Unless Congress Acts -- The Courts Will Belong to Wall Street, Not Main Street

We have staked out our position on the Supreme Court's continued chipping away at the ability of the investor to get redress for wrongs committed by corporate America. Let's just realize that our Supreme Court has been co-opted to protect corporations over individuals. Shutting the door on the ability to pursue aiders and abettors, now loosely defined to be over-inclusive by the Supreme Court, is just one of the areas Senator Spector seeks to remedy. See my post below. But Senator Spector has also introduced a bill to remedy a newer evil----forcing the wronged to plead more than ever before required, just to get access to the court system.

Senate Bill 1504 would reverse the Supreme Courts decision this year, which gives a federal judge the ability to throw out a lawsuit, before discovery, if he does not think it is "plausible." That's a lot of discretion without any guidance, and keeping the case away from a jury based upon personal biases.  

Senate Bill 1504 is designed to return the standard to what it was prior to 2007, when the Court handed down its ruling in Bell Atlantic Corp. v. Twombly. That case and another — Ashcroft v. Iqbal from the most recent term — have raised the standard that pleaders must meet to avoid having their cases quickly tossed. Specter, in remarks prepared for the Senate floor, accused the Court’s majorities of making an end run around precedent with the two recent cases.

“The effect of the Court’s actions will no doubt be to deny many plaintiffs with meritorious claims access to the federal courts and, with it, any legal redress for their injuries,” Specter said. “I think that is an especially unwelcome development at a time when, with the litigating resources of our executive-branch and administrative agencies stretched thin, the enforcement of federal antitrust, consumer protection, civil rights and other laws that benefit the public will fall increasingly to private litigants.”

At issue is how specific a pleading must be under the Federal Rules of Civil Procedure. Rule 8 requires that a complaint include “a short and plain statement of the claim showing that the pleader is entitled to relief,” while Rule 12 allows for the dismissal of complaints that are vague or that fail to state a claim. Under Iqbal, a 5-4 decision written by Justice Anthony Kennedy, many courts are now requiring more-specific facts that aren’t often available until discovery.

The Iqbal -Twombly debate arrived on Capitol Hill when the House Committee on the Judiciary Subcommittee on the Constitution, Civil Rights and Civil Liberties held hearings on October 27, 2009. The hearing was entitled "Access to Justice Denied – Ashcroft v. Iqbal." The Committee’s page about the hearing, including links to the witnesses’ testimony can be found here. From Arthur Miller's written comments:

Not only has plausibility pleading undone the simplicity and legal basis of the Rule 8 pleading regime and the limited function of the motion to dismiss, but it also grants virtually unbridled discretion to district judges. Under the new standard, the Court has vested trial judges with the authority to evaluate the strength of the factual “showing” of each claim for relief and thus determine whether or not it should proceed.

In conducting this analysis, judges are first to distinguish factual allegations from legal conclusions, since only the former need be accepted as true. Some post-Iqbal decisions suggest that the conclusion category is being applied quite expansively, embracing allegations that one might well consider to be factual and therefore historically jury triable.

By transforming factual allegations into legal conclusions and drawing inferences from them, judges are performing functions previously left to juries at trial, and doing so based only on the complaint.

Once trial judges have identified the factual allegations, they then must decide whether a plausible claim for relief has been shown by relying on their “judicial experience and common sense,” highly subjective concepts largely devoid of accepted—let alone universal—meaning.

Further, the plausibility of factual allegations appears to depend on the judge’s opinion of the relative likelihood of wrongdoing as measured against a hypothesized innocent explanation. As is true of the division between fact and legal conclusion, the Court has provided little direction on how to measure the palpably nebulous factors of “judicial experience,” “common sense,” and “more likely” alternative explanation it has inserted into the threshold Rule 12(b)(6) dynamic.

Once again, a citizen’s due process right to a day in court before a jury of his or her peers is threatened.

The subjectivity at the heart of Twombly-Iqbal raises the concern that rulings on motions to dismiss may turn on individual ideology regarding the underlying substantive law, attitudes toward private enforcement of federal statutes, and resort to extra-pleading matters hitherto far beyond the scope of a Rule 12(b)(6) motion to dismiss. As a result, inconsistent rulings on virtually identical complaints may well be based on judges’ disparate subjective views of what allegations are plausible.

Courts already have differed on issues that were once settled. For instance, the Third Circuit has ruled that the 2002 Supreme Court decision in Swierkiewicz v. Sorema, N.A.,which upheld notice pleading in employment discrimination actions, no longer was valid law after Twombly-Iqbal. 27 Courts in other circuits disagree.

Twombly and Iqbal have swung the pendulum away from the prior emphasis on access for potentially meritorious claims; it probably will affect litigants bringing complex claims the hardest. Those cases -- many involving Constitutional and statutory rights that seek the enforcement of important national policies and often affecting large numbers of people -- include claims in which factual sufficiency is most difficult to achieve at the pleading stage and tend to be resource consumptive.

Already, recent decisions suggest that complex cases, such as those involving claims of discrimination, conspiracy, and antitrust violations, have been treated as if they were disfavored actions. Perhaps the propensity to dismiss these claims should come as no surprise: Twombly and Iqbal arose in two such contexts, and lower courts may find it easier to apply the Supreme Court’s reasoning to complaints with seemingly similar facts. Yet ambiguity abounds. Where is the plausibility line and what must be pled to survive a motion to dismiss? How will each judge’s personal experience and common sense affect his or her determination of plausibility? As a result of these and other uncertainties, the value of prior case law and predictability are obscured, and plaintiffs will be left guessing as to what each individual judge will consider sufficient. Throughout, the defendant basically gets a pass.

Moreover, how can plaintiffs with potentially meritorious claims plead with factual sufficiency without discovery, especially when they are limited in terms of time, lack resources for pre-institution investigations, and critical information is held by the defendants? 

Contact your Senators and Congresspersons and ask them to support these bills, before you find that you too have no access to the courts.

It's Time To Reinstate Aiding and Abetting Liability Against Those Who Help Securities Fraud

Now is the time, if ever, for Congress to pass legislation that would reinstate aiding and abetting liability for accountants, lawyers, and others who help corporate executives commit securities fraud that harm investors. The public is outraged from watching all those who assisted in the market meltdown walk away with their huge bonuses.

Senator Arlin Specter, introduced Senate Bill 1551 on July 30, 2009, seeking to do just that. The Bill called the "Liability for Aiding and Abetting Securities Violations Act of 2009," is currently co-sponsored by Edward Kaufman [D-DE], John Reed [D-RI] and Sheldon Whitehouse [D-RI]. The Bill seeks to amend the SEC Act of 1934 subject to liability in a private civil action any person that knowingly or recklessly provides substantial assistance to another person (aids and abets) in violation of that act. The Senator's goal is to restore the ability to sue third parties in securities fraud lawsuits as freely as you could before the U.S. Supreme Court's ruling in Stoneridge v. Scientific Atlanta (Supreme Court docket).

The main provision of the Bill states:

For purposes of any private civil action implied under this title, any person that knowingly or recklessly provides substantial assistance to another person in violation of this title, or of any rule or regulation issued under this title, shall be deemed to be in violation of this title to the same extent as the person to whom such assistance is provided.’.

Senator Spector"s floor speech follows: 

 Mr. President. I have sought recognition to urge support for the legislation I just introduced, the Liability for Aiding and Abetting Securities Violations Act of 2009. My legislation would overturn two errant decisions of the Supreme Court--Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 1994, and Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 522 U.S. 148, 2008, by amending the Securities Exchange Act of 1934 to authorize a private right of action for aiding-and-abetting liability.

 Act's main anti-fraud provision, §10(b), makes it "unlawful for any person, directly or indirectly," to commit acts of fraud "in connection with the purchase or sale of any security." Nearly fifty years ago the Court implied a private right of action under §10(b). The result was that investors could recover financial losses caused by violations of 10(b) and the companion regulation issued by the SEC commonly known as "Rule 10b-5."

Until Central Bank, every circuit of the Federal Court of Appeals had concluded that §10(b)'s private right of action allowed recovery not only against the person who directly undertook a fraudulent act--the so-called primary violator--but also anyone who aided and abetted him. A five-Justice majority in Central Bank, intent on narrowing §10(b)'s scope, held that its private right of action extended only to primary violators.

When Congress debated the legislation that became the Private Securities Litigation Reform Act of 1995, PSLRA, then-SEC chairman Arthur Levitt and others urged Congress to overturn Central Bank. Congress declined to do so. The PSLRA authorized only the Securities and Exchange Commission, SEC, to bring aiding-and- abetting enforcement litigation.

It is time for us to revisit that judgment. The massive frauds involving Enron, Refco, Tyco, Worldcom, and countless other lesser-known companies during the last decade have taught us that a stock issuer's auditors, bankers, business affiliates, and lawyers--sometimes called "secondary actors"--all too often actively participate in and enable the issuer's fraud. Federal Judge Gerald Lynch recently observed in a decision calling on Congress to reexamine Central Bank that secondary actors are sometimes "deeply and indispensably implicated in wrongful conduct." In re Refco, Inc. Sec. Litig., 609 F. Supp. 2d. 304, 318 n.15, S.D.N.Y. 2009. Professor John Coffee of Columbia Law School, a renowned expert on the regulation of the securities markets, has even laid much of the blame for the major corporate frauds of this [sic].

The immunity from suit that Central Bank confers on secondary actors has removed much-needed incentives for them to avoid complicity in and even help prevent securities fraud, and all too often left the victims of fraud uncompensated for their losses. Enforcement actions by the SEC have proved to be no substitute for suits by private plaintiffs. The SEC's litigating resources are too limited for the SEC to bring suit except in a small number of cases, and even when the SEC does bring suit, it cannot recover damages for the victims of fraud.

Last year's decision in Stoneridge made matters still worse for defrauded investors. Central Bank had at least held open the possibility that secondary actors who themselves undertake fraudulent activities prescribed by §10(b) could be "held liable as ..... primary violator[s]." Stoneridge has largely foreclosed that possibility. A divided Court held that §10(b)'s private right of action did not "reach" two vendors of a cable company that entered into sham transactions with the company knowing that it would publicly report the transactions in order to inflate its stock price. The Court conceded that the suppliers engaged in fraudulent conduct prescribed by §10(b), but held that they were not liable in a private action because only the issuer, not they, communicated the transaction to the public. That remarkable conclusion put the Court at odds with even the Republican Chairman of the SEC.

My legislative response would take the limited, but important, step amending of the Exchange Act to authorize a private right of action under §10(b) (and other, less commonly invoked, provisions of the Act) against a secondary actor who provides "substantial assistance" to a person who violates §10(b). Any suit brought under my proposed amendment would, of course, be subject to the heightened pleading standards, discovery-stay procedures, and other defendant-protective features of the PSLRA.

On Thursday, September 17, the Senate Judiciary Committee, Subcommittee on Crime and Drugs held a hearing to consider the Bill, entitled  "Evaluating S. 1551: The Liability for Aiding and Abetting Securities Violations Act of 2009." S. 1551.  Sen. Arlen Specter's chaired the hearing. The witnesses were John C. Coffee, Columbia University School of Law; Patrick J Szymanski, General Counsel, Change to Win (a group of labor unions); Tanya Solov, Director, Illinois Securities Department, of behalf of the North American Securities Administrators Association; Robert J. Giuffra, Jr., a partner in Sullivan & Cromwell LLP, NYC; and Adam C. Pritchard, University of Michigan Law School. Coffee, Szymanski and Solov testified in favor of the Bill. Their can be found here:

Market Manipulation Cases Can Never Be Certified, So Says Ninth Circuit?

In what will hopefully be a short-lived opinion, a panel of the Ninth Circuit issued a per curiam opinion which appears to state that plaintiffs can never certify a class action for market manipulation....only for outright misrepresentations or ommissions---a curious if not frightening holding at a time when Wall Street has proven itself to be ....hmmm...shall we say less than ethical.

The issue: Whether stock purchasers are entitled to utilize a lesser variant of the "fraud on the market" doctrine, called the  "integrity of the market" doctine, to create a rebuttable presumption of reliance, when a stock is maniplutated in a non-verbal way.

In Desai v. Deutsche Bank Securities (9th Cir. - July 29, 2009), a Ninth Circuit panel held that the lower court was correct in refusing to certify a class action based on market manipulation of the stock of GenesisIntermedia, Inc. by various bad actors, including various entities of Deutsche Bank, and one of its Canadian employees. The market manipulation scheme was complex,  the Court accepted that "the scheme had driven GENI's Stock price from $12 per share to over $52 per share." It now trades for pennies. Plaintiffs sued and sought to certify a class of those who purchased the stock during the market manipulation.

Judge Wilson, in the Central District of California, refused to certify the class because each individual member of the class would have to prove its own personal reliance, presumably, the lack of market manipulation, and therefore individual questions of fact predominated. The appellate panel, consisting of Judge John T. Noonan, who wrote the per curiam opinion, and Justices Diermuid F. OScannlain, and Susan P. Graber, agreed.

Justices Noonan and Graber believed that they could reverse the lower court only for a clear abuse of discretion. Plaintiffs had conceded that they needed to prove reliance. ( I'm not sure I would have conceded reliance in a market manipulation case, though I would have conceded lack of knowledge is required). Justice Noonan then drew the battle lines:

Reliance can be presumed in two situations. In omission cases, courts can presume reliance when the information withheld is material pursuant to Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-54 (1972). Reliance can also be presumed in certain circumstances under the so-called “fraud on the market theory.” Basic INc. V Levinson, 485 U.S. 224, 241-49 (1988), Precisely to which cases this presumption applies—that is, to misrepresentation, to omission, to manipulation cases, or to some combination of the three—is an issue the parties contest on appeal. The two presumptions are conceptually distinct.

As explained by the Court, the fraud on the market theory is “based on the hypothesis that, in an open and developed securities market, the price of a company’s stock is determined by the available material information regarding the company and its business.” Basic v. Levinson, 485 U.S. at 241 (internal quotation marks omitted).

So far so good!

But then , Justice Noonan loses his way by picking and choosing verbage from cases that state that the fraud on the market presumtion is available "only" when a plaintiff alleges a material misrepresentation or omission realting to a stock sold in an efficient market. On examination, however, it appear these cases are not market manipulation cases, probably because, up until now, they have been so rare or well hidden.

But plaintiffs had conceded that they could not prove an efficient market. (An efficient market quickly digests new information...from almost any source...causing the stock price to quickly adjusts to incorporate that new information. A thinly traded stock might not absorb the information quickly and therefore any news may not create a price reaction for weeks. In such a case, the disparity between individual investors knowledge becomes an issue. ) Having so conceded, they could not utilize the traditional definition of the fraud on the market presumption.

As for the Affiliated Ute presumption,the lower court rejected the theory that a manipulation was, in essence or fact, an omission. ( A holding with which I strongly disagree).

Applying a "clear abuse of discretion" standard, Judge Noonan agreed. The  Affiliated Ute presumption has only been applied to cases of omission when there exists a duty to speak.  The Court refused to extend the presumption to  manipulative conduct which  "has always been distinct " from omissions., for example, in Rule 10b-5. The Court then claims to "follow" the 10th Circuit in  Joseph v. Wiles, 223 F.3d 1155 (10th Cir. 2000) which is not a market manipulation case. In fact the word "manipulation"only appears once in the lengthy opinion. For those who remember the 1989 Miniscribe class action, Wiles is a related individual case based upon a fraud whereby Miniscribe cooked its books by shipping bricks instead of product to warehouses, thereby overstating revenues and earnings....one of the good ol' frauds).

Regardless, to the extent that an omission might have existed, the plaintiffs failed to allege a duty. And the Court refuses to even attempt to discuss any duty of market participants to the market.

Next plaintiffs argued for a modification of the  fraud on the market theory to fit such a situation, and claimed a rebuttable presumption based upon investors reliance upon the "integrity of the market." The lower court rejected this too.

Judge Noonan first concedes that investors rely on the integrity of the market, citing Basic :

[T]he theory presumes first that “[a]n investor who buys or sells stock at the price set by the market does so in reliance on the integrity of that price.” Id. at 247. Second, “[b]ecause most publicly available information is reflected in market price, an investor’s reliance on any public material misrepresentations . . . may be presumed for purposes of a Rule 10b-5 action.” Id.

He notes plaintiffs argument that investors "typically rely on the 'integrity of the market,' that is, that no one has destroyed its efficiency by manipulation [and] when manipulation allegedly destroys the efficiency of the market, and with it the reliability of the market’s price." And he does not disagree. But when asked to find, that as a matter of law, plaintiffs are entitle to such a presumption, Judge Noonan can only summon the argument, "We are chary."

The Court argues, no authority compelled the lower court to adopt this new theory and that the Supreme Court has evidenced a "restrictive view" of private suits, and to not extend 10b-5 beyond its present boundaries, citing Stoneridge, 128 S. Ct. at 773.

The Court unfortunately pulls the Stoneridge quote out of context. In Stoneridge, the issue was framed as creating a private cause of action for aiders and abettors...a cause of action rejected more long ago in Central Bank. Hence the full quote is:

Concerns with the judicial creation of a private cause of action caution against its expansion. The decision to extend the cause of action is for Congress, not for us. Though it remains the law, the §10(b) private right should not be extended beyond its present boundaries. See Virginia Bankshares, supra, at 1102 (“[T]he breadth of the [private right of action] once recognized should not, as a general matter, grow beyond the scope congressionally intended”); see also Central Bank, supra, at 173 (determining that the scope of conduct prohibited is limited by the text of §10(b)).

Plaintiffs were not seeking to extend 10b-5 or create a private cause of action. The law clearly forbids market manipulation and private causes of action have existed under this law for decades.

Justice Noonan, thus, avoids any analytical examination of the requested presumption. Instead he concludes merely "that the district court did not abuse its discretion in refusing to adopt the integrity of the market presumption." In other words...he punts on what the law is or should be.

O'Scannlain, on the other hand, goes after his colleagues for dodging the legal issue, making out a good argument for en banc review:

Unfortunately, however, we are left to conclude abruptly with a declaration of the result, for we cannot agree on the correct approach. I believe that, because the validity of a presumption of reliance in securities class actions is a matter of law and because errors of law are per se abuses of discretion, we must explicitly decide whether Investors are entitled to this novel presumption as a matter of law. I write separately to explain my view.

Even so, O'Scannlain goes on to find the presumption legally unsupportable and logically inadvisable. On the legal side, he can only summon citations to  non-market manipulation cases that have no application to these facts. On the logic side, he actually makes plaintiffs case. He starts by admitting:

Most investors do, I think it fair to say, assume that the markets are not corrupt. Cf. Basic, 485 U.S. at 246-47 (“It has been noted that ‘it is hard to imagine that there ever is a buyer or seller who does not rely on market integrity. Who would knowingly roll the dice in a crooked crap game?’ ” (quoting Schlanger v. Four-Phase Sys. Inc., 555 F. Supp. 535, 538 (S.D.N.Y. 1982))).

But then he concludes, in logic that escapes rigor, that if the presumption were adopted, then no plaintiff would ever have to prove reliance. In so concluding, he simply forgets that plaintffs seek only to apply this presumption  to market manipulation cases....which the Court has just found to be distinct from misrepresentation and omission cases, legally.

Similarly he argues that the theory "would permit a presumption of reliance no matter how unlikely it is that the market price in question would actually reflect the alleged manipulation." Again, how is it that  the presumption of reliance would not still require the plaintiffs to prove that the price during the entire class period was inflated by the manipulation, and by how much? O'Scannlain does not say.

Revealingly, O'Scannlain seems to back track and recognize the problems with his concurring opinion in his concluding. This footnote accurately captures the entire issue...and best statement for l an en banc court to tackle:

I recognize the possibility that certain allegations of manipulative conduct might change the application of the fraud on the market theory. This is because the plaintiff in manipulation cases often alleges that a defendant directly manipulated the price. Certainly, a plaintiff must still show that the market in question could absorb into the price the misinformation communicated by the alleged manipulation. But need a plaintiff show the same type of proof of an efficient market in a manipulation case as is required in a misrepresentation case? Although I note the doctrinal wrinkle, this is a question I would agree we actually do not need to reach, because Investors forsook the fraud on the market theory.

Justice Graber, in her concurring opinion, defends Justice Noonan's contention that the Court need not reach the legal question:

All we have to decide is whether the district court had to recognize that new theory. If so, then the court made a mistake of law (and hence abused its discretion, see Koon v. United States, 518 U.S. 81, 100 (1996) (“A district court by definition abuses its discretion when it makes an error of law.”)).

I agree with O'Scannlain that the Court should have addressed, as a full panel, a broader application of the fraud on the market theory in market manipulation cases. An efficient market should not and, indeed, cannot be a requirement where there are no statements to be absorbed by the market participants in making their decisions. The Court should not have said that a lower Court has no duty to find the right law for the right circumstances, even if it is a new application of a principle. How else does law evolve. It has to start in the lower Courts. Justices Noonan and Graber, shirked their duty.

But in the end, it may not matter that much to the plaintiffs bar. The reason why there is no authority on the subject is, as O'Scannlain states, simply reflects "the relative rarity of" manipulative conduct cases. So the impact will be minimal on securities fraud cases.....except now that the fear of a lawsuit is gone, maybe the fraudsters will start crawling through the cracks.

Shaun Martin's Blog California Appellate Report, has a very good discussion and first analysis of the case at Desai v. Deutsche Bank Securities (9th Cir. - July 29, 2009).

Did Matrixx ( MTXX ) Commit Securities Fraud By Withholding Adverse Reaction Reports From the FDA?

Yes, Institutional Investors Can Make a Difference in Securities Fraud Litigation

Institutional investors do in fact make a difference as lead plaintiffs in reaching larger settlements and improving corporate governance.

Given the costs of serving as a lead plaintiff and the free rider problem, institutional investors may not want to lead class-action lawsuits even if they hold the largest financial stake in the defendant firm. Consequently, it is important to provide empirical evidence on the effectiveness of institutional monitoring through class-action litigation.

A forthcoming paper to be published in the Journal of Financial Economics, entitled Institutional Monitoring through Shareholder Litigation, concludes that relative to securities fraud class actions with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed, have significantly larger settlements and are associated with more board independence after the lawsuit.  

The paper, which can be found here, is written by professors from four different universities: C.S. Agnes Cheng of Louisiana State University, Henry Huang of Prairie View A&M University, Yinghua Li of Purdue University, and Gerald J. Lobo of the University of Houston. As stated by the authors in a Harvard law blog, found here, the driving motivation behind the paper was the lack of evidence on the effectiveness of institutional investors exercising monitoring power through litigation.

Such evidence is much needed because the Private Securities Litigation Reform Act of 1995 (PSLRA) established a preference of granting lead plaintiff status to plaintiffs with the largest financial stake in the class action, thus providing institutions an opportunity to critically affect the litigation by serving as the lead plaintiffs.

In addition to documenting the implications of the lead plaintiff provision in the PSLRA Act, our findings also underscore the important monitoring role of institutions, as both an immediate discipline of management as well as long-term corporate governance.

The authors hypothesized that generally institutional investors are "free-riders" and take the benefits of class actions led by other individual plaintiffs, unless the potential benefits to them outweigh their agency costs. The study, as described by the authors, used a sample of 1,811 securities class actions filed between 1996 and 2005, and confirmed that hypothesis. The study found that:

1. When the likelihood of winning is high, the potential damage is large, and the defendant firm is important to the institutional owners, institutional owners are more likely to step forward to serve as the lead plaintiff.
2. Institutional investors are more likely to serve as the lead plaintiff when the lawsuit:
• involves an accounting-related allegation,
• has an accounting firm as the co-defendant,
• has a longer class period, has a larger negative market reaction to the revelation event, and
• has a larger potential investor loss.
3. The probability of having an institutional lead plaintiff is also higher when the defendant firm has a larger market capitalization, has a higher level of institutional holdings, and is operating in a high-tech industry.

The authors then sought to control for these determinants to find out whether, even then, there was a difference in litigation outcomes when institutions became involved. Using multivariate regression analysis to control for these determinants of when institutions are likely to get involved, the authors concluded:

1. That relative to lawsuits with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements;
2. All types of institutions show significantly better litigation outcomes with public pension funds generating the largest settlement amount;
3. Within three years of filing the lawsuit, defendant firms with institutional lead plaintiffs experience greater improvement in board independence than defendant firms with individual lead plaintiffs.

These findings should be reason enough for institutional investors to step forward and serve as lead plaintiffs. So get involved!

Fixing the Financial Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform

I waited for March 26, 2009, in great anticipation that we might see meaningful change in protecting investors. I pray that my retirement years are not stolen from me as they have been from those who we represent - those who trusted Charles Schwab, OppenheimerFunds, MassMutual and Madoff. However, March 26 came and went with little recognition of why and how this happened by those our new President entrusted to help steer these changes. 

Both Timothy Geithner (Secretary of Treasury) and Mary L. Schapiro (SEC Chair) testified today on improving our financial regulatory system. Geithner spoke to Barney Frank and his House Committee on Financial Services, and Schapiro spoke to Christopher Dodd's Senate Committee on Banking, Housing and Urban Affairs. Geithner's testimony can be found here, and Schapiro's here.

Before I start in on my criticism, let me say that I understand that both Geithner and Schapiro are long time industry/regulatory insiders. Change comes slow to those who have been part of the system and failed to step forward early. Certainly, it is better to talk about "failures" than to admit that they were asleep at the switch. It is better to talk in the abstract with little criticism that might incite a lynch mob.

Reading both testimonies, I am dumbfounded at how little attention is paid to the mutual fund industry that took investors' money and started pouring it into any asset available regardless of its objectives.

Geithner gives a strong statement recognizing the need for investor protection:

"[W]eaknesses in our consumer and investor protections harm individuals, undermine trust in our financial system, and can contribute to systemic crises that shake the very foundations of our financial system."

 Hear hear! Geithner then swiftly moves on to talk about mortgage lending, not investor protection. Try to sort out the following statement:

"Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system."

It's almost like the financial services industry wrote his words: "Tim, throw in words that make it look like 'things' caused us to commit fraud, and then put the blame on the 'many Americans with obligations they did not understand...'"

Let's pretend our mess was caused by poor consumers who did not know what they were buying, instead of the greed; greed of financiers who "created" packages of garbage loans, and dumped them on retirees for huge fees, profits and commissions. This slight of hand makes my blood boil.

Geithner completely leaves out the crimes of our mutual fund industry. Instead, he focuses on Money Market Funds that broke the buck. Big deal. This cost the American people a tad of what was lost in mutual funds by companies that sold "conservative," "stable" investments to retirees following the models that touted moving to bonds in your retirement years to preserve capital and earn income. The Reserves money market fund, when all is said and done, lost about three percent. Oppenheimer's Champion Income Fund lost 79 percent. Schwab's Ultra Short Term Bond Fund lost more than 50 percent.

Schapiro jumps on the fraud bandwagon too. She deplores penny stock frauds and insider selling, she touts the SEC's recent (mostly pre-Schapiro) enforcement activity, but she appears oblivious to reality, and the following statement is laughable:

"Our capital requirements go a long way to ensuring that customer funds entrusted with a broker-dealer are safe in the event the broker-dealer gets in financial trouble. Again, our focus is not to insulate broker-dealers from competition and the risks of failure, but to protect investors in the event that failures do occur. We conduct examinations of these firms to assess their compliance with laws and regulations. And when we find violations or deficiencies, we direct that corrective action be taken."

Think Bernie Madoff Investment Service (a broker dealer regulated by the SEC). Ahhhhh! Capital requirements? Protect? Examinations? Compliance? Of course note the disclaimer; "And WHEN we find..."

Schapiro does however have a solution for making sure Madoff's don't occur:

"I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets. The list of certifying firms would be publicly available on the SEC's Web site so that investors can check on their own financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide both investors and regulators with information to then evaluate the auditors."

"As part of this effort, I expect to come to you in the near term with a request for authority to compensate whistleblowers who bring us well-documented evidence of fraudulent activity."

 Ok. Let me get this straight...

1. Madoff would be required to sign a certification - big help.
2. The auditors name would be public - oh, this helped the Oppenheimer Tremont Rye fund investors who received audit reports from KPMG and Ernst & Young who believe that they are isolated from liability because they can rely on certifications by Madoff's audit or shoeshine man.
3. The SEC could now pay whistleblowers who present "well documented evidence...because when Madoff's whistleblower Harry Markopolos came to the SEC for free the SEC could not believe that anyone would blow the whistle for free!

As for mutual funds: NADA, Nothing, Zip! Certainly, she recognizes their importance:

"Ultimately, capital comes from investors - people who invest directly in companies; people who invest in financial institutions that lend capital; people who invest in mutual funds and other pooled vehicles that in turn invest in America's businesses; people who buy municipal securities to help fund the operations of state and local governments; and people who look to the capital markets to save, put away money for their kids' education, and prepare for retirement. Markets that attract this capital are critical to America's economic future."

But Schaprio talks only about the past enforcement efforts and current regulations. As for future change, she talks only about money market funds. She apparently does not recognize that current regulations do not work for mutual funds. The Courts have thrown out the private rights of action under the Investment Company Advisory Act, leaving the paltry resources of the SEC to enforce those laws for an industry with more than $9 trillion in assets. The disclosures are impossible to read, and the funds retain near unlimited power to change their focus overnight...if it brings in more profits. The industry is driven by a need to do what it takes to attract capital.

Neither Geithner nor Schapiro seem to recognize these issues, nor care.

Dear, dear. The more things change the more they stay the same.

Madoff, Tremont and More: "I Suppose You Could Program a Computer to Violate A Regulation, But We Haven't Gotten There Yet"

As we proceed to work our way through the Madoff litigation, we focus on cases where we believe there is a source of recovery for our clients. To date, that is largely the Tremont Rye Funds, controlled by Oppenheimer and Massachusetts Mutual, audited by the Big Four accounting firms and supposedly a custodial bank, Bank of New York Mellon.

We have also focused on the feeder funds to the Tremont Rye Funds, such as Spectrum, Future Select, Austin and Meridian. Other funds continue to crop up every day. Nevertheless, these stories are rather dry and our minds still wrestle with how Madoff pulled this off.

A video of Bernie Madoff discussing his business has surfaced online. When I watched this video of Bernie Madoff and his algorithm guru, Josh Stampfli, participating in a round table discussion on the future of the stock market, I expected to find a hint of irrationality or slick behavior. Instead, we hear a very rational human being, thoughtfully discussing fraud, human behavior and profits. We also see tremendous irony in Bernie's statements.

 I highly recommend anyone impacted by this scandal to watch, especially around the 43-minute mark, and I've included an index to Bernie's more ironic statements below:

At minute 26, Bernie Madoff states:

"Now, no one is going to run a benefit for Wall Street, so whenever I go down to Washington and meet with the SEC and complain to them that the industry is either over-regulated or the burdens are too great, they all start to roll their eyes, just like all of our children do whenever we talk about the good old days."

At minute 28, Bernie Madoff states:

"Today, basically the big money on Wall Street is made by taking risks. Firms were driven into that business, including us, because you couldn't make money charging commissions, primarily because the rates were lowered and because of the regulatory infrastructure you had to have dealing with clients."

At minute 30, Bernie says:

"There are so-called Chinese Walls that are required to be established at every brokerage firm. They're called Information Barriers - a term most people would understand - to sort of wall off a brokerage firm from taking advantage of information that he has as to what clients are basically going to trade or not going to trade. There are separate divisions within the firms and it is very carefully enforced and surveillanced. It doesn't mean there are not abuses, for sure, but largely in today's regulatory environment, it's virtually impossible to violate rules. This is something that the public really doesn't understand. If you read things in the newspaper and you see somebody violate a rule, you say well, they're always doing this. But it's impossible for a violation to go undetected, certainly not for a considerable period of time.  And when you consider the volumes of trading, the trillions of dollars of trading that go on today in Wall Street-I mean, our firm, for example, we trade an excess of $1 trillion dollars a year and that's one firm-and you look at what we would consider to be the infractions, they're relatively small, primarily because of all the regulation. Most firms do try to comply with that."

At minute 43, Bernie states:

"So we determined that the best thing for us to do was basically to take the human being out of the equation. That had two advantages in our industry. Number one, when you take the human being out of the equation, you solve your regulatory problems because the nature of any human being, certainly anyone on Wall Street, is the better deal you give the customer, the worse deal it is for you. You're on the other side of the transaction. It's like going into any store-the store sells you a television at a higher price, they're going to make more money. They sell you the lower price, their profit goes down accordingly. As honest as you try and get people to be, there's this normal, natural pole that you have to deal with. By taking the human being out of the equation to a great extent and turning it over to a computer to make your decision-I guess you could also program the computer to violate the regulations, but we haven't gotten there yet."

At minute 69, Bernie states:

"The future is silence. I don't see a lot changing in the marketplaces. It's hard to of course say that because everything always changes, but I cannot imagine what else we'd do, from an automation standpoint..."

At minute 71, Bernie states:

"You know, this is a psychoanalytical group, I guess, right? I'm sort of curious-maybe because no one got a chance to ask any questions about it yet-what are human beings contributing to the marketplace?  Is there any change in their actions?

At minute 111: Bernie states:

"This is the SEC's concern today because they call us all the time and ask us: should we be concerned about the fact that certain firms have left certain areas of the industry and are not serving the public, or not serving even other parts of the industry itself? The answer is it's too late, because you've done it. So there's always this friction that goes on between the regulation side of the industry and the practitioners that say okay, where do you draw the line? I'm very close with the regulators so I'm not trying to say that what they do is bad. As a matter of fact, my niece just married one. 

(Speaker:  My condolences) (Speaker: Did the SEC approve?)

Madoff: He's an attorney.

(Speaker: Okay.)

Madoff: The issue is, the way they tend to look at the industry if you're making a profit there's something wrong, even though intellectually they know that shouldn't be.

At minute 118, Bernie states:

"You know, my theory-and I've always said this even though we were one of the ones that started all this automated algorithmic trading-was that I never wanted to get into a cockpit of a plane and see there wasn't a pilot sitting there...

But more importantly, in our firm-and I don't know that we're unique, but I know there are other firms that do not operate this way-we  have a group of traders that are watching the systems work and the results of the systems to make sure that from their sense of trading things look right. With all due respect to Josh and a lot of other people that we have with similar backgrounds, programmers-not that he's a programmer-but people of his ilk can tend to believe too much in the math and in the model. They fall in love with it sometimes. Not so much Josh, which is why he's with us, but we have a lot of people like Josh that we employ and deal with. They're different. The thing that separates somebody that is a good algorithmic trader from somebody that is dangerous is somebody that just always believes the machine is right. There are people like that. It goes back to what Bob said about the joke of the dog. It's supposed to make sure that nobody touches the machine. You always want to have the human factor involved in the process because that makes it better. At least that's been our experience.

In addition, most disturbing at minute 125:

"Audience:  My question is a little basic. It's open for the whole audience. How do you feel that the baby-boomers retiring, starting this year, will affect the future of the stock market, considering there are probably about 60 million people who are going to retire in the next ten years?

Madoff:  Good luck."

The take away from this is hard to find. Here we have a man who created the NASDAQ, removed the human element out of trading, and clearly likes to spend time with people. Maybe he was bored and needed the human touch. By playing the ‘big man on campus,' and spreading largess, he became the center of attention.

As he states in minute 69...."The reason why is it's quiet. When you went up to our firm you said, "Well, I'm surprised at how quiet it is." I find it difficult to get used to that because I'm used to a lot of noise and screaming."

Clearly, the worst punishment for Bernie Madoff is the silence.

Oppenheimer Champion Income Fund – If it walks like a duck…

Earlier today, we filed a class-action suit on behalf of investors in the Oppenheimer Champion Income Fund (OPCHX). We are claiming that the fund managers misled investors; we contend they painted the fund as a conservative, high-income fund with a risk profile at par with other funds in its class. Instead, we believe Oppenheimer actually morphed the fund into a much riskier, volatile fund, investing in highly speculative derivates.

You know the old saying, if it walks like a duck...

From what we see here and what we've heard from investors, this fund has more in common with a hedge fund than a high-income fund.

The issue is that when Oppenheimer touted these funds to investors, we believe they hid the ugly parts of the duck - the risk - and touted the benefits.

We are learning from clients and through our own investigations that until 2006, the fund was chugging along - dare I say waddling - delivering reasonable returns as a bond fund, but during that year, the fund managers started altering the fund's strategy, likely in hopes of goosing the returns upward. It appears that the fund managers began purchasing complex derivative instruments, along with mortgage-backed securities without informing investors of these monumental changes to the fund's risk profile.

It also appears that Oppenheimer took investor money and purchased Credit-Default Swaps (CDSs), essentially insurance-like products that protect other investors against defaults. In this approach, the fund backed the risks of others' investments in things as diverse as office-building leases. This appears to be a horrible choice. By September, it appears that the losses tied to CDSs alone cost the fund $47 million.

Investors purchased fund shares through major brokerages like Citigroup, Smith Barney, UBS and Merrill Lynch to name a few, thinking they found an investment that would provide a reasonable return for its risk class. Instead, investors lost about 80 percent in 2008, with November delivering a whopping 55 percent loss in that month alone.

Also interesting, is that Oppenheimer didn't discriminate to whom they marketed the fund. It appears about 10 percent of the fund was held by other Oppenheimer funds.

We anticipate that Oppenheimer will try to defend its actions, saying they were acting in the interests of the fund investors. They will probably point to a $150 million injection of capital to increase the fund's liquidity. They will also point to other internal changes, but we also suggest this may be in response to these issues.

For the time being, we have a lot of upset investors, who lost a lot of money and most upsetting is that it could have been avoided. We believe fund managers pushed too hard when they increased the percentage of investments in mortgage-backed investments, violating the funds policies and did so without warning the funds owners, the investors.

We're certainly hearing a lot of ‘quacking.' If you've suffered losses with the Champion Fund we'd like to hear from you - feel free to contact us at oppenheimer@hbsslaw.com. 

Bernie Madoff...We Trusted You So Long

One of the best movies of the year is a French movie, starring Kristen Scott Thomas, entitled, "I Loved You So Long." It is a sad and tragic movie about a love so deep for a child...and how that love, and the mother's assisting her son die peacefully from cancer, haunts her upon her release from prison. Why it reminds me of Bernard L. Madoff is hard to say...but clearly their are parallels. The investors who have approached us have told us of decades old trust...a love so long...and now they are facing a death of their own...and they too are haunted, and some may be for the rest of their lives. And of course there is prison....

Often times securities fraud class actions felt like aiding a gambler who got cheated at the pool table. No tears were felt, but their were rules to be enforced and money returned. Today, it is not the same - in the Madoff matter and others. Today those who fled the tough and tumble of the public markets, and sought safety and security...investing in money market funds, cash, and trusted advisors, are telling us of having lost their entire savings and in too many cases, the funds needed to pay their medical bills and retirement. It is hard not to want to cry.

One of our clients had invested with a partnership pool almost 40 years ago, and that is where his money stayed and grew. Today he got the call where the caller revealed the "worst nightmare" - all of the money had been invested with Madoff, 75 percent or his retirement gone! Shock does not describe his feelings, if any are left.

The SEC has now shut down Madoff's operations, including Bernard L. Maddoff Investment Securities LLC, or BMIS. The freeze order can be found here.

But who else was involved, and where will investors be able to seek recovery?

Our investigation, in its early stages, leads use to believe that many were involved and many knew or suspected. The investors we know invested in partnerships who invested with partnerships... who invested with Bernie M. And Bernie M. and some of the general partners of these partnerships seem to have close relationships. We are trying to learn more about those partnerships and relationships...many of the partnerships seem to have less of a real presence than the three auditors of Bernie M's fund. At least they had a 12 by 18 foot office and showed up for 15 minutes a day in their tie dye T-shirts. We know that there was a group of funds or partnerships funneling money to Bernie M. But the pciture needs paint.

You can help us with our investigation. Help us define the web that allowed this Ponzi scheme to hurt so many. A description of our investigation is available here.

SEC - Regulating the Obvious

We need to invent a new word in the English language that describes an action so absurdly overdue that once finally undertaken it immediately becomes a totem of absurdity.

We could have used this word when the FAA (now TSA) made the decision to ban box cutters and other sharp weapons from carry-on luggage only after 9/11 brought terrorism to the forefront. We could have used this word when our Federal government decided to require testing of Chinese toys for lead paint only after children across the country were poisoned.

Just yesterday, we could have employed that newly coined word to describe the overdue move by the SEC to adopt rules designed to reduce conflicts of interest that are now common in the credit-rating industry.

Faced with the devastating collapse of the mortgage market, and a massive credit crunch, Federal regulators finally concluded that there is something wrong with the way the $5-billion-a-year credit-rating industry governs itself.

Rating agencies play a pivotal role for investors - an opinion issued by ratings agencies signals the creditworthiness of public companies and their securities. What credit agencies say can dramatically affect a company's share price, or a security's yield.  These opinions are touted to investors as an ostensibly objective opinion on the risk of investing in particular securities. 

The three largest players -- Standard & Poor's, Moody's and Fitch - clocked a lot of ducets offering their ratings. It is a $5 billion industry. The public now knows what industry insiders have long discussed - that agencies were spewing ratings on sub-prime mortgages and related securities that had as much in common with reality as a Salvador Dali-inspired nightmare.

Of course we all know the fallout: the big three were forced to recast their ratings and downgrade thousands of securities backed by mortgages, an action that many say led to our current economic meltdown.

The new regulations are a good start.  One regulation tightens up conflict-of-interest rules, which prohibit the rating agencies from giving investment banks exclusive counsel of how to package securities. Another limits the value of gifts from investment banks to rating agency staff. It also requires that the agencies disclose the reasons they upgraded or downgraded a security, amid other disclosure requirements. 

The new regulations did fall well short in many ways. Where are the tighter rules to suspend the licenses of those who acted improperly, and rules to hold the agencies liable for their published opinions? Not to mention a forced separation of rating agency credit analysts and employees responsible for generating revenue.

Yes, these rules could make us safer when it comes to the veracity of rating agencies, but one must wonder why this has taken so long and if they go far enough.

SEC Takes Steps to Improve Mutual Fund Disclosure for Investors

My friend William Lutz, who spearheaded the SEC's Plain English Rules, and now is overseeing a new 21^st Century Disclosure Initiative at the SEC and has alerted me to the Securities and Exchange Commission's (SEC) long overdue step towards helping investors better prepare for prudent decisions about their investments. Specifically, the commission voted for mutual funds to do a better job of disclosing key information about their funds in a way that investors can understand.

This is very good news for investors, and one that should help millions of Americans, especially now as they try to re-establish their investment strategy after the recent re-pricing of the stock market.

In my years of representing individual and institutional investors, I've seen too many cases in which an investor made a decision to buy - or sell - funds thinking they had a clear picture of the risks associated with a fund, when in fact they didn't. I have also spent numerable hours just trying to find information buried in the various filings that make up the prospectus.

It is not to say that the fund managers intentionally obfuscate important information about the funds (although at times one wonders), but it is clear that the wonks who are tasked with writing the fund prospectuses aren't rewarded for their ability to write with clarity or concision.

The new rules say that every mutual fund prospectus must list the fund's investment objectives and strategies, risks, and costs at the front in easily accessible language, along with a snapshot of the fund managers' backgrounds, information about purchase and sale procedures as well as tax implications.

But just as important, the new requirements say that the fund managers must provide potential purchasers this information in standardized format - think of it as the nutrition label on a can of soup; you know where the calories are listed, so it becomes easier to compare one against another.

The new rules mandate that the funds also publish this information - in this structured, standardized format - online. Moreover, they must also allow investors to drill down on information important to them, download the information, and keep an electronic copy.

Will these mandated changes bring an end to investors making bad choices? Of course not, but any time investors have access to more accurate, more accessible information, the better they will be.  

If you want to read more, visit the SEC's news release, aptly written with concision and clarity.

Are Taleo's Insider Sales Suspicious in Light of Auditors Questioning Revenue Recognition Policies?

Since going public in 2005, insiders have unloaded Taleo Corporation (NASDAQ: TLEO) stock with sales in excess of $120,558,011. Within the last six months alone, insiders sold $10,782,049 and purchased no other shares on the open market. CEO, Michael Gregoire, sold $2,500,000 on Aug. 11, 2008. Director Jeffery Schwartz sold $7,829,280 on May 22, 2008, leaving him with no shares.

On Nov. 6, 2008, Taleo's auditor, Deloitte & Touche LLP, requested that the Company review its revenue recognition policy. It was then Taleo notified the Securities and Exchange Commission (SEC) that it could not meet the Nov.10, 2008 due date for quarterly earnings reports. NASDAQ then notified Taleo that it did not meet its listing requirements.

Taleo shares hit a 52-week low on Nov. 11, 2008, after the Company announced it would delay third-quarter earning reports to review accounting practices. After the announcement, Taleo's stock fell 28 percent to $7.99 per share from its annual high of $34.20.

Analysts have expressed concern that the inevitable result will be a restatement. Other than saying that the revenue is there, it's just a matter of when the revenue should be reported. Meanwhile, the Company has remained quiet.

Just last year, Forbes, in conjunction with Audit Integrity, rated Taleo as having Aggressive Accounting & Governance Risk (AGR), receiving an AGR Score of 59 out of a possible 100. In August, Audit Integrity upgraded the rating to Average Accounting & Governance Risk (AGR), receiving an AGR Score of 71 out of a possible 100. This places them in the 64th percentile among all companies, indicating higher accounting and governance risk than 36 percent of companies.

The following forensic risk summary  from Audit Integrity in August 2008 highlights the most material business issue for each risk. AGR Impact shows the deductions from a perfect 100 AGR score due to flagged metrics.

Clearly, Audit Integrity spotted some issues in revenue recognition. Usually this is the result of a lack of transparency.

Getting back to the question at hand, does the possibility of a restatement call into question the insider sales? Was there a motive to get out? While Schwarz was not on the Audit Committee, he did sell all his shares within the last six months. What did he know? There is no news indicating that, as is the usual story, that he was leaving the company, or needed the cash for a new Aspen mansion. As for Gregoire, we can see that he traded in regular bouts. Many of his sales were "automatic," meaning that they might have been part of a pre-set plan. But, even academics, the Court and SEC recognize trading plans can be an abuse. See Kevin LaCroix article, Rule 10b5-1 Plans Drawing Scrutiny. 

More analysis is needed to make sense of this all. Of course, we're all waiting to see the results of the policy review. If you have information, please help us out and drop me an email at reed@hbsslaw.com. Or comment below.

Balancing Sensible Governance against Failed Principles: Is this the End to the Wild West of Investing?

Like the Wild West, hedge funds are a largely unregulated investment vehicle marketed as a tool for reaping large returns for investors willing to accept higher risk. In the current climate of market volatility, it appears that a sheriff is riding into town and the Wild West of investing may soon end. 

From 1999 to 2004, hedge fund assets under management grew by more than 260 percent. It is estimated that by the summer of 2007, more than $1.9 trillion was under management at more than 9,000 hedge funds.

Recently, at the Hedge 2008 Conference in London, one prominent hedge fund manager stated, "In a fairly Darwinian manner, many hedge funds will simply disappear." According to hedge fund research, investors removed $43 billion from hedge funds during the month of September and losses for the past three months top $210 billion. 

The question moving forward is, "Who will the sheriff be and when will the sheriff arrive?" As we see it, there are three possibilities.

Public Pensions and Retirement Funds

Driven to maintain or exceed a higher return rate for their retirement systems, many public pensions have decided to invest in this high-stakes corner of the investment world. 

United States public pensions are uniquely poised to change how these investments are regulated including advocating for transparency from hedge funds and pursuing recovery for investors.

By early 2007, United States public pension funds had invested $24 billion in hedge funds. 

The dilemma is clean, in a climate nearly devoid of oversight, hedge funds do not report trading positions or holdings. They are not required to report how much they owe or to whom they owe.  Such strategies are typically at odds with the transparency requirements for pensions.

The Securities and Exchange Commission

Regulation of hedge funds has been a recurring battle and one the SEC has lost on numerous occasions.

In 2006, the Securities and Exchange Commission passed the Hedge Fund Rule that required hedge funds managing more than $25 million to register with the SEC, provide details about operations and submit to periodic audits.

The SEC's attempt to impose regulation was as short lived as the sheriff riding into early Tombstone. The Hedge Fund Rule became effective on Feb. 1, 2006, and by June of 2006, the Court of Appeals for the D.C. Circuit shot the rule off its horse. 

On Sept. 17, 2008, SEC Chairman Cox asked the commission to consider an emergency disclosure rule requiring hedge funds and other large investors to disclose their short positions.  Managers with more than $100 million invested in securities would be required to begin publicly reporting their daily short positions. 

The SEC's proposed rule was altered when the SEC changed course because hedge fund managers complained that requiring public disclosure would put them out of business because other investors could copy their investing strategies. In response, the new SEC rule only requires hedge fund managers to report their short positions to the SEC on a weekly basis and not to the investing public. 

On Oct. 15, 2008, the SEC extended the rule to Aug. 1, 2009. 

Additional SEC efforts to regulate are likely to emerge in the short term. Turning to the last option, legislators are faced with the burden of fixing a broken market.

Legislators

So, what reforms may be riding into town?

We know that hedge funds are fiercely protective of their investment strategies and that they are girding themselves for a fight over disclosure and regulation. It is clear that this industry is currently under the microscope and there is strong backing from political leaders throughout the country to regulate hedge funds.

There are three schools of thought emerging in Washington: 

Analysts are floating ideas about disclosing investments 45 days after the close of a quarter to allow for a cooling period - making any disclosures historic;

1. Full disclosure to the SEC is necessary but can be confidential; or
2. Total transparency to the market - meaning full disclosure to all.
3. Regardless of the source or solution, reform will take time.

Before reform is agreed upon and in place, the leading edge may come through private litigation. Numerous hedge funds are being sued by investors, including public pensions, for various causes of action including breach of fiduciary duty, gross mismanagement, breach of contract, fraud, negligence, and violations of federal and state securities laws. 

As Ann Yerger, executive director of the Council of Institutional Investors recently stated, "Now is not the time to yield to pressure from Wall Street lobbyists to further shelter financial firms." 

Indeed, now is the time to guide hedge fund reform and to create sensible reforms in the face of failed principles.

You can contact me and view my LinkedIn profile here.

SEC Settlements Compared to Settlements in Private Shareholder Class Actions

NERA Economic Consulting has just published a report on SEC Civil Enforcement Settlements over the past few years. The study, SEC Settlements: A New Era Post-SOX, provides an overview of trends NERA has identified in the number of settlements and settlement values in the six years since the enactment of SOX. The data stems from a database of litigation releases and administrative proceedings published from 31 July 2002 through 30 September 2008. 

Of interest is a comparison of some of the SEC settlements with those achieved by private securities fraud class actions. While the comparison is not made in the report, NERA also published a report entitled 2008 Trends: Subprime and Auction-Rate Cases Continue to Drive Filings, and Large Settlements Keep Averages High.  

Each report contains a chart of top 10 settlements, which is set out below. The first is a chart of the top 10 settlements for SEC settlements for the period of July 2002 - September 2008. The second is for the top 10 private class-action settlements. Interestingly, the lowest of the top ten settlements in private shareholder class actions starts out higher than the highest SEC settlement ($895 million versus $800 million).  

The settling companies are not the same either, except for a few. For example, the SEC disgorged no funds for investors in WorldCom. While it accessed a $750 million civil penalty, civil penalties do not necessarily go to investors. Since enactment of the Sarbanes-Oxley Act of 2002, penalties may be added to disgorgement funds for the benefit of investors. Section 308 of Sarbanes-Oxley (the Fair Funds provision) allows the Commission to take penalties paid by individuals and entities in enforcement actions and add them to disgorgement funds for the benefit of victims. Penalty moneys no longer always go to the Treasury, but there is no hard and fast rule. By way of contrast, the private shareholder class action against WorldCom recovered more than $6 billion for investors, not including institutional investors who opted-out of the securities fraud class action and received their own substantial recoveries.  

Similarly, the SEC accessed penalties of $300 million from Time Warner, and received no disgorgement for investors. By way of contrast, the private shareholder class action against AOL Time Warner recovered more than $2.6 billion for investors. This recovery does not include the recoveries of institutions that opted-out of the class action and pursued their own suits.  

The SEC Settlement report also states that the number of SEC enforcement actions with recoveries relating to misrepresentation claims for the six-year period totals 197 settlements. The Private Shareholder Class Action report, by way of contrast reveals that more than 200 class actions are filed per year with a 60% settlement rate -- or more than 1200 suits with 720 settlements.  

Our comparisons, here, are rough. Hopefully, NERA will do a more in depth statistical and case by case comparison that would stand up to expert review. But even based on this rough comparison, what do we conclude?  

• Private class actions remain the most important vehicle for investor recovery, and dollar-wise provide the biggest deterrent to securities fraud in the area of public company misstatements or omissions. 
• The SEC report, however, remains the primary watch dog for actions involving boiler room operations, pump and dump schemes, Ponzi schemes, financial services (brokers) misappropriation of funds and misrepresentations to clients, and insider selling, and recoveries against individuals. NERA's report has statistics covering each of these areas too. 

This first chart is from the SEC Settlements: A New Era Post-SOX:

The following is a list of top settlements in Private Securities Class Actions from the NERA Shareholder Class Action Report:

Is Cadence's Restatement Likely the Result of Fraud?

On October 15, 2008, Cadence (NASDAQ: CDNS) of San Jose, California, was supposed to announce its third quarter results for 2008. Instead it announced the resignation, "by mutual agreement" of its CEO, Mike Fister and four other executives: Kevin Bushby, executive vice president, worldwide sales operations; James S. Miller Jr., executive vice president of products and technologies; William Porter, executive vice president and chief administrative officer; and R.L. Smith McKeithen, executive vice president, corporate affairs. Porter had also served as CFO between 1999 and April 2008.

Then on October 23, 2008, Cadence announced that it has improperly recognized $24 million in revenue in the first quarter, which should have been recognized over the duration of the contracts beginning in the second quarter.

While a restatement of $24 million is only about 10 percent of the revenue, the impact on the income/loss would have been tremendous, as the first quarter was already a loss of $27 million. Hence, if the executives were scrambling to close the gap on the loss, a little revenue recognition shenanigans might have helped:

Even then, however, the stock took a hit over the next two quarters. Results:

But often a good indicator of fraud is insider selling. However, insider sales have been very small over the last year, though James Miller, one of the executives who resigned, sold about $120,000 in September and an executive who did not resign, sold about $631,000 in February. Much more was sold in the last two quarters of 2007, before the revenue recognition problems, but it is always possible that the executives foresaw the upcoming income declines and sold before they needed to play revenue games.

Of course another incentive could be the need to raise cash for acquisitions such as the failed attempt to acquire Mentor Graphics announced in May 2008.

We will keep monitoring this story, and if you have any information, let us know.