Apparently efforts to include corporate governance provisions in the Bailout Bill have caused a firestorm, with fierce opposition emanating from the White House and Treasury.   The White House put out the following statement on the efforts:

• We certainly understand and are sympathetic to the sentiment regarding the pay of CEOs and senior management of these firms, but we have to focus on the problem, and the problem is that we need these firms to participate in the program and sell us this debt. Having punitive measures would provide a disincentive for firms to participate, and that would make the program much less likely to succeed. 

• CEO compensation and corporate governance in public companies are very important issues — especially when receiving taxpayer support — but we need to be focused on fixing this problem in our markets right now. We can and should return to those issues once we get this legislation passed.
  

The statement demonstrates the fundamental problem with executive compensation in the United States.  The White House is acknowledging that CEOs will not participate, even if participation will benefit their company, if compensation can be affected.  This is another way of saying that under Delaware law, there is really no obligation on the part of management to act in the best interests of the company or shareholders.  Instead, they can put their own interests (in the form of their compensation) above all others.   

Paulson at Treasury has likewise vigorously resisted the efforts.  No surprise there.  This is the same person who spearheaded the current Administration's efforts to oppose allowing shareholders to sue vendors for fraud Rule 10b-5 even where they participated in an issuer's false disclosure by providing backdated and inaccurate documents.  It is the same person who tried, in an anti-regulatory fury, to blame securities litigation for a perceived decline in US competitiveness.  Of course he would object to federal regulation of executive compensation. 

On the legislative front, it has apparenlty been Congressman Frank who has pushed the hardest for the reforms.  It remains to be seen if they stay in the final bill.  It seems likely since a $700 billion bailout will look bad to ordinary voters unless there is some penalty for management.  Nonetheless, whatever the outcome, it is clear that Congress is no longer willing to leave executive compensation matters entirely up to the pro-business courts in Delaware. 

As we have chronicled on this Blog, the days of independent investment banking firms were numbered with the repeal of Glass Steagall.  (This is discussed at length in The "Great Fall": The Consequences of Repealing the Glass-Steagall Act) Once commercial banks were allowed to invade investment banking, their superior competive advantage (better funding sources, particularly deposits, and regulatory oversight that was more trusted by the market) would eventually result in their seizing control of the investment banking sector of the market.

We watched as Bear Stearns and Merrill were acquired by commercial banks and Lehman filed for bankruptcy.  Morgan is in negotiations with Wachovia.  But in the meantime, the last two independent investment banks, Morgan and Goldman, have converted over the weekend to bank holding companies.  The consequences?

• With the move, Wall Street as it has long been known -- a coterie of independent brokerage firms that buy and sell securities, advise clients and are less regulated than old-fashioned banks -- will cease to exist. Wall Street's two most prestigious institutions will come under the close supervision of national bank regulators, subjecting them to new capital requirements, additional oversight, and far less profitability than they have historically enjoyed.

In the short term, there will be no real funding advantage.  The main reason for the shift is for Goldman and Morgan to announce loudly that they are subject to the regulation and protection of the Federal Reserve Board.  This will likely provide the market additional confidence and provide both firms with additional time to develop a longer term strategy that will necessarily involve their paring with a commercial bank.

The NYT had an article over the weekend that discussed the assignment of blame for the recent financial crisis.  There isn't much content, with blame apportioned among democrats and republicans.  We note a few observations, however.   The article gave as one example the repeal of Glass Steagall. As the article notes:

• Perhaps the most significant recent deregulation of the banking industry — the landmark act that allowed commercial banks to expand into other financial activities, like investment banking and insurance — was signed into law by Mr. Clinton in 1999.

This is a theme that we have discussed at great length on this Blog.  The repeal of Glass Steagall may not have contributed to the current risk taking environment on Wall Street but it did spell the demise of independent investment banking firms since commercial banks, once allowed in, have substantial competitive advantages.  With Lehman having filed for bankruptcy and Merrill agreeing to a merger, only two have survived.  Even then, they also will eventually fail or, more likely, merge with commercial banks.

The NYT article also noted that some reformers in Washington left the current administration ouf of frustration.  As the article notes:

• Instead, voices inside the administration for tougher policing of Wall Street found themselves with few supporters. William H. Donaldson, a former Wall Street executive with respected Republican credentials who became chairman of the Securities and Exchange Commission under Mr. Bush, quit after facing resistance from the White House and Republican members of the agency, who criticized his support for stiffer regulations on mutual funds and hedge funds.
  

Republican members of the agency?  The culprits are Paul Atkins and Cynthia Glassman.  We've discussed the anti-regulatory approachtaken by Atkins while he was on the Commission.  It is fitting that he should be remembered when assigning responsibility for the current state of affairs but it would have been more appropriate to mention him by name. 

As for responsibility and the current chairman, Chris Cox, the article notes:

• Critics say the S.E.C. has been less active under its current chairman, Christoper Cox, a former Republican congressman from California. It has spent less on enforcement and imposed less in fines on wrongdoers, according to the Government Accountability Office.  

Other articles have taken the same position.  In fairness to the Chairman, however, he was stuck with a Commission for much of the time where Atkins and Kathleen Casey controlled the agenda.  Moreover, early in his term, he was a vigorous defender of SOX at a time when the knives were out.  The last year or so of his tenure has been less successful, particularly with the decision to bar access (he probably lacked the votes for a rule change that would allow access but he could have left matters alone, without taking steps to affirmatively bar access). 

A better place to put blame?  Henry Paulson and his philosophy that there was no financial problem that couldn't be corrected by the market.  That was a laissez faire approach that only let the wound fester until reaching crisis proportion.  

Published reports indicated that Morgan Stanely and Wachovia have been involved in merger discussions.  Ironically, talks with Wachovia likely contributed to Stan O'Neal's departure at Merrill.  The details are sketchy and Wachovia has its own exposure to the mortgage crisis.  Nonetheless, if the merger goes through, there will be only one independent investment banking firm, Goldman.  And, despite Goldman's relative strength, it will become the new weakest link.

When Secretary of Treasury Paulson entered office, he was on a mission to scale back regulation.  It was only a little over a year ago that he criticized the existing regulatory framework as having gone too far and, indeed, indicated that the administration was considering "a more business-friendly approach to regulation."   And, in addition to reducing the regulatory burden, he wanted to restrict shareholder lawsuits.  As John Holcomb wrote on this Blog:

• Treasury Secretary Henry Paulson has expressed continuing fears about the impact of regulation on the capital markets and instigated the formation of a Committee on Capital Markets Regulation, with leading corporate CEOs as members. The Committee has called for limits on the liability of accounting firms, targeting of individual executives rather than firms for prosecution, and the scaling back of shareholder lawsuits.
  

He likewise didn't care for at least some aspects of SOX, having formed a panel to look into the "problem" of too many restatements.  In other words, he was antagonistic towards regulation, targeted the areas that were mostly designed to protect shareholders and investors, had an inflated view of the power of the market to correct all evils with government (and plaintiffs) best kept out of the process. 

With this in mind, we consider the extraordinary steps taken by Paulson with respect to AIG.  The deal involved an $85 billion loan and the acquisition by the federal government in return for a 79.9% ownership interest in the form of warrants called equity participation notes.  His anti-regulatory philosophy has been entirely jettisoned.  How big is AIG?  Big.  At the end of 2007, it was the 23rd largest company in the Fortune Global 500.  As for the insurance business, the "holding company with its scores of subsidiaries is the second-largest insurer in the United States in direct written premium and the largest in the world when measured by its approximately $1 trillion in assets."  

There are a myriad of questions that the transaction raises.  Does government ownership mean an implicit guarantee of AIG's business, giving the company an unfair advantage in the private insurance markets?  Will the federal government exercise effective control and oversight over the board of directors?  But mostly what it shows is that Paulson's judgment when it comes to regulatory reform is not to be trusted.  This is also true with the attempt to "reform" the securities markets through additional restrictions on shareholder litigation, a theme recently reiterated by the Chamber of Commerce.  The views deserve the same weight as Paulson's earlier positions on the need for regulatory reform.

With Merrill and Lehman gone, the market is down to two independent investment banking firms.  The new weak link is Morgan Stanley, the one more deeply mired in the current financial crisis.  Indeed, Goldman released numbers today indicating that, while not unaffected, it had been able to make money in the prior quarter.  

Nonetheless, it is only a question of time before these firms cease to be independent.  The very actions of the Fed in the current crisis illustrate why this is the case. 

The Fed, in the name of market stability, stepped in and prevented the failure of Bear Stearns.  Ostensibly, this had to occur because of the role played by the investment banking firm, particularly as counterparty to so many complex transactions, and a failure would have roiled the market.  Lehman didn't get the same treatment.  Paulson has rationalized the disparity but the reasons don't hold up under scrutiny.  Instead, they reflect a change in policy that arose from the criticism foisted on the regulators by those who viewed the markets as sacrosanct and shouldn't be subject to such severe government intervention.

The message was heard and while it was too late to undo the intervention with respect to Bear Stearns, the anti-intervention philosophy would be applied to Lehman, as evidenced by the bankruptcy filing this week.  The approach sends an unequivocal message to the market that unlike the largest commercial banks, investment banks are not too big to fail.  The government can't be counted on to rescue the firms.  Whether in this crisis or the next, market participants will eventually flee from the uncertainty of independent investment banks for the certainty of commercial banks.  The end of independent investment banks is near at hand.  It will harm the US capital markets. 

Here is a summary by the WSJ Deal Blog of the board of directors of Lehman Brothers. 

• Nine of them are retired. Four of them are over 75 years old. One is a theater producer, another a former Navy admiral. Only two have direct experience in the financial-services industry.

• Meet the Lehman Brothers Holdings Inc. external board directors, a group of 10 people who, perhaps unknowingly, carried the health of the world’s financial system on their shoulders the past 18 months.

• As the world nervously awaits the effects of the unprecedented Lehman Brothers liquidation, one can’t help but wonder how and why this board let its long-time chairman and patron, Richard Fuld Jr., cling to both hope and power.

• Perhaps it was because Mr. Fuld wanted it that way. Over the years, Mr. Fuld had become the living embodiment of the securities firm, creating a top-down culture that sometimes had a military feel to it. Most mornings, Mr. Fuld rode alone in an elevator up to his executive suite. His colleagues simply call him “The Chairman.” And it is telling that press accounts of Lehman’s capital-raising efforts focused entirely on the efforts of Mr. Fuld, and make nary a mention of the 10 other members of Lehman’s board.

• Who was on this board? Until the 2008 arrival of former US Bancorp chief Jerry Grundhofer, the group was lacking in current financial-knowledge firepower. A number of the members did have past financial-markets expertise, but most of their working lives were tied to a different era: The one before massive securitization, credit-default swaps, derivatives trading, and all the risks those products created.

• The board’s members include John Macomber, 80 years old, a former McKinsey & Co. consultant and chief executive of chemical-maker Celanese Corp; John Akers, 74, former IBM chief; Thomas A. Cruikshank, 77, chief executive of Halliburton Co. prior to Vice President Dick Cheney; and Henry Kaufman, 81. In the 1970s and ’80s, Kaufman, the chief economist at Salomon Brothers, was known as “Dr. Doom” for his bearish views on the U.S. economy. Ironically, in April, Mr. Kaufman termed the credit crisis a “global calamity” and criticized the Federal Reserve for “providing only tepid oversight of commercial banking.”

• Other current members include: Sir Christopher Gent, 60, the one-time chief of mobile-phone company Vodafone PLC; theater producer Roger S. Berlind, 75; former Telemundo Chief Executive Roland Hernandez, 50; Michael Ainslie, 64, former chief executive of Sotheby’s Holdings; Marsha Johnson Evans, 61, one-time head of the Red Cross and a former Navy rear admiral.

• Until 2006, Lehman’s board included Dina Merrill, the 83-year-old actress once featured in the old Katharine Hepburn movie “Desk Set,” as well as “Caddyshack II.”

• How much was Lehman’s board monitoring the company’s on-going risk as it began accumulating its portfolio of real-estate assets and securities? In both 2006 and 2007, the risk committee of Lehman’s board met twice each year, according to Lehman’s SEC filings.
  

The post left out that the directors were also well paid, receiving total compensation in 2007 of around $350,000.  This is the board nominated by the directors.  Not entirely a flattering picture for a board responsible for overseeing an investment banking firm during a period of extraordinary crisis.

Had access been available and shareholders had a greater say in board membership, would the board have been the same?  Given examples to date, the evidence suggests that insurgents usually run high quality individuals.  Moreover, there is reason to believe that if access existed, management would have been under greater pressure to have higher quality boards in place. 

With Lehman and Merrill gone, two independent investment banking firms remain:  Goldman and Morgan.  Which will be next for rumors and expressions of concern from the market?  Morgan Stanley, most likely.  But in either event, both may well have a tough time of things.  As the WSJ notes: 

• The firms live or die by market confidence, given their reliance on wholesale funding, and that has clearly evaporated for the smaller firms. The lure of more stable balance-sheet funding will be strong even for Goldman and Morgan Stanley. The question is who would they partner with? There isn't a long list of banks big enough to step up.

• Even if Goldman and Morgan Stanley dodge the immediate danger, they need to lock in a funding model that is not susceptible to a sudden loss of confidence. Otherwise, they remain at the mercy of the market.

In other words, the outcome is inevitable.  Either they will suffer the fate of Lehman/Merrill or will need to partner with someone that will provide the market will additional confidence and allow them to survive periods of market instability.  Who will this be?  Commercial banks, of course.

With the demise of Lehman Brothers (the firm announced it would file for bankruptcy), the number of independent banking firms in the United States will have fallen from five to three.  But elimination of the weakest link only created a new weak link, with attention then shifting to Merrill Lynch.  That firm announced that it had agreed to a merger with BoA.

In other words, in one short weekend, the number of independent investment banking firms in the US fell from four to two.   We predicted this.  Indeed, it is only a question of time before the remaining two independent investment banking firms (Goldman and Morgan Stanley) are gone.  As we have observed on this Blog multiple times (and written since the 1990s, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act), the elimination of Glass Steagall and the wall that separated commercial from investment banking all but spelled the elimination of independent investment banks in the United States. 

Commercial banks have inherent advantages (both in raising capital and in the perceived safety of Federal Reserve Board oversight) and, particularly in times of financial crisis, business will gravitate in their direction. Back in the 1930s, commercial banks in the US were asserting domination over the investment banking side of securities activities.  Only the forced separation through the adoption of Glass Steagall prevented them from controlling that segment of the financial sector.  With the provision's repeal in the 1990s, it only became a question of time before commercial banks took over.  With JP Morgan acquiring Bear Stearns and BoA acquiring Merrill, the process is well underway. 

Is this a bad thing, to have the investment banking business effectively controlled by commercial banks?  There are no doubt a number of reasons why the US has the most vibrant capital markets in the world.  One of them has to be the existence of a class of intermediaries that profit so extraordinarily from capital market activities.  These firms have an incentive to introduce new products, encourage trading activity, and promote initial public offerings.  They are likely to take larger risks designed to profit from capital market activities, something that likely promotes liquidity and innovation.  Commercial banks, in contrast, are typically more conservatively run and profit from lending relationships.  They are therefore in a position to encourage lending relationships rather than stock offerings and may be unwilling to take the type of risks associated with independent investment banking firms.  Both of these factors may affect the liquidity and vibrancy of the securities markets. 

The disappearance of independents will damage the depth and liquidity of the US capital markets.  We hope to see the   Chamber of Commerce express the same degree of concern over this in its efforts to promote reform designed to improve securities markets as it has with the problem of excessive securities litigation.   

As we have said on this Blog multiple times (and written since the 1990s, see The "Great Fall": The Consequences of Repealing the Glass-Steagall Act), the elimination of Glass Steagall and the wall that separated commercial from investment banking had all but spelled the elimination of independent investment banks in the United States.  Commercial banks simply have inherent advantages, including the ability to raise funds through deposits or the market's awareness that the Fed will back them up when they are in trouble.  As the article above discussed, this happened in Great Britain.  When the barriers on commercial and merchant banking were removed, the independent merchant banks vanished. 

It comes up again on this Blog with the death watch for Lehman, the smallest of the remaining independent investment banks. Bear Stearns, formerly the smallest, is already gone, absorbed by JP Morgan Chase. That leaves four US firms, Goldman Sachs, Merrill Lynch, Bear Stearns, Morgan Stanley, and Lehman Brothers (five if you count Credit Suisse First Boston).  According to the WSJ, Lehman continues to hemorrhage and continues to take drastic steps to remain afloat.

• Lehman Brothers Holdings Inc. said it plans to spin off to its shareholders the "vast majority" of its commercial real-estate assets, sell about a 55% interest in its investment-management division and slash its dividend 93% as it also predicted a fiscal third-quarter loss of $3.9 billion.
  

Lehman has access to funding from the Fed so its not in the same situation as Bear Stearns.  Nonetheless, the market remains pessimistic, with share prices falling 45% on Tuesday alone.  More recent stories suggest that Lehman is shopping for a white knight, with potential buyers including Bank of America, and that a buyout may be as soon as this weekend.  In other words, the venerable investment banking firm may find itself, like Bear Stearns, the subsidiary of a commercial bank.  

The issue is temporal.  If not this crisis, it will be the next.  In a financial market that allows commercial banks to engage in investment banking activities, there is no room for the independents.  For all of the complaints about litigation as a drag on securities markets, the repeal of Glass Steagall may be the most severe blow, elimininating a class of intermediaries that benefit the most unequivocally from active securities markets and therefore have the most incentive to insure their integrity and push for innovative capital raising tools.  Their loss will be damaging. 

Stoneridge involved vendors but the Supreme Court did not limit the analysis to those participants in the transaction.  The case, therefore, arguably left open the need to establish actual reliance on others who participated in the disclosure process but did not actually make the false statement.  Employees within the company amounted to a possible category.

The issue came up in In re Bristol Myers Squibb Co. Sec. Litig., 2008 U.S. Dist. LEXIS 63567  (SD NY Aug. 19, 2008) and largely swatted down.  Bristol Myers was accused of not fully disclosing the terms of a settlement of a patent lawsuit.  The court concluded that the plaintiff had adequately shown that the omissions were material and had established the other elements of a fraud violation against the company.   One of the individual defendants, Andrew Bodnar, a medical doctor, attorney, and  Bristol-Myers's Senior Vice President for Strategy and Medical and External Affairs, sought dismissal on the grounds that, under Stoneridge, there was no reliance on his acts. 

There were no accusations that Bodnar made the false statements.  Instead, he was alleged to have "(1) secretly negotiated a settlement with illegal oral side agreements; (2) knowingly withheld information about the negotiations, the terms of the settlement, and the oral side agreements from shareholders, the Board of Directors, and the federal monitor; and (3) failed to correct Dolan and the Company's material misstatements despite his duties as a senior executive."  In other words, he knew about the false disclosure and did nothing to correct it.  The actions were, the court concluded, sufficient to establish "'the commission of manipulative acts' sufficient to satisfy the Supreme Court's 10(b) pleading standards."

But Stoneridge required more.  There also had to be reliance.  On that issue, the court had this to say:

• In Stoneridge, the Court found that allegations regarding complicit participation by outside suppliers in a cable company's fraudulent scheme were too remote from the investing public to satisfy the reliance element of the 10(b) standard, and therefore insufficient to allege scheme liability under 10(b). Here, however, Bodnar's behavior is at the heart of Bristol-Myers's false and misleading conduct. It is neither implausible, nor too remote to find that the investing public relied on the announcement of the Apotex litigation settlement in deciding whether or not to invest in Bristol-Myers stock, and Bodnar was directly responsible for the settlement agreements. Bodnar made no public statements himself, but investors relied on his good faith in negotiating the Apotex settlement agreement and committing the Company to its terms. Furthermore, unlike in Stoneridge where the defendants' "deceptive acts were not communicated to the public," Bodnar's misconduct and deceptive acts were communicated to the public here through the disclosure of the regulatory rejection of the settlement, the disclosure of the amended settlement's terms, and the revelation of the secret oral side agreements. Bodnar's actions are directly tied to the Apotex settlement, the Justice Department investigation, and the alleged misstatements and omissions. These allegations are more than adequate to satisfy 10(b) and the requirements of the Stoneridge decision.
  

Note that the court did so despite the absence of any statements by Bodnar.  It was enough that Bodnar was directly responsible for the settlement negotiations. 

The case shows the ease to which the courts will find reliance when the behavior is bad enough.  In other words, because the majority in Stoneridge used reliance to achieve a result oriented decision, the element was woefully unexplained, providing the lower courts will little guidance.  As a result, the lower courts have the lattitude largely to find reliance where ever they want, as the facts in Bristol Myers shows. 

The first Stoneridge opinion of the day doesn't even cite Stoneridge.  The Tenth Circuit recently issued an opinion (SEC v. Wolfsen) finding that a non-employee consultant was primarily liable under Rule 10b-5.   The case illustrates the gaps left by the Supreme Court in Stoneridge.  

The consultant was deemed primarily liable because of his involvement in drafting SEC filings.  This was true even though he was not an employee and did not actually make the false statements.  Instead, the false statements were included in filings by the issuer.  As the opinion noted:

• Defendants appeal that decision, principally arguing that they cannot beheld liable under the securities anti fraud statutes because the Commission failed to show that Marple, rather than the public company itself, made the material misstatements and omissions. We disagree and hold that when a non-employee consultant causes misstatements or omissions within periodic financial reports submitted to the Commission, knowing that those misstatements or omissions will reach investors, he can be held primarily liable under the antifraud provisions of the federal securities laws.

There are several things curious about the case.  First, the consultant was charged as a primary violator and not for aiding and abetting liability.  While private parties cannot bring actions for secondary liability under Rule 10b-5, the SEC can.  This failure is unexplained in the opinion.

Second, although involving a tertiary actor, the case nowhere addressed Stoneridge.  Stoneridge arose in an effort to delineate boundaries between primary and secondary liability.  Defendants in that case argued that, in order to be primarily liable, they had to have actually made false statements.  The Court ducked the main issue entirely and instead held that vendors who committed a deceptive act in connection with another company's false disclosure could only be liable if the market actually relied on their behavior.   

The Commission need not establish reliance.  As a result, the Tenth Circuit could determine whether the consultant fell within the definition of primary liability unencumbered by the Supreme Court's analysis in Stoneridge.  The court concluded that it was enough to participate in the drafting of the false statement.     

• Like the defendants in KPMG and McConville, Marple played an integral role in preparing those filings that contained the misstatements and omissions at issue here. Not only did he prepare the drafts of both the 10-QSB and 10-KSB, the draft of the 10-QSB (the more misleading of the two filings) was not modified by either F10’s CEO or CFO, at least insofar as the Sukumo arrangement was portrayed. It was filed as Marple drafted it. Additionally, F10 hired Marple for the very purpose of preparing the relevant SEC filings, based on his prior financial reporting experience, and he well knew that those documents would be distributed to the public and available to investors. That the filings were issued in F10’s name, and that Marple himself did not sign, certify, or physically file the documents, is not dispositive. The relevant question is only whether he can fairly be said to have caused F10 to make the relevant statements, and whether he knew or should have known that the statements would reach investors.

The case, therefore, stands for the proposition that primary liability will arise where the third party had significant involvement in the drafting process.  Nor did the false statement have to be attributed to the participant.   Involvement was enough. 

The facts in Wolfsen are arguably not far from those in Stoneridge.  One can imagine circumstances where a vendor engages in a sham transaction and knows that the transaction will be reported verbatim in the issuer's filings.  In  other words, the vendor caused the issuer "to make the relevant statements, and whether he knew or should have known that the statements would reach investors."

Of course, Wolfsen was an SEC enforcement action.  As a result, the agency did not have to establish reliance.  Private actors will, under Stoneridge, have to plead the element.  But where the sham transaction is disclosed in the filing and the vendor is identified, this may not be a difficult element to meet.

Stoneridge had the potential to be a ground breaking case or, as Don Langevoort put it, a Roe v. Wade for shareholders.   The decision was result oriented.  The Supreme Court as a political rather than legal matter wanted to send a strong message that litigation under Rule 10b-5 was disfavored.  Unfortunately for the majority, the case presented very bad facts, containing allegations that the vendors in the case backdated documents and falsified the reasons for the change in price of the goods sold.  The majority wanted to restrict the reach of Rule 10b-5 by imposing a narrow definition of primary liability, exonerating anyone not actually making the disclosure.  Unfortunately, the Solicitor General did not cooperate, filing an amicus brief concluding that deceptive conduct (as opposed to false disclosure) could constitute a primary violation of the antifraud provision.  This left the majority without a clear theory of exoneration (or the ability to devise one) and instead the Justices turned to reliance, manufacturing an actual reliance requirement for vendors.

As a result, the lower courts were left with no clarification of the standards for primary liability (except to clarify that it applied to deceptive acts) but were left with a decidedly unclear and analytically unsound doctrine of reliance.  With this in mind, we take the opportunity to examine a few post-Stoneridge cases.   The bottom line?  Plus ca change, plus c'est la meme chose.

So, what are the proposed reforms that could solve the excessive litigation problem?  As we have noted, the Chamber Study nowhere suggests the imposition of liability directly on those responsible for the false disclosure, despite noting that this is a failing of the system.  The Study contains no proposal for reforming the system of D&O insurance or limiting indemnification rights. 

The Study calls for the adoption of legislation that would require substantial additional disclosure about the relationship between counsel and client, including campaign contributions.  In some ways, the legislation seeks to fight the last war, attempting to stamp out the type of behavior engaged in by Milberg et al, without any evidence that the behavior continues or ignoring the ability of the existing system to penalize those who engage in the behavior. 

Buried in the proposal, however, is approval for increased interference by the courts in the right of private parties to select counsel.  Rather than have the presumptive plaintiff select counsel (often a large institution), the Chamber supports a proposal that would require courts to "employ a competitive bidding process as one of the criteria in the selection and retention of counsel for the most adequate plaintiff."  The irony in that approach, beyond the call for a form of federal preemption of the right of parties to select their own counsel, is that it will likely trigger the rule of unintended consequences. 

A bidding process will probably favor the largest firms.  Indeed, it may result in the creation of a firm as large and as dominant as the Milberg Weiss of yore.  In other words, the "reform" sought by the Chamber will likely result in the class action business becoming even more concentrated, with companies finding themselves confronting deep pocket law firms more often.  The Chamber Study is so interested in somehow penalizing the plaintiffs' bar, that it has suggested reforms that will only make matters worse for issuers.  This has happened before.  The provisions in the PSLRA designed to give control over litigation to institutional investors were really meant to make life hard for law firms that relied on professional plaintiffs.  But with institutional investors in charge, issuers have had to pay even more.  Unsurprisingly, the Chamber has become critical of the use of institutions (under the rubric of pay to play) and will in time become critical of any proposal to require an auction among law firms, should it ever become law. 

Mostly though the reforms call for a dramatic increase in the number of procedural hurdles forced on shareholders in bringing and maintaining an action.  One of them, the overruling of Makor v. Tellabs, would effectively require Congress to overturn a provision adopted in the PSLRA.  But the irony in all of this is that the approach would add delay and cost to the litigation process which in turn would increase the amount lawyers were paid.  In other words, the very "reform" proposed by the Chamber likely causes an increase in the fees earned by plaintiff's counsel.  Certainly this was one of the impacts of the PSLRA.  The Study, however, omitted any responsibility on the part of the Chamber for these increases. 

Finally, be careful what you wish for.  There is no question that the PSLRA made it harder to bring securities fraud suits.  But it had an unintended consequence.  The Act caused lawyers for the plaintiff to do substantially greater due diligence before bringing a suit.  They often hire investigators and contact anonymous informants.  In other words, they bring better cases and do more homework.  As a result, it is no big surprise that those cases able to survive a motion to dismiss can induce larger settlements than before. 

If the PSLRA is any indication, the Chamber will be back in a few years arguing for changes to reforms that it wanted in 2008 and arguing that shareholders are disadvantaged by the high fees paid to plaintiffs counsel that were at least in part induced by the reforms that it suggested. 

We are discussing the recent report put out by the Chamber of Commerce on the problems of excessive securities litigation in the United States.  We have already noted that the Chamber addressed the issue without ever once mentioning the impact of the subprime problem or without discussing one of the most critical issues in the securities litigation area, the impact of D&O insurance. 

But the Report did find time to talk about the legal problems of Milberg Weiss.  Indeed, the Report concluded that reform is necessary because the "systematic failures of private class action litigation are exacerbated by the trial lawyers who have hijacked the class action mechanism and abused it for profit."  The prosecution of Milberg Weiss and the lawyers from the firm "may also be just the tip of the iceberg." 

The entire section is nothing more than a restatement of the charges brought against Milberg and those connected with the firm.  In other words, the Study is unable to make a solid case that the problems associated with the prosecution goes beyond that firm or continues in any way.  Indeed, the indictment against the firm mostly involved fee sharing agreements that occurred before the adoption of the PSLRA when the system for filing suit was a "race to the courthouse."  At that time, the firm needed a stable of potential plaintiffs to be able to rush to the courthouse at moments notice in order to be first.  The under the table payments were a form of compensation to plaintiffs who remained perpetually available to race to the courthouse. 

In a post-PSLRA era, it is decidedly unclear why a firm would ever need to pay kickbacks.  Presumptive plaintiffs are not the first to file but the ones with the largest potential loss.  These institutions don't need kickbacks.  They can gain an increased payment by driving a harder bargain with counsel on fees.  Unless the Chamber is suggesting that large institutions are being bribed with under the table payments, this practice is unlikely to still be taking place. 

In other words, the Study notes that the problem "seems to be systemic and fundamental" but can't make the case with any examples other than Milberg.  One firm's problems does not make for a systematic issue and certainly evidence of problems that mostly preceded the PSLRA does not make much of a case that they continue.  But alas none of this was discussed in the Chamber's Report.

We are discussing the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” published by the Institute for Legal Reform of the Chamber of Commerce.

The Report also mentions that the lawsuits "pointlessly transfer money from one innocent investor to another."  This has been a popular argument of late.  Essentially, so this argument goes, settlements entail the payment from the company (and the current owners), who had no role in any fraud, to the past owners (although there is of course some overlap in the two groups).  So one group of innocent shareholders (those in the present) are paying another group of innocent shareholders (those injured in the past). 

The first problem with this argument is that it would justify a system where the present owners would never pay for the bad behavior of the past managers.  In other words, based upon this rational, there should never be recovery for fraud in a private action.  But the argument goes much further.  The same argument has been used to oppose the system of fines imposed on companies for fraud by the SEC (see the views of former Commissioner Atkins).  After all, fines are paid by innocent shareholders in the present for bad behavior in the past.   Yet the Chamber Report explicitly favors government enforcement, nowhere reconciling why transfers in the private sector are somehow pointless while transfers in the public sector are apparently not.   

In any event, the main problem with the argument is that most payments made to settle these cases come not directly from the company but from the insurance carriers under D&O policies, something one would never know reading the Chamber Report (some of the mega suits exceeded insurance amounts but this is not the norm).  Insurance involves shared risk among all of the companies in the same pool.  In other words, the settlement comes from the pool of funds maintained by the carrier.  It does not reduce the net value of the company settling and does not involve a transfer from present to past shareholders.  Moreover, the recovering shareholders paid for the protection in the form of D&O premiums back in the year when the fraud occurred.   

Of course, future shareholders may suffer from an increase in the cost of D&O insurance as a result of a settlement.  But that is highly problematic and not easily quantified.  Moreover, the amount of the increase may be small relative to the amount paid to the past shareholders.  Did the Chamber Study address this issue?  It had only this to say: 

• Even when a company's insurance covers the settlement and litigation costs, the company ultimately ends up footing much of the bill because insurance premiums inevitably increase to reflect the higher risk of liability.  These spiraling expenditures in part explain why insurance costs for a Fortune 500 company are over six times higher in the United States than in Europe.
  

Perhaps but this is a noticeably unsupported proposition.  To the extent there is a settlement, the quote suggests that premiums will increase.  It offers no actual authority for the proposition and is, in fact, wrong.  As Kevin  LaCroix (of D&O Diary fame), explained:  

• I agree with your criticism of the Chamber report’s statement that “insurance premiums inevitably increase to reflect the higher risk of liability.” This statement is simply not true. If it were true, insurance rates now would be much higher than five years ago, because of dramatically higher average claims severity. Instead, rates now are less than half of what they were in 2003. The largest determinant of insurance pricing is the availability of capital and related competition. Capital is abundant and competition is fierce, as a result of which buyers enjoy much lower rates than five years ago, despite much higher average claims severity. The mechanism that establishes insurance prices is much more complex and multifaceted than the Report’s statement suggests. Obviously there is a connection but it is neither as direct nor as “inevitable” as the Report suggests.
  

In other words, the report largely ignores the single most important issue in the entire securities litigation area -- the role of insurance and when it does mention the subject, it gets the facts wrong.

The Report has little to say about insurance because the topic represents an "inconvenient truth." First, focusing only on the cost of insurance is not very sexy and may not be excessive relative to other types of commercial insurance.  Thus, for companies with market capitalization over $10 billion, a recent report put their D&O costs at an average of $3 million, hardly the crisis levels claimed by the report.  

Second, those companies that pay the D&O premiums and are never sued may well, as a matter of economics, be the losers in the system.  They pay the insurance proceeds year after year, with no amount ever returned to shareholders (past or present).  A settlement in a securities suit at least returns some of the amount paid in insurance premiums back to shareholders.   

Finally, the focus on insurance gives rise to possible reforms not at all in line with what the Chamber is seeking.  By paying settlement amounts from insurance, the argument is strong that companies do not have sufficient incentive to reduce instances of fraud.  One way to solve the problem would be to eliminate insurance and severely restrict indemnification, making the responsible parties pay for any fraud.  These types of reforms, however, are absent from the Chamber's report. 

We are discussing the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” published by the Institute for Legal Reform of the Chamber of Commerce.

The Report emphasizes the increase in the number of class action suits that have been filed in the first half of 2008.  During the six month period, according to the report, the number of filings increased by 60% from the same period in 2007.  Moreover, the number of suits filed in 2007 was 58% higher than in 2006. 

True enough but what the report mentions nowhere is the cause for much of the uptick.  The implication is that matters have returned to the pre-PSLRA days when litigation was out of control.  But the reasons for the increase have a more specific explanation entirely omitted from the report. 

The Chamber report never uses the words "subprime," which says a considerable amount about the report's neutrality (or lack thereof).  According to NERA, 51% of the filings made in 2008 since June 30 have been "related to the subprime collapse."   In other words, the Chamber study pretends that the increase is a capital markets wide phenomena without making any attempt to isolate the impact of the current subprime problem. 

Similarly, the report contends that settlements have "skyrocketed."  It points in particular to the data from 2007. "The total value of securities class action settlements in 2007 was nearly 15 times the total in 1998."  The report likewise noted that 2007 "featured the highest median settlement amount ever."  NERA, however, has a different take.  "Even as filings were increasing in 2007 and 2008, average settlement values remained around $30 million.  Removing settlements over $1 billion from the calculation, the 2008 average settlement actually fell to $10 million, well below the level of recent prior years, and much closer to the 2008 median of $6 million."  

In other words, the data is not as bad as the Chamber makes it out to be.  Moreover, none of the reforms suggested by the Chamber address any of the problems associated with the subprime crisis.  Indeed, the reforms would make all securities suits more difficult to bring,  essentially making it harder for shareholders injured in the subprime fiasco to vindicate their rights.  In other words, the reforms are not about preserving the integrity of the capital markets in the US but simply cutting of causes of action that arise even out of meritorious facts.   

Now that SOX has faded as the whipping post for everything wrong with regulation and the US capital markets, the problem of excessive litigation has become the replacement.  These were addressed in my piece, Criticizing the Critics: Sarbanes Oxley and Quack Corporate Governance.  

Excessive litigation interferes with competitiveness and causes foreign companies to take their business elsewhere.  These arguments were made, for example, in Stoneridge and the Supreme Court repeated them back.  But in fact, there's not any real evidence supporting the position, irrespective of the number of tendentious studies churned out on the topic.  This is not to say that there isn't room for reform.  But the level of criticism and blame placed on litigation as an explanation for concerns about US competitiveness is unproven. 

In that regard, we'll spend a couple of days examining the recent report,  “Securities Class Action Litigation: The Problem, Its Impact, and The Path to Reform,” put out by the Institute for Legal Reform, a subdivision of the Chamber of Commerce.  The report mischaracterizes data (or is at least highly selective), cites as authority almost nothing except other, comparably reasoned reports, and contains arguments that are internally inconsistent.  Moreover, in analyzing the report, we have the benefit of an equally recent study, 2008 Trends, put out by the National Economic Research Associates.  The NERA report demonstrates some of the biases inherent in the Chamber report. 

The conclusions of the Chamber Report are predictable.  Securities litigation is ruining the US economic system. 

• "The costs of securities litigation are enormous, but the benefits are minuscule.  The culture of abusive class actions drive by a multibillion dollar plaintiffs' lawyer industry, is eroding the competitiveness of the U.S. capital markets at a time when they face perhaps their greatest threat from foreign competition."

In other words, the sky is falling and something needs to be done right away.  The urgency is in fact real but not for the reasons stated in the report.  Whatever happens at the presidential level, the November 2008 elections will almost certainly bring larger Democratic majorities in both chambers.  The urgency is that the days of favorable consideration of these types of arguments (which reached their apogee in the 1990s with the adoption of the PSLRA) are coming to a close.  If something isn't done now, it will only get harder in the next few years.  With that in mind, let us examine the report.  We start in the next post. 

The Race to the Bottom previously discussed the board of directors' role in Bear Stearns demise.  Bear Stearns' troubles began in 2007 when two of its hedge funds failed.  They culminated in an acquisition of the investment bank by JP Morgan Chase.  August's "Vanity Fair" article covered the reaction of the board of directors during J.P. Morgan Chase's first offer. 

J.P. Morgan’s initial offer came in at two dollars a share, and Bear Sterns President Alan Schwartz gave a half hour presentation to the board on its choices: a J.P. Morgan merger or bankruptcy.  Bankruptcy would have resulted in the seizure of the investment bank's assets by creditors and allowed federal regulators to take over customer accounts.  It would also mean the loss of fourteen thousand employees and likely wiped out the equity interests of shareholders. Shareholders, however, complained about the two-dollar share price (the price had been $27 on the Friday before the offer).  The parties renegotiated, and J.P. Morgan raised its offer to ten dollars a share.  Bear Stearns' board approved the merger. 

Because of the merger, shareholders filed a number of lawsuits, including class action lawsuits under the federal securities laws.  The suits generally focus on the disclosure made by Bear Stearns during the period prior to the merger.  Eastside Holding, Inc. alleged that Bear Stearns' officers and directors violated §10(b) and 10b-5.  The wrongful conduct occurred between December 14, 2006 to March 14, 2008, when the defendants allegedly issued false or misleading statements regarding Bear Stearns' business and financial health. 

The complaint alleged that Bear Stearns knowingly allowed its subsidiaries and high yield fund managers to avoid fully disclosing the risks involved in its underlying hedge fund investments.  In addition, the complaint asserted that the firm failed to "inform the market of the ticking time bomb in the Company’s hedge funds due to the deteriorating subprime mortgage market, which would cause Bear Stearns to have to rescue the funds, cause the Company and its officers possible criminal liability and hurt the Company’s reputation."  The plaintiff alleged it would not have bought Bear Stearns' common stock if it had known defendants’ misleading statements had falsely inflated the stock’s market price.  Plaintiff claimed it suffered damages by paying artificially inflated prices for the common stock.  Plaintiff asked for class action certification, damages, and equitable, injunctive, or other relief.  

J.P. Morgan’s S-4 filing stated it would hold harmless and indemnify present and former directors.  This covers "matters" occurring before or at the time of the merger's completion.  The indemnification remains in effect for six years after the merger, with JP Morgan Chase paying for directors' liability insurance coverage during that time.

Subsequent posts will examine the derivative suits against the directors of Bear Stearns. 

The primary materials for this post are available on the DU Corporate Governance web site.

We have discussed before about the gradual disappearance of independent investment banking firms.  With the repeal Glass Steagall back in the 1990s, the day of investment banking firms not owned by commercial banks are increasingly numbered.  Why?  Because commercial banks have natural advantages, including lower cost funding sources and the perceived safety of the Federal Reserve Board.  The topic can (and the prediction) can be examined in greater detail in the piece, The "Great Fall": The Consequences of Repealing the Glass-Steagall Act. 

Let us recap.  At the beginning of this financial crisis, there were six, Goldman Sachs, Merrill Lynch, Credit Suisse First Boston, Bear Stearns, Morgan Stanley, and Lehman Brothers.  Bear Stearns is gone, absorbed by JP Morgan.  Merrill considered offering itself to Wachovia, although ultimately the board stopped the overtures.  The death watch is focused on Lehman, the smallest of the survivors.  The WSJ has indicated that the market is girding for an announcement from the diminutive firm that it will have losses for the quarter of $1.8 billion, with the total for the year exceeding profists in fiscal 2007.  The article indicated that, if the losses continue, Lehman may need additional capital. 

The firm has so far managed to raise sufficient capital and stave off a Bear Stearns type run.  At the same time, however, the market will not, indefinitely, be so forgiving.  If that occurs, Lehman may find itself in bankruptcy or being purchased by a better capitalized savior.  The most likely acquisition candidate?  A large commercial bank, although finding one not so embroiled in the subprime problem that can absorb the investment bank is not easy.  Whatever number survives this current financial downturn and remains independent, it is only a matter of time before that independence is lost.