Eyes On Wall Street : Executive Compensation Lawyers & Attorneys : Labaton Sucharow Law Firm : Class Action Litigation, Shareholder Rights

Cornerstone Research today released its much-anticipated summary of securities class actions filings for 2009. As expected, the data compiled by Cornerstone reflects an overall decline in the number of securities cases filed compared to the bumper year of 2008. However, the summary highlights the fact that financial firms still make up a lion’s share of new filings—underscoring the key role that the these companies played in the financial sector catastrophes of 2007 and 2008.

Cornerstone’s 2009 summary reveals that 84 suits—roughly half of all filings—named financial sector defendants, well above the consumer non-cyclical sector with 33 filings and the communications sector with only 12 filings.

Although the percentage of S&P 500 index financial firms named as defendants in securities class actions dropped from 32.6 percent in 2008 to 11.5 percent in 2009, the financial firms named as defendants in 2009 still represented 39.1 percent of the sector’s total market capitalization.

The report also pointed out that class action filings continue recent upward trends in the numbers of cases including Section 11 and Section 12(2) allegations, and cases naming underwriters as defendants.

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Eyes On Wall Street welcomes Lynn E. Turner, the former Chief Accountant of the U.S. Securities & Exchange Commission. Mr. Turner offers Eyes readers some trenchant insight on controversial new rules for fair value accounting, and their long term implications for investors.

Eyes:     Many investors may not be familiar with fair value accounting. Can you give us a thumbnail sketch of what it involves?

Turner:     In its simplest form, fair value accounting is nothing more than having a company report its investments in terms of what they are worth today rather than what they paid for them when they bought them in past years or even decades.

Eyes:     Why should investors care about the way investments are accounted for?

Turner:     Well, as an investor you’re always interested in how management is stewarding the assets that you’ve given them to use. One good measure of how they’ve done with those assets and dollars is looking at the value that management has subsequently created. And looking at the value of those investments today, rather than some time ago, gives you a much clearer indication as to whether management has wisely invested the assets and got a return on the investments or instead has losses that they might like to hide and not be held accountable for.

Eyes:     Why did fair value accounting come to be so controversial during the financial crisis of 2007 and 2008?

Turner:     You know, I’ve been around for about three decades now and the whole debate over fair value accounting is nothing new. It was a major debate during the first half of the Seventies, when we had the ’72-’73 bear market; it was a major debated item during the savings and loan and banking crisis in the late ‘80s and early 1990s; and again it’s returned as a hot item in the subprime financial crisis. So it’s nothing really new. The arguments are always the same: the bankers say in the down times that they shouldn’t be made to take their losses, or it will destroy their businesses. But in the good times, they always come back and ask to use fair value accounting and take the write-ups. 

The reality is that these financial institutions, some of which have been dismally managed, don’t want to have accountability for the poor management decisions that they’ve made when they’ve invested the assets, the money from investors.

Eyes:     And that’s why the financial sector now has so much antipathy for fair value accounting?

Turner:     Well, the crisis was created when banks made a lot of bad home loans that were never going to be repaid.. We know that for a fact now. When the loans defaulted a lot of homes came on the market that couldn’t be resold, or had to be resold at much lower prices than what they’d been bought for or what people felt they were worth. 

As a result, investments in those loans and those mortgages declined in value significantly. The financial industry, which had packaged and sold the loans and had a significant amount of these assets on their own balance sheets, really didn’t want the public to learn about the magnitude of those losses. The public would be upset that they were sold bad investments by the finance companies. In turn the companies didn’t have enough capital to reverse or to sustain those losses and would become financially unstable requiring taxpayer and government support. 

Eyes:      The financial sector has had some recent success in undermining the fair value accounting rules in both the E.U. and the U.S. Can you describe those changes?

Turner:     What the Financial Accounting Standards Board (“FASB”) in the U.S. and International Accounting Standards Board (“IASB”) in the E.U. have done, interestingly enough, is somewhat interconnected. Initially, the European Commission and the President of the E.U., Sarkozy, put tremendous pressure in October of 2008 on the IASB to relax its rules and give greater latitude to financial institutions in how they go about figuring fair value, and in particular what type of assets they’ve got to apply fair value to. In part in response to what the E.U. did, earlier this year, under pressure from the US Congress, the FASB relaxed some of the accounting rules to give greater latitude in how you would calculate those fair values. These changes allow the banks to manipulate what they report as fair values. As one person said, under the new rules it’s really not “mark to market,” it’s “mark to magic.”

under the new rules it’s really not “mark to market,”
it's “mark to magic.”

Eyes:     Now, what do you make of the argument that fair value accounting just doesn’t work when there isn’t a market on which you can assess the value of some of these mortgage-backed assets?

Lynn Turner:     Well, first of all, the vast majority of these assets do have a market, so it’s not as big an issue as what some people make it out to be. For those where there isn’t a market – that is, those investments aren’t traded day in or day out – you can still make an assessment, and accounting rules allow you to make an assessment, of what the cash flows are going to be coming off those investments, and ultimately what someone else is going to be willing to pay you for that. Smart managers should have made that exact assessment when they initially decided to purchase them in the first place and put them on their balance sheet. 

Eyes:     There’s certainly been a lot of debate earlier this year, and then maybe ongoing next year, about legislative proposals that might undercut the independence of standards boards like the FASB. How important is it that these boards remain independent?

Turner:     It is very important that both the Financial Accounting Standards Board and the International Accounting Standards Board be able to go through a due process that allows them to develop standards that will in fact provide investors with the very high quality information they need to make sound investment decisions. When members of Congress here in the US, or when the European Central Bank or Parliament put tremendous pressure on either of these two bodies to serve special interests like the financial lobby instead of investors, then there’s hundreds of millions of investors that get short changed. 

In the long run, good investment decisions can’t be made without good information. And unfortunately both the European Central Bank, the European Parliament and the US Congress throughout this year – and it will continue into next year – will continue to try to break the arms of these standards setters to provide standards that are more favorable to the banks, which will do destructive damage to the US capital markets and investors.

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Senator Christopher J. Dodd (D-Conn.), Chairman of the Senate Banking Committee, has proposed a bill that would, if enacted, result in a sweeping overhaul of the U.S. financial system. Dodd unveiled a plan that would, among other things, consolidate bank regulators, create a consumer financial protection agency and impose new restraints on exotic financial instruments and credit rating agencies. In unveiling the bill, Dodd said, "I could have tried to draft something that was, sort of, already a compromise… But I think you make a huge mistake by doing that. You're given very few moments in history to make this kind of difference, and we're trying to do that."

If enacted, Dodd’s legislation would:

• Create a Consumer Financial Protection Agency which would focus on protecting American consumers from fraud and abuse, and on ensuring that consumers be given clear information on loans and other financial products from credit card companies, mortgage brokers and banks. This proposed agency would consolidate consumer protection responsibilities currently handled by the Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Deposit Insurance Corporation (FDIC), the Federal Reserve, the National Credit Union Administration and the Federal Trade Commission.
• Create a Financial Institutions Regulatory Administration which would eliminate the alphabet soup of multiple bank regulators, and would ensure that the FDIC and the Federal Reserve do their jobs.
• Address systemic risks posed by derivatives. Over-the-counter derivatives would be more closely regulated by the SEC and CFTC to close regulatory loopholes. Derivative trading would be required to go through central clearing and exchange trading to encourage transparency and accountability. 
• Require advisors to hedge funds and other pools of cash worth over $100 million to register with the SEC and to disclose financial data needed to monitor systemic risk and protect investors. 
• Establish a new Office of Credit Rating Agencies at the SEC which would strengthen regulation of credit rating agencies. This new office would have its own compliance staff and the authority to fine agencies. The bill would also give investors a private right of action against ratings agencies for knowing or reckless misconduct.
• Create the Agency for Financial Stability, an independent agency responsible for identifying, monitoring, and addressing systemic risks posed by large, complex companies as well as products and activities that can spread risk across firms. The Agency would draft strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity.

The Dodd proposal faces some hurdles. Administration officials, House leaders and some Republicans have criticized parts of the plan as untenable. Edward, L. Yingling, President of the American Bankers Association, said the proposal "would tear apart the existing regulatory structure only to create a new one that would produce conflicts among regulators."  However, Treasury Secretary Timothy F. Geithner said that the legislation "moves us one step closer toward comprehensive financial reform."  Dodd has said he plans to move the bill through the banking committee quickly.

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In a November 6, 2009 speech at a roundtable conference hosted by the George Washington University Law School and the Institute for Law and Economic Policy (ILEP), SEC Commissioner Luis Aguilar warned that the powerful financial sector lobby has been working overtime to weaken reform initiatives that would benefit shareholders. 

Aguilar focused on a potentially disastrous amendment to the pending Investor Protection Act of 2009. A late addition to the bill would sharply limit the reach of the investor protections set out in the Sarbanes-Oxley Act of 2002. Section 404(b) of the existing statute requires that executives of all public companies take responsibility for their internal controls, and that the controls be reviewed by independent auditors. The new addition to the Investor Protection Act of 2009, however, would turn the legislation on its head by repealing these crucial requirements for about 6,000 publicly traded companies with market capitalization under $75 million.

The Commissioner also suggested that the current preoccupation with regulating systemic risk embodied in institutions that are “too big to fail” may not adequately address market protection. Noting that “financial services exist to serve investors,” he emphasized that it is essential that the dialogue be shifted from how best to preserve “too big to fail” institutions to “what is best for investors.”

According to Aguilar, "systemic risk regulation should facilitate an environment where no institution is indispensable, and where other firms can step in to meet the needs of the market."

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America is experiencing an extraordinary period of legislative and regulatory executive compensation reform. In fact, executive compensation reform is so much in vogue that many companies are even voluntarily introducing so-called Say on Pay resolutions. 

Since Treasury Secretary Geithner first proclaimed that companies in receipt of TARP assistance would have to subject executive compensation to Say on Pay resolutions in February 2009, thirteen publicly-traded companies that did not receive TARP monies—including Verizon, Motorola, and Blockbuster—have willingly adopted the Say on Pay way. 

In addition to these thirteen corporate compensation pioneers, eleven other leading publicly-traded companies that did not receive TARP funds—such as Microsoft and Apple—have either willingly scheduled Say on Pay votes for 2010 or have already voted but not yet released results. 

These voluntary say on pay resolutions revise compensation disclosure by, among other things, changing the Summary Compensation Table (“SCT”) reporting of stock and option awards and by broadening the scope of the Compensation Discussion and Analysis (“CD&A”) to include a new section that analyzes the link between a company’s overall compensation policies and the company’s risk and management of that risk. 

Say on Pay resolutions further require that compensation committees be independent, and that such committees disclose the use of consultants and advisors (who are also required to be independent). In addition, such provisions require disclosure of specific performance targets, and also seek to enhance proxy access for stockholder proposals and director nominations.   

Adoption of Say on Pay provisions will result in closer scrutiny of executive pay arrangements by boards and compensation committees. Better-informed and qualified boards and compensation committees, in turn, may help restore investors' faith in corporate governance after the crises of the last two years.

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On October 22 Wall Street received a double whammy with the release of plans by the Federal Reserve and the Treasury Department to aggressively regulate pay practices at banks. While both approaches capitalize on public wrath erupting over the announcement of record-setting year-end bonuses at top financial firms, they differ significantly in scope and effect. 

The Federal Reserve’s new compensation proposal, outlined in its October 22 press release, has the broadest sweep, covering thousands of banks, including U.S. subsidiaries of foreign institutions. While the proposed rules would not directly regulate pay, they would include demands that firms take into account losses incurred by employees, make pay tied to longer-term performance, and pay out over longer stretches of time. The only real teeth in this regulation, however, is the Fed’s right to veto compensation plans it does not like, and to require that management come up with better approaches. 

The Treasury plan is more limited in scope, but has a much more immediate impact. The plan, outlined in an October 22 press release titled The Special Master for TARP Executive Compensation Issues First Rulings, applies only to the beneficiaries of bailout funds under the TARP program. It attempts to better align pay with longer-term performance, but takes a more direct approach than the Fed. Treasury official Kenneth Feinberg, the Obama administration’s “pay czar,” slashed cash compensation, increased stock awards, and insisted that stock compensation be held for two to four years. Salaries paid to the highest-earning executives at seven companies getting exceptional federal aid will also be capped at $500K, while the group’s total pay level, annualized, will be 50% lower than last year.

Not surprisingly, the financial services industry is not happy with either approach. Although the sector benefited from last year’s massive infusion of taxpayer capital, banks are bridling at the suggestion that regulators—and the taxpayers they protect—should have any role in reforming the institutions that they helped save.

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The number of active dark pools transacting in stocks that trade on major U.S. stock markets has tripled since 2002. In the face of the rapid growth of these venues, some commentators worry that their lack of transparency could create a two-tiered market that deprives the public of information about stock prices and liquidity.

On October 21, 2009, the SEC voted unanimously to propose measures intended to increase transparency of dark pools so investors get a clearer view of stock prices and liquidity.

The SEC’s proposals address three specific concerns related to dark pools:

The first proposal would require actionable Indications of Interest (IOIs) — which are similar to a typical buy or sell quote — to be treated like other quotes and subject to the same disclosure rules.

The second proposal would lower the trading volume threshold applicable to alternative trading systems (ATS) for displaying best-priced orders. Currently, if an ATS displays orders to more than one person, it must display its best-priced orders to the public when its trading volume for a stock is 5 percent or more. The SEC’s reform proposal would lower that percentage to 0.25 percent for ATSs.

The third proposal would create the same level of post-trade transparency for dark pools as for registered exchanges. Specifically the proposal would amend existing rules to require real-time disclosure of the identity of the dark pool that executed the trade.

While the SEC’s desire to pursue market transparency is commendable, it should also be wary of moving too quickly in regulating “dark pool” markets. Dark pool trading offers significant benefits to large investors, including a shelter from the share price premiums that result from “flash trading.”

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Wall Street has a long history of investors profiting on their access to non-public information about the business prospects of publicly traded companies. However, new kinds of “insider” trading, kinds that are still legal, are the subject of increasing regulatory concern.

These technological advantages take several forms. As recently explained by Eyes, in flash trading, select investors pay for access to information about stock purchases and sales fractions of a second before the information becomes public.

Naked access occurs when brokerage firms pay sponsors-- firms approved to trade on particular exchanges-- to execute orders anonymously through the sponsors’ computers, getting tiny but profitable time advantages over the rest of investors. Accounting for more than half of the daily trading volume, “naked” access is currently solely regulated by rules imposed by participating exchanges and brokers. The SEC has threatened to implement rules that would undercut the speed advantage gained through such access. 

A “dark pool” is a private exchange over which sophisticated traders can electronically buy and sell large amounts of stock, taking advantage of technology that lets them complete transactions faster than could be achieved in the NYSE. As recently reported in a New York Times article about “dark pools,” these exchanges have caused the daily trading volume of the NYSE to decrease by approximately 39% over a four-year period.

While all of these practices pose complicated problems for regulators, they may also highlight a disturbing trend: that technological advantages may be overtaking investor acumen as the key to profiting on the markets.

Update on Dark Pools Regulation

Concerned about problems posed by “dark pool” markets, on October 21, 2009, the SEC voted to propose new rules that would require more stock quotes in the “dark pool” systems to be publicly displayed.  The rule changes may be adopted after a 90-day public comment period.  The SEC Chairman, Mary L. Schapiro, discussed the issue in a speech titled “Statement on Dark Pool Regulation Before the Commission Open Meeting.”

For more details on the proposed regulations, please see the October 28, 2009 Eyes post.

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In the face of a financial crisis fueled by widespread overvaluation of real estate and mortgage-backed assets, investment banks and other financial sector interests have successfully lobbied to undermine accounting rules that ensure the integrity of asset valuations. 

Bowing to intense lobbying efforts, in April of this year the Financial Accounting Standards Board (FASB) altered long-standing rules requiring banks to use “mark to market” accounting—that is, to value assets at what they would fetch in the current market. These changes permit companies to use inflated asset values and allowing companies to avoid having to recognize asset losses in reporting their earnings.

Investors should pay special attention to changes in FASB Staff Position 157-4, called Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.  In FSP 157-4, the FASB states that “[f]air value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation, or distressed sale) between market participants at the measurement date under current market conditions.”

However, amendments to FSP 157-4 contain a loophole permitting companies to disregard an observable market price for assets traded in an “inactive” market—that is, a market in which there is little or no data about current trading values. When markets are inactive, the new rule empowers companies to exercise their own judgment in estimating the fair value of assets traded on inactive markets.

This development is dangerous because companies have the power to ensure that markets are inactive by ceasing to sell or buy risky assets—permitting them to value the assets using their own estimates rather than market prices.

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