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

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 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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In the wake of the mortgage meltdown of 2007-2008, regulators have sought to substantially stiffen lending requirements for lower-income homeowners. This regulatory activity, spurred by the suggestion that overly generous lending to consumers with little ability to pay played a key role in the credit crisis, may make have the unintended consequence of discouraging some well-qualified minority applicants from entering the housing market.

 This potential downside to overly-stringent new rules has resulted in an unusual alliance.

Mortgage lenders and some non-profit organizations, including the N.A.A.C.P. and La Raza, are cooperating in an effort to protect working class and minority communities from stricter regulations on mortgage packaging that may ultimately discourage some applicants from minority groups from obtaining home loans. Among their targets: a proposal that would exempt mortgage packagers from bearing part of the risk in the loans they package if loan recipients provided a 20 percent down payment. 

Submitted by Melanie Boyce

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On April 13, after two years of investigation, Senator Carl Levin and Senator Tom Coburn, Chairman and Ranking Republican on the Senate Permanent Subcommittee on Investigations released a final report on their inquiry into the main causes of the financial crisis. The report presents new facts, findings and recommendations, with more than 700 new documents totaling over 5,800 pages.

The report focuses on the ways that financial firms deliberately took advantage of their clients and investors, on deeply flawed credit ratings, and on federal regulators who apparently cast a blind eye on these unsafe and unsound practices.

The report expands on evidence collected at four Subcommittee hearings in April 2010, examining four aspects of the crisis through a series of detailed case studies: 1) high-risk mortgage lending, using the case of Washington Mutual Bank; 2) regulatory inaction, focusing on the Office of Thrift Supervision’s failed oversight of Washington Mutual; 3) inflated credit ratings, examining the actions of Moody’s and Standard & Poor’s; and 4) the role played by investment banks, principally Goldman Sachs.

The report offers 19 recommendations, including a call for strong implementation of the new restrictions on proprietary trading and conflict of interest. The report also urges, in addition to the reform effected by the Dodd-Frank Act, that the SEC to use its regulatory authority to rank credit ratings agencies according to the accuracy of their ratings.

Contributed by Yoko Goto

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On November 23, the Financial Stability Oversight Council voted to solicit public input in developing rules for designating financial market utilities as systemically important. A notice seeking comments will published in the Federal Register shortly, triggering a 30-day comment period.

The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act proposes to categorize the largest or most interconnected financial firms as systemically risky, requiring them to provide advance notice to regulators of any changes to their operations that would materially affect their level of risk, and subjecting them to additional risk management standards and examination and enforcement oversight.

While this goal seems clear-cut, the task of identifying systemically risky firms is proving to be a thorny problem. To begin the process of fleshing out the new rules, the FSOC is soliciting comments on the criteria that should be used to evaluate a financial market utility’s level of systemic risk; how exposure to or interdependency with other financial firms or market utilities should be weighted; and how to measure the significance that a potential failure might have on the broader markets.

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It’s hard to believe that nearly six months have gone by since the May 6, 2010 “flash crash” that unnerved the financial world. In an attempt to avoid any repeats of this crisis, regulators have implemented “circuit breaker” rules to temporarily halt trading and reset prices in the event stocks plunge suddenly. 

In spite of this heightened regulatory interest, similar, albeit smaller, flash crashes continue to occur with alarming frequency. In fact, it has happened to more than a dozen individual stocks in the last six months. 

For example, on September 27, 2010, Progress Energy’s share price plunged almost 90% in an instant—dropping from $44.57 to $4.57. In effect, a robust company with 3.1 million customers and 11,000 employees suddenly seemed to be on the precipice of insolvency.

The circuit breaker rule worked on the New York Stock Exchange, but because the trading happened so fast, Progress stock still wound up in free-fall going down to $4.57 before other exchanges could catch up and stop trading. Dozens of trades were declared void, and after a five-minute halt, normal trading resumed. It is speculated that the trigger of this event was an erroneous electronic sell order.

Critics worry that the string of mini flash crashes points to deeper problems in the nation’s stock markets. Some analysts say it is a sign that another big event is possible, if not probable.

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Despite the economic decline plaguing most U.S. workers, many bankers and traders continue to be sanguine about prospects for their compensation. About half of respondents to a survey of about 2,100 U.S. bankers and traders expect their bonuses to increase this year compared with 2009.

Worse, although regulators and financial executives have repeatedly urged deferring at least part of  bonuses to future years to discourage irresponsible corporate risk-taking, most employees expect none of their bonuses to be deferred.

Their optimism is well founded.  According to a study by the Wall Street Journal, total Wall Street compensation will reach $144 billion for 2010, marking a record for the second consecutive year.  It also appears that increases in compensation will far outpace increases in corporate revenues.  The report says that according to a survey of 35 firms, pay in 2010 is expected to increase 4%, while annual revenue is forecasted to increase just 3%. 

Contributed by Yoko Goto.

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Investment banks have long disclaimed their culpability for the subprime crisis by arguing that they had been bamboozled by the AAA ratings that credit rating agencies had bestowed on instruments that were in fact very risky. That alibi is looking increasingly unlikely.

On September 23, 2010, D. Keith Johnson, the former president of Clayton Holdings, testified before the Financial Crisis Inquiry Commission  that the rating agencies routinely ignored evidence that the loans they were rating “did not meet lending criteria promised to investors”.

More importantly, he suggested that investment banks were well aware of the infirmity of the ratings. Clayton Holdings was hired by investment banks to analyze the mortgage pools they were bundling into securities. Johnson testified that an analysis of a sampling of the loans revealed that almost half of these mortgages failed to meet the underwriting standards laid out by the banks themselves. These findings were provided to the same investment banks that have been pleading ignorance of the risk associated with the loans they securitized and sold.

Worse, Johnson testified that Wall Street investment firms capitalized on Clayton’s findings. Instead of informing the public about the risky loans, the investment banks used the information provided by Clayton to obtain the bad loans at a lower price from the issuing lenders. And, instead of passing these savings on to the public, the investment banks sold these mortgage pools at the same prices as the loans that actually met underwriting standards.

Contributed by Carol Villegas

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If there were ever an opportunity for meaningful reform of the banking practices that contributed to the financial crisis, that time is now, when the memory of the recent crash is still fresh. The longer we wait, the less likely we are to see any real change. Less than two years after a financial crisis fueled by lax liquidity and capital requirements for banks, a key banking policy group appears to be backpedaling from its previous proposals for reform.

The Basel Committee on Banking Supervision was developed in 1974 by the central-bank Governors of the Group of Ten Countries. The aim of the Committee is to provide uniform supervisory standards and make recommendations for “best practice” approaches to banking.

Last December, the Committee appeared to be pushing for strong reforms. It proposed new standards calling for, among other things, more stringent capital requirements-- including a new approach to calculating capital. It also called for clearer liquidity standards, and a provision that would force banks to accumulate more capital in times of prosperity. 

Now, in response to pressure from the powerful banking lobby, the Committee seems to have weakened its resolve to encourage meaningful change. Instead of following through with its December promises, the Committee concluded a recent meeting with considerable backtracking, including much softer proposals for capital requirements.

Contributed by James Jackson and Melanie Headley 

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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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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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On April 7, 2010, the Securities and Exchange Commission (SEC) began presenting its case against Jon-Paul Rorech, a Deutsche Bank bond salesman and Renato Negrin, a former trader at hedge fund Millennium Partners LP, for insider trading. However, this is not a run-of-the-mill insider trading case. This case is significant because it is the first case the SEC has brought to trial involving insider trading of credit default swaps (CDS), and its outcome could help clarify whether the securities laws reach the murky world of credit default swaps.

Credit default swaps are financial instruments that serve to protect against a default by a particular bond or security. They are essentially a form of insurance against defaults on a company’s debt. Unlike traditional insurance, however, the market for credit default swaps is largely unregulated. Many noted economists consider unregulated CDS trading to be one of the major contributing factors to the financial crisis.

The SEC alleges that Rorech illegally tipped off Negrin about a bond offering from Dutch media company VNU Group, which controls Nielsen Media, the television ratings service. Based on that information, Negrin bought credit default swaps that rose in value when the deal was made public, eventually earning him a $1.2 million profit. 

The defense argues that because credit default swaps are not defined as securities according to securities regulations and are not traded on any exchange, they are more like private contracts between financial players. Therefore, they are not subject to SEC enforcement under the insider trading provisions of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.

The SEC in turn argues that credit default swaps, even though they are not considered securities in the traditional sense, clearly meet the definition of “security-based swap agreements” established by the Gramm-Leach-Bliley Act. Therefore credit default swaps fall within the purview of the SEC.

The decision in this case could very well determine whether credit default swaps, the derivatives blamed for much of the economic meltdown, are subject to the SEC’s anti-fraud actions.

Contributed by Vicky Ku

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Last week, the SEC proposed new rules that would require issuers, instead of credit rating agencies, to vouch for the soundness of their asset-backed securities. The types of securities that would be affected by these regulations are bundles of loans that generate profits through regular payments, such as residential mortgages, student loans and commercial loans.

While current rules require that such asset-backed securities be rated “investment grade” by a nationally recognized statistical rating organization, the 667 page proposal would require asset-backed securities issuers to (1) certify that the assets will likely produce the type of return described in the prospectus; (2) keep at least a 5% stake in the asset backed securities; (3) provide investors with a way to confirm that the assets conform to the issuer’s representations and warranties; and (4) update the SEC with Exchange Act reports on an ongoing basis (as opposed to only updating the SEC with Exchange Act reports after the first year, as these issuers are currently allowed to do).

Credit rating agencies generated large fees in the years leading up to the recent financial crisis when they offered AAA ratings to catastrophically risky bundles of home loans made to unqualified buyers. These ratings failed to give investors sufficient notice of the true risk associated with many asset backed securities, a phenomenon that played a significant role in the financial sector collapse. The SEC has stated that the rule changes, which would also seek to regulate expedited “shelf offerings,” are intended to “eliminate the appearance of an imprimatur” that might result from a rating issued by a government-approved agency.

There is no question that proposed regulations' intent "to better protect investors in the securitization market" is a laudable one.  However, some might suggest that the proposed rules serve mainly to distance the government from the acts of the credit rating agencies, without addressing the conflicts of interest that give rise to flawed ratings in the first place.

Contributed by Carol Villegas

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On March 11, a court-appointed examiner released a 9-volume, 2,200-page report detailing the demise of Lehman Brothers, a Wall Street titan for more than a century. The report lays out how Lehman Brothers used misleading accounting techniques to conceal the bad mortgage holdings that led to its collapse.

Anton R. Valukas, chairman of the law firm Jenner & Block and a former prosecutor, authored the report. He found that Lehman Brothers used "materially misleading" accounting techniques to mask the perilous state of its finances. According to the report, just months before the Company imploded, Lehman Brothers executives used what amounted to financial engineering to temporarily shuffle $50 billion of assets off its books in an effort to conceal the Company's dependence on leverage, or borrowed money. Senior Lehman Brothers executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas.

"Unbeknownst to the investing public, rating agencies, government regulators, and Lehman’s board of directors, Lehman reverse engineered the firm’s net leverage ratio for public consumption," Mr. Valukas wrote.

According to Valukas, Lehman Brothers executives engaged in what the report characterized as "actionable balance sheet manipulation," and "nonculpable errors of business judgment." While the report draws no conclusions as to whether Lehman executives violated securities laws, Mr. Valukas writes in the report that "colorable claims" could be made against some former Lehman executives and Ernst & Young, meaning that enough evidence existed that could lead to the awarding of damages in a trial. 

A large portion of the nine-volume report centers on an accounting maneuver known inside Lehman as "Repo 105." Repo 105 involved transactions that secretly moved billions of dollars off Lehman Brothers’ books at a time when the bank was under heavy scrutiny. According to Mr. Valukas, Mr. Fuld ordered Lehman executives to reduce the bank’s debt levels, and senior officials sought repeatedly to apply Repo 105 to dress up the firm’s results. Repos, short for repurchase agreements, are a standard practice on Wall Street, representing short-term loans that provide sometimes crucial financing. It appears that Lehman used especially aggressive accounting in its Repo 105 transactions: the Company seems to have structured transactions such that it sold securities at the end of the quarter, but planned to buy them back again days later. The effect of the accounting was to artificially and temporarily lower the firm’s debt levels to hit certain targets, making the firm look healthier than it really was.

Contributed by David Sack

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With newly proposed rules regarding naked access and executive compensation, the SEC is making significant inroads in shoring up investors’ confidence in the markets and in the Commission itself. 

One of the Commission’s recent achievements is newly- proposed rules to prohibit broker-dealers from providing customers with “unfiltered” or “naked” access to an exchange or alternative trading system. The proposed rules, which were unanimously approved last week, would require brokers with market access, including those who sponsor customers’ access to an exchange, to put in place risk management controls and supervisory procedures. The proposed procedures would help prevent erroneous orders, ensure compliance with regulatory requirements, and enforce pre-set credit or capital thresholds.

Another notable recent achievement is the new executive compensation disclosure rules that were adopted last December and will take effect with this year’s proxies.

In the past, the executive compensation disclosure rules contained loopholes permitting public companies to hide information regarding equity grants, which is most important part of the package for many executives. Under the new rules, companies will have to disclose this information to investors in a summary table. 

Even under this improved regulatory scheme, however, companies may still be able to minimize the awards they disclose when grants are tied to undisclosed performance goals. The amounts disclosed will reflect only what the company asserts that executives are likely to be paid, with little meaningful way for auditors or investors to assess the reliability of these estimates.

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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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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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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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Eyes welcomes Professor Frank Partnoy of the University of California San Diego, author of The Match King (PublicAffairs April 2009). The Match King is a tautly paced and erudite account of the life and times of Ivar Kreuger, one of the twentieth century's greatest financial innovators—and one of its most notorious scam artists. Partnoy talks to Eyes about lessons investors could learn from Kreuger, and the similarities and profound differences between Kreuger and Bernie Madoff.

Eyes:  Why do investors need to know about Kreuger, a man who died nearly eighty years ago?

Partnoy:  One of the lessons all of us take away from this financial crisis is that we need to remember history.   So many of the financial innovations that recently brought down the banks and AIG are echoed in Kreuger’s story. He was a creator of complex off-balance sheet transactions, he used special purpose entities, he incorporated subsidiaries in regulatory havens. And he manipulated financial statements so that investors wouldn’t understand the truth about what was happening in the bowels of his companies. I think the tragedy is that we should have known about and understood Ivar Kreuger’s story several years ago. 

Eyes:  In your book you give an account of Kreuger’s key role as an innovator of financial products, and you have a great quote from Keynes, who called Kreuger “the greatest constructive business intelligence” of his age. With that in mind, is it fair to compare Kreuger to Bernie Madoff?

Partnoy:  In many ways I think it’s unfair to Kreuger. He, for much longer than Madoff, sustained legitimate businesses. The core of his operations was a compelling idea – the lending of money raised in America to struggling post-World War I European governments in exchange for a match monopoly. He put together these three actors – American investors, European governments, and match producers – in a way that generated gains for all three groups. And he sustained those businesses for many, many years.

Eyes:  Despite their reputations as criminal geniuses, one of the things that is striking about both Kreuger and Madoff is that the frauds they perpetrated were in some ways very crude. How did they go undetected for so long?

Partnoy:  One of the most perplexing aspects of confidence games is that it’s so hard for the people involved in them to see what is happening. Both schemes basically involved paying out very steady, low double-digit payments to people over time, even when markets were volatile. And once people know that there’s a track record of steady, 10 percent payments, they run screaming to get in. One of the lessons of Ivar Kreuger and of Bernie Madoff is that investors should run when they see steady reported returns from a fund. That's a sign not of a well-run business but of danger lurking in the shadows. 

One of the lessons of Ivar Kreuger and of Bernie Madoff is that investors should run when they see steady reported returns from a fund. That’s a sign not of a well-run business but of danger lurking in the shadows.

Eyes:  Looking back both at the 1920s and at the decade preceding our current crisis, how large a role do you think market booms played in the success of Kreuger and Madoff’s schemes? 

Partnoy:  The booms are important because they run parallel with investor psychology. As stocks rise, as companies develop new business models, as financial innovations spread, markets become ripe for financial fraud. Years of stock gains are like the fertilizer that enables fraudulent schemes to flourish and grow. Such gains prime the pump for fraud because they make it easier for companies to come along and tell a believable story about how they can deliver outsized returns. 

Eyes:  If there’s one silver lining to be found when massive frauds are finally exposed, it’s that briefly there is an appetite for reform. And one of the interesting points that you make in your book is that the Securities Act of 1933 and the Securities Exchange Act of 1934 were directly inspired by Kreuger’s fraud . How likely is it, do you think, that Bernie Madoff will inspire similar kinds of reform?

Partnoy:  I’m not especially optimistic. We didn’t get reform immediately after the 1929 crash. We only got reform after the public became very upset about the frauds of Ivar Kreuger and Samuel Insull, and after the federal investigative commission under Ferdinand Pecora started to publicly flog bankers and bring them to their knees. Whether or not we ultimately get reform will turn on whether we experience more scandal and on whether there is someone like Pecora who can galvanize public opinion. It might be the case that Thomas Greene is able to do that with the current version of the financial crisis inquiry commission, but we’ll have to wait and see.

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In the autopsy of last year’s financial meltdown, one of the principal culprits to have emerged is the extraordinarily lax oversight that the boards of some public corporations have exercised over management. On September 17, 2009, Mary Schapiro, the new Chairman of the Securities Exchange Commission, gave a speech, "Address to Transatlantic Corporate Governance Dialogue--2009 Conference," announcing the SEC’s plan to ensure that this practice would come to an end.

Schapiro lambasted boards of directors for failing to reign in management decisions about risk, and suggested that many boards appear to have misunderstand the gravity of risks taken. The new Chairman stated that “[s]enior management took higher returns at face value without questioning why such higher returns were possible for supposedly safe investments and strategies.”

The new Chairman suggests that regulators should ensure that investors in publicly held companies have the opportunity to remove directors who turn a blind eye to irresponsible management. She outlined a proposal by the SEC to remove obstacles to shareholders' ability to nominate candidates for the boards of directors of the companies that they own.

Under the proposed rules, shareholders who otherwise are provided the opportunity to nominate directors at a shareholder meeting would be — subject to certain eligibility and procedural requirements — able to have their nominees included in the company proxy that is sent to all voters.

You can expect a fight. This comment letter (PDF)  in support of the proposal was filed by Labaton Sucharow and other firms representing institutional investors.

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Of all the major players in the mortgage-backed asset debacle of the last two years, credit rating agencies have proven to be the great white whale for injured investors: an attractive target, but difficult to catch. This may be about to change.

The ire directed at the agencies is easy to understand. Only months before the spectacular collapses of Lehman Brothers and AIG, credit rating agencies gave these companies investment grades of A or higher. In email comments uncovered in a recent SEC investigation, one rating analyst suggested that, at her firm, a deal “could be structured by cows and we would rate it.”

Historically, the First Amendment was one of the greatest impediments to suits against the ratings agencies. Ratings agencies argued that a rating is an “opinion” that is entirely protected, or is an assertion about a matter of public interest that is protected by the “actual malice” standard set forth in New York Times Co. v. Sullivan, 376 U.S. 254, 279-83 (1964).

There was a time when such arguments might have made sense. Originally, rating agencies were paid by subscribers to rate most or all of a particular kind of securities for the benefit of the public. However, by the 1970s, they had transitioned to a model where the agencies were paid by the companies whose products they rated, creating insoluble conflicts of interest.

Courts are increasingly unwilling to interpret the First Amendment as giving carte blanche to the agencies.  The U.S. District Court for the Southern District of Ohio recently refused to extend the First Amendment defense to a rating agency because its ratings were not published for the benefit of the investing public at large, but rather were distributed only to a select class of institutional investors.  In re National Century Financial Enterprises Inc., Inv. Litigation, 580 F. Supp.2d 630, 640 (S.D. Ohio 2008).

Such decisions should give investors some cause for hope that credit ratings agencies may yet be held responsible for their role in the market crisis.

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