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

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

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

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

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

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

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

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

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

Contributed by Yoko Goto

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As the scale of corporate fraud in the last years has grown exponentially, it shouldn’t be surprising that settlement amounts are increasing as well.

This is one of the key findings in Securities Class Action filings—2010 Mid-Year Assessment, issued by Cornerstone Research and the Stanford Law School Securities Class Action Clearinghouse. This conclusion is echoed in Trends 2010 Mid-Year Study: Filings Decline as the Wave of Credit Crisis Cases Subsides, Median Settlements at Record High, another recent compilation of securities class action litigation settlements issued by NERA, the defense bar’s go-to economic consulting group.

According to the Cornerstone report, federal securities class action activity continued to decrease in the first six months of 2010, to the lowest semiannual level since the first half of 2007. The decline in filings appears to be associated with the waning of our recent cycle of credit-crisis-related litigation. However, the NERA report shows that the median settlement in the first half of 2010 was $11.8 million, more than three times the 1996 median of $3.7 million—continuing a generally upward trend in median settlements. 

Contributed by Yoko Goto

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Update on Dark Pools Regulation

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

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

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How much of an advantage is it to know about trades three hundredths of second before the investing public? Enough to warrant the concern of the SEC. The issue involves flash trading or high-frequency trading, which gives select traders the ability to see buy and sell orders a fraction of a second before the information becomes public. This tiny time advantage can be highly profitable, because high-speed super computers are able to process the flashed information to help investors capitalize on trading patterns that are not yet public information. Mary L. Schapiro, chairwoman of the SEC commented in a September 17, 2009 speech that, "[f]lash orders may create a two-tiered market by allowing only selected participants to access information about the best available prices for listed securities."

 Last month the SEC voted unanimously to propose regulations that would ban flash trading. If the regulations are adopted, they would effectively prohibit all markets, including equity exchanges, options exchanges and alternative trading systems, from displaying marketable flash orders. The Commission is seeking public comment and data on a broad range of issues relating to flash orders, including the costs and benefits associated with the proposal. It is also seeking comment on whether the use of flash orders in the options markets should be evaluated differently than their use in the equity markets.

The proposed ban on flash orders is just one part of a broader effort by the SEC to more effectively regulate the U.S. stock market in the wake of last year’s financial crisis.

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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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