Negative Reinforcement Out; Positive Reinforcement In: Spitzer’s Got a Committee of His Own

In the most unsurprising press release of the year, Eliot Spitzer announced that he too has commissioned a committee to “identify ways for New York to retain and enhance its status as a world financial capital.” Apparently the headlines Treasury Secretary Hank Paulson was receiving for his three – count ‘em – three committees were too much to pass up.

The creation of all these committees seems to ignore the powers of globalization. Of course New York has lost some of its market share because other financial centers are rapidly developing. Not the least of which is Beijing and if you think the regulatory environment in China is a good model then apparently you haven’t been reading Herb Greenberg’s blogs about the shady accounting procedures practiced at publicly traded Chinese firms. See here, here, and here. Further, more and more companies actually are choosing to list on the New York Stock Exchange. Even today, the U.K.’s largest hedge fund manager, Man Group, choose to publicly list several of its larger funds with the New York Stock Exchange.

But aside from the myth that New York isn’t a competitive financial hub, I do believe there are ways this commission can help investors and brokerages. An abbreviated list goes as follows:

     - Completely restructure securities arbitration. For specifics, you can read my previous blog here.
     - Affirm the right to use SEC Rule 10b-5 in private investor civil cases. Again, for specifics read here.
     - Encourage the NASD to adopt a “qualified” privilege rule covering information inserted into a departing brokerage employee’s Form U-5 and put an end to Wall Street scapegoating and defamation of employees. I won’t hold my breath since Spitzer in part created this problem to begin with. Need evidence? Click here.

Spitzer’s committee is to report its findings and recommendations on June 30, 2008. Hopefully after a year of spending taxpayer’s money, the committee will actually accomplish something for them and not reward Wall Street for its past misdeeds.

Cox’s True Scheme to be Revealed

It finally will come to a hilt. Christopher Cox, Chairman of the SEC, has to make a decision. Is he a friend to big business and corporate interest as his record in the U.S. Congress has shown, or is he a champion of the individual investor as he claimed in his Senate confirmation hearings? We shall see well enough as he must decide whether to file an amicus brief with the Supreme Court weighing in on whether the SEC advocates so-called “scheme liability.” Scheme liability means that after a major corporate fraud is uncovered, other players who may have participated in the fraud share in the liability and may be sued under SEC Rule 10b-5.

The stakes cannot be higher. There are still many victims of dot-com-era fraud who haven’t been able to recoup their losses because the Enron’s of the world are no longer liquid. The liquidity exists with the vendors including the brokerage houses that assisted in hiding transactions, law firms that advised fraudulent deals to hide losses and accountants that swept substantial profit shortfalls under the carpet. In many cases the fraud that brought down Enron, HealthSouth, and WorldCom was the brainchild of a consultant, or at the very least was blessed by outside vendors who charged fat fees for their rubber stamps.

Chairman Cox is no fan of class action law suits and was a champion of tort reform while in Congress, which makes his decision hard to predict. Ever the optimist, I have to believe he’ll keep his promise to investors and ask the court to establish a precedent that broadens the liability to the Wall Street fraudsters that should have gone the way of Jeffrey Skilling and Bernie Ebbers in the first place. It is indeed a defining moment.

Third Times a Charm!!!

No one would mistake me as a fan of Treasury Secretary Henry Paulson or his committees aimed at increasing Wall Street’s competitiveness regardless of the cost to individual investors. Not surprisingly, I was skeptical when I learned of last week’s announcement from the Treasury that it was creating yet another committee, this one with the directive to study problems in the accounting industry.

However, I must admit I was encouraged to learn that former securities chief, Arthur Levitt will be leading the new committee’s efforts. It’s no secret that Mr. Levitt doesn’t think Paulson’s concerns over Wall Street’s competitiveness hold much weight and has in fact made public comments questioning the soundness of proposals that would limit investors’ rights to sue. As Alan Murray writes in Wednesday’s Wall Street Journal “perhaps Paulson sees this as a harmless way to bring the outspoken Mr. Levitt onto the team, and soften his criticism.” Whatever Paulson’s reason for appointing Levitt as co-chairman, I’m encouraged to know that there’s at least one committee member who’s looking out for the rights of investors; not to mention, the Levitt Committee just has a nicer ring to it.

Paulson suggested in an op-ed that appeared in the Financial Times on May 17th that the committee is intended to be a public forum where “investors, advocates, and companies can present a wide range of views, engage in informed debate and provide recommendations.” In the hopes of ensuring that ordinary investors are protected, I decided to take him up on his offer and have submitted a request to Treasury Under Secretary Robert Steel to see if there’s an opportunity for my involvement. Stay tuned.

The Absent Minded Professor

Columbia law Professor John Coffee seems to be unfamiliar with the classic movie, “The Absent Minded Professor” despite appearing to be the real world embodiment. To wit: on Wednesday, the Financial Time’s Patti Waldmeir wrote an article making the case that the SEC needs to combat frivolous investor lawsuits. In particular, comments from Prof. Coffee caught my eye:

“[Coffee] says current law wrongly immunizes secondary participants in fraud – such as banks and accountants. The SEC used to believe that guilt should be spread to all those who actively helped perpetrate a fraud – and it will shortly have a chance to prove whether it has changed that position.” (Financial Times May 23, 2007)

In a previous blog post, I showed that Prof. Coffee has made clear that he advocates preventing class action securities lawsuits and arbitration claims from arguing violations of SEC Rule 10b-5. He thinks the SEC should be the sole user of the so-called “Securities Fraud Rule.” This is a catch-22 for investors.

On the one hand Prof. Coffee’s tying the hands of investors by preventing the use of Rule 10b-5, and then on the other he’s admitting the SEC may not have the appetite to seek retribution against fraudsters like Enron’s bankers. Who’s looking out for the little guy then?

Further Prof. Coffee’s legal career includes helping lawfirm giant Vinson & Elkins evade punishment after they allegedly assisted former Enron CFO Andy Fastow hide illegal personal profits from offshore partnerships in order to deceive shareholders. Apparently banks and accountants who enable fraud: bad…law firms that enable fraud: good.

Absent minded indeed!!

The Wall Street Shell Game – Wanna Play?

Recently, The Wall Street Journal buried a story about a settlement reached between the SEC and Morgan Stanley. The SEC found that after retail investors in their Private Wealth Management unit placed an order to buy a stock, Morgan Stanley would quote them a marked-up price, usually no more than a penny more than the stock’s actual price. According to the article, Morgan Stanley would do this on a massive scale and profit handsomely.

But that gain is likely only one of three profit centers Morgan Stanley and other major Wall Street brokerages are making off the backs of high net worth retail investor clients. The real profits exist on a much darker and sinister level. It’s known in the industry as getting a “threefer,” and the ease at which the scheme is carried out is a result of the erosion of the specialist floor broker at the New York Stock Exchange and the rise of aptly-named “dark pools.”

The easiest way to understand the “threefer” is to consider this scenario:

A major Wall Street brokerage accepts a sell order from a retail investor for 10,000 shares of a thinly traded stock. Revenue stream number one comes from the fee the retail investor must pay the brokerage to sell the stock. The brokerage then enters into what is known as “the dark pool,” where the hedge fund sharks swim. Avoiding any stock exchange or floor trader, the brokerage and the hedge fund negotiate a trade. The brokerage then marks up the stock price representing revenue stream number two and the penny markup represented in the WSJ article.

The hedge fund now sells 9,000 shares and keeps 1,000 in its own portfolio. So, the hedge fund turns back to the brokerage to execute the order via the brokerage’s pipeline to a major exchange. The hedge fund pays a fee for the pipeline to the brokerage, which completes the “threefer,” but the illicit profits don’t end there.

Why would a hedge fund make profitless trades and pay a major Wall Street brokerage for the trouble? Well, when the hedge fund buys the stock, it will be executed through a program in 1,000-share increments usually reducing the stock’s price by a few cents. Once the trade is complete, the hedge fund will ride the stock back up using the 1,000 shares it kept, sometimes increasing its stake if the arbitrage gains are significant enough. The scheme is virtually risk free and equates to a license to print money.

Worse yet, the above scenario occurs all day everyday in plain sight and is a major reason hedge funds can produce outsized returns. High net worth investors are most susceptible because their buy and sell orders are large enough to affect stock prices.

Every investor, whether institutional or retail, is entitled to the “best execution” of his or her buy/sell orders, meaning the best possible price. Institutional investors buy and selling huge positions so they are less likely to be taken advantage of because they’ll check the data.

How can a retail investor do the same? Morgan Stanley and all brokerages are actually required to disclose where a trade was executed. The rule requiring them to do so is SEC 606. The disclosure comes in the form of the confirmation document your brokerage will send to you, usually buried somewhere in the ninth or tenth item. You might see four letter acronyms representing the other market participant. Ask your broker for details on these mysterious four letter words.

If they won’t tell you or do come clean and the four letter acronyms represent a hedge fund or other firm with a proprietary trading desk, you’ve probably fallen victim to Wall Street’s secret little shell game.

So what’s the harm here? The rich-guy investor only paid a penny a share more. No harm no foul, right? Think again. The stock market is based on the principle that a stock price is the reflection of the way the market views it at a particular time. The Wall Street shell game creates a manufactured price. If there’s no guarantee that a stock is priced at market value, then the market will lose confidence, which is bad for investors big and small.

Better Late than Never: Wrap Accounts Finally Wrapped-Up

Thankfully, a federal court has put an end to the free wheeling ways Wall Street treats wrap accounts, also known as the “Merrill Lynch rule,” and this week the SEC announced it will not appeal the decision. Two years ago I published this article in the “Wall Street Lawyer” arguing that the transition from commission-based brokerage accounts to fee-based, or “wrap accounts,” opened up the door for more Wall Street shenanigans. The switch-over was actually well-intended and sought to curb churning for commissions on frequent trading. But churning was replaced with other unscrupulous activities.

For example, Wall Street brokers would convince their clients to double-up assets on margin when a hot stock tip came down the pipe, then charge the 1-3 percent fee based on the client’s gross assets. So someone with a $1 million account would borrow another $1 million to increase profit on a surging tech stock. The broker then charges a fee based on the $2 million, unfairly doubling the fee. Then there’s the “hit and run” brokers who open up wrap-accounts, convince client to buy some speculative stocks and disapear while their client’s assets deteriorate.

By over-turning the Merrill Lunch rule, the court decided that brokers who offer fee-based accounts must register as investment advisors with the NASD and accept “fiduciary” responsibility for their clients. This means brokers now have to put a client’s best interest first (the horror!) and on an on-going basis monitor client trading and make active recommendations reacting to market volatility and a client’s changing risk tolerance (such as a client’s financial circumstance).

What I find most interesting in all this is the shock and horror from Wall Street. Merrill Lynch sent a memo to its legion of brokers saying that it “strongly disagrees with any action that would end fee-based accounts.” The Securities Industry and Financial Markets Association (Sifma), Wall Street’s main lobbying group, calls the decision “an outrage.” Is it so outrageous to put a client’s interest ahead of your own? Wall Street’s outrage is actually somewhat comforting. Finally they are publicly admitting that a client’s best interest play second fiddle to their own.

Paulson Committee’s “Hippocratic Method”

In case anyone doubted the hypocrisy of Treasury Secretary Hank Paulson’s Committee for Capital Markets Regulation, just take a look back at an op-ed published this week in the National Law Journal by Lawrence A. Cunningham, a Boston College Law School professor and leading expert on corporate governance and securities law.

One of the overarching hot-button issues is whether Wall Street and Corporate America should be governed by a “rules-based” or “principles-based” system. Professor Cunningham writes that while on the one hand the Paulson Committee lobbies for an overarching “principles-based” system on the other when an already established principle works to their disadvantage they urge specific language and rules - distancing industry wrongdoers from liability. In other words, the Committee is trying to have its cake and eat it too.

The most egregious example is the Committee’s full scale assault on SEC Rule 10b-5. Rule 10b-5 is a well established “legal principle” that prevents firms from making “false and misleading material statements” and is the basis for which many investor arbitration claims and class action securities lawsuits are filed. While simply telling the truth might seem reasonable, the Committee wants “detailed prescriptive language” to reduce what it considers “uncertainties” with the principle. Translation: they want to make it harder for investors to prove Rule 10b-5 was violated. Committee consultants are already on the record arguing that the rule should not be used in civil trials and arbitrations whatsoever, as my previous blog points out.

Abandoning an established legal principle like Rule 10b-5 and reversing its course in favor of more stringent standards, Paulson’s committee audaciously undermines its own reasoning for deregulation. And Rule 10b-5 is only one of a slew of examples where the Committee favors rules that insulate themselves from the legal system.

Among other examples of duplicity, Cunningham cites the Committee urging the SEC “to abandon its recently stated principle that ‘materiality’ is not a strictly quantitative concept and return to the erstwhile rule that measured materiality in terms of 5 percent of income.” This legalese basically means that fraud is only truly fraud if it equates to 5 percent of a company’s income. The “materiality” argument, mind you, was one of the defense strategies employed by Enron’s Ken Lay and Jeffrey Skilling.

Choosing when and where to apply legal principles based upon the investor’s ability to recoup fraudulently incurred losses shows the Paulson committee’s true motivation is greed. Kudos to Professor Cunningham for helping to expose the Paulson Committee’s “Hippocratic Method.”

A Figment of Paulson's Imagination

It’s strange that Hank Paulson and the Committee on Capital Markets would want to scale back investor protections and regulations, when the hands of the judicial branch are already tied from acting upon the securities industry’s transgressions. Take for example this op-ed by Harold Myerson in Tuesday’s Washington Post,
showing how Merrill Lynch, Barclays and Credit Suisse First Boston were granted near immunity for enabling Enron to cook the books by a Federal Appeals court, despite the judges’ opinions that the banks’ actions were less then honorable.

The decision’s highlight is what Judge James Dennis wrote in the concurring opinion: "The majority immunizes a broad array of undeniably fraudulent conduct from civil liability…effectively giving secondary actor’s license to scheme with impunity, as long as they keep quiet." In other words, you can rob the bank so long as the driver takes the fall.

The ruling revolves specifically around Rule 10b-5 which prohibits companies from making misrepresenting statements leading to the purchase or sale of securities. This rule is crucial to many class action securities suits as well as arbitration claims, so any tinkering can have far reaching implications.

The Committee on Capital Markets has remained ambiguous on its true intentions regarding 10b-5, they just want to "resolve existing uncertainties in Rule 10b-5 liability" Paulson Committee adviser, and Wall Street advocate Prof. John Coffee however has been a little more forthcoming. Back in October, Coffee mentioned to the New York Times (October 29, 2006) that, "he had recommended that the S.E.C. adopt the exception to Rule 10b-5 so that only the commission could bring such lawsuits against corporations." With arbitration and class actions out of the way, the already swamped SEC will be the last investor protection. Who benefits when that happens? Certainly not individual investors.

The real question is, where is the over burdensome legal proceedings that is the object of Committee on Capital Markets whining? With the judicial branch arguing that laws currently let crooks off the hook, it seems to be a figment of Paulson & Co.’s imagination.

Calling into Question the Committee for Capital Market Regulations True Motivations

Today I spoke before the National Association of Securities Administrators Association on Wall Street’s greedy efforts to scale back Enron-era corporate and securities regulation. I’ve posted my speech here.

For the life of me, I can’t figure out how Paulson’s committee is arguing for the deregulation of reforms that are targeted at curbing their own indiscretions. To put it another way, this is like Pete Rose asking Major League Baseball to sanction gambling on games!

FACTS vs. MANAGEMENT SPIN

Having been the catalyst that sparked Wall Street’s $1.4 billion settlement for conflicted research, the quality and accuracy of the Street’s equity coverage is understandably a subject near and dear to my heart. That’s why I nearly choked on my morning breakfast earlier this week when I read the following comment by Andy Kessler, a former Wall Street telecom analyst, about a Banc of America Securities analyst who had the temerity to initiate coverage on about a half dozen pharmaceutical stocks without talking to management.

Initiating coverage without speaking to management "is absolutely pointless for a money manager," Kessler opined to the New York Post.

I beg to disagree.

Disgraced analysts Jack Grubman and Henry Blodget were "tight" with the managements they covered, and we all know about the quality of their work. A more recent example is some divergent coverage on Circuit City, the once darling stock that has imploded.

An obscure research outfit called Rate Financials, which maintains a strict policy of not talking to management, warned investors about the perils of investing in Circuit City nearly 10 months ago. Meanwhile, two prominent retail analysts, Gary Balter of CSFB and "independent" analyst Dana Telsey, were touting the stock. Balter and Telsey apparently had close ties to –and apparently were blinded by -- Circuit City’s management.

Here are the facts I’ve garnered based on published news reports and some of my own research:

Rate Financials last July issued a critical report on electronics retailer Circuit City (NYSE:CC), claiming the company wasn't properly accounting for lease obligations and that earnings were generated almost entirely from the sale of extended warrantees and not from profits earned on peddling electronics. At the time, Circuit City was trading at around $26 a share.

Balter, who in September had an "outperform" rating and a $35 price target on Circuit City shares, didn’t take kindly to Rate Financials’ report after it was highlighted in a September article in the Wall Street Journal. Balter issued a critical report on Rate Financials’ analysis that included this admonition: "Circuit City stock rose 54% in 2004 and 44% in 2005. Which side of the trade would you want the sell side to be on?"

Telsey’s affection for Circuit City was disclosed in a December 14, 2006 article in Fortune magazine, where she included the retailer as being among the nine companies showing "the most near-term promise" of the 38 retailers she covers. Interestingly, Telsey on her website trumpets that she is in "front of the executive management of the most influential companies," and that she speaks "directly with the sales associates in the stores." Telsey told Fortune she had a $30 to $32 price target on Circuit City.

Investors who heeded Rate Financials’ warning fared well. Circuit City last month, announced significant decreases in earnings estimates, fired its CFO, and terminated its most experienced sales staff (presumably the staff Telsey was talking to). And guess what? Contributing to the loss were decreases in warranty sales and lease obligations. Circuit City dropped a second shoe earlier this week by announcing yet another profit warning.

Circuit City now trades at around $16 and change. Balter has cut his rating on the stock to "neutral" from outperform and now has an $18 price target. No public word on Telsey’s view on the stock.

Here are some other interesting facts worth noting.

• Rate Financials apparently isn’t a one-trick pony. In August of 2005, Calpine Corp. issued a special press release denouncing a Rate Financial’s report calling into question its accounting procedures. By December, Calpine had declared Bankruptcy.


• Fortune readers who acted on Telsey’s stock recommendations haven’t fared too well. Her basket of recommended stocks are up 3.3 percent since the article was published, while the S&P Retail Index is up 4.3 percent. Perhaps Telsey should spend a little less time talking to managements and sales clerks and learn how to read the fine print in publicly disclosed documents.

Sadly, Rate Financials research is costly and beyond the reach of individual investors, providing another case in point as to why the markets are stacked against them.