Kathrein on Investor Fraud

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.

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 blog, here, the paper was motivated by the lack of evidence on the effectiveness of institutional investors exercising their 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. 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. 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, from both an immediate disciplining of management as well as a long-term corporate governance perspective.

The authors hypothesized that generally an institutional investor will be a "free-rider" and take the benefits of class actions led by other individual plaintiffs, unless the potential benefits to them outweighed 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.Thus 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 forthese determinants to find our whether, even then, their 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 institutions, get involved!

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

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, Schapiro recognizes the importance of mutual funds:

"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 recently thrown out the private rights of action under the Investment Company  Act, which regulates the fund industry. Because of the structure of the funds, purported independent trustees ( who often sit on the boards of 10, 20 and even 40 funds offered by the same investment adviser), and trust agreements, even state law claims are impossible to bring. That leaves the paltry resources of the SEC to enforce those laws for an industry with more than $9 trillion in assets.

Mutual Funds are sold primairly over the phone or with glossy web pages and/or brochures containing smiley faces, impressive graphics and a sales pitch. To the extent that disclosures can be found, they  are impossible to read, dispursed in a staggering array of documents with indecipherable names, never actually delivered until after the purchase, and even then rarely. The funds' advisers 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, not the interests of the investor.

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

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

Famous Madoff Qoutes: "I Suppose You Could Program a Computer To Violate A Regulation, But We Haven't Gotten There Yet"

 

Famous Madoff Quotes: "I Suppose You Could Program a Computer To Violate A Regulation, But We Haven't Gotten There Yet", 60 million people retire next ten years? "Good Luck " and "I'm very close to the Regulators...my niece married one."

And More

 

As we proceed to work our way through the Madoff litigation, we tend to focus on those cases where we believe we can best find a source of recovery for our clients. To date that has been principally the Tremont Rye Funds which were controlled by Oppenheimer and Massachusetts Mutual, audited by two of  the Big Four accounting firms, KPMG and Ernst & Young, and supposedly had a custodial bank, Bank of New York Mellon. We have focused also on the feeder funds to the Tremont Rye Funds, such as Spectrum, Future Select, Austin and Meridian. Others crop up every day. Nevertheless, these stories, at this point, are rather dry and our minds still drift over to how  Madoff pulled this off. A video of Bernie Madoff discussing his business has surfaced on the internet, and helps lead us there.

 

When I watched this video of Bernie Madoff ( and his computer 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. The link to the video, audio and transcripts can be found here. Instead we hear a very rational human being, thoughtfully discussing fraud, human behavior and profits. Download Madoff TranscriptBut we also see tremendous irony in Bernie's statements. I highly recommend anyone impacted by this scandal to watch, especially around the the 43 minute mark. An index to Bernie's more ironic statements are as follows:

 

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 surveilled. It doesn’t mean there are not abuses, for sure, but by and large 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's 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 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.

 

And 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 were probably about 60 million people who are going to retire in the next ten years?"

 

Madoff:  "Good luck."

What is the take from this...its hard to tell. Here we have a man who created the NASDAQ, and took the human element out of the trading, and yet 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 was 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 worst punishment for Bernie Madoff will be silence.

 

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% 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. The SEC's complaint used to obtain the 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 3 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 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 ten private class action settlements. Interestingly, the lowest of the  top ten settlements in private shareholder class actions covers 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 over $6 billion for investors, not including institutional investors who opt-outed 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 over $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 6 - year period totals 197 settlements. The Private Shareholder Class Action report, by way of contrast reveals that over 200 class actions are filed per year with a 60% settlement rate---or over 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 fo funds and misrepresentations to clients, and insider selling, and recoveries against individuals. NERA's report has statistics covering each of these area 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?

Meaningful Disclosure.

Is Cadence's Restatement Likely the Result of Fraud? Posted by Reed Kathrein 11/04/08 1:38 AM 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:

PERIOD ENDING			28-Jun-08	29-Mar-08	29-Dec-07	29-Sep-07
Total Revene			329,478	287,189	457,943	400,924
Cost of Revenue			59,670	51,734	56,150	52,404
Gross Profit			269,808	235,455	401,793	348,520
	Operating Expenses
	Research Development		120,087	125,356	297,611	125,391
	Selling General and Admin		124,870	130,742	(13,942)	137,910
	Non Recurring		(355)	600	(102)	(4,388)
	Others		5,820	5,760	5,760	4,739
	Total Operating Expenses		250,422	262,458	289,327	263,652
Operating Income or Loss			19,386	(27,003)	112,466	84,868

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. See our post on Meaningfuldisclosure.com.

It's Now Time to Resurrect Our Investor Protection Laws

The National Association of Securities and Consumer Law Attorneys has long fought for the protection of investor rights. But back in 1994, Christopher Cox, our current SEC chairman....the chairman under whose watch this current financial fraud crisis occurred, helped lead the charge to make it nearly impossible to bring a suit against big corporatations who were committing securities fraud. That law was innocently called the Private Securities Litigation Reform Act, or PSLRA.

Again,  in 1998, Mr. Cox was part to the Congress who struck down state laws protecting investors with the passage of the the Securities Litigation Uniform Standards Act, or SLUSA.

One needs ask whether the current crisis is based on lax standards permitting fraud, misrepresentations and omissions to go unanswered as a result of these laws. Like the bust of the dot.com bubble a few years earlier (and the failures of Enron, Worldcom and Tyco ) which Wikepedia ( http://en.wikipedia.org/wiki/Dot-com_bubble  ) defines as having been caused by a "canonical "dot-com" company's business model [which] relied on harnessing network effects by operating at a sustained net loss to build market share (or mind share)," the investment banks, General Electrics, etc. all relied on a similarly "comical" business model of lending (at unrealistic rates, or with cheap introductory rates) at a net loss to build assets whidh they could then sell or pawn off on cash rich investors. As with the dot.com's the "motto "get big fast" reflected this strategy." And also like the dot.coms, where "companies relied on venture capital and especially initial public offerings of stock to pay their expenses," and the "novelty of these stocks, combined with the difficulty of valuing the companies, sent many stocks to dizzying heights and made the initial controllers of the company wildly rich on paper, ' in the investment banks and other asset lenders relied on the Schwabs and Ameritrades, to funnel investor's hard earned cash into novel derivatives (mortgage backed securities and asset-back securities) which were impossible to value, and whose credit risk was unsupported.

Everyone recognizes the need to regulate such out-of-control activity. A need to go back to the days of accountablity. But we cannot do this with big corporations being protected from decieving the public and immune from lawsuit. NASCAT has a recommendation. In a press release dated September 22, 2008, NASCAT states:

“During the past two years, even while Wall Street firms were handing out tens of billions of dollars in bonuses to executives, many of these same firms had misrepresented the value of mortgage backed securities (MBS) and collateralized debt obligations (CDOs) held on their own books and sold to other investors.  At the same time, the actual subprime mortgage loan originators misrepresented the strength and integrity of their lending policies and procedures.  On Friday, Federal Reserve Chairman Bernanke said our problem stems from what in fact were ‘lax underwriting practices’ that were not truthfully disclosed.  Had these corporations been honest about their practices and the true value of, and risks inherent, in these securities, the current crisis may never have developed as it did.

“These practices were not victimless excesses stemming from market exuberance. The calculated wrongdoing of many financial executives has now placed the hard won savings and retirements of the majority of Americans at risk.  At risk are the pensions covering many of NASCAT’s clients including public school teachers, firemen, policemen, union workers and the individual retirement accounts and plans of tens of millions of more Americans. 

“Recognizing this wrongdoing for what it was, state attorneys general, our frequent allies in the fight to uphold investor protection and recover fraud losses, had begun in 2003 to investigate the abusive and misleading practices of subprime mortgage lenders that they believed violated state laws.  Had the efforts of state attorneys general not been halted by the Bush Administration’s federal preemption of the authority of state consumer protection law and law enforcement officers, the subprime mortgage based crisis now upon us might well have been averted.  Certainly, there would be far fewer ‘bad’ sub-prime mortgages sold by loan originators to packagers and marketers of mortgage-backed securities that taxpayers are now being asked to buy.

“Given these facts, as Congress weighs the proposal to federalize vast parts of our financial system and give the executive branch unbridled authority over our markets, law makers should be mindful of the hard-taught lessons of post-Depression American history.  In addition to this bailout plan, the next Administration and Congress will be considering regulatory reforms to ensure such a crisis is not repeated.  As Congress moves forward on all fronts, NASCAT urges it and the next Administration to consider these lessons of experience:
 
-- The authority of federal and state regulators and state attorneys general should neither be diminished nor curbed by any new actions by the legislative or executive branches of our federal government in its effort to address this financial crisis in our capital markets.

-- As we face and work through a financial crisis of unknown magnitude, the SEC should halt its reckless push to shift America’s corporate accounting system from our proven U.S. rule-based Generally Accepted Accounting Standards and regulatory oversight to the more lax and less regulated International Accounting Reporting Standards.  This is no time to endanger investor protection by giving corporate and financial institutions  greater latitude in reporting their financial results. 

-- Investor civil actions remain, in the Securities and Exchange Commission’s traditional words, ‘a necessary supplement to the Commission's efforts.’ In addition to helping police securities markets, private law suits provide the primary method for defrauded investors to recover their losses. It would be a tragic error to further dilute the rights of private investors to take actions against those who perpetrate fraud and abuse.

-- The shields against corporate and financial institution accountability erected by the Supreme Court that protect from liability those who knowingly aid and abet securities fraud and otherwise knowingly engage in schemes to defraud and mislead investors should be removed by Congress.  There is little doubt that these shields against liability helped embolden corporate and financial players to engage in massive wrongdoing and take trillion dollar risks at the expense of investors, homeowners and, now, taxpayers.”

I would add to this list, to reform the PSLRA by dropping the pleading standard that requires evidence to be pled when it is secretly held by the corporation, bringing back aiding and abetting liability, creating private rights of action to sue mutual fund investment advisors under the provisions of the Investment Company Act of 1940, adding a private cause of action against conspirators, and eliminating SLUSA preemption of state law claims which touch upon fraud or misrepresentation....just as a start.

Cornerstone's 2007 Securities Settlement Analysis

Kevin LaCroix's The D & O Diary Blog reports that Cornerstone Research released its review and analysis of 2007 securities class action settlements:

Cornerstone’s press release emphasizes that the aggregate dollar value of all settlements was down 60% compared to 2006, but the full report emphasizes that, when the four largest settlements are removed from the analysis, the aggregate value of all settlements in 2007 exceeded all prior years except the unprecedented year of 2006.

Of interest here is the question of Professor Grundfest concerning the uptick of activity now underway as a result of the "subprime crisis" and whether that will mean more and larger settlements 3-5 years from now. I certainly agree that there is a crisis for investors, and agree that there will be a flury of settlements from these suits which began to be filed last summer. As I lectured at the PLI Institute in September, the demise of securities fraud class actions was nothing more than a temporary lull waiting for the next new financial bubble to crash. All you need to do is follow the money. In the 80's it went into the Savings and Loans, in the 90's into High Tech and in the first decade of the 2000s it flowed into mortgages.

I predict that when this mess is sorted out, we will see that the unsuspecting small investor has been left holding the bag by mutual fund managers chasing yields.

For more on Kevin's analysis of the Cornerstone report, go to his blog.  Links to the report are also there.

Supremes Toss Suit Against Bankers Tied to Enron Scheme to Defraud

Suit against bankers tied to Enron debacle is tossed by Supreme Court: WSJ Law Blog heralds the opinion in its typical anti-plaintiffs lawyer rehtoric

0n January 22, the Los Angeles Times reported that he Supreme Court dismissed the "huge lawsuit growing out of the Enron debacle that sought to hold Wall Street bankers liable for scheming with the executives of the defunct Houston energy trader."

Lawyers for investment funds and pension plans, including the University of California's pension plan, had sued Merrill Lynch and the other bankers, seeking to recover more than $30 billion that was lost when Enron folded in 2001. They argued that all the key players in the scheme that fooled stockholders should be forced to pay.

In dismissing the appeal of the Regents of the University of California vs. Merrill Lynch, the court appeared to doom the big lawsuits still pending against Enron's bankers.

Today's ruling is the most recent of a spate of decisions in which the courts have favored businesses. Last week, the Supreme Court rejected the notion of "scheme liability" in a closely watched stock fraud case involving a cable TV company and its vendors. In a 5-3 ruling, the court said suits for stock fraud are limited to the company that sells stock to the public, not bankers and other firms that had done deals with the company.

And last year, a U.S. appeals court panel in New Orleans also rejected the Enron-related lawsuit. It ruled that Merrill Lynch and the other investment bankers had not directly deceived those who bought Enron's stock.

Lawyers for the investors appealed to the Supreme Court and urged the justices to say that all those who profit from deception should pay. That appeal was formally rejected in a one-line order this morning.

In what has become its typical response (touting for so called "tort-reformers") to the knee-capping of investors' rights, the WSJ's Law Blog, by Peter Lattman, turned the knee-capping into a victory against "extortion":

Now let’s not shed too many tears for the Enron plaintiffs. They and their lawyers, led by Bill Lerach, collected $7.3 billion in settlements from Wall Street banks before the case was scuttled by the Fifth Circuit last year. Tort-reform advocate Ted Frank, in a NY Sun op-ed today, says this amounted to extortion. Yesterday’s ruling, he wrote, “closes an underreported chapter in American litigation history: how trial lawyers used the Enron scandal to successfully and legally extort billions of dollars from investment banks with a legally meritless lawsuit.”

Meritless!!! The Supreme Court never said meritless! They only said they believed Congress did not want investors to recover through the use of private lawsuits, and tried to justify what Congress never said through the use of mumbo jumbo economic theory involving unsupported fear of things like foreign investors fleeing our markets if fraudsters were held accountable.

It has always seemed strange to me that people seem more concerned about the money being made by those who protect their rights, than about the money being made by those who steal from them.

Fortunately, based on the comments to the WSJ Law Blog, most readers disagree with the journal and see the result as wrong. Their comments are worthy or republication and so, as of today, they are as follows:

Just when they thought they were safe---Tellabs: The Return of Judge Posner

What a difference 2 days make. In the wake of Stoneridge, we have proof that securities fraud class actions have not been thrown out of the ballpark, yet. Today, Judge Posner took on Congress and the Supreme Court and, following up on my baseball metaphor on Stoneridge, drew a wide strike zone for plaintiffs seeking to retire the "motion to dismiss" inning of the PSLRA.
In reaffirming the Seventh Circuit's reversal of a district court's dismissal of a securities fraud complaint against Tellabs, Judge Posner’s opinion allows plaintiffs allegations to slide right past the Supreme Courts court’s 8-1 ruling in Tellabs --- drawing wide boundaries for calling  "compelling" and "cogent" inferences. These are Judge Posner's calls against defendants arguments:

Strike One ---The gravity of the risk can create a "strong inference" of scienter:

[L]iability requires proof of the defendant's "scienter," which is to say proof that he either knew the statement was false or was reckless in disregarding a substantial risk that it was false. ... A popular definition of recklessness in this context is "an extreme departure from the standards of ordinary care ... to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." .... This looks like two criteria--knowledge of the risk and how big the risk is--but as a practical matter it is only one because knowledge is inferable from gravity ("the danger was either known to the defendant or so obvious that the defendant must have been aware of it"). When the facts known to a person place him on notice of a risk, he cannot ignore the facts and plead ignorance of the risk. ...

Strike Two---Plaintiffs do not need to plead facts of actual knowledge required by the "safe harbor" for those portions of forward looking statements relating to present facts:

The fact that all the statements challenged in this case that we found in our earlier opinion to be materially false are in the present tense is not decisive on the question whether the statements include predictions: "Our earnings are certain to double" is in the present tense, but is a prediction. But a mixed present/future statement is not entitled to the safe harbor with respect to the part of the statement that refers to the present. When Tellabs told the world that sales of its 5500 system were "still going strong," it was saying both that current sales were strong and that they would continue to be so, at least for a time, since the statement would be misleading if Tellabs knew that its sales were about to collapse. The element of prediction in saying that sales are "still going strong" does not entitle Tellabs to a safe harbor with regard to the statement's representation concerning current sales.

Strike Three---First Out! ---Posner then throws his wit as hard as he can at both Congress and the