The New SEC: Is It an Improvement?
© 2009 PERSPECTIVES
President Barack Obama’s win ushered in the era of the new Securities and Exchange Commission. The new label was meant to differentiate the current SEC from the SEC that had ultimately failed to protect investors, under Chris Cox and the Bush administration, from wild securitization of everything that touched the mortgage market, huge Ponzi schemes such as Madoff and Stanford and credit rating agencies run amok. While the new SEC has spent some time apologizing for its predecessor’s failures, promising reforms were on their way, several recent actions would seem to indicate the new SEC may not be so different.
A recent illustration is Judge Jed S. Rakoff’s rejection of the SEC’s proposed settlement with Bank of America Corp. arising from Bank of America’s misleading disclosures as to bonuses related to its takeover of Merrill Lynch. The $33 million proposed SEC settlement hardly covers the contracts that were barely dry for top Merrill executives brought over from Goldman Sachs, much less the billions of dollars in bonuses paid to other Merrill employees out of taxpayer dollars. Indeed, where is there any mention of punishment for those that actually wrote and/or approved the false and misleading disclosures? As Judge Rakoff aptly put, the proposed settlement “was a contrivance designed to provide the S.E.C. with the facade of enforcement and the management of the Bank with a quick resolution of an embarrassing inquiry - all at the expense of the sole alleged victims, the shareholders.”
But a broader review of the SEC's recent enforcement actions and hirings reveals that the Bank of America settlement does not appear to be an isolated failure by the new SEC, but a trend of what is to come.
Just last year, prior to the Bank of America settlement by the new SEC, the old SEC entered into a similar walkaway with a large telecom company - UTStarcom Inc. The facts in the SEC’s cease and desist order alone established that UTStarcom restated its financial results three times because they improperly recognized $50 million of international revenue, i.e., revenue on sales to customers outside of China; improperly recognized $366 million of revenue on China sales; improperly failed to record a $7.5 million inventory impairment charge on a related party transaction; and improperly failed to record stock compensation expenses on backdated stock options. In other words, UTStarcom’s purported financials, as published to investors, were false to the tune of hundreds of millions of dollars.
When these restatements were announced, investors lost nearly a billion dollars. UTStarcom is now but a $2 stock down from its class period high of over $45 a share. SoftBank, a controlling shareholder that at one time owned 60% of UTStarcom common stock, walked away with hundreds of millions of dollars in profits.
How did the SEC fail to charge UTStarcom, and its top officers, Hong Liang Lu and Michael J. Sophie, with violations of the federal securities laws’ antifraud provisions? Instead, the SEC charged UTStarcom, Lu and Sophie with books and records violations and fined Lu and Sophie a paltry $175,000. That resolution does nothing for investors. Moreover, when Marc Fagel, the SEC’s regional head, reported the settlement on May 1, 2008, he stated: “We did not sue them for fraud; this was more of a negligence-type case.” Fagel's comment was irresponsible and contrary to the facts. Indeed, in our suit on behalf of investors against UTStarcom, defendants’ counsel seized on Fagel’s comments to argue that there was no merit to our fraud claims. Fortunately, the court rejected defendants’ contentions and denied their motions to dismiss.
But, the SEC’s giveaway regarding UTStarcomhad occurred under the watch of Cox and the prior regime. Those that represent investors to recover damages had come to expect little help from this quarter. With the Bank of America settlement, coupled with other recent SEC actions, we question whether there has been any change and fear that investors are in for the worst.
Fagel, who joined the SEC after a six-year stint as an associate at Morrison & Foerster, a big defense firm that specializes in representing defendants in securities fraud class actions, remains the regional head of the San Francisco SEC office. In a recent settlement with VeriFone Holdings Inc., a large public company that provides electronic payment security and solutions, the new SEC asked for less than its predecessor had from UTStarcom. VeriFone had admitted falsifying earnings for three quarters in 2007. The restatement was so severe that it literally erased all of VeriFone’s profits in some quarters and revealed huge losses. VeriFone’s shareholders took the hit, suffering a $1.8 billion loss in value as the stock price declined more than 46 percent.
The facts in the SEC’s complaint alone establish that CEO Douglas Bergeron and former CFO Barry Zwarenstein received internal reports disclosing 1Q07, 2Q07 and 3Q07 gross margins that were substantially less than the guidance they provided to investors; told VeriFone’s supply chain controller, Paul Periolat, and others that the preliminary results were an “unmitigated disaster” and to “figure it out;” provided Periolat with analyses that laid out the relationship between reductions in costs of goods sold and the corresponding increase in the gross margin; knew Periolat made journal entries that increased gross margins by increasing inventory and reducing costs of goods sold; and knew that no one reviewed the journal entries to determine whether they were proper.
The SEC’s complaint fails to mention substantial sales of VeriFone stock by Bergeron, Zwarenstein and other VeriFone insiders as they reported false and misleading financial results licensing its stock to trade at artificially inflated prices. Between Aug. 31, 2006 and Dec. 3, 2007, Bergeron sold more than two million shares at prices as high as $46 per share and received proceeds of $74.7 million. Moreover, Bergeron acquired the shares for just $0.033 per share. Zwarenstein sold 160,585 shares – 98 percent of his VeriFone stock – and received proceeds of $5.8 million. Zwarenstein acquired the shares he sold at an average price of about $4 per share. Moreover, in December 2006, the second month of 1Q07, Zwarenstein amended his 10b5-1 trading plan and increased his monthly sales from 4,000 to 14,000.
In VeriFone’s settlement with the SEC, without admitting or denying the allegations above, VeriFone consented not to do it again. The controller, Paul Periolat, also agreed not to do it again and paid a $25,000 civil penalty. That’s it. No recovery of the nearly two billion dollars in investor losses.
On Sept. 9, 2009, NERA Economic Consulting, not the SEC, announced that Fred Dunbar, a NERA Senior Vice President, had been appointed as Economic Fellow in the SEC’s Office of Economic Analysis. According to the announcement, Dunbar joined NERA in 1979 and founded the firm’s securities and finance as well as the mass torts and product liability practices. NERA is one of the top economic firms on the defense side and Dunbar is its leading expert, put up in Enron and countless other cases, to argue investors suffered little or no loss due to defendants’ fraudulent activities.
The stated mission of the SEC is to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. Dunbar’s 30-year career at NERA has largely focused on helping corporate wrongdoers avoid accountability in SEC or investor legal actions. How can hiring Dunbar be good for investor protection?
One of the more puzzling aspects of the Private Securities Litigation Reform Act of 1995 is the provision to limit damages to the difference between the purchase price and the average closing price following the “information correcting the [alleged] misstatement or omission.” Several articles have noted the lack of any economic basis for this limitation. Nor is there any fairness to the “90-Day Bounce Back Rule” as it favors corporate wrongdoers at the expense of investors for no apparent reason. The discussion of the rationale for the Bounce Back Rule by NERA is particularly interesting because one of its senior people has privately taken credit for the inclusion of this provision in the Private Securities Litigation Reform Act – Dunbar.
Next, let's see how Dunbar deals with investor’s reliance on the market. In fraud on the market cases, an informationally efficient market is necessary to establish reliance. Specifically, because “the price of a company’s stock is determined by the available material information regarding the company and its business... Misleading statements will therefore defraud purchasers of stock even if the purchasers do not directly rely on the misstatements.” As such, does the market incorporate the information, specifically the false and misleading information, in the stock price? With few exceptions, there is little dispute among economists that the securities markets are informationally efficient, as exemplified by Jonathan R. Macey, Geoffrey P. Miller, Mark L. Mitchell and Jeffry M. Netter in Lessons from Financial Economics: Materiality, Reliance, and Extending the Reach of Basic v. Levinson.
Financial economists have shown repeatedly that stock prices react quickly to the release of important new information; though they may differ in their interpretations of this evidence, they do agree it exists. Even prominent financial economists with divergent interpretations of the evidence on market efficiency share similar views on how stock prices react to new information.
Dunbar, however, advocates a much stricter definition of an efficient market, one in which the price of a security has to correctly reflect all publicly available information, pointing to loss aversion, constraints on arbitrage, irrational investors and behavioral finance as evidence of market inefficiency. The benefit to defendants of Dunbar’s definition is that it lowers or eliminates potential damages by accounting for non-quantifiable events. In effect, what Dunbar is really advocating is lack of market efficiency, without saying so, that destroys investor reliance.
In his latest article, Dunbar characterizes anything other than an event study as “junk science.” This necessarily includes all fundamental analyses commonly used in business valuations. He then attacks the standard event study itself as just the starting point of the damage analysis, not the answer – and that in some cases it may be unnecessary altogether.
Dunbar’s solution: response coefficients. The expert first figures out the relationship between earnings and share price (the response coefficient) using econometrics, and then simply multiplies the response coefficient by the earnings surprise to calculate the impact on the stock price. Dunbar’s analysis ignores basic things such as the quality of earnings, the non-linear relationship between earnings and price, and the informational value of the earnings on future cash flows, among others. It is, however, classic Dunbar. Propose a self-serving “solution” to a litigation issue that NERA will stand ready to argue against (no plaintiff's expert will be able to employ their methodology “properly,” and they should know – they came up with it). For some judges, the methodology from one of the world's largest litigation firms (albeit solely on the defense side in securities cases), may provide a false sense of sophistication. Turning the loss causation issue into a statistical black box no judge will understand at the expense of common sense greatly benefits defendants, particularly defendants in blatant fraud cases.
Where is the SEC on current enforcement? Why would the SEC appoint Dunbar? How “new” is the new SEC?
Patrick Coughlin is a co-founder of Coughlin Stoia Geller Rudman & Robbins LLP. The firm is lead counsel in Enron, VeriFone and UTStarcom for classes with investor losses arising from the above-cited actions.
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