Supreme Court Speaks, Investors Lose

OPINION ARTICLE

The Supreme Court published its opinion in the Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., et al. This case asked the court to determine whether, under rule 10(b)5 issued by the Securities Exchange Commission pursuant to the Securities Exchange Act of 1934, a company (a third party wrongdoer) that assists a publicly traded company in misleading the public about its financial results can be held liable to the investors in that public company for damages caused by the misleading actions.

In my humble opinion the case can be summarized as follows: It is better to let investors suffer at the hands of fraudulent business activities than to potentially raise the cost of doing business by holding businesses accountable for their fraudulent actions. The SEC can, in its discretion, take action against a third party wrongdoer but private investors cannot.

Here is my short version - the long version (with details) is below:

The Court noted two issues with allowing investors to sue third party wrongdoers other than its review and manipulation interpretation of prior law. The first is that it would raise the cost of doing business because every company would be exposed to potential liability and harassment by discovery proceedings for investors with weak claims. This could drive up the cost of doing business, and so businesses need to be protected from this harassment. The second is that this additional cost of doing business in the United States could deter foreign companies from issuing securities in our markets and doing business with domestic firms. Interestingly, the Court never addresses the cost to businesses or investors of meltdowns such as Enron and Charter and all of the other fraudulent market disasters experienced over the past decade. How can it conclude that the cost to business would increase when it does not even consider the other side of the ledger? What costs would go down if businesses acted more ethically? What about bad debt write-offs for one? Doesn’t this very decision reduce the cost of wrongdoing? These points are not addressed in the opinion. Nor does the opinion address the cost to the economy of a lower level of investor participation due to a lack of confidence in the market. This decision, in my opinion, was pre-determined and I wrote that back in October.

What businesses stand to gain disproportionately from this ruling? Think about the major financial institutions and all of those very complex transactions they helped structure for Enron. Think about those subprime securitizations and CDOs. You are now getting warm.

Here is the long version if you are interested in some specifics.

Two set-top box makers (Motorola and Scientific-Atlanta) knowingly entered into phony transactions with Charter Communications so Charter could fool its accountants and report higher income than it actually had. It was a classic fraud scheme wherein Charter swapped long-term depreciation expense for short-term reportable income. Charter then issued false financial statements, investors purchased the stock, the scheme was revealed, and the investors lost money. Now the investors want the set-top box makers who entered into these fake transactions with Charter to pay. Here are the facts from the Court:

Charter, a cable operator, engaged in a variety of fraudulent practices so its quarterly reports would meet Wall Street expectations for cable subscriber growth and operating cash flow. The fraud included misclassification of its customer base; delayed reporting of terminated customers; improper capitalization of costs that should have been shown as expenses; and manipulation of the company’s billing cutoff dates to inflate reported revenues. In late 2000, Charter executives realized that, despite these efforts, the company would miss projected operating cash flow numbers by $15 to $20 million. To help meet the shortfall, Charter decided to alter its existing arrangements with respondents, Scientific-Atlanta and Motorola…

Respondents supplied Charter with the digital cable converter (set top) boxes that Charter furnished to its customers. Charter arranged to overpay respondents $20 for each set top box it purchased until the end of the year, with the understanding that respondents would return the overpayment by purchasing advertising from Charter. The transactions, it is alleged, had no economic substance; but, because Charter would then record the advertising purchases as revenue and capitalize its purchase of the set top boxes, in violation of generally accepted accounting principles, the transactions would enable Charter to fool its auditor into approving a financial statement showing it met projected revenue and operating cash flow numbers. Respondents agreed to the arrangement.

So that Arthur Andersen would not discover the link between Charter’s increased payments for the boxes and the advertising purchases, the companies drafted documents to make it appear the transactions were unrelated and conducted in the ordinary course of business. Following a request from Charter, Scientific-Atlanta sent documents to Charter stating—falsely—that it had increased production costs. It raised the price for set top boxes for the rest of 2000 by $20 per box. As for Motorola, in a written contract Charter agreed to purchase from Motorola a specific number of set top boxes and pay liquidated damages of $20 for each unit it did not take. The contract was made with the expectation Charter would fail to purchase all the units and pay Motorola the liquidated damages.

To return the additional money from the set top box sales, Scientific-Atlanta and Motorola signed contracts with Charter to purchase advertising time for a price higher than fair value. The new set top box agreements were backdated to make it appear that they were negotiated a month before the advertising agreements. The backdating was important to convey the impression that the negotiations were unconnected, a point Arthur Andersen considered necessary for separate treatment of the transactions. Charter recorded the advertising payments to inflate revenue and operating cash flow by approximately $17 million. The inflated number was shown on financial statements filed with the Securities and Exchange Commission (SEC) and reported to the public.

So what did the court decide? Well, first it determined that the set-top box makers didn’t make any misleading statements, so they didn’t directly violate the statute in question. The next step, then, is to determine if they can be held liable under a theory of aiding and abetting Charter’s misstatements. The court then goes through a long history of cases explaining that the set-top box makers did not do anything “in connection with the sale of a security” so again they are not liable, and they had no affirmative duty to disclose this information to the public nor did they communicate these acts to the public so the public could not have relied on them. The dissenting opinion does a good job of debunking these arguments in my opinion.

The investors argued:

Liability is appropriate, petitioner [the investor] contends, because respondents [the set-top box makers] engaged in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent Charter’s revenue. The argument is that the financial statement Charter released to the public was a natural and expected consequence of respondents’ deceptive acts; had respondents not assisted Charter, Charter’s auditor would not have been fooled, and the financial statement would have been a more accurate reflection of Charter’s financial condition.

Liability is appropriate, petitioner contends, because respondents engaged in conduct with the purpose and effect of creating a false appearance of material fact to further a scheme to misrepresent Charter’s revenue. The argument is that the financial statement Charter released to the public was a natural and expected consequence of respondents’ deceptive acts; had respondents not assisted Charter, Charter’s auditor would not have been fooled, and the financial statement would have been a more accurate reflection of Charter’s financial condition.

Sounds like perfectly sound logic to me, and it would place liability where it belongs, at the doorstep of the wrongdoers. So why does the Court reject this argument? Here we see the true agenda behind this ruling:

Were this concept of reliance to be adopted, the implied cause of action would reach the whole market-place in which the issuing company does business; and there is no authority for this rule…

In Blue Chip [a prior Court case], the Court noted that extensive discovery and the potential for uncertainty and disruption in a lawsuit allow plaintiffs with weak claims to extort settlements from innocent companies…

Adoption of petitioner’s approach would expose a new class of defendants to these risks. As noted in Central Bank [a prior Court case], contracting parties might find it necessary to protect against these threats, raising the costs of doing business… Overseas firms with no other exposure to our securities laws could be deterred from doing business here. See Brief for Organization for International Investment et al. as Amici Curiae 17–20. This, in turn, may raise the cost of being a publicly traded company under our law and shift securities offerings away from domestic capital markets.

So in the end, the Court does not want to protect individual investors from this type of bad activity because it could raise the cost of doing business for all companies. Inherent in that decision is the belief that it is better to let investors and other businesses suffer at the hands of fraudulent business activities than to potentially raise the cost of doing business by holding businesses accountable for their fraudulent actions. Absent from this reasoning is the cost to businesses of fraudulent practices (which has just gone down for the wrongdoers) and the cost to businesses and society due to lower investor participation in the financial markets. How many businesses entered into transactions with Charter based on its reported financial condition to later find out they could have a write-off on their hands? How many investors burned by these frauds have left the market and what is the cost of this loss of participation?

In making its ruling the Court goes beyond this case into what the law is, concluding that there is no private right of action in the Securities Exchange act (a private right means every day citizens can sue under it vs. only the government) for aiding and abetting in a securities law violation. The Court points to legislative action were the congress passed a new law that specifically provides for this liability but only mentions the SEC for enforcement. From this, the Court concludes Congress did not want to provide a private right of action in these cases. So, in the end, we the people as individuals cannot sue to recover damages from companies that aid and abet in these cases, only the SEC can. If it decides not to, nothing happens, and it may or may not recover damages for the investors.

Who may benefit from this ruling? Think about the major financial institutions and all of those very complex transactions they helped structure for Enron. Think about those subprime securitizations and CDOs. You are now getting warm. Who makes fees from underwriting securities? Warm again. The Court, in its infinite wisdom, has determined that protecting these interests is more important than ensuring ethical business practices.

If you would like to read the opinion of the Court, you can find it here.

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Dirty Little Secrets of Subprime

I was reading through various blogs today when I stumbled upon Paul Krugman’s summary of the Report and Recommendations by the Majority Staff of the Joint Economic Committee (the “Report”) by Senator Charles Schumer, Chairman, and Rep Carolyn B. Maloney, Vice Chair. You can find the Report here: http://jec.senate.gov/Documents/Reports/10.25.07OctoberSubprimeReport.pdf. Since I have been writing on this drama for the past few weeks, I decided to get the Report and take a look under the hood. I found quite a few oil leaks. Unfortunately I believe this report to be another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this adventure the Report attempts to back door a taxpayer bailout of the financial industry. Here are some of my issues with the Report:

1. The Report is stunning in the questions it does not answer. One such question is who is responsible? Of course, that would be investment banks, Wall Street attorneys, accountants, rating agencies, and mortgage servicers who collectively made a market for these mortgages that, from history, they knew (or should have known) were junk. None of these players in the game of wealth redistribution are mentioned in the Report. Instead, the blame falls to the state chartered mortgage bankers and the mortgage brokers. This is like concluding that the reason we have made so little progress in Iraq is because of the soldiers’ ineptitude rather than the generals or the administration. It’s like concluding the drug problem lies with the small time pusher but the cartels have nothing to do with it. The mortgage bankers did exactly what Wall Street wanted them to do – sell loans to feed the securitization machine. To now blame the foot soldiers and state regulatory failures for this mess is a disgrace. I would like the report to address where all of those HUD-1 statements executed at all of these home mortgage closings ended up? Mr. Jackson, please?

2. Another failure of the Report is it never asks the question “who profited from this disaster?” According to the Report, there are approximately $1.5 trillion in outstanding subprime mortgages. Of those, between 50% and 80% were securitized depending on the year in question from 2001 through 2006. If we assume 70%, the total of these loans that were securitized would be $1.05 trillion. Now, I don’t know how much profit is in these securitizations, but I assume that between attorneys, accountants, rating agencies, sponsors, etc., there has to be around 3% coming off of the top (probably multiples if we include servicing fees). That would be (1,050,000,000,000 x .03 = $31,500,000,000) $31.5 billion. It’s party time! It disgusts me that none of this is in this Report. How can it include worthy recommendations when it ignores the facts? If my percentages are off, it’s only because these numbers have not been made available in the Report. This is not to say that the mortgage bankers did not also profit from these transactions. I have seen many profit handsomely from them. The problem is where does that profit come from? It trickles down from the profits up the food chain on securitizing these mortgages. There has been a massive redistribution of wealth and, based on the recommendations of the Report (see below), Senator Schumer believes the taxpayers should pay the tab.

3. The report fails to observe some of the most obvious conclusions that can be reached from the data it presents. Here is one example: according to the Report, “As can be seen in Figure 10, between 2001 and 2006 adjustable rate mortgages (ARMs) as a share of total subprime loans originated increased from about 73 percent to more than 91 percent. The share of loans originated for borrowers unable to verify information about employment, income or other credit-related information (“low-documentation” or “no documentation ” loans) jumped from more than 28 percent to more than 50 percent.

“The share of ARM originations on which borrowers paid interest only, with nothing going to repay principal, increased from zero to more than 22 percent. Over this period the share of subprime ARMs that were originated as “hybrids” increased dramatically. The share of 2- and 3-year hybrid ARM’s accounted for more than 72 percent of all subprime ARM’s originated in 2005 (See Figure 12 in Appendix).”

At the same time, the Report discloses that these subprime ARM loans went to borrowers with, on average, lower FICO scores (624) than any other type of loan. Subprime fixed FICO scores were 636, near prime ARM 711, and near prime fixed 717. Why are the adjustable rate borrowers in these lower FICO scores? Because that’s how you get them to qualify for a loan, by basing their payment on the initial teaser rate or interest only payment. These were the loans being made toward the end of this debacle, and over 80% of them by dollar value were securitized in 2005 and 2006. All of this makes it painfully obvious that the mortgage machine was working its way down the food chain from qualified to unqualified borrowers, while all of the regulators did nothing but brag about how home ownership rates where going up and Wall Street collected fees. In my opinion, heads should roll. The Report does give this point lip service with the following “full” coverage of this topic:

“Because mortgage companies sell many of the loans they underwrite to the secondary market, they have an interest in underwriting loans that are desired by the secondary market investors.51 This observation has special weight because of developments in nonmortgage financial markets. In recent years, as hedge funds have proliferated and the market for structured financial products has expanded, there has been significant demand for highyield assets that can underlie collateralized debt obligations (CDOs) and other financial derivatives. Subprime mortgages have, until recently, been considered terrific assets to include in CDO structures. Hence subprime lenders have had a strong incentive to underwrite high-yielding subprime mortgages, whether or not these loans were best interests of the borrowers.” Yup, that’s it. The fault lands at the feet of the subprime lenders and no further up the food chain. Lets not examine what accounted for the strong incentive lenders had to originate these mortgages.

4. The Report shows a clear relationship between the rate of subprime mortgages and the rise in overall housing prices, yet it never actually makes this connection. In other words, the $1.5 trillion artificial increase in housing demand from subprime borrowers resulted in rising prices that kept subprime default rates artificially low until lenders got far enough down the food chain. Then the house fell down. What device enabled this run-up in subprime and housing prices and now defaults (subprime went from 2.6% of outstanding mortgages in 2001 to 14.0% in 2Q 2007)? The CDO and securitization machine that was making money from it.

5. The Report ignores the role of the rating agencies in this mess. In order to make these loans, they had to be securitized because nobody wanted to hold them in their portfolio. Apparently it was well known that these loans were highly risky. Well known to everyone except the rating agencies who rated tranches too aggressively and are now in the process of downgrading them rapidly. This should come as no surprise. As the Report shows, subprime default rates have always been high with the exception of the period of time when home prices were appreciating at unsustainable levels. This is painfully obvious from the statistics presented in the Report. But the next logical question is how did the rating agencies get this so wrong? Did they actually assume that home prices would continue to appreciate at levels we have only seen in the past for a short period following WW II? Here is what the Report has to say about this:

“Since underwriting deteriorated from 2001 to 2005, and the accelerating housing price boom was giving subprime borrowers important help (see Part II), a cautious analyst might have questioned whether the improvements in subprime performance could be sustained. The financial intermediaries who expanded the supply of these loans were apparently not troubled by this issue. The reasons for their lack of curiosity may lie in the strong incentives they had for expanding the subprime market.”

Who are these “analysts” and what were their strong incentives to expand the subprime market? Other than the mortgage bankers supplying food for the CDO market we have no idea from this Report. So, it is some unidentified “analyst” who is to blame for this massive screw up. Not the CDO wiz kid quants or the rating agencies, but some “analyst”. Please stop insulting our intelligence. Regarding the rating agencies, these issues are not new, and they are now coming to the forefront. The Connecticut AG has issued subpoenas to get answers to questions that many scholars have been asking for a decade regarding rating agency independence and the pseudo regulatory role they play. If you are interested in this issue a good place to start would be with Frank Partnoy’s research paper HOW AND WHY CREDIT RATING AGENCIES ARE NOT LIKE OTHER GATEKEEPERS. This paper can be downloaded without charge from the Social Science Research Network Electronic Paper Collection: http://ssrn.com/abstract=900257. You can also review my piece on the pseudo regulatory role, and the resulting house of cards, that rating agencies play in our banking system here: http://polecolaw.blogspot.com/2007/10/public-and-private-bank-regulation-or.html

6. Where is the SEC? One of the striking issues about this whole mess is that nobody seems to know exactly where all of these CDOs are. This gets us back to the SIVs and M-LEC that have been discussed at length in the media, and I will not re-hash all of my issues with that here. You can read my previous posts on that topic here: http://polecolaw.blogspot.com/2007/10/maybe-stalling-is-viable-master-siv_19.html and here: http://polecolaw.blogspot.com/2007/10/i-did-not-have-sex-with-that-siv.html. It seems to me that there are some people who actually know the answer to that question, whereas most of us do not. Doesn’t this create asymmetry in the markets? Can’t those who are in the know be putting on positions right now to their advantage based on this information? Think now is a good time to be in the markets? This shoe will drop in the woods, and none will hear it.

I could go on, but I think I have made my point that this Report is biased, and I for one am again angry at this snow job that appears to me intended to deflect attention from where the responsibility (and the profits) lie. Of course that's just my opinion.

Now to the recommendations. Total losses to homeowners could be as high as $164 billion (based on the assumption that the inflated real estate values are the real values). Of course, the recommendations do not include any mention of those on Wall Street. Instead, the first thing we should do is “increase FHA’s ability to refinance by passing the Federal Administration’s (FHA) Modernization Act of 2007, which would increase FHA’s capacity and flexibility to insure subprime mortgages that can be refinanced.” In other words, we should push the problem to the taxpayers. Are you ready for the $1.5 trillion bailout? Here it comes! Next, we should expand the capabilities of the GSEs Fannie and Freddie to help subprime borrowers through refinancing. Wait, isn’t that the same as recommendation 1? Taxpayer bailout. There are other recommendations such as educating borrowers, amending the bankruptcy laws, and so on. The bottom line – and I must give credit to a Newsvine friend for this quote – privatize the profits, socialize the costs.

All in all this Report is, in my opinion, another expenditure of taxpayer funds by Mr. Schumer to pull the wool over the eyes of the public and protect his wealthy constituents on Wall Street. By diverting attention away from those who profited from this debacle the Report attempts to back door a taxpayer bailout of the financial industry. This is the same financial industry that benefits from favorable and unjustifiable tax preferences, and represents the largest share of the top 1% income earners in the country. Unfortunately there is nothing new here. For another glaring example see my piece on another Schumer sponsored report here: http://polecolaw.blogspot.com/2007/10/tale-of-two-cities-new-york-and-detroit.html . Shell games at the highest levels of government.

Finally, there is a case in front of the Supreme Court right now that could have an impact on the ability of anyone to hold any third party responsible in this mess. The case, Stoneridge, deals with concepts of third party liability for investor harm. It is not exactly on point, but it is not far from it. Should the Court, as expected, rule in favor of no third party liability, good luck ever getting anyone responsible for this mortgage debacle to pay. You can get my take on Stoneridge here: http://polecolaw.blogspot.com/2007/10/subprime-socialization.html

Looks like all the lose ends are getting tied up nicely.

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Subprime Socialization

I was responding to a post in The Informed Reader section of The WSJ Online Edition (here: http://blogs.wsj.com/informedreader/2007/10/24/the-problem-with-holding-third-parties-liable/#comment-3131) regarding His Honor Richard Posner’s discussion of third party liability. The question is whether a bartender or host should be liable for another person who drinks too much, gets in their car, and then causes a seriously unfortunate accident.

Because I have been following this whole subprime mortgage debacle I decided to take the opportunity for an analogy. Here is what I wrote:

“I wonder what His Honor would think about holding the Wall Street securitization players (banks, bankers, rating agencies, etc.) liable for the devastation caused in the mortgage, commercial paper, and real estate markets. That’s where a lot of the profits went, but it looks like much of the cost will ultimately fall to the taxpayers, the note holders, and the homeowners. I suppose one important question would be whether they are third parties or conspirators. If they are third parties, perhaps we could apply a Grokster inspired logic and find them contributorily liable: “When a widely shared product [MBS, SIV, ABCP Conduit, etc.] is used to commit infringement [fraud by mortgage bankers and clients], it may be impossible to enforce rights in the protected work [prevent the fraud] effectively against all direct infringers [fraudsters (mortgage bankers, etc.)], so that the only practical alternative is to go against the device’s distributor [Wall Street et. al.] for secondary liability on a theory of contributory or vicarious infringement [fraud]. One infringes [commits fraud] contributorily by intentionally inducing or encouraging direct infringement [fraud], and infringes vicariously by profiting from direct infringement [fraud] while declining to exercise the right to stop or limit it.” (From the Grokster syllabus here: http://www.supremecourtus.gov/opinions/04pdf/04-480.pdf, pg. 2.) Hum, it definitely needs some work and it sounds a lot like conspiracy, but it’s not too much of a stretch. I guess I am assuming that people in the securitization stream had actual knowledge that these mortgages were not what they were supposed to be, and I do not really know that for sure. It could just be a massive case of due diligence failure or, if the loans are actually what they were supposed to be, stupidity.

“In any event, it seems to this admittedly smaller legal mind that the moral hazard of a social solution is far worse than the financial losses of those who profited from this misadventure. Of course, that’s just my opinion, and I already hear Mr. Becker speaking up about the social costs of a major credit de-leveraging throughout the economy should we let the liability fall to these parties through whichever legal theory you like. In the interim, I really hope someone is checking the documentation on those loans Countrywide is transferring to FHA loans because I have a guess about just how good the due diligence has been there lately and I, for one taxpayer, do not feel the need to pick up the tab for this one.”

This issue of third party liability comes up a lot, and there is a current third party liability case in front of the Supreme Court now, STONERIDGE INVESTMENT V. SCIENTIFIC-ATLANTA, INC. ET AL. The issue in this case:

Plain language version:
Company A enters into transactions with Company B that have no real business purpose, but which allow Company A to report more earnings than it really had using hocus-poke-us accounting. Company A publishes its financial reports and its stock goes up. People buy the stock. Then the hocus-poke-us stuff is revealed, and the stock tanks. Now the stockholders want Company B to pay because without its participation in the scheme the fraud would not have happened (so they claim).

The way lawyers do it:
The issue presented is whether shareholders of a company that committed fraud resulting in losses to those shareholders can recover damages for deceptive conduct from a third party company that engaged in transactions with the public corporation with no legitimate business or economic purpose except to inflate artificially the public corporation’s financial statements, but where the third party themselves made no public statements concerning those transactions. (Butchered from the court records)

Well, this raises all kinds of questions. If you allow Company B to get away with this, investors will be unprotected and invest less. This dries up available capital and slows the economy. On the other hand, the Banks (often third parties in these misadventures) argue that if they are held to account for the sins of their clients, they will stop lending (and/or it will cost more) and that could dry up capital and hurt the economy. Oh yes, there is also the usual lawyer bashing with claims that it’s the lawyers pushing for liability because they want to be able to bring law suits against all of those third party companies (probably some truth to that too).

Decision due out soon. I have my money on no liability for third parties here. My reason is simple; the banks are on that side and it seems to me that the banks have been getting whatever the banks want these days.

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