So, I belatedly listen to NPR's Planetmoney. I periodically complain about their reporting, but they do have some excellent segments. In particular ten days ago they discussed securities litigation involved in sub-prime cases.
I happen to have a personal interest in this subject. Their treatment of the subject was pretty good, but it failed to address, and I'd like to add to its address of several topics of importance.
1. Who pays in a securities lawsuit?
2. Who is liable?
3. What is a misstatement?
4. Who actually reads the prospectuses?
5. My favorite, what is the taxpayer's role?
So the podcast discussed a toxic asset bought by the Planetmoney team as an experiment, playfully named "Toxie." Toxie was a bunch of mortgages that were originated by Countrywide, and securitized by Royal Bank of Scotland (RBS). It all started when a listener of theirs told them they were being sued, as an owner of Toxie. This is not entirely true. They bought into the liability of Toxie, but long after Toxie was written down, and resold as an asset. Toxie was worth 2.7 million when she was born, but is now worth 36,000. Who do the securities lawyers go after? The orginators and the securitizers, as well as the buyers who bought in at marketprice. But in this context, they became curious about who was to pay if Toxie was found to be fraudalent. To their credit, the Planetmoney team, got really excited by the securities law. They thought that the lawyers were going after the originators and securitizers with guns blazing. Clearly, and much to my own disappointment, the securities laws don't really allow for this. That's what the SEC is supposed to do. But the SEC rarely takes cases to trial. And they humiliatingly lost the last one they brought to trial in the Eastern District of New York, Bear Stearns. In the interest of brevity, let's go to my questions:
1. Question: Who pays in a securities lawsuit?
Answer: The insurance pays for most of it. That's right, just like every other kind of insurance you can buy, most companies buy legal insurance. Given that securities fraud is so hard to prove, its a winning bet for the insurers, usually. The company does pay too. So do the individual defendents. But of a 100 million dollar settlement, an insurer will pay for at least 40 million of it.
This is important because the main argument against it has always been that if you're suing the company to pay the shareholder, you're actually suing the current shareholders. Trading on the stock market is inherently risky, and anyone who isn't prepared to take those risks should get out of the game. There is also the threat that you can sue a company out of existence. This was the fear in the case against Washington Mutual. That case didn't survive anyway, but there was a definite fear that there wasn't enough coin in the till to pay anyone for the loss of market capitalization in the stock drop.
Another myth is that the company that was sued will just "pass on the cost to the consumer." This is untrue because prices are determined by the market. Companies, particularly in commoditized markets really have very little say in how they can price their goods. Diamond markets are a good example of this--the profit margin in diamond selling is pretty narrow, between 2 and 5%. Another reason why this is untrue is because GAAP requries that companies keep loss allowances on their balance sheets. Accountants spend a ton of time, determining how big these reserves should be, and very often they are wildly incorrect (in the case of the mortgage purveyors who failed during the crisis). But those companies never did "pass on the cost to the consumer" they just continued minting cheap money until they died almost overnight. Ml-Implode is one of my favorite sites that points to the 383 mortgage lenders who have failed since the crisis began.
2. Question: Who is liable?
Answer: I've addressed this in question one a bit. But there are other issues. When a company is going bankrupt, or when it stock price drops below a certain value, it becomes a prime target for acquisition. M&A is something that I only know a little bit about. But in terms of my discussion here. When a company buys a company that has been sued, the new owner becomes the owner of all of the liabities of the old owner. This is why most companies prefer to buy only the assets of a company, and of course, those are the first to go in bankruptcy. The adage “sellers sell stock, and buyers buy assets” is appropriate here because the assets in the subprime fiasco were worth a fraction of what they were listed at on the firm's balance sheets. So when Bank of America bought Merrill Lynch, they bought the whole thing. When they realized in horror that Merrill hadn't been exactly forthright in describing their positions, they tried to recoil from the sale. Of course, by then it was too late, Paulson and Bernanke thought it was a good idea, and wouldn't let the bank withdraw from its initial terms. In cases like these, the original executives at the sued firms are still liable, but they're not the deep pockets. Oh, they can afford to shed a couple million, maybe a couple hundred million, but only the successor company can really pay.
3. Question: What is a misstatement?
Answer: NPR did a reasonable job on this, but I don't think they really understood that a "misstatement" is the backbone of all securities litigation, civil or criminal. It all comes down to the Securities and Exchange Acts of 1933-4 and Rule 10b-5.
"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
To employ any device, scheme, or artifice to defraud,
To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security"
So what securities lawyers typically do is that they comb the field of public information and look for bold statements about the health of a company. It has to be public, it has to be bold. If it's not public, or if it can be argued that the audience of a particular statement was too few to be important, than the misstatement will be judged immaterial. If it's not bold, or flagrantly wrong, it will be very difficult for a lawyer to make the argument that the company was "omit[ing] to state a material fact" Corporate executives have become wise to this, and are generally very careful to couch their public statements in mealey mouth terms. They also managed to get a rider stuck into the securities law called the Safe Harbor statement. Talk to any securities lawyer and they'll complain about the PSLRA. This act, established in 1995, was a reform bill to limit the number of "frivolous" securities lawsuits. It was a powerful act, and the numbers of securities cases dropped dramatically afterward. The Safe Harbor statement was one small part of it. It's attached to every public filing, and it states basically. that any forward looking statement is subject to the uncertainty of the market, and unforseen events. It's a legal disclaimer, and it's supposed to say "don't blame us if the ship starts to sink, there's no way we could have known about that iceberg."
4. Question: Who reads the prospectuses?
Answer: Securities analysts, maybe. Securities lawyers, definitely. The laywers who wrote them, obviously. The investing public, never. This is a major issue at stake in cases before the court, right now. When securities are issued, they're offered through a multitude of ways. If you're a large public institition (by which I mean, you trade on a public exchange) then you have issue "FWPs" or Full Writing Prospectuses. These documents are several hundred pages long, and sort of introduce to the investing public, what the security will be. After the prospectus has been filed, 424Bs are issued for that prospectus that are more particular. These 424Bs are equally as voluminous in nature. And in the case of some securities are actually quite honest. You can find FICO scores for all of the loans that a major mortgage lender has used to securitize a pool of assets there. This is a major issue in securities law. If the prospectuses are public--and the toxcicity of an asset was disclosed, then how can the investor sue? It means admitting that the information was out there, and you didn't look. Therefore it's your fault. There is a lot of literature out on this, the least of which is Judges decisions. And that leads to another big issue. Obama needs to get liberal judges to the bench!!!
5. Question: What is the taxpayer's role?
Answer: I've gone into this before, so I won't belabor it. When you pay your taxes, that money ceases to be yours. Just because it's a democracy, doesn't mean it's your money anymore. You'll get some of that money back, through tax refunds, social services, police, fire, transit, utility services, but it's not yours. This came up briefly in the NPR broadcast when Chana-Jaffe asked some random Britt what he thought of his taxpayer money going to the Carpenter's Union of New Jersey. She asked a Britt, because RBS, like BoA and Citi here, was bought almost entirely by the government. The brit made an excellent point, (paraphrased) "Well, if I had to take it out of my pocket, it'd be a different story wouldn't it?" So when a securities settlement collects on a judgement--it's not coming out of your pocket, no way, no how. Furthermore, the government is in the business for the long term. They don't have to sell a toxic asset right away. They can sit on it for sixty years if they want. Maiden Lane LLC, the entity which manages much of the toxic assets has already seen positive returns. The NYT ran a piece describing nearly 4 billion dollars in profits from bailout funds administered to banks--and that was in August of last year!! If the U.S. Government has to payout to investors because of the bad decisions of corporate executives, its the least they can do, considering the fact that the SEC has been settling for hundreths of a penny on the dollar, piddling little settlements and fines like the one issued to Goldman Sachs today.