This Week In Securities Litigation (March 14 to 20, 2008): The SEC And Turmoil In The Markets

Last week, continued turmoil in the markets and the sale of Bear Stearns dominated events. At the same time, there were significant court actions such as the reversal of the conviction of former Quest CEO Joseph Nacchio and the sentencing of former Brocade employee Stephanie Jensen. In addition, the SEC brought another FCPA case and more insider trading cases.

The market crisis

On Thursday March 20th, SEC Chairman Cox provided the Basel Committee on Banking Supervision Working Group with an update on the recent market turmoil. The Chairman wrote the letter because the Working Group was revisiting the Committee’s standards in view of recent events.

The Chairman’s letter makes two key points. First, the sale of Bear Stearns at a bargain basement price to JP Morgan Chase resulted from a lack of confidence, not capital: “Specifically, even at the time of its sale on Sunday, Bear Stearns’ capital, and its broker-dealers’ capital, exceeded supervisory standards. Counterparty withdrawals and credit denials, resulting in a loss of liquidity – not inadequate capital – caused Bear’s demise.” The Chairman went on to argue that net capital rules, which are designed to preserve investors’ funds and securities in times of market stress, served their purpose here.

Second, the SEC has incorporated the Basel standards into the supervision of large broker dealers. Under SEC rules a broker-dealer’s holding company and its affiliates which are known as consolidated supervised entities or CSEs, can elect to be subject to group-wide SEC supervision. The holding company computes its group-wide capital in accord with the Basel standards as Bear did here.

Two days earlier, on March 18th, the Division of Market Regulation issued a release entitled “Answers to Frequently Asked Investor Questions Regarding The Bear Stearns Companies, Inc.” That release states in part: “According to Bear Stearns; reports to the SEC, Bear Stearns’ broker-dealers were in compliance with the SEC’s capital and customer protection rules. The SEC also supervises the Bear Stearns parent company, whose capital also exceeded relevant regulatory standards, and whose liquidity position had been relatively stable, ranging from between $15 and $20 billion in the weeks preceding March 11. As of the morning of Tuesday, March 11, the parent company had over $17 billion in cash and unencumbered liquid assets.”

Nevertheless, by March 19, 2008, the Wall Street Journal was reporting that the SEC’s Division of Enforcement had sent a letter to JP Morgan Chase indicating that it was conducting an inquiry which apparently in part concerned statements by Bear Stearns before its acquisition. At the time of this letter Bear Stearns was already the subject of civil and criminal probes surrounding the earlier collapse of its hedge fund.

At least part of the SEC’s investigation surrounding the circumstances of Bear’s sale may on possible insider trading. Days before the sale there was a surge in put options. Shortly before the sale a number of options traders reportedly were betting that the firm’s stock would drop by about 57% in value. One question is whether those traders had material information about the investment banking firm that was not public – particularly in view of the pre-sale statements of Bear reaffirming the market that it was financially solid as reflected in its disclosure documents. See, e.g., Kara Scannell, WSJ On-Line, http://online.wsj.com/article_ print/SBJ20597050222250293.html

Other events

• The insider trading conviction of former Quest CEO Chairman Joseph Nacchio was reversed by the Tenth Circuit Court of Appeals. U.S. v. Joseph Nacchio, Case No. 07-1311 (10th Cir. March 17, 2008). The case was remanded to the district court for retrial after the appeals court concluded that the trial judge erroneously excluded a key expert witness offered by the defense at the behest of the government. U.S. Attorney Troy Eid announced “The good news is the Circuit Court said our trial team presented sufficient evidence to convict Mr. Nacchio of insider trading.” Apparently Mr. Eid is not familiar with the notion that the government wins when justice is served, not by simply securing convictions of those it accuses of a crime. See generally Berger v. U.S., 55 S.Ct. 629 (1935) (prosecutors have a duty to be fair).

• On March 20, 2008 the SEC filed a settled FCPA books and records case against AB Volvo. The case is another in a series of actions based on the United Nations Oil for Food Program (previously discussed here). SEC v. AB Volvo, Civil Action No. 08 CV 00473 (D.D.C.). The SEC’s Litigation Release is here.

• On March 19, 2008 former Brocade HR chief Stephanie Jensen was sentenced to four months in prison and ordered to pay a $1.25 million fine for her role in a stock options backdating scheme. Ms. Jensen had been convicted in December of conspiracy and falsifying corporate records at Brocade.

• On March 13, 2008 the SEC filed an insider trading case against a former employee of Diebold. The action is based on trading ahead of a disappointing earnings announcement. It is in litigation. SEC v. Cole, Case No. Civ. 08-265 C (W.D. Okla.). The SEC’s litigation release is here.

• On March 13, 2008 the Commission filed an insider trading case against the former Vice Chairman of ISE Holdings and his business partners based on trading ahead of a merger announcement. The action is in litigation. SEC v. Marshall, Civil Action No. 08-CV-2527 (S.D.N.Y.). The SEC’s litigation release is here.

Market Regulators Here and Abroad

Regulators of U.S. and foreign markets frequently face the same challenges. In trying to meet those challenges they often have powers which may appear similar but are very differently administered. Consider the following examples drawn from recent events in overseas markets.

Ireland

Since the passage of the Sarbanes Oxley Act, the officer/director bar has become a standard enforcement remedy. When the remedy was first added to the SEC’s arsenal in the 1990 Remedies Act, the agency had to prove that the person was “substantially” unfit to obtain a bar. SOX changed all that by dropping the “substantially” requirement, morphing a little-used remedy into a staple of the enforcement division.

Nevertheless, the SEC does not have the kind of authority claimed by its Irish counterpart – at least as to officer/director bars. Section 160 of the Irish Companies Act provides for entering disqualification orders which prohibit a person for a specific period of time from involvement in the management of a company on grounds of unfitness. In a recent court hearing, the Director of Corporate Enforcement reminded the Irish High Court that under this section he had the authority to enter a bar order following a finding by the court that the person engaged in insider trading. However frequently the U.S. SEC may invoke its officer/director bar authority, neither Chairman Cox nor Enforcement Director Linda Thomsen have this kind of authority.

Turkey

A new study published in the Turkish Weekly argues that the threshold used by regulators to monitor suspicious trading should be lowered as the size of the deal team increases. After studying possible insider trading in various types of markets, the paper concludes that “regression analysis reveals that syndicate sizes explain our measures of abnormal trading activity.” Intuitively this clearly seems correct – the larger the group that is “over the wall” and knows about the deal, the more activity resulting in more “leakage,” as economists call it.

The findings of the study in turn suggests that enforcement agencies should consider altering their monitoring mechanisms based on the size of the syndicate, lowering the threshold for detecting suspicious activity as the size of the syndicate increases. This of course is only the first step in insider trading enforcement the study authors acknowledge. The real difficulty is identifying the traders and differentiating between lawful and unlawful trading activity.

India

In contrast to the increasing emphasis on enforcing insider trading laws by U.S. officials, the Securities and Exchange Board of India, or SEBI, plans to relax insider trading laws by removing a provision that authorizes criminal actions against employees of a company who do not comply with a code of conduct specified in the current insider trading laws. SEBI’s idea apparently stem from the view that the company should have appropriate controls to prevent insider trading by its employees. In this context, insider trading represents a control failure by the company. Imposing criminal liability on the employee under these circumstances is overly harsh according to the regulator.

SEBI does not intend to simply deregulate insider trading, however. Rather, the regulator intends to permit the market to punish companies for their failures. Listed companies will be required to disclose the insider trading of their employees. This is intended to put a greater burden on management to have appropriate controls.

Australia

Last year there were comments that insider trading is rampant in U.S. markets. In Australia matters appear to be worse. Studies by leading funds including Vanguard, BT Investment Management and the Victorian Funds Management Corporation conclude that there are “unacceptably high” breaches of disclosure rules. According to one study directors at more than 20 corporations on the ASX traded shares in their companies between the time the books were closed and the announcement of the results. Another study found that almost half of the top 200 companies listed on the ASX failed to comply with a listing rule requiring changes in the shareholdings of directors be made public within five days.