silence is golden: stoneridgedecision deals · 2014-04-29 · latest decision, stoneridge...

Bernstein Litowitz Berger &Grossmann LLP

Fourth Quarter2007

Advocate

Supreme CourtRules inStoneridge

1Inside Look

2Record Bonuseson Wall Street

3SEC BarsShareholderAccess to Proxies

5

Eye On The Issues

6Fraud in SubprimeMortgages

8Quarterly Quote

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Contact Us

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F O R I N S T I T U T I O N A L I N V E S T O R S

A Securities Fraud and Corporate Governance Quarterly

Silence is Golden: Stoneridge Decision Dealsa Blow to Investors’ Scheme Liability Claims

Continued on next page.

By Jai K. Chandrasekhar

On January 15, 2008, the Supreme Courtissued a significant and, unfortunately, anti-investor decision in Stoneridge InvestmentPartners, LLC v. Scientific-Atlanta, Inc., No. 06-43,about the scope of “scheme liability” claimsagainst third parties for securities fraud underSection 10(b) of the Securities Exchange Act of1934 and Rule 10b-5. Regrettably, theSupreme Court affirmed — by five to three,with one Justice not participating — the dis-missal of investors’ claims against defendantswho engaged in sham transactions that hadthe purpose and effect of enabling a company

to issue false financial statements. The majorityopinion is, we believe, poorly reasoned, con-trary to law, and driven by the majority’sacceptance of misguided policy argumentsfrom corporate lobbyists who waged anaggressive political campaign to restrictinvestors’ rights. Despite this disappointing,anti-investor result, which is likely to preventvictims of fraud from recovering their losses inmany meritorious cases, we believe that theCourt’s opinion should not prevent investorsfrom vindicating their rights in cases that donot involve scheme liability claims against thirdparties. Stoneridge also might not prevent

investors from recovering their losses in somescheme liability cases with facts different fromthose of Stoneridge.

The Supreme Court majority in Stoneridgeengaged in illogical, circular reasoning.Investors’ right to sue under Rule 10b-5 is an“implied” cause of action, that is, the 1934 Actdoes not expressly provide for private suitsunder Section 10(b), but the courts — includingthe Supreme Court — have recognized fordecades that Congress intended to allowinvestors to bring private actions under thisstatute. The question in Stoneridge was whetherthat longstanding cause of action applies tothird parties who defraud investors. The majorityof the Court, however, simply assumed that thecause of action does not apply to those thirdparties, repeatedly suggesting the investor

The majority opinion is, webelieve, poorly reasoned, contrary to law, and driven bythe majority’s acceptance ofmisguided policy arguments fromcorporate lobbyists who wagedan aggressive political campaignto restrict investors’ rights.

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FOR INSTITUTIONAL INVESTORS

Advocate

plaintiffs were trying to “expand” thescope of the law. Thus, the majority’sreasoning began from a false premise.

The majority also rested its decision onthe theory that the investors, when theydecided to buy the issuer’s securities,did not “rely” on the third parties’ con-duct. This theory was not argued by thedefendants in the lower courts, was notthe basis of the lower courts’ rulings,and was not the focus of defendants’brief in the Supreme Court. Rather, thistheory was introduced only at the lastminute in a brief by the Solicitor Generalof the United States, who rejected theSecurities and Exchange Commission’s

request that the government file a pro-investor brief in Stoneridge, and insteadfiled an anti-investor brief. Thus, theinvestor plaintiffs were not given a fairopportunity to develop their argumentsagainst this theory. As Justice Stevens’forceful and well reasoned dissentpointed out, the fair and proper coursefor the Supreme Court would have beento remand the case for the lower courtsto reconsider under the majority’s newstandard. Instead, the majority affirmedthe final dismissal of the case withoutallowing the investors a fair chance toargue their position.

The Supreme Court majority also devotedconsiderable space in its opinion to par-roting arguments by corporate interestgroups, who argued that allowing

investors to sue fraudsters will some-how harm the American capital markets.But liability for parties that commit secu-rities fraud does not harm Americancompetitiveness; rather, investors’ faithin the integrity and safety of U.S. marketsis what makes those markets strong.

The impact of the Supreme Court’sStoneridge decision will only becomeknown as lower courts interpret andapply it in other cases. The ambiguities,faulty reasoning, and anti-investor rhetoricof the majority opinion may lead lowercourts to interpret Stoneridge as a broadrepudiation of investor rights. Judgeswho interpret Stoneridge broadly maydismiss meritorious cases.

www.blbglaw.com Bernstein Litowitz Berger & Grossmann LLP Fourth Quarter, 2007

STONERIDGE

Continued from page 1.

As we predicted at the start of last year, 2007 was a momen-tous year for investor protections. Battle lines were drawn, butunfortunately corporate interests prevailed in several importantskirmishes. The Supreme Court issued three significant deci-sions, Credit Suisse, Tellabs and Stoneridge, that curtail oppor-tunities for recovery in cases of complex securities fraud. Thelatest decision, Stoneridge Investment Partners, LLC v. Scientific-

Atlanta, Inc., is examined in our cover story “Silence is Golden:Stoneridge Decision Deals a Blow to Investors’ Scheme LiabilityClaims” by BLB&G associate Jai Chandrasekhar.

In 2007, we were reminded that Wall Street always takes careof its own. While shareholders in major Wall Street investmentbanks are suffering staggering losses due to the subprime mort-gage market collapse, top executives at those banks continue toreward themselves handsomely. Yet, little is being done to reinin corporate pay. See “Wall Street, Heel Thyself: Put a Leash on Runaway Exec Pay” on page 3 by BLB&G Counsel TonyGelderman and Bruce Leppla for a probing look at the dispro-portionate world of executive compensation, where pay andperformance are strangers. Also, in this issue, BLB&G associateJon Worm provides an analysis of the causes of the subprime crisisin “The Fingerprints of Fraud in the Mortgage Mess” on page 8.

While the subprime contagionwends its way through our econ-omy, heightening fears of reces-sion, the SEC, under the direc-tion of Chairman ChristopherCox, continues to underper-form in its mission to protectinvestors. BLB&G associateDeval Zaveri reviews the SEC’srecent amendment to SEC Rule 14a, preventing shareholderaccess to the nomination process of company directors in “TheSEC Pulls the Rug Out from Under Investors” on page 5.

I also direct your attention to the regular “Eye on the Issues”column. Firm associate Laura Gundersheim has again provided aperceptive compilation of the most significant recent developmentsin securities litigation and regulation and corporate governance.

We trust that you will find this issue of the Advocate both infor-mative and insightful. As always, we welcome your comments,questions and input and we wish you all a happy and healthy 2008.

Inside Look

Max Berger

Continued on page 11.

By Tony Gelderman and Bruce W. Leppla

As we look back at 2007, we see historicmeltdowns in the United States financialsector. The S&P Financial Index declinedover 20% for the year and many of thelargest investment banks lost nearly 50%of their market capitalization (see chartat right). The collapse of our financialsector has caused a major credit crisisand recessionary worries throughoutthe economy worldwide.

These declines in value, and the billionsof dollars of associated investor losses,are not linked to classic Adam Smithnotions of business cycle expansion andcontraction, but rather are the directconsequence of the current “subprimeloan” scandal — a completely “man-made” economic fiasco. This fiasco hasbeen driven by a chain of greed — startingwith the loan underwriters and theirsales force that pushed inappropriatehome loans on consumers, to the com-plicit appraisers who conjured up valuesto ensure that consumers could qualifyfor such loans, to the bankers who werewilling to ignore underwriting standardsto book such loans and earn commissions,ending with the investment bankerswho packaged and sold the doomedloans to investors without disclosing theassociated risks. In other words, the cur-rent wave of massive investor losses isnot the result of a failed business model,or a paradigm shift in technology, orsome other, natural economic force, butrather was caused by the market’s gradualrealization that Wall Street bankers havebeen knowingly and fraudulently sellinginto the market CDOs and similar securitiesbacked by worthless or near worthlesssubprime loan collateral.

In total, the major investment bankshave taken nearly $80 billion in subprime-related writedowns to date — withpotentially more to come.

However, it will be shareholders whobear the brunt of the losses — not the

in the table on page 4. Incredibly, execu-tives from at least 4 of these 10 firmsdeparted because of mismanagement(Home Depot and Merrill), outright scandal(UnitedHealth), or bringing a companyto the brink of bankruptcy (Conseco).

■ More shocking — the top executivesat 16 firms with potential subprime losseshave contracts that entitle them to sev-erance packages totaling $1 billion, ormore than $60 million each, on average.This figure takes into account the declinein stock value seen so far and its impacton executive stock-based compensation.

■ A Forbes article published in May2007 concluded that the chief executivesof America’s 500 largest companiesreceived a collective pay raise of 38% in2006 alone even though the total returnon the S&P 500 was only 15.8% in thatsame year. In dollar terms, the averageCEO received a $15.2 million raise.

Unquestionably, companies have becomeincreasingly more generous to executives,with outsized salary, options and sever-ance packages. But, how did executivecompensation become so untethered to

Fourth Quarter, 2007 Bernstein Litowitz Berger & Grossmann LLP www.blbglaw.com 3Continued on page 4.

Wall Street executives who facilitatedthe fiasco. Investment firms and publiccompanies will continue to pay their top executives oversized bonuses. Forexample, a Bloomberg article recentlyestimated that the bonus pool at the fivelargest investment banks would total arecord $39 billion for 2007 — a year inwhich the shareholders in the securitiesindustry lost over $200 billion in equity.These firms include Merrill Lynch andBear Stearns, both of which experiencedhuge losses in subprime related securi-ties. To be sure, at least three high-pro-file firms have dismissed their chiefexecutives but, with Charles Prince andStanley O’Neal receiving some $40 mil-lion and $162 million in stock awardsand pension benefits, respectively, ontheir departures, it can hardly be saidthat heads have rolled.

These breathtaking payouts underscorethe need for reform in executive compen-sation in order to return accountabilityto corporate America. For example:

■ O’Neal’s payout at Merrill Lynch isonly in the middle of the top 10 “goldengoodbyes” for corporate CEOs, shown


Advocate

Wall Street, Heel Thyself: Put a Leash on Runaway Exec Pay!

The 2007 bonus pool for the five largest investmentbanks totals $39 billion. Shareholders of securitiesfirms lost over $200 billion in equity in 2007.

Wall Street’s Self-Inflicted Subprime Woes*Subprime Writedowns 2007 Change Lost Market Capital

(in billions) in Share Price (2007 – in billions)

Citigroup $22.1 -47% $118.9

Merrill Lynch 24.5 -42% 32.3

UBS 18.4 -24% 27.2

Morgan Stanley 9.4 -35% 14.2

JPMorgan Chase 1.3 -10% 10.8

Bear Stearns 2.6 -46% 9.9

Lehman Brothers 1.5 -16% 6.3*As of January, 2008

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performance? Bottom line — boards areto blame. Directors, who are supposedto be the stewards of shareholder inter-ests, approve executive compensationpackages. Shareholders, in contrast, havelittle or no opportunity to hold theirboards responsible for executive com-pensation decisions.

Moreover, compensation experts sug-gest that the huge pay packages havedone little to improve performance. Theproliferation of stock-based compensa-tion motivates executives to take enor-mous risks — or even to commit fraud— in the hope of enormous payoffs,knowing that if unsuccessful, the execu-tive suffers no actual out-of-pocket harmwhen options simply expire. While thisrisk-taking behavior might be accept-able where positive outcomes cancelnegative outcomes, a recent study of950 companies in which 50% or more ofCEO pay came from stock option grantsconcludes the contrary. During the eight-year period studied, only 6.8% of the com-panies produced appreciable gains forstockholders while 10.1% of the companieslost value because option-loaded CEOsare riveted on upside possibilities, withlittle concern for downside.

Even recently adopted SEC rules requiringadditional disclosure of executive com-pensation at public companies have notrestrained excessive compensation. Whiledisclosure has improved under the newrules, the line items are carefully buriedin proxy material and, as a practicalmatter, shareholders have no effectiveway of limiting compensation throughthe proxy process.

Perhaps nowhere is pay so disconnectedfrom performance as on Wall Street, whereexecutive compensation is especiallyastonishing in the face of enormousinvestor losses. For example:

■ Bonus payouts to investment bankersin 2007 will average approximately$217,000 per person.


■ The firms paying these bonuses and theindividuals receiving the largest figuresare those at the highest levels — thevery people who failed to exercise duediligence in vetting the credit and under-writing standards and practices of sub-prime lenders in recent years.

■ These same firms and individualsaggressively and knowingly sold high-risk investments to pension funds with-out fully disclosing the investments’inherent risks.

Against this backdrop, the effort toundermine shareholder rights and loosencorporate accountability measures hasgained traction. In the past year, at leastfour high-profile quasi-public interestgroups, funded by Wall Street invest-ment banks or their lobbyists, published“studies” concluding that the U.S. financialmarkets are becoming less competitivethan foreign markets because of overlyrestrictive regulation or excessive litiga-tion. All four recommend similar “solu-tions” to this crisis, including liability capsfor auditors, more lenient standards foroutside directors, “clarification” of severalelements of securities fraud to favor corporate defendants, and the possibilityof requiring arbitration in securities

WALL STREET, HEEL THYSELF


litigations. One group even advocatesjettisoning rules-based accounting infavor of “principles-based” accounting,where auditors would apply a sort of“sniff test” to a company’s presentationof its financial results. Taken together,the recommendations — if adopted —could substantially weaken options forlegal action when fraud occurs. At bot-tom, the recommendations only serveto further insulate corporate executivesand directors from accountability.

While the subprime scandal continuesto wipe out billions of dollars of share-holder value creating the most illiquid,distressed markets in years, the invest-ment banking industry shamelessly takescare of itself. Now, as before, betteroversight, governance and regulationremain the most important safeguardsto keep our markets open, fair, and hon-est against those who would profitthrough exploitation.

Tony Gelderman and Bruce W. Leppla areCounsel to BLB&G. Mr. Gelderman practicesout of the firm’s Louisiana office and can bereached at [email protected]. Mr. Lepplapractices out of both the firm’s Californiaand New York offices and can be reached [email protected].

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Est. PayoutCompany CEO Year in $ millions

Exxon Mobil Corp. Lee Raymond 2006 $ 351

Pfizer Inc. Hank McKinnell 2006 213

Home Depot, Inc. Robert Nardelli 2007 210

Gillette Co. James Kilts 2005 165

Merrill Lynch & Co., Inc. Stanley O Neal 2007 162

UnitedHealth Group Inc. William McGuire 2006 153

WellPoint Health Networks Leonard Schaeffer 2005 137

SouthTrust Bank Wallace Malone 2006 135

Morgan Stanley Philip Purcell 2005 94

Conseco Inc. Stephen Hilbert 2000 73

Top Ten Golden GoodbyesLargest CEO Exit Packages

4 of 10 departed for mismanagement, scandal or bringing company to brink of bankruptcy

By Deval R. Karina Zaveri

Although investors of financial stockshave endured one of the toughest yearson record, hope of being able to replacedirectors at poorly performing compa-nies was shattered on November 28,2007, when the Securities and ExchangeCommission (the “SEC”) adopted anamendment to SEC Rule 14a. The newamendment limits shareholder access tocompany proxies by allowing companiesto prevent shareholders from nominatingtheir own director candidates.

Shareholder access to director ballots,or “proxies” — a protection long soughtafter by shareholder advocacy groups —is especially important because it is themost efficient and cost-effective way forshareholders to hold directors account-able for their performance. Withoutsuch access, shareholders must proposetheir own separate slate of directors intheir own proxy, a prohibitively expen-sive endeavor. This amendment is a particularly devastating blow because,as set forth below, it occurred right aftershareholders had made significantprogress in winning proxy access rightsafter a lengthy legal battle.

In December 2004, the AmericanFederation of State, County & MunicipalEmployees Pension Plan (“AFSCME”)submitted a proposal to AIG for inclu-sion in the company’s 2005 proxy state-ment. The proposal, had it been adoptedby a majority of AIG shareholders,would have amended AIG’s bylaws torequire AIG to publish the names ofshareholder-nominated candidates fordirector positions. AIG sought inputfrom the SEC’s Division of CorporateFinance, the group within the SEC thathandles investor disclosure matters,regarding whether it could excludeAFSCME’s proposal from its proxy state-ment. The Division issued a “no-action”letter indicating that under Rule 14a-8(i)(8), AIG was free to exclude the

investor proposal. AIG did just that.AFSCME then filed a lawsuit in the U.S.District Court for the Southern District ofNew York seeking to compel AIG toinclude the proposal in its proxy state-ment. The District Court ruled againstAFSCME and AFSCME appealed to theSecond Circuit.

The Second Circuit reversed the DistrictCourt and pointed out that from 1976,when the SEC last amended Rule 14a-8(i)(8), through the early 1990s, the SECinterpreted the Rule as AFSCME did, toonly limit shareholder proposals “dealingwith an identified board seat in anupcoming election.” According to theCourt, the SEC changed course withoutexplanation in the late 1990s, and in itsamicus brief advanced the position thatthe Rule applied to proxy access pro-posals. Because the SEC offered noexplanation for the change of course,the Court concluded it was most prudentto defer to the SEC’s original interpreta-tion of the Rule and permit shareholderaccess to proxy statements.

Shortly after the AIG decision, businesslobbying groups began a campaign to getthe SEC to amend Rule 14a. In response,the SEC publicly announced that the ruling was causing “uncertainty” and,on that basis, hosted three public round-table discussions. Notably, only threecompanies had filed no-action requestswith the Division regarding shareholderproxy proposals after the AIG decision.Two of the three companies withdrewtheir requests, and the Division took a

“no view” position on the third request.The company that submitted the thirdrequest ultimately included the proxyaccess proposal on its ballot, and it didnot receive a majority of shareholdervotes. Despite this record, the SEC neverexplained the basis for the “uncertainty”it attributed to the AIG decision.

Based on the public roundtable discus-sions, two diametrically opposed pro-posals were submitted to the SEC. Oneproposal advocated limiting proxy accessto shareholders with a 5% stake in thecompany. The Council of InstitutionalInvestors argued that “a measured rightof [proxy] access would invigorateboard elections and would make boardsmore responsive to shareowners, morethoughtful about whom they nominateto serve as directors, and more vigilantin their oversight of companies.” Theother proposal, supported by theBusiness Roundtable and U.S. Chamberof Commerce, sought to abolish share-holder proxy access altogether. The cor-porate lobbying groups disingenuouslyclaimed that increased proxy accesswould favor unidentified “special interestgroups” and would hurt individualinvestors.

Having heard testimony from bothsides, the Commissioners voted 3-1 infavor of the amendment to limit share-holder access. The new Rule 14a-8(i)(8),which became effective January 10,2008, allows corporations to exclude a

Fourth Quarter, 2007 Bernstein Litowitz Berger & Grossmann LLP www.blbglaw.com 5


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The SEC Pulls the Rug out From Under Investors

Shareholder access to director ballots, or “proxies”— a protection long sought after by shareholderadvocacy groups — is especially important becauseit is the most efficient and cost-effective way forshareholders to hold directors accountable for theirperformance.

SEC Sanctions Fall to the Lowest Levels Since 2002

In 2007, the SEC, led by Chairman Christopher Cox extracted$1.6 billion in fines and illicit profits compared with more than$3 billion in each of the previous three years, according to areport issued by Cox. The steep decline is likely attributable tothe impact of the Paulson Committee, Cox, and RepublicanCommissioner Paul Atkins’s strong belief that the costs of finesare borne by shareholders. The Commission now weighs “thepresence or absence of a direct benefit to the corporation andthe degree to which the penalty will recompense or furtherharm injured shareholders.” The decline may also be partiallyattributable to a procedure set up this year which requires thatthe agency’s enforcement staff seek approval from commis-sioners before negotiating corporate fines. Previously, SECattorneys could enter into settlement talks without obtainingpermission in advance. Significantly, former CommissionerCampos, who stepped down in September, does not believethat the lower penalties imposed by the SEC indicate that thereis less fraud. Indeed, the SEC brought 656 cases in 2007, a 14percent increase from the year before. Bloomberg News,November 19, 2007

New York Raising More Money than London Through IPO’s

Despite falling slightly behind London in raising moneythrough IPO’s in the past three years and great turmoil in thecapital markets, New York is set to surpass London in the IPOrace for 2007. New York has raised more than $52 billion on theNYSE and Nasdaq through stock market debuts — a level notseen since the dotcom boom, while London has raised morethan $4 billion through debuts on the London Stock Exchangeand AIM. However, London did surpass New York in terms ofthe number of companies that have come to market this year,with 208 deals compared with 202 in New York. The FinancialTimes Limited, November 25, 2007

GAO Recommends No Limits to Auditor Liability

A recently published report by the Government AccountabilityOffice (“GAO”) has concluded that the concentration of theaccounting industry into just four major firms does not pose a“significant adverse effect” on the capital markets. After surveying 600 companies and interviewing employees atDeloitte, PricewaterhouseCoopers, KPMG, Ernst & Young andother accounting firms, the GAO concluded that legal liability

protections and other industry reforms designed to insulatethe accounting industry were unnecessary. Rather, the GAOstudy found that protection from lawsuits may eliminate“incentives for auditors to conduct quality work.” There wereeight large accounting firms in 1986, before mergers led to con-solidation. Arthur Andersen LLP, once the fifth largest amongthe group, collapsed in 2002 after being indicted for its role inthe Enron Scandal. Bloomberg News, January 10, 2008

Poison Pill Disappearing

The poison pill, a device designed to allow corporations tofend off unwanted acquirers by flooding the market withshares to dilute their stakes, but also used by corporations toprevent shareholders from removing directors, is disappearingfrom many Fortune 500 companies. Only 20% of Fortune 500companies still have a poison pill, and one-third of those areup for renewal in the coming year. The disappearance of poi-son pills can be attributed, at least partially, to institutionalinvestors and activist shareholders, who, because they regardpoison pills as unfriendly and potentially harmful to share-holders, have voted to remove such poison pills fromCompany bylaws. The Wall Street Journal, November 7, 2007

PCAOB Orders $1 Million Fine Against Deloitte & Touche LLP

in First-Ever Enforcement Case Against a Big Four Accounting

Firm

In its first-ever enforcement action against a Big Four accountingfirm, the Public Company Accounting Oversight Board(“PCAOB”) fined Deloitte & Touche LLP (“Deloitte”) $1 millionand censured the firm in connection with its audit work ofLigand Pharmaceuticals Inc. (“Ligand”). Deloitte had signedoff on Ligand’s financial statements for fiscal year 2003, butLigand later restated its financial results for 2003 and otherperiods because its recognition of revenue on product ship-ments did not comply with GAAP. Ligand’s restatementslashed its reported revenue by about $59 million and boostedits net loss in 2003 by more than 2 1/2 times. The PCAOB foundthat Deloitte had failed to exercise due professional care in theperformance of the audit and failed to obtain sufficient com-petent evidential matter to support the opinion expressed inthe audit report. Specifically, the PCAOB found that Deloittedid not conduct the required audit procedures to analyzeLigand’s ability to make reasonable estimates of future prod-uct returns. Since its formation in 2003, the PCAOB hasbrought 14 enforcement actions against individuals and 10against firms, all of which involved smaller accounting firms.The Wall Street Journal, December 11, 2007

Corporate Whistleblowers Get Raw Deal

Since the passage of the Sarbanes-Oxley Act in 2002 — whichoffers corporate whistleblowers protection from retaliation —approximately 1,000 claims have been filed by employeesalleging that they suffered retaliation after reporting misconduct,

LEGISLATIVE/REGULATORY UPDATES AND RECENT DECISIONS OF INTEREST

By Laura Gundersheim


IssuesEyeon the


Advocate

but only 17 have been found to have merit, according to U.S.Department of Labor. Of those 17 cases, only six have beenupheld after full hearings before administrative law judges. Toobtain relief under Sarbanes-Oxley, an employee claimingretaliation for reporting corporate fraud must first file a claim with the Occupational Safety and HealthAdministration (“OSHA”), the agency charged with investigat-ing initial complaints. Employees can proceed to federal courtif OSHA has not issued a final decision after 180 days, or theycan appeal to an administrative law judge if they disagree withOSHA’s finding. In order to be protected, information from corporate whistleblowers must relate to one of three things:(1) a violation of securities fraud; (2) a fraud on shareholders;or (3) a violation of rules and regulations set by the SEC. Thelaw specifies, however, that an actual violation does not needto be reported, only than an employee must “reasonablybelieve” that a violation occurred. The National Law Journal,October 29, 2007

U.S. Stock Exchanges Losing Immunity

Traditionally, U.S. stock exchanges have been shielded fromliability purportedly because they were serving a quasi-gov-ernmental function. Recently, however, U.S. stock exchangeshave become publicly traded companies with market capital-izations in the billions of dollars. As a result, courts such as theU.S. Court of Appeals for the 11th Circuit and the U.S DistrictCourt for the Northern District of California have held that U.S.stock exchanges no longer have immunity from investorclaims of losses. In the 11th Circuit case, a shareholderclaimed that it would not have invested in WorldCom ifNasdaq had not touted WorldCom as a good investment innewspaper and television ads, despite knowing thatWorldCom failed to meet Nasdaq’s listing standards, and thatNasdaq failed to disclose its potential financial interest in tout-ing WorldCom stock. The shareholder claimed that by toutingWorldCom as an investment, it was no longer acting as a reg-ulatory organization and instead was acting as an organizationthat markets stock in order to encourage and maintain listings.The 11th Circuit agreed, and held that Nasdaq was not pro-tected by absolute immunity. Similarly, in the California case,a private investment partnership sued Nasdaq, claiming that itlost millions when Nasdaq inaccurately calculated its Nasdaq-100 Index. The California court held that, because Nasdaq’sactivity with regard to the Nasdaq-100 Index was neither regu-latory nor adjudicatory, but for the purpose of generating trad-ing volume and profit, it was not entitled to immunity. DowJones, October 31, 2007

Turnover Rate for CEOs and CFOs Tied to Restatements

According to a report entitled “Corporate GovernanceConsequences of Accounting Scandals: Evidence from TopManagement, CFO and Auditor Turnover” by two University ofAlabama professors, there is nearly a 10 percentage point gap

between the adjusted turnover rate for finance chiefs at com-panies reporting lower earnings in a restatement (50.4%),compared to CFOs at non-restating companies (46.17%) and a14% difference among CEOs (46.17% versus 31.73%). Themagnitudes of these effects were found to be even larger forrestatements that are more serious, have worse effects onstock prices, or result in negative restated earnings. However,according to the report, audit firms are no more likely to bereplaced by a company that restates. The report examined asample of 518 U.S. public companies that announced earn-ings-decreasing restatements during the 1997-2002 period andcompared it to a sampling of similarly situated (in terms ofboth industry and size) companies that had not issued restate-ments. CFO.com, November 19, 2007

U.S. Companies Allowed to Used GAAP instead of IFRS in

European Union

The Commissioner of the European Union InternationalMarket has announced that the EU will allow American com-panies based in Europe to continue to use GAAP instead ofswitching to internal accounting standards. Earlier this year,the SEC announced that it would accept International FinancialReporting Standards (“IFRS”) for foreign companies based inthe United States. AccountingWEB.com, November 29, 2007

Laura Gundersheim is an Associate in BLB&G’s New York office. Shecan be reached at [email protected].



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By Jon Worm

The subprime mortgage meltdown overthe past year has sent shockwavesthroughout financial markets world-wide, wiping out billions of dollars ininvestor equity, ruining personal creditand, all too often, putting people out oftheir homes. Did the U.S. housing marketexperience an “irrational exuberance”of its own or were more sinister forcesat work. As the morass deepens, it isbecoming clear that the problems canbe traced back to a decade ago when themortgage lending industry underwent aperiod of radical change and rapidgrowth, presenting irresistible opportu-nities for fraud.

Beginning in the early 1980s, regulationsand business practices in the mortgageindustry changed significantly. Lendersmade billions by selling ill-suited financialproducts to over-extended or unworthyborrowers while subverting — or ignoringaltogether — their own lending standards.Lenders and investment banks packagedthe doomed loans, securitized them, andsold the mortgage-backed securities(“MBSs”) off to unsuspecting investors.These investors have lost massive sumsof money as their investments werenowhere near as solid as the bond issuersoriginally represented.

The subprime crisis has led to a tighteningof credit in the capital markets in theU.S. and worldwide, and many expertspredict the subprime meltdown willleave the country in recession. Over thepast year, the Federal Reserve has strug-gled to stave off recession by loweringthe prime interest rate three times, andmost recently taking additional drasticmeasures. Unfortunately, the impact onglobal capital markets is likely to getworse before recovery can begin.Currently, more than 15 percent of sub-prime adjustable rate mortgages are morethan 90 days past due, and the numberof foreclosures has risen sharply over

the past several quarters. Subprimemortgages originated from late 2005 toearly 2007 are performing the worst.Projections indicate that over 1.5 millionadjustable rate subprime mortgagesare scheduled to reset to higherinterest rates over the next year.Various estimates suggest that upto two million homeowners are indanger of losing their homesthrough 2009.

While the fallout from the subprimemeltdown worsens, the true extentof the corporate malfeasance at itsroot is just beginning to berevealed.

The Securitization of SubprimeMortgages

Until recently, the mortgage marketconsisted almost exclusively of tradi-tional banks lending money to credit-worthy borrowers for 30-year terms andat fixed interest rates, under very con-servative loan-to-value ratios. In contrastto these “prime” mortgages, after changesto applicable laws and regulations in theearly 1980s, lenders began loaning toborrowers who had a higher credit risk.Beginning in the mid-1990s, the “sub-prime” mortgage industry exploded, withsubprime loans making up approxi-mately 20 percent of the $3 trillion mort-gage market as of 2006. The originationand servicing fees from these loans — andthe profits for banks and lenders — wereenormous.

Other factors contributed to the explo-sion in subprime lending. Technologicaladvances made assessing risk easierand reduced the cost of lending to higherrisk borrowers. More importantly, how-ever, the secondary market for sellingmortgages expanded significantly, intro-ducing complexity, shifting risk, andadding players to the process.

Previously,a savings and

loan or bank origi-nated a mortgage, held the loan for theentire term, and collected the interestand principal until repaid. Followingchanges in regulations, mortgage origi-nators predominantly sell their mort-gages to third parties, passing off risk ofdefault and obtaining new funds tofinance additional loans. The third partymay be a government sponsored entity,such as Fannie Mae, or a private finan-cial institution. Through securitization,mortgage loans are pooled and pack-aged as MBSs, which are often sold toinvestors.

Wall Street also began to set up morecomplicated derivative structures,known as collateralized debt obligations(“CDOs”). As a simple example, to forma CDO, a bank would pool large num-bers of MBSs, combine them with otherasset backed securities, and securitizethem again into bonds. The CDOs aresplit into tranches, each offering a bondwith a different level of risk and return.The riskiest tranches suffered the first

The Fingerprints of Fraud in the Mortgage Mess

losses when the underlying loansdefaulted, while bonds from the leastrisky tranches were rated as very safe,even though at base they were backedby subprime loans.

Mortgage lenders were able to sell huge numbers of loans by introducing adizzying array of financial products,each more exotic and risky than the last.Such products include:

■ Adjustable Rate and Interest OnlyLoans — Allow people to get into homesthey may not be able to afford by keeping their monthly payments low fora short period (5 years or less).

■ Low or No Documentation Loans —Also called “stated income” or “liarloans,” these products rely on incomeand asset information provided by theborrower without independent verifica-tion. About 45 percent of subprimeloans originated in 2006 were not fullydocumented.

■ Negative Amortization Mortgages —Also called “pay option” mortgages,these products permit borrowers tomake payments that do not pay theentire interest payment or any principal,as the unpaid interest is added to theprincipal.

Lenders also relaxed other importantlending criteria, such as increasing theloan-to-value ratio for loans, sometimesoriginating mortgages for more thanone hundred percent of the value of theproperty, and selling multiple products

— such as a primary note and a homeequity line of credit — to the same bor-rower secured by the same asset.

Fraud Begets Crisis

The expansion of the secondary marketfor mortgages allowed unregulatedlenders to enter the industry, as securiti-zation allowed lenders to finance them-selves by selling their loans to investors,expanding the market to non-depositoryinstitutions. Similarly, mortgage brokersplay a large role in subprime origina-tion, connecting borrowers with lenders,especially with regard to borderline borrowers. As of 2005, stand-alone mort-gage companies and mortgage brokers,unregulated by the federal government,originated over half of all subprime mort-gages. Lack of federal oversight likelycontributed to loosening of lendingstandards.



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Along with the lack of oversight, the newlending paradigm created strong finan-cial incentives for lenders to weaken orignore underwriting standards and orig-inate and sell more loans. The loanswere quickly sold off to third parties,shifting the risk of default to purchasersof the mortgages and, subsequently, toinvestors in MBSs. Similarly, becausemortgage brokers and lenders’ in-houseoriginators worked on commission,they were incentivized to originate asmany loans as possible, regardless ofquality. Appraisers colluded with loanoriginators by validating inflated homevalues, as originators pressured appraisersto appraise homes at exaggerated valuesthat would allow loans to close, therebyincreasing loan volume. All of theseplayers had the incentive to originate asmany loans as possible, and manyresorted to improper conduct. Put simply,

While the fallout from the subprime meltdown worsens,the true extent of the corporate malfeasance at itsroot is just beginning to be revealed. The pattern iseerily similar to past abuses, such as misuse ofreserves (Computer Associates), use of off-balancesheet entities to hide losses (Enron), improper capitalization practices to hide ordinary line costs(WorldCom), and more recently, backdating of stockoptions (UnitedHealth). Will the subprime era cometo be known as the next wave of corporate fraud?

The Advocate For Institutional Investorsis published quarterly by Bernstein Litowitz Berger & Grossmann LLP, 1285 Avenue of the Americas, New York, NY 10019,212-554-1400 or 800-380-8496. The materials in this newsletter have been prepared for information purposes only and arenot intended to be, and should not be taken as, legal advice. Bernstein Litowitz Berger & Grossmann LLP prosecutes classand private actions, nationwide, on behalf of institutions and individuals. Founded in 1983, the firm’s practice concentratesin the litigation of securities fraud; corporate governance; antitrust; employment discrimination; and consumer fraudactions.

© 2008. ALL RIGHTS RESERVED. Quotation with attribution permitted.




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a significant portion of borrowers enteredinto loans that they had no hope ofrepaying.

Investment banks and other financialinstitutions joined in the frenzy withtheir increasing need for mortgages tosecuritize and sell. Historically low inter-est rates forced investors to seek higherreturns from low risk investments, andtraditionally risk-averse investors beganto purchase large numbers of CDObonds, which were marketed as safe.Thus, thanks to increasingly complicat-ed securitization into MBS and CDOstructures, and thanks to aggressivemarketing of the bonds by Wall Street,subprime originators had a market foreven their riskiest mortgages. Along the

way, firms collected huge fees, leadingto higher stock prices and massive exec-utive compensation.

Additionally, investment banks investeddirectly in the subprime mortgage busi-ness. Some purchased companies thatoriginated and serviced mortgages, andsome formed complex off-balance sheetinvestment vehicles, which in turninvested in mortgages and securitiesbacked by mortgages.

The Collapse

The entire subprime machine churnedalong as rapidly appreciating homeprices and low interest rates masked theburgeoning problems — even if a bor-rower could not afford to make his orher payment, he or she could refinanceinto a new mortgage or sell. Themachinery screeched to a halt, however,

once home price appreciation slowedand interest rates rose. Mortgagedefaults shot up, and lenders and invest-ment banks revealed that they hadunderestimated the risks of default.

As a result, the market for CDO bondsdried up, and banks were stuck withsubprime mortgages and CDOs thatthey could not sell. Given the multiplelevels of repackaging, the CDOs andother complex investment vehicles wererelatively illiquid, and banks had resortedto mathematical models to price them.As it turns out, the banks had overvaluedthe mortgages and related securities.These overly positive valuations allowedfor inflated earnings, causing share pricesto increase and executives to collectmassive compensation packages thatwere largely tied to stock performance.Once mortgages started to fail atincreased rates, however, banks wereforced to disclose their exposure to thesubprime market and began to takelosses. Some revealed that they had created off-balance sheet entities toinvest in the subprime mortgage market.In many instances, banks were requiredto bring losses from these entities ontotheir balance sheets, compounding losses.

The market has reacted drastically tothese disclosures. For example, followingCitigroup’s writedown of billions of dollars tied to mortgage-backed invest-ments, its stock declined 30 percent,wiping out roughly $70 billion of marketcapitalization. Merrill Lynch’s stock pricealso sharply declined following similardisclosures and writedowns.

The Aftermath

While the extent of the meltdown is stillunsettled, the scramble to staunch thebleeding has begun. President Bush andTreasury Secretary Paulson recentlyannounced an agreement with the mort-gage industry to freeze interest rates forup to five years for some homeownerswho bought homes with subprime loansover the past couple of years. The plancontains many limitations, however,

FINGERPRINTS OF FRAUD



We believe, however, that Stoneridge, ifproperly interpreted by the lower courts,should allow investors to pursue securi-ties fraud claims against third partiesthat engage in deceptive conduct, aslong as information about the defen-dants’ deceptive conduct is publicly dis-closed and relied on by investors. TheSupreme Court held in Stoneridge that“the implied right of action in Section10(b) continues to cover secondaryactors who commit primary violations.”Thus, Stoneridge affirms that Section10(b) and Rule 10b-5 impose primary lia-bility on secondary actors who engagein deceptive conduct upon whichinvestors rely. Such claims may beviable against financial market partici-pants such as investment banks,accountants, and lawyers that join anissuer in engaging in deceptive conductabout which public disclosures aremade to investors.

The defendants in Stoneridge were out-side “suppliers” and “customers” of theissuer of the securities in question inthat case, and the outside parties “hadno role in preparing or disseminating[the issuer’s] financial statements.”Accordingly, the Court held that “[i]nthese circumstances the investors can-not be said to have relied upon any of[the vendors’ and customers’] deceptiveacts in the decision to purchase or sellsecurities.”

Thus, Stoneridge primarily addressesthe question whether scheme liability isa viable theory to hold a commercialcounterparty liable for knowinglyengaging in transactions that enable anissuer to misrepresent its financial state-ments. The Supreme Court’s decisionappears to place some weight on theStoneridge defendants’ status as suppli-ers and customers acting “in the mar-ketplace for goods and services, not inthe investment sphere.” Stoneridge alsostates that the defendants were“remote” from investors in the issuer

with which they did business: “[W]econclude [defendants’] deceptive acts,which were not disclosed to the invest-ing public, are too remote to satisfy therequirement of reliance. It was [theissuer], not [the issuer’s customers andvendors], that misled its auditor andfiled fraudulent financial statements;nothing [the customers and vendors]did made it necessary or inevitable for[the issuer] to record the transactions asit did.” Thus, Stoneridge might not pre-clude claims against financial marketprofessionals, as opposed to commer-cial customers and suppliers.

The Supreme Court also held inStoneridge that there need not be “aspecific oral or written statement beforethere could be liability under Section10(b) or Rule 10b-5.” Rather, the Courtheld that “[c]onduct itself can be decep-tive.” By acknowledging that non-verbalconduct can give rise to liability underSection 10(b), the Supreme Court reject-ed earlier rulings by the 8th Circuit and5th Circuit Courts of Appeals that liabili-ty requires either a false statement, oran omission by a defendant who has aduty to speak. This aspect of theSupreme Court’s decision might allowsecurities fraud claims against third par-ties such as accountants, lawyers, andinvestment bankers who actively struc-ture sham transactions for an issuerwithout themselves making false state-ments to the investing public.

It is also worth noting that Stoneridgedoes not limit in any way the 10b-5 lia-bility of a securities issuer itself, and itsofficers and directors, when the issuerand its officers and directors make falsestatements to the investing public. Nordoes Stoneridge in any way limitinvestors’ right to sue issuers, officersand directors, auditors, and underwrit-ers for materially misleading statementsin registration statements and prospec-tuses for public offerings of securitiesunder the Securities Act of 1933.Stoneridge only concerns the scope of10b-5 liability of parties other than theissuer for securities fraud affecting after-market trading.

In sum, we believe that Stoneridge waswrongly decided and represents anunfortunate diminution in investors’rights, which will deny investors anyrecovery in many cases of serious fraud.However, the decision in this caseshould not prevent investors from vindi-cating their rights in all cases.

Hopefully, members of Congress willsee the exposure innocent, defraudedinvestors will face in light of this deci-sion and will act quickly to restore theirremedies through legislation.

Jai Chandrasekhar is an Associate inBLB&G’s New York office. He can be reachedat [email protected].



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STONERIDGE


“[A]s Members of Congress made clear, privatelitigation under section 10(b) continues to playa vital role in protecting the integrity of oursecurities markets....I respectfully dissent fromthe Court’s continuing campaign to render theprivate cause of action under section 10(b)toothless.”Justice Stevens on January 15, 2008, in his dissenting opinion in Stoneridge

Quarterly Quote...

12


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shareholder proposal “[i]f the proposalrelates to a nomination or an election formembership on the company’s board ofdirectors or analogous governing bodyor a procedure for such nomination orelection.” The two Republican-appoint-ed Commissioners, Paul S. Atkins andKathleen L. Casey, voted for the amend-ment. The lone Democratic appointee,Annette L. Nazareth, opposed theamendment; the other DemocraticCommissioner seat is vacant. SECChairman Christopher Cox surprisedmany when he sided with fellowRepublicans and voted for the amend-ment, despite having previously statedthat “the federal proxy system shouldprotect and enforce that most importantlegal right [of shareholders to selectdirectors], not stand in its way.”

Chairman Cox promised that the SECwill revisit the issue next year when theCommission is back to full strength.When the Commission vote wasannounced, Robert Feckner, President ofthe Board of Directors of the CaliforniaPublic Employees’ Retirement System,stated that “[t]his [vote] is a serious


Contact UsWe welcome input from our readers.

If you have comments or suggestions,

please contact Editors Hannah Ross in our

New York office at

212-554-1400 / [email protected] or

Benjamin Galdston in our California

office at 888-924-1888 / [email protected].

If you would like more information about

our firm, please visit our website at

www.blbglaw.com

Editors: Hannah Ross

and Benjamin Galdston

Marketing Director: Alexander Coxe

“Eye” Editor: Laura Gundersheim

Contributors: Max Berger,

Jai Chandrasekhar, Tony Gelderman,

Bruce Leppla, Deval Karina Zaveri

and Jon Worm

800-380-8496

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THE SEC PULLS THE RUG OUT


FINGERPRINTS OF FRAUD


Commissioner AnnetteNazareth did not hide herdisgust with the vote ofChairman Cox and herother Republican SECcolleagues, stating: “I donot see a principled way tovote for the [amendment]and claim to be supportiveof shareholder rights inthe longer term.”wrong turn from the Commission’s dutyto adopt regulations that ‘do no harm’ toinvestors.” Commissioner Nazareth didnot hide her disgust, stating: “I do notsee a principled way to vote for the[amendment] and claim to be supportiveof shareholder rights in the longer term.”Unfortunately, Commissioner Nazarethhas announced plans to leave theCommission by year-end, leaving investorswithout their lone supportive voice.

Deval Karina Zaveri is an Associate inBLB&G’s California office. She can bereached at [email protected].

and preliminary estimates suggest thatit will only reach a small percentage ofrecent subprime borrowers. Further,critics note that freezing the rate willonly postpone the risk of default untilthe freeze is lifted.

Others look to punish the wrongdoers.Both California and Illinois are investi-gating the lending practices of mortgagebankers and brokers. Recent revelationsalso indicate that the bond issuers andservicers knew of the impending melt-down much earlier than they disclosed,while continuing to market their securi-ties as safe investments. New York’s

Attorney General, Andrew Cuomo, hassubpoenaed major Wall Street firms,looking for details regarding their poolingand selling of subprime mortgages. Heis reportedly looking into how closelythe banks and bond rating agenciesevaluated MBSs. Further, the SEC isinvestigating how companies valuedtheir own holdings of complex debtinstruments. Numerous civil suits havebeen filed against lenders and investmentbanks seeking individual and class-widerelief for investors. Meanwhile, countlesshomeowners are simply trying to holdonto their homes.

Jon Worm is an Associate in BLB&G’sCalifornia office. He can be reached [email protected].

silence is golden: stoneridgedecision deals · 2014-04-29 · latest decision, stoneridge...

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