This Week In Securities Litigation (January 2, 2009)

The market crisis and the Madoff scandal continue to be the dominant events this week, with the SEC publishing its mark-to-market study as required by Congress and Mr. Madoff providing the SEC with a listing of assets. SEC Chairman Cox defended the response of the Commission to the current market crisis. In the interview, Mr. Cox termed the imposition of the short sale ban earlier this year as his biggest mistake, blaming the Treasury Secretary and Fed Chairman for the move. Mr. Cox also reiterated his earlier assertion that the failure to uncover the Madoff matter sooner is not his fault, while insisting that enforcement under his tenure is robust. Ironically, two new academic studies show that the short sale ban by the SEC and other regulators has not had a negative impact on price discovery and that the number of prosecutions for securities fraud have declined significantly.

The market crisis

Mark-to-market accounting study: The SEC published its Report on Mark-to Market Accounting this week. The report was mandated by the Congress in the Emergency Economic Stabilization Act of 2008. In essence the study recommends that fair value accounting continue to be used but with improvements. The Report contains eight key recommendations:

1) SFAS No. 157 should be improved and not suspended;

2) Existing fair value and mark-to-market requirements should not be suspended;

3) Additional measures should be taken to improve the application and practice related to existing fair value requirements;

4) The accounting for financial asset impairments should be readdressed;

5) Further guidance is needed to foster the use of sound judgment in this area;

6) Accounting standards should continue to be established to meet the needs of investors;

7) Additional formal measures to address the operation of existing accounting standards in practice should be established; and

8) There is a need to simplify the accounting for investments in financial assets.

Chairman’s interview: SEC Chairman Christopher Cox defended the actions of the SEC during the current market crisis in comments made during a recent interview (available here, registration required). Mr. Cox stressed that the restrained approach taken by the agency to the financial crisis has been the correct one. Two other key points during the interview:

• His biggest mistake during his tenure, Mr. Cox noted, was imposing the short sale ban earlier this year. He took that action at the request of Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke.

• Mr. Cox reiterated his earlier comments that he is not responsible for the failure to detect the alleged fraudulent scheme of Bernard Madoff.

At the same time, Mr. Cox noted that enforcement has been effective under his tenure claiming that the agency has been a strong cop on the beat.

The Madoff scandal

Investigators continued to focus on trying to unwind the actions surrounding the alleged $50 billion Ponzi scheme of Bernard Madoff. On New Year’s Eve Mr. Madoff filed an accounting in the SEC’s civil action against him. That accounting, produced under the terms of a consent decree entered in the SEC’s case, is supposed to identify all of the assets Mr. Madoff and his entities controlled. Many of those assets are offshore, according to some reports. If the report is complete, it should provide SEC investigators with significant insights into the workings of investment fund managed by Mr. Madoff. Eventually it may aid investors with trying to recover at least part of their losses.

Suits also continued to be filed by investors. Some of these actions are investor suits filed against the so-called “feeder funds.” Those are the investment funds which channeled huge sums of money to Mr. Madoff. One suit, which probably reflects investor frustrations more than legal merit, was brought against the SEC.

Additional investors suffering huge losses also continue to appear. According to some reports, an Australian bank will have to be bailed out by the government of that country as a result of its losses.

Congress is now set to look into the Madoff matter. Next week, a House committee is scheduling hearings and the SEC inspector general is set to testify. The inspector general is currently conducting an internal investigation to determine why the agency did not discover the alleged fraud sooner.

Private actions

A class action fraud suit was filed which names, among others, Mary Schapiro, the nominee to be the next SEC Chairwoman. The suit claims misrepresentations were made by the defendants about payments made to NASD Members to induce them to vote in favor of the transactions between the NASD and the New York Stock Exchange Group, Inc. which created FINRA. Benchmark Financial Services, Inc. v. Financial Industry Regulatory Authority, Inc., Case No. 1:08-cv-11193 (S.D.N.Y. Filed Dec. 23, 2008).


Securities fraud prosecutions down: A new study by Syracuse University using Department of Justice data shows that there has been a significant decline in the number of securities fraud cases brought during the first eleven months of this fiscal year. According to the study, there were 133 prosecutions for securities fraud during that time period. In contrast in 2000 there were 437 securities fraud cases. The highest number of securities fraud cases was 513 in 2002.

At the SEC prosecutions for securities fraud dropped from 69 in 2000 to just 9 in 2007, a decline of 87% according to the study.

No impact from short sale restrictions: A study of the impact of the emergency short sale rules imposed by the SEC and other regulators around the world has concluded that the restrictions did not change the behavior of stock returns. Specifically, the study concluded that the short selling restraints did not have any detrimental impact in terms of reduced efficiency of pricing. The study was done by professors at London’s Cass Business School.