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

 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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