. Surely material information a real investor would want to know about when deciding whether to buy or sell a stock in these days of the imperial CEO. But deeply unprivate. Anyway, here's Jamie Dimon's letter to the staff, in part, on the very good news that, after been stricken with throat cancer, he now appears to be free of it.
Subject: Sharing Some Good News
Dear Colleagues -
This past summer, I let you know that I had been diagnosed with throat cancer. Having concluded my full treatment regimen a few months ago, I wanted to give you an update on my health. This week I had the thorough round of tests and scans that are normally done three months following treatment, including a CAT scan and a PET scan. The good news is that the results came back completely clear, showing no evidence of cancer in my body. While the monitoring will continue for several years, the results are extremely positive and my prognosis remains excellent.
The stock is up 2% on the day. It will be interesting to see whether this email makes its way into a securities filing.
Which means a redo of the argument. We'll outsource, via Corporate Counsel, to Cooley:
The D.C. Circuit court of Appeals has granted the petitions of the SEC and Amnesty International for panel rehearing (and the motion of Amnesty to file a supplemental brief) in connection with the conflict minerals case,National Association of Manufacturers, Inc. v. SEC. (The Court also ordered that the petitions filed for rehearing en banc be deferred pending disposition of the petitions for panel rehearing.)
[In prior litigation, the D.C. Circuit,] "specifically citing the NAM conflict minerals case, ... indicated that “[t]o the extent that other cases in this circuit may be read as holding to the contrary and limiting Zauderer to cases in which the government points to an interest in correcting deception, we now overrule them.”
Zauderer applies a lenient standard of review to requirements of disclosure of purely factual information. Looks good for the SEC.
It is one data point, but the cases where the the SEC would settle without requiring an admission of guilt or statement of facts were always likely to be those civil suits following criminal cases that did not go well. Rengan Rajnaratnam, Raj's brother, proved to be the one inside trader defendant that the Manhattan USAO could not convict. So the SEC is picking up sticks as well, in exchange for $840,000 bucks and a "let's just move on" kind of attitude. It's the kind of case where seeking an admission would likely just make the defendants dig in their heels, as I suggested here. And indeed, here's Rengan's lawyer, sounding threatening:
“The S.E.C. elected to offer, and Rengan elected to accept, a no admit/no deny settlement,” said Daniel Gitner, a lawyer for Mr. Rengan. “Rengan is moving on to the next phase of his life. If the S.E.C. has further comment, so will we.”
Earlier this week, the SEC announced that it would award $30 million to a whistleblower in an enforcement action. Here is the press release and here is the more interesting order. If you are like me, it may be hard to wrap your mind around a one-time payment of $30 million for anything short of selling your start-up or single-handedly producing an Avengers movie, but I guess that is what happened. But, I think I'm not convinced this kind of award is an awesome idea. Here are a few reasons.
First, to preserve the anonymity of the whistleblower, which may not be possible anyway, all facts of the case are not disclosed. Any information that could have been provided to other companies or to the public are unknown. Other companies receive no guidance on what sorts of behaviors were problematic and I suppose the investors in that company aren't told. (I would think that the enforcement action would need to be disclosed to shareholders, which is another reason anonymity may be delayed if not illusory).
Second, this is $30 million we are talking about. If we believe that the optimal level of whistleblowing is higher than the current level, is this much money really necessary to achieve that level? The standard is 10-30% of the penalty received, and I guess the theory is that the SEC would never have uncovered the fraud but for the whistleblowing, so the SEC is up $270 million? Are we over-incentivizing whistleblowing? (Since enacting the whistleblower program, the SEC has given 14 awards, but has received over 6500 tips.) I heard someone on NPR arguing that those in the position of being whistleblowers for reporting companies make so much money that the carrot has to be worth losing their job. The speaker argued that if the average salary of someone on Wall Street is $26 million, then the carrot has to be bigger than that. I'm not sure that most SEC whistleblowers average seven figure salaries, but we can't know because of the anonymity! Surely this is a large carrot to incentivize people to be honest. If honesty is that expensive, wow.
Third (really Second - A), money is fungible. The SEC emphasizes that this money does not come from taxpayer funds or investor recoveries. But, the money is going out the door, so it could be used for other things, like more personnel, really good enforcement work, etc.
Fourth, let's think who we are giving the $30 million to. The whistleblower argued to the SEC that the $30 million was too low. (That's some chutzpah.) The SEC countered that the $30 million may have been lower than the average whistleblower fee paid as a percentage because of the whistleblower's unreasonable delay in reporting. So, our whistleblower doesn't exactly have clean hands. But they are full of money.
Joe Nocera thinks that the new SEC whistleblower program is a winner, as it is rewarding people who go first to the firm, and only then to the agency, and the promise of a payday.
The Dodd-Frank law has provisions intended to protect whistle-blowers from retaliation, but there are certain aspects of being a whistle-blower that it can’t do anything about. “People started treating me like a leper,” recalls Lloyd. “They would see me coming and turn around and walk in the other direction.” Convinced that the company was laying the groundwork to fire him, he quit in April 2011, a move that cost him both clients and money. (Lloyd has since found employment with another financial institution. For its part, MassMutual says only that “we are pleased to have resolved this matter with the S.E.C.”)
In November 2012, MassMutual agreed to pay a $1.6 million fine; Lloyd’s $400,000 award is 25 percent of that. It was a slap on the wrist, but more important, the company agreed to lift the cap. This will cost MassMutual a lot more, but it will protect the investors who put their money — and their retirement hopes — on MassMutual’s guarantees. Thanks to Lloyd, the company has fixed the defect without a single investor losing a penny.
Could be. The most difficult cases of this kind are those posed by lawyers or compliance officers who go outside their firm, rather than staying within it, when they raise questions. That's something that seems to be happening at Vanguard right now, and Dave McGowan thinks such disclosures should be okay. Disclosing private documents more broadly, he feels, looks more like theft:
a former in-house lawyer who has filed a complaint in NY alleging Vanguard has underpaid federal taxes. Vanguard is reported to accuse the lawyer of breaching confidentiality; the lawyer has asked the SEC to intervene on his side.
Such cases may raise two distinct issues: the report itself, which may fall within exceptions to confidentiality in a Model Rules jurisdiction or under the SEC's rules, and backup for the report in the form of information--such as documents either in hard copy or digital form--the reporting lawyer might take from his or her employment. Even if we assume the report is protected the taking of documents raises distinct issues regarding client property.
I tend to think those issues should be resolved as issues regarding the report are resolved--i.e., taking such information does not violate a duty to a client to the extent the information is reasonably necessary to facilitate a permissible report. In essence the report would create a privilege (in the tort law sense) covering the disclosure to enforcement officials or courts; no privilege would attach if the lawyer put the documents up on the internet or mailed them to a reporter.
Like Lisa, I participated in this excellent discussion group at the SEALS conference co-organized by Joan Heminway. As I told co-organizer and friend-of-Glom Mike Guttentag, for a week I had a Word document open with the titular question at the top. Participants were supposed to submit a 2-3 page paper before the meeting. I totally lamed out. I kept trying to write, but couldn't come up with anything coherent.
I do have an answer to the question, though: Yes, the public/private divide does make sense. But it's gone, daddy, gone.
As I said at the conference, I think I'm essentially a conservative person: I'm resistant to change. And when I learned the world of securities, it seemed to me that there was this Grand Bargain. If you wanted to go public, you got many benefits, most notably a high degree of liquidity and access to public capital markets. But you had to take the bitter with the sweet: mandatory disclosure and increased liability risks. If you stayed private, your equity was far less liquid, and you couldn't make use of general solicitation. Your capital raising was much more circumscribed. But within those limitations you were free to order the firm more or less as you saw fit. Other substantive areas of law of course constrained private firms--environmental law, labor law, etc.--but in terms of corporate and securities law, they were relatively free. I realize this is a simplification, but in broadstrokes I think it's true.
No more. The Grand Bargain is gone. General solicitation for private firms. Conflict minerals rules. Emerging growth companies. Disclosure of executive pay ratios. Private secondary markets. Dodd-Frank, the JOBS Act, and technology have made a hash out of it. Or at least, the line between public and private is blurred.
This blurring makes me uneasy. I feel like there's a disruption in the natural order of things. But I can't tell if that's my innate conservatism talking, or if there really was something we lost with the Grand Bargain.