by T. GormanPosted on Posted in SECActions

The SEC filed its first action against a state, charging New Jersey with fraud in connection with multiple offerings of municipal bonds dating back to 2001. In the Matter of State of New Jersey, Adm. Proc. File No. 3-14009 (Aug. 18, 2010).

The Order for Proceedings alleges fraud in violation of Securities Act Section 17(a)(2) & (3) in connection with 79 municipal bond offerings from August 2001 through April 2007 for $26 billion. The cases center on the failure of the state to make certain disclosures regarding the financial condition of two large pension funds, the Teachers’ Pension and Annuity Fund (“TPAF”) and the Public Employees’ Retirement System (“PERS”). Specifically, the state created the fiscal illusion, according to the SEC, that the two pension funds were being adequately funded when in fact they were severely under funded. The illusion was created through a series of misrepresentations regarding legislation adopted in 2001 which increased benefits, subsequent legislation intended to fund the costs associated with the increased benefits, the adoption of a so-called five year phase in plan under which the plans were to be funded and the fact that the phase in plan was abandoned.

New Jersey was aware of the underfunding, according to the Order, but took no steps to correct the misleading documents used in connection with the bond offerings. Indeed, its disclosure regarding contributions to the plans omitted present and historical information about the contributions.

During this period the state did not have any written policies and procedures regarding the review or update of the bond offering documents. No training was given to its employees regarding disclosure obligations. This resulted in material misrepresentations.

Following an April 2007 news article which raised questions about the adequacy of the disclosure by New Jersey, the state retained disclosure counsel. During 2007 and 2008 the state, with the assistance of disclosure counsel, reviewed, evaluated and enhanced its disclosures. The state has also adopted formal, written policies and procedures. A committee now oversees the entire disclosure process and an annual mandatory training program has been implemented.

To resolve the proceeding the state consented to the entry of a cease and desist order from commencing or committing or causing any violations and any future violations of the Sections on which the Order is based.

Although this is the first proceeding against a state, others have been brought against governmental entities. For example, in 2006 an administrative proceeding named the City of San Diego as a respondent. The Order there is based on fraud allegations made in connection with municipal bond offerings, discussed here.

by T. GormanPosted on Posted in SECActions

Reliance is a critical element of proof in a private securities fraud suit. Thus, in rejecting a theory of scheme liability two years ago, the Supreme Court predicated its decision in part on a close reading of the reliance element. Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008).

One way to establish reliance in a class action is through the use of the efficient market theory. Under that theory, as adopted by the Supreme Court in Basic Inc. v. Levinson, 485 U.S. 224 (1988), in an open and developed or efficient market, the price of a security is determined by the available material information about the company and its stock. Stated differently, the material information about the stock is absorbed into its price. This includes misstatements. Under this theory reliance is presumed in a fraud on the market case.

In Malack v. BDO Seidman, LLP, Case No. 09-4475 (3rd Cir. Aug. 16, 2010), the court considered a theory of reliance with a similar title, but called the fraud-created-the-market theory. This theory posits that the investor relied on the integrity of the market to the extent that the securities were entitled to be in the marketplace. The presumption can only be used where it can be established that the defendants conspired to bring the securities to the market and they were not entitled to be there.

In Malack, the Third Circuit rejected the fraud-created-the-market theory as essentially baseless. The case arose from a note offering by American Business Financial Services, Inc., a subprime mortgage originator. Defendant BDO issued an unqualified audit opinion on the financial statements. After issuance, American Business collapsed and was liquidated. The notes became worthless. Plaintiffs brought suit against BDO, claiming fraud in violation of Exchange Act Section 10(b). The district court denied class certification, concluding that plaintiff had failed to establish the predominance requirement of Federal Civil Rule 23(b)(3) because he did not demonstrate a presumption of reliance.

A presumption of reliance is permissible the court held in two instances. First, where there is a material omission and a duty to disclose. Second, under the fraud on the market theory of Basic. Some courts, such as the Fifth and Tenth Circuits, have accepted the fraud-created-the-market theory as a third alternative. Others such as the Seventh Circuit have not.

Plaintiffs here argued that the securities were legally unmarketable. Regardless of the theory however, the Third Circuit concluded that the case must fail. Common sense suggests that in fact the theory is wrong, the circuit court concluded. If the availability of the securities in the market suggests that they are genuine, there must be some entity involved in the issuance process that “acts as a bulwark against fraud.” There is not. The SEC’s review of securities is not based on merit, but disclosure. If this theory were credited, investors would be free to rely only on the fact that the securities have been issued. In effect, the theory would create a kind of investor insurance policy. That notion is contrary to the basic premise of securities regulation which is that investors armed with the material facts can make their own investment decision. It is also contrary to the teachings of Stoneridge which cautioned against expansive readings of the reliance requirement, particularly in view of the fact that the cause of action under Section 10(b) has been crafted by the courts, not Congress.

While the fraud-created-the-market theory has a name which is similar to that of the fraud on the market theory, it lacks a sound foundation. The fraud on the market theory is built on economics. The fraud-created-the-market theory is not. Rather, the “fraud-created-the-market theory lacks a basis in common sense, probability, or any other reasons commonly provided for the creation of a presumption. As such we decline to recognize” it.