This Week In Securities Litigation (December 26, 2008)

As the world pauses this week for the holidays, the markets continue to rock and reel from the on-going crisis of credit and confidence and the Madoff scandal. Wall Street and Main Street wonder how we got to this point. Who would have thought last year that all the great investment bank holding companies would be gone within a year? Who would have believed last year that, within months, once venerable Lehman Brothers would have disappeared and that the mighty bull of Wall Street, Merrill Lynch, would be a subsidiary of a bank? Which Madoff investor, thinking that they got in on a thing so good that only the select chosen few could profit, would have suspected last year at this time that it was all a fraud?

Recriminations, theories and explanations and calls for reform are everywhere. Some such, as the Economist, blame at least in part the SEC. This view suggests the Commission needs to be revitalized. Some suggest that the entire regulatory structure is outdated. This leads to calls to merge the SEC, the CFTC and the banking agencies to create a new agency in the name of reform and modernization. Still others, such as Wall Street historian and Professor Joel Seligman, think the deregulatory trend in Congress over the years is the problem. This theory leads to a call for a renewed focus on investor protection and a revamping of the securities laws. Each of these ideas has merit. None of this, however, seems to quite hit the mark.

To be sure, the SEC needs a new focus. Likewise, Mr. Seligman is undoubtedly correct that Congress needs to bolster investor protection and consider the holes in the securities laws. This includes regulation over investment bank holding companies, as he suggests (although this seems a little late since none are left), credit default swaps and hedge funds. A new focus on investor protection is also called for. But, this is only part of the equation.

If the current market crisis and the Madoff scandal teach anything, it is that there needs to be focus on investor protection and what might be thought of as market protection – more regulation to ensure the markets function in an efficient, competitive manner. The notion that the markets have become so large, so sophisticated and so efficient that they can do without basic regulation which ensures their proper functioning simply misses the mark. Equally incorrect is the notion that more regulation and enforcement will make the U.S. markets uncompetitive, resulting in a flight of capital and business. Indeed, even the author of years of deregulation, Alan Greenspan, recently acknowledged in Congressional testimony that the markets suffer from insufficient regulation. And, if a strong market regulator will cause business to go elsewhere, one has to wonder why market regulators around the world such as the U.K.’s FSA are working hard to become what the SEC once was.

Investor and market protection will not be achieved by creating a new super agency from a merger of an alphabet soup of regulators. Viewing agencies such as the SEC, CFTC, the Federal Reserve and the OTC from 10,000 feet may suggest that the answer is to merge them all. This view however, ignores the fundamental differences in approach of these institutions which stems not from the statutes and regulations they administer, but from the markets they regulate.

Rather, meaningful reform begins with a refocusing of the statutes and regulations regarding investor protection and market protection, plugging the gaping holes in the disclosure system we call the securities laws. Improved disclosure regarding major market players, such as investment bank holding companies (if any return) and hedge funds, is fundamental. Likewise, the disclosure rules need to be revamped regarding important products, such as credit default swaps and all derivatives. Adequate amounts of sunlight have always been the first line of defense against fraud and excess. This holds true for investment banks that piled up way to much high risk debt, as well as fraudsters such as Bernard Madoff who reportedly managed his Ponzi scheme from a secret set of books.

In re-vamping the statutes, steps should also be taken to ensure that that investment firms have adequate capital and sufficient cash flow. Recall that as Bear Stearns spiraled toward its demise the markets were repeatedly reassured that it had adequate capital. Perhaps so. But without cash flow which stems at least in part from investor confidence, it could not survive. And, if this adequate capital and cash flow is coupled with proper disclosure, perhaps the rumors many Wall Street executives fear the short traders will generate to cause their stock to sink in a death spiral will be of less concern – rumors typically result from half truths, not adequate disclosure of the facts.

Finally, once the statutes are re-written. the SEC itself has to be re-focused and re-vitalized. Its mission, typically described as investor protection, has to become that, plus market protection and safety. The agency needs to regain its zealous focus on enforcement, rather that what seems to be its current approach of “arrive at the scene after the fact and punish.” If the SEC’s mission is refocused on investor and market protection, its statutes are overhauled and its new Chairman and the other Commissioners lead the charge on enforcement, it will benefit investors, business and the markets while helping to avoid a repeat of the current debacle.

Cases of note this week

Option backdating: The Commission filed two additional settled civil injunctive actions stemming from the option backdating scandal at UnitedHealth Group, Inc. These two actions are similar to earlier backdating cases. First, in SEC v. Lubben, the Commission filed a settled action against former UnitedHealth General Counsel David J. Lubben. The complaint claims that that between 1994 and 2005 the company backdated more than $1 billion in stock option compensatory grants given to senior executives and others. The options were “in-the-money” as a result of the backdating scheme.

Mr. Lubben settled the case by consenting to the entry of a permanent injunction which prohibits future violations of the antifraud, reporting, record-keeping, internal controls and proxy provisions of the federal securities laws. He also agreed to the entry of an order barring him from serving as an officer or director of a public company for five years and to the payment of disgorgement of over $1.4 million plus prejudgment interest and a civil penalty of $575,000. SEC v. Lubben, Case No. 08-CV-6454 (D. Minn. Filed Dec. 22, 2008).

Second, in SEC v. UnitedHealth Group, Inc., Case No. 08-CV-6455 (D. Minn. Filed Dec. 22, 2008) the Commission’s three-count complaint charged violations of the periodic reporting requirements, a failure to maintain accurate books and records and a failure to maintain adequate internal controls. The factual allegations are similar to those in other UnitedHealth cases. To settle the case, the company consented to the entry of a permanent injunction based only on the three claims in the complaint. The injunction did not contain a fraud provision. The Commission also did not seek a financial penalty. The case, discussed here, is noteworthy for its discussion of the cooperation credit factors the SEC considered in making its prosecutorial decision. Earlier UnitedHealth cases are discussed here.

FCPA: Following up on last week’s blockbuster Siemens case, DOJ and the SEC filed the latest in a series of FCPA cases based on the U.N. Oil For Food Program. This case involved Italian manufacture Fiat and is discussed here.

The criminal case involved Fiat and three of its subsidiaries, Iveco S.p.A. (“Iveco”), CNH Italia S.p.A. (“CNH Italia”) and CNH France, S.P. (CNH France). Iveco and CNH Italia were each charged with conspiracy to commit wire fraud and to violate the books and records provisions of the FCPA. CNH France was charged with conspiracy to commit wire fraud. The claims focus on allegations that from 2000 to 20002 Iveco, CNH Italia and CNH France paid about $4.4 million to the Iraqi government in connection with the humanitarian aid side of the U.N. program. The contracts were for industrial pumps, gears and other equipment.

Under the terms of the deferred prosecution agreement, Fiat agreed to pay a $7 million penalty. In entering into the agreement Fiat acknowledged responsibility for the actions of the subsidiaries and agreed to cooperate with the Department’s on-going Oil for Food Program. This agreement was based on the cooperation of Fiat and its adoption of enhanced compliance procedures. If Fiat abides by the terms of the agreement the charges will be dismissed after three years. U.S. v. Iveco S.p.A. and U.S. v. CNH Italia S.p.A. Both cases were filed in the District of Columbia on December 22, 2008.

The SEC filed a settled, related case. SEC v. Fiat S.p.A., Case No. 1:08-cv-02211 (D.D.C. Filed Dec. 22, 2008). The SEC complaint names Fiat and CNH Global, N.V., a Dutch subsidiary which is a provider of agricultural and construction equipment as defendants. The allegations are similar to those in the criminal case. The action was settled with the entry by consent of a permanent injunction prohibiting future violations of the books and records provisions and an agreement to pay disgorgement of about $5.3 million plus prejudgment interest and a civil penalty of $3.6 million.