Archives For securities litigation

When the SEC announced its settlement with Citigroup a couple of weeks ago, I said:

The SEC has reached another peculiar settlement, this time $75 million from Citigroup, plus fines against executives. As with the Goldman settlement, Citigroup didn’t admit fraud, or even, as in that case, a mistake. Citigroup was accused of misleading investors about its exposure to subprime. The bank knew it was exposed to the housing market, but thought its senior tranches were safe. The misrepresentation concerned $37 billion and basically the life or death of the company. The fine was $75 million, which either ludicrously fails to match the misrepresentation, or suggests Citigroup didn’t really do anything wrong. If it didn’t do anything wrong, then why a fine? * * *And then there’s the problem that whatever was going on, Citigroup, or more accurately its shareholders, were getting hit for mere negligence of its executives * * *

I noted that the SEC settlement essentially boils down to questioning executives’ business judgment, and that it smacked of a politically motivated move to show the SEC was doing something about the financial meltdown.

The SEC defended the settlement by citing Judge Rakoff’s approval of the earlier SEC BOA settlement. But it forgot to mention that Judge Rakoff had thrown out the first version of that settlement as “half-baked justice” and “inadequate and misguided.”

Now the court reviewing the Citibank settlement is in the process of pulling a BOA. Here’s the WSJ article:

A federal judge refused to approve the Securities and Exchange Commission’s $75 million settlement with Citigroup Inc. over the bank’s disclosure of subprime-mortgage problems, saying she is “baffled” by the proposed pact. * * * The judge, striking a frustrated tone, fired several questions at the SEC, among them why it pursued only two individuals in the case and why Citigroup shareholders should have to pay for the alleged sins of bank executives. * * * “You’ve focused on two individuals and I can’t for the life of me figure out why,” the judge told the SEC lawyers. * * * The judge * * * suggested the [Citigroup executives] “could only be culpable if they knew” the size of the exposure.

The judge had some of the same problems I did. If there’s fraud, the settlement is inadequate. If none, why the fine? And in any event why should the shareholders be left holding the bag?

What it boils down to is that the courts are getting tired of playing political charades with the SEC.

The SEC has reached another peculiar settlement, this time $75 million from Citigroup, plus fines against executives. As with the Goldman settlement, Citigroup didn’t admit fraud, or even, as in that case, a mistake. Citigroup was accused of misleading investors about its exposure to subprime. The bank knew it was exposed to the housing market, but thought its senior tranches were safe.

The misrepresentation concerned $37 billion and basically the life or death of the company. The fine was $75 million, which either ludicrously fails to match the misrepresentation, or suggests Citigroup didn’t really do anything wrong. If it didn’t do anything wrong, then why a fine?

As the WaPo’s new financial crime blog asks:

What if the reality is that, in the SEC’s view, Citigroup’s alleged crimes weren’t such a big a deal, in the big scheme of things? What if any more severe a punishment against the bank or its executives would be disproportional to the alleged wrongdoing? If that’s the SEC’s view, then why bring the case in the first place? Because Citigroup was a big actor in the financial crisis, and regulators needed to show that it would be punished — however lightly — for wrongdoing that helped feed the crisis. That’s called symbolism. And symbolism might have value, so long as we call it what it is.

Or maybe we could call it something else – another politically driven settlement, in what is becoming a disturbing trend.

And then there’s the problem that whatever was going on, Citigroup, or more accurately its shareholders, were getting hit for mere negligence of its executives, as discussed in today’s WSJ. The only way you get fraud out of this is that the securities law section Citigroup was charged under (Section 17(a) of the 1933 Act) includes fraud. The WSJ quotes the SEC’s assistant enforcement chief as noting “[t]here’s not a doubt in the world that this is an antifraud provision.” Well, yeah, but that doesn’t mean that the SEC found fraud, or even recklessness, and it didn’t. The article also noted:

John Coffee * * * said the statute has some “symbolic” value as a fraud charge. “If the SEC wants to call it that, they can.”

Guess so.

Note that the Delaware chancery court dismissed the shareholder suit against Citigroup directors last year because the allegations didn’t show conduct outside the protection of the business judgment rule, and specifically not in breach of the “Caremark” bad faith standard. More precisely, as I discussed at the time,

Chancellor Chandler held that merely claiming that directors made a bad business decision by failure to monitor business risk was not enough to excuse demand in a derivative suit. * * *

Plaintiff alleged that the board (a majority of whom had also been on the Enron board) ignored problems “brewing in the real estate and credit markets” starting in 2005. And, indeed, plaintiff likely could support that claim. The Citigroup management basically bet the company’s future on the vast Ponzi scheme of the real estate market amid growing signs that the scheme was unraveling.

Chancellor Chandler, however, rightly held that this is not the sort of deliberate failure that will establish a duty of loyalty claim for breach of Caremark duties. As the Chancellor reasoned, courts should not second-guess business decisions, particularly when this second-guessing leads to personal liability.

The court’s unwillingness to second guess a business decision rests on two sound bases: courts are poor managers of corporations; and excessive liability for negligent management will deter the sort of risk-taking that diversified shareholders would want corporate managers to engage in. True, the judgment looks like a bad one in retrospect. But we must be concerned about the signals liability sends to corporate executives who do not have the benefit of hindsight.

The important point for present purposes is that this is the sort of judgment about internal corporate governance that is traditionally left to state court. Yet the SEC has decided, in effect, to impose its own rule.

Of course this was supposedly about disclosure, not substantive management. But you have to know about a risk to disclose it. In fining Citigroup for breach of a duty to know, the SEC is getting quite close to the same issue as in the state court case – what did the executives have a duty to know?

The other difference between the cases is that the big SEC fine was against the company rather than liability of executives as in the Delaware case. But should we worry less about the liability because the firm’s innocent shareholders pay it? Not that it makes much of a difference given indemnification and insurance.

By little steps such as this case is the law of corporate governance being shifted from the states to the feds. It is far from clear on general principles that the SEC is the appropriate decision-maker. This case does not give cause for comfort on that issue.

The SEC is heralding the $550 million settlement in its suit against Goldman as “the largest penalty ever assessed against a financial services firm in the history of the SEC,” and “a stark lesson to Wall Street firms that no product is too complex, and no investor too sophisticated, to avoid a heavy price if a firm violates the fundamental principles of honest treatment and fair dealing.” Surely the agency had a strong incentive to try to use the Goldman settlement to obscure the memory of Madoff, Stanford and the Bank of America settlement. Meanwhile, today’s NYT concludes its Goldman story with a quote suggesting Goldman got off lightly.

The truth is far more disturbing: the SEC got a big payday in what would have been seen as a strike suit had it been a private securities class action lawyer.

As I said when the suit was filed, there was always a serious problem with materiality. Goldman was accused of not affirmatively disclosing John Paulson’s role in selecting the portfolio that its CDO purchaser IKB bet on. This was supposedly important because Paulson, a notorious bear on the real estate market, was betting against the portfolio. However, the materiality of this non-disclosure was highly questionable given the facts that:

  • IKB, a sophisticated player that had engaged in the same kind of deals for its own gain presumably knew the basic risks in the transaction. Paulson’s presence on the other side was of dubious importance given that, at the time, he was a fairly minor player who had been losing his bets, not some proven super-guru with psychic powers.
  • The portfolio manager, ACA, and not Paulson, was ultimately responsible for the portfolio’s contents. The WSJ quoted a derivatives expert as saying, “if ACA performed an independent analysis and concluded that the [Abacus] portfolio met ACA’s criteria, I’m not sure what the issue is. * * * One sophisticated market participant thought that the portfolio was a good ‘buy’ and another a good ‘sell’ — that happens all the time in financial markets and is what makes markets.”
  • ACA did know about and didn’t disclose Paulson’s involvement and yet was not named in the SEC complaint. As the party charged with the obligation of selecting the portfolio, ACA was a lot closer than Goldman to being a fiduciary with an affirmative duty to disclose.

So why did the SEC sue despite this obvious materiality problem?

  • Its own complaint makes clear the strong connection between the suit and the financial reform bill then pending in Congress by alleging that “[s]ynthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.” Clearly a suit alleging that Goldman, which had made out quite well from the financial crisis, particularly in the AIG bailout, had fraudulently sold the type of securities that helped trigger the crisis.
  • A WSJ story bolsters this explanation noting that the SEC had begun its probe on the transaction at least by August 2008, never offered Goldman the opportunity to settle, and had not contacted Goldman from September, 2009 until suddenly moving ahead with the charges during the critical final Congressional deliberations on financial reform.
  • The SEC’s usual role is to protect unsophisticated individual investors, not sophisticated market players like IKB. Why did this suddenly change in this case?
  • The SEC was under a lot of political pressure to come up with something out of the financial crisis. This case was evidently the best it could do.
  • The suit was disposed of as soon as it had no more political use – right after financial reform squeaked through Congress. Even Carl Levin expressed pleasure with the settlement. Why shouldn’t he? He got what he wanted.

And so now we have the settlement. What exactly did Goldman admit? Here it is:

Goldman acknowledges that the marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was “selected by” ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure.

Well, ok, we knew the marketing materials were “incomplete” because they didn’t disclose Paulson’s role. I am not surprised that Goldman now believes this nondisclosure was “a mistake” which Goldman “regrets.” I would regret any actions that cost me $550 million plus attorneys’ fees.

But is that all there is? What about fraud, which would include an admission that the omission was material? Every disclosure is “incomplete” in some way. The materiality requirement is designed to protect parties from having to dump bewilderingly huge amounts of information on the market.

The WSJ quotes a former SEC enforcement lawyer as noting that dropping the strongest fraud charge is “usually a strong indication the SEC had some doubt whether it could prove intentional fraud.” Well, if that’s true, then what supports the extraordinary fine, of which less than half is going to the supposed victims who bought the securities?

Notably, according to the above WSJ story, the same Republican commissioners who opposed bringing the suit also opposed the settlement:

People familiar with the matter say Republican Commissioner Kathleen Casey questioned the SEC staff Thursday on their decision to abandon the strongest fraud charge and strike a settlement involving a lesser allegation, and given that, how the SEC could justify such a large penalty on a lesser charge. The political split over the case comes at a time when the agency remains under fire for its policing of the financial markets during the financial crisis. The SEC commissioners often split on party lines over policy decisions, but rarely do so on such high-profile enforcement cases. The disclosure of the dispute also raises fresh questions about how strong a case the SEC had against Goldman.

The settlement is disturbing for the additional reason that it leaves costly uncertainty about what duties Wall Street players now have. This issue now becomes very important as the SEC must rule on the fiduciary duties of broker-dealers under Section 913 of Dodd-Frank.

As I testified in a Senate hearing (at 7-8) on whether to impose fiduciary duties on investment bankers:

If the facts are as alleged [in the Goldman complaint] and the non-disclosures are material, Goldman may be held liable under existing law and no new fiduciary duty is necessary to create an obligation to disclose. On the other hand, if Goldman did not breach an existing duty to disclose material facts, there is no apparent justification for holding Goldman liable under any theory, including a fiduciary theory. This is true whether or not Goldman can be deemed to have an interest that conflicts with that of its customer.

More specifically, I asked soon after the complaint was brought:

[W]hat lesson should Wall Street take away from this case? What, exactly, does a bank in Goldman’s position have to disclose to a customer? The identity of another customer on the other side, as the complaint suggests? Only when that customer is somebody like Paulson. What does that mean? Only if the customer has selected the portfolio? What does that mean? Many deals are put together with buyers in mind. Suppose ACA (the collateral manager) assembles the portfolio here with Paulson in mind, and then Paulson says, “that’s for me. Now I’ll invest.” Is this more “material” than having Paulson take the initiative? Suppose they collaborate in putting the portfolio together?

What clues on all this can be gleaned from a settlement that involves a huge amount of money but only an admission of a “mistake”?

The bottom line is that this suit has proved to be no more than a common “strike” suit, no better than the sort of private securities class actions that triggered Congressional reform 15 years ago. Instead of attorneys’ fees, the SEC’s objective appears to have been purely political. In the end it extracted a ransom payment from Goldman so the firm could reclaim its reputation and get back to business.

The court must now review the settlement. It should take a cue from the dissenting Commissioners and reject it because of the puzzling and troubling inconsistency between the amount of the settlement and Goldman’s meaningless admissions. The SEC should have to prove exactly what Goldman did wrong. This will force Goldman to either litigate or make a meaningful settlement. Goldman is hardly an object of pity at this point. In any event, the issues here go far beyond Goldman to, among other things, the proper role and function of the SEC.

It is sad that the SEC not only cannot be trusted to find fraud, but that it can no longer be trusted to litigate and settle cases involving the supposed frauds that it finds. But this is where we find ourselves in the days following “financial reform.”

The Supreme Court, per Scalia, opined yesterday in Morrison v. National Australia Bank that foreign plaintiffs who transacted in foreign shares on a foreign exchange (hence, “f cubed”) could not bring a 10b-5 action. Margaret Sachs has a good analysis on the Glom. I want to emphasize one important and generally overlooked aspect of the case: its effect on jurisdictional competition.

As Professor Sachs observes, the Court threw out the Second Circuit’s longstanding conduct/effects analysis as unsupported by the statute and difficult to apply, and substituted an arguably clearer and more predictable transactional test.

Justice Scalia noted a basic problem with the prior test: “The probability of incompatibility with the applicable laws of other countries.” He noted:

Like the United States, foreign countries regulate their domestic securities exchanges and securities transactions occurring within their territorial jurisdiction. And the regulation of other countries often differs from ours as to what constitutes fraud, what disclosures must be made, what damages are recoverable, what discovery is available in litigation, what individual actions may be joined in a single suit, what attorney’s fees are recoverable, and many other matters. * * * [Foreign amici] all complain of the interference with foreign securities regulation that application of §10(b) abroad would produce, and urge the adoption of a clear test that will avoid that consequence. The transactional test we have adopted—whether the purchase or sale is made in the United States, or involves a security listed on a domestic exchange—meets that requirement.

Justice Stevens, concurred in the result because, he said, “this case has Australia written all over it.” However, he objected to the reasoning:

The Court . . . elects to upend a significant area of securities law based on a plausible, but hardly decisive, construction of the statutory text. In so doing, it pays short shrift to the United States’ interest in remedying frauds that transpire on American soil or harm American citizens, as well as to the accumulated wisdom and experience of the lower courts.

Professor Sachs worries that the opinion ignores

the loss of investor protection that will result from the switch to the transaction test.  For example, it leaves unprotected US citizens who purchase or sell securities outside the United States.  Likewise unprotected are foreign citizens trading abroad who are victims of domestic conduct perpetrated by Americans over whom the foreign forum lacks personal jurisdiction.

But she notes that Justice Scalia’s approach recognizing differences in countries’ securities regulation “may help to promote globalized securities markets.” I would add that the particular way that it promotes globalized securities markets is by adopting a test that enables investors to choose the applicable regulation by deciding where to trade.

The point that Justice Stevens and Judge Friendly, who developed the Second Circuit’s test, miss is that investors may not want the “protection” of U.S. law because it may actually be better for plaintiffs’ securities lawyers. The Second Circuit test makes U.S. law like the ex-lover in the old Dan Hicks song: How can I miss you if you won’t go away? (Sorry, I’ve always wanted to use that in a blog post.)

I’m delighted to report that the Liberty Fund has produced a three-volume collection of my dad’s oeuvre.  Fred McChesney edits, Jon Macey writes a new biography and Henry Butler, Steve Bainbridge and Jon Macey write introductions.  The collection can be ordered here.

Here’s the description:

As the founder of the Center for Law and Economics at George Mason University and dean emeritus of the George Mason School of Law, Henry G. Manne is one of the founding scholars of law and economics as a discipline. This three-volume collection includes articles, reviews, and books from more than four decades, featuring Wall Street in Transition, which redefined the commonly held view of the corporate firm.

Volume 1, The Economics of Corporations and Corporate Law, includes Manne’s seminal writings on corporate law and his landmark blend of economics and law that is today accepted as a standard discipline, showing how Manne developed a comprehensive theory of the modern corporation that has provided a framework for legal, economic, and financial analysis of the corporate firm.

Volume 2, Insider Trading, uses Manne’s ground-breaking Insider Trading and the Stock Market as a framework for many of Manne’s innovative contributions to the field, as well as a fresh context for understanding the complex world of corporate law and securities regulation.

Volume 3, Liberty and Freedom in the Economic Ordering of Society, includes selections exploring Manne’s thoughts on corporate social responsibility, on the regulation of capital markets and securities offerings, especially as examined in Wall Street in Transition, on the role of the modern university, and on the relationship among law, regulation, and the free market.

Manne’s most auspicious work in corporate law began with the two pieces from the Columbia Law Review that appear in volume 1, says general editor Fred S. McChesney. Editor Henry Butler adds: “Henry Manne was an innovator challenging the very foundations of the current learning.” “The ‘Higher Criticism’ of the Modern Corporation” was Manne’s first attempt at refuting the all too common notion that corporations were merely devices that allowed managers to plunder shareholders. Manne saw that such a view of corporations was inconsistent with the basic economic assumption that individuals either understand or soon will understand the costs and benefits of their own situations and that they respond according to rational self-interest.

My dad tells me the sample copies have arrived at his house, and I expect my review copy any day now.  But I can already tell you that the content is excellent.  Now-under-cited-but-essential-nonetheless corporate law classics like Some Theoretical Aspects of Share Voting and Our Two Corporation Systems: Law and Economics (two of his best, IMHO) should get some new life.  Among his non-corporations works, the classic and fun Parable of the Parking Lots (showing a humorous side of Henry that unfortunately rarely comes through in the innumerable joke emails he passes along to those of us lucky enough to be on “the list”) and the truly-excellent The Political Economy of Modern Universities (an updating of which forms a large part of a long-unfinished manuscript by my dad and me) are standouts.  And the content in the third volume from Wall Street in Transition has particular relevance today, and we would all do well to re-learn the lessons of those important contributions.

The full table of contents is below the fold.  Get it while it’s hot! Continue Reading…

I have been asked a few times today to opine, as a corporate and securities law scholar, on President Obama’s nomination of Judge Sonia Sotomayor for the Supreme Court.  ( has a couple of quotes reflecting my thoughts.)

I have three main comments:

First, this is a pivotal time in American securities and corporate law jurisprudence.  Any appointment to the Supreme Court has the potential to significantly influence the evolution of corporate and securities law.  The Supreme Court has recently granted certiorari for a couple of big-ticket securities and corporate law cases, and there is every reason to believe, particularly in light of the SEC’s recently announced rulemaking and Senator Schumer’s recently proposed Shareholder Bill of Rights Act of 2009, that the Supreme Court will continue to handle important business matters like these in the near future.  Federal preemption, Securities and Exchange Commission rule-making authority, corporate governance reform, damages, and the reach of federal securities laws are all incredibly important topics that are certain to come before the Supreme Court in the next few terms.

Second, it is difficult to gauge where exactly Judge Sotomayor falls on the spectrum of pro-management versus pro-investor jurists.  Is she a shareholder primacist, does she defer to the invisible hand of the market, does she interpret Section 10(b) of the Securities Exchange of 1934 broadly or narrowly?  These are questions to which Judge Sotomayor’s judicial writings provide no clear answers.  Sotomayor was nominated to the federal bench by President Bush, so one might have suspected that she would embrace ardent pro-management leanings.  However, the business and securities opinions she has penned have not evinced such a bent.  For example, she penned the Second Circuit’s relatively recent shareholder-friendly opinion in Merrill Lynch v. Dabit (a detailed summary of the case is available here).  Indeed, upon reflection, one recalls that Sotomayor was viewed as a less conservative Bush nominee (proposed by Moynihan) when she was appointed, and it was President Clinton who elevated her to the Second Circuit.  Yet Judge Sotomayor has dismissed numerous cases in favor of management despite her more liberal affiliations.

Third, Judge Sotomayor has a strong background in sophisticated corporate and securities law cases, as she comes from the Second Circuit, a jurisdiction that generates a significant number of these cases (given that Wall Street falls within the jurisdiction of the Second Circuit).  This bodes well, in that pundits often query whether Supreme Court jurists fully appreciate the complex business nuances arising in many securities and corporate matters.  That Judge Sotomayor has been both a district court judge and an appellate judge in a jurisdiction where these difficult business cases arise delights me, and I think she would add a valuable perspective on the Supreme Court.

Taking off the “corporate and securities law scholar” hat, and putting on the “Chair of the American Association of Law Schools Section on Women in Legal Education” hat, I can say that I am thrilled that President Obama has nominated a woman to the Supreme Court.  I was disheartened that Justice O’Connor’s seat was not filled by a woman, but I remain optimistic that someday the number of women on the Supreme Court will mirror, as a percentage, the number of women in the average law school entering class.

Of course, given that, in the almost 30 years since a woman first ascended to the United States Supreme Court, we appear to have reached a plateau, with only two women serving at any one time over the past 16 years, perhaps my optimism is misplaced.  I remain optimistic nevertheless.

is here, over at eCCP, and differs somewhat from Thom’s.

The takeway excerpt is:

Credit Suisse has important implications for antitrust practice. The decision’s effect is to narrow the scope of antitrust law and to invite efforts by regulated industries to narrow it still further. The court’s “clearly incompatible” standard is new and (though it purports not to) seems to water down considerably the old “plain repugnancy” test of Gordon v. New York Stock Exchange, Inc. 422 U.S. 659, 682 (1975). Under the new incompatibility standard, there no longer has to be an actual conflict between antitrust and other federal law for antitrust implicitly not to apply. Even a mere regulatory overlap may now be sufficient to trigger antitrust immunity. (Recall that in Credit Suisse the Court assumed that both antitrust and the SEC disapproved of the tying and other practices in question, and yet the Court still considered the two bodies of law incompatible on account of the regulatory overlap.) ….

Going forward, the Court will need to tighten the rule in Credit Suisse if it wants antitrust to continue to operate as Congress intended it to in conjunction with the compartmentalized maze of federal regulatory law. No one thinks that securities firms should be exempt from the legal obligations that generally flow from non-securities law (antitrust aside). If we expect to hold securities and other regulated firms accountable for torts and breaches of contract, or for crimes and discrimination, then why not also hold them accountable for antitrust violations? If Congress says otherwise, that is one thing. But if Congress is silent on the question, a federal agency should not have have any more power than a state to confer antitrust immunity upon those that it regulates. Of states we require a clearly articulated policy that presents an actual conflict, not merely the possibility of future potential incompatibility. From federal agencies we should not expect any less.

Just yesterday, in its historic decision in Leegin, the Court strongly reaffirmed its confidence in the Rule of Reason’s workability by overturning Dr. Miles and extending the rule’s reach to vertical RPM. That workability should make us equally confident that antitrust can peacefully coexist with the reguatory state.

Securities fraud class-actions are down. In an op-ed in yesterday’s WSJ, Joseph Grundfest observed that both the number of such actions and the dollar value of total damages claims have dropped dramatically since mid-2005. Why has this decline occurred? Grundfest considers several possible reasons.

First, the decline might be due to the criminal prosecution of Milberg Weiss, the leading securities fraud plaintiff firm. Grundfest rejects that explanation:

[T]here is no shortage of plaintiff class-action lawyers in America, and the barriers to entry in class-action securities fraud are quite low. The lawyers who abandoned Milberg in droves haven’t forgotten how to file class action complaints, and their incentives to sue every firm in sight remain as strong as ever.

Next, Grundfest considers whether the decline is due to recent “strong equity markets, combined with low volatility.” He rejects that explanation because “the change in the litigation market is rather sudden in comparison to a relatively smooth shift in the larger stock market patterns” and because “current activity levels are low even when measured by pre-boom standards” (i.e., even when compared to levels preceding the boom-bust period of the late 1990s).

Finally, Grundfest considers a theory he deems more plausible: there are fewer securities fraud class actions because there is less fraud, and there is less fraud because the government (post-Enron, WorldCom, and Sarbanes-Oxley) has more effective tools for prosecuting fraud:

From this perspective, class-action securities litigation is in decline because there is a new, tougher and superior enforcement mechanism in place. The SEC and the Department of Justice now insist that any corporation suspected of a sufficiently serious fraud conduct an internal investigation that will finger the executives responsible. The corporation must also cooperate in prosecuting these executives. This enforcement technique is stunningly effective, if often overbearing. It eliminates the government’s need to conduct expensive and lengthy investigations and provides the authorities with extraordinary leverage over every executive suspected of wrongdoing. Private litigation doesn’t have an equivalent deterrent effect because it can’t threaten executives with jail and because damages are almost always paid by corporations and insurers, not the executives who cause the fraud.

I’m wondering what others think about this theory. It would be interesting to see whether both accounting fraud and non-accounting fraud claims have decreased by similar proportions. The recent government enforcement efforts have been focused on accounting fraud, so if we’re seeing a greater decrease in accounting fraud claims than in non-accounting fraud claims, then Grundfest’s “supply side” story may be plausible. If non-accounting fraud claims have been decreasing by a similar proportion, then it would seem the decrease should be attributed to something else.

In any event, I’d be reluctant to infer from Grundfest’s statistics that increased prosecutorial activity is desirable. I’d echo Larry Ribstein’s query:

Does the dip in securities litigation suggest that the corporate criminal prosecutions have been worth these costs? … [E]ven if we do have less fraud to litigate, I’d wonder whether it’s been worth the price. Do we have less risk-taking? A zero fraud world is not necessarily paradise.

Grundfest, of course, is well-aware that stepped up prosecutorial activity can have serious negative effects. Not too long ago, he wrote eloquently about the downsides of such prosecutorial activity in the New York Times. Some highlights:

The Supreme Court has overturned Arthur Andersen’s conviction for obstruction of justice in the Enron case. But to Andersen, the court’s ruling doesn’t matter, the original trial at which it was convicted didn’t matter and the verdict at any coming trial won’t matter. Andersen was destroyed when it was indicted.

… Andersen’s demise did serve as a stern reminder to corporate America that prosecutors can bring down or cripple many of America’s leading corporations simply by indicting them on sufficiently serious charges. No trial is necessary.

… Prosecutors are aware of their power, as are potential corporate defendants. Both sides have therefore reached an entente cordiale in which no major corporation has been forced out of business since Andersen’s demise. Instead, corporations have entered into deferred-prosecution agreements, paid huge penalties, and undertaken fundamental internal reforms, all under conditions that allow the corporation to survive.

… The upside of this arrangement is clear. Corporations now have an even more powerful incentive to abide by the law, to root out wrongdoing, and to cooperate with governmental authorities. Unbridled prosecutorial discretion will not end fraud in corporate America, but wrongdoing will certainly decline as executives learn that they are expendable if a prosecutor simply threatens the corporation.

… The downside is just as clear. The prosecutor’s decision to indict is largely immune from judicial review. The prosecutor acts as judge and jury. Traditional due process safeguards, like the right to confront witnesses, can’t protect the potential corporate defendant. The innocent can therefore be punished as though they are guilty, and penalties imposed in settlements need not bear a rational relationship to penalties that would result at a trial that will never happen.

No More 10-Qs?

Bill Sjostrom —  7 November 2006

According to the Financial Times (via, the Big Four accounting firms will recommend in a joint paper to be released tomorrow that the current system of quarterly reports be scrapped for “real-time, internet based reporting encompassing a wider range of performance measures.” It will be interesting to see what exactly they have in mind. In particular, how will liability issues be addressed? Obviously, more frequent and quicker disclosure is good for market efficiency but increases the chances of misstatements and omissions of material facts. Oh, yeah, the SEC is going dis-imply Rule 10b-5 private causes of action and cap auditor liability, so maybe increased liability exposure isn’t a big concern. But seriously, in addition to potential 10b-5 liability, how will the proposal impact incorporation by reference into registration statements and the attendant potential Section 11 and 12 liability?

In a post over at Co-op, Dave Hoffman wonders why so many in the blogoshpere are publicly outraged by Jeff Skilling’s 24-year sentence, but not, seemingly, by similar-length sentences for drug crimes.  Larry and Christine Hurt (hers is the fifth comment down on Dave’s post) deftly handle the response.

As I noted a while back:

there is a huge and under-appreciated difference, even — yes, it’s true — in the business world, between the bad behavior of private individuals and firms and that of the government.  Among other things, the former is generally localized, susceptible to economic pressures, and, quite often, ambiguous in its effect.  The latter is far-reaching, corruptible, difficult to constrain, and largely immune to economic limits.  And these are just the utilitarian concerns.  These differences are all-too-well appreciated in other contexts (and I often find myself in embarrassing agreement with the crackpots on left-wing radio who fulminate against the exercise of excessive state power when it comes to wire-tapping, war-making, the drug war and online gambling), but here, where the social costs are so enormous, there is naive belief in the government rather than skepticism.  It’s outrageous.

The social costs I refer to here are those attributable to over-deterrence of risky, innovative, entrepreneurial behavior.  In point of fact, although I find sentences for minor drug crimes to be outrageous, as well, I seriously doubt that the social consequences of over-deterrence loom as large.  (But if Dave thinks public criticism of one requires public criticism of the other, he should now feel satisfied, right?)

The problem in the drug war context is quite different, at least for me.  Given a social (or at least government) policy of deterring drug use, perhaps draconian sentences are required and appropriate (given the difficulty of deterrence).  But I happen to think the policy itself is idiotic and the practice shouldn’t be deterred in the first place.  In that sense, I think punishments for drug use are approximately infinitely too large.  But there’s little sense in quibbling over the length of sentencing and optimal enforcement policy given my priors.  

The same doesn’t go for corporate fraud:  It should be deterred.  The question there, however, is how to do so optimally, given the staggering social costs of over-deterrence; the risk of self-aggrandizing, politically-motivated, error-prone prosecution; and the reality of pretty good, existing agency-cost controls.  Was Skilling’s prosecution, conviction and sentencing here optimal from a deterrence standpoint?  I doubt it, and so do many others.

So Skilling’s sentence is problematic not only because, as Larry points out, it is probably disproportionate to the actual crime (which I take it is the point Dave wants to see the rest of us make about drug prosecutions), but also and primarily because the costs of excessive prosecution are so large.

(I hasten to add that the costs of the drug war are also large and socially wasteful.  But I think almost all of the waste in the drug war comes not from over-deterrence (although that probably causes some social harm) but from the misdirected costs of prosecution.  Which seems like a relevant distinction to me.)

UPDATE:  Christine expands magisterially on her comments to Dave’s post.

Since 1997, the SEC’s Manual of Publicly Available Telephone Interpretations has been available online (see here). It is also searchable on Westlaw (see the FSEC-MISC database). The manual contains a bevy of interpretations of various SEC regulations. As to legal status of these interpretations, the manual states as follows:

The responses discussed in this manual do not necessarily reflect the views and policies of the Commission or the Division of Corporation Finance. These responses are not rules, regulations, or statements of the Commission. Further, the Commission has neither approved nor disapproved these responses. The responses discussed in this manual do not necessarily contain a discussion of all material considerations necessary to reach the conclusions stated. Accordingly, these responses are intended as general guidance and should not be relied on as definitive. There can be no assurance that the information in this manual is current, as the positions expressed may change without notice.

Nonetheless, securities practitioners routinely rely on manual statements in large part because it provides the only “authority� on the minutiae of various securities regulations. This is similar to widespread reliance on SEC no-action letters notwithstanding SEC pronouncements that no-action letters do not constitute official expressions of SEC views (for an excellent analysis of the legal status of no-action letters, see Donna Nagy, Judicial Reliance on Regulatory Interpretation in SEC No-Action Letters: Current Problems and a Proposed Framework, 83 Cornell L. Rev. 921 (1998)). And courts do frequently defer to interpretations reflected in no-action letters, although Professor Nagy argues automatic deference is inappropriate.

So what about the legal status of manual interpretations? My quick research found nothing definitive on the issue. While nine SEC releases and twenty-eight no-action letters cite the manual, only a single judicial opinion does. Should manual provisions be viewed the same as no-action letters? They seem less formal than no-action letters but, unlike no-action letters, are not addressed to a specific party under a backdrop of specific facts.

Following up on this post, according to this Reuters article the Justice Department has filed a “statement of interest” asking the court to dismiss the PCAOB constitutionality case.

[T]he lawsuit was filed “at the wrong time, in the wrong court” and should be dismissed. It said a challenge to the constitutionality of PCAOB must first be reviewed by the U.S. Securities and Exchange Commission.