The SEC’s Continuing Efforts On The Market Crisis

As efforts to quell the current market crisis continue, the SEC extended a temporary market rules regarding short selling. At the same time, the agency reiterated its requests for additional regulatory authority from Congress over credit default swaps while discussing its current difficulties in investigating that market.

The Commission extended its rule requiring large institutional investment managers to disclose certain short sales and positions. An emergency order issued on September 18, 2008, discussed here, initially imposed the disclosure obligation at a time when the Commission was concerned about the impact of short selling on certain financial institutions and others. That order was later extended, with some modifications. The new order, published on October 15, 2008, extends the disclosure and filing requirements as to certain short positions of large institutional investment managers until August 1, 2009. This apparently reflects the Commission’s continuing concern regarding the impact of short trading on the market.

In addition, Erik Sirri, Director of the Division of Trading and Markets, testified on October 15, 2008, before the House Committee on Agriculture about credit default swaps. In his testimony, Mr. Sirri reiterated the Commission’s request for additional authority over that market. Chairman Cox has repeatedly urged Congress to grant the Commission this authority as discussed here, as the market crisis has unfolded.

After noting that the Commission’s current authority with respect to OTC credit default swaps is limited to enforcing the antifraud prohibitions, Mr. Sirri noted that the SEC staff is involved in discussions with the Federal Reserve Bank of New York, the Commodity Futures Trading Commission and industry members with a view toward creating a central counterparty for credit default swaps. Currently there are four potential central counterparties for CDSs: Eurex, NYSE Euronext, CME Group/Citadel and Intercontinental Exchange/The Clearing Corporation. In view of the important relationships between the securities markets and the CDS market, the Commission staff intends to pursue these discussions as a way of reducing risk in the market.

Mr. Sirri went on to note that the Commission is “doing what it can under its existing statutory authority to address concerns regarding this market” despite the fact that market participants typically structure their activities in credit default swaps to fall within the swap exclusion of the Securities Act and the Exchange Act. The comments of Mr. Sirri referenced the expansion of the Commission’s investigations into these markets regarding possible manipulation involving certain institutions.

In his testimony, Mr. Sirri noted that “[t]he expanded investigations will require hedge fund managers and other person with positions in CDSs to disclose those positions to the Commission and provide certain other information under oath. This expanded investigation should help to reveal the extent to which the risks I have identified (regarding the lack of a central clearing mechanism, counterparty risk and a lack of uniform records) played a role in recent events. Depending on its results, this investigation may lead to more specific policy recommendations.”

Nevertheless, the investigations into these markets have apparently proven difficult. The lack of uniform record keeping and filing requirements has apparently resulted in the production of incomplete and inconsistent information. At the same time, Commission investigators have found the inquiries difficult and time-consuming in view of the SEC’s limited jurisdiction in the area.

The Second Circuit And Market Efficiency On Class Certification

The Second Circuit handed down a decision on Tuesday which may become of increasing importance as the market crisis continues to spawn litigation. The court clarified its prior guidance on the standard of proof required for class certification and ruled on the application of the fraud-on-the-market presumption in a securities class action based on trading in mortgage backed “certificates” among sophisticated institutional investors.

In Teamsters Local 445 Freight Division Pension Fund v. Bombardier, Inc., Case No. 06-3794 (2nd Cir. Oct. 14, 2008), the circuit court affirmed an order denying certification of the class. Plaintiffs purchased what are called “certificates” issued by Bombardier Capital Mortgage Securitization Corporation, a wholly owned subsidiary of Bombardier, Inc. The “certificates,” sold in seven offerings between 1998 and 2001, were each secured by a pool of mobile home loan contacts and mortgages. The certificates traded infrequently. Plaintiffs claimed that defendants disregarded underwriting standards, regularly under wrote loans to borrowers who were not creditworthy and purchased large quantities of facially defective and deficient mobile home loans. All of this caused escalating delinquency rates which were systematically underreported. Once the certificates were downgraded below investment grade and there were news stories regarding possible write offs by defendants, the market collapsed.

The court began its analysis by clarifying the evidentiary standard which a plaintiff must meet at class certification. In this regard the court held that “we dispel any remaining confusion and hold that the preponderance of the evidence standard applies to evidence proffered to establish Rule 23’s requirements.” This clarified the circuit’s prior cases which the circuit court conceded were unclear.

In the next part of its opinion, the court concluded that the Teamsters could not satisfy Rule 23(b)’s predominance requirement as to reliance utilizing the fraud-on-the market theory of Basic Inc. v. Levinson, 485 U.S. 224 (1988). Accordingly, class certified was properly denied.

The resolution of this question hinged on whether the market is efficient. To analyze the issue, the court focused on three of the factors identified in Cammer v. Bloom, 711 F. Supp. 1264 (D.N.Y. 1989), which had considered the question as to the equity markets. First, the court considered whether there were financial analysts who report on the security. If there are a number of analysts following the security, that fact would support an inference that the market is efficient. Here, the court rejected expert testimony offered by plaintiff claiming that in fact analysts followed the security. The court noted that the testimony was based on the fact that analysts followed publicly traded Bombardier, not the “certificates” involved here.

The court also found that plaintiff failed to meet its burden on a second key prong of the test – whether market makers were making a market in the securities, since this promotes efficiency. The securities here were traded infrequently among institutions. The fact that the lead underwriter would furnish bids and quotes on request did not make it a market maker.

Finally, the court rejected evidence offered by the Teamsters that the price of the securities reacted immediately to news of unexpected corporate events, another hallmark of efficiency. Plaintiff’s expert economist offered an event study which they claimed supported the argument that in fact the securities reacted to such information. The court rejected this evidence as inadequate however, because the study focused on the disclosure of information immaterial to the certificates and which related primarily to the parent company.

In conducting its analysis, the court acknowledged that Cammer is based on the equity rather than the bond markets and that there are differences between the two markets. Here, however, the factors from the case were properly used as an “analytical tool” to evaluate the question of efficiency the court noted.