In 2002, Arthur Andersen LLP collapsed in the wake of an obstruction of justice conviction. Since then, conventional wisdom has been that the U.S. Department of Justice (DOJ) resists filing criminal charges against large business entities because of fears of another similar failure. Indeed, the DOJ has consistently acknowledged that it considers such risks, and the U.S. Attorneys’ Manual expressly identifies “collateral consequences” as a factor that should be weighed in making charging decisions. In the wake of the Great Recession, however, the DOJ has been faced with competing pressures, especially with respect to financial institutions. On the one hand, the Lehman Brothers bankruptcy, among other bank failures and near-failures, suggested vulnerability on the part of some financial institutions and illustrated the potentially grave consequences that the collapse of a financial institution can have on the broader economy. The DOJ clearly does not want to cause a financial institution to fail. On the other hand, there is a pervasive public sentiment that large financial institutions were responsible for the economic collapse from which the country is only now emerging. Particularly in recent months, the DOJ has been criticized for its decision not to bring criminal charges against any major financial entity.

…continue reading: Collateral Consequences of the UBS and RBS LIBOR Settlements

In the past 25 years, the size of settlements, fines and penalties for individual corporations found guilty of wrongdoing has escalated from millions of dollars, to tens of millions, to hundreds of millions, to billions. Think Siemens and widespread bribery — about $2 billion. Or, bigger yet, think BP and the gulf disaster — almost $20 billion to date, with another $20 billion-plus likely in the future.

But during this period, there has been another change: highly expensive scandals across business sectors, not just in single companies, and this is reflected in the January 7th agreement by major banks to pay $8.5 billion due to derelict mortgage and foreclosure processes.

These sectoral scandals raise profound issues for business leaders: in a highly competitive global economy, in which some sectors are flooded with money, how do you assess sector-wide integrity risks and achieve a culture of corporate accountability before, not after, bad behavior occurs?

…continue reading: Why Are Some Sectors (Ahem, Finance) So Scandal-Plagued?

Our paper, The Lessons from Libor for Detection and Deterrence of Cartel Wrongdoing (forthcoming Harvard Business Law Review), examines the antitrust implications of Libor. We are cautious to draw overly broad conclusions until more facts come out in the public domain. What we note at this time, based on public information, is that the alleged Libor conspiracy and manipulation seems not to be the work of a rogue trader. Rather it seems to have been organized across firms and apparently required the active knowledge of a number of individuals at relatively high levels of seniority among certain Libor setting banks.

…continue reading: Libor for Detection and Deterrence of Cartel Wrongdoing

In a decision troublesome to the business community, the New York Court of Appeals has now determined that the New York Martin Act does not preempt private plaintiff lawsuits based solely upon traditional common-law causes of action such as negligence and breach of fiduciary duty — even where there may be overlap with statutory claims reserved to the New York Attorney General. From the fact that the Act itself had been held years ago not to give rise to a private cause of action, numerous rulings from both New York State and Federal courts held that the Act preempted non-fraud common-law tort claims. Deeming itself unable to find anything in either the text of the statute or its legislative history that would support such preemption, the Court affirmed a more recent ruling by the Appellate Division, First Department, and ruled the doctrine out. Assured Guarantee (UK) Ltd. v. J.P. Morgan Investment Management Inc., No. 227 (N.Y. Dec. 20, 2011).

In doing so, the Court nevertheless reaffirmed its prior rulings that the Martin Act itself creates no private right of action and that preemption would continue to exist where the claim is entirely dependent upon a violation of the Martin Act or its implementing regulations, including certain specific real estate provisions that are part of the Act.

…continue reading: The Martin Act and Common-Law Claims

In the paper, Executive Overconfidence and the Slippery Slope to Financial Misreporting, forthcoming in the Journal of Accounting and Economics as published by Elsevier, our detailed analysis of a sample of 49 firms subject to SEC Accounting and Auditing Enforcement Releases (AAERs) suggests two distinct explanations for the misstatements. Just over one quarter of the cases represent many of the well-publicized examples of corporate fraud including Adelphia, Enron, Healthsouth, and Tyco. The nature of the misstatements, their timing, and an analysis of the executives suggest that the activities are consistent with a strong inference of intent on the part of the respondent and consistent with the legal standards necessary to establish fraud.

However, perhaps more surprising, we find that the actions by the executives in the remaining three quarters of the cases are not consistent with the pleading standards required to establish an intent to defraud. Rather, our analysis of the 49 AAER firms suggests that optimistic bias on the part of executives can explain these AAERs. We show that the misstatement amount in the initial period of alleged misreporting is relatively small, and possibly unintentional. Subsequent period earnings realizations are poor, however, and the misstatements escalate. Using a matched sample of non-AAER firms, we show that the misreporting firms did not simply get a bad draw on earnings. Nor does it appear that weaker monitoring relative to the matched sample explains why the misreporting manager’s optimistic bias affects the financial statements.

…continue reading: Executive Overconfidence and the Slippery Slope to Financial Misreporting

A recent decision by the highest court in New York highlights once again the broad finality of a general release given in a transactional context, even in cases where significant fraud is subsequently alleged. As we noted in a prior M&A Update, courts are reluctant to permit parties to circumvent the typically broad language of general releases by allowing the aggrieved party to argue that it really did not mean to release the claim being pursued despite the claim clearly falling within the literal words of the release.

The recent Court of Appeals decision arose out of a complicated set of transactions involving interests in various Latin American telecom businesses that culminated in a majority shareholder affiliated with Carlos Slim buying out the interests of minority shareholders. The sellers later alleged that they sold their interests at the agreed price only as a result of fraudulent information provided to them by the purchaser, resulting in an undervaluation of almost $1 billion. The purchaser asserted that all claims were barred by a broad release (“all manner of actions…whatsoever…future, actual or contingent…”) given by the sellers at the time the buyout was completed.

…continue reading: General Release — Handle with Caution

Two and half years removed from the worst financial crisis since the Great Depression, the investing public has grown increasingly frustrated with the lack of criminal prosecutions of, and absence of truly significant fines levied against, the senior executives and companies responsible for igniting the subprime meltdown. Pundits have criticized the Securities and Exchange Commission (the “SEC”) and the Department of Justice (the “DOJ”) as capitulating to the interests of “big finance,” citing SEC settlements that have been characterized as mere “slaps on the wrist” and the DOJ’s failure to convict a single executive responsible for creating the “great recession” despite significant evidence of intentional misconduct.

For decades, the public’s trust in the integrity of U.S. capital markets was a source of economic stability and unparalleled prosperity. To maintain this trust, investors must believe that they compete on a relatively equal playing field and that the laws governing the markets will be strictly enforced. In furtherance of these goals, violators of federal rules face civil penalties from the SEC or criminal prosecution by the DOJ. In connection with previous corporate scandals, the government held a significant number of the principal wrongdoers civilly and criminally accountable for their misconduct. In the wake of the current financial crisis, however, many argue that the lack of such accountability has eroded the public’s faith in U.S. capital markets.

…continue reading: Too Big to Fail or Too Big to Change

In Erica P. John Fund Inc. v. Halliburton Co., No. 09-1403 (June 6, 2011), the Supreme Court of the United States decided that in seeking class certification, a plaintiff in an action under the federal securities laws is not required to prove facts demonstrating loss causation. [1] In so holding, the Supreme Court rejected a contrary rule, adopted only by the Fifth Circuit, that proof of loss causation is a prerequisite to class certification. Halliburton was the Supreme Court’s first significant re-examination of the “fraud-on-the-market” theory of reliance adopted in Basic Inc. v. Levinson, 485 U.S. 224 (1988).

The Supreme Court, however, decided only the narrow issue of whether loss causation is a prerequisite to class certification. According to arguments advanced by the Halliburton defendant before the Supreme Court, the Fifth Circuit had intended to rule only that in order to obtain class certification, a plaintiff in an action under the federal securities laws must prove “price impact.” “Price impact” refers to proof that the defendant’s alleged misrepresentation in fact distorted the market price of the security at issue in the case. The Supreme Court rejected the Halliburton defendant’s characterization of the Fifth Circuit’s decision. The Supreme Court viewed the Fifth Circuit as having required proof of “loss causation,” as the Supreme Court’s cases have defined that concept, and held only that this aspect of the Fifth Circuit’s decision was erroneous. The Supreme Court thus left open what were arguably the most important issues potentially presented by Halliburton. Those issues involve (i) whether a district court should examine evidence of price impact at the class certification stage, and (ii) whether, if so, at that stage a plaintiff has the burden of affirmatively proving price impact; a defendant instead has the burden of rebutting a presumption of price impact; or an intermediate structure of shifting burdens may apply.

…continue reading: Supreme Court Holds “Loss Causation” Not a Prerequisite to Class Certification in Fraud Cases

The fraud on the market class action no longer enjoys substantive academic support. The justifications traditionally advanced by its defenders—compensation for out-of-pocket loss and deterrence of fraud—are thought to have failed due to the action’s real world dependence on enterprise liability and issuer funding of settlements. The compensation justification collapses when considered from the point of view of different types of shareholders. Well-diversified shareholders’ receipts and payments of damages even out over time and amount to a wash before payment of litigation costs. The shareholders arguably in need of compensation, fundamental value investors who rely on published reports, are undercompensated due to pro rata distribution of settlement proceeds to all class members. The deterrence justification fails when enterprise liability is compared to alternative modes of enforcement. Actions against individual perpetrators would deter fraud more effectively than does enterprise liability. If, as the consensus view now has it, fraud on the market makes no policy sense, then its abolition would seem to be the next logical step. Yet most observers continue to accept it on the same ground cited by the Supreme Court in 1964 when it first implied a private right of action under the 1934 Act in J.I. Case v. Borak—a private enforcement supplement is needed in view of inadequate SEC resources. Restating, even a private enforcement supplement that makes no sense is better than no private enforcement supplement at all.

…continue reading: The Political Economy of Fraud on the Market

In the paper, CEO-Director Connections and Corporate Fraud, which was recently made publicly available on SSRN, we study the propensity of firms to commit financial fraud using a sample of SEC enforcement actions from 2000 to 2006. Controlling for year effects, Fama-French 48-industry effects, and several firm characteristics, we find a significant relation between fraud probability and CEO-board connectedness.

The nature of this relation depends on the institutional origin of the connection. While nonprofessional connectedness due to shared educational and non-business antecedents increases fraud probability, professional connections formed due to common prior employment decrease fraud. The positive effects of professional connectedness are pronounced only when individuals share prior service as executives. The impact of professional-connections persists after the 2002 Sarbanes-Oxley Act while nonprofessional connections lose significance after SOX.

…continue reading: CEO-Director Connections and Corporate Fraud