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Category: Securities

8

Wild KPMG Fees Decision

Barely one day old, and Gonzalez-Lopez is already making waves in corporate law. To see the connection, however, you’ll have to bear with me for a bit of brush-clearing.

Judge Lewis A. Kaplan (S.D.N.Y.) today ruled on certain individual defendants’ motions to dismiss an indictment arising from the KPMG tax shelter investigation. (Large pdf here.) According to the defendants, their due process rights were violated when the U.S. Attorney pressured their former employer (KPMG) not to advance and reimburse legal fees incurred as individuals defendants. Judge Kaplan found a due process violation, scolded the government, and suggested a new lawsuit against KPMG to recover those legal fees, in which today’s decision would have collateral effect and make the proceedings summary. In short: the decision seems to constitutionalize the right to receive indemnification from your employer.

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4

Whistleblowers and Stereotyped Cultural Norms

I’m a little slow to weigh in on this issue, but I just received the latest edition of the ABA Journal. This month, they have a story, “Culture Clash,” by John Gibeaut describing how Sarbanes-Oxley’s whistleblower provisions are causing trouble for foreign cross-listed companies. Ideoblog and Conglomerate have already provided some commentary about the article, which begins as follows:

Americans like to elevate whistleblowers to near folk-hero status, from Daniel Ellsberg, who leaked the Pentagon Papers to Sherron Watkins, who exposed the Enron Corp. financial scandal that in 2002 moved Congress to pass the fraud-busting Sarbanes-Oxley Act. Indeed, Watkins shared Time magazine’s Person of the Year honors in 2002 with World Com Inc. whistleblower Cynthia Cooper and FBI agent Collen Rowley, who accused the bureau of mishandling information on suspected hijacking plotter Zacarias Moussaoui before the Sept. 11 terrorist attacks.

Say whistleblower in Germany, however, and the term most likely conjures up memories of the Gestapo, Adolf Hitler’s secret police. In France, the term evokes images of the Vichy regime’s collaboration with the Nazis and of neighbors ratting out one another.

I think that the beginning of the article relies on some flawed cultural stereotypes of both Europeans and Americans. Be that as it may, I would question the author’s proposition that American whistleblowers enjoy some sort of elevated status. About a year and a half ago, I wrote an article about (American) whistleblowers and the Sarbanes-Oxley Act. In the article, I argue that whistleblowers are not being given enough protection. Not under state employment law, and not under Sarbanes-Oxley either. Studies – cited in my article – show in graphic detail that American whistleblowers end up unemployed, broke, divorced, and depressed.

2

On the Milberg Indictment

MW.gifI’ve been mulling over the Milberg indictment. Since I waited a weekend to post, I have the advantage of having read lots of other folks’ views. Quick summaries follow:

  • Michael Dorf: Kickback payments slaved the named plaintiffs to MW, bloating agency costs.
  • Steve Bainbridge:Kickbacks encourage “nuisance claims.” We may need criminal sanctions to crank the Hand formula to optimal levels, but only against individual lawyers.
  • Walter Olson:”[MW was] taking no chances on the watchdogs staying pacified: It threw regular chunks of raw liver into their cages.”
  • Larry Ribstein: Who cares? Lawyers are fungible.
  • Ed Morrissey: Bad for Democrats and ambulance chasers.
  • Christine Hurt: It’s high noon, and MW can’t blink.
  • And let’s not forget MW itself: It was just a referral! And the theory is overreaching! And our interests remained aligned!

Wow. Lots of words. So here is what I think.

First, I still don’t particularly understand the economics of outrage here. I’ve seen two arguments about why kickbacks are bad (apart from their being unlawful, which we’ll put aside briefly). First, I’ve heard the argument that they “capture” the lead plaintiff, making that person less able to monitor the lawyer’s work. As Dorf points out, however, plaintiffs in securities class actions are sort of like shareholders stockholders: they have deputized oversight and management to lawyers, in return for fiduciary duties. Some folks seem to have in mind a more active role for lead plaintiffs – something like a controlling stockholder(?) – but given the relatively low bonuses awarded in settlements for lead plaintiffs, why would anyone want to play that role? That is, you can’t have distributed, small-stakes, high-impact, governance by private actions and have plaintiff management at the same time. The capture argument is another way of saying that these types of claims are not in the public interest. But we don’t criminalize inefficient lawyering. Not usually.

The second argument I’ve seen is related to the first – it is Bainbridge’s – and it suggests that kickbacks encourage securities actions that are (on the merits) weaker. Yup, that sounds right. But that isn’t an argument against kickbacks, it is an argument that judges aren’t doing enough to raise hurdles to weak actions at early stages, as the PSLRA was designed to accomplish. To the contrary, I have found that judges are quite hostile to securities claims.

The argument that I haven’t seen on the blogs, but which is larded through the indictment, suggests that MW was, in effect, selling out the rest of the class to benefit the folks at the head of the line. And in a way, this is (for me) the strongest argument against the practice. If MW really did countenance paying referrals-as-kickbacks to named class members out of their portion of the settlement, then we know that dollars were being taken out of the mouths of the rest of the class pretty directly. On the other hand, one might argue that MW had to pay off the named plaintiffs to bring the cases in the first place – that it is a an expense like overhead.

Two additional aspects of the case trouble me. Obviously, indicting the entire firm feels excessive. I don’t agree with Larry R. that reputational effects won’t follow MW’s innocent lawyers. I know lots of counsel at MW – I litigated against them – and I thought they were incredibly hard working, tough, honest, passionate adversaries. One of my worst days as a lawyer came across a deposition table from an experienced Milberg partner: he taught me a great lesson on how to get one’s opponent to hang himself on the record. And I’d be shocked if more than a handful of lawyers at the firm had any knowledge of the activities charged. If the USAO is really indicting out of pique for failure to roll over as most corporations would do in response to a patently unreasonable discovery demand, well, many folks who think of themselves as white knights are going to be tarnished unfairly.

Second, I have some problems with the continued federalization of state practice ethical rules. Although the indictment doesn’t come out and say this, some of the illegality is premised on state fiduciary duty and referral laws. (Some, granted, is based on Rule 23.) Shouldn’t this type of prosecution be the job of Elliot Spitzer and his imitators? Which raises a question: why didn’t Spitzer get here first?

0

A Reckoning In Houston

Tomorrow the Enron jury will hear closing arguments in the Lay/Skilling trial. Given both defendants’ reported weaknesses as witnesses, the futures market estimate of conviction on at least several charges for Lay (76% ) and Skilling (73%) is predictable. (Although, the line has shifted significantly from February.) And even if a verdict arrives this week, the defense team(s) are already no doubt working on an appellate strategy. One tack: Judge Lake appears to have accepted the government’s intent instruction.

This raises an issue which I’ve been thinking a bit about recently. Given research showing that juries often ignore instuctions, especially in complicated cases, and instead focus on a narrative and attributions of blameworthiness, why does the government so often appear to overreach and thus preserve great defense issues for appeal? Does the federal prosecution manual discount the research? Or, more cynically, is the phenomena a problem of incentives? In the ordinary case, the marginal gain from the prosecution instruction is reaped by the line attorney, but the marginal cost of the instruction is usually discounted by time and by the likelihood that the government attorney defending the appeal is a different unit, or a different office altogether.

4

Empirical Studies at ALEA

Bill Henderson (at the ELS Blog) has a very useful round-up of empirical papers presented at the recent ALEA conference. Blog-traveller Kate Litvak comes in for special praise:

Kate Litvak [presented] “The Effect of the Sarbanes-Oxley Act on Non-US Companies Listed in the U.S.,” which was an extremely well-done event study that used a natural experiment approach to capture the market reaction to SOX (it was generally negative). In the last couple of years, Kate, who does not have a PhD, has spent a lot of time learning sophisticated econometric techniques. It really showed. Very impressive (and easy to follow) presentation.

To be frank, I’ve been quite skeptical of studies showing a negative relationship between SOX and equity prices, on several grounds: (1) my practice experience managing the creation of event studies that dealt with changing legal regimes suggested that results are rarely as robust as one might hope; (2)) the passage and eventual implementation of SOX were so attenuated that event studies would seem hard to perform; and (3) the debate is quite politicized, with folks already disposed to dislike federalization of corporate law leading the charge on the empirical front as well. But, having read Kate’s paper, I’m inclined to rethink my position. It is well-worth a read.

6

Performance of spam stocks – a very non-scientific survey

I get a fair number of spam e-mails advertising stocks. They’re often penny stocks, and the e-mails often project outrageously high returns (“5 day expected return: 325%”). On a whim, I saved the e-mails that I’ve gotten for the past 10 days, to see how well the spam stocks performed. This is what I found:

April 20: MDBF.PK, then $1.25, “profits of 300% to 500% expected.”

Result: I can’t locate a Yahoo chart going back to April 20. (I don’t think Yahoo keeps charts that long for some pink sheet stocks). (Note: Most of these Pink Sheet stocks – not particularly surprising.) I did locate current price and a 5-day chart. It’s currently trading at .60 . It’s been up to $1.20 in the past 5 days. There’s no indication that it ever came close to the $5 suggested in the spam e-mail.

April 21: SIKY.PK, then trading at 0.26, spam e-mail suggesting “great” returns.

Result: It’s now trading at 0.26; 5 day charts show that it did make it to the 60-to-80 cent range a few days ago.

April 24: KKPT.PK. Then trading at .86, spam e-mail suggested target price at $3.25 in 5 days.

Result: Yahoo has longer charts for this stock, so we can see: The price rose on the day of the spam, going to $1.12. Volume went from 87,000 to over a million, a thirteenfold increase. It peaked a day later at $1.13, and is now back to 90 cents.

April 24: CWTD.OB. Then trading at $1.39; spam e-mail suggested 200-400% profits in the next few days.

Result: This one is actually doing quite well. The spam drove the price from $1.39 to $2.10 in a single day, as volume rose from 62,000 to over 3 million. It peaked a day later, and is now standing at $2.00.

April 26: IKMA.PK. Then trading at 30 cents a share; no target announced, but spam suggested that doubling of value would not be unusual.

Result: Volume went up, from 200,000 to 400,000. Price dropped like a rock. Currently trades at 13 cents.

April 27: PGCN.OB. Then trading at 45 cents; 5 day target of $2.

Result: Appears to be another spam-created spike. Volume shot up, and the stock briefly went over a dollar, shortly after the spam; it’s currently in free fall.

Results: This very non-scientific survey — based only on what’s come into my inbox in the past few days — suggests a few possible take-home points, none of them particularly earth shattering.

First, spam works. Pump and dump works. Someone almost certainly made a lot of money on these stocks by buying them ahead of the spam, and then pumping them with the spam, and then presumably selling when the stock peaked.

Second, spam e-mails do a very good job of generating volume. I knew going in that these sorts of schemes work by generating volume in a usually thinly traded penny stock; still, it was sobering to see volume go from 60 thousand to 3 million in a day – and to note the perfect correlation with the date of the spam e-mail.

Third point (related to the last) is that the old adage is true, there is indeed a sucker born every minute. Three million plus shares worth of suckers for one spam alone (and many, many more for other spams) — all hopping on to a badwagon being promoted by spam e-mails sent by automated programs and authored by “analysts” with names like “Cranach U. Flagellates.” Incredible.

Finally, this short glimpse of spam results drives home a point I already knew (and I really hope you knew as well) — these penny stocks seldom make anyone rich except those who run the scam. Some of these stocks did skyrocket briefly — but the lion’s share of the gain came very early, and so almost certainly went to people who knew about the scheme to begin with. No surprise there.

So nothing earth shattering; still, it’s fun to see old-school common sense points confirmed by a quick check of my own inbox. And yes, you have my permission to forward this post to your Uncle Charlie when he calls you excitedly tell you about the latest surefire stock, e-mailed to him by someone named Cranach U. Flaggellates.