The SEC’s Bold Step Into The Markets Mandates Quick Follow Up Measures

Last week, the SEC took extraordinary action with a package of measures discussed here which injected the agency into the trading markets in an unprecedented manner. By temporarily banning short sales in the shares of selected financial institutions – presumably those thought to have large portfolios with toxic mortgage related assets – the Commission halted part of the downward pressure on the shares of those institutions. Effectively, the Commission acted as a circuit breaker to halt what many thought might be severe downward pressure on the share price of financial institutions which could lead to further dislocation in the markets. The actions were taken in conjunction with Federal Reserve and Treasury, who, along with Congress, are now racing to create a bail out of these institutions and stem further collapse and turmoil in the markets.

While nobody wants to see further market turmoil or the collapse of addition institutions, many have questioned, if not protested the Commission’s emergency actions. Many claim that the shorts have been unfairly targeted without any proof that their trading has been improper or manipulative. Others argue that the SEC’s actions are inappropriately propping up the shares of the 799 financial institutions whose shares can no longer be traded short. Still others contend that at best, the up-tick rule, long a mechanism thought to prevent causing so-called “bear raids” with short trading, should be reinstated. And, still others claim that it is unfair to change the rules of the game in the middle.

No doubt all of the Commission’s critics make valid points. At the same time, each of the critics misses the point. The actions by the Commission are temporary, limited and tailored to the situation at hand. At the moment, there is tremendous uncertainty in the markets and with good reason. These are extraordinary times. Many financial institutions hold millions and in some cases billions of dollars in toxic mortgage related assets on their books. At the same time, there is a lack of sold factual information about the true value of these assets today and in the future. Many of those assets today may not have much value if measured in terms of what a willing buyer would pay. At the same time, long term, those assets may have significant value. Today, however, nobody knows. The markets hate uncertainty. Trading is being driven in many instances by rumors and speculation. While that is frequently the case, in these extraordinary times the impact can be very dramatic and multiplied many times beyond what would be typical because of the conditions.

In today’s market, the share price of a financial institution can easily be driven into a “death spiral” starting with rumors causing traders to bail out, followed by more bailing out, added to by computer programs that get tripped and all added to by traders assessing the trend who start selling short. Very quickly, the share price plummets to near zero causing an already shaky institution to crumble. That sends even more shock waves through the market. This is not the kind of bear raid that many believe caused Bear Stearns to collapse. It is just a rumor-driven spiral to collapse.

Regardless of the cause of a death spiral, when the share price free falls to zero, not because it reflects the inherent value of the company – and markets are about price discovery – the loser is not just the institution or Wall Street, but also Main Street. Thousands of small investors across the country hold shares of these financial institutions either directly in their retirement accounts or through mutual funds. When these institutions crash, it is those shareholders who are the real losers. It is those small shareholders who have worked hard for years to build their retirement accounts and are counting on it for their future that are wiped out and left with nothing. And, it is thousands of people at those institutions who lose not just their jobs and much of their savings which is frequently tied up in the stock of their company. The SEC’s step into the markets last week protects all of these interests.

At the same time, there is little doubt that the SEC’s extraordinary market intervention is interfering with the normal operations of the market and that its critics make have valid concerns. For this reason, it is imperative that the Commission’s circuit breaker action be brief.

The SEC made it clear in instituting its market measures that it was expanding its enforcement investigations and taking other actions to examine trading in the markets. It is imperative that the SEC and its enforcement division move quickly in conducting these inquiries. At the same time it is important the Commission and its investigators look for more than evidence of the typical “bear raid.” Investigators must carefully consider what is driving the kind of trading which might cause the share price to spiral down and which necessitated the Commission’s step into the markets. It may be that much of this action stems from rumors and speculation that are driven by a lack of hard market information about the true financial condition of the 799 financial institutions covered by the short sale orders. It may be that what is needed is not an enforcement action against a few manipulators, but new and better disclosure rules and provisions. If so, the Commission should be prepared to act quickly with either new rules or proposals for legislation.

The extraordinary acts taken last week are a circuit breaker, not a long term fix. By stepping into the market, the SEC took a bold step to stabilize the current situation. Now it must quickly follow up and stay in lock step with the Federal Reserve, Treasury and Congress to restore market confidence and the traditional trading rules.

This Week In Securities Litigation (September 19, 2008)

This week, the market crisis continued to dominate all events. The SEC took extraordinary steps to curtail short selling and is considering additional emergency measures which would require large hedge funds and institutional traders to disclose their short positions. To supplement these measures, the Enforcement Division is conducting expanding existing investigations to focus on the short selling of some traders. Each of these steps is intended to quell the turmoil in the markets and preclude market manipulation which might send some share prices spiraling down.

In private securities actions, there were two significant circuit court decision, one regarding the CSX case and another implementing the Supreme Court’s decision in Tellabs. The were also enforcement actions based on option backdating, financial fraud and one SEC insider trading case which may be unique since one of the named defendants passed away three weeks before the case was filed.

The market crisis

Short sale rules: As the turmoil in the markets continued, the SEC focused on short trading and market manipulation, announcing that it may add to the new regulations already in place. On Wednesday, Chairman Cox noted that he is going to request that the SEC adopt a new rule on an emergency basis which would require hedge funds and other large institutional investors with more than $100 million invested in securities to disclosure their daily short positions. In the same release, the Chairman noted that the Division of Enforcement is expanding their ongoing investigations “by undertaking a series of additional enforcement measures against market manipulation. The Enforcement Division will obtain disclosure from significant hedge funds and other institutional traders … [about] their past trading positions in specific securities.”

The announcement of the proposed emergency rule and enforcement efforts follows the implementation by the SEC of other new provisions aimed at naked short selling. Under a new rule which will became effective on Thursday, September 18, 2008, the Commission imposed a hard T+ 3 close out requirement on all short sales. This rule requires any short seller and their broker-dealer to deliver the securities by the close of business on the settlement date which is three days after the transaction. In addition, the options market maker exception was also eliminated and the Commission adopted Rule 10b-21 regarding fraudulent short selling as discussed here.

Auction rate securities: The Committee on Financial Services, U.S. House of Representatives, began hearings this week into the auction rate securities markets. Those hearing are focused on the continuing crisis in those markets. Prepared testimony was offered by Linda Thomsen, Director of the Division of Enforcement. In her remarks, Ms. Thomsen reviewed the division’s investigative efforts into events in the ARS market. Those efforts have been coordinated with FINRA, the New York Attorney General’s Office and the North American Securities Administrators Association. As a result of these combined inquiries, several significant tentative settlements have been announced as previously discussed here.

Private litigation

Two recent significant rulings focus on disclosure obligations under Section 13d and the interpretation of the Supreme Court’s decision in Tellabs which construed the PSLRA requirement of a “strong inference” of scienter as discussed here.

Section 13d disclosure: The Second Circuit Court of Appeals affirmed Judge Kaplan’s decision not to enter an injunction which would sterilize the shares of two hedge funds found to be in violation of Section 13d. That ruling came in the midst of a hotly contested proxy contest regarding CSX in which the two hedge funds were seeking board seats as discussed here. CSX v. Children’s Investment Fund, No 08-2899 -cv (2nd Cir. Sept. 15, 2008).

Tellabs: An Eighth Circuit ruling continued to develop the jurisprudence applying the Supreme Court’s “strong inference” of scienter test developed in its Tellabs decision. The Circuit Court affirmed a pre-Tellabs ruling dismissing a class action complaint for failing to adequately plead a strong inference of scienter. The district court analyzed the question on an allegation by allegation basis rather than using the Tellabs approach of considering the complaint as a whole. In reviewing the district court order, the Circuit Court analyzed the question in the same manner as the district court and by considering the complaint as a whole. In conducting its analysis, the Circuit Court did not follow its prior post-Tellabs approach which combined the Supreme Court’s approach with the Circuit’s pre-Tellabs “motive and opportunity” test derived from Second Circuit jurisprudence. In reaching its decision Court accepted allegations from confidential witnesses without commenting on the PSLRA pleading requirements although detailed facts about those witnesses were presented as discussed here. Western Pa. Electrical Employees Benefits Fund v. Ceridian Corp., No 07-2707 (8th Cir. Sept. 11, 2008).

Enforcement actions

Option backdating: The Commission filed two option backdating cases this week, while trial commenced in a criminal case. The first is a clear reminder to independent directors of their watchdog role, SEC v. Kohavi, Case No. 08-43-48 (N.D. Cal. Sept. 17, 2008), discussed here. Named as defendants in the action are three former outside directors of Mercury Interactive, Igal Kohavi, Yair Shamr and Giora Yaron. The complaint alleges that from 1997 through 2002 directors approved 21 separate backdated option grants and that they were reckless in not heeding a series of red flags which should have told them the grants were backdated and improper. To settle the action, each defendant consented to the entry of a permanent injunction prohibiting future violations of the antifraud, proxy and reporting provisions of the federal securities laws and agreed to pay a civil penalty of $100,000. The Commission previously settled its action against the company as discussed here. SEC v. Mercury Interactive, LLC, Case No. 07-2822 (N.D. Cal May 31, 2007).

The second is a settled action against the former chairman and CEO of KB Home, Inc., SEC v. Karatz, Civil Action No. CV 08-06012 (C.D. CA. Filed Sept. 15, 2008) discussed here. The action alleged that the defendant engaged in a multi-year scheme to backdate stock options for himself and others between 1999 and 2005. To resolve the action, Mr. Karatz consented to the entry of a permanent injunction prohibiting future violations of the antifraud, reporting and proxy provisions of the federal securities laws and an order requiring him to pay disgorgement and interest of about $6.7 million and a civil penalty of $480,000. The order also bars him from serving as an officer or director of a public company for five years.

Finally, trial began in U.S. v. Roberts, Case No. 3:07-cr-00100 (N.D. Cal. Feb. 27, 2007). This case is based on option backdating at McAfee, Inc. Mr. Roberts is the former general counsel of the company. He is alleged to have increased his potential profit on options by over $197,000 by backdating options. The proceedings got off to a rocky start when the company suddenly produced a group of e-mails that had long been sought.

Financial fraud: The Commission filed a financial fraud case against American Italian Pasta Company and three separate actions against three former officers this week, SEC v. American Italian Pasta Co., Case No. 4:08-cv-00675 (W.D. Mo. Filed Sept. 15, 2008), discussed here. The complaint claims that after an earnings short fall in 2002 the defendants crafted a scheme to ensure that the company would meet Wall Street expectations using a variety of improper accounting techniques. As a result, the company overstated pre-tax income by over $36 million and EPS by about 23% for fiscal 2002, 42% for fiscal 2003 and 59% in the first quarter of fiscal 2004. To resolve the actions, the company and two of the former officers consented to the entry of permanent injunctions prohibiting future violations of the antifraud and reporting provisions. In addition, one former officer consented to the entry requiring him to pay disgorgement of about $750,000 plus prejudgment interest and a civil penalty of $250,000 and barring him from serving as an officer or director. A second officer agreed to pay a civil penalty of $25,000.

Insider trading: The SEC filed an insider trading case against four men alleged to have traded on inside information about the acquisition of Georgia-Pacific Corporation. SEC v. Zeglis, Case No. 08-CV-5259 (N.D. Il. Sept. 16, 2008). According to the complaint James Zeglis misappropriated material nonpublic information from his brother, a member of Georgia-Pacific’s board of directors about a takeover of the company. Just before the transaction announcement, Mr. Zeglis tipped Gautum Gupta and Jim Dixon. Mr. Gupta is alleged to have then tipped Lance McKee. Each defendant traded. Messrs. McKee and Dixon settled the action by consenting to permanent injunctions, agreeing to pay disgorgement and civil penalties. According to press reports, Mr. Zeglis died three weeks before the action was filed. A Commission spokesman is quoted as saying that the agency could still pursue Mr. Zeglis’ assets. There was no mention of continuing to pursue the injunctive relief requested in the complaint.