NYSE, Bear Stearns and Concerns About Lax Enforcement

We have noted numerous times that the for profit status of the NYSE (and Nasdaq) creates an disincentive to rigorously enforce its rules, including listing standards.  It is not a phenomena limited to the US, as we noted in a post about the Nordic Stock Exchange.

With JP Morgan Chase raising its offering price for Bear Stearns from $2 to $10, it received the right to buy 39.5% of Bear Stearn's shares, effectively locking up the deal.  It so happens that the NYSE has a rule requiring shareholder approval anytime the company issues more than 20% of its shares.  As Rule 312.03 of the NYSE Manual provides:

• (c) Shareholder approval is required prior to the issuance of common stock, or of securities convertible into or exercisable for common stock, in any transaction or series of related transactions if:
  (1) the common stock has, or will have upon issuance, voting power equal to or in excess of 20 percent of the voting power outstanding before the issuance of such stock or of securities convertible into or exercisable for common stock; or
  (2) the number of shares of common stock to be issued is, or will be upon issuance, equal to or in excess of 20 percent of the number of shares of common stock outstanding before the issuance of the common stock or of securities convertible into or exercisable for common stock.

But JP Morgan is acquiring 39.5% without shareholder approval.  The acquisition, therefore, would seem to violate the listing standards of the exchange.  Buried in theJournal article was how the bank planned to avoid the requirement -- ignore it. 

• The New York Stock Exchange, where shares of J.P. Morgan and Bear Stearns are listed, generally requires shareholders to approve an issue of new shares that are convertible into more than 20% of a listed company. Bear Stearns and J.P. Morgan said that approval isn't necessary, citing an exception for cases where "delay...would seriously jeopardize the financial viability of the listed company."

But in fact while one could argue that the JP Morgan and Bear Stearns acquisition was important to the stability of the financial markets and perhaps even the solvency of Bear Stearns, a lock up purchase of almost 40% was another matter.  Particularly with the Fed spigot open and the JP Morgan guarantee, the public case for a cash infusion involving more than 20% of Bear Stearn's shares has not been made.  Moreover, the purchases are in stark contrast to the original deal where JP Morgan obtained the right to buy 29 million shares but in no case more than 19.9% of the outstanding stock of Bear Stearns.  As theoptions agreement noted:

• Issuer hereby grants to Grantee an unconditional, irrevocable option (the "Option") to purchase, subject to the terms hereof, up to 29,000,000 fully paid and nonassessable shares of Issuer's Common Stock, par value $1.00
  per share ("Common Stock"), at a price of $2.00 per share (the "Option Price");  provided, however, that in no event shall the number of shares of Common Stock for which this Option is exercisable exceed 19.9% of the Issuer's issued and outstanding shares of Common Stock without giving effect to any shares subject to or issued pursuant to the Option. The number of shares of Common Stock that may be received upon the exercise of the Option and the Option Price are subject to adjustment as herein set forth.

In other words, at a time when the financial health of Bear Stearns was even more precarious, JP Morgan found a way to live with the 20% cap on new shares. 

At the same time, the 39% could have had a purpose unrelated to a necessary financial infusion.  The size of the purchase all but makes the agreement a sure thing.  In other words, with 39% plus any votes by Bear Stearns management, JP Morgan doesn't have to worry about an interloper coming in and making a counter offer. 

It is possible that the 39% is necessary for the financial safety of Bear Stearns.  It is also possible it is not, a point made by others.  Eyes will by on the NYSE to see if in fact the SRO takes this requirement seriously and engages in the type of due diligence necessary to determine whether in fact the rule is being violated.  To the extent it has already approved the exception, it makes a mockery out of the notion that listing standards are meaningful devices to protect the rights of shareholders, creating an argument that alternative enforcement mechanisms for these requirements should exist.       

Senator Grassley and SEC Oversight of Stock Exchanges

In a February 1, 2008, press release, Senator Charles Grassley (R-Iowa) announced that the SEC will employ greater measures to fulfill its responsibility to police self-regulatory organizations, such as the New York Stock Exchange and other financial markets.

Grassley, who is the ranking member of the Senate Finance Committee, issued his release in response to a new report on the SEC by the Government Accountability Office. The report focuses primarily on the SEC’s oversight of the various stock and options exchanges- investors’ first line of defense against market manipulation and insider trading. The report details how the commission has declined to use the audits in its oversight procedures despite that the internal audits conducted by the nation’s stock and options exchanges are the best tool that the SEC has in its battles against insider trading and market manipulation. Moreover, the report noted that the SEC investigators’ efforts to track questionable trading are hampered by a computer system that does not allow investigative referrals from the major exchanges to be searched easily and efficiently.

Grassley asked the SEC to explain why its staff has not routinely obtained and reviewed the internal audits and investigations of the organizations, and asked SEC Chairman Christopher Cox to remedy the Commission's failure to use such investigative resources provided by self-regulatory organizations as part of its work to safeguard the integrity of U.S. markets. While SEC guidance called for the organizations "to allow ‘on-site’ access to internal documents during SEC inspections," Grassley noted that this does not provide an adequate substitute. Rather, he explained that “reliance on self regulatory organizations, such as the major stock exchanges, to police their members can work effectively only if the operations of the self regulatory organizations are open and transparent." As such, Grassley urged Chairman Cox to ensure that SEC staff obtain and review internal self regulatory organization audit reports on a routine basis. "It took way too long, but now maybe the SEC is finally getting serious about its duty to oversee self-regulatory organizations,” Grassley said in the release.

Stock Exchanges, Corporate Governance, and Problems of Enforcement

One of the topics addressed often on this Blog is the role played by the stock exchanges in the corporate governance process.  It is the stock exchanges that require a majority of the board to be independent and that boards have audit, compensation and nominating committees.  But with requirements come concerns.  Particularly as the stock exchanges have converted to "for profit" businesses, with the traditional pressure (indeed fiduciary obligation) to profit maximize, concern arises with its regulatory role.  In the context of listing standards, one of the issues concerns the adequacy of enforcement, a problem that was identified as early as 1934 when Congress held hearings on the role of the NYSE.

Courts have, in the past, found that stock exchanges, because of their regulatory role, have absolute immunity from suit.  But in a for profit era, the courts are being forced to differentiate between the regulatory and non-regulatory role of the exchanges.  The most notable example so far has been the 11th Circuit's decision (en banc) in Weissman allowing a private suit to go forward against Nasdaq for allegedly misleading advertisements.  Michelle Larson, a student at the University of Denver Sturm College of Law, has a post today that examines another step in this direction, a petition for certiorari filed by Calpers in a case that will explore the immunity issue. 

The other issue concerns SEC oversight.  It is the Commission that can sanction the exchanges for failing to enforce their rules.  A second post today by JP Thibeault, examines efforts, based upon a GAO Report, to get the Commission to step up its oversight of the stock exchanges. 

CALPERS and Supreme Court Review of NYSE Immunity

On January 16, 2008, the California Public Employees’ Retirement System (CalPERS) filed a petition for writ of certiorari requesting Supreme Court review of a decision to dismiss fraud claims against the New York Stock Exchange (NYSE) based on governmental immunity. The Second Circuit’s Judge Sotomayor held that the NYSE is entitled to absolute immunity even when it abandons its quasi-governmental role as a regulator. In re: NYSE Specialists Securities Litigation (California Public Employees’ Retirement System v. New York Stock Exchange, Inc.), 503 F.3d 89 (2d Cir. 2007).

Because of the NYSE’s status as a self-regulatory organization (SRO) under the Securities Exchange Act of 1934, the SEC delegates significant authority to the NYSE to enforce trading rules and regulations. When the NYSE stands in the shoes of the SEC, the absolute immunity that shields the government entity from liability also extends to the exchange.

In the lower courts, CalPERS’ class action lawsuit contended that the exchange effectively abandoned its regulatory role when the NYSE and the specialist firms that managed trading for its listed companies acted to defraud public investors from October 17, 1998 until October 15, 2003.  Specifically, CalPERS alleged that the NYSE falsified trading records, tipped off the specialist firms to pending investigations, and worked with the specialists to hide evidence from the SEC during the class period. Petition for Writ of Certiorari at 4, California Public Employees’ Retirement System v. New York Stock Exchange, Inc., No. 07-946 (U.S. Jan. 16, 2008).

The recently filed petition asks the Supreme Court to consider whether the NYSE should be entitled to absolute immunity even when it fails to perform the regulatory function delegated to it by the SEC. CalPERS exhorts the Court to resolve what it views as the Second Circuit’s inconsistent holdings: 1) SROs are private, non-governmental actors beyond the reach of constitutional limits on governmental power; and 2) SROs are entitled to absolute immunity even when failing to perform their delegated regulatory duties.

The primary materials discussed in this post may be found at the DU Corporate Governance website.  Please see earlier posts for more on SROs.

Stock Exchanges and Director Independence

We have noted problems associated with enforcement of listing standards.  The issue comes up most clearly in the context of director independence.  The NYSE provides that directors will not be independent if they have a "material relationship with the listed company (either directly or as a partner, shareholder or officer of an organization that has a relationship with the company)."  NYSE Guide 303A.02.  According to the attached comment,

• it is best that boards making "independence" determinations broadly consider all relevant facts and circumstances. In particular, when assessing the materiality of a director's relationship with the listed company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others. However, as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.

In other words, its up to the board but the board should take into account all relevant facts and circumstances.  In addition to "material relationships," the NYSE includes a number of categorical rules that result in the payment of more than $100,000 in direct compensation from the listed company.  The $100,000 is calculated without considering "director and committee fees."   As the rule notes, this test is "in addition" to the material relationship test. 

So, under the rules, the board must first screen for material relationships, taking into account all relevant facts and circumstances.  Even where the board concludes that there is no material relationship, payments in excess of $100,000 render a director not independent.  While fees are specifically excluded from the $100,000 test, they are not specifically excluded from the material relationship portion of the definition. 

Proxy statements are full of representations that they have complied with the rules and made the requisite determinations.  See International Games 2008 Proxy Statement ("Our board of directors has made an affirmative determination that the following members of the board, constituting a majority of our directors, meet the standards for “independence” set forth in our Corporate Governance Guidelines and applicable NYSE rules.").  In making that determination, however, it is quite clear that boards do not typically consider fees when determining independence, including application of the material relationship portion. 

Some even admit it.  See Merrill Lynch 2007 proxy statement (noting that compensation "for service as a Director is not considered in making independence determinations.").   And, where there is any doubt, there's always a pass from the stock exchange.  See Owens Corning Oct. 2007 Proxy Statement  ("The New York Stock Exchange has confirmed to us that receipt of such fees should not be considered in evaluating Mr. McMonagle's independence as a director of the Company.").   

There is little question that fees can result in a material relationship, whether objectively or subjectively.  Not always of course.  But it seems clear that with respect to fees, the stock exchanges simply do not enforce the "material relationship" test.  The failure to consider fees makes the concept of independence a charade.  Moreover, it also makes a mockery of the requirement in the listing standards that independence is lost through the existence of a "material relationship with the listed company."

We understand the motivation by the NYSE for not giving sufficient content to the "material relationship" requirement.  It is, after all, a for profit company.  But what about the Commission?  The Agency has increasingly relied on independent directors to ensure the integrity of the financial disclosure process.  Why isn't the Commission making sure that directors calling themselves "independent" in fact have no material relationship with the company, including through the payment of fees?  

Weissman v. NASD (the 11th Cir. Decision)

We continue our discussion about the importance of listing standards as a source of corporate governance and the need for proper enforcement of these standards.  This has become particularly important in an era when self regulatory organizations such as stock exchanges have become for profit entities.  With a profit maximization motive, questions exist about whether stock exchanges will enforce their rules and listing standards even when it means a loss of trading revenue.  One thing that would help would be a private enforcement mechanism, either to sue the violator of the listing standard or the stock exchange for failing to enforce its own rules. 

With that in mind, we return to our analysis of Weissman v. NASD – a case that defines the limits of absolute immunity afforded to SROs for performing quasi-governmental function.  The case illustrates some of the consequences of the movement by stock exchanges to go public and the private remedies that may become available. 

On September 18, The United States Court of Appeals for the Eleventh Circuit, sitting en banc, upheld a lower court decision denying a Rule 12(b)(6) motion (failure to state a claim) made by the National Association of Securities Dealers, Inc. (NASD) and its subsidiary, NASDAQ Stock Market, Inc. (NASDAQ).  Weissman v. NASD, No. 04-13575, 2007 WL 2701308 (11th Cir. Sept. 18, 2007).  The court held that while NASDAQ enjoys absolute immunity from claims arising out of its “statutorily-delegated regulatory or disciplinary functions,” its alleged advertising activities promoting WorldCom, Inc. stock relate to private commercial conduct and as such are not afforded the same level of protection.  Id. at *14.

The present dispute arose from NASDAQ’s $100 million marketing and advertising campaign, allegedly aimed at promoting and selling WorldCom, Inc. stock, in early 2000 through 2002 (prior to the collapse of WorldCom & Enron).  Weissman claimed that during this period he purchased over 80,000 shares of WorldCom, Inc.’s stock while relying on NASDAQ’s statements regarding the credibility of WorldCom’s stock.  He asserted that NASDAQ violated Florida State law by “promoting WorldCom… without disclosing that its revenues were directly enhanced by increased trading in WorldCom stock.”  Id. at *3.

In its defense, NASDAQ insisted it was absolutely immune from suit because it served important quasi-governmental statutorily delegated regulatory functions.  Id. at *10.  Although a publicly traded company:  

• “NASDAQ serves as a self regulatory agency (SRO) within the meaning of the Exchange Act § 78(c)(26), which vests it with a variety of adjudicatory, regulatory, and prosecutorial functions, including implementing and effectuating compliance with securities laws; promulgating and enforcing rules governing the conduct of its members and listing and de-listing stock offerings.”  Id. at *6. 

In its analysis, the court stated that simply because an entity performed governmental functions, did not mean it was afforded “immunity when [it] performs non-governmental functions” – noting SEC Release No. 34-5-700, expressing concern over the growing pressures for the markets to attract order flow, and the inherent conflict between “SRO regulatory and market operations functions.”  Id. at *7.  

The court then set the standards for determining the application of absolute immunity – stating that, in the interest of justice,  “grants of immunity must be narrowly construed.”   Therefore, when an SRO is not strictly performing quasi-governmental tasks, but is instead "acting in its own interest as a private entity, absolute immunity from suit ceases to obtain.”  To determine whether an SRO is performing quasi-governmental functions, “we look to the objective nature and function of the activity for which the SRO seeks to claim immunity,” without regard for the “SRO’s subjective intent and motivation.”  Id. at *9.  

As a result, the Eleventh Circuit concluded that NASDAQ’s advertising activities alleged in this case did not serve as quasi-governmental functions, and therefore affirmed the lower court’s decision.  Id. at *14-15.

The case stands for the proposition that private parties may sometimes successfully sue a self regulatory organization when it acts in a commercial rather than quasi-governmental role.  Primary materials for this case may be found on the DU Corporate Governance website.   

Corporate Governance, Stock Exchanges and Enforcement of Listing Standards

One of the topics covered by this Blog is the role of stock exchanges in the corporate governance process.  The exchanges impose a number of important governance obligations, including the need for a board with a majority of independent directors.  These requirements apply not only to the main exchanges (NYSE, Nasdaq, and Amex), but also to the regional exchanges such as the Boston Stock Exchange. 

Listing standards, however, are only enforceable by the stock exchanges themselves, or at least so the law has held to date.  Courts have refused to imply a private right of action for violations.  Most of the cases in this area, however, have involved broker-dealer regulation and not listing standards.  Whether courts would treat listing standards required under the Exchange Act (the audit committee requirements contained in SOX) differently is an open question.  

For now, however, enforcement rests with the stock exchanges themselves, with delisting the only real remedy for violations.  Because delisting costs the stock exchange revenue, there is an incentive not to want to delist (and, perforce, enforce listing standards).  The concern is even greater in an era when stock exchanges have become for profit entities and have a fiduciary obligation to profit maximize.  To the extent exchanges fails to enforce, it is the SEC that can bring actions.  This is, therefore, an area where the Commission needs to be particularly attentive.

The next two posts, written by a student, Armin Sarabi, examine some recent actions by the Commission against the Boston Stock Exchange. 

What is a Regional Stock Exchange?

Regional stock exchanges are organized national securities exchanges that are registered with the Securities Exchange Commission (SEC), and are located outside of the main financial center in New York City. These exchanges operate in the trading of regional issues, over-the-counter (OTC) equities under the SEC's Unlisted Trading Privileges (UTP), and securities listed on the New York exchanges (broadening the market for regional exchanges' securities).

Through the use of electronic trading systems - such as the Intermarket Trading System (ITS) - regional exchanges have gained strength in their competitive positions on the market.

ITS is a computer system that links regional exchanges to the major exchanges in New York City. Using ITS, regional exchanges can view competing quotes for the securities traded on a computer screen, and members in any participating market can send orders to trade at the bid or offer on any other participating market. ITS has been criticised for being out of date, and was recently replaced with the NMS Linkage Plan.

Even though these stock exchanges are regional, they are still registered with the SEC and are under the same requirements to enforce rules governing member firms under Section 19(g) of the Exchange Act as the national stock exchanges.

Every self-regulatory organization shall comply with the provisions of this title, the rules and regulations thereunder, and its own rules, and (subject to the provisions of Section 17(d) of this title, paragraph (2) of this subsection, and the rules thereunder) absent reasonable justification or excuse enforce compliance-- in the case of a national securities exchange, with such provisions by its members and persons associated with its members; in the case of a registered securities association, with such provisions and the provisions of the rules of the Municipal Securities Rulemaking Board by its members and persons associated with its members; and in the case of a registered clearing agency, with its own rules by its participants.

Regional stock exchanges were more abundant during the early to mid 1900's, however, over the years they have either merged with other exchanges or simply died out.  Most recently, the Pacific Stock Exchange (PSX) closed the doors to its trading floor and its traders began trading remotely from separate offices rather than a centralized location.  The exchange was later purchased by the NYSE and is now known as NYSE Arca, Inc.  Additionally, Nasdaq announced its plans to purchase the Boston Stock Exchange in early October.  Regional exchanges currently registered with the SEC include:

• Boston Stock Exchange (BSE or BSX)

• Chicago Board Options Stock Exchange (CBSX)

• Chicago Stock Exchange (CHX)

• National Stock Exchange (NSX)

• Philadelphia Stock Exchange (PHLX)

SEC v. Boston Stock Exchange

We return today to a topic discussed in a previous post, regarding the importance of listing standards as a source of corporate governance; and the need for proper enforcement of these standards.  Recent action by the SEC against the Boston Stock Exchange and it's former president further demonstrates that the need for enforcement is not limited to the national exchanges, but applies to the smaller regional exchanges as well.

On September 5, 2007, the Securities and Exchange Commission (Commission) initiated a settled inforcement action against the Boston Stock Exchange (BSE), and its former president, James B. Crofwell (Crofwell), for violation of Section 19(g) of the Exchange Act – failure to enforce Exchange rules to prevent specialists from trading for their own accounts, ahead of marketable customer orders.  

According to the Commission, from 1999 to 2004, the BSE and Crofwell failed to enforce Exchange Rules Ch. 2 §§ 6 & 11, and Ch. 15 § 2(b), which prevent specialists from trading securities from their own propriety accounts, and benefiting from the spread between their cost and the price quoted to their customer, when other customer market orders could be matched at the same or better price.

Specifically, the Commission contends that the BSE did not adequately monitor specialists to detect and prevent violations of the customer priority rules – pointing to problems with BEACON (Boston Exchange Automated Communication and Order-Posting Network), the BSE’s propriety trading platform, and the adoption of a competing specialist initiative during 1996.  The Commission asserts further, that both the BSE and Crofwell where aware of the fact that these procedures were inadequate, and that despite repeated warnings from the Commission neither took appropriate action to correct the problem.  

As part of the settlement agreement, the BSE and Crofwell both consented to a censure and an order to cease and desist from future violations of Section 19(g) of the Exchange Act.  Furthermore, the BSE has agreed to the expenditure of at least $1 million to retain an outside consultant/auditor to help the BSE improve its surveillance, examination, investigation and disciplinary programs relating to trading.

In a related civil action, Crofwell consented to the entry of a final judgment ordering him to pay a $75,000 penalty for aiding and abetting the Exchange’s violations of the Section 19(g) of the Exchange Act.

In other news, Nasdaq announced its plans to purchase the Boston Stock Exchange and its key assets in early October.  The  acquisition, which is  valued at  nearly $61 million, has been approved by the BSE board of directors, and is set for completion in the first quarter of 2008. 

The primary materials for this case may be found on the DU Corporate Governance website. 

Enforcing the Rules of the Stock Exchange: SEC v. Salvatore F. Sodano

The listing standards of the stock exchanges represent an important source of corporate governance.  The requirements,  however, are only as good as the level of enforcement.  Recent actions by the Commission against Amex and the former chairman of Amex, Salvatore F. Sodano (Sodano), has raised questions about whether enforcement is adequate. 

On March 22, 2007, the Securities and Exchange Commission (SEC) issued an Order Instituting Proceedings (OIP) against Salvatore F. Sodano (Sodano), pursuant to Section 19(h) of the Securities Exchange Act of 1934 (Exchange Act).  This section reads:

The appropriate regulatory agency for a self-regulatory organization is authorized, by order, . . . to remove from office or censure any officer or director of such self-regulatory organization, if such appropriate regulatory agency finds, on the record after notice and opportunity for hearing, that such officer or director has . . .  failed to enforce compliance.

The OIP charged Sodano with failure to enforce compliance with the federal securities laws while he was chairman and CEO of the American Stock Exchange (Amex) from 1999 to 2005.  An earlier post discusses the OIP in more detail. 

The latest chapter occurred in August.  In a Motion for Summary Disposition (Motion) pursuant to Rule 250 of the SEC's Rules of Practice, Sodano sought dismissal of the charges - claiming that, according to Section 19(h)(4), the SEC lacked the authority to institute proceedings against an individual who was no longer an officer or director of a self-regulatory organization (SRO).  In an August 20, 2007 decision, the administrative judge agreed with Sodano's argument and dismissed the case without prejudice.

In support of his Motion, Sodano argued that Section 19(h)(4) only applied to current officers and directors of an SRO.  Further stating that "[if] Congress had intended to extend the Commission's… jurisdiction over 'officers and directors' of an SRO… it could have (and would have) said so explicitly."  In the Matter of Salvatore F. Solano, Exchange Act Release No. 333 (August 20, 2007).  Sodano pointed to Section 15(b)(6) of the Exchange Act and Section 203(f) of the Investment Advisers Act of 1940; both of which were amended by Congress to authorize a broader reach.  Furthermore, Sodano argued that the remedies authorized by Section 19(h)(4), removal from office and censure, further demonstrated Congress' lack of intent to broaden the SEC's reach to former officers and directors.

The SEC has since filed an appeal, expressing concern because the case was decided on jurisdictional issues rather than on its merits.  On appeal the SEC has argued that the judges findings would create a loophole for officers and directors who are otherwise subject to such proceedings by allowing them the option of resignation.  If the law is interpreted in this way, former officers and directors who have failed to enforce compliance with federal securities laws could easily re-enter the securities industry.

The staff is correct that it will impair enforcement if a responsible person can avoid sanction by resigning.  

Primary materials for these proceedings may be found at the DU Corporate Governance website.

Arbitration and Arbitrator Compensation

There was an interesting article in the Journal about two Senators (Feingold and Leahy) who have indicated an interest in making arbitration between investors and brokers voluntary. Right now investors almost all agree to mandatory arbitration as part of the account opening process.

I serve as an NASD arbitrator and view it as a privilege. Moreover, as someone not dependent upon billable hours, the amount of compensation is not a particularly important matter. Nonetheless, it is interesting to understand the compensation structure for arbitrators and some of the rational practices that this may induce.

Most cases are heard by a panel of three arbitrators. Arbitrators are paid an honorarium equal to $200 for each hearing session. A hearing session is any meeting between the parties and the arbitrators of four hours or less.  Thus, arbitrators receive $400 each full day the panel is in session (with an additional $75 paid to the chair). There is no honorarium paid for preparation (other than a $100 payment where the hearing is postponed within three business days of the scheduled date) and no honorarium paid for the decision making process. Honorariums may be paid when arbitrators convene for the prehearing conference, to decide discovery disputes, or to resolve a contested subpoena.

The compensation formula does not encourage preparation in advance of the hearing.  To the extent the case settles shortly before the hearing, arbitrators receive no compensation for the time expended.  Similarly, the compensation formula discourages lengthy deliberations.  To the extent the arbitrators deliberate outside of a hearing session, there is no compensation. 

It is a careful balance. To the extent the honorariums are too high, it will discourage investors from bringing actions.  At the same time, however, a system that pays a relatively small amount will likely discourage some qualified individuals from becoming arbitrators.  Moreover, the failure to compensate for preparation and deliberation could impact the quality of the proceedings and the decision making process. 

Whatever system is put in place to resolve disputes between investors and brokers, it should be designed to produce thoughtful, prepared decisions from highly qualified individuals.  It is not clear that the existing system of arbitration does so. 

The SEC, Corporate Governance, and Jawboning the Exchanges

We are discussing the efforts by the Commission to influence substantive standards of corporate governance.  For more on this topic, go to Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure

These efforts arose from the Agency’s growing understanding of the connection between accurate disclosure and internal accountability. Moreover, with fiduciary obligations weakening under state law, the need to impose standards became even more compelling.

As an initial matter, the Commission turned to listing standards as the principal mechanism. The Commission began to pressure the exchanges to increase their corporate governance requirements, particularly by requiring audit committees and independent directors. See Exchange Act Release No. 41987 (Oct. 7, 1999)(“Since the early 1940s, the Commission, along with the auditing and corporate communities, has had a continuing interest in promoting effective and independent audit committees. It was, in large measure, with the Commission's encouragement, for instance, that the self-regulatory organizations first adopted audit committee requirements in the 1970s.”). The initial foray didn’t accomplish much. For one thing, the definition of independent did not actually ensure independence. For another, the requirements did not define the responsibilities of the audit committee, something left to state law. Similarly, enforcement of the new requirement was left to the exchanges, not a particularly robust source.

Moreover, jawboning worked only as long as all of the principal trading markets cooperated. As competition among the self regulatory organizations grew, however, resistance developed, with matters coming to a head over efforts to ensure shareholder voting rights. Confronting the need to delist General Motors or to abandon its longstanding policy of one share one vote, the NYSE opted for the latter. Delisting would have sent GM to Nasdaq, where no comparable rule existed. The decision, therefore, was not about good corporate governance but the result of competitive pressures.

The Commission tried, behind the scenes, to induce the NASD (the owner of Nasdaq) to adopt a comparable rule. Unsuccessful, the agency adopted a rule that required national exchanges and Nasdaq to implement a one share, one vote standard, thereby ensuring uniformity. In what will no doubt be viewed as a Pyrrhic victory, the Business Roundtable challenged the rule and ultimately prevailed, inducing the DC Circuit to conclude that the Commission lacked authority to regulate the substance of corporate governance through the mechanism of listing standards. Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1986). Listing standards represented a method of intervening that only applied to particularly categories of companies and involved regulations that did not give rise to a private right of action. Had the SEC retained this avenue, it is possible that the need for much of SOX could have been avoided.

Without the use of listing standards, the Commission tried to increase accountability through the use of enforcement proceedings. Most noticeable was In WR Grace , Exchange Act Release No. 39157 (admin proc Sept. 30, 1997), a Section 21(a) report. The agency took the opportunity to instruct the board on the need to maintain adequate procedures to ensure accurate and complete disclosure. As the report emphasized:

• "Serving as an officer or director of a public company is a privilege which carries with it substantial obligations. If an officer or director knows or should know that his or her company's statements concerning particular issues are inadequate or incomplete, he or she has an obligation to correct that failure. An officer or director may rely upon the company's procedures for determining what disclosure is required only if he or she has a reasonable basis for believing that those procedures have resulted in full consideration of those issues." 

The Report suggested that directors could be charged for failing to implement adequate procedures, a task typically regulated under state law fiduciary duties.

Although calling on officers and directors to play a more active role in the disclosure process, the legal premise for the approach was unclear. It mostly involved areas traditional regulated under fiduciary obligations rather than the federal securities laws and, therefore, outside the bailiwick of the Commission. Perhaps as a result, there was little follow-up, with the decision having at bet marginal impact on board behavior.

Instead, the Commission was back to the beginning. The only real weapon available to combat the declining standards at state law was disclosure. Beginning in earnest in the 1990s, the Commission began to use disclosure not so much to provide material information but to directly influence the behavior of officers and directors.  We will pick up on this thread tomorrow.

In-House Counsel Sues NASD After Being Convicted for Perjury (Scher v. NASD)

In a recent decision, the U.S. Court of Appeals for the Second Circuit affirmed an earlier decision by the U.S. District Court for the S.D. of New York, which entitled the NASD and it’s officers absolute immunity from money damages because its actions were taken within scope of its official duties under the Securities Exchange Act. Scher v. NASD, 386 F.Supp.2ed 402, 407-08 (D. S.D.N.Y. 2005).

Jamie K.C. Scher, Plaintiff, brought action against NASD and various NASD officials for failure to adequately warn her that false or misleading testimony given during an interview, which was conducted while Scher was under oath, could result in a perjury conviction. Among other things, Scher claimed that her constitutional right afforded by the 5^th Amendment was violated due to “improper collusion or collaboration between the NASD and the Manhattan District Attorney’s Office.” Id. at 408. However, the district court held that the NASD is not a state actor, and therefore constitutional principles do not apply to its proceedings. 386 F.Supp.2ed at 408. (“It is by no means ‘inconsistent’ to find that, on the one hand, the NASD exercises insufficient state action to trigger constitutional protections… while nevertheless holding that the NASD is entitled to absolute immunity in the exercise of its quasi-public regulatory duties.”).

On appeal, the Second Circuit Court affirmed the lower courts decision, noting that as a self-regulatory organization, the NASD stands in the shoes of the SEC in interpreting the securities laws for its members, and therefore, it follows that the NASD should be entitled to the same immunity enjoyed by the SEC. Scher v. NASD, No. 05-5139-cv, 2007 WL 631687 (2^nd Cir. February 26, 2007).

The primary materials for this case may be found on the DU Corporate Governance website.

The SROs and the Definition of Independent Director: The Case of UnitedHealth

The Denver Post revealed today that the managing partner of the local office of Hogan & Hartson, Tom Strickland, was leaving to take the position of chief legal officer at UnitedHealth.  In addition to a well known lawyer in the local metropolitan area,  Strickland is a political mover and shaker, having twice run for the US Senate.  Last summer he hosted a fundraiser at his home for Senator Menendez of New Jersey with Bill Clinton, among others, in attendance. 

The article in the Denver Post provides an opportunity to revisit the situation at UnitedHealth, a company embroiled in a backdating scandal.  After publication of an article in the Wall Street Journal about possible backdating, the Board began an investigation, hiring Wilmer Cutler to conduct an independent review.  The law firm issued a report on Oct. 15, 2006.  In a quick succession of  current reports, the company disclosed the existence of the Wilmer Hale report, the resignation of the CEO, William McGuire, and an inquiry from the SEC over the matter, and announced that certain financial statements could no longer be relied up.  The current reports and the WilmerHale report are on the DU Corporate Governance web site. 

For our purposes, the most interesting aspect of the scandal was the disclosure in the WilmerHale report about one of the directors, William Spears, who also served as the chair of the compensation committee during most of the period covered by the report.  According to the report:

• "Beginning in 1992 Mr. Spears served as a trustee for two trusts for the benefit of each of Dr. McGuire's children.  From 1994 through mid-2006, Mr. Spears acted as an investment manager for certain assets of Dr. McGuire and his family.  The amount of assets managed for Dr. McGuire fluctuated over time, from approximately $15 million in 1996 to over $55 million in 2006.  In June 1999, Mr. Spears accepted an investment of $500,000 from Dr. McGuire in connection with Mr. Spears's repurchase of the money management firm that bears his name from the financial conglomerate that had earlier acquired it.  Dr. McGuire had unwound that investment by early 2003." (footnote omitted)

These relationships were never disclosed in the company's proxy statement.  How well were these relationships known inside the company?  The report addressed that as well.

• "Handwritten notes made by David Lubben, the Company's General Counsel, in connection with an Audit Committee meeting in February 1999, make clear that Mr. Lubben was aware of some 'conflict' issue involving Mr. Spears and Dr. McGuire.  Although it is possible that the notes indicate that Mr. Lubben discussed this relationship with the Audit Committee, neither Mr. Lubben nor any member of the Audit Committee recalls such a discussion.  Mr. Lubben also sent an e-mail to outside counsel on October 12, 1999 generally outlining the McGuire/Spears relationship and indicating that disclosure of some 'conflict' had been made to the 'full' Board.  In addition, Dr. McGuire and Mr. Spears have each stated that they believed the Board was aware of the money-management relationship.  However, there are no minutes or other documentation to confirm that such disclosure took place in that time frame.   . . . All Directors believed that they first learned of the investment that Dr. McGuire made in Mr. Spears's firm after the commencement of this investigation."

The report does not disclose what response, if any, was received by the outside law firm. 

The report indicates a serious amount of finger pointing.  McGuire/Spears claim the board knew; the directors contend they did not.  The general counsel and outside counsel played some indeterminate role. 

What can be concluded with certainty is that the relationship was never disclosed.  Thus, despite the fact that the chairman of the compensation committee engaged in outside business activities with the CEO, he was treated as independent.  Moreover, even had the board been aware of the relationship, it is not at all clear that it would have disqualified Spears as independent under the NYSE definition.  Then and now, the applicable standards was that a director could not have a "material relationship with the listed company".  See NYSE Rule 303A.02.  Spears' potentially "material" relationship was with McGuire, not UnitedHealth.  Thus, a director can apparently have significant business interaction with the CEO and still be treated as independent under the definition of the SROs (and, by the way, under the definition employed by Delaware, discussed at length here). 

At least the SEC has taken steps to stop the finger pointing.  Freshly minted Item 407(a)(3) of Regulation S-K requires disclosure "by specific category or type, any transactions, relationships or arrangements" considered by the board in determining whether a director is independent.  The requirement is discussed in Exchange Act Release No. 54302A (August 29, 2006).  Had this been in place during the time period covered by the WilmerHale report, it would likely have required disclosure of any consideration by the board to disclose the business relationships between Spears and McGuire had they considered them.    

CEO Compensation and Nasdaq

The WSJ reported over the weekend that the CEO of Nasdaq, Robert Greifeld, received compensation of over $18 million.  He beneficially owns 2% of Nasdaq and participates in an incentive program that provides for bonuses up to $2 million.  The bonuses are based upon performance, with performance in turn based mostly upon operating income and total revenue.

We thought we would take the time to examine the compensation paid to the directors of Nasdaq.  According to the company's proxy statement, all of the directors are independent except Greifeld.  The directors on the management compensation committee, by the way, included Casey (chair), Gorman, Hutchins, Sodhani, Stemberg & Wince-Smith.  The proxy statement can be found at the DU Corporate Governance web site. 

2006 Director Compensation Table (footnotes and empty columns deleted)

Name		Fees Earned or Paid in Cash				Stock Awards							Total
H. Furlong Baldwin		$	144,500			$	82,619						$	227,119
Michael Casey		$	39,500			$	67,438						$	106,938
Daniel Coleman		$	74,000				—						$	74,000
Jeffrey N. Edwards		$	45,000			$	33,718						$	78,718
Lon Gorman		$	79,667			$	21,173						$	100,840
Patrick J. Healy		$	64,500			$	15,181						$	79,681
Glenn H. Hutchins		$	42,000			$	40,271						$	82,271
Merit E. Janow		$	64,750			$	35,317						$	100,067
John D. Markese		$	36,000			$	61,444						$	97,444
Thomas F. O’Neill		$	56,000			$	35,317						$	91,317
James S. Riepe		$	53,000			$	40,180						$	93,180
Arvind Sodhani		$	38,500				—						$	38,500
Thomas G. Stemberg		$	52,500			$	33,677						$	86,177
Mary Jo White		$	12,500				—						$	12,500
Deborah L. Wince-Smith		$	41,500			$	42,907						$	84,407

Several observations can be made about this structure.  First, the proxy statement itself noted that directors would not be treated as independent "who accepted any compensation from the company in excess of $100,000 during any period of twelve consecutive months within the three years preceding the determination of independence"  Yet at the same time, the board ignores comparable amounts paid as part of the fee structure, raising serious questions as to whether these directors ought to be treated as independent. 

Second, the compensation of the CEO is largely based upon revenues and share prices.  In that sense, it creates an incentive to maximize earnings and profits.  While an ordinary standard for "for profit" companies, Nasdaq also has a regulatory mission, including the enforcement of listing standards.  This salary structure does not take into account this regulatory mission at all and puts and emphasis on factors that are largely inconsistent with the regulatory mission. 

Listing Standards and the Problems of Enforcement

Increasingly, stock exchanges have become the source of improved corporate governance.  In the aftermath of Enron, the stock exchanges adopted listing standards that included tougher governance provisions, including the requirement that boards have a majority of independent directors.  Section 301 of SOX commanded the Commission to use listing standards to require audit committees consisting of independent directors and having the authority to hire and fire the outside auditors.  The Commission did so.  See Rule 10A-3, 17 CFR 240.10a-3. 

Listing standards, however, raise significant concerns, particularly over enforcement.  In general, private parties cannot bring an action for violations.  Instead, enforcement is left to the exchanges.  The exchanges, however, have a history of weak enforcement.  Moreover, with the NYSE and Nasdaq having assumed "for profit" status, the pressure to earn profits could impact the willingness to enforce listing standards.  As Andrew Hayden has written, the Commission has brought an action against the Amex and key officials that shows the concern is more than theoretical.

Where this can be seen with some clarity concerns the definition of independent director used by the exchanges.  The determination of whether a director qualifies as independent is made by the board of directors.  The board has to determine, among other things, whether a director has a material financial relationship with the company.  Evidence indicates that this determination does not always involve a rigerous process.  See the post here.  Moreover, it is clear that boards have been willing to find that directors do not have a material financial relationship even when they are paid fees that approach $400,000.  Why are boards so lax in enforcing the independence requirements?  Because they know that there are no consequences since the standards are not subject to serious enforcement by the exchanges.   

The SEC Begins Clean Up of The American Stock Exchange After Years of Neglect

On March 22, 2007, a group of actions were handed out by the SEC surrounding the regulatory self monitoring and enforcement of the American Stock Exchange (“AMEX”). In three separate releases the SEC laid out what it sees an era of neglect within AMEX for the period of 1999 to 2004. The releases were aimed at former AMEX Chairman and CEO Mr. Salvatore F. Sodano, former Vice President Richard Robinson in charge of AMEX’s Derivatives Trading Analysis Department (“DTA”), and the AMEX.

Order # 34-55509, in a matter not yet settled, alleges that Mr. Sodano was derelict in his duties as an officer of AMEX for failing to enforce AMEX rules and securities law. The language of the order is strong stating Mr. Sodano’s failures over the period of 1999 to 2004 created “an environment in which regulation was not a priority.” The SEC found these failures to be especially egregious in lieu of a September 2000 order which the SEC made Sodano aware of similar problems in AMEX’s options and equities markets. The March 2007 order alleges that, despite the Sept. 2000 findings, which Mr. Sodano understood to be dire, he failed to institute regulatory reform centered on correcting the shortfalls and that this lack of attention is emblematic of even broader neglect.

 In order # 34-55508, the SEC accepted an offer to settle from Mr. Robinson to entry of an “[o]rder Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing a Cease-and-Desist Order.” The SEC found that during the period of 1999 to 2003, Mr. Robinson was derelict in his duties. Mr. Robinson was in charge of overseeing the DTA’s “regulatory surveillance programs for the derivative and options markets.” Moreover, as was the case with Mr. Sodano, Mr. Robinson was aware of the September 2000 which listed AMEX’s inadequate regulatory programs. Specifically, Mr. Robinson failed to institute adequate surveillance and enforcement programs in the shadow of the September 2000 order. As a result, Mr. Robinson agrees to “cease and desist from causing any future violations.”

Similarly, in order # 34-55507 the SEC announced it was accepting a settlement offered by AMEX to improve its internal regulatory enforcement mechanisms. In the settlement AMEX consented, without admitting or denying the findings, to an entry of an “[o]rder Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions, a Censure, and a Cease-and-Desist Order.”

The SEC determined that AMEX, under the tenure of Mr. Sodano and Mr. Robinson, failed to adequately surveil, investigate and subsequently to enforce rules and or laws of violations to “certain options order handling rules.” Further, AMEX’s internal policies continue to be inadequate. Pursuant to the order AMEX must now institute policies that would enhance its ability to effectively manage its regulatory functioning. The SEC created a four point plan to establish the goal of effective regulatory management. For its part AMEX agrees to be censured, to cease and desist from further violations, and to institute the SEC plan. Primary materials for the case may be found at the DU Corporate Governance website.

Listing Standards, Profit Maximization and SRO Competition

This Blog is not intended to be focused on current events, but very now and them there are articles that go to the heart of the focus of this forum. We have discussed the shift in the NYSE (and Nasdaq) to “for profit” status and questioned whether, in the specific context of the merger between the NYSE and Euronext, these entities can run their business and provide adequate regulatory oversight.  In particular, we have questioned the conflict between profit maximization and the enforcement of listing standards.

In Journal article earlier this year (NYSE, Nasdaq Drop Gloves To Battle for Stock Listings, Feb. 28, 2007), the Journal  noted the increased competition for listings between Nasdaq and the NYSE, mentioning that the stakes are high, involving $550 million in revenues. The NYSE lost its first listing to Nasdaq in 2000, and since then, ten additional companies have departed for the competitors. On the other side, 150 companies have left Nasdaq for the NYSE during the same period. 

All of this merely highlights the dollar amounts involved in maintaining listing standards and the harm to profit margins that can result from delisting.  

11th Circuit to rehear Weissman

As discussed in an earlier post, the 11th Circuit held in Weissman v. NASD that there is a private cause of action against an exchange for activities not related to its regulatory activity. That 11th Circuit has, however, vacated the panel opinion and scheduled the case for rehearing en banc. Check back here for further coverage of this case as it develops.

Click here for the rehearing order.

NYSE and the Large Company Exception to the Delisting Policy

This Blog has previously discussed a tradition of weak enforcement of listing standards by the exchanges, although some companies do get delisted from time to time. But how do Self Regulatory Organizations (SROs) determine which companies to delist? As we saw in the case of Fog Cutter Capital Group Inc. v. SEC , No. 3-11934, 2007 WL 148833 (DC Cir. Jan. 23, 2007) a company can be delisted for conduct by the CEO and the board's response to the conduct.  Another basis for delisting is noncompliance with the periodic reporting requirements under Section 13(a) of the Exchange Act.  

Any company listed with the NYSE that fails to file its periodic reports with the Commission in a timely manner is subject to the delisting procedures contained in NYSE Rule 802.01E.  The Rule gives the NYSE the sole discretion to provide a company up to two consecutive six-month extensions and to continue listing a company beyond that period  in “certain unique circumstances" so long as the Exchange finds, among other things, "that the company may have a position in the market – such that delisting from the Exchange would be significantly contrary to the national interest and the interest of public investors.”  

In the case of Navistar Int’l Corp., Securities Exchange Act Rel. No. 55304 (Feb. 13, 2007), the Commission addressed the "national interest" exception.  Navistar failed to file its annual report for fiscal year 2005.  The Company received two six month extensions but still did not file the report.  As a result, the NYSE ordered the company delisted.  In an appeal to the SEC, Navistar argued, among other things, that the "national interest" exception applied and that it ought not to be delisted.  

Navistar's main argument was based on the fact that its market capitalization ($3.2 billion) and its role in the trucking industry (particularly supplying vehicles to the military for use in Iraq and Afghanistan) was enough to justify application of the "national interest" exception.  The Commission disagreed.  "These facts alone, however, fail to establish a substantial likelihood that NYSE abused its discretion by concluding that Niavstar's delisting would not be significantly contrary to the national interest or have serious implications for the country as a whole.  Navistar does not contend, and nothing in the briefs or other submissions to date support the conclusion, that the NYSE's delisting of Navistar will prevent it from continuing to operate its business and to provide military vehicles for use in Iraq and Afghanistan." 

Thus, the decision, at least in part, turned on the fact that the market capitalization of Navistar was not enough to warrant continued listing.  In other words, very large companies potentially get a pass because of their market capitalization (even if they meet the "national interest" element, the rule has five other criteria that must be met).  See, e.g., Fannie Mae  (delisting of company with market capitalization of $49.75 billion would not be in public interest).  

The case, therefore, demonstrates a bias in favor of larger companies, which, one suspects, is highly consistent with a for profit company seeking to maximize its profits.  See a prior post here discussing the profit making nature of the NYSE.  Where a company’s actions are so egregious that the NYSE decides to delist, larger companies are still awarded more protection since it will rarely be the case that they can be taken off the Exchange without “serious implications” to the country as a whole.

Additional material on the process used by the NYSE for delisting a company may be found on the DU Corporate Governance website.