Judicial Limitations on Investor Protection: Fiero v. FINRA (Part 6)

We note one final point about the decision.  Although entirely dictum, the court noted that position of the SEC that it could seek to collect fines where it had affirmed the sanction.  Rather than reaffirm the position, the court all but invited parties to challenge this authority as well.  As the opinion noted:

  • The SEC takes the position that it has the authority to bring an action in a federal district court to enforce any order it issues that affirms sanctions, including fines, imposed by FINRA. See Delegation of Authority to the Office of the General Counsel, SEC Release No. 42,488, 71 S.E.C. Docket 1910 (March 2, 2000); 15 USC 78(e)(1). Although several other Courts of Appeals have affirmed the SEC's authority to enforce FINRA-imposed sanctions pursuant to Section 21(e), this issue is not before us on this appeal.

The court, therefore, left open the possibility that even the SEC does not have the authority to enforce the judgment. 


Judicial Limitations on Investor Protection: Fiero v. FINRA (Part 5)

We are examining Fiero v. Financial Industry Regulatory Authority, 2011 U.S. App. LEXIS 20173 (2nd Cir. Sept. 29, 2011), the recent decision by the 2nd Circuit that concluded FINRA lacked the authority to file an action to collect fines imposed on members.

Is there a right answer to this question?  Congress clearly contemplated the imposition of fines.  The fines were to be part of the rules and regulations of the SRO.  The House and Senate Reports on the Maloney Act do not provide much additional insight.  See HR Report No. 2307, 75th Cong., 3d Sess. (MAY 6, 1938); Senate Report No. 1455, 75th Cong., 3d Sess. (Jan. 5, 1938). The argument that fines are meaningless if they cannot be collected seems to create a strong argument for the implicit authority to bring an action. 

Moreover, since members prior to 1983 did not have to join an SRO, the threat of expulsion for nonpayment arguably had little meaning.  It merely meant that the brokers would become subject to SEC oversight, rather than the oversight of the NASD.  Moreover, the comparison to the authority given to the SEC to bring actions is inapposite.  In addition to the fact that the authority to impose penalties (and bring actions for nonpayment) came long after the adoptin of the Maloney Act, a federal agency is a very different animal than an SRO.  Government agencies are entirely a matter of statute and can have no authority except what is in the statute.

An SRO is different.  Depending upon the business form used (a for profit company in the case of the exchanges, a non-profit in the case of the NASD/FINRA), the entity has certain types of legal authority that does not need to be granted by Congress.  Thus, for example, the rights of a non-profit are largely determined by state statutes, not Congress. 

All of this suggests that Congress did not consider the authority to impose fines a matter that required much thought.  At the same time, however, it suggests that Congress did not view the authority as superflous, something that would be the case if a broker could simply exit the NASD.  Most likely, Congress intended any registering organization to have whatever authority to enforce that it would have as is typical of that type of entity.  FINRA, as a non-profit, brought an action againt the member for collection of an amount under a theory of breach of contract.  A non-profit has status to maintain an action for breach.  In those circumstances, it would appear FINRA has the right to bring an action for nonpayment. 

Moreover, the determination of the New York court that the action had to be brought in federal court prevents one of the concerns raised by the Second Circuit from occuring.  Resolution of the issue, to the extent requiring an interpretation of the securities laws, will be undertaken by a federal court which has the expertise to do so.

The consequence of the decision is that the court has essentially eliminated fines as a mechanism by FINRA for enforcing the securities laws.  Since fines can only be enforced by revocation of membership, FINRA can only enforce the securities law by threatening to put the broker out of business.  This is not unlike the situation with the exchanges that can only suspend or delist companies (in addition to letters of admonition in some cases) in the case of violations of listing standards. 

In effect, therefore, the SROs have only a nuclear weapon as a penalty.  The SROs are unlikely to impose such a draconian remedy for modest violations.  One way of doing so is to reduce the willingness to find such a violation and to enforce the securities laws.   

In any event, whatever the outcome of the decision, the reasoning used by the Second Circuit panel was unpersuasive.  It will be of considerable interest to see whether FINRA challenges the decision.  To the extent it does not and it declines to seek recovery of fines, it will raise questions about whether FINRA is the appropriate regulator to ensure the protection of investors.


Judicial Limitations on Investor Protection: Fiero v. FINRA (Part 4)

We are examining Fiero v. Financial Industry Regulatory Authority, 2011 U.S. App. LEXIS 20173 (2nd Cir. Sept. 29, 2011), the recent decision by the 2nd Circuit that concluded FINRA lacked the authority to file an action to collect fines imposed on members.

There are a number of aspects of the decision that call into question the reasoning used by the court.  First, the case, as the court noted a number of times, depends upon congressional intent.  Yet the source of that intent, the legislative history to Section 15A, was entirely unexamined.  There are no references in the opinion to the hearings on the Maloney Act or the House/Senate Reports on the legislation.  

Second, the opinion placed considerable reliance on the explicit authority given to the SEC to seek and collect penalties in Section 21 of the Exchange Act.  But the SEC only received the authority to collect penalties in the 1980s, long after the adoption of Section 15A.  See Arthur B. Laby and W. Hardy Callcott, PATTERNS OF SEC ENFORCEMENT UNDER THE 1990 REMEDIES ACT: CIVIL MONEY PENALTIES, 58 Alb. L. Rev. 5 (1994) (“The debate over whether the SEC should have the power to seek or assess civil money penalties stretches over several decades. As enacted in the 1930's, the federal securities laws relied almost exclusively on non-monetary sanctions, such as injunctions, with the possibility of criminal prosecutions for egregious violations. The Exchange Act originally contained only one civil money penalty provision, Section 32(b), which allows a penalty of $ 100 per day against an issuer that fails to file required reports. This sanction has rarely been used; as of 1990, the SEC had invoked it only once.”). While the authority in Section 21 with respect to penalties may reflect the views of Congress in the 1980s and later, it is a stretch to use the same langauge to provide insight into what Congress intended in 1938. 

Third, the court relied on something akin to the reenactment doctrine.  Congress knew that the NASD did not have the authority to bring actions to collect fines and never did anything to legislatively correct the matter.  It is highly unlikely that Congress knew about the absence of authority.  More importantly, the NASD apparently began to bring these actions after 1990.  Yet Congress never stepped in to put an end to the practice, despite the adoption of SOX and Dodd-Frank.  To the extent there is a proper application of the reenactment doctrine, it is to show that Congress knew the practice was taking place yet did nothing to stop it.  In other words, it supports the opposite position taken by the Second Circuit. 

Finally, the court put considerable weight on the ability of the NASD to collect fines through alternative mechanisms.  To the extent members do not pay the requisite fines, they can be expelled from the NASD. 

  • FINRA fines are already enforced by a draconian sanction not involving court action. One cannot deal in securities with the public without being a member of FINRA. When a member fails to pay a fine levied by FINRA, FINRA can revoke the member's registration, resulting in exclusion from the industry.

The court, however, did not take into account that the scheme created by Congress in 1938 did not contemplate mandatory membership in an SRO.  Indeed, until the the 1980s, brokers were not required to be members of an SRO.  Those who were not were regulated directly by the SEC under the SECO program.  Indeed, the SEC only got the right to directly regulate these brokers in 1964.  See Exchange Act Release No. 9420 (Dec. 20, 1971) (“Nonmember broker-dealers are subject to the so-called "SECO program" of the Commission adopted pursuant to Sections 15(b)(8), (9), and (10) of the Securities Exchange Act of 1934 (the Act). Enacted in 1964 as amendments to the Act, these provisions empowered the Commission to establish for such nonmember broker-dealers and their associated persons supplementary regulatory procedures and rules comparable to those adopted by the NASD for its members and their associated persons.”). Only in 1983 was the SECO program discontinued and brokers made to join an SRO.  See Exchange Act Release No. 20409 (Nov. 22, 1983). 

To be sure, the Commission did eventually adopt a rule that provided expulsion by an SRO acted as a bar to registration under the SECO program.  See Exchange Act Release No. 9290 (August 23, 1971)(proposing rule 15b8-2).  But the rule was not in place until the 1970s.   Moreover, the rule applied to expulsions "for conduct inconsistent with just and equitable principles of trade".  Whether the nonpayment of a fine falls within this status us unclear.  Finally, a member not wanting to pay the fine could avoid expulsion by resigning, thereby avoiding any action by the NASD that might trigger denial under the SECO program.

In other words, back in 1938, the ability to expel members for nonpayment had little signficance.  It would not, as the court suggested, result in an expulsion from the industry.  The Second Circuit instead used legislative changes adopted in the 1980s to construe legislative intent in 1938.


Judicial Limitations on Investor Protection: Fiero v. FINRA (Part 3)

We are examining Fiero v. Financial Industry Regulatory Authority, 2011 U.S. App. LEXIS 20173 (2nd Cir. Sept. 29, 2011), the recent decision by the 2nd Circuit that concluded FINRA lacked the authority to file an action to collect fines imposed on members.

The court gave a number of reasons for concluding that the NASD lacked the authority to file an action to collect unpaid fines. 

First, it pointed out that with respect to the SEC, Congress was quite specific in setting out its authority to bring actions.  Specifically, the court looked to Section 21(d) of the Exchange Act and the “express statutory authority for the SEC to seek judicial enforcement of penalties.”  15 USC 78u.  With respect to the NASD, "Section 15A, in contrast, did not provide any mechanism for seeking judicial enforcement of the sanctions it imposed."  Said another way, the court relied on the negative implication arising from the absence of express authority. 

Second, the court divined a congressional intent not to allow actions to collect fines from the process contained in the Exchange Act.  Congress was careful to provide for an appeal to the Commission in any disciplinary proceeding brought by FINRA.  Given this, “[h]ad Congress intended judicial enforcement, it would surely have provided for some specific relief other than leaving SRO's to commonlaw proceedings in state courts or in federal district courts under diversity jurisdiction.”   

The court did note the conundrum created by the language in Section 15A that gave FINRA the authority to impose fines.  The language at least raised the possibility that Congress implicitly contemplated the ability to collect the fines imposed. The court, however, concluded that the inability to collect fines was unnecessary to ensuring enforcement of the securities laws.   

  • One might argue that an inference of congressional intent to authorize such legal actions by FINRA can be drawn from the seemingly inexplicable nature of a gap in the FINRA enforcement scheme: fines may be levied but not collected. However, the gap does not support an inference of inadvertent omission because  significant underenforcement of the securities laws and FINRA rules is hardly the inevitable result of FINRA's inability to bring fine-enforcement actions. FINRA fines are already enforced by a draconian sanction not involving court action. One cannot deal in securities with the public without being a member of FINRA. When a member fails to pay a fine levied by FINRA, FINRA can revoke the member's registration, resulting in exclusion from the industry. Moreover, where a fine is based on a violation of the Exchange Act, the violator will also face a panoply of private and SEC remedies.

Finally, the court noted that the NASD "[s]o far as we can tell" not tried to file actions to collect unpaid fines.  This supported an inference "that NASD believed that it lacked judicial enforcement power."   Moreover, this "longstanding reliance" on other methods of enforcement was known to Congress and Congress "left that reliance unaltered."

We will critique this analysis in the next post. 


Judicial Limitations on Investor Protection: Fiero v. FINRA (Part 2)

We are examining Fiero v. Financial Industry Regulatory Authority, 2011 U.S. App. LEXIS 20173 (2nd Cir. Sept. 29, 2011), the recent decision by the 2nd Circuit that concluded FINRA lacked the authority to file an action to collect fines imposed on members. 

FINRA has the authority to impose fines on members.  See Section 15A of the Exchange Act, 15 USC §78o-1.  Section 15A was added to the Exchange Act in 1938 as part of the Maloney Act, an attempt to address the over-the-counter market.  The provision provided that member organizations could register with the SEC if they met the requirements of the statute.  These included requirements that: 

  • its members and persons associated with its members shall be appropriately disciplined for violation of any provision of this title, . . . or the rules of the association, by expulsion, suspension, limitation of activities, functions, and operations, fine, censure, being suspended or barred from being associated with a member, or any other fitting sanction.

To the extent imposing a fine, the member can appeal to the SEC, 15 USC  §78s(d), and from there to the US Court of Appeals.  See 15 USC  §78y. Only one organization registered, the NASD.  See In re NASD, 5 SEC 627 (1939).  The approval was apparently not controversial.  See Id. ("After due notice a public hearing was held before the full Commission on August 1, 1939 on said application. No one appeared except representatives of the applicant and counsel to the Commission."). 

In Fiero, the NASD imposed a fine on a member.  The member did not appeal the action to the Commission.  See FINRA v. Fiero, 853 NYS 2d 267 (NY 2008).  The member, however, refused to pay the amount and FINRA brought an action in state court to collect the amount.  The action was, however, ultimately dismissed.  The state court found that the matter involved an action under the Exchange Act.  Because Section 27 vested exclusive jurisdiction in federal courts, state courts lacked subject matter jurisdiction.  See FINRA v. Fiero, 853 NYS 2d 267 (NY 2008). 

The member then brought an action seeking declaratory relief in federal court arguing that FINRA had no authority to collect fines through a judicial proceeding.  The district court declined to provide the requested relief.  On appeal, however, the Second Circuit sided with the member.  While Section 15A permitted the imposition of fines, it did not provide “express statutory authority for SRO's to bring judicial actions to enforce the collection of fines.”  In arriving at the decision, the court relied on the intent of Congress in adopting Section 15A. 

We will examine the analysis in the next post.


Judicial Limitations on Investor Protection: Fiero v. FINRA (Part 1)

We have noted on this blog before that one of the most significant impediments to investor and shareholder protection will come from the courts.  

In some respects, this includes the Delaware courts.  While they have always been management friendly, this has become more pronounced in recent years.  The days of shareholder victories such as Van Gorkom or not complete losses such as Unocal are long over, replaced by the likes of Disney and Airgas.  But the Delaware courts are simply engaging in a variation on an expected theme.

The federal courts, however, have been the most significant proponents of this approach.  The Supreme Court has, for example, stretched credible analysis in an effort to pin pack Rule 10b-5.  Certainly the recent decision in Janus fits into that category. 

Similarly, the DC Circuit's decision in Business Roundtable is not justifiable based upon the precedent.  While it may have been possible to write a narrow opinion to strike down Rule 14a-11, the court did nothing of the kind.  It chose: to second guess the studies used by the SEC, to require the SEC to assume legal violations then assess the costs, and to apply, during a cost benefit analysis, fiduciary duty standards that appear inconsistent with state law.  For more on this decision, see Shareholder Access an Uneconomic Economic Analysis:  Business Roundtable v. SEC.

The most recent addition to this approach is Fiero v. FINRA.  In what has to be viewed as a surprising decision, the Second Circuit decided that FINRA, which has the authority to assess fines, does not have the authority to collect them. 

The case is not necessarily wrong.  The language in the statute concerning FINRA's right to bring an action to collect unpaid fines is ambiguous.  But the analysis used by the Second Circuit suggests that the outcome was driven more by a desire to pin pack the authority of FINRA than to ascertain the real intent of Congress.  This can be seen from the analysis used by the court in reaching the unexpected conclusion. 

The case has broad potential implications.  It raises questions about the role of SROs in the enforcement of the federal securities laws.  We will spend the next few posts looking at the case and examining the reasoning used by the Second Circuit. 


The Changing Regulatory Role of the SROs

Self regulatory organizations play an important role with respect to corporate governance.  Primarily through the mechanism of listing standards, they impose a number of requirements on pubic companies, whether the need for certain board committees or the requirement that a majority of the board consist of independent directors.

The main SROs in the governance area are the NYSE, Nasdaq, and FINRA.  The NYSE and Nasdaq are "for profit" organizations, while FINRA is a Delaware non-profit.  The structure matters.  As for profit companies, the two exchanges have both a legal duty to profit maximize on behalf of shareholders and a legal duty to protect the securities markets, primarily by enforcing listing standards and other legal requirements. 

We note this in part because the courts are having to wrestle with the consequence of the change in status of the SROs.  Courts have traditionally given SROs immunity for actions taken as part of their regulatory function.  See California Public Employees' Retirement System v. NYSE, 503 F.3d 89 (2nd Cir. 2007) (written by Judge Sotomayor).  In the pre-profit maximization era, most of what the SROs did was regulatory.  As a result, the approach translated into a complete immunity from private law suits. 

With the advent of for profit activity, however, the two exchanges are more likely to engage in activity designed to promote commercial rather than regulatory activity.  The result has been a greater struggle by the courts to decide when immunity applies and when it does not.  Thus in Weissman v. NASD, 500 F.3d 1293 (11th Cir. 2007) (en banc) (a case involving activity by Nasdaq, then owned by the NASD), the court allowed a case against an SRO to go forward. 

All of this brings us to Standard Investment Chartered v. NASD, 637 F.3d 112 (2nd Cir. 2011).  The case arose out of the merger between the NASD and the broker-dealer regulatory function of the NYSE.  Plaintiff challenged the proxy solicitation involving a bylaw amendment.  The change was necessarily to effectuate the merger.

The court noted that the merger was a regulatory function and entitled to immunity.  The proxy solicitation, however, was "incidental" to the regulatory function. As the court reasoned:

  • The question confronting the court, however, was whether the proxy solicitation regarding amendments to the bylaws, which was incident to the consolidation, also constituted an exercise of NASD's regulatory function. On this point, the district court explained that, "[a]lthough the shareholder vote for which the proxy statement  was issued did not constitute a vote on the regulatory consolidation itself, the approval of the by-law amendments was not only a necessary prerequisite to the completion of that consolidation, but also was promoted as such in the proxy itself." Id. The district court further noted that "amendment of the by-laws itself falls within the parameters of NASD's statutory rule-making authority." Accordingly, as the district court correctly concluded, the proxy solicitation, which was the only vehicle available to NASD for amending its bylaws, was plainly "incident to the exercise of regulatory power," sand therefore an activity to which immunity attached.

The court emphasized that regulatory role of the SEC in the process.

  • We also believe that it is significant that  NASD cannot alter its bylaws without approval from the SEC, that the SEC is authorized to develop its own procedure for receiving input on new rules from those affected by any proposed changes, . . . and that the SEC retains discretion to amend the rules of any SRO, . . . The statutory and regulatory framework highlights to us the extent to which an SRO's bylaws are intimately intertwined with the regulatory powers delegated to SROs by the SEC and underscore our conviction that immunity attaches to the proxy solicitation here.

While the court emphasized the broad role of the Commission, the test itself ("incident to the exercise of regulatory power") did not seem to require it.  Thus, the court's analysis was narrow but the test actually adopted was very broad.  The test will make it even more difficult for courts to separate regulatory from non-regulatory actions. 

The Supreme Court may get an opportunity to weigh in on the matter.  Plaintiffs in the case have filed for cert.  The issue is:

  • Are SROs entitled to absolute immunity for unlawful conduct that is ‘‘incident to’’ their regulatory powers but does not involve performance of any regulatory duty on behalf of the government.

Whether or not the Court takes the case, the issue will continue to surface.  It may well provide another reason why some of the SROs (the stock exchanges, for example), ought to reconsider their role as regulators.      


The Declining Regulatory Role of the Stock Exchanges 

The NYSE is a for profit public company.  It has had that status since 2006.  See Exchange Act Release No. 53382 (Feb. 27, 2006).  As with all for profit corporations, the board has traditional fiduciary obligations that require it to act in the best interests of shareholders and to maximize profits.  At the same time, however, the NYSE retains a regulatory function.  At the moment of demutalization, the Exchange was responsible for broker-dealer oversight, surveillance, and listing standards, among other things.

The need to profit maximize potentially conflicts with the regulatory function.  Delisting a company or evicting a broker might adversely affect profits.  Both the SEC and the NYSE were aware of this tension at the time of demutalization.  One possibility would have been to remove all regulatory functions from the exchange, perhaps transferring them to the SEC or another self regulatory model.  Some countries have done this.  The other possibility, and the one ultimately selected, was the retnetion of regulatory responsibilities but with creation of a separate body within the NYSE designed to insulate the function from the profit making motives of the holding company. 

This was done through the creation of NYSE Regulation, a New York non-proft.  Although a subsidiary, , all directors on NYSE Regulation must be "independent" of the holding company's management.  While directors of the holding company can sit on the NYSE Regulate board, they must remain a minority of the board.  (Two of the eight directors of NYSE Regulation are also directors on the holding company).  The CEO of NYSE Regulation reports only to that board.  These requirements are ensconced in the bylaws of NYSE Regulation. 

Despite these prophylactic measures, some commentators at the time of demutalization remained concerned that the for-profit structure was inconsistent with regulatory functions.  A commentator raised concern about funding, questioning "whether NYSE Regulation will have to generate sufficient sanctions and penalties to fund its own operations, or, alternatively, whether NYSE Group and New York Stock Exchange LLC will be willing to adequately fund NYSE Regulation's expenses without regard to the impact on NYSE Group's 'bottom line.'"  Exchange Act Release No. 53382 (Feb. 27, 2006).

Nonetheless, the Commission allowed the NYSE to retain its regulatory function.  Since then, however, the NYSE has given up its regulatory functions at a rapid pace.  The merger between the NASD and the NYSE broker-dealer oversight function saw the consolidation of member regulation in the hands of FINRA.  See Exchange Act Release No.  56148 (July 26, 2007).  The transaction left the NYSE with some modest broker-dealer oversight responsibilities (mostly enforcement of NYSE only rules), surveillance responsibilities, and oversight of listing standards.  See Id. n. 13 ("Following the closing of the Transaction, NYSE Regulation will continue to oversee market surveillance and listed company compliance at the NYSE and NYSE Arca."). 

The next shoe to drop was the transfer of surveillance functions to FINRA.  In a press release dated May 4. 2010, FINRA and the NYSE announced that FINRA would assume "responsibility for performing the market surveillance and enforcement functions currently conducted by NYSE Regulation."  There was a compelling logic to the decision.  With much of the trading of NYSE stocks taking place off the exchange, surveillance by the NYSE of its own activities was capturing less and less of the market.

Nonetheless, the reality is that the latest transfer (once approved by the Commission) leaves that NYSE with only one significant regulatory function:  Listing standards.  Listing standards are critical components of the governance process.  Indeed, the market reforms likely to emerge from Congress will continue to use listing standards as a way of strengthening governance, particularly with respect to compensation committees of the board.

The time has come to reconsider whether the NYSE ought to spin off this remaining regulatory function.   How might that come to pass?  Perhaps the functions could be transferred to the Commission.  Indeed, this process is already underway.  In the financial reform legislation, the Commission is largely given the authority to define critical terms such as independent director (for the compensation committee) and independent compensation consultant.  In other words, listing standards will increasingly be written not by the NYSE but by the Commission.

The NYSE is a for profit company.  It deserves to engage in profit making activities without the constraints of regulatory obligations that can conflict with this goal.  


Deregulation and the Declining Competitiveness of US Stockmarkets

The Economist reported on a study by Grant Thornton about a decline in US securities markets.  The Study, A Wake-up Call for America, is here

It seems that as the number of listed companies decline, replacements are few and far between.  The lack of replacements comes from an IPO market that has yet to revive in any significant matter.  The reasons for the decline?  Not SOX, as much as some would like to believe. 

Instead, the problem can be traced to deregulation that encouraged "high-frequency" trading that largely ignores smaller public companies.  As the Economist described:

  • The slide in listings began in the mid-1990s, at around the time that America saw an array of regulatory changes designed to advance high-speed, low-cost trading, such as the introduction of online brokerages and new order-handling rules. An accidental victim of this technological revolution, the report says, was the ecosystem that helped bring small firms to market and then nourished them once there. “It’s a bargain-basement market today,” says David Weild, a co-author of the report. “You get what you pay for, and that’s nothing but trade execution.”     
  • The “high-frequency” traders who have come to dominate stockmarkets with their computer-driven strategies pay less attention to small firms, preferring to jump in and out of larger, more liquid shares. Institutional investors, wary of being stuck in an illiquid part of the market, are increasingly following them.
And, in the end, what does Grant Thornton recommend?  More, not less, regulation.
  • More is needed to stop the precipitous listings decline, argues Grant Thornton. It proposes a twofold solution: the establishment of a new market segment without automated trade execution but with fixed trading commissions, some of which would be used to fund research; and looser rules governing institutional investment in pre-IPO companies. Such upheaval would be controversial. But something dramatic may be needed if America wants to retain its stockmarket hegemony.

SOX and Protecting the NYSE from Itself

We haven't heard any good SOX bashing lately, particulary in an era when the need for more rather than less regulation of corporate governance is the order of the day.  Nonetheless, we were treated to a dose of criticism by Duncan Niederauer, the CEO of the NYSE.  After discussing the delisting of the insurance giant, Allianz, and conceding that the company went home because of deeper, more liquid markets, he turned his sights on SOX.

  • The bad news, according to Mr. Niederauer, is that while Allianz had some legitimate reasons to delist, the 2002 Sarbanes-Oxley law may very well have been the nail in the coffin. The act—which increased the reporting burden on companies—is "one of the things that has made us less competitive," and "hurt the U.S. capital markets competitiveness."
  • How so? He says some companies "use it as a differentiator because they don't have a strong reputation and don't come from markets with solid regulatory oversight." But "I'm afraid in the case of companies like Allianz, it's a drag," because complying with Sarbanes-Oxley ends up costing companies a lot of money. It is worth noting, he adds, that though five Russian companies are listed in New York, not one has been added since 2004.

There are several observations to make about this comment.  First, Allianz is a very large company, with 703 billion euros under management.  Could it really be the case that a company this large decided to delist because of the marginal costs associated with SOX?  Highly unlikely.

Second, Niederaus notes in his own remarks that 70 Chinese companies have listed on the NYSE.  These companies did not have to turn to the NYSE.  If they merely wanted a presence outside of China, they could have listed on the London Stock Exchange (LSE).  One reason they likely chose to list in the US is that the NYSE has a much tougher set of corporate disclosure and corporate governance requirements.  Because of these stricter requirements, investors in China know that companies listing on the NYSE are the best and safest.  As a result, they attract more investors and their share prices undergo a commensurate increase.  It has long been empirically demonstrated that foreign companies listing in their home market and on the NYSE see a statistically significant increase in share prices.  The same is not true for the LSE. 

In other words, SOX helped the NYSE get those 70 Chinese companies.  Regulations can go too far but in this case, the US (and the NYSE) benefited from the higher bar rather than the lower one that Niederauer seems to want.

Broker Non-Voting and the SEC: The Next Steps

With Rule 452 amended, are matters finished?  Not exactly. 

First, the rule applies to members of the NYSE.  Brokers that are not subject to the requirement are outside the rule's boundaries.  That means that brokers who hold shares for NYSE or Nasdaq companies but are not members of the NYSE (only members of FINRA) can vote in uncontested elections (or on any other matter).  The only limits are those imposed by state law.  As a result, management may still receive in each election a block of discretionary votes.  Having said that, it is likely that most discretionary votes are in the hands of NYSE brokers.  Moreover, non-NYSE brokers may follow Rule 452 anyway as a sort of safe harbor.

Second, the Rule continues to regulate discretionary voting in the negative.  There is no definition of routine.  Instead, there are 18 categories of non-routine and one catch-all category.  The catch-all provides:  

  • the person in the member organization giving or authorizing the giving of the proxy has no knowledge of any contest as to the action to be taken at the meeting and provided such action is adequately disclosed to stockholders and does not include authorization for a merger, consolidation of any matter which may affect substantially the rights or privileges of such stock.

In other words, a proposal that has the potential to substantially affect the rights or privileges of stock would be included. 

Notwithstanding the list, the NYSE will note each matter that is or is not subject to discretionary voting in the weekly bulletin.  See Rule 452.11 (“When member organization may not vote without customer instructions.—In the list of meetings of stockholders appearing in the Weekly Bulletin, after proxy material has been reviewed by the Exchange, each meeting will be designated by an appropriate symbol to indicate either (a) that members may vote a proxy without instructions of beneficial owners, (b) that members may not vote specific matters on the proxy, or (c) that members may not vote the entire proxy."). 

This places extraordinary discretion in the hands of the NYSE in determining when discretionary votes can be cast.  Indeed, the NYSE has been criticized on occasion for its exercise of discretion in this area.  See Amy Goodman & John Olson, A practical guide to SEC proxy and compensation rules, at 12.3[1], n. 21 (2001).

Rule 452 should be amended to reverse the presumption.  All matters submitted to shareholders should be deemed non-routine, with discretionary voting not allowed.  Only if specifically listed as routine would discretionary voting be permitted (approval of the auditor, etc.).  This will reduce the discretion of the NYSE and ensure that shareholders and investors are aware of the matters considered routine.  It will put on public display the matters that brokers can influence with their discretionary votes, making the system more transparent.

The amendment to Rule 452 adopted by the Commission is a start but there is a long way yet to go.


The Constitutionality of the PCAOB Goes to the Supreme Court

The Supreme Court has agreed to hear the case arguing against the constitutionality of the PCAOB.  The case raises issues about the limits that can be imposed on presidential removal authority for officials in the executive branch.  The PCAOB members can only be removed for cause by the Securities and Exchange Commission.  As a result, there is a double layer of removal restrictions, not something unheard of but the first time it has been raised so explicitly before the Supreme Court.  The PCAOB was a unique organization created with the intent of melding together private market sensibilities and government regulation.  Thus, the organization is a non-profit that pays private sector salaries but is overseen by the SEC. 

To the extent that the PCAOB is struck down (and there is reason to believe the conservative majority will do so), it will ironically eliminate an experiment with a more market driven form of regulation.  The PCAOB can instead be transformed into a full blown independent agency or a division of the SEC, something one would ordinarily think the plaintiffs in the case would eschew.


Nasdaq Listing Requirements Suspension Continued, Joined by NYSE

We wrote on Feb 4th that Nasdaq received an extension of its request to suspend the one dollar minimum listing standards until April 19th. That request has now been extended through July 19, 2009, and the NYSE filed a proposed rule to adopt a similar suspension until June 30.


The rule to be suspended requires that if a security fails to have a closing bid price of at least one dollar for 30 consecutive business days, it is considered deficient and given a 180-day period to regain compliance. Under the suspension, both the 30-day period and the 180-day period are held in abeyance until the suspension is ended.


In addition to suspending the dollar bid value requirement, the NYSE previously suspended its average global market capitalization listing requirement that companies not fall below $15 million for 30 consecutive days. This rule suspension was to have expired April 22, but is now proposed to be extended to June 30, corresponding to the dollar value suspension.


These requests for continued suspension of the listing standard are not surprising. The suspension is immediately effective and is certain to be approved as markets continue to be in “unprecedented turmoil.”


Nasdaq Listing Requirements Suspended Until (at least) April

Last October Nasdaq requested that the SEC allow it to suspend the listing requirement that requires companies to have a minimum bid price of $1. Nasdaq rules classify a security as “deficient” if it has a closing bid price of less than $1 for thirty consecutive business days. Once deficient, issuers have an automatic180 day period to regain compliance by having a closing bid price of at least $1 for ten consecutive business days, and can receive an additional 180 days if all other listing requirements are met. According to the Nasdaq proposal to the SEC, by October 9, 2008 there were 344 securities trading below $1, and another 300 securities trading between $1 and $2, up from 64 securities below $1 at the end of September.


The SEC agreed with Nasdaq’s assessment that this drop in bid price was not a result of a “fundamental change in the underlying business model or prospects” for these companies, but was a result of “decline in general investor confidence,” and that these companies remain “suitable for continued listing.” Since the proposed rule change would not endanger investors or burden competition and was in the best public interest, the SEC waived the 30-day operative delay between receipt of the proposal and its implementation. The rule suspension became immediately effective on October 16, 2008 and was to expire January 16, 2009.


The effect of the rule suspension is not only to ignore share bid price in determining whether a listing deficiency exists, but also to suspend calculating the 180-day recovery period for any security that was deficient before October 16. If a company’s security was 150 days into its initial deficiency period at October 16, the company would have 30 days after January 16th to recover or seek an additional 180-day extension.


On Dec 18, 2008, Nasdaq requested an extension of the rule suspension to April 19, 2009, noting that “extraordinary” market conditions continue. (As of January 30, 2009, there were 430 shares listed on Nasdaq for $1 or less.) Unlike the first proposal, for which the SEC waived the 30-day operative delay, there is time for the SEC to publish this rule for notice and comment. The initial proposal was published post-approval, and received one supportive comment.  One blogger suggests that the rule be permanently eliminated as a way to discourage companies from doing a reverse stock split merely to meet the listing requirement.  Comments must be submitted to the SEC referencing File Number SR-NASDAQ-2008-009 on or before February 5, 2009.


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Wachovia and the Issue of Adequate Enforcement of Listing Standards by the Stock Exchange (Part 2)

Wachovia agreed to lock the transaction on behalf of Wells Fargo by turning over 40% of the Bank's voting power to the purchaser (by issuing ten shares of supervoting stock, perhaps a new record for the number of votes per share).  With that percentage, Wells Fargo need not worry about any other suitor swooping in and making a better offer.  We have no trouble understanding why Wells Fargo would want the shares and assume that the Wachovia Board issued them in a manner consistent with its fiduciary obligations.  Watching financial institutions drop like stones, the Wachovia Board managed to work out a deal with Wells Fargo that saved some value for its shareholders.

The more problematic part of this, however, is the decision to dispense with shareholder approval and its approval by the NYSE.  The two banks could have avoided the need for a dispensation had Wachovia issued less than 20% of its voting shares, a still formidable percentage that would likely have locked up the transaction for Wells Fargo.  But instead, by going above 20%, Wachovia triggered the obligation to obtain shareholder approval imposed by the NYSE.

There will be no shareholder approval, however.  The NYSE in lightning quick fashion approved the setting aside of the vote, needing only days (perhaps a single day) to do so.  Apparently, the Exchange determined that the delay "would seriously jeopardize the financial viability of the enterprise".  Exactly how was that the case?  No one doubts the importance of Wachovia's need for a rescuer.  But there did not seem to be a shortage of suitors, with Wells Fargo and Citgroup vying for control of the financial institution.  The issuance of the preferred stock seems less likely to have been necessary to induce Wells Fargo to enter the fray than it was to prevent Citigroup from making a competing offer.  In other words, the decision by the NYSE to set aside shareholder approval wasn't about "financial viability" but about allowing Wachovia to favor one side over the other.  

The decision seems questionable on other grounds.  First, there was in fact time to get shareholder approval since shareholders still have to vote on the merger.  Second, the transaction could have been structured to avoid the need for a vote.  Had Wachovia issued less than 20% of the voting shares of the company, the voting issue would have been avoided.  

It is possible that the NYSE weighed all of the facts and concluded that waiver of the requirement was necessary for reasons of financial viability.  It is also possible that the NYSE takes a very broad view of the exclusion, one that allows issuers to dispense with shareholder votes whenever management wants to issue a lock up percentage of shares.  

The central problem is that the NYSE is enforcing a legal requirement (listing standards) but as a for profit company not subject to government transparency requirements (the FOIA, for example), it does so in secrecy with little opportunity for transparency.  The public has no real opportunity to learn the reasons for the decision or to study the patterns to try to determine the true motivation for the decision, something particularly important given the for-profit nature of the business.  If the NYSE is going to stay in the regulatory business, its decisions ought to be subject to transparency requirements.  The decisions to set aside listing standards, particulary those that protect shareholders, and the process by which the decision was reached, should become public, allowing investors to know how often and when the NYSE will set aside the requirement.  Either the Exchange should voluntarily do so or it should be required by federal legislation.


Wachovia and the Issue of Adequate Enforcement of Listing Standards by the Stock Exchange (Part 1)

The WSJ contained a somewhat confusing article indicating that Wachovia would not submit its "deal to be acquired" by Wells Fargo to shareholders "because delaying the transaction to get shareholder approval would seriously jeopardize the financial viability of the bank." The article also noted that the NYSE has approved the decision to cancel the shareholder vote.

The problem with the article is that the "deal to be acquired" is a merger. The merger agreement is here. Neither Wachovia nor the NYSE has the authority to waive shareholder approval of a merger. So what's going on?

It turns out that what Wachovia wanted was to avoid shareholder approval of a lock up option issued to Wells Fargo. Under theShare Exchange Agreement filed on Thursday, Wachovia agreed to issue Class M preferred stock to Wells Fargo representing approximately 40% of the target company's voting power. Under the rules of the NYSE, shareholders must approve the transaction. Rule 312.03(c) provides that shareholders must approve the issuance of 20% or more of the voting power of a company. The rules contain exceptions. Rule 312.05 provides that approval is not necessary where, upon application to the Exchange, the "delay in securing stockholder approval would seriously jeopardize the financial viability of the enterprise" and the decision to invoke the exception has been "expressly approved by the Audit Committee of the Board."

It is this exception that Wachovia is invoking. The Bank filed a current report on Form 8-K on Friday announcing that it would invoke the exception. As the Company explained in a letter to shareholders:

  • Simultaneously and in connection with the entry into the Merger Agreement, Wachovia and Wells Fargo also entered into a Share Exchange Agreement (the “Share Exchange Agreement”), pursuant to which Wachovia will issue and sell 10 shares of Series M, Class A Preferred Stock, no par value, of Wachovia, which shares will represent in the aggregate approximately 39.9% of the voting power of Wachovia’s outstanding voting securities after giving effect to the issuance, in exchange for 1,000 shares of Wells Fargo common stock and the entry by Wells Fargo into the Merger Agreement.

What was the purpose of the transaction? To lock up the deal for Wells Fargo. As the letter to shareholders explained, "The share issuance and exchange contemplated by the Share Exchange Agreement was a necessary condition to Wachovia’s ability to obtain the benefits of the Merger Agreement, which in turn were essential to maintaining Wachovia’s financial stability."

The letter also explained that there would be no shareholder approval despite the apparent requirements of the NYSE. This was because "the Audit Committee of Wachovia’s Board of Directors unanimously determined that the delay necessary in securing shareholder approval prior to the issuance of the preferred stock to Wells Fargo would seriously jeopardize the financial viability of Wachovia and has expressly approved the reliance by Wachovia on the exception under Para. 312.05 of the NYSE Listed Company Manual." The letter listed various factors that were considered in reaching the decision, "including factors specific to Wachovia, the extraordinary and highly uncertain economic, financial and political environment and the experience of other financial institutions."

Finally, the letter noted that "The Exchange has accepted Wachovia’s application of the exception." It is this last item that requires more consideration. We will discuss this in the next post.


NYSE and NASDAQ to Change Director Independence Standards

Last month the SEC approved a proposal by NASDAQ to change the definition of director independence. The NYSE is seeking approval for an identical change to its independence tests, which is still in the comment phase. While the rule change does not significantly alter independence requirements, we follow all developments in this area with great interest.

NASDAQ Rule 4200(a)(15)(B) and NYSE Rule 303A.02 previously disqualified any director from being considered independent who received, or had an immediate family member who received, over one hundred thousand dollars in compensation from the company during any twelve month period in the last three years. The new rules adopted by the exchanges increases this threshold amount to one hundred twenty thousand dollars. The SEC notes in its releases that this is the same amount requiring disclosure of a single transaction between a director and the company under Reg. S-K, Item 404.

The NYSE has also requested a change to the independence test for a director’s relationship to the company’s outside auditor. The current NYSE standard disqualifies a director from being considered independent if the company’s external auditor employs an immediate family member of the director. This applies even if the family member has never worked on an audit of the company. The NYSE is requesting a new test that only includes family members that are partners of the company’s outside auditor or have worked on the company’s audit during the past three years.

Both SEC releases are available on the DU Corporate Governance web site.


Fannie Mae, Freddie Mac and the Problem of Assigning Government Regulation to "For Profit" Businesses

The government has seized control of Fannie Mae and Freddie Mac, with both having gotten themselves into serious financial trouble during the current crisis in the financial markets.   The decision by the government to seize control of Fannie Mae and Freddie Mac eliminates an uncomfortable fiction.  The two companies were garbed in private sector clothing, with shareholders, boards of directors and, most critically, an obligation to profit maximize. 

Lets take a look at the proxy statement for Fannie Mae.  The directors weren't paid at Goldman Sachs rates, but they did do nicely.  In 2007, the Fannie Mae board met 22 times. See 2007 Proxy Statement , at 23 ("The Board of Directors met 22 times during 2007. During 2007, each of our current directors attended at least 75% of the total number of meetings of the Board of Directors and Board committees on which he or she served.").  They  earned, in general, somewhere in the vicinity of $200,000 each.  Admittedly, they had to work harder for the pay than most other boards.

2007 Non-Employee Director Compensation Table
    Fees Earned or
  All Other
  Paid in Cash ($)(1)   Awards ($)(2)   Awards ($)(3)   Compensation ($)(4)   Total ($)
Stephen B. Ashley
  $ 500,000     $ 21,802     $ 17,732     $ 20,125     $ 559,659  
Dennis R. Beresford
    138,300       13,980             40,115       192,395  
Kenneth M. Duberstein(5)
    17,100       (26,090 )     24,762       413,327       429,099  
Louis J. Freeh
    57,833                   17,099       74,932  
Brenda J. Gaines
    109,567       20,317             20,209       150,093  
Karen N. Horn
    132,500       20,317             27,732       180,549  
Bridget A. Macaskill
    110,500       8,595             21,303       140,398  
Joe K. Pickett(5)
    119,500       21,802       17,732       15,889       174,923  
Leslie Rahl
    127,800       22,510       17,732       20,310       188,352  
John C. Sites, Jr. 
    23,833                   19,014       42,847  
Greg C. Smith
    136,300       32,926       2,491       20,209       191,926  
H. Patrick Swygert
    117,100       21,802       17,732       39,549       196,183  
John K. Wulff
    129,800       18,253       9,038       25,052       182,143  

So the directors won't paid excessively by public company standards but they were certainly well paid by government standards.  How about the CEO of the company?  How well was he paid?  Total compensation was over $12 million, with almost a million in salary, $2.2 million in "performance" bonus and $9 million in long term incentive awards. 

Compensation Paid or Granted for 2007
                Total of 2007
  Total of 2006
                Base Salary,
  Base Salary,
                Bonus and
  Bonus and
        2007 Annual
  2007 Long-Term
    Base Salary as
  % Change
Named Executive
  of 12/31/07(1)   Plan Bonus   Award(2)   Stock Award   Stock Award   from 2006
Daniel Mudd
  $ 990,000     $ 2,227,500     $ 9,000,000     $ 12,217,500     $ 14,449,947       (15.4 )%
Stephen Swad(3)
    650,000       955,500       3,200,000       4,805,500             N/A  
Robert Blakely(4)
    663,000       1,113,840             1,776,840       5,239,936       N/A  
Robert Levin
    788,000       1,477,500       6,200,000       8,465,500       9,504,354       (10.9 )
Peter Niculescu
    585,000       889,199       2,625,000       4,099,199       4,408,982       (7.0 )
Michael Williams
    676,000       1,189,760       4,784,000       6,649,760       7,527,643       (11.7 )

In other words, Fannie Mae (and presumably Freddie Mac) were set up with all of the flaws associated with Delaware corporations.  The directors received lucrative amounts and so did the top officers they were responsible for supervising.  At the same time, the financial giants had an incentive to maximize short term profits for shareholders, something that no doubt contributed to the decision, as the WSJ descirbed, to "expand[] their exposure to riskier loans."  In other words, while some government responsibilities can be offloaded to the private sector and improved with a healthy dose of profit maximizing behavior, some cannot.  This is one of them.  

Are there other entities garbed with regulatory or public sector responsibilities that are now engaging in profit maximizing behavior?  Nasdaq and the NYSE.  


Self Regulation and Insider Trading

Self regulation predates the adoption of the securities laws and has long been a component of the system of oversight for the capital markets.  There has always been problems with the approach, most noticeably concerns over adequate enforcement.  Particularly with respect to the exchanges, there has been the potential of capture by the industry being regulated and the possibility that requirements designed to protect investors would remain unenforced.  The SEC's actions against the the Boston Stock Exchange for failing to police the activities of the specialists is a good example.

The problems have only been exacerbated in recent years.  Nasdaq and the NYSE have tranformed into "for profit" organizations.  As a result, they have the additional burden of profit maximization, something that did not exist before.  Profit maximization and strong enforcement do not always go hand in hand.  As a result of this change, pressure has already been brought to bear to weaken aspects of exchange behavior designed to protect investors. 

The NYSE reduced its regulatory role when it transferred broker-dealer oversight to FINRA.  Nonetheless, the exchanges retain two important regulatory aspects.  They retain the authority to write and enforce listing standards.  In addition, they retain market surveillance functions.

The Commission recently took steps to centralize the monitoring function.  In Exchange Act Release No. 58350 (August 13, 2008), it approved a plan to centralize "surveillance, investigation, and enforcement of common insider trading rules" in the hands of the NYSE and FINRA.  The NYSE gets responsibility for companies traded on its exchange, all the rest fall to FINRA.  In short, this approach removes surveillance functions from all other exchanges, including Nasdaq and the Amex.  All of the participating entities have entered into a cost sharing arrangement and have agreed to meet periodically "to discuss the conduct of regulatory responsibilities, identify issue or concerns, and receive and review reports." 

There are several interesting observations to make about this approach.  Centralization has its benefits, including the concentration of resources and improved expertise.  But of great interest, the SEC has effectively removed most of the surveillance function from entities that operate on a for profit basis, having transferred much of the surveillance function to FINRA, a private, non-profit organization.  That leaves Nasdaq and the Amex with little more than enforcement of listing standards as the exclusive regulatory function.

The NYSE becomes the only "for profit" organization to continue to have surveillance functions.  In any for profit organization, pressure always exists to cut overhead (and increase profits), with surveillance falling into the overhead category.  It may well be the case that the NYSE will eventually give up the surveillance function, allowing FINRA to do all of it.  This is in fact what happened with broker-dealer oversight, a function already moved from the NYSE to FINRA.

This will leave the "for profit" exchanges with one primary regulatory function, the drafting and enforcement of listing standards.  This is another area that may suffer in a "for profit" environment.


Henry Paulson and the Self Regulatory Organizations

Henry Paulson, the Secretary of the Treasury, has built much of his tenure around the them of excessive regulation.  His preference is for the market to solve matters.  Yet the current crisis has demonstrated the failings of the market and put pressure on him to devise a regulatory correction.  He is having a hard time philosophically coming to terms with this new approach. 

One example concerns his treatment of self regulatory organizations. While Paulson usually refers to SROs generically, he seems most concern with the stock exchanges (NYSE-Euronext and Nasdaq).  His proposals calls for the streamlining of SEC approval of SRO rule changes, with some becoming effective upon filing.  As the summary notes:

  • The SEC should issue a rule to update and streamline the self-regulatory organization (“SRO”) rulemaking process to recognize the market and product innovations of the past two decades. The SEC should consider streamlining and expediting the SRO rule approval process, including a firm time limit for the SEC to publish SRO rule filings and more clearly defining and expanding the type of rules deemed effective upon filing, including trading rules and administrative rules. The SEC should also consider streamlining the approval for any securities products common to the marketplace as the agency did in a 1998 rulemaking vis-à-vis certain derivatives securities products. An updated, streamlined, and expedited approval process will allow U.S. securities firms to remain competitive with the over-the-counter markets and international institutions and increase product innovation and investor choice.

There is no question that the exchanges, both of which are for profit companies, face competitive pressures.  There is also no doubt that they would like the right to act more quickly in the face of changed competitive circumstances. 

But if the exchanges want to act like profit making entities, they should receive the responsibilities that come with it.  For all of the difficulty or delay associated with regulatory approval, the exchanges receiveimmunity from lawsuits for anything done pursuant to their regulatory mission. 

The exchanges have reduced their regulatory role, particularly in the aftermath of the NYSE merging its broker-dealer oversight role into the NASD (now FINRA).  Perhaps the future for the exchanges ought to be that they exist the regulatory function entirely.  They would benefit competitively by reducing regulatory oversight but would likewise be subject to the market disciplining process, including law suits for wrongful behavior.