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

On July 8, the European Parliament approved the world’s strictest rules on bankers’ bonuses. The rules apply to banks and investment firms, but not to hedge-fund managers.

The new rules ensure that bonuses provide less incentive for risky practices that increase executive compensation in the short term, at the expense of long term corporate financial stability.

Under the new regime, no more than 30% of bankers’ bonuses can consist of up-front cash, and, in the case of very large bonuses, no more than 20% can be cash. More importantly, about 70% of total bonus value would be deferred for up to three years and would paid in a new class of security called “contingent capital”.

Ordinarily, bonuses can be paid in the form of a note or “IOU” from the Company. Under the contingent capital scheme, however, in the event of financial difficulties, this debt is converted into equity, which, like stock, falls in value with declining company fortunes.

The new rules are likely to be formally adopted at a meeting of EU finance ministers this week, allowing them to come into effect at all banks operating in the European Union before this year’s bonus season. American policy-makers eager to prevent future financial crises would be wise to look closely at these overseas developments.

Contributed by Yoko Goto

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The G-20, an international group of banking policy makers, have elected to delay the adoption of a uniform set of banking regulations requiring member nation banks to hold more capital—measures necessary to forestall the kind of bank runs that recently brought down several finance sector giants.  This new set of banking regulations is designed to increase banks’ capital and liquid assets, improving their ability to absorb losses and to weather severe short-term market declines.  However, the G-20 avoided issuing a mandate that would have required uniform adoption of the new capital requirements by the end of 2012.  Instead, the G-20 committed to permitting countries to phase in the adoption of these new capital requirements. 

By permitting a transitional period for the adoption of a new set of capital requirements, the G-20 enabled member nation banks to hold different levels of capital and liquid assets.  This approach poses risks to investors everywhere.  As seen in the recent financial crisis, risk migrates to the path of least resistance.  In light of the G-20’s delay, banks can be expected to shift risk to offshore entities in countries that have yet to adopt the more stringent capital and liquid asset requirements prescribed by the G-20.  Until all countries fully implement the G-20’s capital requirements, investors are still exposed to significant losses as banks, instead of mitigating risk, shift exposure to countries with less onerous capital requirements.

Contributed by Craig Martin

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After a 20-hour marathon session, legislators reached agreement last Friday on a final version of a financial reform bill that, if enacted, will transform financial regulation in the U.S. It is expected that there will be enough support to for the bill to pass in both chambers later this week.

In some respects, the agreement is tougher on the banking industry than the bill drafted by the Treasury department last summer. Lawmakers agreed to a provision known as the “Volcker rule,” named after former Federal Reserve Chairman Paul Volcker, which restricts the ability of banks whose deposits are federally insured from trading for their own benefit. In order to win wider support for the legislation, Democrats agreed to allow financial companies to make limited investments in areas such as hedge funds and private-equity funds, although banks can invest no more than 3 percent of a fund’s capital and those investments could also total no more than 3 percent of a bank’s tangible equity. This would have a significant impact on many Wall Street firms such as Goldman Sachs and Morgan Stanley that have long engaged in amounts of trading for their own accounts.

The final version of the financial reform bill also includes a provision restricting banks’ derivative trading. However, it is not as strict as Senator Blanche Lincoln’s proposal which would have required banks and their parent companies to segregate much of the derivatives trading business. The agreed-upon version of the bill would allow banks to trade in derivatives to hedge their own risk, but would forbid banks from speculating in highly risky credit default swaps and other exotic instruments. As an additional safeguard, the Commodity Futures Trading Commission would be given greater oversight of derivative trading.

Contributed by Yoko Goto

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In 2009, the Financial Accounting Standards Board (“FASB”) caved to immense pressure from financial sector lobbyists when it eliminated a requirement that companies disclose market-related losses on asset values.  In the furor that followed, scholars and institutional investors pointed out that these changes are likely to set the stage for a repeat of the market catastrophe of 2007-2008. FASB now appears to agree, and is showing the backbone necessary to do something about it.   

On May 26, 2010, FASB issued an Exposure Draft of a proposed Accounting Standards Update (“ASU”), Accounting for Financial Instruments, that improves the accounting for financial instruments by updating rules for classifying, measuring and recognizing impairments for financial instruments. The ASU is designed to provide greater transparency in financial statements reporting financial instruments. 

Under the proposed accounting standard, almost all financial instruments, including loans, would be reported at fair value. For example, a bank’s portfolio of loans previously classified as held-to-maturity or held-for-investment and reported at amortized cost would now be reported at fair value with any fair value adjustments recorded in other comprehensive income on the balance sheet. 

Most likely to be affected by the rule change are traditional banks, which have large loan portfolios that under current accounting rules are reported at amortized cost, net of impairments for credit losses. Under the FASB’s proposed rule, the traditional banks would value their loan portfolios using fair market value, reporting the loans at amortized cost and fair value on the balance sheet and recording any fair value adjustments in other comprehensive income in the equity section of the balance sheet.  

These traditional banks are also likely to be affected by a related proposed amendment concerning the threshold for recognizing credit impairments. Under the proposed guidance, FASB would eliminate the rule that credit impairments need only be recorded when they are probable. The “probable” threshold under current accounting rules results in delayed recognition of credit losses. Instead, the new rule would require banks to record a credit impairment charge in net income when the bank doesn’t expect to collect all contractual amounts due under a loan. With a lowered threshold for credit losses, entities will provide more timely information about expected credit losses on financial assets.

In the near term, FASB’s Exposure Draft is open to comment from the public. However, if the ASU were to be approved, the financial landscape of banks will forever change. Under the new rules, banks will be required to fair value large portfolios of loans that were once carried at cost on their balance sheets. Further, FASB’s proposed amendments will make it difficult for banks to ignore impairments caused by credit losses in loan portfolios. As the financial crisis still shadows the financial markets, the FASB’s new push for transparency will be welcomed by many investors.

Contributed by Craig Martin

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On May 6, beginning at approximately 2:30 p.m., the stock market plunged 1,010 points in just 16 minutes. In what is now being called the “Flash Crash,” the Dow plummeted 998.50 points, the biggest intraday drop in the history of the index. During the brief drop, at least eight stocks in the Standard & Poor’s (S&P) 1500 index fell to a price of one cent per share – essentially a 100% decline. Although the market quickly rebounded, the speed of the plunge left Wall Street stunned and concerned.

On May 18, the Securities and Exchange Commission and U.S. Commodity Futures Trading Commission issued a preliminary report on the flash crash, in which the regulators stated that they had not yet been able to determine any definitive cause for the incident. However, the report suggested that the crash had been accelerated by a lack of uniform rules to slow or halt trading in extremely volatile stocks.

Despite the lingering mystery over the crash’s origins, the SEC and CFTC are wasting no time in putting temporary safeguards in place to prevent similar trading crises. They announced a six-month pilot program, starting June 14 and ending December 10, that will create trading “circuit breakers” for the stocks listed in the S&P 500 index. The circuit breakers will pause trading in those stocks for five minutes if share prices move by at least 10% --whether up or down--in a five-minute period. This band-aid will have will have to suffice until the real causes of the crisis are better understood.

Contributed by Vicky Ku

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 On May 20, the Senate approved a bill that, if enacted, would represent the most sweeping regulatory overhaul since the Great Depression. Among other things, the Senate bill would:

• Establish a new council of “systemic” risk regulators to monitor growing risks in the financial system.
• Empower the Federal Reserve to supervise the largest, most complex financial companies to ensure that the government understands the risks and complexities of firms that could pose a systemic risk.
• Give the Securities Exchange Commission the authority to grant shareholders proxy access to nominate directors.
• Establish a new self-regulating organization for credit rating agencies designed to eliminate conflicts of interest in the issuer-pay model. The SEC would appoint members of the regulatory body which would assign rating agencies to provide initial credit ratings of financial instruments.

The Senate bill differs significantly in some ways from the House version of the Wall Street reform legislation. While both bills contain provisions calling for the creation of a new consumer protection agency, in the House version the agency would be substantially independent, while the Senate version would put the agency under the umbrella of the Federal Reserve, an institution not famous for its concern for consumer rights.

With respect to regulating the massive over-the-counter derivatives market, however, it is the Senate bill that calls for stricter rules—perhaps because it passed in the wake of the recent Goldman Sachs imbroglio   Both bills give regulators new powers to oversee the derivatives market and to force most derivative contracts to be traded through third party “clearing houses.” However, the Senate bill would make it more difficult for companies to seek exemption from the new rules.

Investors and taxpayers alike should stay tuned to what happens in the process of reconciling the two bills: the results may shape the U.S. markets for generations to come.

Contributed by Yoko Goto

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Goldman Sachs hosted its annual shareholder meeting on May 7, 2010, just ten days after the company’s CEO and chairman, Lloyd C. Blankfein, was put on the hot seat by the Senate committee at a hearing to discuss the bank’s suspect trading activities and a fraud suit by the SEC. While the meeting was widely seen as a potential referendum on investor confidence in Blankfein, there were surprisingly few questions about the investigations of Goldman’s past mortgage trading or the various lawsuits pending against the Company. 

Nevertheless, Goldman shareholders expressed their continued interest in paying a more active role in corporate decision making. Following the 2009 annual meeting, a majority of shareholders requested that the Board take steps to eliminate the supermajority voting provisions from the company’s Bylaws and Certificate of Incorporation.  In the 2010 annual meeting, the Board itself proposed a resolution to change the supermajority voting provision, which had required an 80% vote, to a majority provision, which requires a vote only above 50%. The proposal received support from an overwhelming 82.5% of outstanding shares and was approved. The passage of this proposal effectively increased shareholder power by decreasing the amount of votes needed to pass proposals at annual meetings.   

However, shareholders were much more ambivalent about a proposal to separate the Chairman and CEO roles at Goldman. The proposal emphasized that the “role of the Board of Directors is to provide independent oversight of management and the CEO” and addressed the “potential conflict of interest for a CEO to be his/her own overseer while managing the business.” It also referenced a 2009 report by Yale University’s Millstein Center for Corporate Governance and Reform that stated, “Having an independent chairman is a means to ensure that the CEO is accountable for managing the company in close alignment with the interests of shareowners, while recognizing that managing the board.” The Goldman board recommended that the resolution be voted “against,” and the resolution did, in fact, fail--with support from only 19.1% of the vote. In so voting, Goldman parted company with banks such as Morgan Stanley, Bank of America and Citigroup, which have all split the chairman and CEO roles.

Submitted by Carol Villegas

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In a recent hearing, the Senate Permanent Subcommittee on Investigations lambasted credit ratings agencies for their role in the financial crisis. During an April 23 hearing, the Senate Subcommittee found that the credit rating agencies were “too influenced by investment bankers,” and had used credit ratings models with inaccurate and inadequate data. The findings came on the heels of an 18-month long investigation into some of the causes and consequences of the financial crisis.

The Subcommittee released several damning email messages, one from a Standard & Poor (S&P) employee who explained that it was necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another email complained of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.” 

Former executives at both Moody’s and S&P testified that competitive pressures and conflicts of interest were allowed to consistently undermine accurate, fair and unbiased ratings of complex securities that Wall Street sold to investors. Eric Kolchinsky, a former managing director at Moody’s who oversaw the ratings of collateralized debt obligations backed by subprime mortgages, testified that “[i]t was an unspoken understanding that loss of market share would cause a manager to lose his or her job.”

The results of the agencies’ conflicts of interest are all too apparent. From 2002 to 2007, the credit rating agencies earned record profits, reporting $6 billion in gross revenues in 2007. However, 93% of all AAA-rated subprime-mortgage-backed securities issued in 2006 have now been downgraded to junk status.In a recent hearing, the Senate Permanent Subcommittee on Investigations lambasted credit ratings agencies for their role in the financial crisis. During an April 23 hearing, the Senate Subcommittee found that the credit rating agencies were “too influenced by investment bankers,” and had used credit ratings models with inaccurate and inadequate data. 

Contributed by Vicky Ku 

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On Friday April 16th, the Securities and Exchange Commission (SEC) filed a civil complaint against Goldman Sachs and one of its vice-presidents, Fabrice Tourre, for allegedly defrauding investors by failing to disclose vital information about a financial product linked to subprime mortgages. Goldman’s shares tumbled, dragging the markets down with it.

The instrument in question, structured and marketed by Goldman, was a synthetic collateralized debt obligation (CDO), whose performance was tied to that of residential mortgage-backed securities. Goldman told its investors, who included some European banks, that the securities underlying the CDO had been selected by an independent third party, ACA Management. The SEC alleges that Goldman failed to disclose that another firm, Paulson & Co, a big hedge-fund manager, in fact had a hand in choosing what went into the CDO.

This was a crucial omission, since Paulson & Co—run by John Paulson, who made billions in 2007-08 betting against the housing market—had taken a short position against the CDO; in other words, the firm would profit if the instrument performed poorly. 

According to the SEC's complaint, Paulson shorted the portfolio it helped to select by purchasing insurance against the default of certain layers through derivatives called credit-default swaps (CDSs) it entered into with Goldman. The SEC argues that these derivatives gave the hedge fund an incentive to select mortgage securities that would bomb. And bomb they did. The deal closed in April 2007; by the end of January 2008, 99% of the portfolio had been downgraded by credit-rating agencies.

Goldman called the charges “completely unfounded in law and fact” and said it would contest them vigorously. Paulson & Co, which has not been charged, issued a statement saying that ACA, as the third-party collateral manager, had sole authority over the selection of securities in the CDO. In a more detailed response issued later, Goldman insisted that extensive information about the portfolio had been provided to the buyers, who were sophisticated investors aware of the risks.

It may seem surprising that Paulson is not named as a defendant in the SEC's complaint. However, the decision not to name Paulson as a defendant was likely influenced, at least in part, by the Supreme Court's recent landmark decision in Stoneridge Investment Partners, LLP v. Scientific-Atlanta, et al. (2008). The Stoneridge holding restricts plaintiffs from alleging 1934 Exchange Act fraud claims against "non-speaking" participants in schemes to defraud investors. Rather, investors may only sue those who issued statements or otherwise took direct action that the investors had relied upon in buying or selling stock. Thus, under Stoneridge, the SEC could not bring securities fraud allegations under Section 10(b) against Paulson without demonstrating that Goldman's investors directly relied on false statements or misleading conduct by Paulson.  

Given the public and official outrage over Paulson's involvement in the Tourre scandal, recent legislative efforts to overturn Stoneridge seem timely and well taken. 

Contributed by David Sack

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