INSIDE THIS ISSUE
On June 24, 2010, the United States Supreme Court rendered a landmark decision clarifying the reach of the United States securities laws. In the closely watched case of Morrison, et al. v. National Australia Bank Ltd., et al., the Supreme Court held that Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) – which is the statute that provides investors with protection from securities fraud – does not apply to stocks and other securities unless those securities are listed on the U.S. securities exchanges, or are bought or sold in the U.S. The Court’s opinion not only impacts those cases pending in U.S. federal court brought on behalf of investors who purchased stock listed on foreign exchanges, but may also signal significant changes in U.S.-based investors’ international investment strategies.
The U.S. Supreme Court determined that it was not enough that the wrongdoing occurred in the U.S. Rather, the Court explained that an investor can only invoke the protections of Section 10(b) of the Exchange Act if the investor buys or sells the subject stock in the U.S. It is a longstanding principle of American law that legislation is meant to apply only within the territorial bounds of the United States, unless the legislation specifically provides otherwise. When a statute gives no clear indication of an extraterritorial application, it has none. In the case of Section 10(b) of the Exchange Act, the Supreme Court concluded that the statute was silent with respect to any potential extraterritorial reach. As a result, the Court explained that the longstanding presumption against any extraterritorial reach should be applied, and Section 10(b) could not be applied to stocks or securities unless they were listed on the U.S. stock exchanges or were bought or sold in the U.S. The Supreme Court went on to explain that it was not enough that the alleged wrongdoing occurred in the U.S. Rather, the stock must be listed on a U.S. exchange, or bought and sold there. The Court explained that this is the case because Section 10(b) does not focus on the place where the deception occurred but, instead, focuses on the place where the securities were bought or sold. The Court further noted that the Exchange Act was passed to regulate conduct on the U.S. exchanges, and that the Exchange Act’s registration requirements apply only to those securities listed on a U.S. exchange. Thus, the Court reasoned that the place where the deception occurred is immaterial to whether or not the U.S. securities laws cover the fraudulent conduct at issue in a case.
Impact of Morrison
In the wake of the Morrison decision, investors should expect significant changes in how international securities transactions are executed from newly emboldened foreign issuers. For instance, because the Supreme Court’s opinion in Morrison provides U.S. and foreign issuers a virtual roadmap for avoiding liability under the U.S. securities laws, foreign issuers selling securities not listed on a U.S. exchange to an institutional investor may now require that the purchase is made through an offshore transaction involving a non-U.S. affiliate to avoid liability. The Supreme Court’s opinion, however, also indicates that the Securities and Exchange Commission could develop regulations aimed at preventing foreign issuers from evading liability under the Exchange Act by including language addressing its extraterritorial reach.
Although Morrison shows issuers how they can currently avoid liability under the Exchange Act, the decision does provide investors with substantial leverage and protection for their future international securities transactions. For example, Morrison gives large U.S. institutional investors the necessary leverage to insist that their purchases be made in the U.S. to ensure that the Exchange Act would apply to the purchase. Furthermore, should the lower courts adopt a liberal reading of Morrison, investors who purchase securities on a foreign exchange through the Internet accessed on U.S. soil may also be afforded protection, though there is not a significant likelihood of such an interpretation prevailing.
Furthermore, the recently enacted Financial Reform Bill and Consumer Protection Act, otherwise known as the Dodd-Frank Bill has the potential to reverse or at least moot any effect Morrison might otherwise have on securities class actions. Indeed, the bill applies tests similar to those that were used to determine extraterritorial jurisdiction prior to the Morrison decision for Securities and Exchange Commission (SEC) and Department of Justice (DOJ) enforcement actions. In addition, the Dodd-Frank Bill directs the SEC to study whether this should also be done for private civil actions. If this results in a similar change being applied to private litigation, override Morrison.
In the meantime, there is little doubt that the Supreme Court’s opinion in Morrison will significantly impact those cases current pending in U.S. courts that involve investors who purchased stock that is listed on foreign exchanges. Because the Court’s opinion involves the clarification of the legislative reach of an existing statute, it is certain to be applied retroactively to those cases that are currently pending in U.S. district courts. The Court’s opinion will also bar investors from bringing similar cases on behalf of investors who purchased on foreign exchanges in the future. Those investors will have to look to the securities laws in the country where the securities are listed to see if they have a remedy for claims of securities fraud. Investors are also expected to revisit their current investment strategies to account for the lack of protection from fraud afforded them under the U.S. securities laws for their non-U.S.-based securities investments.
According to NERA’s semi-annual study, which was published on July 27, 2010, the median settlement in the first half of 2010 in federal securities class actions was $11.8 million. At $11.8 million, the median settlement exceeded 2009’s value of $9 million by almost one-third, crossing the $10millionmark for the first time. The first half 2010 median settlement is more than three times the 1996 median, which was $3.7 million. The median has only exceeded $6 million once between 1996, the first year under the Private Securities Litigation Reform Act (PSLRA), and 2004, however, since 2005, the median has exceeded $7 million every year.
According to the authors of the study, one factor driving the increase in median settlement values was a substantial increase in median investor losses—a variable which correlates strongly with settlement size. In the first half of the year, median investor losses in cases settled were $436 million, the highest level since 1996. Also, settlements were considered high relative to investor losses in the first half of 2010, with the median ratio of settlements to investor losses reaching 3.1%, a proportion higher than or equal to that observed in any year since 2002.
The NERA study draws from more than 15 years of NERA research on case filings and settlements in securities class actions, and includes data on filings, dismissals, and settlements through June 30, 2010. From1996 to the present, the NERA study has found that a majority of the federal securities class actions filed and resolved—about 60%—have settled. According to the study, recent credit crisis-related cases are only just beginning to be resolved: most of these cases were filed in 2007-2009, with only 17 filed in the first half of 2010. Over two-thirds of credit crisis cases are still pending. As of June 30, out of the 212 credit crisis-related federal securities class actions, 12 have settled and almost a quarter have been dismissed. Credit crisis cases filed in years prior to 2010 had higher investor losses than other cases, especially in 2008, when median investor losses for credit crisis cases were $3.472 billion, as compared to median investor losses of $417 million for cases not related to the credit crisis. However, according to the study, in the first half of 2010, median investor losses for cases filed related to the credit crisis fell below the median investor losses for other cases.
On July 22, Dell, Inc. agreed to pay $100 million to settle civil charges by the Securities and Exchange Commission. The SEC complaint alleged that Dell’s senior executives regularly employed improper accounting to make it appear that the computer maker was meeting its Wall Street earnings targets. In addition, Michael Dell, the company’s founder, chairman and chief executive, agreed to pay a $4 million fine.
Dell had seemed to prosper in the wake of the tech crash. While other companies were struggling to survive, the company met or exceeded its earnings per-share targets quarter after quarter. Dell’s continued success was often attributed to its aggressive supply-chain management. Now, courtesy of the SEC investigation, the truth has been revealed — Dell utilized payments from Intel to smooth its earnings.
According to the SEC complaint, at one point, 76% of Dell’s quarterly operating income came from Intel, via lump sum payments and a rebate system designed to keep Dell from offering AMD chips in its computers — $723 million in one quarter alone. Over four years, Intel paid Dell $4.2 billion, which it used to shore up its results and stashed away into so-called “cookie jar” reserves.
Cookie jar accounting, or cookie jar reserves, is an accounting practice in which a company uses generous reserves from income, such as the Intel payments, in good quarters against losses that occur in lean times. A cookie jar reserve is a liability created when a company records an expense that is not directly linked to a specific accounting period — the expense may fall in one period or another. Companies may record such discretionary expense when profits are high because they can afford to take the hit to income. When profits are low, the company reduces the liability (the reserve) rather than recording an expense in the lean period. The desired result of cookie jar accounting is a "smoothing" of net income over the course of several years.
According to the SEC, Dell would have missed analysts' earnings expectations in every quarter between 2002 and 2006 were it not for cookie jar reserves. The SEC's complaint said Dell had maintained reserves using Intel's money that it could dip into to cover any shortfalls in its operating results. The Commission’s account of how Dell used the cookie jar accounts reads like a textbook explanation of some of the accounting manipulations most frequently used by companies desperate to make quarterly estimates. Dell, after getting wind of the SEC's inquiry, announced in 2007 that it was moving on its own to review accounting procedures and restate financial reports.
The Dell case is just one highly publicized example of how companies cross the line separating legitimate funds from illegal manipulation of reserves. On June 2, for example, the SEC filed a complaint and proposed settlement with voting machine maker Diebold, accusing the company and some of its officers of "manipulating reserves and accruals; improperly delaying and capitalizing expenses; and improperly writing up the value of used inventory."
Pursuant to an agreement in principle with the SEC, Diebold settled an enforcement action by neither admitting nor denying the civil securities fraud charges while paying a penalty of $25 million and agreeing to an injunction against committing or causing any violations or future violations of certain specified provisions of the federal securities laws.
According to the complaints filed by the SEC against Diebold and certain of its executives, when end-of quarter earnings reports internally received by company management showed that the company's actual earnings were below analyst consensus forecasts, the company's financial management allegedly would use fraudulent accounting transactions that had been designed to improperly recognize revenue or otherwise inflate the company's financial performance in order to reach the analyst forecasts.
Among these transactions were reserve manipulations. For example, the SEC charged that during 2003, in order to fund the under-accrued liability for the company's long-term incentive plan, Diebold reduced unrelated accounts rather than adjusting the incentive plan’s liability accrual on a quarterly basis, as required under GAAP accounting rules. The SEC also made allegations related to improper material under-accruals for other incentive- and commission-related liabilities. In addition, the SEC alleged that a $7.5 million reserve, which was established after the company's auditor concluded that the company had prematurely recognized revenue on certain transactions, was released without a legitimate accounting basis under GAAP in order to fill shortfalls in the company's operating results, and a corporate obsolescence and excess inventory account was also used as a cookie-jar reserve.
There is plenty of evidence of companies managing earnings by manipulating their financial statements. In the past four months alone, other technology companies settling with the SEC for various types of accounting fraud charges included Trident Microsystems and data capture technology maker Symbol Technologies. In a highly publicized case last year, the SEC entered into a $50 million settlement with General Electric. "GE bent the accounting rules beyond the breaking point," said Robert Khuzami, director of the SEC's Division of Enforcement, in a statement that appears to acknowledge a generally accepted reality that companies strive to "manage" earnings results.
When the U.S. Supreme Court makes a ruling the decision is not appealable to any other court. One way that parties have attempted to continue the appeal process, however, is to appeal to Congress. Although Congress cannot technically “overrule” a Supreme Court case, it can change the laws that the Court based its ruling on, thereby diminishing the impact that a Supreme Court case has as binding precedent on other courts. Recently, members of Congress attempted to override certain Supreme Court cases involving securities fraud liability by including a specific amendment in the initial drafts of the Dodd-Frank Bill. The proposed amendment was aimed at broadening the scope of liability under the federal securities laws by allowing claims against third-party defendants under an “aiding and abetting” theory of liability. Ultimately, Congress decided to prolong the Supreme Court’s rulings by rejecting the amendment.
The July 2010 edition of the PT+ newsletter addressed several provisions that made it into the newly enacted Dodd-Frank Bill. Absent from the final version of the bill, however, was a rejected amendment that would have overridden the rulings made by the Supreme Court in the 1994 case City Bank Denver NA v. First Interstate Bank of Denver, and the 2008 case Stoneridge Investment Partners LLC., v. Scientific-Atlanta Inc. In both City Bank of Denver (a 5-4 decision) and Stoneridge (a 5-3 decision), the Court ruled that there is no private right of action under Section 10b of the Securities Exchange Act of 1934 under an “aiding and abetting” theory of liability or under a “scheme liability” theory. These theories are commonly understood as encompassing individuals who provide substantial assistance to those violating the provisions of the securities laws. Citing these two cases, judges routinely dismiss Section 10(b) claims against these secondary actors, typically outside accounting firms and rating agencies.
Certainly, it is well settled that the SEC and Department of Justice may prosecute any person who knowingly provides substantial assistance to any person or entity that violates the federal securities laws. But, defrauded investors, who include public and labor pension funds among other significant investors, have been barred from effectively asserting claims for relief in private securities actions against these same “aiders and abettors” who knowingly participate in plans to defraud the market.
Although the expansion of liability did not make it into the final bill, a compromise was reached that leaves open the door for future legislation on this topic. Pursuant to the new law, the Government Accountability Office (GAO) is required to conduct a study on the impact of authorizing a private right of action against those who aid and abet others in the violating the securities laws. The GAO must provide a report to Congress by July 21, 2011, one year after President Obama signed the Dodd-Frank Bill into law, detailing the agency’s findings. Based on this report, future legislative amendments aimed at overriding City Bank of Denver and Stoneridge may become law after all.
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