ANOTHER SUBPRIME MARKET CRISIS CASE – WHERE ARE THE OTHERS?

The SEC has repeatedly discussed the dozens of investigations it has underway regarding the market crisis. Reportedly, a significant amount of Commission resources are being invested in these inquiries, as indicated by the remarks of Commissioner Walter, discussed here, and others. Despite what has been billed as a major effort, few cases have been brought. One is SEC v. Mozilo, involving former senior officials of former number one subprime lender Countrywide. That case, discussed here, centers on a “disclosure fraud” – that is, the defendants did not disclose what the SEC said was the deteriorating financial condition of the company as the market crisis unfolded.

The SEC filed another market crisis case against the senior officers of a one-time high-flying subprime lender. This action involves the once number three subprime lender, New Century Financial Corporation. SEC v. Morrice, Case No SAC09-01426 (C.D. Cal. Filed Dec. 7, 2009). The defendants are former CEO and co-founder Brad Morrice, CFO Patti Dodge and Controller David Kenneally.

Like the case against the Countrywide executives, Morrice begins with disclosure fraud. The complaint adds allegations charging accounting fraud and ties those to investor losses from offerings of securities. Unlike Mozilo, there are no allegations of insider trading, although the individual defendants are alleged to have obtained ill-gotten gains through compensation.

The disclosure fraud is predicated on what the company, primarily Mr. Morrice and Ms. Dodge, failed to tell investors about the loan portfolio of the one time giant lender. According to the complaint, New Century, which was a REIT, originated and purchased loans through two divisions. The company focused on subprime lending, according to its periodic filings. In those filings the company repeatedly played down the risks associated with this type of lending program.

During the second and third quarters of 2006 as the market deteriorated, New Century experienced a liquidity crisis. Mr. Morrice and Ms. Dodge were receiving reports titled “Storm Warning” which detailed the impact of the crisis on the company during the period. Yet, each executive failed to ensure the disclosure of this information, leaving investors with false information about the financial condition of the company.

A second facet of the fraud involved accounting manipulations, according to the complaint. Specifically, Ms. Dodge and Mr. Kenneally are alleged to have improperly made significant reductions in the reserves during the second and third quarters of 2006. This action was taken in the face of dramatically increasing loan repurchases and repurchase requests. As a result, the repurchase reserves were understated and the financial results were overstated for the second quarter of 2006 by 165%. For the third quarter pre-tax earnings were reported as $90 rather than $18 million.

These actions artificially inflated the share price, injuring shareholders. In the second half of 2006, the company raised $142.5 million by selling stock to new investors. When the company announced on February 7, 2007 that it would restate its financial results for the first three quarters of 2006 to correct errors for its allowance for loan repurchase losses and that it had a material weakness in internal controls, the share price fell nearly 40% from just over $30 to about $19. By early April, the company filed for bankruptcy. The Commission’s complaint, which alleges violations of the antifraud and reporting provisions as well as a claim for failure to reimburse under SOX Section 304, is in litigation. See also Litig. Rel. 21327 (Dec. 7, 2009).

The SEC has now brought cases against executives of the former number one and number three subprime lenders. The former number one company has, of course, been acquired. The former number three has been in bankruptcy for two years after announcing a restatement that furnished at least a partial road map to its difficulties. A handful of other market crisis cases have been brought. When others will be brought is unclear.

ANTITRUST SUIT BASED ON SHORT SELLING PREEMPTED

The Second Circuit concluded that a putative class action brought by Electronic Trading Group, LLC on behalf of short sellers against Bank of America Securities, LLC and other prime brokers was preempted. Specifically, the court held that the securities laws preempted Sherman Act Section 1 liability for claimed price fixing regarding the fees charged for certain securities located to cover short sales. In re Short Sales Antitrust Litig., Docket No. 08-0420-cv (2nd Cir. Decided Dec. 3, 2008).

Plaintiff claimed that defendants arbitrarily designated certain securities as “hard-to-borrow” and then fixed the price for them in violation of the Sherman Act. SEC regulation SHO requires that, before selling short, the party must borrow the securities. The prime broker charges a fee for this service. The district court dismissed the complaint based on Credit Suisse Securities (USA), LLC v. Billing, 551 U.S. 264 (2007) in which the Supreme Court found that antitrust liability was precluded by the securities laws in the IPO litigation. .

Under Billings, the preclusion analysis turns on four key points: (1) if the area of conflict is squarely within the “heartland” of securities regulation; (2) whether the SEC has clear and adequate authority to regulate; (3) if there is active and ongoing regulation; and (4) whether there would be a serious conflict between antitrust and securities regulation. Here, an analysis of each prong dictated preclusion.

First, the “heartland” prong of the test requires the court to determine if the practices challenged are squarely within the area that is regulated. In this case, the question is thus whether short selling is within the heartland of the securities business. Here, the district court concluded that it is, a point the plaintiff admitted.

The second prong of the test focuses on the existence of regulatory authority. Under Section 10(a) of the Exchange Act, the SEC is given broad regulatory authority. That authority, the court concluded, extends not just to the prevention of fraud, but also permits the SEC to regulate the role of the prime brokers in short selling and the borrowing fees charged. In addition, Section 6 of the Exchange Act permits a national securities exchange to impose a schedule or fix rates of commissions, allowances, discounts or other fees to be charged by its members. This Section, at a minimum, gives the SEC the indirect authority to regulate rates. It is thus clear that the SEC has adequate regulatory authority in this area.

Equally clear is the fact that there is on-going regulation in this area – the third factor. In 2004, the SEC adopted Regulation SHO which imposes a “locate” requirement on brokers involved in short selling before the trade can be accepted. This regulation constitutes an exercise by the SEC of its authority over prime brokers in the area of short selling. Indeed, the complaint here implicitly confirms active regulation, the court found.

Finally, it is also apparent that there is a conflict between the two regulator regimes. The question here is whether allowing antitrust liability in this case would inhibit otherwise permissible market behavior. In this regard, plaintiffs claimed that there should be little difficulty in distinguishing between collusive fee-fixing agreements and routine communications regarding stock availability under Regulation SHO.

The Second Circuit rejected plaintiff’s claim, concluding that there are both actual and potential conflicts with the securities regime. Antitrust liability would inhibit the conduct that the SEC permits and which assists the efficient functioning of the market. “It is a lot to expect” of a broker, the court stated, “’to distinguish what is forbidden from what is allowed,’ so that the broker collects just so much information as required to satisfy the locate requirement and for the efficient functioning of the short selling market – but not an iota more – or suffer treble damages,” quoting Billings.

Likewise, a potential conflict exists since the SEC may act on its authority to regulate the borrowing fees set by prime brokers. This potential conflict, coupled with the actual one, considered in conjunction with the other three Billings factors makes is clear that antitrust liability is precluded and that the district court correctly dismissed the action.