CBLR staff member Daniel Sockwell’s blog post, “Writing a Brief for the iPad Judge,” has become a hit, widely cited by legal bloggers, notably The Volokh Conspiracy. In his piece, Daniel discussed how lawyers should alter their format and style for the benefit of judges who read briefs in tablet format. Daniel’s blog post has also been discussed by The Researching Paralegal, Simple Justice (a criminal defense blog), At Counsel Table, and The Center for Innovative Justice and Technology. We look forward to seeing where it’s cited next!
On Friday, February 28, 2014, Mt. Gox, one of the largest-volume Bitcoin exchanges in the world, shut down and filed for bankruptcy in Tokyo. Once the most favored place to buy Bitcoins, Mt. Gox stated that it most likely had lost 750,000 of its own customers’ Bitcoin holdings and more than 100,000 of its own coins, totaling over $470 million. The steady erosion of faith in the Bitcoin community dealt the final blow to Mt. Gox, which had already been facing a series of problems, including having accounts frozen by U.S. authorities last year. Those close to the exchange say that the lack of public backing from Bitcoin believers prevented it from obtaining the financing it needed to sustain operations.
But what does the bankruptcy of the once largest-volume Bitcoin exchange in the world mean for the currency itself? Bitcoin, a virtual currency, was supposed to increase payment freedom, reduce processing fees, decrease risks for merchants, increase security and user control over transactions, and provide generally a more transparent and neutral currency that governments cannot provide. However, its extreme volatility— Bitcoin traded for $1,117 on December 4, and now only commands about half that amount—and the current Mt. Gox bankruptcy have skeptics wondering whether Bitcoin will be able to survive.
Those critical of Bitcoin argue that the volatility of the currency outweighs its secure feature benefits, which include protecting against identity theft or making it impossible for merchants to force unwanted charges. Since there is no government that has yet recognized the currency as legal tender to buy goods and services or pay taxes, Bitcoin lacks a tangible connection to many facets of the real economy. As such, it is hard to value day-to-day, even when compared to limited supply commodities such as gold or silver.
Moreover, Bitcoins are stored in virtual wallets, private computers, or exchanges like Mt. Gox, which may function like commercial banks but are not guaranteed by the FDIC or other regulatory agencies around the world. Even the coordinated efforts of several Bitcoin exchanges to ensure security cannot serve as a substitute to a government guarantee. In response to such mounting concerns in the days leading to Mt. Gox’s bankruptcy, chief executives of major Bitcoin exchanges pledged to “coordinate efforts to assure customers of the security of their funds.” This, however, failed to assuage investor nerves as the currency fell from $550 to below $500.
Bitcoin’s supposed privacy feature has also not been much of a benefit, as government security agencies and hackers are still able to spy on user transactions. The government can even subpoena Bitcoin records, while hackers have been successful in stealing the virtual currency, as witnessed in Mt. Gox. In fact, at a RSA Security Conference, Etay Maor, fraud protection solutions manager at IBM, and Uri Rivner, head of cyber-strategy at BioCatch, demonstrated how to steal Bitcoins in seconds, a pre-arranged theft from one researcher to the other.
Others, however, remain unfazed by the bankruptcy and continue to support Bitcoin as it revolutionizes global finance. Ken Shishido, who lost his Mt. Gox deposits, likened the bankruptcy and Bitcoin failures to the traffic accidents faced in the early days of the automobile. Just as the automobile was not banned because of accidents in the days without traffic lights and pedestrian crossings, Shishido argued that Bitcoin too would overcome this obstacle. Supporters argue that the Mt. Gox bankruptcy, while affecting a major service provider, is not representative of Bitcoin as a whole, which they laud as technologically impressive.
Mt. Gox’s demise, while impactful, should not necessarily spell the end of Bitcoin. Friendster, which founded the social network, and Napster, which helped start an era of digital music downloads, eventually failed, yet the ideas and technology they brought forth remain in place today. When Napster collapsed in 2001, because its initial model simply allowed users to steal music, some speculated that this was the end of the digital music business; it was not the end, but rather, just the beginning.
Mt. Gox’s failure could in fact be interpreted as a testament to the incredible demand generated for Bitcoin. The currency still needs to mature and improve its security preferences, but the failure of one exchange should not be interpreted as the beginning of Bitcoin’s end. SecondMarket CEO Barry Silbert believes that the failure of Mt. Gox will actually help improve Bitcoin for the better, as exchanges that are not responsible in maintaining sufficient investment in technology, resources, customer service, and in public relations, should eventually fail. Eliminating a bad actor, a poorly run business, Silbert argues, will only improve the Bitcoin ecosystem in the long run. While Mt. Gox’s bankruptcy will certainly affect the Bitcoin market in the short term, investors in Bitcoin technology and Bitcoin holders alike seem to view the future with promise. Though a costly lesson, Mt. Gox may soon be remembered as a mere Napster or Friendster, one whose failure certainly affected early adopters of the technology, but didn’t affect the overall technology’s future growth and rapid societal acceptance.
A Supreme Court decision that has provided significant support to investors in securities fraud litigation since its publication in 1988 may be overturned in the near future. On March 5th, the Court is set to hear oral arguments in Halliburton Inc. v. Erica P. John Fund, Inc., a case in which Halliburton is challenging a legal precedent that has helped plaintiffs bring securities fraud class actions for over a quarter century: the presumption of reliance established in Basic Inc. v. Levinson. In Basic, the Supreme Court famously held that individual investors do not need to prove that they directly relied upon the alleged fraudulent statement when they purchased the stock. Instead, reliance on that misinformation could be presumed based upon the fraud-on-the-market (FOTM) theory. This theory states that, in an efficient market, any stock’s price takes into account the effects of all available, material information. Therefore, fraudulent statements can defraud investors just due to the misstatement’s impact on the stock’s price. While this presumption is rebuttable on the merits, it provided significant support to investors by allowing them to satisfy the predominance requirement for class certification. This presumption has affected lawsuits and settlements worth billions and billions of dollars over the years. But Basic’s holding is at risk.
Halliburton was originally brought by a group of investment funds and individual investors in 2007, which accused the company of fraudulent statements about its financial condition and its exposure to a major source of liability (asbestos litigation). The lawsuit has only dealt with whether it can move forward as a class action. In fact, this same lawsuit was in front of the Supreme Court once before at the class certification stage. In 2011, the Supreme Court unanimously reversed a lower court’s holding requiring investors to show loss causation (a showing that the misstatements actually caused their losses) before being allowed to use Basic’s reliance presumption for class certification. The opinion, written by Chief Justice Roberts, stated that loss causation should be decided on the merits and the Court had “never before mentioned loss causation as a precondition for invoking Basic’s rebuttable presumption.” The case was remanded and certified as a class action. Halliburton has challenged the certification, bringing the case in front of Supreme Court for a second time to address whether Basic’s presumption of classwide reliance should be overruled or changed, or, alternatively, whether the presumption may be rebutted at an earlier stage, to prevent class certification.
Halliburton is arguing that Basic’s presumption should be overruled because it is founded on a flawed economic theory. This argument echoes a major line of criticism of Basic. There has been widespread debate over the merits of the FOTM theory, with many arguing that the reliance presumption does not accurately reflect the way in which the market and stock prices work. Many also argue that Basic incentivizes meritless claims brought only for their settlement value. Companies are then forced to settle meritless claims just to avoid the risk of litigating the claim. The class actions allowed based upon Basic’s presumption expose companies to the risk of staggeringly high damages that end up exceeding any net social harm caused. Furthermore, because of the rise of investor insurance in response to that risk, shareholders may ultimately be the ones who end up suffering. As a result of many of these concerns, Congress passed the Private Securities Litigation Reform Act (PSLRA), making it harder for plaintiffs to bring securities fraud claims. Many see this Act and the decades-long controversy that has resulted from the 1988 case as a sign that it is time for the Supreme Court to put an end to the Basic era of private securities litigation.
On the other side of the matter, the investors suing Halliburton contend that overturning Basic’s presumption would fundamentally change the nature of private securities litigation for the worse. Without the power to bring class actions that Basic’s presumption allows, the majority of investors will simply not bring meritorious suits because of the minimal amount of damages involved. The resulting underenforcement will incentivize fraud and, consequently, the integrity of the market as a whole will be hurt. Basic’s presumption, while not perfect, serves as a pragmatic response to uncertainty at the pretrial stages of fraud claims, saving time by allowing educated guesses. Interestingly, proponents also argue that Congress’ passing of the PSLRA actually supports continued adherence to Basic’s presumption. If Congress wanted to amend Basic’s holding, it would have done so through the PSLRA. Congress’ decision to remain silent signals its intent to preserve Basic, which courts should respect. The Supreme Court even addressed this matter in a 2013 opinion, stating that Congress “rejected calls to undo the FOTM presumption of class-wide reliance endorsed in Basic” through its enactment of the PSLRA. However, it is possible that the Court’s opinion on this matter will change, based upon the amicus curiae brief that former Congressman and SEC officials filed in Halliburton. The brief did not state a position on the case’s merits, but it argued against the Court equating Congress’ silence with approval because the matter was not adequately addressed or discussed during the passing of the PSLRA. Perhaps most importantly, Basic’s presumption supports what many consider an important public policy argument: realistic or not, investors should be entitled, based on normative considerations, to rely on the integrity of stock prices
Four of the current justices indicated in a 2013 dissenting opinion that they are willing to reconsider Basic’s presumption. However, it remains unclear which way the Court will go in Halliburton, especially considering that Chief Justice Roberts rejected confronting Basic’s use of the FOTM theory in that case, instead siding with a narrower ruling. The Court has several ways in which it could address Basic through Halliburton: it could uphold the long-standing presumption of reliance, overrule the presumption completely, or it could take a less extreme position, requiring investors to prove that the stock price was in fact impacted by the misinformation before allowing class certification in misstatement cases. Depending on which route the Supreme Court decides to take, Halliburton has the potential to fundamentally change private securities litigation in the United States today. One thing that can be said with certainty: with oral arguments set for early March and a decision likely to be published by late June, the future of Basic will not remain uncertain for long.
Many of us celebrated this past Valentine’s Day in a somewhat untraditional manner. Rather than extol the virtues of love over a romantic dinner or lament the loneliness of single living, we indulged in a wholly unrelated pursuit: Season 2 of House of Cards. The recent explosion of internet-based “television” shows affirms our suspicions about the online marketplace—it is a platform for a growing level of commercial competition. Last month a federal district court turned this cultural phenomenon into a concrete facet of our law. In Verizon v. FCC, the D.C. Circuit struck down Federal Communication Commission (“FCC”) regulations called the Open Internet order, which banned Internet service providers (“ISPs”) from making commercial arrangements with services such as Amazon or Netflix.
More specifically, the Open Internet Order encompassed three key rules affecting broadband. First, transparency. Fixed and mobile ISPs were required to disclose their network management practices, performance characteristics, and terms and conditions of their service. Second, no blocking. ISPs were prohibited from blocking any legal content, applications, services, devices, or websites, in particular those applications that directly competed with their own voice or telephony services such as Skype. Finally, antidiscrimination. ISPs were prohibited from discriminating in the transmission of lawful Internet traffic. The majority opinion held that while the FCC retains the authority “to promulgate rules governing broadband providers’ treatment of Internet traffic,” “it may not impose requirements that contravene express statutory mandates.” As such, the Court struck down both the anti-blocking and antidiscrimination rules but upheld the transparency rule.
Such regulations were based on the concept of “net neutrality,” a term coined by Columbia Law School’s own Professor Tim Wu. It stands for the idea that there should be free and open access to the Internet and its content regardless of who the content provider or the user might be. Writing for the Court, Judge David Tatel highlighted the importance of understanding the history of the Internet, and the FCC’s regulation thereof, in understanding the Court’s final conclusion. As a general matter, the FCC has broad authority to regulate “all interstate and foreign communications by wire or radio,” including the Internet, under the Communications Act of 1934 (“’34 Act”). (The Court was split on the issue of the FCC’s jurisdiction. Judge Laurence Silberman wrote separately, partly concurring and partly dissenting, on the grounds that the Communications Act does not give the FCC jurisdiction over the Internet at all.)
In 1980, the Commission drew a hard line between “basic” services, which are regulated as common carriers under Title II of the ’34 Act, and those that are not. A service is considered basic if it involves mere transmission of information rather than additional processing. Because of their designation as common carriers, providers of basic services are subject to stringent regulation under Title II. For example, they have a duty to provide communication service upon reasonable request and must charge “just and reasonable” rates to consumers. This important distinction was reaffirmed with the passage of the Telecommunications Act of 1996, which created two separate categories: telecommunications carriers, which provide basic services, and information-service providers, which provide other “enhanced” services requiring advanced processing. Originally the Internet was subject to common carrier regulation. This is unsurprising considering that it was formerly transmitted over telephone wire. But most recently, in 2002, the FCC determined that broadband providers deliver an information service and are therefore exempt from Title II regulation. In National Cable & Telecommunications Ass’n v. Brand X Internet Services, 545 U.S. 967 (2005), the Supreme Court upheld the Commission’s classification, providing Chevron deference to the Commission’s interpretation of the vaguely defined “telecommunications service” and bringing us to this recent D.C. Circuit case. The Court ultimately concluded that the anti-blocking antidiscrimination rules were akin to common carrier regulation and therefore could not be applied to broadband providers.
There remains extensive debate over whether the decision bodes well for the broadband business and for consumers. Verizon and other industry leaders point to the fact that they have invested billions of dollars in building their networks and therefore preserve the right to independently manage those networks. Certain commentators agree and believe the end of net neutrality allows ISPs to compete with one another, ultimately resulting in bigger and faster broadband service for consumers. On the other hand, supporters of the regulation lament the Court’s decision, arguing that the higher cost of providing content eventually will be passed on to consumers. This is especially problematic in a market severely lacking in true competition. Throughout most of the United States, households have one option for broadband service: their local cable providers. There are several companies such as AT&T and Verizon that provide just Internet service, but they are often slower than their counterparts. Thus, the FCC has only widened the prospect of true monopolization.
What we do know for certain is that we are entering a new era in Internet commerce. According to Professor Wu, the decision “leaves the Internet in completely uncharted territory. There’s never been a situation where providers can block whatever they want.” That has not stopped some from making predictions about the so-called “Web 3.0.” Wealthy companies may have a significant advantage over smaller ones because they will be able to buy quick delivery of their content to consumers. There may also be multiple “levels” of Internet in which “discount” subscribers have access only to a limited number of content providers while “premium” subscribers have access to a greater number. On the flip side, the content providers themselves may be charged higher rates for access to those “discount” subscribers. Finally, ISPs may be able to curate your Internet experience, much like Cable TV providers, and do so to their economic advantage. Time Warner may be tempted to block sites such as Hulu and Amazon Prime Instant Video, as many consumers have opted to watch television shows online the next day in lieu of purchasing cable service. It’s unclear whether the FCC will appeal the ruling, but Chairman Tom Wheeler seems generally opposed to federal meddling in the online marketplace.
Months after United States regulators approved the Volcker Rule in December 2013 to curb banks’ abilities to engage in risky activities, Commissioner Michel Barnier, the European Union’s Financial Services Chief in charge of financial market reform, introduced his own proposal for reforming the European banking sector. Barnier’s proposal essentially aims to separate potentially risky trading activities from banks’ depository functions and to increase the transparency of the shadow banking sector. Unlike the United States Volcker Rule, which bans proprietary trading by all banks, the European rule is aimed only at the banks considered “too-big-to-fail.” In practical effect, this would only impact approximately 30 of the biggest banks operating in the European Union. Furthermore, the earliest that Michel Barnier’s plan could be implemented is in 2017, only after the European Parliament and the individually involved countries’ legislatures approve the plan. This plan has been criticized by both France and Germany, and it departs in some significant ways from its United States counterpart’s Volcker Rule.
Proposed European Banking Plan:
While some overarching reforms have already been put in place to strengthen the EU’s financial sector after 2008 financial crisis, Barnier’s new plan is more narrowly targeted at the largest, most complex European banks engaging in significant trading activities, or in his words “the small number of very large banks which otherwise might still be too-big-to-fail, too-costly-to save, too-complex-to-resolve.” The plan’s main proposals include: (1) banning proprietary trading in financial instruments and commodities to minimize the risk involved for the bank, the bank’s clients, and the European economy, (2) granting supervisors the power and even the obligation to “require the transfer of other high-risk trading activities (such as market-making, complex derivatives and securitisation operations) to separate legal trading entities within the group (“subsidiarisation”),” and (3) providing rules on the “economic, legal, governance, and operational links” between the bank and its separated trading entity. The plan also includes measures to increase transparency and prevent shadow banking, (i.e. when banks shift regulated activities to less regulated non-banking financial intermediaries that nonetheless can provide similar banking services).
This plan is a departure from original proposals, called for in the Liikanen report, to split up the big banks. The Liikanen report, the final product of a high-level expert group appointed by the European Commission to make bank structural reform proposals, recommended in 2012 that banks separate their trading functions into separately capitalized entities. But ultimately, France, Germany and several European banks opposed the Liikanean proposals and argued that mandatory separation was unnecessary, would raise costs for banks, and spur the growth of shadow banking. Barnier’s new plan attempts to strike the middle ground between the Liikanean proposals and the opposition. Unlike the Liikanean proposals, Barnier’s plan allows for the different levels of activities to be carried out by a single banking group, as long as certain subdivisions are performing the regulated activities approved for them (i.e. banks targeted under this legislation must spin off subsidiaries to carry out the riskier trading activities). However, despite this middle ground, Barnier’s plan has been met with significant criticism.
Criticism of Europe’s Banking Plan:
Because Barnier’s plan was recently introduced, many European politicians are arguing that the plan’s introduction is too late to be approved by the European Parliament and passed on for approval by the individual EU countries’ legislatures before May’s elections, when many of the lawmakers will have left office. Barnier has countered that the new banking proposals, if not introduced now, would be severely watered down by the time they could be proposed again next year to the European Parliament. Because European financial implementation is moving much slower than in the United States, Barnier’s attempt to build momentum behind the plan sooner rather than later makes sense.
Individual countries, specifically France and Germany, have also criticized the plan as being too restrictive on banks. France and Germany each passed regulations to help separate speculative activities from other banking activities in response to Liikanean proposals and argue that Barnier’s new proposals are unnecessarily restrictive. The two countries also worry that this plan will unduly benefit rival United States banks based in London. The United States-based banks in the UK will be operating under their own banking regulations through the Volcker Rule. Meanwhile, United Kingdom banks would not be required to remove their riskier trading activities to subsidiaries because they are not part of the Eurozone and also have tough banking legislation under the Vicker’s Rule, which restricts rather than bans proprietary trading unlike the Volcker rule. On the opposite spectrum, other European lawmakers are criticizing the plan as not being restrictive enough. These lawmakers would prefer that trading activities be completely separated from retail operations in order to truly curtail excessive risk-taking as recommended by the Liikanean report.
Comparison of the Proposed European Banking Plan with the American Volcker Rule
Because both the European and American economies were greatly impacted by the financial crisis of 2008 and the risky activities of banks played a large role in the financial crisis, most agree that banking reform was necessary and even long overdue. But how effective is the proposed European banking regulation compared to the already implemented American Volcker Rule?
Michel Barnier’s European rule is definitely less stringent than the American Rule by only targeting proprietary trading amongst the 30 European banks considered too big to fail, whereas the American Rule prohibits all banks from engaging in proprietary trading. The EU proposal also contains exemptions for these banks “if a national supervisor introduces special measures to ensure the effective separation of certain activities to prevent financial instability, a wording financial experts say gives countries leeway.”
But there are some key differences between Europe and America that might make this relaxed rule more workable for the European context. First, Dodd-Frank legislation in America began much sooner after the financial crisis, and that allowed there to be more momentum in crafting stricter banking rules. Second, the European rule has to go through many more hoops than the American Volcker rule did for implementation, and a rule stricter than Barnier’s current proposals could take until later than 2017 to pass, given the criticisms by France and Germany. Finally, European banks have already significantly reduced the amount of proprietary trading they are engaging in; the market combined with the stricter American rule already in place, therefore, might be enough to prevent European banks from engaging in risky behavior. Because Barnier’s proposal is still in early implementation, we still have to wait to see if and what final rules are adopted by the European legislatures and whether its laxity compared to the American rule is enough to stave off another financial crisis.
For better or worse, Delaware has overwhelmingly remained the preferred location for incorporation in the United States. This preference can greatly be attributed to the State’s court system, including the Court of Chancery, which prides itself on its commercial expertise. In addition to the reassurance that judges competent in business matters will handle disputes, Delaware also provides a very appealing regulatory environment to prospective corporations. Given the financial benefits that come to the State as a result, it is no surprise that Delaware would attempt to continue offering such accommodations.
One of the more recent steps that Delaware has taken to preserve its status came in 2009 when the legislature amended its laws to set up a process, whereby the Delaware Chancery Court could arbitrate private disputes confidentially without public access. The idea behind the plan was that Delaware corporations could continue to benefit from the specialized knowledge of the Delaware Chancellors, while simultaneously being afforded the benefits that private arbitration offers as an alternative to litigation. As long as one party was a Delaware corporation, and the amount in dispute exceeded one million dollars, the parties could consent to the process. For its role, Delaware would charge a twelve thousand dollar filing fee, and six thousand dollars per day for the service, a good deal for all parties involved.
The process came under legal attack shortly after its implementation, with the Delaware Coalition for Open Government claiming that it violated the public’s First Amendment right of access to court proceedings. Fundamentally, the argument is that the arbitration proceedings mimic a civil trial, and thus are constitutionally required to be public. Although private arbitration is generally permissible, and has even been endorsed by the Supreme Court, the unique thing about Delaware’s program is its use of Chancellor Judges as the arbitrators. The district court agreed with the Coalition, as did a divided Third Circuit, with the majority particularly emphasizing the interests of the state and the public in openness, given the state’s function in the proceedings. Taking some solace in the dissenting opinion of Judge Jane Roth, Delaware recently asked the Supreme Court to review the lower court’s decision.
Implications & Policy Discussion:
Although there is disagreement over whether the Supreme Court will take up the case, it is clear that, either way, there will be implications for multiple parties going forward. Underlying the program’s implementation is the desire for the State of Delaware to keep up with the ever-increasing trend of resolving business disputes through private arbitration. For corporations, the advantages of a permanent program are numerous: speedy resolution, cost effectiveness, anonymity, and most importantly, the unique feature of having Delaware’s specialized Chancellors act as the arbitrators. There is great concern that without this option, corporations would turn to foreign jurisdictions, where arbitration courts are set up for exactly these purposes. There is an argument to be made that this concern is overblown, given that there have been fewer than a dozen cases tried by the court since the program’s inception. One commentator notes, however, that this low usage may have been due to the ongoing legal uncertainty involving the program.
The more significant concern revolves around the private nature of the proceedings. Although corporations desire such secrecy, as a way to avoid embarrassment and/or the exposure of proprietary information, this benefit should not be afforded at the expense of infringing on the public’s constitutional right of access to court proceedings. Upholding the program would be a pretty unprecedented move, whereby the Supreme Court would be allowing a public court system to engage in such a private undertaking. Ultimately, the fear is that corporations, armed with the safeguard of such an option, may be more prone to engage in publicly disfavored action. Such a lack of public accountability could prove to be a major detriment to society in the long run.
Though the interests of corporations and the public seem to fall somewhat neatly on one side or the other, the case becomes more complicated when we look at Delaware’s interests. At first glance it seems that the program would undoubtedly serve their short-term financial motivations, however, in the long run this isn’t so clear. As already noted, a major reason Delaware has become the go-to state for incorporation is because of all the resources it can offer. One such resource is its expansive and well-developed body of corporate law doctrine. By removing disputes from the public eye, great uncertainty could arise to threaten this attribute. How would the Chancellors reconcile novel principles brought about from arbitration decisions when dealing with public trials? How would future parties know of such novel principles in the face of great secrecy? How would prospective corporations react to this changing environment? While, no answers can be for certain, the fact that these questions need to be asked show that the case for Delaware is more complicated than it seems.
If the Supreme Court grants review of the Third Circuit decision they will have the opportunity to provide greater direction to not only Delaware, but all states, when it comes to the issue of private arbitration. As ADR continues to grow in popularity, some guiding principles may help states adapt. If the Supreme Court remains silent it will be a win for the public, although an explicit confirmation of the Appellate Court decision would substantiate their position even further. For corporations who would make use of private arbitration, a reversal is no doubt desired. If they can’t keep their disputes anonymous here, they may very well turn to foreign tribunals. More complicated is the case for Delaware. If the Supreme Court disagrees with the Chancellors, they may very well be saving the Chancery Court from themselves.
Although I have my doubts that the Court will review the case, given that the program is unique to Delaware, it would be favorable for them to do so. They have already endorsed private arbitration, and with the likelihood that arbitration will continue to take hold in other states it would be better to provide direction sooner rather than later. Delaware’s program seems extreme, however, if the Court does take up the case I believe they should leave open the possibility for a system that finds a middle ground between completely private arbitration, and a full-blown public trial. Such a system, if designed appropriately, could be a victory for all parties involved.
Fannie Mae and Freddie Mac have made headlines once again for the startling realization that they too may prove profitable investments for the federal government. The two government-sponsored enterprises (GSEs), which have now paid the Treasury $185.2 billion in dividends against their $187.5 billion in draws, appear likely to join a growing crowd of bailout recipients who have since made good on their promises to pay back taxpayers for the 2008-2009 rescues. Despite clamoring junior equityholders, however, the GSEs are unlikely to secure the return to normalcy that their bailed-out brethren now enjoy. In fact, both Congress and the Administration are eager to wind down the housing giants, just as soon as consensus emerges on how.
While questions on how GSE reform should proceed present issues too large for a single blog post, one innovative initiative springing from the GSEs’ indefinite conservatorship bears mention: credit-risk sharing. This initiative, encouraged by the GSEs’ conservator, the Federal Housing Finance Agency (FHFA), seeks to preserve the benefits to borrowers and investors of the current GSE system while offloading the detrimental credit risk that proved so costly to taxpayers. Though largely behind the headlines, this initiative has already produced three successful transactions, which provide a template for credit-risk sharing in any future housing finance system that contains a government guaranty.
This blog post explores these innovative credit-risk sharing transactions and explains their importance to housing finance reform proposals currently in Congress.
In housing finance, credit risk is the risk to mortgage-backed security (MBS) investors that borrowers will default on their mortgage obligations. Credit risk contrasts with interest rate risk, which is the risk to MBS investors that interest rate swings will cause their outgoing liabilities to exceed their incoming fixed-rate mortgage payments. Because interest rate risk requires only the general gauging of market-wide rate fluctuations, whereas credit risk requires the sophisticated diligencing of many thousands of idiosyncratic loans, “rates investors” greatly outnumber “credit investors.”
Traditionally, in order to spur mortgage markets, the GSEs have assumed all of the credit risk for a certain class of loans meeting GSE underwriting guidelines (so-called “conforming loans”) by guaranteeing to investors the timely payment of principal and interest on MBSs backed by conforming loans (GSE MBSs). In other words, the GSEs agreed for a fee to make GSE MBS investors whole if borrower defaults occasioned losses.
This guaranty has had two beneficial effects. First, the guaranty allows rates investors otherwise wary of credit risk to store their capital in housing markets, thereby lowering interest rates for borrowers. Second, the guaranty renders GSE MBSs an entirely fungible product, a characteristic that has enabled the development of a GSE MBS futures market (the so-called “to-be-announced” or “TBA” market). Much as commodity futures markets serve commodity producers, the TBA market allows lenders to hedge against short-term rate swings, enabling them to extend the 30-to-90-day “rate locks” now familiar to borrowers.
Unfortunately, the GSE assumption of credit risk remains the fount of taxpayer exposure to the housing market. Prior to the crisis, the GSEs’ “implicit” government support empowered them to underprice the credit risk they guaranteed. Rising borrower defaults and delinquencies in the wake of 2006-2009 house price declines required the GSEs to stand behind their guaranties despite razor thin capital of only 2%. When that capital ran out, the Treasury and FHFA stepped behind the GSEs’ credit guaranties to halt a market disaster.
Going forward, policymakers are seeking to strike a balance that retains the benefits of the government guaranty (once implicit, now explicit), but nonetheless requires that private capital share credit risk and losses.
The GSEs completed three transactions in the second half of 2013 using a funded “credit-linked note” (CLN) structure: two Freddie Mac “STACR” deals and one Fannie Mae “C-Deal.” These transactions represent an attempt to strike that balance between government guaranties and private credit risk sharing.
First, a primer on CLNs. In general, CLNs resemble debt securities with embedded credit default swaps (CDSs) that trigger upon the occurrence of a predetermined credit event. The CLN buyer pays a principal amount to the CLN seller in exchange for CLNs that reference cash flows emanating from a “reference” pool of assets. Like CDSs, the CLNs specify conditions relating to the performance of the reference assets, such as a default, that constitute a “credit event.” The CLN seller is obligated to pay the CLN buyer fixed payments over the course of the deal, returning the full principal amount at termination; however, if a credit event occurs before termination, the CLN seller is relieved of part or all of its obligation to return the principal. In other words, the CLN seller in fact buys protection against the occurrence of the credit event, whereas the CLN buyer sells protection.
For the GSEs, the credit-linked note transactions have generally proceeded as follows. First, the GSEs imprint their standard guaranty on the real GSE MBSs, which are bought by rates investors and are fungible for TBA market purposes. Next, the GSEs sell CLNs that reference a portion of the GSE MBSs’ underlying mortgages to credit investors, who provide a principal amount equal to the underlying credit risk. If the borrowers perform, the GSEs pay back the principal amount to the CLN credit investors; if the borrowers default, the GSEs’ payment obligation to credit investors is relieved. The GSEs in this way may fund their guaranty to rates investors through savings on their relieved obligations to credit investors. Effectively, the GSEs offload the credit risk of GSE MBSs to CLN-buying credit investors, while at the same time maintaining the guaranty on the real GSE MBSs critical to rates investors and the TBA market.
Importance to Housing Finance Reform
The real importance of these deals is not their impact on GSE portfolios, however, but rather that they might serve as a template for risk sharing between a government entity and private market participants after Fannie and Freddie are wound down. Indeed, one Senate bill, introduced by Senators Bob Corker and Mark R. Warner, contemplates doing just that. Corker-Warner would abolish the GSEs and FHFA, and replace them with a Federal Mortgage Insurance Corporation (FMIC), roughly modeled after the FDIC. The FMIC would serve as a catastrophic reinsurer to the mortgage finance system, but, unlike the FDIC, would require that private capital absorb the first 10% of credit losses before the FMIC steps in.
The Corker-Warner legislation, which now marshals significant bipartisan support, does not mandate a particular mechanism through which the FMIC and private capital would share credit risk. Instead, it prescribes examination into CLN-structured deals alongside two alternatives: senior-subordinated-structured deals (similar to multi-tranched private-label securitizations) and using prudentially supervised private bond guarantors. Both of these alternatives, however, would in key ways fail either to retain the benefits to borrowers and investors of the current GSE guaranty scheme or to diminish sufficiently the risk of future taxpayer bailouts. In fact, in a recent hearing on Corker-Warner, Laurel Davis of Fannie Mae testified that Fannie employed the CLN structure in its C-Deal, as opposed to the senior-subordinated structure, primarily because the senior-subordinated structure would work harm on the TBA market.
Whether through Corker-Warner or some other vehicle, Congress will likely wind down and replace the GSEs. That replacement will likely include some form of government guaranty, as any fully private alternative would foist much higher rates on American homebuyers. As such, given the probable presence of government support in any reformed housing finance system, the GSE credit risk-sharing CLN transactions provide an innovative template for how a government guaranty-based system could maximize taxpayer protection and borrower/investor benefits. In other words, credit-linked notes in housing finance may be here to stay.
*This blog post was written prior to Martoma’s conviction for insider trading but nonetheless provides valuable insight into defense strategies and potential approaches in future insider trading cases.
On December of 21, 2012, former SAC Capital Advisors portfolio manager Matthew Martoma was indicted on securities fraud and conspiracy charges. According to the indictment, Martoma effectuated the “insider trading scheme” by receiving confidential information about clinical trials of an Alzheimer’s drug being developed by the companies Elan and Wyeth. Martoma received information on the negative results of the drug’s clinical trials from two doctors: Sidney A. Gilman and Joel Ross. After being put on notice of the negative results, Martoma convinced Steven Cohen (SAC Capital Advisors’ founder) to sell a $700 million position in Elan and Wyeth. As a result, SAC Capital Advisors made a combined profits and avoided losses in an estimated amount of $276 million.
In response to the government’s accusations, Martoma pled not guilty and eschewed the opportunity for a plea bargain. Instead, the case is currently being tried in the Southern District of New York. The case is notable for multiple reasons. First, federal prosecutors indicate this is the most profitable insider trading case on record. Second, Martoma’s trial is part of an ongoing ten-year investigation of SAC Capital Advisors for potential insider trading activity. Finally, given the magnitude of the case, the tactics employed by the defendant’s attorneys in the course of adjudicating the dispute likely will be replicated in subsequent securities fraud cases.
This third unique feature will be the subject of this post. More specifically, the defense’s tactics of (1) keeping the defendant off the stand, and (2) creating a case-in-chief by establishing that the defendant’s trading patterns were ‘usual,’ and therefore should not signal the application of insider information, will be analyzed in greater depth.
Value of Keeping the Defendant off the Stand
One of the difficulties that securities fraud defense litigators face is overcoming the negative implication of keeping the defendant off the stand. In choosing to exclude testimony of the defendant, the defense surrenders the opportunity to have the accused personally deny the charges levied against him, a potentially persuasive piece of testimony. As such, this begs the question as to why the defense would choose to forego this opportunity. Simply stated, by keeping the accused off of the stand, the defense team prevents the jury from hearing potentially prejudicial information about the defendant.
Under the Federal Rules of Evidence 608, if a defendant takes the stand, the prosecution may impeach the credibility of the defendant’s testimony by asking probative questions that call into question the accused’s character or veracity. Martoma’s case is illustrative of the potential perils associated with allowing a defendant to take the stand. In 1999, Martoma was expelled from Harvard Law School for forging grades reported on his transcripts. While such evidence does not directly implicate Martoma in securities fraud, by inquiring into this dishonest behavior, the prosecutor can suggest that the defendant’s propensity for dishonesty may have in fact manifested itself in his business dealings. Since such a tactic is explicitly sanctioned by the Federal Rules of Evidence, by preventing Martoma from taking the stand, the defense team would prevent the introduction of this potentially damning “dirty laundry.”
Defending a Transaction by Framing it as ‘Usual’ Business
Given the relative likelihood that the defendant himself will not testify in the context of an accusation of insider trading, an alternative tactic to rebut the prosecution’s case is to argue that the accused did not act with scienter. In other words, the defense may contend that the allegedly fraudulent transaction was instead a transaction conducted in the ordinary course of business. In order to maintain this claim, the defendant will have to prove that the trading patterns of the transaction in question were not “dramatically different from” previous trading patterns.
In Rothman v. Gregor, the Court of Appeals for the Second Circuit outlined when a transaction qualifies as being not “dramatically different” from previous transactions. In that case, shareholders of GT Interactive Software Corporation filed suit against two officers accusing them of artificially inflating prices to make a profit through IPO sales. One defendant sold stock worth $20 million and the other worth $1.6 million during the IPO. Despite the profit made during the IPO, the sales were not unusual, because they comprised 9% of each defendant’s total stock holdings in the company. In other words, Rothman stands for the proposition that the court will consider the magnitude and timing of the transactions at hand, and whether the transaction varies greatly from previous transactions, in determining the culpability of the defendant.
Whether or not Martoma will be able to successfully employ this tactic is debatable given its factual distinctions. Unlike Rothman, SAC Capital Advisors quickly sold its positions in Elan and Wyeth after Martoma allegedly received information about the negative clinical trial results. In addition, Elan and Wyeth stock holdings were two of SAC Capital Advisors’ largest stock holdings. Coupled with Gilman and Ross’s testimony, the timing and magnitude of SAC Capital Advisors’ trading is very suspect and seems to suggest that the transaction would qualify as “dramatically different” from previous transactions, thus implicating Martoma.
Impact of Martoma’s Trial
If Martoma’s defense team is successful, the tactics it chooses to employ may serve as a model in subsequent insider trading cases. Whether Martoma’s defense team will successfully convince the jury is yet to be seen. If successful, the case may have a few important implications for framing a transaction as ‘usual.’ First, the case may stand for the proposition that even if the defendant traded a large portion of their total stock holding, a jury may still be convinced that such a transaction is not “unusual.” Second, even if witnesses corroborate the fact that the large transaction occurred at a suspect time, it may be possible to persuade a jury that the transaction occurred as part of the defendant’s ordinary course of business. As such, if Martoma’s defense team is successful, the case may foreshadow a trend in which defendant’s elect to try their case before a jury as opposed to subjecting themselves to a bench trial.
In November 2013, the Supreme Court granted certiorari to reconsider the class-wide presumption of reliance derived from the fraud-on-the-market theory in cases brought under Rule 10b-5 of the 1934 Securities Exchange Act. The Court’s decision is likely to have important implications. Reversal of the presumption could sharply limit the use of class actions under the federal securities laws.
A private plaintiff who seeks to bring an action under Rule 10b-5 must show, amongst other things, that he relied on the misrepresentation in making his decision to purchase or sell a security. Courts have referred to this requirement as “transaction causation” or “reliance.” However, the fraud-on-the-market theory affords a Rule 10b-5 plaintiff who bought or sold a publicly traded security in an efficient market a rebuttable presumption of reliance. The rationale is that, according to the Efficient Capital Market Hypothesis (ECMH), all available information about securities traded in the principal securities markets is fully incorporated into stock prices almost immediately. An investor who buys or sells stock at the price set by the market relies on the integrity of that price. Misleading statements, according to the theory, therefore defraud purchasers or sellers of stock, even if the purchasers are not aware of the misstatements, because the misstatements affect the stock price.
In Basic v. Levinson, the U.S. Supreme Court formally adopted a rebuttable presumption of reliance based on the fraud-on-the-market theory for Rule 10b-5 claims. There, plaintiffs brought a Rule 10b-5 claim against a company and its directors for making false or misleading statements when it stated publicly three times that it was not engaged in merger negotiations. Plaintiffs sold their stock after the company issued its first press release and alleged that they sold their shares in a depressed market in reliance on the company’s statements. After plaintiffs sold, the company announced it had been engaged in merger negotiations and the following day its Board approved the merger. A plurality of the Supreme Court held that plaintiffs were entitled to a rebuttable presumption of reliance based on the fraud-on-the-market theory; “[b]ecause most publicly available information is reflected in the market price, an investor’s reliance on any public material misrepresentations, therefore, may be presumed for purposes of a Rule 10b-5 action.” The Court based its holding on the ECMH; “Recent empirical studies have tended to confirm . . . the market price of shares traded on well-developed markets reflects all publicly available information, and, hence, any material misrepresentations.”
Many have since called into question the theoretical underpinnings of the theory. For example, Robert Shiller, recipient of the 2013 Nobel Prize in Economics, has argued that the ECMH does not properly account for the effect of behavioral finance, such as “human foibles and arbitrary feedback relations” on the market. Similarly, Larry Summers and Andrei Shleifer have argued that the ECMH fails to acknowledge the effect of “noise trading” in determining asset prices.
Nonetheless, one important implication of the Supreme Court’s decision in Basic is that it has made it easier for plaintiffs to bring securities class action suits. This is because the Basic ruling has been understood as recognizing a presumption of class-wide reliance derived from the fraud-on-the-market theory. Any investor who purchased the security following a misrepresentation is entitled to a presumption that he relied on the misrepresentation in making his decision. This enables a court, as in Basic, to conclude that common questions of law or fact predominate; “without the presumption it would be impracticable to certify a class under Fed. Rule Civ. Proc. 23(b)(3).” In contrast, requiring proof of individualized reliance by each member of the proposed plaintiff class would effectively ensure that individual questions of law of law or fact would overwhelm common questions of law or fact, and thereby prevent certification of a plaintiff class.
However, over the last two decades Congress has repeatedly limited the scope of securities class actions because they make U.S. capital markets less competitive relative to foreign markets—where class action procedures generally do not exist and contingency fee arrangements are not prevalent. In 1995 Congress enacted the Private Securities Litigation Reform Act and three years later it enacted the Securities Litigation Uniform Standards Act to add new requirements that limit securities class action litigation. The effect of expanding the putative class in securities class actions through a rebuttable presumption of reliance raises a number of concerns. It increases settlement pressure on defendants, allows the opportunistic use of discovery by plaintiffs, and could jeopardize the rights of absent class members if class representatives do not adequately represent their interests. Class members can be harmed by the actions of a class representative who accepts a low settlement amount or otherwise fails to adequately advance the interests of the class. Class members may be bound by such class settlements or judgments. The Supreme Court articulated some of these concerns in Blue Chip Stamps v. Manor Drug Stores.
Justice White’s dissent in Basic warned of the dangers of expanding securities class action litigation, “This Court and others have previously recognized that inexorably broadening . . . the class of plaintiff[s] who may sue in this area of the law will ultimately do more harm than good.” Justice White emphasized that, in the context of the fraud-on-the-market theory under section 10(b), the Court should have followed the choice by Congress not to adopt the theory; “[a]ny extension of these laws . . . should come from Congress, and not from the courts. Congress has not passed the fraud-on-the-market theory the Court embraces today. That is reason enough for us to abstain from doing so . . . The majority’s adoption of the fraud-on-the-market theory effectively eviscerates the reliance rule in actions brought under Rule 10b-5, and negates congressional intent to the contrary.”
The Supreme Court now has an opportunity to revisit its decision in Basic and scale back the expansion of securities class actions suits. In November 2013, the Court granted certiorari to hear the case of Halliburton Co. v. Erica P. John Fund. There, shareholders sued Halliburton on behalf of all purchasers of Halliburton stock between June 1999 and December 2001 alleging that the company understated its asbestos liabilities and overstated its revenues in certain businesses and the benefits of its merger with Dresser Industries in public disclosures. The plaintiffs allege that Halliburton’s misrepresentations inflated the price of the company’s stock, and that purchasers suffered damages when the truth was revealed and the stock price fell. The district court certified the plaintiff class, and the Fifth Circuit affirmed.
The Supreme Court is likely to directly address the fraud-on-the-market theory when it announces its decision by June 2014. Significantly, the first “question presented” in Halliburton’s petition for a writ of certiorari was “Whether this Court should overrule or substantially modify the holding of Basic Inc. v. Levinson . . . to the extent that it recognizes a presumption of class-wide reliance derived from the fraud-on-the-market theory.”
Fabrice “Fabulous Fab” Tourre is facing a large fine from the SEC due to his involvement in the now-infamous deal known as Abacus 2007-AC1. On December 16, 2013, the SEC requested that Judge Katherine Forrest order Tourre to pay $910,000 in penalties and return $175,463 in gains plus interest. In papers filed January 21, 2014, Tourre responded to regulators’ request for what amounts to about $1.15 million, asking instead that the fines not exceed $65,000.
Background: Abacus 2007-AC1
In 2013, Fabrice Tourre was found liable for securities fraud in a Manhattan Federal courtroom stemming from his involvement in a 2007 transaction while working as a Vice President at Goldman Sachs (“Goldman”). The transaction, known as Abacus 2007-AC1 (“Abacus”), involved Collateralized Debt Obligations, which, in the Abacus deal, amounted to high-risk bonds dependent upon the performance of subprime residential mortgage-backed securities. According to the SEC, Goldman Sachs failed to disclose to investors the knowledge that John Paulson, the well-known hedge fund manager of Paulson & Co., had approached Goldman to structure the deal while Paulson simultaneously planned to bet against the mortgage-backed securities, or “short” the housing market. Goldman collected about $15 million in fees (though Goldman also claims it lost close to $100 million), while Paulson, when the U.S. housing market collapsed, made close to $1 billion. In 2010 Goldman settled with the SEC for its role in the deal for $550 million, the largest penalty a Wall Street firm has ever paid to the SEC.
Fabrice Tourre’s Involvement
In its complaint, the SEC specifically alleged that Tourre was principally responsible for structuring and marketing Abacus. The SEC also claimed that Tourre was aware of Paulson’s short position with regard to the securities and misled investors into believing that Paulson had taken a long position. After a two-week trial, a federal jury found Tourre guilty of six out of seven securities law violations. Tourre now faces a steep fine from the SEC—a fine that his attorneys say he will personally pay. Tourre has left Wall Street and is currently workings toward a doctoral degree in economics at the University of Chicago.
Request for Leniency
Tourre’s attorneys took issue with the requested fine and proffered various defenses against an amount they deemed “unwarranted and unjust” and “unreasonably severe.” One defense offered by Tourre’s attorneys from UK-based law firm Allen & Overy was that the case lacked evidence that Tourre’s actions had impacted Abacus’s performance or that he had an affect on investors. Additionally, attorneys pointed out that Tourre’s behavior was not “recurrent,” calling his track record at Goldman before the Abacus deal “immaculate.” The attorneys also balked at the SEC’s request that Tourre disgorge his 2007 bonus from Goldman, including a declaration from Daniel Sparks, head of Goldman’s mortgage department in 2007, stating that Tourre’s compensation for that year was not explicitly linked to how profitable his trading desk was.
In its previous filing, the SEC had called the sum appropriate in light of Tourre’s “egregious” conduct.
In light of the economic downturn, while many Americans face unforeseen economic hardships, corporate compensation has become a heated topic. When we debate compensation, however, we often look at the enormous amounts paid to CEOs of companies. Mr. Tourre, however, was no Lloyd Blankfein; instead, the then 28-year-old was “one of thousands of midlevel vice presidents at Goldman.”
At first glance, the $1.15 million the SEC seeks against Tourre ostensibly pales in comparison to the $550 million settlement paid by Goldman. However, when one compares that number with Goldman’s 2010 net income ($8.35 billion), $550 million quickly becomes palatable. Meanwhile, Mr. Tourre’s total compensation package in 2007 was $1.7 million.
To some, the hardline the SEC has taken against Tourre, while simultaneously neglecting to go after higher-ranking Goldman officials, is laughable. The quick and relatively small settlement with Goldman compared with a relatively large penalty it seeks against Tourre is puzzling. The failure to prosecute Tourre’s higher-ups is frustrating to those who feel that Tourre was likely following orders, with Tourre’s own attorney’s agreeing that the S.E.C “has failed to take enforcement action against any of the other people whom the S.E.C. has tactically labeled co-schemers.”
To others, including the SEC, the victory against Tourre was a chance to prove to naysayers that the SEC could successfully litigate the complex financial cases stemming from the economic collapse. While the SEC has taken admirable steps to hold all parties accountable, the company and the individual it claims was the principal force behind Abacus, it is unlikely that Tourre acted alone. It’s more likely that he was executing orders from his superiors, none of whom were individually fined. While there was clear evidence against Tourre, the penalty perhaps outweighs his responsibility in the situation.
Much of the difficulty in assessing what fulfills the notion of a “fair penalty” in the Tourre case is that is involves an employee that structured, at least in part, a deal that sent massive shockwaves throughout the U.S. economy. There is certainly room to argue that the S.E.C.’s case against Tourre sends a well-deserved and unequivocal warning to individual employees at all levels working at financial institutions that they will be held accountable for their role in securities fraud. At the same time, the penalty the S.E.C. extracted from Goldman operated as an efficient manner to return money (albeit a relatively small amount as compared to the damage) to harmed investors. Or perhaps, the S.E.C. is continuing it build its case against other Goldman employees involved in the Abacus deal, though there is no indication that this is the case.
Judge Forrest will rule on Tourre’s penalties in the next few weeks. An order from Forrest that Tourre pay an amount towards the larger end of the spectrum could vindicate the S.E.C.’s decision to so vigorously pursue Tourre. Meanwhile, others may be left wondering if the penalty has any significance while higher-level executives remain untouched.
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