Securities Litigation Blog
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Posted on March 12, 2012 Email This Link
The Emerging Growth Companies Act – Engine For Growth Or Recipe For The Next Market Meltdown?
On March 8, 2012, the House of Representatives passed H.R. 3606, the “Reopening American Capital Markets to Emerging Growth Companies Act of 2011” (the “Act”), by a resounding vote of 390-23. The Act would, if passed by the Senate, make it easier for companies with less than $1 billion in annual revenues, also known as “emerging growth companies” (EGCs), to solicit investors, go public and otherwise reduce regulatory burdens.
Specifically, the Act would, among other things, do the following –
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Amend the 1934 Securities Exchange Act (SEA) and Dodd-Frank to exempt EGCs from the requirement that their boards of directors present a non-binding resolution on executive compensation, including golden parachutes, to shareholders, at least every three years. This exemption would apply until such time as the EGC in question no longer qualifies as an EGC. (A company is no longer an EGC at the earlier of either (a) such time as revenue exceeds $1 billion or (b) five years have passed since the IPO.)
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Amend Sarbanes-Oxley to exempt a registered public accounting firm that prepares or issues a report on its audit of an EGC from the requirement that it attest to, and report on, any assessment of internal controls the company’s management has made.
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Exempt EGCs from any requirement that the PCAOB may impose (see PCAOB Concept Release 2011-006) that the EGC “rotate” its audit firm.
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Authorize an EGC or any person authorized to act on behalf of one, to solicit potential investors, provided that the investors are qualified institutional buyers (QIBs) or institutions that are accredited investors, either before or after the filing of a registration statement with the SEC.
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Amend the Securities Act of 1933 (SA) such that a broker-dealer’s publication of research or other reports about an EGC that is going public would not constitute an offer for sale or offer to sell a security even if the broker dealer is participating or will participate in the registered offering of the issuer’s securities. Further, the Act would prohibit the SEC from issuing any rule that would bar a broker-dealer from publishing or distributing a research report or making a public appearance with respect to the securities of an EGC.
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Amend the SA such that an EGC need not present more than two years of audited financial statements in order for its registration statement, with respect to an IPO of common equity shares, to be effective. For any other registration statement thereafter, the Act would amend the Securities Exchange Act of 1934 (SEA) to state that an EGC need not present financial data for any period before the earliest audited period before the earliest audited period presented in connection with its IPO.
If the Senate ultimately embraces the provisions of the Act, or something very similar, the question becomes what impact such a law would have on the capital markets and on investors big (QIBs and accredited) and small. Each of the provisions of the various statutes and regulations that would be amended or impacted by such a law were put into place for a reason and the changes proposed under the Act should be evaluated with such purposes in mind.
For example, on January 25, 2011, the SEC, pursuant to Section 951 of Dodd-Frank, adopted its “say-on pay” rule, which requires all public companies to provide their shareholders with the opportunity to vote on a non-binding resolution regarding executive compensation at least every three years. That provision of Dodd-Frank and the SEC’s rule are designed to prevent abusive compensation practices that sometimes go unchecked by boards of directors.
The Act would exempt EGCs from this requirement up until such time as they no longer qualify as an EGC, which occurs at the earliest of the first year that revenues exceed $1 billion or five years after the IPO. While not impossible, it is unlikely that depriving shareholders of their one time opportunity (Dodd-Frank only requires the presentation of resolution once every three years) to vote on a non-binding resolution regarding executive compensation in an ECG would seriously undermine the force of say-on pay. Further, in the context of recently private growth companies, it is often the case that executive compensation is tied up with the performance of the company due to restrictions put in place by private equity investors prior to the IPO. Management may not be free of such restrictions for some time after the IPO.
In the final analysis, whether the exemption from say-on pay and other provisions of the Act are good ideas for small companies, capital markets, and investors remains to be seen. Reducing the regulatory burdens shouldered by emerging companies is a good idea in principle but, as the extreme regulatory looseness that preceded the recent economic crisis shows, too much of a good thing can leave a serious hangover.
By William A. Haddad
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Posted on December 8, 2011 Email This Link
The Honorable Jed Rakoff – Protecting the Public or Prolonging Economic Uncertainty?
On November 28, 2011, Judge Jed Rakoff loudly benchslapped Citigroup Global Markets Inc. and the SEC by refusing to approve the parties’ proposed Consent Judgment in a case in which the SEC has accused Citigroup of committing securities fraud. See U.S.Securities and Exchange Commission v. Citigroup Global Markets Inc., 11 Civ. 7387 (JSR) (S.D.N.Y. Oct. 19, 2011). According to the SEC’s complaint, Citigroup allegedly misrepresented its role in the structuring and marketing of a collateralized debt obligation or “CDO.” The CDO consisted primarily of credit default swaps which referenced other CDO securities that in turn were collateralized mostly by subprime residential mortgage-backed securities. This type of CDO transaction, commonly referred to as a “CDO squared,” was a popular investment prior to the collapse of the financial markets. Unfortunately, as went the housing market, so went the CDOs.
None too pleased with the SEC during the past several years, Judge Rakoff has become a vocal critic of settlements between the Commission and the Wall Street Banks, particularly when the settlements do not require the Banks to admit any wrongdoing. In September 2009, he rejected a $33 million deal between the SEC and Bank of America Corp. claiming that the settlement reflected “a rather cynical relationship between the parties.” SEC v. Bank of America Corp., 653 F. Supp. 2d 507, 512 (S.D.N.Y. 2003). Despite his purported misgivings, however, Judge Rakoff approved a revised settlement that he reportedly regarded as “far from ideal” just a few months later in which Bank of America agreed to pay $150 million. See SEC v. Bank of America Corp., Nos. 09 Civ. 6829(JSR), 10 Civ. 0215(JSR), 2010 WL 624581, at *5-6 (S.D.N.Y. Feb. 22, 2010).
Judge Rakoff’s concern seems by and large to be directed at the SEC’s refusal to force the Banks to admit to their alleged sins, which he fears effectively lets the Banks off the hook and encourages recidivist behavior down the road. His concern, however, is misplaced. If Judge Rakoff’s goal is to protect the “public interest,” rejecting the Banks’ settlements with the SEC is not the way to go. Rather than preventing a second Great Recession, Judge Rakoff’s rejection of the settlements could very well prolong the country’s economic woes by injecting additional uncertainty into already wobbly financial markets. The markets respond positively to settlements, because of the finality – and thus stability – that they bring. Yet, resolutions (and therefore stability) will remain elusive if Judge Rakoff has his way, because no rational defendant (Wall Street Bank or otherwise) will agree to settle a case if doing so will require the defendant to admit to facts that can and will be used against the defendant in subsequent litigation. At the end of the day, the Banks might as well take their chances at trial than outright admit to facts that they know will come back to haunt them over and over and over.
The SEC’s ability to enter into settlements without requiring the Banks to admit to wrongdoing is a powerful tool. Its use exponentially increases the likelihood that the Banks will agree to pay tens of millions – if not hundreds of millions – to settle the lawsuits while simultaneously preserving the SEC’s own limited resources for future cases. Removing this tool from the SEC’s tool chest will inevitably ensure that greater strain is put on the SEC’s resources, because the Banks will be forced to vigorously defend their positions at trial knowing that a loss would prove immensely costly to them both now and in the future.
Perhaps Judge Rakoff should instead direct his ire at the SEC’s apparent failure to enforce its settlement agreements. To Judge Rakoff’s chagrin (and according to the SEC’s own admission), at no point during at least the last ten years has the Commission ever pursued civil contempt proceedings against a large financial institution after uncovering evidence that tended to show that the institution may have violated a previous order. Approving settlements encourages financial stability and enforcing their terms encourages good corporate behavior. That’s a win-win all around.
By Christine Genaitis
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Posted on August 15, 2011 Email This Link
Regulation Overkill? Massachusetts Securities Division Proposes Regulation Making It Illegal for Investment Advisers to Hire Industry Experts or “Consultants” Unless Consultant Certifies That He or She Will Not Give Confidential Information to the Adviser
The Massachusetts Secretary of State's Securities Division (the "Division") has proposed a new regulation that would expand the list of specifically enumerated "dishonest or unethical conduct or practices" under the Massachusetts securities laws to include the hiring of an industry expert or consultant by an investment adviser unless the expert provides the adviser with a certificate setting forth, among other things, a representation that the expert will not provide any confidential information to the adviser. “Confidential information” is defined as “any non-public information, which one is bound by a confidentiality agreement or fiduciary (or similar) duty not to disclose.”
Expert networks are essentially matchmakers, connecting investment advisers and hedge fund managers with company executives and employees who offer insights about their businesses. Under existing securities laws, there is nothing per se illegal about using expert networks to gain information about companies in which an expert network client is considering investing. Illegal insider trading occurs, however, if the information obtained or provided is material, non-public information and someone trades securities while in knowing possession of the “inside” information.
The Division’s proposed regulation is an effort to combat insider trading problems involving expert networks, most famously highlighted in the Galleon Group hedge fund case in New York, in which federal prosecutors have obtained high profile convictions this year. In the case brought against Galleon’s head, Raj Rajaratnam, a jury convicted him of 14 counts of securities fraud. The jury concluded that Mr. Rajaratnam had received non-public information from experts about companies such as Google and Akamai through expert networks and had traded based on that information reaping millions of dollars for his fund and for himself. Assuming the conviction stands, Mr. Rajaratnam is expected to receive a substantial prison term.
In the past 18 months, forty-nine hedge fund managers and others have been charged criminally in a broad crackdown by prosecutors on insider trading; of these, forty-six have been convicted or pleaded guilty. Nor are such government actions limited to federal prosecutions. In Massachusetts, the Division has brought an administrative proceeding relating to expert networks and consultants. See In the Matter of Risk Reward Capital et al., Docket No. E-2010-57. In that case, the Division alleges that Risk Reward, a registered investment advisor that runs a hedge fund focusing on biotechnology stocks, had hired an expert network firm called Guidepoint Global LLC to provide Risk Reward with access to industry insiders who had material non-public information about the results of clinical tests on certain experimental drugs. The Complaint asserts various violations of the Massachusetts Securities Act, M.G.L. c. 110A and its associated regulations, 950 CMR 10.00 et seq. At its core, however, the Division’s Complaint alleges a relatively straightforward insider trading case. Specifically, the Division alleges that Risk Reward hired Guidepoint Global to obtain access to doctors and scientists who had direct knowledge of how various drugs were performing in clinical trials, all prior to public disclosure of the results of the trials. The Division is seeking disgorgement of profits, revocation of Risk Reward’s and its principal’s investment advisor registrations and other sanctions. The matter is pending.
Regardless of the outcome in the Risk Reward case, it is clear that existing federal and state laws prohibiting insider trading provide prosecutors and regulators with the tools they need to bring successful insider trading cases. Already in the past year and half there have been almost 50 convictions. Furthermore, the issue is not the existence of expert networks, the issue is, as ever, whether corporate insiders, middlemen, and/or people on the outside with access to insiders have an unfair trading advantage because they have access to material information that the rest of the public does not. Trading on such information, even merely providing such information, is already illegal under federal and state securities laws. The use of expert networks as a conduit of such information is simply a new fact and new context, which apparently poses no obstacle to prosecutors or regulators.
Adding the hiring of a consultant through an expert network without requiring a certificate to the list of presumptively illegal activities under the Massachusetts Securities Act does nothing to advance the Division’s regulatory goals. Investment advisors have been on notice for many years that the use of material non-public information is potentially illegal and can cause advisors who step over the line to lose their ability to work in the industry or worse. Who could forget the “go-go 1980s” or the “dot-com” bubble of the late 1990’s? Requiring advisers to obtain a certificate putting them on notice of a duty they already have (to not trade on or forward insider information) only adds additional compliance costs. And, as with many regulations, the burden of compliance will likely fall harder on smaller investment advisers who do not have large compliance departments to assist them with myriad regulatory requirements.
In short, the proposed regulation is a case of over-regulating an already heavily regulated industry. Perhaps as the flow of news of convictions in the Galleon and other cases continues, the Division will consider whether the proposed regulation really adds value or practical weight to the Division’s already expansive regulatory powers.
By William A. Haddad
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Posted on July 19, 2011 Email This Link
Liberty Mutual Sues Goldman Sachs in Massachusetts Federal Court Alleging Securities Fraud
On July 6, 2011, Liberty Mutual and four of its subsidiaries brought suit in Massachusetts federal court against Goldman Sachs alleging that Goldman failed to disclose material information in an offering circular for certain preferred stock issued by Freddie Mac, the federally-chartered corporation that buys existing mortgage loans and repackages them into residential mortgage-backed securities (RBMS) for resale on the secondary mortgage market. See Liberty Mutual Insur. Co. v. Goldman Sachs & Co., 11-cv-11194 (D. Mass) (Complaint). Specifically, Plaintiffs allege that they bought $37.5 million worth of Freddie Mac preferred stock in reliance on the offering circular, which failed to mention that Freddie Mac was severely undercapitalized. The Plaintiffs further allege that Goldman made such misrepresentations while it was contemporaneously making large bets against the health of the mortgage-backed securities market in general. The Plaintiffs are seeking their invested capital back, plus treble damages and attorneys' fees under Massachusetts' unfair business practices statute -- M.G.L. Chapter 93A. A Goldman spokesperson has stated that the allegations are "without merit" and that Goldman will vigorously defend against the lawsuit.
Although the specific misrepresentation alleged in the Complaint is the failure to disclose Freddie Mac's undercapitalization, a large part of the Complaint is devoted to allegations that Goldman was acting contrary to its customers' interests by taking large short positions against the mortgage-backed securities market and not telling customers about such positions. In doing so, the Complaint echoes, to a certain extent, the allegations in the matter of SEC v. Goldman Sachs & Co. and Fabrice Tourre, 10-cv-3229 (S.D.N.Y. 2010). In that case, the SEC alleged that Goldman sold billions in collateralized debt obligations (CDOs) in 2007 while failing to disclose that the firm that Goldman had hired to select the securities underlying the CDOs, Paulson & Co., had itself taken the opposite position to that provided to investors through the CDOs. In July 2010, Goldman agreed to settle the Tourre matter without admitting or denying liability under the securities laws. SEC Litig. Rel. No. 21592 (Apr. 6. 2010). While neither admitting nor denying the basic allegations in the SEC Complaint, Goldman did admit that it had made a "mistake" by not disclosing the role of Paulson in the CDO marketing materials. Goldman agreed to pay $550 million in civil penalties and disgorgement.
The similarities, if any, between the Tourre/SEC matter and the Liberty Mutual matter may be of little legal import. Liberty Mutual, after all, unlike the SEC, must prove reliance and damages causation. That said, the thematic similarities between the cases, if supported, could have a practical effect as the Liberty Mutual case unfolds.
By William A. Haddad
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