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

Last week Fed Chairman Ben Bernanke announced a delay in the implementation of the Volcker Rule, news that should make investment banks give a big sigh of relief.

Everyone knows the role that risky asset backed securities played in financial crisis. What's less clear to some people is how the collapse of the market for these exotic instruments almost brought down our banking system.

The problem was that banks were trading in these securities for their own benefit. That is, they weren't buying them on behalf of customers, they were acting as investors themselves.

And when enormous banks make really bad investment decisions, they can bring the financial system down with them. Whether or not you liked the idea of taxpayer bailouts of the big banks, they happened because regulators were afraid that the collapse of the big banks would bring the whole system down.

Unfortunately the bailout also taught the investment banks a valuable lesson. They could make massive, risky bets-- and if they were profitable, they could keep the money. If they failed, taxpayers would pick up the tab. That's a recipe for disaster.

The Volcker Rule, part of the Dodd Frank law passed in 2010, was an attempt to prevent investment banks from taking advantage of their taxpayer safety net by engaging in risky trading. It is a simple idea- a ban on proprietary trading by banks that have the backing of taxpayers.

Not surprisingly, the ban is very unpopular with banks, who have been fighting it tooth and nail. Proprietary or "Prop" trading is often their most profitable business. When the Volcker Rule goes into effect, Goldman Sachs and Morgan Stanley, which have already seen a decline in profitability, could take a hard hit.

While the delay puts off the day of reckoning for the investment banks, the story isn't over yet, as the banks and shareholder advocates continue to wrestle over how the rule should be implemented.

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While a raft of new "capital formation" proposals are currently enjoying broad bipartisan support in Congress, they are likely to deeply undermine key investor protections at a time when confidence in the integrity of the markets is more important than ever.  One set of bills supporting a process called "crowdfunding" would permit high-risk start-up companies to troll for retail investors over the internet with little regulatory oversight -- a recipe for disaster.  Another initiative, termed an "IPO on-ramp" would permit companies with revenues of up to a billion dollars a year to avoid basic disclosure and internal control requirements for up to five years after an IPO.  While advocates suggest that these efforts to reduce investor protections will increase the number of IPOs, there has been little attention given to whether investors will be bearing a disproportionate share of the risks.

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Surprising new proposals for corporate governance reforms are being issued by an agency not generally associated with investor protection—the Federal Reserve.  

On December 20, 2011, the Federal Reserve Board issued proposed rules to strengthen regulation and supervision of large bank holding companies and systemically important non-bank financial firms. The proposal, which applies to U.S. bank holding companies with consolidated assets of $50 billion or more, addresses issues such as capital, liquidity, credit exposure, stress testing, risk management and early remediation requirements.

However, the new rules also provide for a series of significant corporate governance reforms. The new rules would require better oversight of any covered company’s liquidity risk management by its board of directors, who, together with senior management, would be ultimately responsible for the liquidity risk assumed by the company. 

Under the proposed rules, senior management of a covered company would be required to establish and implement liquidity risk management strategies, policies and procedures, and the board of directors would be required to review and approve them. In addition, the company would be required to establish and maintain an independent review function to review and evaluate the adequacy and effectiveness of the company’s liquidity risk management processes.

Contributed by Yoko Goto

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Investors hoping for strict enforcement of the new Volcker Rule guarding against risky proprietary investing by big banks shouldn't hold their breath.

The Volcker Rule, part of the Dodd Frank reforms inspired by the financial crisis, restricts U .S. banks from making certain kinds of speculative investments that do not benefit their customers. The rule's provisions are scheduled to be implemented on July 21, 2012.

However, Wall Street interests are fighting to weaken the proposed rule through intense lobbying efforts, vastly outgunning investors and their advocates.

A new Duke University study by Professor Kimberly D. Krawiec,based on agency records, determined that 94 percent of meetings between regulators and private interests regarding the Volcker Rule were arranged by financial institutions and their law firms -- while only six percent of such meetings involved public interest groups and unions. The intensity of industry lobbying should make investors everywhere feel nervous about the final product of the rulemaking process.

Contributed by Jodian Davis

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Today the EU unveiled the most sweeping reforms to date of the troubled credit rating industry. The proposed rules, which will require the approval of the European Parliament and EU member states, represent some significant progress in ongoing efforts to improve ratings. 

The reform proposal includes “mandatory rotation provisions” which would force issuers of financial products in Europe to rotate the credit rating agencies they use at least every three years. In addition, the proposal also contains a “cooling off” provision which would compel issuers to wait four years before hiring the same agency. The purpose of these provisions is to increase competition and reduce conflicts of interest. 

While US regulators have been reluctant to intervene in rating methodologies, the reform proposals would give ESMA, the European market regulator, the power to develop technical standards and approve specific rating methods. New rating methodologies, or adjustments to existing models, would have to be open to consultation and submitted to ESMA for approval.

Crucially, the proposed rules include a method for private enforcement, in that they would allow investors to sue credit rating agencies for compensation if they break EU regulations "intentionally or with gross negligence.”

Regulators apparently have dropped one of the most controversial proposed rules, which would have permitted ESMA to ban agencies from rating sovereign debt issued by countries in the process of being bailed out—an edict that would have further undermined the confidence of investors in sovereign debt.

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Regulators in the United States and abroad have embarked on an effort to crack down on market abuses involving computerized high-frequency trading. High-frequency trading was found responsible for the “flash crash” of May 6, 2010, and regulators suspect that it is contributing to the recent volatility observed in the markets.

High-frequency trading has become very popular, especially among large trading firms, since regulatory reforms encouraged exchanges to shift from floor-based trading to electronics several years ago. This practice now accounts for two-thirds of all trading volume on U.S. exchanges.

Critics warn that high-frequency traders fundamentally undermine the fairness of the financial system, because they make large profits at the expense of retail investors who have no access to such high-frequency trading technology. Long-term investors such as pension funds also complain that some traders may be using high-frequency trading technology to detect large buy or sell orders, and, by trading a fraction of a second ahead of large trades, take advantage of price moves. This concern is driving some large investors to move to venues away from public exchange, called dark-pools.

Domestic and overseas regulators are weighing several ideas for cracking down on manipulation by high-frequency traders. In the U.S., the Securities Exchange Commission approved a “large trader” rule in July that requires high-frequency traders to offer additional information about their activities. Some regulators have called for compulsory registration of high-frequency firms and pre-trade testing of their algorithms. The SEC has also proposed a powerful monitoring system called a consolidated audit trail that would gather data on trades in real time from all U.S. exchanges.

Institutional and retail investors concerned about market volatility should keep a close eye on regulators’ attempt to keep one step ahead in this technological arms race.

Contributed by Yoko Goto

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A new move by the legislature threatens to increase risk in already dangerously volatile markets.

Section 404(b) of the Sarbanes-Oxley Act sets out detailed internal control reporting requirements intended to better educate investors about the reliability of reported financial results. These protections were weakened by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which created an exemption to this rule for companies with less than $75 million in market capitalization.

A newly introduced bill, “The Startup Expansion and Investment Act” would further erode this check on the reliability of financial filings.  

Under the proposed Act, new companies with market capitalizations of up to $1 billion would be allowed to opt out of the requirement under Section 404(b) for the first 10 years after going public – so long as they disclose this opt-out in their annual reports.

In an SEC study released last April, the Commission concluded that, while extending exemptions might result in some decrease in compliance costs for companies, such savings could not “justify the loss of investor protections and benefits to issuers.” 

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On August 4, 2011, the New York Stock Exchange LLC (“NYSE”) and NYSE Amex proposed more stringent rules governing reverse merger companies – companies that became public without having to meet the strict rules covering IPOs. The proposed rules contain a series of “seasoning” requirements that would effectively delay exchange listings for reverse merger companies.

Under the proposed standards that the NYSE submitted to the SEC, reverse merger companies would have to trade for at least a year in the U.S. over-the-counter market, or on another U.S. exchange or a regulated foreign exchange before obtaining an NYSE listing. They would also be required to maintain a minimum $4 stock price for a “sustained” period, and would have to file audited financial statements and an annual report with the SEC. In addition, the NYSE would have the discretion to impose tougher requirements on a particular reverse merger company if the exchange deems warranted.

The NYSE’s move followed an SEC warning to investors about the risks associated with reverse merger companies. 

Contributed by Yoko Goto

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On June 9, the U.S. Securities and Exchange Commission issued a bulletin warning investors about companies that enter U.S. markets through so-called “reverse mergers”—and explaining how they can be detected.

In a reverse merger, a private company merges with an existing public shell company to become listed on a U.S. exchange and gain access to capital markets—a process that avoids the regulatory scrutiny given to IPOs.

The bulletin points out that the lack of transparency in reverse merger companies poses grave risks to investors.  However, it can be very difficult to determine whether a public company has undergone this process.

To assist investors, the SEC identifies risk factor disclosures in SEC filings that may serve as red flags signaling a reverse merger.  For example, the SEC urges that investors look out for words or phrases such as “lack of public company experience,” “lack of history of compliance with U.S. securities laws and accounting rules,” “inability to comply with federal securities laws” or “inability to attract the attention of major brokerage firms.”   

The risks involved in reverse mergers are more than theoretical.  The SEC and U.S. exchanges have recently cracked down on many companies that became public through this process.  Trading in more than a dozen such companies has been suspended due to a lack of current, accurate information about these firms and their finances.  In addition, several reverse merger companies have recently seen their securities registrations revoked because of failures to make required periodic filings.

Submitted by Yoko Goto

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