by T. GormanPosted on Posted in SECActions

High speed traders are a topic of much debate these days. By most reports they are a significant part of the markets. Those markets have become increasingly volatile. Many think that technology may be playing a part. There has been the “flash crash,” a programming glich at Knight Capital, difficulties on the NASDAQ related to trading in Kraft Foods, issues on the Tokyo Stock Exchange and others. All of this has lead to numerous media reports, Congressional hearings and roundtable discussions by regulators.

Now, as regulators continue to struggle with the implementation of Dodd-Frank, and market participants gulp to digest the changes, there are calls for a new round of regulation aimed at high speed trading. CFTC Commissioner Bart Chilton, addressing the 2012 Allegro Customer Summit in Dallas, Texas on October 16, 2012, outlined a proposal for regulating such trading in remarks titled “Texas Hold ‘Em – Time to Fold ‘Em” (here).

The Commissioner began by developing a theme that would run through his presentation regarding the role of speculators and regulation. While Texas Hold ‘Em may be time honored in the town of Robstown, Texas, officially recognized as the home town of the game, and speculators may have a valid role in the markets – even high speed traders – that does not mean that regulation is inappropriate. Reminding us that then Treasury Secretary Hank Paulson one stated that leading up to the market crash of 2008 there was insufficient regulation because “No one wanted it. We were making too much money,” the Commissioner recounted the accomplishments of Dodd-Frank in five key points:

  • Transparency was brought to markets where there was little;
  • Systemic risk has been lowered;
  • Accountability has been brought to markets that often had little; and
  • Integrity had been increased in the markets.

Dodd-Frank does not mention computerized trading however. As Commissioner Chilton noted, the Act was signed into law just after the flash crash. The prospects for market disruption by the specter of millions of shares being traded in milliseconds require that there be at least some governing regulation. The “fix,” according to the Commissioner, is a six part proposal:

  1. Registration: High speed traders should register as a “pedestrian first step;”
  1. Testing: Traders should be required to test their programs before they are “unleashed in a live production” which is something many do now;
  1. Kill switches: Traders should be required to have a kill switch in the event something goes wrong – a proposal the SEC and CFTC are currently working on;
  1. Wash blocker technology: There should be pre-trade controls which prevent the traders from engaging in wash or cross trades with themselves which are already illegal;
  1. Compliance reports: Traders and their officers should be required to execute compliance reports and be accountable for false or misleading information; and
  1. Penalties: Traders should be accountable in damages for any loses they cause from rogue activities.

Moving forward with new regulations while still struggling with the older ones is perhaps a natural part of ever evolving markets in which regulators struggle to keep up and then market participants work hard to figure out how to participate under a new regulatory regime. While all this is going on, however, it is good to remember that tomorrow’s markets still begin with fundamental fairness today. That point should be clear from the Commission’s recent action against the New York Stock Exchange which for years gave informational advantages to select customers. If the public is going to trust the nation’s capital markets it all begins with making sure that the investing public is playing in a fair game, not one in which the dealer has an ace up his sleeve. If the game is not actually and perceived to be fair, its time to fold ‘em.

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by T. GormanPosted on Posted in SECActions

The Public Company Accounting Board or PCAOB was created under the Sarbanes Oxley Act of 2002. Under the SEC, the board is charged with overseeing the audit of public companies that are subject to the securities laws to protect investors. As part of those protections the PCAOB is empowered to conduct inspections and investigations of registered accounting firms that audit public companies. A key question in conjunction with those inspections is the extent to which materials and information related to the process is protected from disclosure from privilege.

The court in Bennett v. Sprint Nextel Corporation, Case No. 11-90144 (W.D. MO.), in an order and opinion dated October 10, 2012, defined the scope of that privilege. It also created a conflict with a ruling in another district.

The question arose in the context of a putative class action against Defendants Sprint Nextel Corporation and others. The complaint alleges securities fraud based on the merger of Sprint and Nextel tied to accounting issues for the fourth quarter of 2006 and the first three quarters of 2007.

In July 2006 the PCAOB began an inspection of KPMG, the outside auditors for Sprint. The audit firm circulated an Engagement Profile and Appendix A to various employees to be completed and sent back to Board inspectors. The next month the audit firm made a presentation on the Sprint 2005 audit to PCAOB inspectors. As the inspection continued KPMG had additional meetings with inspectors and prepared material for them. At the conclusion of the process the audit firm prepared responses to an inspection report from the Board.

Plaintiffs issued subpoenas to KPMG for documents. While a number of documents were produced, certain materials relating to the inspection were withheld based on privilege assertions which were challenged in a motion to compel. The privilege assertions are based on SOX Section 105(b)(5)(A) which provides in part: “[A]ll documents and information prepared or received by or specifically for the Board, and deliberations of the Board and its employees and agents, in connection with an inspection under section 104 . . . shall be confidential and privileged . . .” The statute thus provides for privilege in two circumstances, according to the court. The firstinvolves requests to the Board, a question not involved here. The second concerns requests to the target of a Board investigation which is the question here. In this regard the court held that “the privilege protects those who are under investigation from being required to divulge their responses to that investigation . . . [but] does not extend to documents from the underlying transaction or work . . . “

The court went on to hold that the privilege extends beyond materials held by the board to include those in the hands of third parties, here KPMG. The court thus rejected a claim by the plaintiffs that would have limited the privilege to materials held by the board. The court also held that the term “Board” as used in the statute includes the staff of the PCAOB, not just the Board itself as plaintiffs argued.

Central to the decision is the question of whether internal KPMG materials were privileged under the statute. Plaintiffs argued that documents created internally at the audit firm about the PCAOB inspection but which are not specifically communication with the Board are not privileged, citing Silverman v. Motorola, No. 07-C-4507, 2010 WL 4659535 (N.D. Ill. 2010). The district court here concluded that the Silverman court read the statute too narrowly. The court adopted Silverman’s overall holding that the protection of the statute is limited to materials that are “specifically for” the Board. It broadened the reach of the privilege, however, concluding that “internal KPMG communications that discuss confidential questions or comments made by the Board or which reflect KPMG’s development of responses to board inquires are also protected.” The privilege thus includes any internal communications that reveal those comments or work to develop the responses to the comments.

Applying its holdings to the issues in this case, the court found that a series of documents are privileged. Those include: direct communications between the Board inspectors and the audit firm; forms labeled “Public Company Accounting Oversight Board Inspection Comment Form,” including the board comments and KPMG responses and drafts; spreadsheets of data prepared for the Board; materials that would reveal specific questions or inquiries from the Board and drafts and final versions of responses; drafts and final versions of the Engagement Profile and Appendix A; and the presentation file for the initial meeting with the Board. The court rejected KPMG’s claim that the privilege extends to materials that might reveal some aspect of its deliberations. Rather, it only extends to materials that are prepared or received by or specifically for the Board.

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