Zamansky: More Half-Baked Justice From the SEC

Last year, Judge Jed Rakoff of the United States Southern District of New York struck a blow on behalf of all investors when he ordered the SEC and Bank of America back to the negotiating table. He deemed the settlement agreement the SEC submitted for Bank of America’s alleged failure to disclose billions of dollars of losses at Merrill Lynch as inadequate and poorly constructed. When the SEC and Bank of America went back to the drawing board and agreed to somewhat stricter terms, still without admission of guilt, Judge Rakoff reluctantly approved. But not without a last salvo.

Judge Rakoff proclaimed that the revised settlement represented “very modest punitive, compensatory, and remedial measures that are neither directed at the specific individuals responsible for the nondisclosures nor appear likely to have more than a very modest impact on corporate practices or victim compensation…While better than nothing, this is half-baked justice at best.”

The same “half-baked justice” Judge Rakoff described last year was evident in the SEC’s recent settlement with Citigroup. The SEC alleged Citigroup executives hid $40 billion in toxic mortgage industry assets from its shareholders. Citigroup paid a $75 million fine for what might be one of the biggest accounting scandals on record and managed to avoid using the word “fraud” to describe its actions. Carefully crafted by Citigroup’s attorneys, the terms of the settlement were clearly designed to protect executives from liability and undermine shareholder’s seeking to recover their losses.

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Zamansky: Goldman Sachs and the SEC Take the Easy Road

The SEC deserved a lot of credit for filing the case against Goldman Sachs for its dubious creation of the ABACUS CDO transaction.  To recall, Goldman created the ABACUS deal so that a hedge fund manager could short the mortgage market, and then sold the securities to an unsuspecting client without disclosing the investment was built to fail.

But while the SEC deserves plaudits for filing a challenging case, settling the case without requiring Goldman to address whether fraud was committed misses the point entirely.  Moreover, this allows Goldman Sachs to avoid turning over potentially incriminating documents about the ABACUS deal, other CDO transactions and the failure by Goldman to disclose the Wells Notice it received after the SEC initially launched its investigation.  Having filed a  shareholder class action case against Goldman Sachs, it was a slight disappointment to see Goldman pay a fine rather than be truly held accountable for its actions.  Speaking of which, while the fine appears to be substantial, its a drop in the bucket for Goldman Sachs, and the “admission” of a mistake was crafted by Goldman lawyers to be later able to deny liability.

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Rating Agencies Face Curbs

The Senate approved a provision that would thrust the government into the process of determining who rates complex bond deals, in a move to end alleged conflicts of interest blamed by some for worsening the financial crisis.

The 64-35 vote Thursday represents one of the strongest moves yet by Congress to change how business is done on Wall Street. The amendment aims to resolve what’s considered one of the thorniest problems in financial markets: Bond issuers choose ratings agencies and pay for ratings, meaning raters’ revenues depend on the very firms whose bonds they are asked to judge.

Under the new provision, the Securities and Exchange Commission would instead establish and oversee a powerful credit-rating board that would act as a middleman between issuers seeking ratings and the rating agencies. The board would select which agency provides the “initial rating” for certain securities known as structured bonds.

Critics of the status quo say the issuer-pay model led to inflated ratings in the housing boom, particularly of securities backed by mortgages. Many bonds rated triple-A ended up getting downgraded to junk, unleashing mayhem in the financial system. Congress has drubbed ratings agencies for being too cozy with the banks that bring them business and too focused on market share rather than independent analysis.
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New York AG Investigates Whether Big Banks Deceived Rating Agencies

The New York Times reports this morning that the New York Attorney General has issued subpoenas to eight banks, investigating whether they provided false information to rating agencies to obtain higher ratings for mortgage-related securities.  The banks include the usual suspects — Goldman Sachs, Morgan Stanley, UBS, Citigroup, and Merrill Lynch.  NYTimes, Prosecutors Ask if 8 Banks Duped Rating Agencies.

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Choi et alia on Judicial Ability and Securities Class Actions

Judicial Ability and Securities Class Actions, by Stephen J. Choi, New York University - School of Law; G. Mitu Gulati, Duke University - School of Law; and Eric A. Posner, University of Chicago - Law School, was recently posted on SSRN.  Here is the abstract:
We exploit a new data set of judicial rulings on motions in order to investigate the relationship between judicial ability and judicial outcomes. The data set consists of federal district judges’ rulings on motions to dismiss, to approve the lead plaintiff, and to approve attorneys’ fees in securities class actions cases, and also judges’ decisions to remove themselves from cases. We predict that higher-quality judges, as measured by citations, affirmance rates, and similar criteria, are more likely to dismiss cases, reject lead plaintiffs, reject attorneys’ fees, and retain cases rather than hand them over to other judges. Our results are mixed, providing some but limited evidence for the hypotheses.

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GAO Issues New Report on SEC’s Fair Fund Collections and Distributions

Since Sarbanes-Oxley gave the SEC the authority to distribute civil penalties to investors harmed by a corporation’s fraud (the “Fair Fund” provision), the GAO has issued a number of reports and a series of recommendations on improving the collection and disbursement of these funds.  It just issued another such report — Securities and Exchange Commission: Information on Fair Fund Collections and Distributions. Here’s its summary conclusion:

Since 2007, fewer Fair Funds have been established and the collection and distribution of Fair Funds have increased, but many Fair Funds continue to remain open and active for years. From 2002 through February 2010, $9.5 billion in Fair Funds were ordered, with the majority of this total ordered prior to May 2007. Since that date, only $521 million, or less than 6 percent, of total Fair Funds have been ordered. Of the $9.5 billion total Fair Funds ordered, $9.1 billion (96 percent) has been collected and $6.9 billion (76 percent) of the Funds collected has been distributed. In comparison, in 2007, only 21 percent of Fair Funds had been distributed. Although the percentage of Fair Funds distributed has increased, there are many Fair Funds that remain open and active for years. For example, our analysis of SEC data shows that of the 128 ongoing Fair Fund cases, over half have been ongoing for more than 4 years. SEC officials offered several reasons why Fair Funds remain open, including difficulties in obtaining investor information and legal objections and appeals that must be settled. To improve its management of Fair Fund cases, SEC proposed a performance metric of tracking the number of cases that have completed distribution within 2 years of the appointment of a Fund administrator. However, to date, SEC has not started collecting the data in a manner necessary to track this measure.

SEC has taken steps to increase efficiency and assess Fair Fund distribution, but a number of actions that are necessary to improve tracking of distribution related information are still pending. In response to our recommendations, SEC centralized the administration of collections and distributions under OCD and subsequently eliminated the dual reporting structure that initially existed in this new office. According to SEC, the creation of OCD has allowed the opportunity to build institutional knowledge and decreased inefficiencies by developing key administrative aspects of the program. SEC officials also told us that they have implemented other operational and administrative changes that are designed to improve Fair Fund distribution. For example, SEC established a working group to share information and to coordinate between functions on distribution plans and to identify problems that may slow distribution. However, SEC officials acknowledged that Fair Fund information and data tracking still need improvement. SEC officials said they have not implemented any major improvements to Fair Fund-related data management since 2007 and that additional improvements are needed in recording and monitoring of Fair Fund data. For instance, Fair Fund data are housed in several different databases that have not been reconciled and aggregate information on Fair Fund administrative expenses is unavailable. According to SEC officials, an extensive review of the Fair Fund program is under way, the findings of which may result in changes to workflow, procedures, and information systems. While SEC is taking steps to better capture, report, and manage the programmatic and financial impact of the collections and distribution process, it is too early to determine the impact and ultimate success of these efforts.

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U.S. Supreme Court Hears Oral Argument in Morrison v. National Australia Bank

The U.S. Supreme Court heard oral argument yesterday in Morrison v. National Australia Bank(Download Morrison Transcript), the securities class action involving foreign plaintiffs that purchased shares of a foreign issuer abroad suing foreign defendants for Rule 10b-5 fraud.  The Second Circuit dismissed the plaintiffs’ claim, relying on a balancing test developed by Judge Friendly over 30 years ago.

The difficulty that petitioners faced from the outset was that, as Justice Ginsburg expressed it, this case “has ‘Australia’ written all over it.”  Petitioners’ attorney argued that, to the contrary, this case has “‘Florida’ written all over it because Florida is where the numbers were doctored, Florida is where the fraudulent conduct in putting the phony assumptions into the valuation portfolio were done,” but it does not appear (from my reading of the transcript) that the Justices were persuaded.  As several Justices noted, the communication of the doctored numbers took place in Australia, where the documents were prepared by the Australian bank.

The hard question put to respondents’ attorney was suppose that Schmidt, a citizen of Germany, flies to New York and meets Jones in a New York hotel, where Jones persuades him that he owns the Brooklyn Bridge,  and Schmidt buys shares in Jones’ company on the German exchange.  Should the U.S. courts not take jurisdiction over this dispute?  Petitioners’ attorney appeared to waffle on this, but ultimately argued that any balancing test that would allow application of U.S. law would infringe the sovereign authority of other nations.  Judge Breyer wondered how it would hurt the interests of a foreign nation if the court asserted jurisdiction over a case that involved terribly bad conduct that took place in the U.S.

Finally, the United States argued as amicus curiae.  The government’s position is driven by its concern that it would not be able to go against those who hatch a fraud in the U.S. that is directed against foreign investors — e.g., boiler rooms operating here that target only foreign investors.  Thus, it argued for a distinction between government actions and private claims.  The Justices worried that sorting out significant from insignificant frauds, and domestic from overseas conduct, might not prove so easy.

Finally, I’d like to applaud Professor Margaret V. Sachs (UGeorgia), whose groundbreaking scholarship in this area was repeatedly referenced by Justice Breyer, who took an active role in questioning all three attorneys.  Justice Breyer asked each attorney to square their positions with Professor Sachs’.  In 1990, Professor Sachs took on the “received wisdom” of Judge Friendly, who believed that Congress did not address the question of extraterritoriality in the 34 Act.  To the contrary, asserts Professor Sachs, Congress was aware, in 1934, of overseas securities markets, and Congress made a deliberate choice not to extend federal securities laws to overseas transactions.

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Zamansky: Annuities and the Avoidance of the Fiduciary Standard

There’s a saying on Wall Street: “Structured products are never bought, only sold”. The same could be said of annuities.

Selling annuities is an extremely lucrative and virtually risk-free business, which is one of the reasons why insurance companies and some Wall Street firms are aggressively lobbying Congress not to require brokers and other purveyors of financial products to adhere to a so-called “fiduciary standard.” Under the proposed standard, brokers and insurance salesmen would be required to put their clients’ interests ahead of their own, likely forgoing high-commission annuities for other, more appropriate investments.

Not surprisingly, Morgan Stanley has voiced concerns that the fiduciary standard would cut into its business. Morgan Stanley has good reason to worry: The firm earned $37 million from selling annuities in the first quarter of 2009 alone, or 1.22 percent of its noninterest income, according to a report by the American Bankers Insurance Association (ABIA). A Morgan Stanley spokesman recently told Bloomberg that expanding the fiduciary standard to include brokers would impinge upon the firm’s ability “to provide clients with products and services they want.” Or, perhaps more accurately, don’t want.

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Judge Rakoff Approves Settlement, Calling it “Half-Baked Justice at Best”

“While shaking its head,” the Court (i.e., Judge Rakoff) approved the proposed consent judgment between the SEC and Bank of America settling the two enforcement actions, one of which was scheduled to begin trial on March 1.  Finding that the settlement was “half-baked justice at best,” nevertheless the judge felt constrained by the law’s requiring the court to give substantial deference to the SEC as the regulatory agency having principal responsibility for policing the securities markets.  Even more weighty in his view were considerations of judicial restraint:

We can balk when a bank tries to escape the implications of hiding material information from its shareholders, and we can protest when the regulatory agency in charge of deterring such misconduct seems content with modest and misdirected sanctions; be, in the words of a great former Justice of the Supreme Court, Harlan Fiske Stone, “the only check upon our own exercise of power is our own sense of self-restraint.”

The opinion (Download SEC V BOA) is well worth reading in its entirety, but here are some specifics:

It is clear to the court that the BofA proxy statement failed adequately to disclose the Bank’s agreement to let Merrill pay $5.8 billion in bonuses and also failed adequately to disclose the Bank’s ever-increasing knowledge that Merrill was suffering historically great losses during the fourth quarter.

It is also obvious to the court that these failures to disclose were material.

What is not obvious is whether these material nondisclosures resulted from negligence or from more culpable conduct.  Because the New York AG’s complaint alleges the latter, the court was obliged to review deposition testimony provided by the AG  to determine if the SEC’s conclusions were unreasonable.  Specifically, the court reviewed the testimony concerning the termination of BofA GC Mayopoulos’ employment.  While the SEC and the Bank assert his firing was done to move current CEO Brian Moynihan into the position, the New York AG alleges Mayopoulos was fired because he was pressing for more disclosure.  The court, after its review, concludes that “none of the evidence directly contradicts the Bank’s assertion that Mayopoulos’ termination was unrelated to the nondisclosures or to his increasing knowlege of Merrill’s losses.”  The judge, however, makes it clear that he is not making any determination as to which of the two competing versions of the events is the correct one.

As to the prophylactic measures designed to prevent nondisclosures in the future, the court finds that the remedial steps “should help foster a healthier attitude of ‘when in doubt, disclose.”

As to the $150 million penalty, the court continues to find it problematic.  The amount is very modest, indeed “paltry.”  A bigger problem, and one that the judge emphasized in his disapproval of the first proposed settlement, is that payment of the penalty by the corporation means that innocent shareholders bear the loss caused by the managers, rather than those managers themselves.  Because the distribution will be structured so that former Merrill shareholders who are now BofA shareholders will not receive a distribution, the effect serves as a renegotiation of the price paid to Merrill shareholders by the BofA shareholders.  But the effect is “very modest.”

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Investors Demand Home Loan Principals be Reduced

Real estate investors are beginning to agree on one thing, reducing principals on underwater loans could save the continually growing number of foreclosure filings. The U.S. housing crisis needs answers and solutions for people suffering from financial hardships due to economic failure. Reducing the principal amounts on homes that are no longer worth the value they were 5 years ago could help thousands of homeowners.

The principal amount of a home loan is the base amount owed, not including interest. When an economic recession takes over however, greatly reducing the value of a home’s worth, than the base amount of that loan no longer represents a current buyer’s initial investment goal, thus causing the loan to be “underwater.”

“Principal reduction is the only answer,” says Laurie Goodman, a senior managing director at mortgage-bond trader Amherst Securities Group L.P. Investors and housing market activists are urging banks to lower the base amount of home loans across the country. Not only could this help future investors to improve the market but also help the current problem of people trying to make their mortgage payments every month.

One of the nation’s largest bailout receivers is considering this. Isn’t that what bailout money was for anyway? Bank of America received $20 billion last year to help recover from a $1.7 billion loss. The U.S. Treasury also stated it would “provide protection against the possibility of unusually large losses on an asset pool of approximately $118bn of loans”.

“Everybody’s realizing there is a place for principal reductions to a much greater extent than before,” says Jack Schakett, a senior Bank of America Corp. executive involved in loan workouts. Restrictions on executive pay were given along with with the bailout money, but corporations such as AIG have continually disappointed American taxpayers by continuing to reward their top executives with millions of dollars in bonuses, despite continued losses, and foreclosures.

“The US government was never going to cut up too rough when the biggest lender in America asked for a bit of additional help in absorbing the losses incurred on Merrill’s holding of poisonous assets,” BBC’s business editor states, referring to what lead to Bank of America’s initial downfall.

Months after the bailout however, Bank of America received criticism about their lack of quickness to loan out all of the billions of dollars it received. In a statement released by Bank of America’s by Barbara Desoer, president of B of A’s home loans division, she states:

“Despite our aggressive efforts to find solutions for homeowners in default, we must improve our processes for reaching those in need. Additionally, we continue to work with Treasury to find solutions for at-risk homeowners who fall outside the eligibility requirements of the current program as well as the growing number of customers now unemployed. Bank of America has not proceeded with foreclosure sales for customers with whom we have established contact that may be eligible for a modification under Making Home Affordable or our other modification programs.”

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