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The Citi That Almost Slept

As Susan Weiswasser reports in the current issue of The Pomerantz Monitor, a New York District Court has preliminarily approved a $590,000,000 securities class action settlement between Citigroup, the country’s third largest bank, and its shareholders, who lost millions when the value of Collateralized Debt Obligations (CDOs) held by Citi plunged. A final fairness hearing on the settlement is set for January 15, 2013. Citi allegedly failed to disclose its potential exposure to catastrophic losses if the housing market tanked, which, as we all know, it did.

To fool investors, Citi fed them false information designed to make them believe it had sold off, or hedged, the risk of many of these subprime mortgages; it also manipulated its books to create the perception of good financial health. These deceptions caused Citi’s stock price to be inflated. Once the truth came out, the price of Citi’s shares plummeted and investors lost billions.

Citi, which received a huge amount of federal bailout money to prop it back up, still faces a multitude of litigation by investors, as well as the Securities and Exchange Commission, for alleged misrepresentations and omissions regarding the value and safety of a variety of securities it was trading. The course of some of the cases has been tortuous. As Tamar Weinrib reported in February’s issue of The Pomerantz Monitor, one of the SEC’s cases against Citi was settled last year for $285 million, but the federal judge overseeing the case refused to approve the settlement because he did not believe it to be fair and adequate for shareholders. The Second Circuit Court of Appeals stayed that ruling, pending its review of the court’s action,which should occur early next year.

Judges around the country are considering, some with trepidation, other settlements involving the behavior of major financial institutions that led to the financial crisis. Another New York federal judge recently approved a settlement entered into by the SEC with two former Bear Stearns hedge fund managers. However, he did so grudgingly, stating that he was “constrained to accept the settlement,” and expressing disappointment that the SEC had such limited power to bring financial relief to plaintiffs. Only by disgorgement can the SEC possibly recover any money for injured investors; the power to return the money is discretionary. When the money isn’t there, investors have no chance of recovery in an action brought by the SEC. The court encouraged Congress to consider expanding the SEC’s powers “to recover amounts more reflective of investor losses.” For the foreseeable future, investors must rely on private litigation if they have any hopes of recovering any of their losses.

Things Get Rough in Mr. Roger's Neighborhood

As reported in the current issue of The Pomerantz Monitor, Duke Energy recently acquired Progress Energy. When their proposed merger was announced 18 months ago, the two companies said that Johnson, head of Progress, would take over as chief of Duke. But hours after the deal was done on July 2, the board, dominated by continuing Duke directors, ousted Johnson and reinstalled former Duke CEO Jim Rogers in the top job. Johnson’s surprise dumping may be tempered a bit by the fact that he is due to receive up to almost $45 million in severance, pension benefits, deferred compensation, and stock awards. Utility regulators in North Carolina were investigating whether this bait and switch routine was a fraud on Progress shareholders.

The Failure of Self-Regulation

In the current issue of The Pomerantz Monitor, Joshua Silverman reports on self-regulatory organizations (SROs). In 1938, then SEC general counsel Chester Lane told a group of bond dealers that the Commission believed that the job of regulating broker-dealers “can best be handled … by placing the primary responsibility on the organized associations of securities dealers throughout the country.”  Ever since, the financial services industry has spent billions of dollars on lobbyists ($101 million in 2011 alone, according to opensecrets.org), and has succeeded in getting lawmakers to delegate important oversight functions to SROs  such as the National Futures Association (NFA) and the Financial Industry Regulatory Authority (FINRA). Unfortunately, as recent history proves, self-regulation all too often means lax regulation that perpetuates misconduct rather than protecting customers.

For example, the NFA has twice in the last two years failed to notice that member brokers were stealing hundreds of millions of dollars of customer funds from segregated accounts. It is not for lack of regulatory authority – the NFA receives daily reports from each of its member brokers describing the custody and amounts of all customer funds, audits each of these brokers on a periodic basis, and has full authority to investigate any suspected deficiencies. However, the NFA is either not competent or not willing to effectively use those tools to root out misconduct within its own ranks.

Most recently, on July 9, 2012 the NFA disclosed that about 95%, or $220 million, of customer funds were “missing” from a segregated account that futures brokerage PFGBest (formerly Peregrine Financial Group) maintained at US Bank. NFA documents conceded that most of these funds were also missing when the NFA audited PFGBest in February 2010 and again in March 2011. The fraud was not uncovered in either audit, apparently because the NFA auditor accepted manipulated copies of bank documents provided by PFGBest rather than independently verifying the balances with US Bank. Whether this lack of diligence was caused by ineptitude, or the fact that PFGBest CEO Russell Wasendorf, Sr. sat on the NFA’s board of advisors, is not clear.

If the story of missing customer funds at a futures brokerage sounds familiar, it should. Less than a year ago, customers of MF Global (including Joshua Silverman, the author of this Monitor article) learned that hundreds of millions of dollars of purportedly segregated funds had been pilfered by that firm’s management to margin their own proprietary speculations on European debt. NFA regulators also failed to notice those transfers.

Self-regulation has fared no better in the securities industry. Ron Rhoades, chairman-elect of the National Association of Personal Financial Advisors, was recently quoted as saying that FINRA  “is a colossal failure, by any measure.”  Internal FINRA reports confirm that FINRA regulators failed to adequately probe into the Madoff fraud, though FINRA oversaw Madoff’s principal entity, Madoff Securities, for more than two decades, and also repeatedly disregarded tips about Allen Stanford’s $7 billion fraud.

PFG, MF Global, Madoff, and Stanford all teach the same lesson: industry SROs cannot be trusted to protect customer funds or ferret out misconduct. If we really want to regulate the financial industry, there is no substitute for strong, independent regulators.

Seizing Property to Unseize Property Markets

In the current issue of The Pomerantz Monitor, Jay Douglas Dean reports on the potential use of eminent domain to free up the stagnant housing market. Millions of home owners are still underwater, defaulting on a massive scale.  As foreclosures sweep across America, they depress real estate values for everyone.
 
Many economists have concluded that the best way out is to get lenders to reduce the principal balance on these mortgages to reflect the actual value of the real estate. The government has tried several times to push such a process along, but with very little success. Not only have lenders been reluctant to swallow losses on these mortgages, in many cases the banks don’t even own the mortgages. Millions of them have been sliced and diced into mortgage-backed securities, which are owned by thousands of investors. Getting them all to agree to modify particular mortgages in their portfolios is impossible. As “Irrational Exuberance” author Robert Shiller has said, owners of securitized mortgages “live all over the world and have no way of communicating with each other, let alone coming to an agreement to give homeowners a break.”

One possible way around this problem would be for local governments to employ a novel legal tactic: use their eminent   domain power to acquire these mortgages from the holders, a process that would not require their consent. Governmental entities would have to pay “fair value” for these underwater mortgages, but in this market fair value would be far less than the outstanding principal balance on them. Once the localities acquire the mortgages, with money provided by private investors, they could refinance them for the homeowners, letting them hold onto their homes while making more reasonable payments.  

According to a July 5 video on the online Wall Street Journal, some county and city officials in California are giving this “silver bullet” serious consideration. New investors can expect to be repaid by homeowners who are issued new mortgages and who are no longer underwater.

Credit for this idea probably belongs to Cornell Law Professor Robert Hockett.  Joe Nocera of The New York Times recently interviewed professor Hockett, who has served as an adviser to Mortgage Resolution Partners, a company consulting with California municipalities on the issue. Hockett told Nocera that to invoke eminent domain powers, the governmental entity has to show merely that it is paying fair value for the property, and that it is acquiring it for a legitimate public purpose.
 
Keeping people in their homes and salvaging real estate markets could well be construed as a legitimate public purpose. “This is a yoke around the American economy,” said Steven Gluckstern, the chairman of Mortgage Resolution Partners.
 
The eminent domain solution is already getting pushback from investors in mortgage backed securities who, obviously, don’t want to suffer the losses such transactions would impose on them. A draft of proposed rules circulating among members of the Securities Industry and Financial Markets Association, a trade association of mortgage bond investors, would threaten municipalities that are thinking of using eminent domain to acquire underwater mortgages. The rules would disqualify mortgages from those communities from being packaged into certain types of mortgage backed securities. Gluckstern called this maneuver “reprehensible and immoral,” and also “probably illegal.”

A Lawyer Looks at Obamacare

In the current issue of The Pomerantz Monitor, Brian Hufford, one of the most respected healthcare counsel in the country, writes about theJune 28, 2012 U.S. Supreme Court decision on the constitutionality of Patient Protection and Affordable Care Act, otherwise known as “Obamacare.”

The focus of the challenge to the bill was on its controversial “individual mandate,” whereby individuals would be subjected to a financial penalty if they did not purchase insurance. As soon as the bill was signed on March 23, 2010, 14 state attorneys general, with support from the Republican Party, filed suit to strike down the law, contending that this provision in particular was unconstitutional. Ironically, the individual mandate was originally a Republican idea, first raised in a 1989 proposal by the conservative Heritage Foundation, then, in 1993, as part of the Republicans’ proposed alternative to then-President Clinton’s health reform bill, and finally, and most famously, as an integral part of Governor Romney’s health care plan for Massachusetts. However, by the time President Obama’s proposed healthcare overhaul began to gain traction, every single Republican Senator went on record declaring the individual mandate unconstitutional.

In its landmark decision, written by Chief Judge John Roberts, the Court upheld the mandate by a 5-4 vote. The fact that Justice Roberts chose to find that the individual mandate exceeds federal authority under the Commerce Clause, but is indeed constitutional as a tax, has pundits shaking their heads. Some see this as proof of Robert’s alleged desire to gut the Commerce Clause – the clause that has provided national protection for civil liberties such as desegregated facilities and labor laws – and as such, a gift to conservatives and libertarians anxious to limit the role of the federal government. As Justice Ginsberg wrote in her opinion, “[Justice Robert’s] rigid reading of the [Commerce] Clause makes scant sense and is stunningly retrogressive.” The Court upheld not only the mandate but also the rest of the Affordable Care Act, including: eliminating exclusions based on pre-existing conditions for children up to age 19; allowing young people up to the age of 26 to be covered under their parents’ policies; phasing out annual and lifetime limits on most benefits; prohibiting cancellation of insurance policies based on honest mistakes in applications; requiring insurance companies to publicly justify rate hikes as a means to combat unreasonable increases; requiring that the bulk of insurance premiums be spent on health care, not administrative costs; permitting access to emergency care to hospitals outside the insurer’s network; and requiring preventive care at no cost to the subscriber. 

The one notable provision that was not upheld concerned the significant expansion of Medicaid, which will now cover anyone earning up to 138% of the federal poverty level (including individuals without children who previously were excluded). The Act sought to compel states to go along by threatening to withdraw federal funding of all Medicaid payments to any state that didn’t agree to the expansion. By a 7-2 vote, however, the Supreme Court found that, while expanding Medicaid was fine, the financial penalty imposed on the states was not. Thus, the federal government cannot take away current funding to compel states to accept expanding Medicaid coverage, but they can voluntarily agree to do so and accept additional funding.  A number of Republican Governors have already announced that they will not agree with the Medicare expansion in their states, leaving millions of people in an uncertain position as to what insurance coverage will be available to them.

In addition, the Affordable Care Act establishes ten categories of “essential health benefits” which must be included in the individual and small group market policies, including ambulatory patient services; emergency care; hospitalization; maternity and newborn care; mental health and substance use disorder services, including behavioral health treatment; prescription drugs; rehabilitative and habilitative services and devices; laboratory services; preventive and wellness services and chronic disease management; and pediatric services, including oral and vision care. According to the Department of Health and Human Services, these provisions will mean that 8.7 million Americans will gain maternity coverage; 4.8 million will gain substance abuse coverage; 2.3 million will gain mental health coverage; and 1.3 million prescription drug coverage.

The new law also allows the Department of Labor to adopt regulations to govern all claims processing, reimbursement, denials and appeals for nearly all healthcare claims accept those falling under Medicare. Thus, whereas current regulations under the Employee Retirement Income Security act of 1974 (“ERISA”) applies only to insurance policies issued by private employers, they now will extend to non-ERISA plans, including those issued by governments and individual policies. Regulations issued under the Act also establish that if health care plans fail to adhere strictly to all of the requirements, they will be entitled to file lawsuit immediately, rather than having to proceed through internal appeals first. This incorporates a “deemed exhaustion” provision previously applied under ERISA, but exchanges a strict compliance requirement for a previously permitted “substantial” compliance, which offered an easier hurdle for insurers to exceed.  As for Medicare, the Act expands rights there as well, by allowing free wellness exams; excluding preventive services, such as mammograms, bone scans and depression and diabetes screenings, from deductibles and copays; and gradually closing the current “doughnut hole” gap in drug coverage, including continued discounts on drug costs.

Love's LIBOR Lost

As Adam Prussin reports in the current issue of The Pomerantz Monitor, a few weeks ago news erupted of what may be the worst financial scandal in years: the systematic manipulation of interest rates by the largest banks in Europe and the U.S. On June 27 the Department of Justice and regulators in the U.S. and  England announced that they had reached a settlement with Barclay’s, the giant British bank, in a case involving the fraudulent fixing of the so-called LIBOR interest rate. LIBOR (short for “London interbank offered rate”) is the benchmark for trillions of dollars of loans worldwide – mortgage loans, small-business loans, personal loans, and interest rate derivatives contracts called swaps.

The regulators allege that Barclay’s made false daily submissions to the British Bankers’ Association – which calculates LIBOR – probably from 2005 to 2009. The submissions are not based on an actual market rate of interest for interbank loans. Rather, submitters estimate what they think they would have to pay. 

Obviously, since all the big banks submit data, Barclay’s normally could not manipulate LIBOR by itself; they would all have had to cooperate. And now, in its settlement agreement, Barclay’s has admitted that this is exactly what happened, with the result that LIBOR deliberately underestimated the interest rates that the banks were paying for loans.

This is no ordinary scandal, because this time there will likely be big-time consequences. Barclay’s has paid $453 million to settle the cases; and its Chairman, CEO and CFO have all been forced to resign. The four top executives of the firm reportedly voluntarily agreed to give up their bonuses this year. But that is only the tip of the iceberg.  

Two Courts Refuse to Enjoin Proposed Class Action Settlement

As Matthew Tuccillo reports in the May/June issue of the Pomerantz Monitor, corporate transactions are typically challenged by shareholders in multiple jurisdictions. Courts will sometimes stay duplicative cases, so that defendants do not have to fight the same claims in different places at the same time, and subject themselves to duplicative proceedings and possibly inconsistent rulings. When a stay is not entered, it can lead to problems, particularly when defendants try to settle one case without involving counsel from the other(s). That is because any settlement will include a release dismissing all pending cases raising the same claims, whether the other plaintiffs like it or not.

That is exactly what happened recently in two cases involving claims that the directors of Bank of America (“B of A”) breached their fiduciary duties in 2008 in connection with the $50 billion acquisition of Merrill Lynch (“Merrill”). This notorious transaction led to many lawsuits, because B of A’s board proceeded with the deal even after allegedly learning before the merger closed that Merrill had suffered catastrophic losses and that Merrill was paying huge bonuses to management. Not only did B of A’s board fail to abort the deal, they also allegedly misled B of A shareholders about those facts before they voted to approve the merger.

Two derivative actions pursued those claims, one in New York federal court and the other in Delaware state court. Although the Delaware case had been far more heavily litigated, with more discovery, more motion practice, and an October 2012 trial date set, defendants chose to settle the claims with New York counsel. This decision prompted Delaware counsel to challenge the settlement, claiming that defendants had engaged in an improper “reverse auction” to settle far more cheaply than they could have in Delaware.

The proposed settlement of the New York action, reached on April 12, 2011, provided for a payment of $20 million in damages, all of which was to come from B of A’s insurance coverage. Delaware counsel had demanded far more, including that the defendant directors pay some of the damages out of their own pockets, given that potential damages were alleged to be $5 billion and that the Securities and Exchange Commission had previously imposed a $150 million penalty (after the court rejected a $33 million settlement) regarding the adequacy of disclosures concerning the Merrill deal.

In order to recover anything from directors, however, plaintiffs would have had to overcome their “raincoat” legal protections, which bar the recovery of damages from them unless they are guilty of intentional wrongdoing. Moreover, counsel’s submissions to the New York court have been redacted to remove discussion of applicable insurance coverage. So, it is not self-evident to non-parties exactly how much this case is really worth, given the likelihood of recovery from available sources.

Study Says Broker Rebates Cost Investors Billions

As Adam Prussin reports in the current issue of The Pomerantz Monitor, stock trading in the United States stock market has not only failed to recover since the 2008 financial crisis, it has continued to fall. The New York Times reports that in April the average daily trades in American stocks on all exchanges stood at nearly half of its peak in 2008: 6.5 billion compared with 12.1 billion shares. In contrast, trading returned to normal within two years after the market declines of 1987 and 2001.

Declining trading leads to declining trading commissions, which have apparently led to fierce competition between trading venues for the action that remains. The latest weapon in these trading wars is rebates: exchanges are now paying brokers for sending trades to them. NASDAQ, for example, reportedly paid out $306 million in rebates in the first quarter of this year, or nearly half of its revenue. These rebates go to the brokers, not the customers. That’s not good, because the lure of potentially significant rebates can entice brokers to place the trade on an exchange that does not offer the best price.

Stockbrokers are legally required to seek out the best prices for clients who pay them to buy and sell shares; but that “best execution” rule is riddled with loopholes. For example, a broker may send the first 100 shares of an order to the exchange with the best price, but the rest of the shares to the exchange where the broker will receive a larger rebate.

A new study using industry data reveals that such rebates could be costing mutual funds, pension funds and ordinary investors as much as $5 billion a year. The study, released in early May, was written by Woodbine Associates, a financial consulting firm that does business with players on all sides of the issue. Woodbine said the report was done independently, without support from industry participants.

The study estimates that investors lost an average of four-tenths of a cent on each of the 1.37 trillion shares traded last year because of orders being sent to exchanges that were not offering the best final price. This conclusion comes in the wake of a 2010 report by two former chief economists at the SEC, who concluded that “in other contexts, these payments would be recognized as illegal kickbacks.”

Merger Deals: When "Protections" Become Straitjackets

As Ofer Ganot reports in the current issue of The Pomerantz Monitor, the Delaware Chancery Court’s recent approval of a settlement in a case involving the Celera Corporation highlights the tension that occurs when companies entertain acquisition proposals. Bidders want to lock up a deal as tightly as possible, so that if they reach an agreement it will be more than just an opening bid in a free-for-all auction of the company. Targets, on the other hand, want to get the best deal they can, and therefore want as much freedom as possible to consider potentially better offers. Many volumes of case law have been devoted to trying to find a perfect balance between these competing interests.

 For example, it is common for targets to open up their financial records to potential acquirers, so that they can do “due diligence” before preparing a bid for the company. However, to protect themselves, targets typically insist on a confidentiality agreement that includes ”standstill” provisions prohibiting potential bidders who inspect the records from making an offer for the target without an express invitation from the target’s board. These provisions also typically prevent the bidder from asking the board to waive these restrictions so that they can make an unsolicited bid.

 A key feature of Delaware law is that merger agreements need to contain some kind of “fiduciary out” clause: even after a deal is signed, if a significantly better offer then comes in, the board needs to be allowed to consider it. To protect itself from such an eventuality, bidders routinely insist that the merger agreement contain deal protections, which make it more difficult – but in theory not impossible – for other companies to come in after the fact and bid against them. Among such protections are “no solicitation” clauses, which prevent the target, after a deal is signed, from soliciting a higher offer from somebody else.

 The combination of standstill agreements and no solicitation deal protections in the same transaction can, however, create a huge problem:  in conjunction, they provide no way for the target company to find out if anyone else is willing to make a better offer for the company. It can’t ask anyone if they want to make a better bid, because that would violate the “no solicitation” clause; and other potential bidders will probably have signed confidentiality agreements that don’t allow them to submit a bid unless the target asks them to do so. The result can be that there is no way for the board of the target company to find out if a better deal is out there – which they are obligated to do as part of their fiduciary duty.

 In the Delaware Court of Chancery’s recent ruling in the Celera litigation, Vice Chancellor Parsons approved a settlement of a shareholder case arising from the acquisition of the company where both a “no solicitation” clause and standstill agreements were in effect, preventing the company from finding out if anyone else was ready or willing to submit a superior bid. A major part of the settlement was defendants’ agreement to waive the standstill agreements and allow other potential bidders to submit competing bids. Vice Chancellor Parson, commenting on the importance of that waiver as a benefit of the settlement, stated that, “taken together,” these two commonplace devices “are more problematic.” Since this mix blocked the board from inquiring further into “once-interested parties’” interest, Vice Chancellor Parson stated that “[p]laintiffs have at least a colorable argument that these constraints collectively operate to ensure an informational vacuum” and that “[c]ontracting into such a state conceivably could constitute a breach of fiduciary duty.”

In another recent decision involving the El Paso Corporation, which we discussed in a previous issue of the Monitor, the Delaware Chancery Court “reluctantly” refused to enjoin a merger even though the negotiation of that merger was heavily tainted by conflicts of interest. The court didn’t want to risk killing the only deal that was available to El Paso shareholders, because it would give them a substantial premium over the current market price. Chancellor Strine determined that shareholders were well-positioned to turn down this deal “if they did not like it” and that because no other bidders had materialized, the shareholders “should not be deprived of the chance to decide for themselves about this merger . . . ”

 The confluence of “no solicitation” and standstill provisions, such as we saw in the Celera case, will present this very situation: no one else can make a bid, and in the absence of other potential bidders, the court will be reluctant to enjoin consummation of the only offer that is actually on the table.

Here Comes the JOBS Act

As Fei-Lu Qian reports in the current issue of The Pomerantz Monitor, on April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (“JOBS Act”), with the purpose of spurring job creation by improving access to the public capital markets for “emerging growth companies” (“EGCs”). The JOBS Act classifies start-up companies as EGCs until, for example, they generate $1 billion in annual gross revenues, or the fifth anniversary of their initial public offering (‘IPO’).”

The main goal of the JOBS Act is to make it easier for start-up companies to go public. IPO registration statements will now need to include only two years of financial statements, and only selected financial data will have to be provided for any previous period.  Prior to an offering, an EGC will be able to expand communications and file with the SEC a draft IPO registration statement and amendments on a confidential basis, for its review and comment, and the EGC would not need to release those confidential filings to the investing public until just 21 days before the company’s IPO “road show.” Moreover, before filing a registration statement, an EGC will not be restricted to communicating only with qualified institutional buyers or institutional accredited investors. Perhaps most significantly, the EGC’s auditor will not have to certify the efficacy of internal controls and procedures under Section 404(b) of Sarbanes-Oxley.

Critics contend that the JOBS Act will lead to increased financial problems and fraud, and make it more difficult for shareholders to detect those problems.  For example, an EGC will be able to resolve issues with the SEC without investors finding out about them until only 3 weeks prior to an IPO.  Case in point: if the JOBS Act had been in effect prior to Groupon’s IPO, that company probably would have been able to resolve its accounting problems with the SEC without ever disclosing them to the public. Recently, Groupon disclosed that its executives failed to reserve enough money for customer refunds on expensive offers.

According to a survey conducted by the CFA Institute, a global association of investment professionals, only 29% of its members wanted the legislation to pass, and 63% believed that the bill “would create additional gaps in investor protection and transparency.” The Institute believes that the Act’s permission to allow brokerage firm analysts whose firms are underwriting an IPO to write and distribute research on companies “is a return to the kind of conflicted research that decimated investor confidence after the burst of the dot-com bubble.”