ARE MORE RULES NECESSARY?

The SEC approved new rules proposed by the exchanges and FINRA to ensure that market makers make real, meaningful quotes. In September the SEC proposed rules governing short term borrowings to address what many call “window dressing.” The proposals are unrelated. Yet each raises the same question: Are more rules necessary?

The new market maker rules are designed to prohibit what are called “stub quotes.” This is a price quote which is “an offer to buy or sell stock at a price so far away from the prevailing market that it is not intended to be executed, such as an order to buy at a penny or an offer to sell at $100,000.” This type of offer was involved in the “flash crash.”

Under the new rules, market makers will effectively be barred from making stub quotes. Now, depending on the security, a market maker will have to make a bid which fits within certain parameters. For example, for securities subject to the circuit breaker pilot program, the market maker will be required to enter a quote that is not more than 8% away from the best bid and offer. For exchange listed equities that are not included in the circuit breaker pilot program, a market maker will be required to enter quotes that are no more than 30% away from best bid and offer.

The short term borrowing rules proposed in September focus on a similar practice. According to the release, many financial institutions and others engage in short term borrowing to fund operations. These types of borrowings can fluctuate significantly during a reporting period. Those changes may not be shown on financial statements prepared as of the end of a period. The borrowings can also be used to improve the balance sheet at the end of the period reporting requirements. This practice, called “window dressing,” was supposedly involved in the collapse of Lehman Brothers. The proposed rules will provide additional disclosures to try to ensure that investors are informed about the short term borrowings.

Before writing any new rules it is good to return to basics. The Exchange Act defines “market maker” in Section 3(38) as any “specialist permitted to act as a dealer . . . who, with respect to a security, hold himself out . . . as being willing to buy and sell such security for his own account a regular or continuous basis.” This type of activity is critical to the proper functioning of the markets. It relies on the market maker to put real quotes in the market place which can be executed.

In contrast, a market maker who uses a stub quote, according to the SEC’s release, is only doing so “to nominally comply with its obligation to maintain a two-sided quotation at those times when it does not wish to actively provide liquidity.” Stated differently, the stub quote is not really an offer to buy and sell. Rather, it is a kind of place holder which permits the market maker to give the appearance of fulfilling his or her obligations. In reality, the stub bid is an illusion, lacking substance. No doubt there are rules to prevent this type of conduct.

Financial statements are supposed to provide the shareholder and investor with a snap shot of the enterprise’s financial condition at a point in time. Accounting principles are applied consistently from period to period to ensure the statements can be compared from period to period. MD&A is supposed to put the investor in the seat of management, showing the cash flows of the company. It goes along with the pictures in the financial statements.

Transactions undertaken as “balance sheet window dressing” are the same as a stub quote – they lack economic substance. Round trip transactions or those done and undone just to temporarily improve the balance sheet undercut the purpose of furnishing investors with financial statements. Investors and shareholder are entitled to see how their money is being used by those to whom they trusted it. As with the stub quote, there are rules which preclude giving investors what amounts to a photo shopped picture.

In the end, the federal securities laws are a code of ethics for the market place, not a rule book to plan around. This means market makers have an obligation to offer real quotes to the market, not place holders lacking substance. It means companies have an obligation to give investors an accurate picture of their company’s financial health, not which hides it. The new rules are no doubt well intended and may add to the market and the total mix of disclosed information. At the same time, if the current provisions are being ignored, there seems little reason to believe that more rules will change anything.

SEC ASKS THE HIGH COURT FOR EXPANSIVE READING OF SECTION 10(b)

The Commission is again asking the Supreme Court to adopt an expansive reading of Exchange Act Section 10(b). The argument is in its amicus curiae brief filed in Janus Capital Group., Inc. v. First Derivative Traders, No. 09-525 (S.Ct.) in support of Respondent. The case presents a critical issue of primary and secondary liability in private securities fraud actions Section 10(b) (here).

This will be the third time the High Court has considered the question. Previously, in Central Bank of Denver, N.A. v. First Interstate Ban of Denver, N.A., 551 U.S. 164 (1994) the Court held that Section 10(b) does not include a claim for aiding and abetting. Subsequently, in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008), the Court rejected a claim that scheme liability is covered by the antifraud provision.

Janus again focuses on the reach of Section 10(b). The action was brought against Janus Capital Group, Inc. and Janus Capital Management LLC. The former is the publicly traded asset-management firm that sponsors a family of mutual funds known as the Janus Funds. The latter is a wholly owned subsidiary of Janus Capital and is the investment adviser to the Janus Funds. The complaint claims that the defendants made false statements regarding the market timing policies of the Janus Funds. Specifically, plaintiff claims the prospectus gives the impression that market timing is not permitted. This is false since certain traders were permitted to use the practice, according to plaintiff. The complaint does not state that either defendant actually wrote the statements in the prospects or that they were publicly attributed to them. The district court dismissed the complaint. The Fourth Circuit reversed.

In the Supreme Court, the SEC argues for a reading of the Section 10(b) which would support plaintiff’s claim that the investment adviser is primarily liable. Stressing the language of the statute, the Commission begins its analysis focusing on the word “make,” contending that its traditional interpretation of this statutory term encompasses the conduct here. That interpretation, the Commission argues, is predicated on the ordinary meaning of the term and is entitled to deference. It includes those who create or write a statement. Since it is clear that an issuer can speak “indirectly” to the markets and be liable under Section 10(b), it “follows that someone else can make a statement indirectly by creating it and having it appear in a prospectus formally issued in the name of another entity.” Under this interpretation of the word, the investment adviser here “made” the false statements about market timing here.

The Commission goes on to distinguish between those who aid and abet a violation and those who may be secondary actors, but commit a primary violation. The former are not within the ambit of Section 10(b) while, as Stoneridge made clear, the latter are covered. Thus, even if Respondent here is viewed as a secondary actor, the allegations in the complaint constitute a primary violation. Therefore, they are sufficient. In this regard, the Court need not decide when an outside accountant or lawyer may be subject to liability under the Section the SEC argued.

The Commission concludes it arguments by disputing Petitioner’s claim that the complaint fails to satisfy the causation requirements of a Section 10(b) cause of action. Under Basic v. Levinson, 485 U.S. 224 (1988), the fraud-on-the-market presumption is sufficient, according to the SEC. Neither that case nor Stoneridge contain an attribution requirement which some circuit courts follow and which requires that the statement be attributed to the speaker to be held liable. Here, in view of the nature of the relationships in a mutual fund complex it is clear that Respondent can be held liable under Section 10(b), according to the Commission.

The SEC’s argument here is consistent with its historic expansive reading of Section 10(b). The agency’s position is, however, reminiscent of its argument regarding scheme liability. Under that theory, the Commission claimed that those who participate in a scheme to defraud under certain circumstances may be held primarily liable. A variation of the Commission’s theory was adopted by the Ninth Circuit in Simpson v. AOL Time Warner, Inc., 452 F.3d 1040 (9h Cir. 2006).

The Stoneridge Court did not adopt the Commission’s scheme liability theory. There, the High Court focused on the element of reliance and the remoteness of the conduct of the third party vendors who were alleged to have participated in a “scheme” with Charter Communications to falsify its financial statements.

Underlying the Court’s analysis in Stoneridge are two key points. First, the cause of action for damages under Section 10(b) was created by the courts and not Congress. The Supreme Court has repeatedly cited this fact in limiting private claims under the Section. Second, the Court prefers a bright line test. Like its theory of scheme liability, the Commission’s arguments in Janus do not appear to fully address these points. And, the Commission is advancing it theory of liability at a time when Congress just refused to extend aiding and abetting to private damage actions in favor of a study on the question by the SEC (here). On the other hand, perhaps the third time is the charm.

Argument is scheduled for December 7, 2010 at 10:00 a.m.