The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

My weekend reading over the Memorial Day holiday included a hefty selection from the stack of law firm memos that accumulated in my inbox in recent weeks. Many of the most recent memos related to the Senate’s passage of its version of the financial reform legislation, but the memos also reflected a variety of other developments, including recent significant case developments and the passage of the UK bribery bill. I have set out below some of the more noteworthy recent law firm memos that have crossed my desk.

　

The Senate Financial Reform Bill

The Senate’s passage of the Restoring American Financial Stability Act of 2010 has triggered a flood of law firm memos. Though many of the memos have attempted to provide an overall description of the sweeping legislation, some have concentrated on focused on a narrow part of the bill. Several law firms have released memos focused just on the bill’s proposed corporate governance.

 

A May 24, 2010 memo from Sullivan & Cromwell provides an overview of the bill’s corporate governance reforms, including the bill’s provisions relating to majority voting for directors, "say on pay," executive compensation clawbacks, compensation committee independence and disclosures, and limitations on broker non-votes. The Sullivan & Cromwell memo points out that a number of the provisions in the bill – whistleblower protections, amendments relating to whistleblowers, private placement provisions and broker voting—would apply to non-U.S. issuers.

 

A May 28, 2010 memo from the Bingham McCutchen law firm also discusses the bill’s corporate governance reforms. Of particular interest, the Bingham memo contains an extensive discussion of the proposed "say on pay" reforms, with particular emphasis on concerns about "the amount of power the change would place in the hanks of proxy advisory firms," which provide compensation guidelines in connection with the proxy advice.

 

The Morgan Lewis firm also issued a May 27, 2010 memo about the Senate bill, here. The Morgan Lewis firm memo has an interested in discussion about the provision in the Senate bill that would require the securities exchanges to include the adoption of a compensation clawback policy as a listing requirement (by which incentive based compensation would be clawed-back from company officials in the event of a financial restatement of the financial statement of prior periods to which the compensation relations). The memo details the way that this provision the existing clawback requirements promulgated by SOX.

 

A May 27, 2010 memorandum from the Sidley Austin firm also provides an overview of the corporate governance reforms in the bill, and notes that that the bill contains additional compensation limitations for bank holding companies, and a separate provision requiring public companies to file a special SEC report of they using certain specified mineral products that may have originated in the Democratic Republic of Congo.

 

　

The Senate bill contains provisions designed to encourage corporate employees to blow the whistle on securities fraud. A May 21, 2010 Morgan Lewis memo (here) points out that these new provisions "give whistleblowers significant enhanced incentives to make a report" as part of the SEC’s new whistleblower program, and also provides extensive additional retaliation protections. The provisions would allow whistleblowers to receive rewards of between 10% and 30% of the monetary recovery. The provisions would also allow the whistleblower claiming retaliation to bypass existing administrative procedure requirements and proceed directly in federal court. The provisions also proposed a much longer statute of limitations and would create a double-back-pay remedy for retaliation claims, which created an incentive to bring retaliation claims.

 

Finally, a May 25, 2010 memo from the Faegre & Benson firm reports that the Senate’s financial reform bill "may give plaintiffs little to celebrate," noting that Congress "largely has chosen not to empower private parties" to enforce the rules. Indeed, the House bill’s provisions that would create the new consumer protection agency specifies that "nothing" in the provision establishing the new consumer protection "shall be construed to create a private right of action."

 

The Faegre & Benson memo does note that both the House and the Senate versions of the bill have "carved out a role for private litigants" to "help safeguard the integrity of the rating process" by allowing investors to sue credit rating agencies for securities fraud. The two versions disagree on the standard of liability to be required. Though the two versions must now be reconciled, some allowance private civil litigation against the rating agencies seems likely.

 

Securities Law Case Developments

A number of law firms have written memoranda discussing the Second Circuit’s April 27, 2010 opinion in the Pacific Investment Management Co. v. Meyer Brown case. Though the case outcome, in which the Second Circuit affirmed the dismissal of the securities fraud lawsuit against Refco’s lawyer, may have been unsurprising given the Supreme Court’s decision in Stoneridge, the law firm memos make the point that we may not have heard the last of the case.

 

As detailed in Arnold & Porter’s May 2010 memo about the case (here), the Second Circuit rejected the "creator theory" that both the plaintiffs and the SEC (in an amicus brief) had urged the court to adopt and instead held that "a secondary actor can only be held liabile for false statements in a private damages action for securities fraud only if the statements are attributed to the defendant at the time the statements are disseminated."

 

The Arnold & Porter memo points out that the decision, adopting the attribution test and rejecting the creator theory, has "two crucial limitations"; that is that it relates only to private civil actions under Rule 10b-5 and "does not speak" to government enforcement actions; and the Second Circuit refrained from addressing the question whether attribution is required for claims against corporate insiders.

 

The memo also notes that "perhaps most significant" is the fact that the decision was accompanies by Judge Barrington Parker’s concurring opinion, essentially calling for en banc review and even inviting the Supreme Court to weigh in on the matter. In other words, the memo notes, the Second Circuit’s recent opinion may not be the "final word on the subject."

 

Chadbourne & Parke also has a May 6, 2010 memo on the case, here. The Paul Hastings firm’s May 2010 memo on the case can be found here.

 

Finally, a May 26, 2010 memo from the Pillsbury Winthrop law firm discusses the Second Circuit’s May 18, 2010 decision in Slayton v. American Express , in which the Second Circuit held that even though forward-looking statements in the defendant’s SEC filing was not accompanied by meaningful cautionary disclosure, the plaintiffs failed to show that the statements were made with actual knowledge that they were misleading.

 

The Pillsbury firm memo identifies two "key takeaways" from the case: first, that "meaningful cautionary language must be specifically tailored to the statement at issue," as "boilerplate disclosure can be turned against a registrant because of its inherent lack of specificity." The Second Circuit’s holdings confirm the importance of "regularly reviewing the cautionary statements and risk factor disclosures contained in their public filings to ensure that the disclosure continue to be current and meaningful."

 

Second, the Second Circuit considered it to be a close call whether the plaintiffs had carried the burden of proving actual knowledge of falsity, "executive officers should remain vigilant and thoughtful when evaluating whether they have a reasonable basis for a particular forward-looking statement."

　

The U.K.’s Bribery Act 2010

The Morgan Lewis firm has a May 2010 memo entitled "The New UK Regime on Bribery" (here) describing the "far reaching implications" of the U.K.’s Bribery Act 2010. Among other things, the memo notes that the new law expands the scope of behavior that is targeted; no longer limited just to bribes paid to foreign officials, the new law applies to all bribes including purely commercial bribes, and applies to both the person paying and the person accepting the bribe.

 

Even more significant, the Act’s new Section 7 creates a new strict liability offense for organizations if a person associated with the organization bribes another person with the intent of benefiting the organization. However, organizations have a defense if they can show that they have in place "adequate procedures" to prevent bribery. In essence, the new Act is mandating compliance programs, to create controls against improper payments.

 

The Act has what the memo describes as a "wide territorial scope," applying of an act or omission forming part of the violation occurs in the U.K, or if in is carried out by a person with a "close connection" to the U.K.

 

A May 24, 2010 memo from the Weil Gotshal firm says that the new Act "provides the UK with one of the toughest regimes for regulating corruption in the world.

 

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One consequence of the current economic crisis that has long seemed inevitable is some form of legislative overhaul of the financial regulatory system. This possibility may have taken one step toward realization with the October 1 release of a package of legislative proposals by Pennsylvania Democratic Congressman Paul E. Kanjorski, the Chairman of the House Financial Services Subcommittee on Capital Markets, Insurnace and Government Sponsored Enterprises.

 

In his October 1, 2009 press release (here), Kanjorski released "discussion drafts" of three pieces of proposed legislation that, in the words of the press release, are "aimed at tracking key parts of reforming the regulatory structure of the U.S. financial services industry. The three bills include the Investor Protection Act (here), the Private Fund Investment Advisors Registration Act (here), and the Federal Insurance Office Act (here).

 

Most of the media coverage of these initiatives has focused on the second of these three proposals, the Private Fund Investment Advisors Act, as reflected for example in an October 2, 2009 New York Times article (here) about Kanjorski’s proposals. This proposed Act would for the first time require many financial providers, such as hedge funds and private equity funds, to register with the SEC. The proposed provisions specify recordkeeping and disclosure requirements and provide regulators with the authority to, as the press release states, "examine the records of these previously secretive investment advisors."

 

The Federal Insurance Office Act, as its name suggests, would create a national office of insurance. It does not appear that the proposed legislation would supplant state regulator of insurance or even provide for the so-called dual option that has been discussed for some time and which would allow insurers to choose whether to be regulated at the state or federal level, as banks do now.

 

The creation of a Federal Insurance Office would be intended to remedy a perceived "lack of expertise within the federal government" regarding the insurance industry. The new Insurance Office would "provide national policymakers with access to information" in order to allow them to respond to crises and to ensure a "well functioning financial system."

 

Though it has received less attention, the third piece of proposed legislation, the Investor Protection Act, also contains some potentially significant provisions, including some proposed revisions to the federal securities laws.

 

The Investor Protection Act contains a number of proposed legislative changed designed to strengthen the SEC and boost investor protection. Among other things, the Act would, according to the press release, double the SEC’s funding over five years and provide "dozens of new enforcement powers and regulatory authorities."

 

The Investor Protection Act also introduces a number of proposed innovations, including a proposed whistleblower "bounty" that is intended to "create incentives to identify wrongdoing in our securities market." These provisions allow for bounties of up to 30 percent of monetary sanctions imposed on wrongdoers to be paid to whistleblowers, and also provide protection for whistleblowers from retaliation. The proposed Act also includes a number of provisions designed to facilitate collaboration between the SEC and foreign securities regulators. Broc Romanek outlines a number of the other provisions of the proposed Act on his CorporateCounsel.net blog (here).

 

Among the changes proposed in the Investor Protection Act are the jurisdiction provisions proposed in Section 215 of the Act, relating to "Extraterritorial Jurisdiction."

 

It has long been noted that federal securities laws are silent about their extraterritorial reach. The courts have long struggled with jurisdictional issues in securities cases involving foreign-domiciled companies – as, for example, was extensively reviewed by the second circuit in its 2008 decision to Morrison v. National Australia Bank (about which refer here) and by the 11^th Circuit in its recent decision in the CP Ships case (refer here).

 

Section 215 of the proposed Act would in effect legislatively mandate a jurisdictional standard for extraterritoriality. The jurisdictional reach proposed in the statute is very broad. By way of contrast, the defendants and amici in the Morrison case had urged the court to adopt a "bright line" test that would have held that mere conduct in the U.S. alone should not be enough for U.S. courts to exercise subject matter jurisdiction when the conduct had no effects in the U.S.

 

In its opinion in the Morrison case, the Second Circuit had rejected this proposed bright line test, holding that subject matter jurisdiction exists "if activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused the losses abroad."

 

Section 215 would amend the ’33 Act, the ’34 Act and the Investment Advisors Act of 1940 to specify that U.S. courts could properly exercise jurisdiction in any action involving "conduct with the United States that constitutes significant steps in furtherance of violation, even if the securities transaction occurs outside the United States and involves only foreign investors," as well "conduct outside the United States that has a foreseeable substantial effect in the United States." Under the first of these two prongs, U.S. based conduct alone would be sufficient jurisdictional basis, even with respect to foreign purchasers of who purchased their shares of foreign-domiciled companies on foreign exchanges (so-called "f-cubed claimants").

 

This proposal may represent a legislative effort to head off the Supreme Court, which is currently considering whether to grant certiorari in the Morrison case. Of course, it remains to be seen whether or not this jurisdictional provision will survive the legislative process, or even whether regulator reform legislation in any form remotely resembling the proposal Congressman Kanjorski has put forward.

 

According to the Times, the House Financial Services Committee has scheduled an October 6, 2009 hearing to discuss this issue of hedge fund regulation, among other issues. Though there is a glut of items on the current Congressional agenda, reform of financial regulation in some form seems likely in the current political and economic environment. What will emerge of course will only be revealed in the fullness of time, but Congressman Kanjorski’s opening salvo suggest that the process could be interesting and that the final outcome could included significant innovations and alterations on a wide variety of topics.

 

Special thanks to a loyal reader for sending along links to Congressman Kanjorski’s press release.

 

PLUS Chapter Event: On Wednesday, October 7, 2009, I will be moderating a panel at a Professional Liability Underwriting Society Midwest Chapter event at the Hyatt Hotel in Cincinnati, Ohio. The title of the panel is "Bankruptcy and Barriers to Coverage." The panel, which will go from 3 pm to 5 pm, followed by a reception, will include several of the leading D&O coverage experts. Registration information is available here.

 

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Do private securities lawsuits play an important role in deterring fraud and compensating defrauded investors, or are they simply wasteful and ineffective? These were the questions that on October 23, 2008 Stanford Law School Professor Joseph Grundfest and Duke Law School Professor James Cox debated in New York at the Forum for Institutional Investors sponsored by the Bernstein Litowitz Berger & Grossman law firm.

 

The professors' discussion, moderated by Bernstein Litowitz partner Sean Coffey, addressed some of the perennial questions concerning private securities litigation. I have summarized the professors’ comments below, followed by my own observations.

 

The Professors’ Debate

Professor Grundfest: Professor Grundfest addressed the issues first. He characterized private securities litigation as a process "for moving money around for the benefit of the people moving the money around." Professor Grundfest was particularly emphatic in arguing that private securities litigation is a poor deterrent of misconduct. He pointed to the many allegations of wrongdoing that have accompanied the current financial crisis as evidence that private securities litigation is not a deterrent to misconduct.

 

Professor Grundfest argued that because the vast preponderance of private securities litigation is settled with insurance proceeds or company money, there is no "individual responsibility," because the "wrongdoers" are not "hit in the pocketbook."

 

In order for the system to provide deterrence, Professor Grundfest suggested, the process should be changed so that rather than having as its objective simply to be to produce "the largest pot of money" from whatever source derived, the objective should be geared toward settlements funded directly out of individuals’ pockets, even if it results in a much smaller settlement.

 

Professor Grundfest described the current system as a "drug induced fantasy," as it essentially involves institutional lead plaintiffs suing companies in which institutional investors are the primary shareholders. Professor Grundfest asserted that this system produced nothing more than a very elaborate and costly pocket shifting, as a result of which it is mathematically impossible for a fully diversified investor to come out ahead. The only effective deterrent, Professor Grundfest argued, would be to require individual settlement contributions as a regular part of private securities litigation settlements.

 

Professor Cox: Professor Cox challenged the assertion that private securities litigation provides no deterrence, stating that it is not enough to look at litigation defendants alone to determine whether securities litigation has a deterrent effect. Rather, Professor Cox argued, the question is whether the threat of litigation raises the standard of conduct across the marketplace, among all companies. Professor Cox said that it is difficult to measure the benefit to the entire marketplace of increased disclosures and other conduct calculated to avoid litigation.

 

Professor Cox specifically observed that the performance of the U.S. markets in the current financial crisis demonstrates that these safeguards do work. He noted that while the markets around the world are all down, the U.S. markets are down less than other markets because the U.S. markets generally are viewed as more transparent and more trustworthy.

 

Professor Cox also noted that as it has evolved, our system of securities enforcement has come to require a public/private partnership. He cited research that looked at circumstances where both public enforcement and private litigation were involved, as well as circumstances where only one or the other initiative was involved. He said this research shows that the SEC has tended to pursue enforcement cases against securities violations involving smaller companies where fewer dollars are involved, while the private securities litigation bar has concentrated on the larger companies where more is at stake, where both the costs and the incentives for private action are greater. Professor Cox argued that this private/public partnership has contributed to a more comprehensive enforcement of the securities laws.

 

Professor Cox was dismissive of the portfolio theory against the effectiveness of private securities litigation. He noted first that Chamber of Commerce research had shown that the analysis that diversified institutional investors could not come out ahead, at a minimum, does not apply in the IPO and M&A context. He also pointed out that this portfolio theory is not raised as an objection to other types of commercial litigation, where one company sues another to recover damages. The same pocket shifting argument could be applied to all commercial litigation, but no one is suggesting that all commercial litigation be eliminated as unjustified under portfolio theory.

 

In the end, however, Professor Cox is not opposed to the idea of having individuals contribute toward class settlements, and he even suggested that the judiciary should have their consciousness raised about asking what the individual defendants have contributed towards settlement.

 

Sean Coffey: The panel moderator, Sean Coffey, commented that he believed that in order for private securities litigation to be most effective, individuals need to feel that they are "at risk." Coffey commented that he believed that the spectacle of the individuals being required to contribute to the WorldCom settlement did produce the kind of heightened awareness that could deter improper behavior.

 

But at the same time, Coffey noted, "because you don’t want to deter people from serving" on boards, the instances when individuals should be required to contribute should be "rare."

 

Professor Grundfest closed by commenting that individual responsibility is "the message that needs to go out" and he asked rhetorically, "why is it so rare?" He also asked "isn’t it was really works?" -- adding that motivating behavior is a more important goal than moving money around.

 

Discussion

Anyone who has had a close look at the securities litigation process can only be appalled at the wasteful expense, most of which has little to do with the merits or anything else important that is at stake, but has more to do with the enrichment of the process participants. But as profligate as the process inefficiency is, this costliness is not unique to securities litigation. Our system of litigation may not have been designed to enrich the lawyers, but that certainly is one of its most apparent effects.

 

But while there undoubtedly are ways our securities litigation system could be improved, that does not mean that the system overall fails to achieve its intended goals. In particular, I believe that private securities litigation does have a deterrent effect.

 

My perception is that most corporate officials have a strong desire to avoid accusations of fraud, even if the accusation were to come only in the form of a private securities lawsuit. For most corporate officials, the idea of their name and picture appearing in the local newspaper accompanied by the word "fraud" is their worst nightmare. Most corporate officials work hard to prevent this from happening. Of course there are those individuals whose greed overcomes their fear, and about this group I have further comments below.

 

As for whether the system compensates investors or simply moves money around, all I can say is that there are a large number of sophisticated, well-informed and profit motivated institutional investors that continue to actively participate in securities litigation, some serving frequently as lead plaintiffs. These institutional investors believe that the litigation is in their financial interest, notwithstanding what modern portfolio theory might purport to suggest. In addition, many of these investor plaintiffs are often interested in using litigation to achieve governance changes or other nonmonetary objectives. They clearly believe that private securities litigation helps them to achieve those goals.

 

And as for the idea that individuals should be forced to contribute routinely out of their own assets towards civil litigation settlements, I think we need to take a giant step back and look at what we are talking about. Most securities cases settle in their early stages, often even before motions for summary judgment have been determined. Rarely at the time of settlement have there been any factual determinations of any kind, much less any findings of culpability.

 

Most securities lawsuits settle because of the costs and burdens of litigation and because of the catastrophic loss potential involved if the case were to go forward through trial. Given these virtually universal settlement dynamics, it would, in my view, be a miscarriage of justice if individuals were to be required routinely to contribute out of their own funds toward settlement. Indeed, in the absence of culpability findings, any mandate requiring individual contribution arguably would be confiscatory and could violate due process, at least when there otherwise would be indemnity and insurance available.

 

We do not bar defendants in other contexts from availing themselves of liability insurance. We do not bar, say, defendants in auto accident cases from availing themselves of auto liability insurance, though one might hypothesize that drivers would be more careful if liability insurance were unavailable. Similarly, doctors are permitted to insure against allegations of malpractice, though mandated uninsured liability might motivate greater caution (or, more probably, result in fewer doctors). Why should defendants in securities lawsuits be any less able to benefit from contractual indemnity or liability insurance provisions?

 

There are of course those individuals whose greed outweighs their fear, and for whom the threat of litigation is no deterrent. These kinds of people undeniably are out there, but these people are not going to be forestalled by any deterrence mechanisms, even the threat of direct personal liability. The most effective approach to these kinds of bad actors is prevention, not deterrence. Meaningful transparency requirements and effective systems of internal controls monitored by independent watchdogs– that is how to fight bad actors’ misconduct.

 

Finally, even if there are occasional circumstances where individuals’ behavior theoretically might dictate their individual contribution toward private securities litigation settlements, these occasions should be rare. In that respect, I agree with the Sean Coffey’s comments that if these kinds of impositions were to become routine, talented individuals correctly might conclude that it is not in their personal financial interest to serve on a corporate board.

 

Looking Ahead

Regardless who wins the upcoming Presidential election, that there will be significant postelection efforts to strengthen regulatory mechanisms to try to prevent future financial marketplace crises and misconduct. There is some danger in this environment, where scape-goating is in high gear, that the idea of mandating the imposition of financial burdens directly onto individual directors and officers might gain some traction. Indeed, the Wall Street Journal op-ed column discussed below underscores that risk.

 

If this initiative were premised on the idea of requiring individual contributions toward settlement even in the absence of findings of culpability, any initiatives along these lines would inappropriately and unfairly shift costs to individuals. Attention more appropriately should be focused on mechanisms designed to improve monitoring, oversight and disclosure, so that greater transparency will allow the marketplace to do more to police behavior and prevent misconduct.

 

It will in any event be interesting to watch what unfolds after the election. There is little doubt that there will be an enormous effort to overhaul the financial markets’ regulatory structure. The outcome of these efforts will substantially affect markets and market participants, and could even affect the liability exposures of corporate officers and directors.

 

Where Were the Directors?: If early indications are any gauge, the idea that board members should be held individually accountable is likely to be a featured part of the regulatory reform discussions that undoubtedly lie ahead. By way of illustration, in an October 25, 2008 Wall Street Journal op-ed column entitled "Where Were the Boards?" (here), Papa John’s founder and Chairman John Schnatter asked, with respect to the current financial crisis "Where were the boards of directors of the companies that helped create this mess?"

 

Schnatter noted that boards "have a clear-cut fiduciary responsibility to provide oversight," as a result of which he observed that "we should not ignore their roles in contributing to this financial meltdown."

 

Schnatter conludes that "politicians in Washington would be wise" to "adjust their focus upward" (where, as Schatter noted "true power lies") and "set greater accountability for boards, requiring stringent oversight by those who are empowered to set the ground rules for American companies." He does, however, allow that penalties should not be so "harsh" that "no sensible business person would become a director."

 

Regardless of the level of authority with which Schnatter may speak, the concept of "greater accountability" at the director level undoubtedly will be part of the regulatory reform dialog that will follow the upcoming election. The practical usefulness of any conversation along these lines will depend critically on the extent to which the concern about the willingness of sensible business people to serve as directors is appropriately respected.

 

To Encourage the Others: The very idea that a few individual directors should be punished periodically as deterrent against the misbehavior of all others reminds me of the unfortunate British admiral, John Byng, who was court-martialed and shot to death for "failing to do his utmost" during the Battle of Minorca at the outset of the Seven Years’ War.

 

Voltaire included this incident in his novel, Candide, in which the main character, Candide himself, witnesses Admiral Byng’s execution in Portsmouth. Candide is told "Dans ce pays-ci, il est bon de tuer de temps en temps un amiral pour encourager les autres." (In this country, it is wise to kill an admiral from time to time to encourage the others.)

  

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The intervening subprime meltdown makes it seem longer ago than it really was, but it was only a short time ago that regulatory reform was a very hot topic (as noted, for example, here). Dramatic intervening events have advanced other priorities. Indeed, efforts to increase rather than reduce financial markets regulation seem to be the current fashion.

 

Many of the same people whom only a short time ago were pleading that overregulation was harming U.S. financial markets’ global competitiveness are now clamoring for increased regulation. As former SEC Chairman Arthur Levitt noted in a March 21, 2008 Wall Street Journal op-ed piece entitled “Regulatory Underkill” (here), it is “ironic” now that the “most eminent voices in the business community” were “fixated on questionable measures of financial health” even while “the seeds of today’s market turmoil were being nourished not by regulatory excess, but by fundamental failures in oversight at almost every level.”

 

Even thought the climate unquestionably has changed, on July 24, 2008 the U.S. Chamber of Commerce’s Institute for Legal Reform released yet another call for reform, particularly with respect to securities class action litigation. The Institute’s Report, which is entitled “Securities Class Action Litigation: The Problems, its Impact and the Path to Reform,” can be found here. The Institute’s July 24 press release can be found here.

 

Among other things, the Report decries the “culture of abusive class actions” that is “eroding the competitiveness of U.S. capital markets at a time when the face perhaps their greatest threat from foreign competition.”

 

The Report is interesting and it is effective in summarizing the excesses and abuses of the current U.S. securities litigation system. The Report also contains some useful proposals. In particular, the Report focuses on the potential of abuses of a “pay to play” system where public officials responsible for public pension funds solicit campaign contributions from plaintiffs’ firms that are later selected to act as the pension funds’ litigation counsel. The Report advocates passage of the currently pending “Securities Litigation Attorney Accountability and Transparency Act” (H.R. 5463) to eliminate pay-to-play conflicts and other suspicious connections between attorneys and elected officials.

 

The Report also advocates a number of procedural reforms, including taking steps to ensure greater coordination between public and private enforcement, and enacting provisions to allow defendants whose motions to dismiss are denied to take immediate interlocutory appeals.

 

Overall, the Report’s recommendations are useful. There unquestionably is value in examining these issues, and the current litigation system unquestionably suffers from excesses and abuses. I question whether any of these kinds of reform proposals are likely to gain much traction in the current environment.

 

I also think that any reform initiative should also acknowledge several important additional considerations. The first is that our securities enforcement approach presumes active private litigation. As the Supreme Court noted in its 2007 Tellabs opinion, “meritorious private actions to enforce federal antifraud securities laws are an essential supplement to criminal prosecutions and civil enforcement actions.” While there unquestionably are excesses and abuses in the current system, any reform attempt should also acknowledge private securities litigation’s important role.

 

The other important consideration relates to the fundamental question of U.S. competitiveness in the global economy. Ultimately, the greatest advantage that the U.S. markets historically have enjoyed is their reputation for integrity. As Arthur Levitt wrote in the op-ed piece cited above,

Ultimately, those who were so concerned with Wall Street’s competitiveness need to realize that the true competitive advantage of America’s capital markets has long been their high quality. With that quality in doubt, leaders and policy makers need to put their ideological fixations aside and commit themselves to giving investors the levels of transparency and accountability they deserve and expect from the world’s strongest markets.

It may well be useful and even important to consider ways to improve our system of private securities litigation. But it is also critically important that any reform proposal appropriately take into account the very things that have historically given the U.S. markets their strength -- that is, their reputation for transparency and integrity, a reputation that U.S. financial markets already have much work to do to rehabilitate. Somehow, these rehabilitation efforts seem higher priority now than proposals for securities class action reform, no matter how meritorious.

 

Special thanks to several loyal readers for forwarding a link to the Institute’s Report.

 

More Credit Crisis Litigation: In prior posts (most recently here), I have detailed that the current litigation wave has spread far beyond the subprime lending arena where it first originated. A recently filed lawsuit underscores the extent of this spread.

 

As detailed in the plaintiffs’ counsel’s July 25, 2008 press release (here), plaintiff shareholders have filed a purported securities class action lawsuit in the United States District Court for the Southern District of New York against CIT Group and certain of its directors and officers. A copy of the complaint can be found here.

 

CIT is a commercial and consumer finance company whose share price fell in March 2008 after reports circulated about the possibility that the company would have to charge off loans made to students of Silver State Helicopter, which had filed for bankruptcy. The complaint alleges that the defendants made false statements about the company’s financial condition, and specifically that “CIT’s public financial statements failed to account for tens of millions of dollars in loans to [Silver State], which were highly unlikely to be repaid and should have been written off.”

 

These have been prior lawsuits as part of the current credit crisis litigation wave that have involved student loans. For example, both Sallie Mae (refer here) and The First Marblehead Corporation (refer here) previously have been sued in securities lawsuits arising from troubled student loans. Whether or not there will be further lawsuits relating to student loans, there undoubtedly will be further litigation involving other types of credit as the current economic turmoil unfolds.

 

In any event, I have added the CIT Group lawsuit to my running tally of subprime and credit crisis related litigation, which can be accessed here. With the addition of the CIT Group lawsuit, the current tally of subprime and credit-crisis related securities lawsuits now stands at 102, of which 62 have been filed in 2008.

 

Break in the Action: The D&O Diary will be on a reduced publication schedule for the next week. The D&O Diary will resume its normal schedule during the week of August 4^th.

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On May 17, 2007, Treasury Secretary Henry M. Paulson, Jr. announced (here) his latest "initiatives...to enhance U.S. capital market competitiveness." In a Financial Times op-ed piece published the same day (here), Paulson said the purposes of the initiatives were to "ensure we preserve an efficient financial reporting system that provides reliable information, is supported by a sustainable auditing industry, and has enhanced compatibility with foreign reporting requirements."

The most substantial part of the initiatives is the commencement of two studies. One study, to be led by former SEC Chairman Arthur Levitt and former SEC Chief Accountant Donald Nicolaisen will "address auditing industry concentration" and "consider options available to strengthen the industry's financial soundness and its ability to attract and retain qualified personnel." The second study will "analyze the factors driving financial restatements and their impact on investors and financial markets."

The rise in the number of restatements, up from 116 in 1997 to 1,876 in 2006 (or one for every ten public companies), is a point of particular emphasis in Paulson's op-ed piece. Paulson notes that "restatements pose significant costs on our capital markets. They have the potential to confuse investors and erode public confidence in public reporting." The volume of restatements reflects, in part, "the complexity of our financial reporting system." The Treasury' study is intended to complement the SEC's efforts to reduce the complexity.

The Treasury Department also announced its support of the SEC's and the PCAOB's efforts to "improve the application of Section 404" of the Sarbanes Oxley Act. In his op-ed piece, Paulson states that "a more risk-based implementation will be a positive step." Finally, the Treasury Department also expressed its support of SEC effort to effect the convergence of the U.S. GAAP and International Financial Reporting Standards, and eliminating the U.S. GAAP reconciliation requirements by IFRS-reporting foreign companies by 2009.

With their proposal for a couple of studies and their expression of support for SEC proposals, the Treasury initiatives are strikingly modest. (To be sure, the recent announcement took great pains to emphasize that this is only the first salvo; the Treasury announcement specifically notes that "Secretary Paulson will continue to provide follow up steps to other ideas.") But even if the initiatives themselves are modest, it seems fair to ask whether their underlying premise is overstated, or even valid. That is, while Paulson and others (refer here) are fretting loudly about U.S. capital markets' competitiveness, the markets are busy surging ahead.

According to news reports (here), total U.S. capital markets equity underwriting of common and preferred stock during the first quarter of 2007 rose 42.6 percent compared with the prior year period, and raised $61.4 billion in connection with 202 deals. Corporate bond issuance rose during the first quarter to a record $308 billion, up 23.6 percent from the first quarter of 2006. According to a PricewaterhouseCoopers report (here), U.S. IPO activity during the first quarter of 2007 was at its highest first quarter level in 7 years. During the first quarter of 2007, there were 64 IPOs that raised $12.1 billion, compared to 54 deals that raised $11.6 billion during the first quarter of 2006. And as I have noted in prior posts (most recently here), foreign companies continue to be attracted to U.S. capital markets, contrary to the contention of the would-be reformers.

There may or may not be good reasons for the various studies Paulson has launched, and there is no harm at taking a closer look at things. But to the extent reform proposals emerge that are premised on the supposed declining competitiveness of the U.S. capital markets, there is reason to be skeptical, if not concerned. As the CFO Blog noted (here), the "whole argument" for Paulson's Capital Market Plan is "looking kind of shaky." While studies themselves can do no harm, the danger is the possibility of reform proposals that undermine the very things that give the U.S. markets their strength, -- that is, their justified reputation for transparency and integrity.

Whistleblower's Lament: In prior posts (most recently here), I have examined the question whether the whistleblower protection under Sarbanes-Oxley may actually be discouraging fraud detection. Anyone who doubts this concern may want to review the May 18, 2007 CFO.com article entitled "Five Years Out of Work" (here). The article contains an interview with David Welch, the first person to file for whistleblower protection under Sarbanes-Oxley. After five years of unemployment and attorneys'fees of over a half million dollars, his case if far from over and seems likely to have years left to run. His conclusion?: " If you are a whistleblower and you have no money, you have to stop. The deep pockets of corporations can starve out an unemployed whistle-blower."

As I noted in a prior post (here) discussing Welch's case, the Sarbanes-Oxley whistleblower protection may be "more theoretical than real."

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In recent months, several blue ribbon panels, concerned about the competitiveness of the U.S. securities markets, have proposed reforming U.S. securities regulation, on the theory that the regulatory burden that has driven overseas companies to list their shares outside the U.S. As I have discussed at length previously (most recently here), there are a host of reasons why overseas companies have been list their shares on other exchanges. But despite all of these reasons driving the growth of other countries' markets, there nevertheless seems to be a continuing and arguably growing interest among overseas companies, particularly Chinese companies, to list their shares on U.S. exchanges.

According to the May 11, 2007 Financial Times article entitled "Chinese Listing Influx Begins" (here, subsciption required), 35 Chinese companies expect to list on U.S. exchanges this year, as many as listed in the last three years combined. Three Chinese companies - Qiao Xing Mobile, Acorn International and LDK Solar - together expect to raise $1 billion in U.S. listings.

A second May 11, 2007 Financial Times article entitled "New York Proves an Attractive Destination" (here) explains that the reason for the influx of Chinese companies is that "a pipeline of private equity and venture capital investments, mostly made by U.S. based funds...have reached maturity." These companies are drawn to the U.S. markets and are not deterred by U.S. regulations because "despite Sarbox, they can still get better valuations and wider analyst coverage ... than in the resurgent Chinese domestic markets or in other parts of the world." Chinese companies have been drawn to the U.S., according to one commentator, because "they were looking to establish their brand internationally and nothing matches that like a U.S. listing."

As one source quoted in an April 4, 2007 Law.com article entitled "Law Firms Compete for Chinese Companies' IPO Action" (here) put it, "in China, everyone wants to get registered to raise funds in the public markets in the U.S." A U.S. listing, another commentator in the article notes, "provides legitimacy and transparency."

A prior post on the "healthy" U.S. market for foreign IPO market can be found here.

The Chinese companies' perception that they will enjoy a better valuation on the U.S exchanges is supported by recent academic research. According to an April 2007 paper by Craig Doidge of the University of Toronto and George Andrew Karolyi and Rene Stulz of the Ohio State University entitle "Has New York Become Less Competitive Over Time? Evaluating Foreign Listing Choices Over Time" (here), there is a significant valuation premium for U.S. exchange listings, and the premium did not decline after the passage of SOX. The article go on to state that "all of our evidence is consistent with the theory that there is a distinct governance benefit for firms that list on the U.S. exchanges." An April 27, 2007 Wall Street Journal article entitled "Maybe U.S. Markets Are Still Supreme" (here, subscription required) discusses the academics' research.

As I have previously argued (most recently here), the would-be reformers' case for regulatory reform is "weak." But if, as further evidence increasingly seems to substantiate, overseas companies on balance find U.S. markets preferable to other markets, the case for reform goes from weak to nonexistent.

All of this underscores a point I have frequently made, that Wall Street may be attempting to use the effects of the evolving global financial marketplace as a pretext to undermine regulatory requirements that occasionally prove to be uncomfortable because they actually have teeth. The would-be reformers may claim that they seek to advance U.S. competitiveness, but anything that weakens the U.S regulatory structure could remove the greatest advantage the U.S. markets enjoy - that is, the U.S. markets are the most highly regarded precisely because they are the most highly regulated.

Over There, Over Here: As I have also frequently noted, overseas investors are becoming much more accustomed to using litigation as a means to hold management accountable. Further evidence of this can be found in a May 2007 Institutional Investor Services paper entitled "Accountability Goes Global: International Investors and U.S. Securities Class Actions" (here) takes a look at the growing role of overseas institutional investors as lead plaintiffs in U.S. securities class actions.

Among other things, the paper notes that "in every year since 2002, international institutional investors have filed lead plaintiff motions in more than 5% of all securities class actions," including not only suits against companies that are domiciled in their home countries, but also suits against U.S.-based companies. The international institutional investors, drawn from 17 countries, sought to serve as lead counsel in 182 cases between 1996 and March 31, 2007.

The paper was written by Adam Savett, who also maintains the Securities Litigation Watch blog (here).

Hat tip to the 10b-5 Daily (here) for the link to the ISS paper.

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Two of the recent reports of blue ribbon groups looking at the competitiveness of U.S. capital markets recommended among other things that the SEC should consider permitting public companies to amend their charters to provide for arbitration of securities claims. According to an April 16, 2007 Wall Street Journal article entitled, "SEC Explores Opening Door to Arbitration" (here, subscription required), the SEC, as part of a "broader package" of shareholder rights proposals, is now exploring whether or not to allow corporate charter provisions requiring the arbitration of complaints by aggrieved shareholders.

The Interim Report of the Committee on Capital Markets (here, at pages 109 to 112) recommended "that the SEC should permit public companies to contract with their investors to provide for alternative procedures in securities litigations, including providing for arbitration (with or without class action procedures) or non-jury trials." The Interim Report went on to state that "the Commission should not force shareholders to accept the costs that go with class action securities litigation, particularly the substantial and unpredictable risk of large jury verdicts that effectively force settlement of what may well be non-meritorious claims."

The Bloomberg/Schumer Report (here, at pages 100-104) recommended that the SEC reverse "its historical opposition to the arbitration of disputes between investors and publicly traded companies." The Report asserts that "shareholders should have the opportunity before the fact to determine whether submitting the future securities grievances to arbitration is in their own and the company's best interest." The Report also states that arbitration "would benefit all parties involved," by reducing cost and speeding resolution, while permitting SEC enforcement action in appropriate cases.

While the SEC is exploring the possibility of allowing companies to amend their charters to require arbitration of shareholder claims, the Journal reports that SEC Chairman Christopher Cox does not believe that arbitration is a "panacea."

There are several obvious shortcomings for the use of arbitration for shareholder fraud claims. First, there is limited opportunity in an arbitration proceeding for discovery, in a type of dispute that increasingly depends on extensive review of electronic communications and other electronic documents and data. Second, there is limited opportunity for appeal, which could substantially affect the rights of plaintiffs and defendants whose legal rights are determined by the arbitration panel. Third, arbitration hearings typically are conducted in private, rather than in a public forum, which would undercut the deterrent effect of private securities claims. Fourth, even if the company were able to require shareholders to pursue claims against the company and company officials through arbitration, shareholders would still be free to pursue related claims against other defendants (underwriters, accountants, lawyers, for example) in court. An overview of arbitration can be found here.

The Journal article anticipates that the arbitration proposal "is likely to spark fierce opposition from both investor-rights groups and trial lawyers." Another group that might be motivated to object is the states' attorneys general, who have recently discovered the profit and political appeal of class action opt-out cases (refer here) and who recently filed an amicus brief in the Tellabs case in the U.S. Supreme Court arguing against pleading restrictions that would limit their rights to bring shareholder claims (refer here). The Journal article notes that as a result of likely opposition, there is "a good chance" that the idea of permitting companies to require arbitration of shareholder claims "could fall flat."

But even if the SEC were to go ahead, the possibility of a charter amendment requiring arbitration would be optional - that is, companies, would have to affirmatively choose to include the arbitration requirement in their charters. For existing public companies, that would presumably require a shareholder vote approving the charter amendment. To consider what shareholders might be asked to approve, it is worth thinking about what a proposed charter amendment might look like.

A prescient April 10, 2007 article entitled "Compelling Arbitration of Stockholder Class Actions Based on Federal Securities Law" (here), by Joseph Bartlett and Cathy Reese of the Fish & Richardson firm, takes a look at what enabling charter language might look like (including a sample charter amendment). The proposed language has some interesting features, including, for example, a requirement that the SEC be notified of the arbitration and have the opportunity to participate. The sample language brings home some of the limitations as well - for example, should a shareholder be compelled to Wilmington, Delaware to arbitrate? Looking at the proposed charter amendment makes me wonder how many companies' shareholders would approve these kinds of charter amendments?

Interesting blog posts on the arbitration proposal can be found on the FEI Financial Reporting Blog (here), the 10b-5 Daily blog (here), and Ideoblog (here).

D & O Conference: This week, I will be participating in the American Conference Institute event entitled "D & O Liability Insurance" in New York City (refer here). On Wednesday April 18, 2007, I will be speaking on a panel entitled "State of the Market: New Coverages and Developing Exposures," and on Thursday, April 19, 2007, I will be on a panel entitled "Boards of Directors: What are They Worried About and What are They Looking For?" If you attend the Conference, I hope you will greet me and introduce yourself.

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Amidst the current clamor over the competitiveness of the U.S. financial markets, a recurring theme has been the burden on the financial markets of U.S. litigiousness. One variant of this theme that has gotten air time is the idea that private securities lawsuits should be eliminated. The most prominent proponent of this idea is Stanford Law School professor Joseph Grundfest, whose Wall Street Journal op-ed piece on this topic (here, subscription required) was the subject of a prior D & O Diary post (here).

The editorial page editors at the Journal clearly like this particular idea, because on March 20, 2007, they ran a second op-ed piece on this same topic, this one (here, subscription required) entitled "Capital Complaints," by Peter Wallison of the American Enterprise Institute. (Wallison served as White House counsel during the Reagan administration.)

Wallison's article starts with the notion that the "financial pre-eminence of the U.S. is eroding," and if "you listen closely to what foreign and U.S. business and financial people are saying, there's one central cause - private class action enforcement of the SEC's Rule 10b-5." Wallison invokes a parade of horribles weighing on U.S. competitiveness, each component of which "is exacerbated by class action risk." The solution, according to Wallison, "is restoring what Congress originally intended - enforcement of Rule 10b-5 only by the SEC."

I have previously reviewed elsewhere (here) the reasons why an SEC monopoly on enforcement of the securities laws is not necessarily in investors' best interests. Essentially, I believe that private investors ought to have the ability to seek redress of their grievances without having to depend on an over-burdened SEC to enforce their rights. And while Congress may not have originally put an explicit private right of action in the securities laws, during the decades since the courts first implied a private right of action, Congress has revised the securities laws multiple times but has never gone back to legislatively prohibit private lawsuits.

The most significant problem I have with Wallison's article is its very premise, that the most significant cause in the erosion of U.S. financial markets is the existence in the U.S of private securities class action lawsuits. Would foreign companies view the U.S more favorably if they "only" had to worry about the SEC? And as I have discussed at length previously (most recently, here and here), the causes of the increased competitiveness in the global financial marketplace are myriad, diverse, and subtle, and have more to do with the growth overseas capital and the increased sophistication of overseas markets.

The only evidence that Wallison cites for his premise that the existence of private securities lawsuits is undermining U.S. competitiveness is his assertion that the cause is apparent if "you listen closely to what foreign and U.S. finance people are saying." I don't doubt that this particular notion may have a certain currency in certain circles, and that people who talk to each other all the time have persuaded themselves, but that does not make it true. If you look at what companies are doing rather than what "finance people" are saying, the picture looks quite a bit different.

For example, if Wallison's premise were true, you would think there would be evidence that foreign companies were fleeing the U.S. because of the threat of litigation. While the evidence shows that some companies are, indeed, leaving the U.S. securities markets, it is not for the reasons Wallison cites.

A March 19, 2007 CFO.com article entitled "Bluff or Bluster?" (here) takes a look at delistings from U.S. exchanges, and concludes that "predictions of mass delistings have failed to materialize" and the companies "that have delisted rarely cite onerous regulation." Of the 12 European companies that delisted from the NYSE in 2006, "nine were because the company was taken over." Of the remaining three, one (Vivendi) delisted to save costs because its trading volume was virtually nonexistent; one, Tatneft, and energy company controlled by the Russian state of Tatarstan, delisted after failing to submit audited financials; and one, Espirito Santo Financial, a Luxembourg-based company that delisted because its trading volume on Euronext was six times greater than on NYSE.

The CFO.com article also notes another important point that often gets overlooked amidst the hubbub about U.S. competitiveness; that is, while its global equity market share may be declining, its participation in the debt marketplace is booming. According to the article, the number of European companies going to the U.S. to raise debt capital increased by 77 percent between 2000 and 2006, and the annual volume of debt raised during that period grew from $174 billion to $396 billion.

In other words, the global marketplace is dynamic and is changing in many ways, with a variety of effects and from a diversity of causes. To seize a single aspect as the sole or even the most important cause, and to use that as the pretext for radical changes to the enforcement of our securities laws, simply ignores the complexity of the global marketplace. Given the diversity of causes and effects, the elimination of private lawsuits would have only an uncertain impact on U.S. competitiveness, but it would eliminate the means by which private investors can seek redress without depending on the government to take up the cause on their behalf.

None of this should be interpreted to suggest that I think our system of private securities litigation could not be improved. Anyone who watches these cases up close knows that that system can be wasteful and excessive. But while it undoubtedly can (and should) be improved, I do not think it is in the best interests of investors or the markets for private securities lawsuits to be eliminated.

Professor Larry Ribstein has some interesting comments on his Ideoblog (here) about Wallison's column.

One final observation: as I have previously noted (here), differences between the litigation systems in the U.S. and elsewhere may be diminishing over time. A recent interesting post along those lines can be found on the Drug and Device Law blog (here).

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On March 12, 2007, in the latest in the apparently never-ending series of big thick reports on the competitiveness of U.S capital markets, the U.S. Chamber of Commerce released the Report and Recommendations of its Commission on the Regulation of the U.S. Capital Markets in the 21st Century (here). An Executive Summary of the Report can be found here.

The Chamber Commission advertises itself as "an independent bipartisan Commission established by the U.S Chamber of Commerce.' The Commission is co-Chaired by Arthur Culvahouse, who is Chairman of the O'Melveny & Myers law firm and former White House counsel in the Reagan administration, and William Daley, Vice Chairman of JPMorgan Chase and Commerce Secretary in the Clinton administration. The Chamber Commission report will be formally released on March 14, 2007, as part of the Chamber's "First Annual Capital Markets Summit: Securing America's Competitiveness" (here)

Including appendices, the Chamber Commission's Report weighs in at 179 pages, putting it in a competitive position, girth-wise, with the Interim Report of the Committee on Capital Markets Regulation and the Bloomberg/Schumer Report. (The Chamber Commission's Executive Summary even weighs in at 20 pages.) The Chamber Commission did reduce its recommendations to six bulleted points:

* Reform and modernize the federal government's regulatory approach to financial markets and market participants.

* Give the Securities and Exchange Commission (SEC) the flexibility to address issues relating to the implementation of the Sarbanes-Oxley Act of 2002 (SOX) by making it part of the Securities Exchange Act of 1934.

* Convince public companies to stop issuing earnings guidance or, alternatively, move away from quarterly earnings guidance with one earnings per share (EPS) number to annual guidance with a range of EPS numbers.

* Call on domestic and international policy-makers to seriously consider proposals by others to address the significant risks faced by the public audit profession from catastrophic litigation, as well as the Commission's suggestion that national audit firms be allowed to raise capital from private shareholders other than audit partners.

* Increase retirement savings plans by connecting all employers of 21 or more employees without any retirement plan to a financial institution that will offer a retirement arrangement to those employees.

* Encourage employers to sponsor retirement plans and enhance the portability of retirement accounts through the introduction of a simpler, consolidated 401(k)-type program.

The six principal recommendations are discussed further in the March 12, 2007 Wall Street Journal article (here, subscription required). The recommendation regarding the incorporation of SOX into the '34 Act is discussed further on the FEI Financial Reporting Blog (here). The CorporateCounsel.net Blog also has a post on the Report, here.

While not included in the six principal recommendations, the Chamber Commission does also make "a number of specific recommendations designed to enhance the effectiveness of the U.S. legal system." The most significant of these recommendations is based on the Commission's view that there is a "strong need to investigate the accuracy of the widely held global perception that the U.S. securities litigation and regulatory environment makes it dangerous to participate in our capital markets."

But rather than make any specific reform recommendations in that regard, the Commission "recommends that Congress call upon the SEC to undertake a comprehensive study of state and federal securities enforcement mechanisms to assess whether they are enhancing the goal of investor protection and capital formation and whether the PSLRA is achieving the objective set forth by Congress." The Commission specifically recommends that the study analyze:

* civil and criminal cases brought by governmental agencies and regulatory actions brought by [self-regulatory organizations];

* PSLRA's impact on the effectiveness of the federal securities laws; and

* impact of post-PSLRA litigation on the dual objectives of protecting investors and promoting capital formation.

The Chamber Commission notes that "time is of the essence" in the study's completion. (These issues are discussed at pages 28 to 31 of the full Report.)

The Chamber Commission Report also identifies three other "problem areas" in private securities litigation and makes recommendations that "should reduce costs while preserving investor protections":

Fair Funds: The Chamber Commission recommends that "the SEC adopt a forma policy that prohibits duplicative payments from Fair Funds and private litigation on the same claim." (Discussed at page 88-89 of the full Report)

Scope of Professional Liability: The Commission recommends the adoption by the other federal judicial circuits of the Second Circuit's bright-line test for primary liability of secondary actors in securities fraud cases; and the Commission advocates that other circuits follow the Eighth Circuit in rejecting "scheme liability" as "incompatible with the Supreme Court's rejection of aiding and abetting theories under Section 10b and Rule 10b-5." (Discussed at pages 90-92 of the full Report).

Selective Waiver: The Commission recommends that Congress adopt legislation "establishing a selective waiver that would permit corporations to share privileged information with the SEC and continue to assert the privilege against other parties." The Commission also recommends that Congress establish a selective waiver that would "permit a private party to share privileged information or documents with external audit firms or government appointed corporate compliance monitors...without waiving the attorney-client privilege to other third parties." (Discussed at pages 92-95 of the full Report)

The Chamber Commission's Report also has extended discussion (at pages 80-87 of the full Report) of the controversies surrounding the federal prosecution of business organizations. The bulk of this discussion related to concerns regarding prosecutorial ability to seek or require production of attorney-client privileged materials or work-product materials. The Commission expresses its concern that the Department of Justice's (DoJ) McNulty Memorandum "does not adequately address the concern that companies feel pressured to waive attorney-client privilege and work product protection under threat of indictment or other enforcement actions." The Chamber Commission endorses the "ongoing efforts to have the DoJ eliminate as a cooperation credit factor a company's decision to waive the attorney-client privilege or attorney work product protection."

The Chamber Commission also recommends that Congress and the DoJ "reevaluate the standards of corporate criminality" to "place more weight on the proactive efforts of corporations to prevent criminal conduct." The Commission recommends that "corporate criminal conduct should be largely reserved to instances where the corporate form is a mere shell or in which criminal conduct is pervasive within the company's senior executive ranks."

The SEC Actions Blog has a thoughtful discussion (here) of the Chamber Commission's recommendations regarding the McNulty Memo, the attorney client privlege and federal corporate criminal prosecutions.

The Report contains quite of number of other interesting suggestions, as a result of which the Report merits a full review, notwithstanding its daunting length. The sheer number of reform recommendations defies quick summary, but there are several that are particularly worth closer review, including the Report's suggestion (at pages 71-77) that all public companies "eliminate the practice of providing quarterly guidance" because "reducing the pressures to meet precise quarterly earnings targets...is an important first step toward shifting the focus away from quarterly results and toward the long-term performance of U.S. companies." The elimination of qurterly earnings guidance was previously recommended by the Business Roundtable Institute for Corporate Ethics in is July 2006 Report (here). The D & O Diary's prior views regarding the pitfalls of earnings guidance can be found here and here.

The Report also recommends the creation of two federal chartering mechanisms, one for accounting firms and one for insurance companies. In both cases, the objective is to reduce regulatory burdens that add friction costs and impeded competitiveness. The D & O Diary believes the recommendation for an option federal level insurance chartering system is particularly noteworthy and is a concrete suggestion that could in fact actually help U.S. based insurance companies (which are very important participants in the U.S. financial markets) to operate more efficiently and compete more effectively.

The Chamber Commission's Report is merely the latest in a series, and we will be hearing more of the same tomorrow (March 13) when the Treasury Department holds its conference on U.S. Capital Markets (here). But the Chamber Commission deserves credit for not replowing the same ground as the prior reports, and for avoiding the shortcoming of the prior reports of confusing the interests of Wall Street with the interests of the overall economy. The Chamber Commission's Report seems much less concerned than prior reports with simply removing things that Wall Street finds annoying, and more focused on ideas that will aid capital formation and competitiveness of U.S.-based financial enterprises.

As the regulatory reform dialog continues, the process seems to be becoming additive and cumulative. There have unquestionably been a number of interesting and promising ideas that have emerged, and the more the continuing dialog focuses on improving U.S economic prospects and the less it focuses on weakening the integrity of the U.S. regulatory system, the more promising will be the outcome.

The D & O Diary's prior discussion of the Interim Report of the Committee on Capital Markets Regulation can be found here and here. The D & O Diary's prior discussion of the Bloomberg/Schumer Report can be found here. My prior commentary on the weak case for regulatory reform can be found here and here.

Another Damned, Thick, Square Book: According to history (here), when Prince William Henry, Duke of Gloucester and Edinburgh (the younger brother of King George III, and pictured above) was presented in 1781 with Volume II of Edward Gibbon's classic The History of the Decline and Fall of the Roman Empire, the Prince is reported to have said "Another damned, thick, square book! Always scribble, scribble, scribble! Eh, Mr Gibbon?"

Welcome to the Litigation Consulting Blog: The D & O Diary would like to welcome the Litigation Consulting Blog (here), which appears to be a worthy addition to the blogsphere. The blog is relatively new but has already had a number of interesting posts, including today's post (here) about activist investing. D & O Diary readers will undoubtedly find this new blog interesting. Hat tip to Werner Kranenberg of the With Vigour and Zeal blog for the link.

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In a series of recent editorials, the New York Sun has raised some interesting and troubling questions about a New York City's pension fund's involvement as lead plaintff in the Apple Computer options backdating securities litigation.

The first Sun editorial on the topic, entitled "New York Versus Apple "appeared on January 25, 2007 (here). The editorial noted the irony that the same day as the city's Mayor, Michael Bloomberg, and its senior U.S. Senator, Charles Schumer, released a report (here) asserting among other things that meritless securities litigation was undercutting the competitiveness of the city's financial markets, the New York City Employees' Retirement System (NYCERS) was named as lead plaintiff in a class action lawsuit against Apple Computer and its executives and directors. The editorial observed that the city's law firm in the lawsuit, Grant & Eisenhofer, includes on staff as Senior Counsel, Leslie Conason, whose firm website bio reports that prior to joining the law firm, she "was responsible for managing all securities lititgation for the City of New York, where she was in charge of securities litigation for the $100 billion in pension assets held by the workers and retirees of the City of New York."

The editorial also points out that a partner at the Grant & Eisenhofer law firm, Keith Fleischman, had made a $1,000 campaign contribution to the city's Comptroller, William Thompson, Jr., in 2003, when Fleishman was at the Milberg Weiss firm. (As reported on the Comptroller's website, here, among Thompson's duties is the managment of the city's pension funds.) The editorial concludes by saying that:

The notion of a shareholder suit against Apple strikes us, in any event, as a stretch. Whatever shenanigans went on with Steve Jobs' stock options, the company's stock price is up 600% over the past two years, far outpacing the overall gains by the stock market or NYCERS. Any reasonable shareholder should be happy as a clam. New York's economy and streetscape have certainly benefited from the city's Apple Stores in SoHo and at the plaza of the GM building. If there's a bright spot, it's that one of the Apple directors named as a defendant is Albert Gore, Jr. By the time the vice president is done being deposed by the class action lawyers hired by the NYCERS board, he may be ready to line up with Messrs. Schumer and Bloomberg the next time they call for legal reform.

 

In a letter to the editor printed in the February 27, 2007 issue of the Sun (here), Thompson defended himself and the city's process for selecting counsel. His letter explains that after a selection process that included interviews and reference checks, the city executed agreements with nine plaintiffs' firms in mid-2006. His letter also points out that each of the city's pension systems' Board of Trustees makes the final determination as to whether or not to proceed with this type of litigation. Thompson's letter also defended the decision to pursue the Apple litigation, and the city's role in shareholder litigation generally.

In the same February 27, 2007 issue in which Thompson's letter to the editor appeared, the Sun ran a second editorial, this one entitled "Thompson's Trial Lawyers" (here). The paper found that six of the nine firms in New York City's "securities litigation pool," had made a total of $102,491 in donations to Mr. Thompson's 2005 election campaign - an election in which Thompson "faced only token opposition" and in which he was "reelected with more than 90% of the vote." Among other firms, the Kirby, McInerney & Squire firm is reported to have given $39, 975, and the Wolf Popper firm is reported to have given $36,256. Wikipedia notes that Thompson is a leading candidate to become the Mayor of New York in 2009 and has amassed a compaign fund of over $2 million.

In addition, the editorial reports that the head of the pensions division in the city's Law Department said that the Grant & Eisenhofer "brought the idea of NYCERS filing a lead plaintiff application to the Law Division." In other words, the editorial notes, the city didn't discover it was injured and look for a lawyer, "a lawyer chased down a perfectly healthy client and brought the client the idea of a lawsuit, even though the Apple stock the city owned was up 600% in the past two years." The editorial concluded that:

It's one thing... to take campaign money from trial lawyers. It's another thing entirely to turn around and allow those lawyers to use the good name of the city pension fund to pursue litigation with no redeeming value other than racking up huge fees for those same trial lawyers. The price Mr. Thompson pays for the more than $100,000 in campaign contributions he has taken from the class-action aecurity lawyers who represent the city is inevitability that the newspapers -- and, someday, perhaps, voters -- are going to question his judgment in pursuing this sort of litigation.

The Sun added a third editorial on February 28, 2007, entitled "Absentee Trustees" (here) in which the paper took a closer look at Thompson's assertion that a pension fund Board of Trustees had supervised the decision to pursue securities litigation on behalf of the fund. The paper found that at the October 24, 2006 Board "regular meeting" at which the city's Law Department claims that the vote to pursue litigation took place, "the so-called meeting of the 'board' included not 11 trustees [the total number of trustees on the board], not 10 trustees, not nine trustees, not eight trustees, but exactly one. That's right, just one actual trustee." The editorial points out that the board may want to reconsider its processes; "after all, the directors of Apple Computer are being sued by NYCERS for allegedly failing to provide proper oversight." The editorial concludes with the observation that "if things take an unfortunate turn for the New York City Employees' Retirement System, it's conceiveable that some enterprising class-action lawyer might look at them as a target. Apple stock appreciated 600% and it still got sued."

Way back in the optimistic era of securities litigation reform, back when Chris Cox was still just a Congressman from Orange County, when Congress enacted the Private Securities Litigation Reform Act of 1995, there was a notion that institutional investors needed to become more involved in order to eliminate abusive lawyer-driven securities litigation. So Congress promulgated a lead plaintiff process, in which the "most adequate platiniff" would be selected based on which plaintiff showed the "largest financial interest." Whatever Congress thought might result from this reform, it seems fairly likely that it did not envision institutional plaintiffs pursing lawsuits as a result of an unsupervised and campaign finance driven process, supplemented by a revolving door between the institutional investors and the plaintiffs' firms. (As an aside, I also suspect that Congress did not envision institutional investor driven opt-out litigation either, about which I recently commented here.)

The Sun identifed the ironic propinquity of the Bloomberg/Schumer report's release and NYCERS' selection as lead plaintiff in the Apple litigation. An irony the Sun missed is that the Paulson Committee Interim Report (here), which preceded the Bloomberg/Schumer report by only a few weeks and raised similar concerns about the adverse competitive effects of meritless securities litigation, specifically decried "pay to play" practices between institutional investors and the plaintiffs' bar. The Paulson Committee Report asserted that:

When political contributions are made by lawyers to individuals in charge of a state or municipal pension fund, the attorneys should not be permitted to represent the fund as a lead plaintiff in a securities class action. Following the lead of the municipal bonds industry, the securities litigation regulations should be comprehensive and should cover any direct contributions as well as indirect contributions (made through "consultant" or other similar arrangements) ... At a minimum, the SEC, as an amicus, should ask courts to require disclosure of all political contributions or fee-sharing arrangements between class counsel and a lead plaintiff (or controlling individuals within the lead plaintiff organization). This disclosure should occur prior to the court's appointment of either counsel or plaintiff and should be followed by a similar disclosure at the fee award hearing. (Emphasis added)

 

The D & O Diary has a suggestion for Mayor Bloomberg. If he really thinks abusive securities lawsuits are undermining the competitiveness of his city's financial markets, he should toss the report that he and Senator Schumer paid McKinsey to write and read the Paulson Committee's Interim Report's comments about "pay to play" practices. And then he should take a very hard look at practices in his city's Law Department. The good news for Mayor Bloomberg is that he doesn't even need to await the SEC action the Paulson Committee's Interim Report advocated; he can institute his own securites litigation reform without any fuss or bother or press conferences or grandstanding speeches or anthing like that. For reasons the D & O Diary has elaborated upon at length elsewhere (most recently here), this reform is unlikely to affect the relative competitiveness of the city's financial markets in the global marketplace, but it certainly would clean up some pretty unattractive looking circumstances and practices.

How to Find out Who is "Paying to Play": Readers who are interested to know more about plaintiffs' lawyers campaign contributions (or those of anybody else, for that matter) will definitely want to spend some time on the website (here) of the Center for Responsive Politics, where campaign contributions are searchable by donor name. (Click on the "Who Gives" tab and select "Donor Lookup" from the dropdown menu.) For example, a search on the name William Lerach identifes 150 separate donations totaling $1,283,430 (including several donations to Hillary Clinton ) A search on the name Mel Weiss shows that Weiss made 120 donations totaling $699,102. Among other candidates, Weiss made a number of donations to Senator Schumer. Hmmm, that's kind of interesting... maybe after the law firm's indictment, Schumer felt he could...yep, that's probably it.

Isn't It Ironic, Don't You Think?: The Sun obviously has an eye for irony and an interest in securities fraud litigation. The Sun's outlook must be in its DNA, because its founding investors, according to Wikipedia (here), included none other than Conrad Black, who has been working for years on his own wing in the securities fraud litigation house of blues. You don't suppose that has anything to do with the paper's obvious and manifest hostility to securites lawsuits? Nahhh...

The D & O Diary wishes to acknowledge with grateful thanks the two alert readers who prefer anonimity and who provided links to the Sun editorials and to the Center for Responsive Politics website.

 

 

 

 

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The would-be reformers who propose restructuring the U.S securities regulation regime cite the loss of U.S. IPO market share to overseas markets, particularly London's Alternative Investment Market (AIM), as justification for regulatory reform. But as The D & O Diary has previously noted (most recently here and here), these overseas markets, especially the AIM, face precisely the opposite pressure - that it, to validate their regulatory integrity in order to maintain investor confidence.

Along those lines, on February 20, 2007, the London Stock Exchange (LSE) announced a variety of new rules for AIM companies, providing further disclosure obligations and clarifying guidance regarding the rules for "Nominated Advisors" (or Nomads, as they are more popularly known). In its press release (here) announcing the rules changes, the LSE said that the "changes are intended to ensure the AIM maintains the right regulatory balance as the market continues to grow and thrive internationally." The AIM Director of Markets is quoted as saying that "as the market grows and becomes increasingly international, the Exchange will take incremental steps to build on the quality and integrity of the market."

The LSE's summary of the rules changes, as well as a summary of the process leading up to the changes, can be found here. The amended Rules for AIM Companies can be found here.

The key changes in the new Rules for Companies include new requirements for disclosure of critical information on each AIM Company's website; enhanced disclosure requirements for pre-admission announcements; and guidance regarding reverse takeovers. The changes also include revisions to the AIM disciplinary guidelines, including the provision for the LSE to be able to issue warnings for AIM rules violatins, and an increase in the maximum disciplinary fine (from 25,000 pounds to 50,000 pounds). A good summary of the new rules by the Pillsbury Winthrop Shaw Pittman law firm can be found here.

The AIM summary of the changes (here) notes that a number of commentators on the proposed rules during the notice-and-comment period had suggested that that the LSE "should mandate particular corporate governance requirements for AIM companies." The LSE declined to implement uniform corporate governance standards, observing that "given the wide range of companies that admit to AIM, the Exchange believes that the corporate governance measures to be adopted remain a matter for the nomad to provide advice about, on a company-by-company basis, both on admission and also on an ongoing basis as the company develops."

Even though the LSE declined to require uniform governance measures, the LSE's increased emphasis on disclosure, and tightened requirements for Nomads, as well as the increased disciplinary provisions, bespeak an appreciation for the need to encourage regulatory integrity to maintain investor confidence. As The D & O Diary has noted in the past, companies attracted to the AIM out of a perception of a lighter regulatory touch there will find that they still face regulatory scrutiny. Moreover, the changes suggest that the comparative landscape among the various global exchanges is evolving. For that reason, the U.S. should hesitate to alter its regulatory structure to address what may be transient differences in the global financial marketplace.

Special thanks to Werner Kranenburg of the With Vigor and Zeal blog and to alert reader Doug Edinburgh for links regarding the AIM rules changes.

A Baker's Dozen of Canadian Securities Regulators: In the meantime, Canada is wrestling with a different issue - whether to unite its current system of 13 provincial securities regulators into a single, national regulator. According to news reports (here), a panel convened last year concluded that a single regulator could "consistently enforce investor rights across Canada." Canada is the "only major developed country without unified securities regulation, " as a result of which bad actors who have been fined or barred from activity can simply move from province to province.

The push for a single unified regulator has recently gained momentum because of several high profile insider trading cases, and the movement got a further boost when Alberta's finance minister came out in favor of a unified regulatory approach (here). But the boost proved shortlived, as the head of the Alberta securities commission publicly opposed both the single regulator proposal and the finance minister (here). The Ontario government has been pushing for a single regulator, but other provinces, notably Quebec, have been pushing back.

Epic Poet: Homer -- first the Illiad and the Odyssey, then the Simpson. Read Homer's most eternal statements, here. (Better not to have any food in your mouth when you read these.)

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Regular readers know that I have previously questioned (most recently here) the case for regulatory reform. Among the grounds the reformers routinely cite as the basis for regulatory reform is the U.S.'s loss of global IPO marketshare. A February 20, 2007 Wall Street Journal article entitled "Do Tough Rules Deter Foreign IPO Listing in the U.S.?" (here, subscription required) reports the findings of a recent study by Thomson Financial which found "little evidence of foreign companies shying away from U.S. exchanges since the adoption of Sarbanes-Oxley." Thomson Financial apparently studies new stock issues in the past 20 years and concluded that "in terms of dollars raised, foreign IPO activity in the U.S. looks very healthy indeed."

The study found that foreign IPOs (excluding investment funds and closed end funds) accounted for 16% of 2006 IPOs in U.S. exchanges, the highest proportion in the 20-year period studied. In addition, the $10.6 billion raised in foreign company offerings represents 26% of 2006 IPO volume, the highest level since 1994. According to the study's author, "the statistics show that things look rather healthy" and that even after Sarbanes-Oxley, "there doesn't seem to be any really significant deterioration of the IPO market."

The competitive challenge for the U.S. markets is not that they can't attract foreign companies' listings, it is that financial activity in general is increasingly global, and that global growth has more to do with what is happening overseas than with the state of regulation in the U.S. markets. As the February 20, 2007 Bloomberg.com article entitled "IPOs Shun U.S. Exchanges While Wall Street Collects Record Fees" (here) points out, activity on overseas markets may be booming, but "it is not that America's economy and markets are shrinking - it is that the other ones are growing." The article also notes that "for companies based in Europe, the Middle East and Asia, the choice of where to raise capital often comes down to geography and time zones."

The increasing competitiveness of the global financial marketplace is due to a host of causes, most having nothing to do with the level of regulatory scrutiny in the U.S. As I have noted in prior posts, we should be wary of allowing the effects of larger global financial forces to serve as a pretext for reducing the level of regulation in our markets. The evidence above does not support the hypothesis that foreign companies are unwilling to list their shares here, and the increased financial activity overseas has no relation to the level of regulatory rigor in this country.

There is, however, one area, where the U.S. securities markets clearly are at a competitive disadvantage - cost. As the Bloomberg article notes, "for all the talk about keeping U.S. markets competitive and safeguarding jobs, the reality is that investment banks have helped price the U.S. out of the global IPO market." U.S firms charge more to underwrite shares than do firms elsewhere; according to Bloomberg, U.S. investment banks charged fees averaging 4.4 percent of the value of stock sales in 2006, by comparison than 2.3 percent in Europe.

Whether or not the higher underwriting costs for listing in the U.S. really are deterring foreign business, cutting costs would be a particularly easy way to remove at least one impediment to doing business here, and it is a step that doesn't require any governmental authority's cooperation to accomplish. At a time when U.S. financial firms are booking record profits, this seem like a reasonable first step toward removing impediments to the competitiveness of the U.S markets.

In my commentary on reform proposals, I have also frequently noted (refer here) that other countries' reforms are narrowing differences between the U.S. and other countries. An article in the February 17, 2007 issue of the Economist magazine entitled "If You Can't Beat Them, Join Them" (here, subscription required) comments that while European business interests may not welcome American style class action lawsuits, "welcome or not, class action lawsuits are on the way." Britain, Netherlands, Germany and Spain all already permit some form of collective action, and Italy and France are considering their own versions. (France recently tabled its version until after the May elections.) To be sure, these European versions lack many of the attributes of American class action litigation, including contingent fees, jury verdicts on damages, and the possibility of punitive damages awards. The Economist declares that these new forms of collective action deserve a "caution welcome" because they permit efficient resolution of widespread claims, and because they provide injured European investors a way to seek remedies without having to resort to U.S. courts.

Reasonable minds can disagree over whether the differences or similarities between the U.S and the European models of collective civil actions are most important now. But as global investors become more accustomed to seeking judicial remedies for management misconduct, the similarities will matter more than the differences.

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In a recent post (here), I noted that the cross-border Siemens bribery investigation shows that regulators throughout the world increasingly recognize the importance of vigilance and scrutiny, and that the extent of alleged misconduct in that case could spur further efforts for oversight and reform. In that same vein, a February 15, 2007 New York Times article entitled "Germany Battling Rising Tide of Corporate Corruption" (here) notes with respect to the Siemens case and other investigations that "the current spate of scandals will prompt a serious, systemic effort by German companies to impose more stringent internal controls and systems of legal compliance to stop corruption from happening in the first place."

Whether the current wave of German corruption cases reflects lax legal compliance or simply more aggressive prosecution, it is clear that the number of cases is increasing. Germany did not have laws allowing prosecutors to bring bribery cases until 1997, by contrast to the United States, which has had the Foreign Corrupt Practices Act for over 30 years. One source quoted in the article says that in the last five years, "the notion that we need to prosecute economic criminality took on an entirely new dynamic."

This new dynamic clearly will influence both prosecutorial priorities, and by extension, expectations of corporate compliance. As I have previously noted (here), as these regulatory efforts elsewhere gain traction, differences in regulatory standards between the U.S. and other countries will diminish - a consideration that is clearly relevant to the current calls for regulatory reform in the U.S.

Ready, Fire, AIM: In prior posts, I have raised concerns (most recently here) about regulatory standards for London's Alternative Investment Market (AIM), and more recently (here) I have suggested that the AIM may be facing increasing pressure to tighten up. In a February 12, 2007 article in The Times (London) entitled "Most AIM Fundraisers Fail to Enrich Backers Over Three Years" (here) takes a look at the 802 companies that listed on the AIM during the three years ending on December 31, 2006, and finds that 52 percent were "either trading at or below their issue price, or have had their shares suspended."

The Times concludes that the "findings are likely to fuel criticism of AIM that, although it has been the most successful growth market in terms of new listings, it has often sacrificed quality for quantity."

Whatever conclusions may be drawn from the data about the quality of AIM listed companies, the fact that over half of the last three years' listings have failed to make money for investors does have important implications for the likelihood of the past level of listings to continue in the future. This is just one more example of the reasons why current global marketplace circumstances may well change for their own reasons, without any of the regulatory revisions for which the would-be reformers in the U.S. are clamoring.

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At the heart of recent calls for regulatory reform in the Interim Report of the Committee on Capital Markets Regulation and in the Bloomberg/Schumer Report is the assertion that the U.S. securities markets are losing global IPO marketshare because of supposed regulatory overkill and the litigious environment in the U.S. Accompanying this assertion is the concern that foreign securities markets (particularly in London) are supposedly attracting IPO activity by their comparatively light regulatory touch. Reform of the U.S regulatory approach and litigation system is needed, these Reports assert, so that the U.S. can recapture a larger share of the global IPO activity.

The D & O Diary has previously presented (most recently here) its belief that the reformers' case for regulatory reform is "weak." More recently, events both overseas and in the U.S. further belie both ends of the reformer's premise - that is, these recent events suggest that companies (even foreign companies) may yet seek to list on U.S. exchanges, in preference to other exchanges, even without regulatory reform; and that companies might not be able to count on a lighter regulatory touch on competing exchanges.

1. London's Attraction To (or Appetite For) Russian and Chinese Companies May be Waning:

A very large part of the London markets' success in growing their share of the global IPO market in recent years has been based on their success in attracting listings from Russia (and other former Soviet republics) and from China. Indeed, in 2006 alone, 12 offerings by companies from Russia or other former Soviet republics raised proceeds of nearly 6.6 billion pounds. But now in early 2007, the bloom very much seems to have gone off the rose for Russian offerings in London. As reported in a February 8, 2007 Financial Times article (here), the listing of the shares last week of two Russian companies (Polymetal and Sitronics) came in at the low end of the offering range and in response a third company, GV Gold, withdrew its offering amidst "lackluster demand." According to the Financial Times article, these developments "underline the increasingly tough environment companies from Russia and other former Soviet states are likely to face this year as investors become increasingly selective."

At the same time the pipeline of Russian companies to London has started to slow, two Chinese companies, 3SBio and JA Solar Holdings, completed successful offerings on NASDAQ.

Without the flood of Russian listings, and with Chinese companies successfully listing in the U.S., the apparent market share advantage enjoyed by the London exchanges could be diminishing

2. The Successful Fortress Investment Group IPO Will Attract Additional Hedge Fund and Private Equity Fund Listings on U.S. Exchanges

Fortress Investment Group's successful February 9, 2007 IPO was not the first public offering by a private equity fund or hedge fund, nor was it the largest. But it was the first public hedge fund offering on a U.S securities exchange, and it was the most successful. According to the February 10, 2007 Wall Street Journal (here, subscription required) 19 private equity and hedge fund firms sold shares in 2006 on foreign markets, raising $12.4 billion. U.S. groups have been among the firms to list their shares in these offering. KKR, for example, sold shares in a private equity fund on the Euronext Amsterdam exchange. But the KKR fund shares trade in a narrow range close to their offering price.

Fortress chose to list its shares on the NYSE, notwithstanding those supposedly prohibitive regulatory constraints that are driving companies away from the U.S. securities markets. Its reward was that its offering priced at the top end of the range and its shares jumped 68% in the first day of trading. Commentators can argue all they want about whether regulatory burdens are deterring companies from listing on U.S. exchanges, but high valuations and a successful debut like Fortress Investment Group's will unquestionably attract companies to list on U.S. exchanges.

The title of the Wall Street Journal's February 10, 2006 article about the offering, "Hedge Fund Crowd Sees More Green As Fortress Hits Jackpot with IPO" (here, subscription required) says it all. Along those lines, a February 9, 2007 Business Week article (here) reporting on the Fortress Investment Group IPO contained a prediction that more than 30 hedge funds and private equity funds could seek to list their shares on U.S. exchanges by the end of 2008.

It should also be noted that the Fortress group was one of 17 offerings this week on U.S. securities exchanges, raising over $3.4 billion, the most active week in terms of deal value in over three years. It certainly seems like the market for IPOs on the U.S. exchanges is healthy -- perhaps healthy enough to question whether the reformers' dire warnings about the competitiveness of the U.S. markets are seriously overblown.

3. London's Regulators, Perhaps Spurred by Criticism, Have Begun to Show Some Teeth

It probably has nothing to do with the remarks (here) of John Thain, the head of the NYSE, at the recent World Economic Forum in Davos, Switzerland, that the London markets need to "tighten up" to avoid "damage" to "their reputation." But within days of these remarks, the U.K.'s Serious Fraud Office launched an investigation (here) into Torex Retail, following the London Stock Exchange's suspension of trading of Torex Retail's shares on the Alternative Investment Market (AIM).

The Torex Retail matter may involve only one company, but it does serve as a reminder that markets will strive to maintain their integrity in order to preserve investor confidence. There are no advantages for being perceived as having won the race to the bottom. Companies attracted to the London markets out of a perception of a lighter regulatory touch will find that they still face regulatory scrutiny. It will not take too many cases like Torex Retail before the London regulators will have shown their vigilence is not less than regualtors elsewhere.

UPDATE: On February 12, 2007, another AIM listed company, Adamind LTD, disclosed (here) that the Financial Services Authority had initated an investigation regarding the company. The Adamind investigation is noteworthy because it involves one of those companies -- Adamind is a U.S.-based company with R & D facilities -- that chose to list in London and about which the would-be reformers have been fretting so much. Special thanks to alert reader Uri Ronnen of the AccountingClues blog for the link to the Adamind disclosure.

Each of these developments serve as a warning against seizing upon possibly temporary or transient phenomena as pretexts for reducing regulatory rigor in the U.S. In the global economy, transactions will go where they can realize their greatest financial advantage. The factors that in the recent past led to a greater number of listings in London may have had little to do with the regulatory regime in the U.S. The changing IPO market place so far in 2007 suggests that the competitive landscape among the various securities markets is already evolving, and will continue to evolve - and that that is happening without the adoption of any of the various proposed regulatory reforms. We should be very wary of compromising this country's regulatory rigor based on transient shifts in the global financial marketplace that have no relation to the level of regulation in this country.

Now This: When we heard about the untimely death of Anna Nicole Smith, we found that we could not think of her marriage to J. Howard Marshall without associating this scene from the film, Best in Show:

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In prior posts (here, here and here), I argue that the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) made a "weak case" in its Interim Report for regulatory reform. Virtually all of my points apply equally to the recently released Bloomberg/Schumer report as well. The themes I sounded in my earlier posts are underscored in a January 25, 2007 Wall Street Journal article entitled "In Call to Deregulate Business, a Global Twist" (here, subscription required), which suggests that "the changing nature of global finance," rather than the U.S regulatory environment, explains U.S. markets' declining share of global finance business.

The Journal article explores at length the improved competitiveness of foreign markets, which in recent years have closed their "quality gap" with the U.S. markets. Developing world markets are "deep enough and liquid enough" that listing companies no longer have any financial imperative to list or trade their shares on U.S. exchanges, as they may have had in the past.

The article also zeroes in on one of the prime points cited to justify regulatory reform - that is, the declining U.S share of global IPOs. With the exception of the London's Alternative Investment Market (AIM), IPOs are down on all developed countries' exchanges - "the London Stock Exchange's blue-chip Main market has seen foreign listing decline 23% since 2000. The Deutsche Borse is down 58%; Tokyo down 39%." In other words, the declining IPO volume "is hardly an American disease." And even with respect to AIM, the article points out that many of the AIM companies don't "meet U.S. requirements" or are "too small to attract interest from U.S. underwriters and investors." (My prior post, here, reviews the Bloomberg/Schumer report's discussion of the AIM and the report's conclusion that the U.S. markets should not lower its standards to compete for more of AIM's business.).

The article also shows that overseas companies are now able to trade their shares freely, and even attract U.S. investors, without the need for a U.S. listing - or the need to pay the $1 million NYSE listing fee. In addition the article examines the fact that increased private equity takeover activity is a global phenomenon, not just a U.S. trait, and that rather than reflecting U.S. companies' interests to "go private" and avoid public company regulation, the high level of private equity activity is simply a reflection of the fact that private equity firms have so much cash.

At the same time as global markets have become better, they have also closed the regulatory gap with the U.S. The article quotes the director of the SEC's office of international affairs as saying that Sarbanes-Oxley has "not competitively disadvantaged U.S. markets, simply by virtue of the fact that they have been widely adopted elsewhere." Even though the U.S. regulatory burden has risen, the same is true for most countries' markets.

The article gives the advocates for regulatory reform an opportunity for rebuttal. The best that Glenn Hubbard, the chair of the Paulson Committee, can offer, is the declining "investment premium" enjoyed by foreign companies based in developed countries that cross list their shares on U.S. exchanges. Hubbard argues that the declining investment premium for these developed world companies shows that for companies already meeting their more stringent governance standards at home, the costs of meeting the U.S. benefits exceeds the costs.

I have extensively examined the investment premium issue before (here), but it is worth noting here what a total non sequitur Hubbard's argument is. First, it concedes that there is still an investment premium for companies based in developing countries - that is, the countries with the growing economies that are most likely to be the source of increased economic activity in the years ahead. Second, while the investment premium for companies based in developed countries has declined, it has not gone away, there is still an investment premium for listing on U.S. exchanges, and that is because of the integrity of the U.S. markets, which would be eliminated if regulation were relaxed. And third, to the extent the investment premium has declined, isn't it obvious that it is because the integrity of many foreign markets has improved? If that is the case, then why does that argue in favor of weakening U.S markets' regulation? It just seems to me that the only conclusion that can be drawn from the investment premium issue is that we would be best served by striving to maintain the integrity of our markets, not weakening our regulatory rigor in a race for the bottom.

All of this underscores the point I have made in prior posts that business interests in the U.S. may be seizing on the effects of the changing global finance environment as a pretext to undermine regulatory requirements that may occasionally prove uncomfortable because the requirements actually have teeth. The advocates for regulatory reform may want to advance U.S. competitiveness, but steps that threaten to weaken the integrity of the U.S regulatory structure could remove the greatest advantage the U.S. markets enjoy - that is, the U.S. markets are the most highly regarded precisely because they are the most tightly regulated.

That is not to say that none of the reformers' ideas have validity. To the contrary, the Bloomberg/Schumer report's suggestions for immigration reform and immediate adoption of the Basel II Capital Accords are sound and should be pursed, as should many of the report's suggestions for harmonization of competing U.S. regulatory structures, and the harmonization of U.S and international accounting standards. But aggressive revision of the U.S regulatory and legal structure, at least in the name of the competitiveness of the U.S. markets, could represent a misplaced effort that could do more harm than good.

It is worth noting that the Journal article contains an interesting quote from former Treasury Secretary Lawrence Summers, who says that "well-functioning capital markets are central to the success of the economy. What faction of capital market transactions runs through New York is of much less broad-based significance." Summers' observation is one that is not being heard much, but it is a point worth keeping in mind. Perhaps we should be more focused on adapting to the new reality of the global marketplace, rather than attempting to preserve the benefits of market advantages that no longer exist.

Finally, it is worth noting that several of the overseas companies discussed in the Journal article mentioned the high listing fees for U.S. exchanges. While the two task force reports released so far have tried to downplay the importance of listing fees and U.S underwriters' fees (which also tend to be higher than European fees, as much as twice as high), evidence and logic suggest that these fees and costs are a factor affecting overseas companies' willingness to list on U.S. exchanges. As I have argued before, the U.S. financial industry, rather than sniping at a regulatory structure that other countries are imitating, perhaps they should overhaul their cost structure, which the rest of the world has substantially improved upon.

UPDATE: The January 26, 2007 New York Times has an article (here) that raises many of the same themes as the Journal article linked about, including specifically the point that the U.S. should not be stressing about the loss of very small companies to the AIM.

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On Monday January 22, 2007, Republican New York City Mayor Michael Bloomberg and Democratic New York Senator Charles Schumer released the joint report they commissioned from McKinsey & Company, entitled "Sustaining New York's and the U.S.'s Global Financial Services Leadership." The report can be found here, and the joint press release describing the report can be found here. The report is written in the same vein as the Interim Report of the Committee on Capital Markets Regulation, or the Paulson Committee as it is popularly known, and the two reports are both of similarly impressive length. (My prior discussion of the Paulson Committee Report can be found here). There are, however, several important differences between the two reports, both in tone and in substance.

Among the more important visual differences is the explicit bipartisan support for the Bloomberg/Schumer report. Indeed, newly elected Democratic New York Governor Eliot Spitzer showed up for the ceremony to release the report, about which there is some significant irony, given the report's concern about the problems caused by conflicting regulatory schemes. The Wall Street Journal's discussion of the unsubtle irony of Spitzer's involvement can be found here and here (subscription required).

The Bloomberg/Schumer report, like the Paulson Committee's Interim Report, is focused on the competitiveness of the U.S. capital markets, but its recognition of the reasons for the heightened competitiveness of foreign securities markets is more comprehensive and detailed than the Paulson Committee's Interim Report. The Bloomberg/Schumer report examines at length the "strong dynamics outside the U.S. driving international growth." Its review of the reasons why many foreign companies are seeking to list their shares on exchanges outside the U.S. examines at length the geographic and economic reasons for this shift, including in particular the increased availability of adequate capital in foreign markets and improved technology and communications that has opened these markets to all international investors (including even U.S.-based investors).

The Bloomberg/Schumer report is also much less concerned about the purported threat of London's Alternative Investment Market (AIM) that then Paulson Committee's Interim Report. While recognizing that the AIM has successfully tailored its listing requirements to attract smaller companies, the Bloomberg/Schumer report also notes that "small-cap markets are clearly riskier that their more established counterparts." The report also notes in a sidebar that while the AIM has attracted a growing number of listings in recent years, the growing number "masks the large and increasing number of de-listings (480 since the beginning of 2003) and low liquidity of most AIM stocks." The Bloomberg/Schumer report concludes that because of concerns over the "disproportionate impact a bear market might have on small-cap markets and investors," and the limited economic benefit of such markets, the report "does not recommend that U.S. exchanges lower their listing requirements to attract more small issuers.'

The Bloomberg/Schumer report also emphasizes several issues that are not addressed at all in the Paulson Committee's Interim Report. For example, the Bloomberg/Schumer report takes a look at legal barriers that may prevent domestic markets from attracting top global financial talent and concludes that U.S immigration policies are making it harder to attract non-citizens to move to this country, and these barriers are undermining the competitiveness of U.S. securities markets. The report proposes a number of specific immigration reforms. The Bloomberg/Schumer report also recommends the rapid implementation of the Basel II Capital Accords, so that U.S.-based commercial banking institutions do not face higher capital level requirements than their foreign counterparts, which would put them at a competitive disadvantage.

Based on its conclusion that the regulatory and legal environment in this country is a substantial factor diminishing the attractiveness of U.S capital markets, the Bloomberg/Schumer report proposes a number of reforms. While the Bloomberg/Schumer report, like the Paulson Committee report, singles out Section 404 of the Sarbanes-Oxley Act, the Bloomberg/Schumer report comments that the fault does not lie with the Act itself but with the implementing regulations. (This observation coincides with the remarks of SEC Commissioner Paul Atkins on January 22, 2007 at the Corporate Directors Forum, here). The Blooberg/Schumer report urges the SEC and the PCAOB to proceed quickly with their current efforts to reform the implementing regulations (see the PCAOB's press release on its current reform efforts, here), provide further guidance with regard to what constitutes a "material weakness" in internal controls, and help implement an internal control review that is "top-down, risk-based, and focused on what truly matters to the integrity of a company's financial statement.'

The report also suggests that the SEC should consider giving "smaller companies" (the report does not define "smaller") the opportunity to opt-out of the more onerous requirements of the Sarbanes-Oxley Act, provided the choice is "conspicuously disclosed to investors." In addition, the report suggests that the SEC should consider exempting foreign companies from certain parts of the Act, provided they already comply with sophisticated, SEC-approved foreign regulators' requirements.

The Bloomberg/Schumer report also proposes limited "securities litigation reform," which it proposes that the SEC implement through its authority under Section 36 of the Securities Exchange Act of 1934 to exempt certain companies from regulations when it deems such exemptions to be in the public interest. Specifically, the report suggest that the SEC choose to limit the liability of foreign companies with U.S. listings to securities related damages proportional to their degree of exposure to U.S. markets; and impose a cap on auditors' damages that would maintain a deterrent effect but reduce the likelihood that the auditing industry would lose another major player. The report also repeats the suggestion that the SEC could allow companies to opt out of part of SOX (again, with "conspicuous disclosure.") The report also proposes that the SEC promote arbitration as a means of resisting disputes between public companies and investors.

The report also proposes two legislative changes to address "long-term structural problems." The report suggests that Congress should consider limiting punitive damages and allow litigants in federal securities actions to appeal interlocutory judgments immediately to the Circuit Courts. The report contains a number of suggestions to harmonize the various U.S. regulatory structures. It also suggests the creation of a permanent body (the "National Commission on Financial Market Competitiveness") to focus on the competitiveness of the U.S securities markets.

Compared to the Paulson Committee Interim Report, the Bloomberg/Schumer report is both more comprehensive (for example, with its reference to immigration reform and the Basel II Capital Accords) and, in some ways, more realistic (for example, in its recognition of the myriad reasons not to lower regulatory standards simply to attract smaller listing companies). The report also presents a few modest proposals that could help incrementally improve the competitiveness of the U.S. securities markets. The report struggles to maintain the air of modesty for reforms that may not be quite so modest or feasible (for example, using federal legislation to eliminate state law provisions for punitive damages, or using regulatory provisions to create damages caps). The proposal to create an arbitration remedy for investors disputes with public companies may seem superficially attractive, but even a brief referral to one of the more serious securities class action lawsuits will reveal that these kinds of lawsuits are peculiarly unsuited for that forum and process.

But with the arrival of the Bloomberg/Schumer report and its addition to the Paulson Committee's Interim Report, and with the added prospect of the conference that the Treasury Department plans to hold this spring on the issue of the competitiveness of the U.S Securities markets (here), it is pretty clear that momentum is building for action to be taken to assist the U.S. markets. In this environment, particularly where there seems to be a bipartisan consensus emerging, it seems likelier that regulatory and even legislative reforms may well occur. In this environment, ideas such as the increased regulatory flexibility for smaller companies and foreign companies, may receive a more sympathetic reception, even though it would have to be asked whether these changes might represent a lowering of standards that arguably could weaken the overall strength and integrity of the markets.

It also appears the regulators are reading reading the newspapers. The PCAOB's intiative to reform Auditing Standard 2 and argubly even the Department of Justice's revision of the Thompson Memo with the release of the McNulty Memo are undoubtedly the result of a multitude of factors, but the timing of these reforms may be due to the growing calls for reform. The regulators may well be attempting to get ahead of the curve; there may be further regulatory intiatives ahead.

One final observation: it is interesting to note that the Bloomberg/Schumer report concludes, in examining the reason for the decline in the number of securities class action lawsuits in 2005 and 2006, that the decline in the number of lawsuits is largely attributable to favorable economic conditions and that "if economic conditions were to decline in the future, then a strong resurgence of lawsuits would likely follow."

Additional interesting commentary about the Bloomberg/Schumer report can be found at the AAO Weblog (here) and the SOX First blog (here).

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When the Committee on Capital Markets Regulation (popularly known as the Paulson Committee) in its Interim Report (here) recommended "setting a cap on auditor liability," the Committee relied for support on the steps in that direction that have been taken by the European Commission. In its latest effort along those lines, the European Commission on January 18, 2007 launched a "public consultation on whether there is a need to reform the rules on auditor liability in the EU." A copy of the Commission's press release can be found here. A copy of the Staff Working Paper can be found here.

In the Working Paper, the Commission's staff offered four alternative proposals to cap the liability accounting firms potentially face when auditing public companies. (The Commission is asking for comment on the four proposals by March 15, 2007.) The four proposals are: a fixed monetary cap on damages that could be sought from auditors; a cap based on the audited company's market capitalization; a cap based on a multiple of the audit fees charged; or the introduction of proportionate liability , which would hold the auditor responsible only for the damages that could be specifically attributed to them.

The initiative to afford accountants some form of liability protection is being led by Charlie McCreevy, the European Commissioner for Internal Market and Services. The initiative would potentially extend protections across the EU's 27 member countries, although the member countries would not be required to enact them. However, the Working Paper notes that "auditor's liability is currently capped in five Member States (Austria, Belgium, Germany, Greece and Slovenia)."

The Commission's motivation for exploring auditor liability caps is essentially the same as that noted by the Paulson Committee in its Interim Report. That is, the Commission is concerned that as the number of audit firms capable of auditing the largest companies has dwindled down to four, the potential consequences from the failure of one of the remaining firms would be harmful to investors. In an October 27, 2006 interview in the Financial Times (here), McCreevy expressed his concern that "further reduction in the number of global firms would make it very hard for companies to get accounts signed off and published - dealing a blow to investors." McCreevy himself advocates a cap on auditor liability.

A January 19, 2007 Wall Street Journal article entitled "EU Offers Plans for Accounting Firms' Audit-Liability Caps" (here, subscription required) suggests that the EU proposals "could help a push by the largest firms for similar protection in the U.S." The article goes on to note that the "adoption of a European auditor-liability shield, even if the member countries weren't required to enact it, would potentially add to a sense that U.S. markets are increasingly at a competitive disadvantage to those in Europe, and, in particular, London."

The competitiveness of the U.S. capital markets will be the theme of a conference that will convened in the spring by Treasury Secretary Henry Paulson. (For a description of the planned conference, announced on January 17, 2007, refer here.) The accounting industry will be one of the three major topics to be discussed at the conference, along with regulation and corporate governance. Robert Steel, the Treasury's undersecretary for domestic finance, in describing the conference's anticipated topics, said that (unnamed) officials are "concerned about the accounting industry," and that the conference will look at whether there are "structural issues" that hurt the industry, such as an "unattractive liability construction." Steel, along with Paulson, recently joined the Treasury Department from Goldman Sachs.

Is the PCAOB Shielding the Big Four?: With the anxiety surrounding the possible investor consequences to investors were another of the Big Four accounting firms to fail, could it be that regulators are treading softly around the "remaining Four?" As The D & O Diary noted in a prior post (here), the Public Company Accounting Oversight Board (PCAOB) does not reveal much about its inspections of the Big Four accounting firms. For example, the PCAOB does not reveal the number of Big Four audits it inspects as part of its annual inspection process, or the percentage of audits inspected that proved to have concerns - even though it releases this information for smaller firms.

A January 18, 2007 post on CFO Blog (here) reports on a recent speech by PCAOB founder and board member Bill Gradison, in which Gradison suggests that the PCAOB considers itself a supervisory body rather than an enforcement agency, and so the agency wants to work with firms to restore "integrity" and even "luster" to the profession. For that reason, the PCAOB prefers to give the audit firms a 12-month grace period to fix problems, rather than to make them public when they happen, since "reputation is so important in a field like auditing."

While I am sure the accounting firm's appreciate this deference to their reputation, investors' interests are definitely forced into the back seat by this ordering of priorities. As my prior post linked above notes, the PCAOB's annual inspection report disclosure leaves a great deal to be desired from the investors' point of view. First and foremost, the PCAOB ought to inform investors what percentage of audits inspected produced inspection concerns. In addition, the PCAOB ought to tell the investing public how many of the audit concerns were material, which audit concerns were material, and what order of magnitude the material concerns represent.

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In my prior comments on the Paulson Committee's calls for regulatory reform (most recently, here), I have suggested that perhaps the U.S. securities markets may be better off without at least some of the companies that are avoiding the U.S. exchanges' tougher listing requirements. A recent report by a U.K. accounting firm contains interesting data that may be pertinent to this question.

BDO Stoy Hayward reports (here) that annual reported instances of fraud in the U.K. rose 33% between 2005 and 2006 and the value of the reported fraud rose almost 40%. (According to the firm's website, the full report will be available in February.) A January 8, 2007 New York Post article reporting on the BDO Stoy Howard study, entitled "Brits Get Bit: Lax British Marts Attract Fraud Along With U.S. Biz" (here), examines whether the increase in London-listed offerings by companies unwilling or unable to meet the U.S. listing requirements explains part of the increase in U.K. fraud. The article notes (as The D & O Diary has previously noted, here) that the London exchanges have "accepted scores of new listings of Chinese and Russian companies that may not have met New York exchanges' stricter rules." The article quotes the head of the BDO Stoy Hayward firm's fraud unit as saying that "I have no doubt that some businesses' plans have been deliberately optimistic, and property, including intellectual property falsely valued."

As Jack Ciesielski notes on the AAO Weblog (here), commenting on the New York Post article linked above, "Investors should be thankful that seedier companies have found the U.S. markets too difficult to easily game because of Section 404." And as I previously have noted (here and here), lowering standards to attract weaker companies is not a sustainable advantage. The valuation premium that companies listing on U.S. exchanges enjoy - because of the stricter regulatory environment - is a real and sustainable advantage.

UPDATE: The With Vigour and Zeal blog (here) adds an important additional perspective on this post. The WVZ blog does concede that the BDO Stoy Hayward study may be relevant to the question whether U.S. exchanges are better off without the companies drawn to London by lighter regulation; however, the WVZ blog also emphasizes that the BDO Stoy Hayward study is concerned with a very wide variety of frauds, not all of which involve listed companies. Among other things, the accountants' report is concerned with a species of tax fraud that is peculiar to the U.K. So, the WVZ blog concludeds, it is "therefore not wholly representative to discuss the report's findings in the context of the securities markets" or in connection with the question of the competitiveness of the U.S. securities markets. I don't disagree with the WVZ blog, but simply note that if the accountants' study is not entirely relevant, it is not entirely irrelevant either. Nevertheless, I agree that the WVZ adds an important additional gloss to this post, and for that reason, readers should refer to the WVZ blog for a more complete picture of the implications of the BDO Stoy Hayward report.

Speaking of the London markets, Legalweek.com has a recent article (here) discussing the potential liability of the London Stock Exchange's Alternative Investment Market's Nominated Advisors (or Nomads) in U.S. courts under U.S. securities laws. Hat tip to the With Vigour and Zeal blog (here) for the link to the Legalweek.com article.

Korea Adopts Securities Class Actions: Another cause the Paulson Committee cited as a reason foreign companies may be shunning U.S. exchanges is the U.S. litigation environment. But as I have previously argued (most recently, here), investors in other countries increasingly are demanding (and getting) the right to hold company management accountable in local courts, and as a result the differences between the U.S litigation environment and those of at least some other countries may be diminishing. The most recent example of another country moving toward a U.S. style class action litigation system is Republic of Korea, better known as South Korea.

According to a January 8, 2007 Korea Herald article entitled "Open Season for Securities-Related Class Actions" (here), South Korea adopted the Securities Related Class Action Act of 2005, subject to a "grace period" during which its enforcement was stayed. The grace period expired on December 31, 2006, meaning that companies listed on the South Korean stock exchanges (including the approximately 730 companies listed on the Korea Exchange), face potential securities class action exposure starting in 2007. At least based on the article, the new Korean class action sounds similar to the U.S.-style securities class action lawsuit, post PSLRA. The article's author, a Korean attorney, speculates that as many as 30 of Korea's 1,600 listed companies could face securities class actions annually.

An interesting discussion of the state of corporate governance reform in Korea, including a discussion of the new Act, can be found here.

The D & O Diary notes that one U.S.-listed Korean-based company, Pixelplus, was sued in a securities class action lawsuit in the U.S. (here) during 2006.

More on Short Selling in PIPE Financing Transactions: In a recent post (here), I reported on two recent SEC enforcement actions involving short selling by investment banks or broker dealers in connection with PIPE financing transaction. On January 4, 2007, the SEC filed yet another settled enforcement action (here) involving short selling in connection with a PIPE transaction, alleging alleged that a trader and a hedge fund entered into contracts to purchase shares in a PIPE offering and then sold those shares short. The SEC Actions blog has a detailed and interesting discussion (here) of the new enforcement action, as well as of the SEC's position regaring short selling in connection with PIPE transactions, including current SEC rule making regarding short selling in PIPE transactions.

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When the blue-ribbon Committee on Capital Markets Regulation (popularly known as the Paulson Committee) released its Interim Report (here) calling for regulatory reform, it based its case for reform in large part on the U.S securities exchanges' loss of market share in the global IPO marketplace. As The D & O Diary has previously noted (here), there are serious grounds on which to question this premise. Recent developments provide additional grounds on which to question many of the Paulson Committee's presumptions. Several of these presumptions are reviewed below, in light of these developments.

1. Lower Regulatory Requirements Give Foreign Exchanges an
"Advantage"

The Paulson Committee's Interim Report focused in particular on London's Alternative Investment Market's (AIM) "hands off" approach to regulation. The Report noted that the U.K. has been "relentless in stressing its regulatory advantage and indicating its commitment to maintaining a 'light touch' in regulation." This lighter touch may be attractive to certain companies, but whether this is an advantage for investors is doubtful.

A December 20, 2006 Wall Street Journal article entitled "Uncertain AIM: A Hot Market In London Has Its Risks, Too" (here, subscription required), examines whether AIM market's "laissez faire" approach may be "treacherous for investors" because some of the companies that have gone public on AIM are "intrinsically dangerous businesses." The article also examines the limitations of, and inherent conflicts of interest involved with, the AIM market's system of "nominated advisers" or "nomads," who both vet potential deals and pitch the new company's shares to the marketplace. Indeed, because of perceived abuses, AIM is "finalizing a new rulebook that toughens some standards" and "may be preparing further steps to restore confidence in the market." In the meantime, investors have suffered, The article cites examples of "unpleasant surprises" for AIM investors in the last 18 months, including one AIM company whose shares plunged 60% when the company disclosed one month after its offering that the oil field it was exploring was not "commercially viable."

The AIM experience suggest that while lax standards have made it attractive for weaker companies, that is not a sustainable "advantage." AIM's belated attempts to shore up its oversight weaknesses underscores that the most important advantage a marketplace can have is investors' perception of trustworthiness. U.S. market's regulatory standards allow companies whose shares trade here to enjoy a valuation premium (see my prior post about the valuation premium here). A valuation premium, now that is a competitive advantage. A regulatory race to the bottom to attract marginal companies would be a huge step backwards.

One undeniably real advantage that foreign exchanges do offer is lower cost access, both in terms of lower underwriting fees and lower listing fees. Concerns about the competitiveness of U.S. securities markets' competitiveness would be more appropriately focused on these cost disadvantages, rather than the regulatory integrity of the U.S. securities markets.

2. The U.S. Securities Markets' Loss of Market Share is Due to the
Regulatory Burden and Threat of Litigation Here

The U.S. securities markets have lost global marketshare for IPO business, but the causes are even more numerous and diffuse than the Paulson Committee assumes. The Committee's Interim Report acknowledges that part of the reason for the decline is that foreign markets have improved. But as I have discussed previously (here), the biggest reason for the decline in the U.S. marketshare is the decline in the number of U.S.-based companies' IPOs. This decline in U.S. companies' IPOs may be due to cyclical reasons -certainly recent IPO activity gives reason to hope that this activity may be cycling back up. According to CFO.com (here), the number of U.S. based companies completing IPOs through November 2006 (186) represents the highest annual number since 2000. And according to the Wall Street Journal (here, subscription required), last week's 16 offerings made it the busiest week of the year for IPOs. The recent high level of U.S. based company IPO activity raises the question whether the concerns the Paulson Committee seeks to address may be temporary and have less to do with the attractiveness of the U.S. exchanges to foreign companies than with the conditions for companies inside the U.S.

And even with respect to foreign companies, the decline in U.S. market share may be a reflection of the mix of foreign sources for IPO companies. As a December 18, 2006 Wall Street Journal article entitled "Israel Fades, China Takes the Lead on Foreign IPOs Listed in the U.S." (here, subscription required) discusses, Israel was "the most active foreign source of listing...by a wide margin" in the late 1990s. Since that time, the number of Israeli companies conducting offerings, both inside and outside the U.S., has been "sparse," primarily as a result of M & A activity in Israel. Also, in the 90s many of the Israeli companies "went public too early," but the "level of sales and profits that you need to go public are much higher now."

China has replaced Israel as the leading source of foreign offerings, but Chinese companies often have unique political or economic reasons for staying with local exchanges. And experience has shown that some Chinese companies may not be completely ready for the scrutiny of public ownership.

All of this should show that there are many reasons - the cyclical nature of the U.S. based IPO activity, declining IPO activity in key foreign countries - that are contributing causes for the decline in U.S. marketshare of global IPOs, and these causes certainly do not justify radical changes to the U.S. regulatory approach. Given these various factors, regulatory reform seems poorly calculated to alter the level of U.S. exchanges' market share.

3. The U.S. Exchanges' Loss of Global Market Share Will Hurt New York City, Its Businesses, Its Employees, and Its Taxpayers

Let's be honest here. Nobody on Wall Street is starving. According to a December 20, 2006 New York Times article (here, registration required), securities industry employees in New York will receive almost $24 billion in compensation in 2006, up 17% from a year ago. Wall Street investment bankers are receiving record bonuses. (Goldman Sachs paid its 26,467 employees an average of $622,000 per person.) This translates into $1.6 billion in tax revenue for New York State and $580 million for New York City.

Remind me again: exactly what is the problem that New York City is facing and why does that justify gutting the U.S.'s strong regulatory regime? Isn't it just possible that what makes all those New York investment bankers so filthy rich is that they have the privilege of working in a city with the most highly respected markets in the world?

Certainly if Wall Street is really worried about being competitive, it needs to take a hard look at its current level of profitability and then take another look at its underwriting and listing fees. Perhaps if Wall Street were a little less astonishingly profitable, the U.S. exchanges might be more attractive to foreign investors. But instead, according to news reports (here), NASDAQ plans to raise its listing fees, in order to support certain auxiliary services that it owns. That certainly is not going to make U.S. exchanges more attractive to foreign companies, or even to U.S. based companies.

4. The U.S. Litigation Environment Creates a Competitive
Disadvantage

The U.S. litigation culture does represent a burden. But as I have previously discussed (here), foreign investors increasingly are demanding accountability from company management, and increasingly are seeking (and getting) the ability to seek redress for alleged management misconduct in local courts. The most recent example of this is the class action (here) that investors in Australia initiated against senior officals at the Multiplex Group. (Hat tip to Adam Savett at the Lies, Damned Lies blog for the link). These kinds of suits will become even more common as foreign investors increasingly demand accountability from senior corporate officials. These trends mean that while the U.S. is more litigious, differences between the U.S and other countries in this respect are diminishing and will become less and less of a factor.

5. The Time is Right for Regulatory Reform

As I have previously stated (here), it is more than a little strange to be talking about regulatory reform so soon after the Enron criminal sentencings and in the midst of the options backdating scandal. But the call for reform is premature in other ways as well. An noted above, the causes of the ills the Paulson Committee seeks to remedy may in part be cyclical, and indeed there is some evidence that the evolution of the cycle will itself alleviate come of the issues with which the Committee is concerned.

Other evolutionary change may provide further relief without the need for an elaborate regulatory reform effort. Just within the last few days, the SEC (here) and the PCAOB (here) have announced efforts to address concerns about the requirements of Section 404 of the Sarbanes-Oxley Act, which is one of the Paulson Committees' big issues. In addition, according to news reports (here), Pink Sheets LLC is looking at creating marketplace mechanisms that could prove more competitive with the AIM (refer also here). Incremental changes of these kinds may be more effective and cause less damage that a wholesale program of regulatory reform.

One thing is certain -- the globalization of capital is neither a small nor a temporary phenomenon. According to an Ernst & Young study (here) released on December 18, 2006, global IPO activity was at record levels in 2006, and offerings from emerging market companies are leading the way. The largest offerings involve Chinese companies, and their listings on the Hong Kong Stock Exchange have given that marketplace the largest share of the new companies. The global economy is huge and dynamic, and financial capital has become increasingly global as well. But while the U.S. has lost manufacturing jobs to companies with lower environmental standards and fewer labor protections, few think the solution is for the U.S. to lower its own environmental standards or eliminate its labor protections. The threats and complications of the global economy represent very significant challenges, but we will not improve our lot by weakening ourselves just to compete. Just as in manufacturing, the most likely approch for success in the global economy for the financial services sector may lie in innovation, specialization and, most importantly, increased efficiencies.

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As noted yesterday (here), the Committee on Capital Markets Regulation (often referred to as the Paulson Committee) has released its Interim Report (here). The Report contains much text, many graphics, and 32 recommendations supposedly addressed to how to improve the competitiveness of the U.S. securities markets. As proof that the U.S. markets are losing their competitive edge, the Committee cites two key measures: the decline of U.S. marketshare of global IPOs; and the increase in going private transactions. The Committee correctly observes that there are a variety of factors behind these trends, including improvements to foreign public markets and increased liquidity in foreign and private markets. The Committee nevertheless believes that the U.S. regulatory and litigation systems are also important causes. The Committee's focus surprisingly is not so much on the Sarbanes-Oxley Act, the discussion of which is relegated to the end of the report. Rather, a much more prominent place is given to reforms of civil and criminal litigation.

By contrast to early leaks suggested that the Committee might recommend far more dramatic revisions (for example, see my prior post here discussing reports that the Committee might recommend eliminating private securities litigation), the Committee's actual securities litigation reform recommendations are surprisingly modest; the Committee recommends that :

The SEC should proved more guidance, using a risk-based approach, for the elements of a Rule 10b-5 actions, including materiality, scienter, and reliance (a good summary of the Report's detailed recommendations with respect to these points can be found on The 10b-5 Daily blog, here);

The SEC should require that any private damage awards should be offset by any amount the SEC has collected from the defendants under the SEC's Fair Funds authority;

The SEC should prohibit certain supposed practices of the plaintiffs' bar (about which more below);

In order to improve the defenses available for IPO companies' outside directors, the SEC should revise Rule 176 to clarify that outside directors may conclusively establish their "due diligence" defense (and thereby avoid liability under Section 11) by showing their good faith reliance on the company's audited financial statements;

As another means of protecting IPO companies' outside directors, the SEC should reverse its longstanding position (here) that indemnification of directors for damages awarded in Section 11 actions is against public policy, at least if the directors have acted in good faith.

With respect the practices of the plaintiffs' bar, the Report notes that "some plaintiffs may have private motives for bringing suit that they do not share with other shareholders." The Report examines the possibility that some public institutional shareholders may be motivated to initiate lawsuits as a result of plaintiffs' lawyers' contributions to public officials electoral campaigns, a practice the Report calls "pay to play." Without citing any specific data or examples, the Report asserts that "pay to play practices are likely to result in some class actions being filed by pension funds that would not have been filed in the absence of reciprocal arrangements." The Report acknowledges that the extent of these practices is "uncertain," but then goes on to say that "there seems to be little downside to discouraging such practices." The Report recommends that the SEC create regulations specifying that lawyers who directly or indirectly may political contributions to state of municipal pension funds should be prohibited from representing the fund as lead plaintiff in a securities class action. The Report also recommends prohibiting paid plaintiffs.

The Report also recommends that the SEC should permit shareholders to "adopt alternative procedures for resolving disputes with their companies." These alternative remedies might include arbitration or waiver of jury trials. The Report notes the difficulties companies might face in adopting these reforms. The Report recommends that shareholder votes be permitted allowing the revision of companies' charters or bylaws to permit these alternative procedures.

While most of the Report's proposed litigation reforms focus on civil lawsuits, the Report also includes recommendations relating to criminal litigation. The Report recommends that the Justice Department "revise its prosecutorial guidelines so that firms are only prosecuted in exceptional circumstances of pervasive culpability throughout all offices and ranks." The Report also recommends that the Justice Department revise the prosecutorial guidelines in the Thompson Memo to "prohibit federal prosecutors from seeking waivers of the attorney-client privilege or the denial of attorneys' fees to employees, officers or directors."

Perhaps predictably, the Report has triggered a wide variety of responses, as reflected in the December 1, 2006 New York Times article entitled "Sharply Divided Reactions to Reports on U.S. Markets" (here, registration required). The most colorful comments are those of former SEC Commissioner Richard Breeden, who referred to the Report as "very elegant whining" consisting of "a bunch of warmed-over, impractical ideas, many of which have been kicking around for a long time."

The motivations behind the Report have also been questioned because of the Committee's financial backing. A December 1, 2006 Washington Post article entitled "Report on Corporate Rules is Assailed" (here, registration required) reports that the Committee "received $500,000 in financial support from the C.V. Starr Foundation," described in the article as a charity with "longstanding ties to [former AIG Chairman] Maurice R. Greenberg." The article states that investor groups have "sounded alarms" because of the Committee's ties to "an executive battling civil charges."

An interesting commentary by Walter Olson of the PointofLaw.com blog about the need for U.S. market to "Learn from London" can be found here.

The D & O Diary is frankly disappointed in the Report's proposals with respect to litigation reform. After painting a dire picture about the declining fortunes of America's financial markets, the Report essentially comes up with few litigation reform items that can at best be described as academic tinkering at the margins. Some of the ideas, like the proposal to allow shareholders to adopt alternative dispute resolution mechanisms or waive their rights to a jury trial, are so obviously not going to be adopted you have to wonder why the Committee even bothered to include them. (Jury trial waiver would be of zero practical value anyway, since virtually no securities cases actually go to trial). Other ideas, like the improvement to outside directors' Section 11 defenses and indemnification rights are unquestionably worthwhile. The suggested revision to the Thompson Memo's cooperation guidelines concerning the attorney client privilege and the payment of employees' attorneys fees are absolutely correct.

But event though the Report does have some worthwhile suggestions, as well as others that have been criticized elsewhere (see here and here), the most obvious objection is the question whether any of the proposed litigation reforms would really make any difference for the competitiveness of the U.S. securities markets. The D & O Diary is prepared to concede that America's peculiar penchant for litigation might well contibute to foreign companies' decisions to avoid our securities markets. But The D & O Diary doubts that the Report's proposed litigation reforms, even if adopted verbatim immediately, would improve the competitiveness of the U. S securities markets. Do the managers of foreign companies really weigh the value of outside directors' indemnification rights or the possibility of a double recovery under the SEC's Fair Funds authority? Seems pretty unlikely to me, which make me wonder why these kind of marginal reforms are even included in a report intended to address a supposed lack of global competitiveness. All of these proposed bandaids seem poorly calculated to dress the wound. As I have noted elsewhere (here), I am also skeptical that attempts to rollback the currently regulatory rigor are the right approach to improving the competitiveness of the U.S. securities markets.

I also continue to find the timing of this reform initiative puzzling. We are only weeks away from the very public sentencing of the leading figures in the Enron scandal. And we are only in the beginning stages of the unfolding options backdating scandal. There may indeed be a day when it is appropriate for the regulatory pendulum to swing back, but this does not seem like the right time.

The D & O Diary feels compelled to make a final observation. The Report cites the high cost of D & O insurance in the U.S., relative to the much lower cost in Europe, as a factor deterring foreign companies from listing on U.S. exchanges. The D & O Diary concedes, as it must, that there are material differences between D & O pricing in the U.S. and in Europe. But we find it amusing that the Report finds the differential in insurance costs significant, but at the same time concludes that the significant differences in investment bank underwriting fees and exchange listing fees are not a factor. The Report's observations seem to have been strained through a very peculiar kind of lens.

The Report notes at the outset that "during the next two years, our Committee will continue to explore issues affecting other aspects of the competitiveness of the U.S. capital markets." The Economist magazine reports (here, subscription required) that the Committee's second report is "due next year," and is likely to call for "better coordination between state and federal regulators by suggesting that the SEC and other agencies merge some operations." The next report "will also tackle other factors considered disadvantageous, such as an insistence on all firms using the GAAP accounting standard."

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The Committee on Capital Markets Regulation (popularly known as the "Paulson Committee") has released its "Interim Report" (here). Weighing in at 148 graphic intensive pages, the 11.50 mb document is a memory hog. Readers who want a quick overview and don't want to spend the rest of the day trying to download the entire report will want to refer to op-ed commentary by Committee members R. Glenn Hubbard and John L. Thornton, entitled "Action Plan for Capital Markets" in today's Wall Street Journal (here, subscription required), which provides an overview of the Report's recommendations "needed to maintain and improve the global competitive position of U.S. capital markets for investors."

The authors cite the declining valuation premium afforded to foreign securities listed on U.S. exchanges as evidence of the U.S. markets declining competitiveness. (The D & O Diary's prior post about the valuation premium can be found here.) The Committee recommends a number of regulatory or legislative changes to address this concern including:

• better implementation of Sarbanes-Oxley's Section 404 internal control requirements, including a revision of PCAOB Auditing Standard No. 2 to ensure that reviews are risk based and focused on significant control weaknesses;
• elimination of uncertainty in private enforcement of Rule 10b-5, through the SEC's provision of more guidance on the elements of a Rul10b-5 action, including materiality, scienter, and reliance;
• reduction of the risk of criminality of the corporate entity so that it is a last resort, and the elimination of existing guidelines in the Thompson Memo that require companies to waive the attorney client privilege and eliminate employees' attorneys' fee;
• strengthening of shareholder rights and elimination of barriers to an efficient and competitive market (focusing on such elements as poison pills, staggered board, and classified boards) allowing shareholders to devise alternatives to the present litigation system, such as the waiver of the right to a jury trial or adoption of arbitration, implemented at the time of the IPO or amendment to corporate charters or bylaws;
• elimination or reduction of gatekeeper litigation against auditors, either through a cap on auditor liability or creation of a safe harbor for certain auditor practices, and reduction of outside directors' gatekeeper exposure by making an outside director's good faith reliance on an audited financial statement sufficient to meet the standard of care;
• adoption of a cost-benefit analysis for future regulation, to assure that regulations achieve the intended effect at an appropriate cost;

The Wall Street Journal has a more detailed bullet point summary of the Committee's recommendations here.

While the Committee's Interim Report is impressive, if nothing else for its sheer girth, this is merely the opening salvo in what will likely be a very prolonged exchange of views and proposals. Among other things, the U.S. Chamber of Commerce is expected to release its own report early next year. In addition, Sen. Charles Schumer and NY Mayor Michael Bloomberg have hired McKinsey & Co. to assess market competitiveness and its impact on the city's economy. The Treasury department is hosting a conference early next year to discuss the state of the country's regulatory, legal and accounting environment. What changes, if any, will ultimately emerge at the end of this process will only be revealed in the fullness of time.

The Interim Report obviously has a lot to say about issues potentially affecting the liability exposures of directors and officers of public companies. The D & O Diary will be taking a look at these portions of the Report and providing its views in a blog post to be added in the next day or two. In the meantime, I would be very interested in any thoughts or comments that readers have about the Interim Report.

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The Committee on Capital Markets Regulation (or the "Paulson Committee" as the group has come to be known) is scheduled to release its recommendations later this week, on November 30. The Paulson Committee is concerned with the competitiveness of the U.S. securities exchanges in the global marketplace, and the perceived inability of the U.S exchanges to compete due to the heavier regulatory and litigation burden in the U.S. Anticipation is building as the release date approaches; The Economist magazine's cover this week (reproduced above) depicts the iconic Wall Street bull entangled in red tape and asks the question "Wall Street: What Went Wrong?" A prior D & O Diary post examining some of the potential litigation reforms may be found here.

But while we are awaiting the Committee's actual recommendations, it is still timely to ask whether the regulatory burdens really are causing the non-U.S. companies to list their shares on other exchanges or if perhaps something else may be going on.

A speech earlier this fall by Public Company Accounting Oversight Board (PCAOB) board member Charles Niemeyer entitled "American Competitiveness in International Capital Markets" (here), provides a critical challenge to many of the presumptions behind the regulatory reform efforts.

First, with respect to the notion that the regulatory burdens of the Sarbanes-Oxley Act caused a recent decline in the number of non-U.S. companies listing their shares on U.S. exchanges, Niemeyer shows that the decline of the U.S. share of IPOs listed throughout the world began declining long before Sarbanes Oxley; the U.S. share of IPOs declined dramatically between 1996 and 2001 (from about 60 percent of all IPOs to less than 6 percent), but between 2001 and 2005 - that is, the period after Sarbanes-Oxley's enactment - the U.S. share increased somewhat (to about 15 percent in 2005). Sarbanes-Oxley clearly is not the explanation for the reduced U.S. IPO marketshare.

Niemeyer asserts that the decline in U.S. share of the global IPO marketplace may be due to a number of causes, the most significant of which may simply be the availability of capital in local markets due to the universally low level of interest rates. Niemeyer also notes that "several countries are in the midst of multi-year programs to privatize state-owned businesses." For example, five of the largest 2005 IPOs (by market capitalization) were privatizations of state owned entities in China and France. As Niemeyer notes, "there are considerable political, cultural, and other influences on such companies to list locally when their markets offer sufficient liquidity." The low interest rate levels and high level of capital availability means that shares of this type tend to be listed locally -- and many of these companies are quite large which explains the larger aggregate capitalization of IPOs outside the U.S.

Niemeyer also notes that foreign companies are often dominated by narrow "control groups" that, in countries with poor investor protections, "tend to have valuable private benefits derived from control, because they are able to extract benefits from the company unchecked by minority shareholder rights." Niemeyer notes that these control groups are loathe to submit to the types of investor protections provided by a listing of shares in the U.S. markets. So there may be many foreign companies that would not under any circumstances choose to list on U.S. exchanges either because of their nationalistic affiliation of because of their managers' self-interested aversion to U.S. shareholder rights.

Niemeyer also points out that a substantial part of the drop in the U.S. share of worldwide IPOs is due to a dramatic decrease in the number of IPOs by U.S. companies, from about 375 in 2000 to less than 100 in 2001. Even more important for purposes of assessing the competitiveness of U.S. exchanges, "there was no commensurate shift by U.S. based companies to markets in other countries." While a great deal has been made about the competitiveness of the London Stock Exchange's Alternative Investment Market, Niemeyer points out that as of March 2006, only 29 of the AIM's 2,200 companies were based in the U.S., and seven of those 29 have dual listings or otherwise trade their shares on a U.S. exchange. Niemeyer questions whether the remaining 22 companies would even have qualified to list on U.S. exchanges, given AIM's lower thresholds for offering size and other lower offering prerequisites.

The question whether we should care that even some companies are resorting to AIM was underscored in the Wall Street Journal's November 21, 2006 article entitled "For LSE, A Troubling Trend" (here, subscription required), which reported that "a number of companies [on AIM] have issued profit warnings lately." The article goes on to quote an AIM spokesman that "the profit warnings have more to do with the smaller size of companies, where you have greater economic risk." Another LSE official is reported to have conceded that some companies allowed to list on AIM, in hindsight, shouldn't have. In other words, AIM's low barriers (smaller size, earlier offering) to entry may be attracting some less qualified companies - companies that simply couldn't list on U.S. exchanges. The article also reports that the AIM benchmark index is down 1.8% this year, compared with London's benchmark FTSE 100 index, which is up about 10%.

Can the case be made that perhaps the U.S. exchanges are better off without the companies that can satisfy the lower regulatory burdens in other countries but not the U.S.? A November 25, 2006 Wall Street Journal article by Herb Greenberg entitled "Is IPO Slowdown a Bad Thing, As Sarbanes-Oxley Foes Claim?" (here, subscription required) poses the question: "Has anybody stopped, just for a moment, to ask whether fewer IPOs might actually be a good thing? Seriously, maybe some of these companies shouldn't go public in the first place, especially if they fear or don't want to pay for laws that are attempting to crack down on skullduggery." Greenberg points out that "going public is a privilege and companies going through the process should welcome scrutiny and encourage proper barriers to entry."

Whether or not the U.S. exchanges are better off without some of the companies that are driven away by high regulatory barriers, it is unquestionably true that the high regulatory barriers produce benefits for the companies that meet the requirements. According to Niemeyer, companies that list their shares on U.S. exchanges receive a premium on their valuations. Niemeyer shows that non-U.S. companies that cross list in the U.S. enjoy a significantly lower cost of capital - in fact, the lowest in the world. This reduction in the cost of capital translates into a valuation premium that can reach as high as 37 percent more than their valuations would have been in their home markets. As Greenberg points out in his article, it is not as if the U.S. IPO business has withered and gone away. According to Greenberg, as of November 22, 2006, 172 companies had conducted offering on U.S. exchanges during 2006, raising a combined $38.8 billion. That compares with 213 offerings in all of 2005, raising a total of $38.5 billion. Hardly a slowdown, as Greenberg notes. {See the Update at the end of this post for additional information regarding the vaulation premium}

When the Paulson Committee releases its recommendations later this week, it will be worth asking with respect to the proposed reforms whether there really is a problem that needs to be remedied. As Niemeyer points out, one of the most important aspects of Sarbanes-Oxley is that it "reduces the risk of future catastrophic financial reporting failures." As the companies caught up in the current options backdating are finding now to their everlasting regret with respect to financial reporting, the "costs of getting it wrong still exceed the costs of getting it right."

Finally, while the reformers may be militating in favor of lowering U.S. regulatory burdens, other countries may be moving in the opposite direction. A November 23, 2006 Dow Jones Newswire article entitled "Insurers See Risk From U.S.-Style Lawsuits in Europe" (here) discusses concerns regarding the spread of U.S lawyers and the possible consequent spread of U.S. litigation to Europe and elsewhere. The article quotes European insurers for the view that "there are significant signs that the number of lawsuits is rising" outside the U.S. The article specifically cites the increase of class action litigation in Norway, Germany, Sweden and the U.K.

Hat tip to Jack Ciesielski at the AAO Weblog (here) for the link to the Niemeyer speech. Ciesielski also has an interesting commentary on the Greenberg article here. An interesting contrarian perspective on Greenberg's article may be found on Professor Larry Ribstein's Ideoblog, here.

The Economist Magazine's Perspective on Regulatory Reform: The article in The Economist magazine's issue with the red tape bound bull on the cover (reproduced above), entitled "Down on the Street," (here, subscription required) takes a characteristically balanced approach to the topic of regulatory reform. The article notes that many publicly listed companies are fleeing the glare of the public marketplace by going private; the article states "more of corporate America was taken out of public ownership by private-equity firms (spending $178 billion) in the first ten months of this year than in the previous five years combined ." The D & O Diary thinks this argument is a red herring; the boom of private equity acquisitions can only be understood as a direct outgrowth of the astonishing availability of private equity funding to invest. Corporate managers may welcome the chance to avoid the headaches of being a public company, but if there were not huge pots of money involved, the companies would remain public. The article is perhaps closer to the mark when it recalls that overly tight restrictions in the 1960s may have driven lenders and borrowers to London , leading to the creation of the Eurobond market, which now accounts for the largest share of publicly traded debt. The financial centers, New York, in particular will want to avoid ceding additional advantages.

The Economist may be closest to the mark when it recounts the quip from one unnamed Washington source that referred to the Paulson Committee as the "7% committee," referring to Wall Street's typical IPO underwriting fee, double that charged by European underwriters. The unstated suggestion is that the Committee's real goal is preserving Wall Street's oversized fees, which a neutral party assumes would be the first place that objective parties interested in advancing the competitiveness of America's securities markets would turn, rather than attempting to reduce regulatory protections.

The D & O Diary thinks investors' interests might be best served if we tried cutting underwriters' fees first, before cutting investors' protections, and see if that helps make U.S securities markets more attractive to foreign companies. That might also help preserve all the advantages that higher regulatory standards produce.

And Finally: In an earlier D & O Diary post, which may be found here, I reviewed the op-ed piece written by the head of an Indian company, in which the official explained his reasons why he proudly listed his shares on a U.S. exchange, notwithstanding the higher regulatory burdens. He felt that for his company the benefits far outweighed the burden.

Update: A November 28, 2006 Wall Street Journal article entitled "Is a U.S. Listing Worth the Effort?" (here, subscription required) reports on a recent study that will "figure prominently in a report to be released" by the Paulson Committee, and that reportedly concludes that "investors have sharply reduced the premium they pay for shares of foreign companies since a regulatory crackdown on corporate malfeasance in 2002." The newspaper article's lead would seem to suggest that this new study supports the Paulson Committee's underlying premise -- that is, that the new regulation has eliminated the valuation premium (discussed above) and therefore the Sarbanes Oxley related regulation is making the U.S. less competitive. However, the article discloses that in fact the premium has increased for companies from certain countries that have less rigorous local regulation (Italy, Austria and Turkey are specifically named), and that the decrease in the valuation premium has only taken place for companies from countries that have their own rigorous regulatory programs (Japan, Hong Kong, Canada and the United Kingdom). And for that matter, even in those countries with a decline, the decline is from 51 percentage points during the period 1997 to 2001, to 31 percentage points between 2002 and 2005.

While the study's sponsors interpret these data to mean that increased regulation is decreasing the valuation premium and therefore making the U.S less competitive, I have a hard time getting to that conclusion from this information. I think the fact that the premium has increased in countries with less rigorous local regulation means that the U.S regulatory approach is even more highly valued than before. Even if there is a decrease in the valuation premium for companies from more rigorously regulated, there is still a very significant valuation premium, and the decrease could be understood in any one of a number of ways, including the possibility that increased regulatory effectiveness in the other countries have started to reduce the value that is placed on the benefits of the U.S. scheme. The willingness of the London market to accept listings for companies that would not meet U.S standards is probably also a factor. Given the increase in the valution premium for companies from less rigorously regulated countries, and the still substantial valuation premium even for companies from more highly regulated countries, it is hard for me to see how decreasing regulation would improve U. S. competitiveness. It is entirely possible that what a lax regulatory scheme would accomplish is reducing the valuation premium (and the attractiveness of U.S. markets) for companies from the economies that will be growing most quickly in upcoming years.

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As The D & O Diary has previously noted (most recently here), the attempts by the Paulson Committee to propose ways to improve the competitiveness of the U. S. securities exchanges in the global marketplace may include securities litigation reform. Interest in the Committee's reform efforts increased substantially as a result of media reports (here) that among other things the Paulson Committee was considering recommending the elimination of a private cause of action under Rule 10b-5. However, in a November 16, 2006 New York Law Journal article entitled "Capital Markets Competitiveness and Securities Litigation" (here, subscription required), Columbia Law School Professor John C. Coffee, Jr. (who supposedly was the source of the recommendation to eliminate private Rule 10b-5 actions) disclaims having made any such recommendation. Instead, Coffee is recommending a "far more modest proposal."

Coffee's reform proposal begins with his view that the current private securities litigation system is "dysfunctional," but "not because the lawsuits are frivolous or extortionate." Rather, the problem, Coffee believes, is "the circularity of the securities class action." The problem is that

Shareholders are suing shareholders. As a result, diversified shareholders wind up making pocket-shifting wealth transfers to themselves. In the common securities class action dealing with a stock drop in the secondary market, the recovery will go to those shareholders who bought the stock during the "class period"... and the recovery will be bourne by the other shareholders who bought the stock before or after that class period...Inherently, this implies that such an action produces only a shareholder-to-shareholder wealth transfer.

Nevertheless, Coffee thinks that the argument can still be made that securities class action lawsuits may be justified by their deterrence effect. But the problem is that they accomplish deterrence "by punishing the innocent - the shareholders." Coffee proposes a "system of managerial and agent liability that places costs instead on the culpable."

Coffee proposes that the SEC use its regulatory authority under Section 36 of the Securities Exchange Act of 1934 to shield non-trading public corporations from liability under Rule 10b-5. (Section 36 gives the SEC the authority to exempt "any person, security or transaction from any securities laws or regulations, if the exemption is "necessary or appropriate in the public interest, and is consistent with the protection of investors.") According to Coffee, this "would not eliminate a private cause of action under Rule 10b-5, but it would force the plaintiff's bar to sue and settle with corporate officials and agents - i.e., auditors, underwriters and law firms - instead of treating the corporate entity as the deep pocket."

Coffee anticipates that the targeted directors and officers would seek to rely on indemnification and insurance if they are targeted by the plaintiffs' lawyers. Coffee recommends that the SEC should act to force corporate boards to take their decision whether or not to indemnify much more seriously, as a result of which, Coffee claims, "in some cases, indemnification might not be paid, and in all cases there would be greater uncertainty." With respect to D & O insurance, Coffee anticipates that active wrongdoers would face substantial coverage barriers (such as the conduct exclusions) as a result of which "the insurer and the corporate insider might well settle such an action on a basis that required some payment out the insider's own pocket." At that point, Coffee says, "real deterrence begins to be generated."

Coffee's recommendation to exempt companies from private securities lawsuits to force individuals to bear greater personal exposure as a way to increase deterrence is detailed in Coffee's October 2006 law review article entitled "Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation" (here). Coffee's law review article has an extensive review of the fact that although corporate insiders are regularly sued "they rarely appear to contribute to settlement," with specific examples. In the law review article, Coffee also examines at greater length the SEC's authority under Section 36. Coffee's article anticipates that his recommendation to exempt companies from Rule 10b-5 liability would "alter the market for D & O insurance" because "executives would demand more insurance;" on the other hand, the recommendation would also "eliminate entity insurance." Coffee's law review article does not examine whether carriers might alter their basic terms and conditions, as insureds maneuver to assure that coverage for their liability would not be excluded and as carriers jockey to recapture premium revenue lost after entity coverage is eliminated.

The D & O Diary thinks Coffee's reform proposal is interesting. We do wonder how all of this would actually improve the competitiveness of the U.S. securities markets. Are the managers of foreign companies more likely to list their companies' shares on U.S. exchanges if the regulatory system is changed to increase their individual liability exposure while at the same time trying to reduce their access to indemnity or insurance? Coffee's proposal may or may not be a good idea, but it doesn't seem like it really has anything to do with the reasons for which the Paulson Committee was formed.

Hat tip to the Securities Litigation Watch blog (here) for the links to the New York Law Journal article and Coffee's law review article.

Thompson Memo Reform?: Reform seems to be today's theme. According to news reports (here), the U.S. Department of Justice is considering modifying the Thompson Memo to address concerns that prosecutorial pressure is forcing companies to cut off legal support to employees under investigation and to reveal confidential communications with the company's lawyers. According to the news reports, all prosecutors in each of the 93 U.S. attorneys' offices would have to get the approval of the attorney general or his top deputy before seeking attorney-client waiver. In addition, companies would not be penalized for refusing to reveal confidential communications with their lawyers - but the could still get credit for cooperation. The Justice Department reportedly is also considering deleting the language in the Thompson Memo referring to legal fees for "culpable employees."

According to the news reports, Deputy Attorney General Paul McNulty has not yet signed off on the proposed changes.

As Professor Ellen Podgor notes on the White Collar Crime Prof blog (here), these proposals represent "baby steps" in the right direction, but they "would not alleviate the problem" that has led to criticisms of the Thompson Memo. For a review of The D & O Diary's prior posts discussing the Thompson Memo criticisms, refer here and here.

Fortune Smiles on Larry Sonsini: A November 17, 2006 Fortune.com article entitled "Scandals Rock Silicon Valley's Top Legal Ace" (here) contains a lengthy portrait of Larry Sonsini and discusses his recent involvement in a number of high-profile imbroglios. After reviewing Sonsini's rise to prominence, the article looks at Sonsini's involvement, as an NYSE board member, in the dispute over former NYSE CEO Richard Grasso's compensation; at Sonsini's connection to the board pretexting scandal at H-P; and Sonsini's involvement with several companies (including Brocade Communications) implicated in the options backdating scandal. The article essentially exonerates Sonsini on all issues, with the exception of Sonsini's service on the boards of companies of which he also acted as outside counsel. However, the article reports that Sonsini has resigned or will resign from all of the nine corporate boards on which he previously served.

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In an earlier post (here), I commented on the initative of the so-called Committee on Capital Markets Regulation to take a look at the impact of regulation on the competitiveness of the U.S. securities markets in the global marketplace. (The Committee has become known as the Paulson Committee because of the public support that Treasury Secretary Henry M. Paulson, Jr. has shown the Committee.) An October 29, 2006 New York Times article entitled "Businesses Seek Protection on the Legal Front," (here, registration required) takes a comprehensive look at the Committee's efforts, and also reports some criticism that has already formed in anticipation of the Committee's recommendations.

Although the Times article is a bit vague on the details, the article reports that the Committee is looking at a number of possible reforms, including proposals to limit the liability of accounting firms; to reduce the burdens of Sarbanes-Oxley; to limit "overzealous state prosecutions"; to curtail the ability of the Justice Department to force companies under investigation to withhold paying executives' legal fees; and to limits abusive lawsuits by investors. The article reports that "to alleviate concerns that the new Congress may not adopt the proposals... many are tailored so that they could be adopted through rulemaking."

The article quotes one Committee member as saying that "the legal liability issues are the most serious...Companies don't want to use our markets because of what they see as substantial and in their view excessive liability."

The article reports that among the issues under discussion is the possible revision or elimination of Rule 10b-5. The article says that Columbia Law Professor John Coffee (a member of the Committee) has recommended "that the SEC adopt an exception to Rule 10b-5 so that only the commission could bring such lawsuits against corporations."

In an October 30, 2006 Wall Street Journal op-ed piece entitled "Is the U.S. Losing Ground?" (here, registration required), two Committee members, R. Glenn Hubbard and John L. Thornton lay out their views of the Committee's work. (Hubbard, who was Chairman of the Council on Economic Advisors under the current President Bush, is now dean of the Columbia Business School; Thornton, now chairman of the Brookings Institution, was President of Goldman Sachs). Among other things, the authors state:

The liability system can also affect the competitiveness of U.S. Markets. Firms are sometimes confronted with circumstances in litigation, including securities class action suits, where even a small probabability of loss, given the size of the claims, could result in bankruptcy. Consequently, companies often must agree to large settlements that result in reduced value for shareholders rather than pursuing a successful outcome on the merits of the case.

Clearly Hubbard and Thornton perceive securities litigation reform as a critical part of the Committee's mission.

The Committee's report has not yet been released (according to Hubbard and Thornton, it will be released on November 30), but the Committee's work is already the target of criticism. The Times article quotes former SEC Commissioner and Columbia Law Professor Harvey J. Goldschmid as saying "It would be a shocking turning back to say that only the commission can bring fraud cases. Private enforcement is a necessary supplement to the work that the S.E.C does. It is also a safety valve against the potential capture of the agency by industry." Professor Peter Henning of the White Collar Crime Prof blog (here) notes that the proposal to have the SEC as the sole agent to enforce against securities fraud "would be truly radical because private actions far outnumber the enforcement cases filed by the SEC and some signicifant recoveries in private securities cases have provided relief to investors." Both Henning and Professor Larry Ribstein on his Ideoblog (here) note that the inherent limitations on the SEC's resources suggests that the agency alone could not be expected to enforce the securities laws.

Economist and pundit Ben Stein has a much less reserved attack on the Paulson Committee's anticipated work in his October 29, 2006 New York Times column entitled "Has Corporate America No Shame? Or No Memory?" (here, registration required). Among other things, Stein asks "Is it really right for prominent American executives, amid a host of scandals involving other executives looting their shareholders blind, to have the best and brightest of academe and the Street lobbying for less accountability to shareholders?" (More about Stein below.)

The Paulson Committee has clearly succeeded in attracting attention to its work. As a result, it is fair to describe its planned November 30, 2006 report as "much anticipated."

At one level, it is perfectly understandable that leading academics and business people are focused on the competitiveness of the U.S. securities markets. But there is something more than a little bit "off" with the timing. The unfolding options backdating scandal does not exactly provide the best backdrop against which to contend that what corporate American really needs right now is less regulation. Moreover, the SEC's hands are already pretty full. I would be surprised if anyone there were really excited about taking over the work of the entire plaintiffs' securities bar. (I also wonder when we will start to hear from the plaintiffs' bar on these issues; I can't imagine they are too thrilled to see the possibility that their livelihood would be entirely eliminated.)

The timing may be "off" in another significant respect. While the Committee plans to propose reform through regulation rather than legislation, the Nov. 7 elections could put a very interesting context around all of these efforts. If one or both houses emerge from the election with a Democrat majority, one or both houses of Congress could well perceive the Committee's proposals for regulatory rather than legislative change as an effort by a lame duck administration to end run Congress and the democratic process. The Paulson Committee cannot pass itself off as bipartisan, and it would face all the challenges in Congress of identification with the current administration. Perhaps the Committee will anticipate these concerns when it puts its recommendations forward (it will have the advantage of knowing the election's outcome before it releases its report).

But in any event, the Committee's report will make interesting reading and could lead to some interesting developments. Stay tuned...

Update: An October 30, 2006 article on Reuters (here) contains the reactions of several promienent plaintiffs' attorneys to the proposals to reform the securities laws. Bill Lerach is quoted as saying, "Securities lawsuits have fallen off sharply in the last few years and yet they want to further cripple them. Why? Because its the one effective weapon that shareholders have." Sean Coffey of the Bernstein Litowitz firm is quoted as saying, "The body isn't even cold yet and they are already acting like there were no corporate scandals. It's mind boggling."

"The Curmudgeon's Guide to Practicing Law": We here at The D & O Diary were delighted to see the WSJ.com Law Blog post of a very favorable review (here) of The Curmedgeon's Guide to Practicing Law. The Guide was written by Jones Day partner Mark Herrmann, with whom I attended law school. (Not only that, his wife is my dentist.) The WSJ.com Law Blog describes the book as

a well-written and clear guide on how to be an effective law-firm associate. It's also funny: Hermann writes as The Curmudgeon, a grizzled law-firm partner who has zero tolerance for such horrors as the passive voice, long string cites and sloppy billing records. Were this material covered in some big-firm internal handbook, it would surely bore us to tears. But Hermann's cutting wit and lively writing bring to life such painful topics as how to write a brief, how to treat your assistant and how to take a deposition.

The WSJ.com Law Blog has posted a book excerpt here, reviewing the book' s chapter on how to prepare a witness for a deposition.



Bueller? Ben Stein actually launched his acting career ad-libbing as a high school economics teacher in the movie Ferris Bueller's Day Off. A wave file of Stein's now famous line ("Beuller? Beuller?") can be found here. Stein's own parody of the Bueller scene can be found here.

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When the soi-disant "Committee on Capital Markets" announced (here) on September 12, 2006 that it was forming an independent group of business and academic leaders to study how to improve the competitiveness of U.S. capital markets, the press coverage (here) generally presumed that the group would be focused on reforming the Sarbanes-Oxley Act. But in the Committee's press release describing the study group's mission, Sarbanes-Oxley was the second item on the list; the first item listed was "[l]iability issues affecting public companies and gatekeepers (such as auditors and directors) with a focus on securities class action litigation, criminal enforcement and federal versus state authority." (The Committee's press release included a statement of support from Treasury Secretary Henry Paulson, and so the Committee has come to be known as the "Paulson Committee.")

An October 16, 2006 post on the Securities Litigation Watch entitled "'Paulson Committee' May Soon Recommend Dramatic Limits on Securities Class Actions"(here) attributes a number of statements from Columbia Law School professor and Committee member John Coffee about the Committee's prospective suggestions to mitigate the threat of securities litigation. Coffee reportedly expects the group to make recommendations to "impose limits on securities class actions" and that the "SEC could take action to change the role of the securities class action" within 6 months.

According to the Securities Litigation Watch, Coffee has said that the possible alternative changes that could be proposed include the following:

1. The SEC could "dis-imply" a private cause of action under Rule 10b-5 against corporations, leaving enforcement of that rule to the government, not private plaintiffs. The SEC might also "dis-imply" such a private cause of action with respect to the corporation only when the SEC has sued the corporation. Coffee states... that "That idea does have some support."
2. "Stock drop" cases could be moved out of the courts and into the arbitration arena.

According to the Committee's September 12 press release, the group plans to release recommendations to key policy makers for specific changes in regulation and legislation by the end of November.

The intervening Congressional election could have some impact on the Committee's recommendations' prospects for success. There is every possibility that after the election the Democrats could control one and possibly both houses of Congress. While the Committee's membership of academics and corporate leaders gives it the air of independence and disinterest, the group is associated with the current Treasury Secretary and does include some Republican affiliation (e.g., former Secretary of Commerce Donald Evans), but lacks any obvious Democratic affiliation, so the Committee seems unlikely to be able to call itself bipartisan. Moreover, while the Committee's membership is prestigious, it omits any representation of shareholder groups, labor unions or others who might oppose easing legislative or regulatory constraints. Any recommendations for radical change that could emerge from the group would likely face the prospect both a sharp reaction from other constituencies and could also face a hostile Congress. In any event, the prospects for securities reform while the options backdating scandal continues to play out on the front pages of the newspapers seems questionable.

Nevertheless, it will definitely be interesting to see what the Committee comes up with. Add this one to the list of "Things to Watch."

Adding Inquiry to Insult: A resource for just the right slight, here.

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