SEC

Madoff Victims Sue the SEC…Can They?

There’s a very old legal maxim that we Yankees adopted from the British. It’s so old it even has a Latin name: Rex non potest peccare. It means “the King can do no wrong.” This concept of sovereign immunity remains and it is nearly impossible to sue the government for something. Must have been fun for the old British monarchs. Some former US Presidents thought they were immune too. That didn’t work out too well. In any event, there’s an exception. If, for example, the guy waxing the floor at the Pentagon doesn’t warn people and someone slips and falls and breaks their collar bone, you can sue the government for that. So if they are negligent in carrying our their function, you can sue. But you cannot sue them for making policy, declaring war, things like that.

So sure enough two victims of the Bernard Madoff $65 billion Ponzi scheme (as an aside, prosecutors now estimate losses much lower, at around $13 billion, though of course still huge!), Phyllis Molchatsky and Steven Schneider, are suing the SEC for negligence and asking for $2.4 million that they lost. They say the SEC missed countless opportunities (including at least 6 formal complaints) that they should have followed up on to get this guy. They cite an internal SEC report that essentially admits this. The SEC says it’s a meritless case. Everyone acknowledges that mistakes were made on this one. But merely as a legal observer it will be interesting to see whether the court lets this go forward. Was the decision not to follow-up essentially a policy decision of some sort, or was it merely implementing an existing policy? I’ll keep an eye on this one for you guys.

New Financial Regulatory Structure: Are You Systemically Significant?

This is a phrase it appears we will be hearing a lot in the coming months. In the largest proposed overhaul of financial regulation since the 1930s, President Obama and his team have proposed an 88-page restructuring that does not address the financial markets (they’ve decided to leave that to regulatory changes rather than major change in approach) but does address how banks, major financial institutions and hedge funds will be overseen.

It seems to be the feeling of Treasury Sec. Tim Geithner and the Administration that the credit crisis which started in 2007 might have been prevented or the damage restricted if there had been better powers to regulate the large banks and brokerage firms. The proposal, still being reviewed, gives the Federal Reserve much more power to oversee institutions. Given that a number of the governors of the Fed are selected by the very banks being regulated, and the criticism leveled against their preparation for and response to the crisis, one wonders if this is where the new powers should lie, but that is the suggestion.

In addition, according to Marketwatch, an “eight-member, multi-agency financial services oversight council that would seek to identify potential risks with large financial institutions and problematic investment products.” It is not clear if that means they will oversee broker-dealers that are otherwise regulated by the SEC, and whether this means there will still be overlapping regulation that supposedly this process is supposed to streamline. The key is giving the new board power to take action where “systemically significant” companies are failing, similar to the powers currently in the hands of the FDIC with regard to savings and loans.

As more details emerge we can talk more about this. Obama introduced the plan with soaring rhetoric, noting,  “I have always been a strong believer in the power of the free market. I believe that our role is not to disparage wealth, but to expand its reach; not to stifle the market, but to strengthen its ability to unleash the creativity and innovation that still make this nation the envy of the world.” Let’s hope the rhetoric matches the fine print.

Finance Industry Regulatory Reform: Not So Much

SEC Targets Countrywide’s Mozilo

Remember that really tan guy appearing on all the cable news shows when the credit crunch began? That was Angelo Mozilo, head of one of the biggest lenders of subprime mortgages in its day, Countrywide Financial. Reuters has now confirmed that Mozilo is under SEC investigation for civil fraud apparently resulting from alleged insider trading and filing misleading reports to their shareholders and the public. Bank of America, which bought Countrywide last month for about $2.5 billion, confirmed the report.

In October 2006, as things were beginning to get bad, Mozilo changed an otherwise legitimate pre-arranged stock selling program to increase the amount of shares being sold. The question is whether that decision was based on material nonpublic information. Mozilo denies insider trading. Question is whether he will become a poster child of the subprime meltdown. We shall see.

SEC Veteran Returns to Run All-Important Division of Corporation Finance

Reprinted from our sister blog, www.reversemergerblog.com.

Meredith Cross, an SEC staffer through the 1990s, has been selected by Chairman Mary Schapiro to return and run the all-important Division of Corporation Finance. “Corp Fin,” as it is known, oversees every public company’s disclosure.

It took a little longer than expected for this spot to be filled. Ms. Cross has a strong background, having been a lawyer in Corp Fin’s chief counsel’s office, and worked her way up to Chief Counsel. She also worked in the Office of Small Business, which bodes well for those of us focusing on that area. Sometimes we find that the backgrounds of Corp Fin directors did not provide them with sufficient ability to truly understand the unique needs of smaller public companies.

Now that this important role has been filled, we hope the Division can begin to turn its attention to matters that have been on the table for awhile, including our request for the SEC to consider reversing the ill-advised “evergreen” requirement limiting shareholders of former shell companies in their ability to sell shares without registration.

Best of luck Ms. Cross.

Great Update on Securities Issues for Smaller Companies

Reprinted from our sister blog at www.reversemergerblog.com

I was again honored to be part of an amazing panel of prominent lawyers at the American Bar Association spring meeting of the Section of Business Law at the spanking new convention center in Vancouver. Here are a few interesting highlights:

• SEC Director of Small Business Policy Gerald Laporte indicated it is not likely there will be any further delay in implementing Sarbanes-Oxley Section 404 compliance for smaller public companies.
• The SEC is pushing the “compliance and disclosure interpretations” (CD&Is) as a place where previously interpretations mixed with no-action letters and the like. Keep an eye on these.
• One CD&I makes clear, for example, that vested unexercised stock options can be included in net worth to determine accredited status.
• Mr. Laporte addressed the fact that there may be some technical amendments to the smaller public company reporting regime rulemaking that eliminated Regulation S-B. Included in this might be clarifying that a no revenue company (such as a shell company) can include a “plan of operation” rather than full management’s discussion and analysis section. But he all but said it appears you can do it based on existing regulations, but they might want to clarify.
• A senior PCAOB representative gave a good tip for issuers: in your audit engagement, have the auditor promise to infom the company if its engagement is ever reviewed by the PCAOB. Without that they have no obligation to tell the company.
• Mary Schapiro of the SEC is not the biggest fan of IFRS (conforming all accounting standards to one).
• Update on Regulation D and pending proposal:
  • The effort on getting the 2007 proposal passed may have “run out of steam” according to Laporte. They are waiting to see what appetite Schapiro and other new commissioners have for finishing it.
  • Congress recently encouraged the SEC to address qualification standards for accredited investors in hedge funds, and since the SEC probably won’t single them out, it might be the impetus to finalize the Reg. D proposal.
  • The SEC Inspector General recently recommended reinstating the requirement that Form D be filed as a condition to receiving the Reg. D exemption. Staff is not thrilled.
  • It will take awhile before “one stop” filing of Form D with SEC and the states will be accepted (if ever) and implemented. There is a consultant working on it but that seems to be about it. For now, it’s still electronic with SEC and paper with the states.
  • Changes to new Form D: when is first sale? Seems to suggest if you take someone’s money and they give it to you irrevocably, even if not closed, that it counts as a sale and the Form D has to be filed within 15 days thereafter. Problem is whether you then have to pre-file in states.

Thanks to moderator and friend Lee Liebolt for arranging this very interesting and dynamic panel.

Another One..A Mere $20 Million Ponzi Scheme

The SEC went after a Colorado man this week for taking $20 million from about 40 midwest investors. He used the money to buy cars and artwork and never invested it. But he sent them statements showing they were earning 7-20% on their money annually. When withdrawals were requested he used new investor money to pay. Classic Ponzi scheme. The SEC was in court this week trying to get the assets of Shawn Merriman, 46, frozen.

His lawyer says Merriman has called and personally apologized to each of his clients, and has gone voluntarily to criminal prosecutors and gave them information. “We lost everything” was the refrain I saw on TV from the bilked friends and others. There are more of these, they are beginning to come out of the woodwork. The SEC is trying hard to negate the view of some that the nine times the SEC investigated Madoff and found nothing showed some real deficiencies in their techniques.

SEC Offers Chinese Menu Options on Short Selling

Yesterday, in a somewhat unusual move, the SEC proposed five different possible ways to limit short selling, where an investor bets on a stock going down, sometimes causing the very result simply by making the bet. Folks will have two months to put in comments on the proposals. Note: the SEC really really does look at comments and typically feels obligated to report in its final release what the commenters said. So don’t hesitate if you are interested in this topic.

One key proposal involves a return of one of a number of possible versions of the “uptick rule” which was eliminated in 2007 following studies that basically showed the rule didn’t really work, and additional rules put in such as a requirement for hedge funds to report all their shorting activity.  The uptick rule says you can’t short a stock if the last trade was at a higher price than the one before, or if it is sold short at a price higher than the last sale price. The rule went into place way back in 1938. The original purpose was to stop fraudsters who pooled their money to short a stock for the sole purpose of driving down its price so they can win their bet.

The Democrats now control the SEC with three votes, and the two Republicans on the Commission expressed concern about the return of uptick. Other proposals offered for comment would stop shorting only if a stock drops a certain amount (they are suggesting 10%). Regardless of some skepticism, SEC Chair Mary Schapiro feels pressure to deal with this, telling the hearing that they’ve got more emails and calls about short selling than anything else since she took office in January.

See my last entry on this the other day for my thoughts on short sellers, some of whom indeed serve an important purpose. Don’t ever complain about government action unless you participate in the process. If you have thoughts on this, let the SEC know. You can submit a comment easily online at www.sec.gov under “proposed rules.”

Will Bernie Be Forced into Bankruptcy?

The Wall Street Journal reports that several bilked investor clients of Bernard Madoff are trying to get a court to force Bernie into involuntary bankruptcy. This would require lifting a stay on that action imposed in connection with the SEC’s case against Madoff. The SEC and the prosecutors don’t want the distraction, and costs of trustees and such, that a bankruptcy would yield. The clients trying to force the bankruptcy say the SEC and prosecutors are not as good at finding and protecting assets as people who work with the bankruptcy court, who are expert in that.

Bernie’s firm is being liquidated through a trustee in an action taking place in bankruptcy, but this proposed action would require him to go personally bankrupt. There are some who are a little concerned when the SEC these days says, “Trust us, we have everything under control.” Or if federal prosecutors, in the same world as those who withheld evidence against former Senator Ted Stevens and now may face criminal charges (Stevens’ conviction was overturned the other day), say the same thing. But I do think that the significant costs involved in a bankruptcy could be problematic. So up to you court.

SEC To Propose Limits on Short Selling Today

There’s an open meeting of the SEC at 10 am today where the agenda is as follows: “The Commission will consider whether to propose rules restricting short sales under certain circumstances.” As we know, in a short sale, the investor bets that the stock will go down and profits if it does. It has been reported the SEC is considering reducing the impact of “death spiral” moments when short sales drive a stock price down, then there’s more short sales, driving it down even more. I hear that what they might propose is that after a stock has dropped a certain amount in a certain time, short sales would be stopped for some period. There is a belief that restricting short sales might have helped the market not drop as much as it did recently. I am not so sure that’s true, but some feel that shorts killed Bear Stearns, for example.

No question short selling has been a tool of bad guys to try to manipulate a stock even where there is nothing particularly wrong with the company. But short selling is also a tool of good guys legitimately concerned about the direction of a company, serving as a message to management when an investor feels things are not going right. It’s also a tool of investors and hedge funds simply wanting to hedge their investment to protect their downside. So the SEC needs to balance this. The best way is to use their enforcement dollars to nab the cheats on stock manipulation. But probably that’s not going to happen. So instead it looks like they are simply going to limit it to try to reduce the impact of the next bear market.

In the meantime, Ms. Schapiro, I hope you will appoint a new head of Corporation Finance soon, so the agenda of those of us working with public companies, in particular smaller ones, can move forward.

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