Securities Mosaic® Blogwatch
April 15, 2013
Promontory Probably Would Prefer Not To Be So Interesting
by David Zaring

Promontory, the consultancy firm for banks in distress, is the place you go if you are a senior regulator and you want to cash out. Eugene Ludwig, its founder and the former OCC head, makes $30 million per annum, way more than CEOs of banks with actual branches and loans and so on. His subordinates include a raft of Obama first termers confirmed by the Senate.

Felix Salmon thinks that this means that Promontory needs to be regulated. But I think that the firm's services are bought for two reasons. One- the bad old Washington lobbyist one- is to try to get the regulators to lay off. But the other- the government alumni promotes law observance one- is to concede that the regulators might lay off if you implement some reforms, and hire some people who can tell you what those reforms need to be, and how to sell them to the government.

That means that the strange thing about Promontory- and it is strange- is that it is so, so profitable. Washington lobbyists look at seven figure salaries with awe. Eight figures? Hard to even parse. The gap between SEC deputy director and Promontory executive is stunning when the competition amounts to law firms and Ernst & Young. In the next set of Promontory stories, I'd like to see more about how all of the money is made.

April 15, 2013
Responding to Objections to Shining Light on Corporate Political Spending (3): The Claim that Political Spending is Good for Shareholders
by Lucian Bebchuk and Robert J. Jackson, Jr.

Editor's Note: Lucian Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School. Robert J. Jackson, Jr. is Associate Professor of Law and Milton Handler Fellow at Columbia Law School. Bebchuk and Jackson served as co-chairs of the Committee on Disclosure of Corporate Political Spending, which filed a rulemaking petition requesting that the SEC require all public companies to disclose their political spending, discussed on the Forum here. Bebchuk and Jackson are also co-authors of Corporate Political Speech: Who Decides? and Shining Light on Corporate Political Spending, coming out this month in the Georgetown Law Journal. This post is the third in a series of posts, based on the Shining Light article, in which Bebchuk and Jackson respond to objections to an SEC rule requiring disclosure of corporate political spending; the full series of posts is available here.

The SEC is expected to consider a rulemaking petition requesting that the SEC develop rules requiring that public companies disclose their spending on politics. The petition has received significant support - including nearly half a million comment letters urging the SEC to act as advocated by the petition - but has also attracted opponents. In our article Shining Light on Corporate Political Spending and in this post series, we respond to each of the objections that opponents of the petition have raised.

In our first two posts (available here and here), we explained why opponents' claims that corporate spending on politics is immaterial to investors, and that disclosure in this area would empower special interest investors, provide no basis for opposing rules requiring public companies to disclose their political spending. In this post, we focus on a third objection that opponents of these rules have raised: the claim that political spending is good for shareholders - and that disclosure will discourage directors and executives from engaging in spending on politics that would be beneficial for investors.

Several opponents of the petition have argued that political spending is usually good for shareholders, and that mandatory disclosure rules will constrain public companies' freedom to pursue political spending that could increase shareholder value. For example, the Chamber of Commerce, in a comment letter urging the Commission not to adopt the rules proposed in the petition, argued that one cost of such rules would be to discourage public companies from engaging in political spending that would be beneficial for investors.

This argument offers no basis for opposing rules requiring disclosure of corporate spending on politics. For starters, it is important to note that we take no position on whether corporate political spending is good for shareholders; the resolution of that question is not necessary to know whether disclosure of such spending is needed. In our view, such disclosure is needed regardless of the relationship between political spending and firm value. We note, however, that the claim that corporate spending on politics is good for shareholders is hotly debated. Several researchers, including John Coates; Stephen Ansolabehere, James Snyder, and Michiko Ueda; Michael Hadani and Douglas A. Schuler; Deniz Igan, Prachi Mishra, and Thierry Thiesel; and Rajesh Aggarwal, Felix Meschke, and Tracy Wang, have taken the opposite view, and have provided empirical support for that claim. It will not be possible for researchers, and more importantly investors, to determine whether corporate spending on politics is beneficial for investors until there is adequate disclosure of such spending. At present, because so much corporate spending on politics occurs under the radar screen, it is not possible to evaluate the extent to which such spending is consistent with investor interests.

But even if one believed that, on average, political spending is beneficial for shareholders, that fact would not suggest that all political spending by all public companies is good for investors. The accountability that would come from mandatory disclosure of political spending would still improve the alignment of corporate political spending with shareholder interests. And there is no basis for concern that disclosure rules will come with the cost of deterring companies from engaging in political spending that is beneficial for shareholders. Instead, we should expect that disclosure will deter companies from engaging in political spending that is not consistent with shareholders' interests. This, we think, should be considered a benefit of disclosure rules in this area - not a cost.

For the same reasons, even if one takes the view that executive pay arrangements in public companies, in general, are beneficial for investors, this hardly implies that rules requiring disclosure of executive pay are unjustified. Even if executive compensation arrangements on the whole benefit investors, there may be significant departures from shareholder interests at some firms. Thus, shareholders should be given information about pay arrangements at those firms. Giving investors this information will make it less likely that the pay arrangements at all companies will deviate from shareholder interests.

Finally, it would be inconsistent with the basic philosophy of the securities laws to take the paternalistic view that investors need not receive information about significant decisions made by directors and executives merely because outside researchers think those decisions are generally beneficial for shareholders. Whether political spending is beneficial for investors in general - or at a specific firm - is a matter on which investors should be free to form their own judgments, and we think it is clear that investors should be given the information necessary to make those judgments.

April 15, 2013
Hedge Fund Governance
by June Rhee

Editor's Note: The following post comes to us from Houman Shadab, Associate Professor of Law at New York Law School.

Concerns about the internal governance of hedge funds have dramatically increased in recent years. During the financial crisis of 2008, investors became frustrated when numerous hedge fund managers suddenly prevented them from withdrawing their capital yet nonetheless continued to charge them fees. Since the financial crisis, concerns about hedge fund governance have focused on transparency, operational practices, and the growing view that fund directors do not effectively monitor fund managers.

In my paper, Hedge Fund Governance, which was recently made publicly available on SSRN, I provide the first comprehensive scholarly analysis of hedge fund governance. In doing so, my paper makes several contributions. First, it contributes to the literature on corporate governance by conceptualizing the unique way in which hedge funds are governed and situating their style of governance within established paradigms. I argue that hedge fund governance is a type of responsive managerialism.

Hedge fund governance is a form of managerialism because the funds' underlying legal regime gives managers near complete authority over the structure and operations of the funds they manage. Hedge fund managerialism arises from the fact that hedge funds are organized as privately-held limited partnerships (or their functional equivalents) that highly circumscribe equity investors' rights with shares that have no voting rights nor any mechanism to replace managers or directors. Hedge fund managerialism gives hedge fund managers more control and authority over their firms than managers of public companies, mutual funds, and other private investment funds (e.g., private equity).

However, hedge fund governance is also uniquely responsive in the sense that to obtain and retain investor capital, hedge fund managers must be highly responsive to the preferences of equity investors (the limited partners). This responsiveness arises from a fundamental dynamic of hedge fund governance - the propensity of investors to "pull the plug" and cash out of a fund if they are dissatisfied. Although hedge fund investors usually face short-term redemption restrictions, they typically can interrupt the operations of a fund or cause it to wind down in a few months to a year by withdrawing their capital.

The uniqueness of hedge fund governance stems from the fact that the exit rights of hedge fund investors puts hedge fund managers on a much shorter leash than managers of public corporations and other types of investment funds. Corporate scholars recognize that an essential feature of the corporate form is that it permits a firm to have access to permanent, "locked-in" capital from equity investors. Private equity and venture capital funds likewise have access to long-term capital because investors in such funds are bound to them by contract for seven to 10 years. Managers with access to permanent or long-term capital do not have to be concerned about investors pulling the rug out from beneath them and causing their firms to shut down. Hedge fund managers do not have that luxury.

In addition to the underlying hedge fund legal regime, I argue that the primary components of hedge fund governance consist of:

  • investors with a high propensity to exercise their short-term redemption rights;
  • managers with high pay-performance sensitivity due to being compensated with an annual performance-based fee and their own investment in the funds they manage;
  • demand by sophisticated investors for quality governance; and
  • close monitoring by short-term creditors and derivatives counterparties.

The second primary contribution of my paper is to examine and assess hedge fund agency costs and the governance mechanisms used to reduce them. Overall, I find that hedge fund managers are not systematically ripping off investors. This is because empirical studies do not find that hedge fund fraud or other types of agency costs are pervasive and significant. In addition, empirical studies strongly suggest that hedge funds outperform stock and bond markets on a risk-adjusted basis even after managers are paid their fees.

Nonetheless, hedge fund governance still has plenty of room for improvement. The third contribution of my paper is to provide a normative framework and principles to improve governance. My analysis suggests that the areas in which hedge fund governance needs the most improvement are performance reporting (valuation) and the timing of performance-fee calculations.

I also argue that investors should be careful what they wish for when choosing or negotiating governance structures. Although investors generally benefit from low fees and significant transparency and liquidity, if investor-friendly governance devices are improperly structured or taken too far, investors run the risk of undermining the unique performance-based incentives and other governance mechanisms that enable hedge funds to produce superior returns in the first place. Importantly, investors are often better off with higher fees, less transparency, and less access to their capital.

The full paper is available for download here.

April 15, 2013
SEC Charges Rogue Trader with Bringing Down Brokerage Firm
by Barbara Black

The SEC charged David Miller, a former institutional sales trader at Rochdale Securities, a Connecticut-based brokerage firm, with scheming to personally profit from placing unauthorized orders to buy Apple stock. When the scheme backfired, it ultimately caused the firm to cease operations.

Miller agreed to a partial settlement of the SEC's charges and also pleaded guilty today in a parallel criminal case.

The SEC alleges that on Oct. 25, 2012, Miller misrepresented to Rochdale Securities LLC that a customer had authorized the Apple orders and assumed the risk of loss on any resulting trades. The customer order was to purchase just 1,625 shares of Apple stock, but Miller instead entered a series of orders totaling 1.625 million shares at a cost of almost $1 billion. Miller planned to share in the customer's profit if Apple's stock profited, and if the stock decreased he would claim that he erred on the size of the order. The stock wound up decreasing after an earnings announcement later that day, and Rochdale was forced to cease operations in the wake of covering the losses suffered from the rogue trades.

To settle the SEC's charges, Miller will be barred in separate SEC administrative proceedings from working in the securities industry or participating in any offering of penny stock. In the partial settlement in court, Miller agreed to be enjoined from future violations of the antifraud provisions of the federal securities laws. A financial penalty will be determined at a later date by the court upon the SEC's motion.

In the criminal proceeding, Miller pleaded guilty to charges of wire fraud and conspiracy to commit securities and wire fraud. He will be sentenced on July 8.

April 15, 2013
Further Developments on the Benefit Corporation Front (Part 1)
by Celia Taylor

Legislation to amend the General Corporation Law of the State of Delaware (the "DGCL") and related sections of title 8 of the Delaware Code is currently before the Corporate Law Section of the Delaware State Bar Association for approval. If the amendments become effective, they would result in several significant changes to the DGCL, including adding a new subchapter to the DGCL authorizing benefit corporation status under Delaware law.

As discussed in earlier posts, benefit corporation legislation permits a corporation to state in its articles of incorporation that it intends to operate in furtherance of a specific public benefit (or benefits). The Delaware statute includes among permissible "public benefits" having a positive effect (or causing a reduction in negative effect) on persons, entities, communities or interests, including those of an artistic, charitable, cultural, economic, educational, literary, medical, religious, scientific or technological nature.

The legislation states that directors of a benefit corporation must balance the pecuniary interests of stockholders, the interests of those materially affected by the corporation's conduct, and the identified public benefits, and make it clear that benefit corporation directors shall not have any duty to any person solely on account of any interest in the public benefit and would provide that, where directors perform the balancing of interests required of them, they will be deemed to have satisfied their fiduciary duties to stockholders and the corporation if their decision is both informed and disinterested and one that a person of ordinary, sound judgment would approve.

Stockholders in a Delaware benefit corporation may bring a derivative suit asserting that the directors are not advancing the stated public benefits adequately if they own at 2% of the corporation's outstanding shares (or, in the case of listed companies, the lesser 2% of the outstanding shares or shares having at least $2 million in market value).

Additionally, the legislation sets limits on the ability of benefit corporations to amend their certificates of incorporation or effect mergers or consolidations if the effect would be to abandon their public benefit purpose. These limitations would be imposed through a 66 2/3% vote of each class of the public benefit corporation's outstanding stock. It also restricts the ability of corporations that are not benefit corporations to amend their certificates of incorporation to become public benefit corporations or to effect mergers or consolidations that would result in their stockholders receiving shares in a public benefit corporation. This would be done by requiring a 90% vote of each class of the corporation's outstanding stock to effect such a change, and grants appraisal rights to any stockholder of a corporation that is not a public benefit corporation that, by virtue of an amendment to the corporation's certificate of incorporation or any merger or consolidation becomes such a corporation.

Benefit corporations would be subject to all other applicable provisions of the DGCL, except as modified or supplanted by the new benefit corporation legislation. We may see a groundswell of benefit corporations in Delaware if benefit corporation status becomes available (The B Corporation website currently states that there are a total of 720 benefit corporations in existence.) Opting into that status would overcome the general stance of Delaware corporate law, which while not mandating shareholder primacy certainly permits easy perpetuation of the myth that it is a legal mandate.

April 15, 2013
Financial Analyst Survey: "Chinese Wall? Reg FD? Never Heard of Them..."
by Broc Romanek

Financial Analyst Survey: "Chinese Wall? Reg FD? Never Heard of Them..."

This new study about sell-side equity research analysts entitled "Inside the 'Black Box' of Sell-Side Financial Analysts" by Profs. Brown, Call, Clement & Sharp may surprise you- or it may not given all that is wrong with this world. The findings are disturbing, including:

- Analyst compensation- 44% of the analysts surveyed indicate that their success at generating underwriting business or trading commissions is very important to their compensation (see page 43).

- Private communication with management- Analysts rated private phone calls with management as the most useful form of direct contact with management of the companies they follow. Further, the analysts specifically responded that private communication with management is very useful for determining their earnings forecasts and stock recommendations. In interviews, analysts said their private phone calls with management provide color and granularity and that management is more candid on private calls than public calls. Analysts said they get to check their model assumptions on private calls, and that management goes into details on private calls that they aren't willing to discuss on public calls (see discussion from pages 23-25). Thus, the analysts appear to be receiving private information (from these calls) that benefits them directly in terms of their performance.

Meanwhile, in this survey of hedge fund professionals- commissioned by Labaton Sucharow, HedgeWorld and the Hedge Fund Association- 46% said they believe that their competitors engage in illegal activity, 35% have personally felt pressure to break the rules, and 30% have witnessed misconduct in the workplace. When asked if they would blow the whistle or report the misconduct, 87% of respondents said they would report wrongdoing given the protections and incentives such as those offered by the SEC Whistleblower Program.

The Debate Over Audits Signed by Audit Partners

Last week, the SEC brought an enforcement action against a former KPMG partner for insider trading seems to have renewed calls to have individual audit partners identified as part of audit reports. This garden variety case has brought a flurry of interest by the media into a 2011 PCAOB proposal that would require to disclose the names of audit partners on financials, rather than just the firm name. The idea is that this requirement would allow investors and companies to know who is responsible for audit work- particularly useful if a specific individual gets into trouble like this. As noted in this WSJ blog, the PCAOB is expected to act on this proposal in the next few months- but is facing opposition from auditors who are concerned about increased liability for audit partners.

Meanwhile, this WSJ blog notes that Hallador Energy already publishes the names and ages of its lead and concurring audit partners for its financials. And this article discusses a new Cornerstone study showing that accounting class-action lawsuit filings declined sharply last year after a spike in 2011- but settlement amounts in such cases have grown since 2011.

SEC Announces EDGAR Update for XBRL 2013 US GAAP Taxonomy

As noted in this memo, the SEC recently announced that, if approved by the Commission, the EDGAR system would begin accepting submissions with XBRL exhibits based on the 2013 US GAAP taxonomy on April 29th (and no longer accept submissions with XBRL exhibits based on the 2011 GAAP taxonomy).

- Broc Romanek

April 15, 2013
Warren Buffett v. Modern Finance Theory
by Lawrence A. Cunningham

Experienced readers of Warren Buffett's letters to the shareholders of Berkshire Hathaway Inc. have gained an enormously valuable informal education. The central theme uniting Buffett's lucid essays is that the principles of fundamental business analysis, first formulated by his teachers at Columbia Business School, Ben Graham and David Dodd, should guide investment practice.

This stance conflicts with the dominant view of contemporary teachers of finance, which stresses modern finance theory's efficient market hypothesis to challenge whether such fundamental analysis can be practiced successfully. Debate over this question nevertheless continues, in academia and on Wall Street, raising issues of great important to corporate law and securities regulation as well. This post, adapted from my book, The Essays of Warren Buffett: Lessons for Corporate America, which grew out of a law school conference, will highlight some of Buffett's perspectives on this question.

Modern finance theory, now nearly 50 years old, was among the most revolutionary investing ideas of our time. This is an elaborate set of ideas that boil down to one simple and misleading practical implication: it is a waste of time to study individual investment opportunities in public securities. According to this view, you will do better by randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense.

One of modern finance theory's main tenets is modern portfolio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio that is, it formalizes the folk slogan "don't put all your eggs in one basket." The risk that is left over is the only risk for which investors will be compensated, the story goes.

This leftover risk can be measured by a simple mathematical term called beta that shows how volatile the security is compared to the market. Beta measures this volatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule.

Reverence for these ideas was not limited to ivory tower academics, in colleges, universities, business schools, and law schools, but became standard dogma throughout financial America in the past thirty-five years, from Wall Street to Main Street. Many professionals still believe that stock market prices always accurately reflect fundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks.

Being part of a distinguished line of investors stretching back to Graham and Dodd which debunks standard dogma by logic and experience, Buffett thinks most markets are not purely efficient and that equating volatility with risk is a gross distortion. Accordingly, Buffett worried that a whole generation of MBAs and JDs, under the influence of modern finance theory, was at risk of learning the wrong lessons and missing the important ones.

A particularly costly lesson of modern finance theory came from the proliferation of portfolio insurance a computerized technique for readjusting a portfolio in declining markets. The promiscuous use of portfolio insurance helped precipitate the stock market crash of October 1987, as well as the market break of October 1989. It nevertheless had a silver lining: it shattered the modern finance story being told in business and law schools and faithfully being followed by many on Wall Street.

Ensuing market volatility could not be explained by modern finance theory, nor could mountainous other phenomena relating to the behavior of small capitalization stocks, high dividend-yield stocks, and stocks with low price-earnings ratios. Periodic market bubbles undercut the model as well, whether the technology and Internet stock bubble that blew up in the late 1990s and early 2000s of the bubble in the financial sector a decade later. Growing numbers of skeptics emerged to say that beta does not really measure the investment risk that matters, and that capital markets are really not efficient enough to make beta meaningful anyway.

In stirring up the discussion, people started noticing Buffett's record of successful investing and calling for a return to the Graham-Dodd approach to investing and business. After all, for more than forty years Buffett has generated average annual returns of 20% or better, which double the market average. For more than twenty years before that, Ben Graham's Graham-Newman Corp. had done the same thing.

As Buffett emphasizes, the stunning performances at Graham-Newman and at Berkshire deserve respect: the sample sizes were significant; they were conducted over an extensive time period, and were not skewed by a few fortunate experiences; no data-mining was involved; and the performances were longitudinal, not selected by hindsight.

Threatened by Buffett's performance, stubborn devotees of modern finance theory resorted to strange explanations for his success. Maybe he is just lucky the monkey who typed out Hamlet or maybe he has inside access to information that other investors do not. In dismissing Buffett, modern finance enthusiasts still insist that an investor's best strategy is to diversify based on betas or dart throwing, and constantly reconfigure one's portfolio of investments.

Buffett responds with a quip and some advice: the quip is that devotees of his investment philosophy should probably endow chaired professorships at colleges and universities to ensure the perpetual teaching of efficient market dogma; the advice is to ignore modern finance theory and other quasi-sophisticated views of the market and stick to investment knitting. That can best be done for many people through long-term investment in an index fund. Or it can be done by conducting hard-headed analyses of businesses within an investor's competence to evaluate. In that kind of thinking, the risk that matters is not beta or volatility, but the possibility of loss or injury from an investment.

Assessing that kind of investment risk requires thinking about a company's management, products, competitors, and debt levels. The inquiry is whether after-tax returns on an investment are at least equal to the purchasing power of the initial investment plus a fair rate of return. The primary relevant factors are the long-term economic characteristics of a business, the quality and integrity of its management, and future levels of taxation and inflation. Maybe these factors are vague, particularly compared with the seductive precision of beta, but the point is that judgments about such matters cannot be avoided, except to an investor's disadvantage.

Buffett points out the absurdity of beta by observing that "a stock that has dropped very sharply compared to the market . . . becomes riskier' at the lower price than it was at the higher price" that is how beta measures risk. Equally unhelpful, beta cannot distinguish the risk inherent in "a single-product toy company selling pet rocks or hula hoops from another toy company whose sole product is Monopoly or Barbie." But ordinary investors can make those distinctions by thinking about consumer behavior and the way consumer products companies compete, and can also figure out when a huge stock-price drop signals a buying opportunity.

Contrary to modern finance theory, Buffett's investment knitting does not prescribe diversification. It may even call for concentration, if not of one's portfolio, then at least of its owner's mind. As to concentration of the portfolio, Buffett reminds us that Keynes, who was not only a brilliant economist but also an astute investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy. On that view, risk rises when investments and investment thinking are spread too thin. A strategy of financial and mental concentration may reduce risk by raising both the intensity of an investor's thinking about a business and the comfort level he must have with its fundamental characteristics before buying it.

The fashion of beta, according to Buffett, suffers from inattention to "a fundamental principle: It is better to be approximately right than precisely wrong." Long-term investment success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success.

Such "flitting from flower to flower" imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes. Buffett jokes that calling someone who trades actively in the market an investor "is like calling someone who repeatedly engages in one-night stands a romantic." Investment knitting turns modern finance theory's folk wisdom on its head: instead of "don't put all your eggs in one basket," we get Mark Twain's advice from Pudd'nhead Wilson: "Put all your eggs in one basket and watch that basket."

April 15, 2013
UBS Willow Fund Investors Filing Arbitrations
by Mark Astarita


In October 2012 investors were informed that the Willow Fund would be liquidated, after having sustained substantial losses. In a recent New York Times article on the UBS Willow Fund, it was reported that the fund had suffered losses of approximately 80% in the first three quarters of 2012 after its manager made a radical change in investment strategy and "piled into some colossally bad derivative trades." "The investors, some of whom hadn't realized they were holding a portfolio filled with risky bets against the debt of European nations, were stunned," says the article.

The Willow Fund's exposure to credit default swaps began to significantly increase, and by the end of 2008 while corporate bonds amounted to only 6% of the portfolio, the value of credit default swaps rocketed to 25% of the portfolio, from only 2.6% in 2007. By 2009, credit default swaps amounted to 43% of the Willow Fund's portfolio composition, the article claims. In 2012, the Willow Fund posted an 89% decline and, as the fund was being wound down, UBS reported that approximately 70% of its losses derived from exposure to credit default swaps- a stunning fact.

It has been reported that UBS Willow Fund investors are expected to receive pennies on the dollar after liquidation of the fund.

Various press reports have stated that the Willow Fund's radical change in investment strategy through its increasing exposure to credit default swaps, and commensurate decrease in exposure to corporate bonds, transformed the fund into a highly speculative and aggressive gamble on, in essence, the debt of European nations. Did Willow Fund investors really understand what they were invested in and the magnitude of risk to which they were exposed and, if they did, would they have agreed to invest or remain invested?

Investors seeking to file arbitrations will allege that securities brokerage firms, like UBS, have a legal obligation to ensure that when offering and selling an investment, like the Willow Fund, it makes full, complete and accurate disclosures of all material facts to its customer, and ensures that the recommendation to purchase is suitable. The failure to do so is a violation of securities laws and securities industry rules and may give rise to liability for losses sustained.

Securities arbitration attorneys are presently reviewing cases for investors against UBS for their purchases of the Willow Fund. UBS customers who purchased the Willow Fund can contact our office to explore whether they can recover their Willow Fund losses. All calls handled on a confidential, no obligation basis. Cases taken on a contingency fee basis, meaning no attorney's fee owed to the law firms if no recovery. Call 212-509-6544 for additional information regarding Willow Fund arbitrations, or email us at

April 15, 2013
Former Credit Suisse Managing Director Pleads Guilty in Market Crisis Case
by Tom Gorman

In one of the most significant market crisis cases to date, the former Global Head of Structured Credit Trading at Credit Suisse pleaded guilty to a conspiracy charge based on falsifying asset values which ended with the financial institution to take a $2.65 write down. Kareem Serageldin was charged in an indictment with conspiracy, falsifying books and records and wire fraud charges based on allegations that he and other falsifyed the values of certain mortgage backed securities held by Credit Suisse in late 2007. Two other members of his department, David Higgs and Salmaan Siddiqui, also entered guilty pleas. Mr. Higgs had been the Managing Director and Head of Hedge Trading. He reported to Mr. Serageldin. Mr. Siddiqui was a vice president in Credit Suisse' CDO Trading Group in New York. He reported to Mr. Higgs. U. S. v Serageldin, 12 Crim 090 (S.D.N.Y.). The SEC's parallel case alleging violations of Exchange Act Sections 10(b), 13(a), 13(b)(2)(A), 13(b)(2)(B) and 13(b)(5) is pending. SEC v. Serageldin, 12 Civ 0796 (S.D.N.Y.).

Mr. Serageldin and his group specialized in structuring and trading mortgage backed securities. The bonds held on the books of the bank had to be priced daily to record their fair value. In the absence of a liquid market traders looked to the ABX Index as a benchmark for certain securities backed by home loans.

As the market crisis unfolded and residential mortgage values declined, the value of the bonds dropped. In late August 2007 Mr. Seregldin and the others began marking the bonds to the P&L rather than to fair value or referencing the ABX Index. They knew at the time that if their book of bonds was properly priced the financial institution would have to take millions of dollars in write downs. By improperly pricing the bonds those write downs were avoided. At the same time it falsified the books of Credit Suisse.

The indictment provides a month by month account in the Fall of 2007 of how the defendants falsified the prices. In September and October, for example, the indictment details telephone calls in which the conspirators discussed the value of the bonds and how to price them in relation to the P&L. A key participant in those telephone calls was an individual identified only as "CC- 2."

As a result of the scheme, Mr. Serageldin and the others gave Credit Suisse the false impression that their book of bonds was profitable. In mid-February Credit Suisse reported net income of CHF 8.55 or $7.12 billion, with fourth quarter earnings of CHF 1.3 or $1.16 billion. Those results were incorrect.

The scheme directly benefited Mr. Serageldin and the others, according to the indictment. The success of the section was a key factor in determining bonus amounts. For 2007 Mr. Serageldin was paid a bonus of over $1.7 million and his Incentive Share Unit Award was $5.2 million.

Shortly after reporting the fourth quarter results, Credit Suisse senior management began to unravel the fraud. They detected abnormally high prices on certain bonds controlled by Defendants. On February 19, 2008 the firm issued a press release stating that its financial results were incorrect. Subsequently, the bank revised net income for 2007 downward from $7.12 billion to $6.47 billion and for the fourth quarter of 2007 from $1.16 billion to $471 million, according to the SEC. The write downs centered on the defendants' book of bonds which ended with a write down of about $1.3 billion.

April 15, 2013
M&A Representations and Warranties Insurance:What Every Buyer and Seller Needs to Know
by Kevin LaCroix

Insurance to provide coverage for breaches of representations or warranties in M&A transaction documents has been available in the marketplace for several years, but the specialty insurance product has not always been fully understood. More recently, interest in the product has grown and the product has improved, and so take-up for the product has increased as well.

In the following guest post, Joseph Verdesca and Paul Ferrillo of the Weil, Gotshal & Manges law firm take a close look at reps and warranties insurance and explain what M&A transaction participants need to know about the product.

I would like to thank Joseph and Paul for their willingness to publish their article on this site. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Joseph and Paul's guest post follows:

No less than two years ago, had one tried to initiate a conversation with a Private Equity Sponsor or an M&A lawyer regarding M&A "reps and warranties" insurance (i.e., insurance designed expressly to provide insurance coverage for the breach of a representation or a warranty contained in a Purchase and Sale Agreement, in addition to or as a replacement for a contractual indemnity), one might have gotten a shrug of the shoulders or a polite response to the effect of "let's try to negotiate around the problem instead." Perhaps because it was misunderstood or perhaps because it had not yet hit its stride in terms of breadth of coverage, reps and warranties insurance was hardly ever used to close deals. Like Harry Potter, it was the poor stepchild often left in the closet.

Today that is no longer the case. One global insurance broker with whom we work notes that over $4 billion in reps and warranties insurance was bound worldwide last year, of which $1.4 billion thereof was bound in the US and $2.1 billion thereof was bound in the EU. Such broker's US-based reps and warranties writings nearly doubled from 2011 and 2012. Reps and warranties insurance has become an important tool to close deals that might not otherwise get done. This article is meant to highlight how reps and warranties insurance may be of use to you in winning bids and finding means of closing deals in today's challenging environment.

When Is Reps and Warranties Insurance Best Used?

Deal Size. Reps and warranties insurance is best suited to deals of a certain size range and type. Given the amount of limits that can be purchased in the marketplace for any particular deal, insurance pricing and the size of a typical escrow or indemnity requirement, the "sweet spot" for reps and warranties insurance are deals between $20 million and $1.5 billion. While reps and warranties insurance might have a role to play in larger or smaller deals, it can play a central role in facilitating transactions within this size range. The type of deal is relevant because it is much easier to obtain reps and warranties insurance when the business being acquired is privately owned rather than publicly held. In sum, insurance companies generally prefer to insure transactions where an identifiable seller (rather than a diverse stockholder base) is standing behind the representations of the target business.

Sell-Side Examples. For those finding themselves selling a business or asset, situations that may warrant purchase of a reps and warranties policy for the transaction include the following examples

Minimization of Seller Liability. A Private Equity or Venture Capital seller near the end of a Fund's life wishes to limit post-closing indemnification liabilities on the sale of a portfolio company in order to safely distribute deal proceeds to the Limited Partners, but the buyer wants a high cap on potential indemnities or a long survival period for the reps at issue. Insurance could be the means to bridge this gap.

Removal of Tax Contingency from Negotiations. A seller restructures itself immediately prior to the closing of a deal for tax purposes. During due diligence, both seller's and buyer's tax advisors agree the deal should be recognized as a tax-free reorganization. In the remote event that the IRS took a different position, the tax consequences to the buyer would be significant. The Seller wishes to retire with the proceeds from the deal, and does not want to provide an indemnity to the buyer for this potential risk. Insurance could serve to remove this risk from the scope of matters needing negotiation between the parties.

Minimization of Successor Liability Risk. In an asset sale transaction where a portion of assets and liabilities remain with the seller, the buyer would have no control over the seller's conduct post-closing and does not want to be subject to potential liabilities related to such excluded assets on a successor liability theory. If the seller is unwilling or unable to provide an indemnity for such matters, insurance could help the parties past this issue.

Buy-Side Examples. For those wishing to acquire a business or asset, situations that may warrant purchase of a reps and warranties policy for the transaction include the following examples:

Bid Enhancement. A competitive auction process is being held by a seller of prime assets. A potential buyer wishes to distinguish his or her bid from others by arranging and agreeing to look to a reps and warranties insurance policy to take the place of an indemnity from the seller. Such a use of insurance could elevate the likelihood of the buyer winning the auction.

Public M&A Indemnity. In a public M&A acquisition, the buyer could arrange for reps and warranties insurance to provide the indemnity that would not otherwise typically be available in light of the publicly held nature of the target.

Distressed M&A Indemnity. Similarly, in a distressed M&A setting in which the buyer is concerned about the credit risk of the seller post-closing, the use of reps and warranties insurance would enable the buyer to be indemnified for breaches of reps and warranties in the acquisition agreement, while avoiding the seller's credit risk.

What Should the Insurance Cover?

While each policy is unique, a reps and warranties policy generally covers "Loss" from "Claims" made by Buyer for any breach of, or an alleged inaccuracy in any of, the representations and warranties made by the Seller in the Purchase and Sale Agreement ("PSA"). Though a rep and warranty policy can be structured to cover very specific reps or warranties, coverage is generally afforded on a blanket basis for all reps and warranties. The definition of "Loss" in the policy should generally mimic the extent of the Indemnity negotiated in the PSA (which could include things like consequential or special damages). Loss can also include defense costs, fees, and expenses incurred by the Insured (for instance, the Seller) in defense of a Claim brought by a third party (for instance, the Buyer) arising out of alleged breach of a representation or warranty. Note that such policies almost always have a self-insured retention ("deductible") associated with them. The size of the retention can vary considerably from deal to deal, but usually in some fashion equates to the amount of the hold back negotiated.

What Should the Insurance Exclude?

Though the exclusions in a reps and warranties policy are not as numerous as those contained in a traditional directors and officers liability policy, they should do exist and be thoughtfully considered and negotiated. Reps and warranties policies do not cover known issues, such as issues discovered during due diligence or described in disclosure schedules. They also do not cover purchase price, net worth or similar adjustment provisions contained in the PSA. "Sell-Side" reps and warranty policies do not cover claims arising from the adjudicated fraud of the seller. Either buy side or sell side policies might have deal-specific exclusions where the carrier involved simply cannot get comfortable in insuring the particular representation or warranty at issue. Lastly, a rep and warranty policy would also generally not cover any breach of which any member of the deal team involved had actual knowledge prior to the inception of the policy or any material inaccuracy contained in the "No Claims Declaration" typically in connection with the issuance of the policy.

Cost of Coverage

Reps and warranties insurance is priced based on a number of factors, including most prominently the nature of the risk involved, the extent of the due diligence performed by the parties, and the relative size of the deductible. Reps and warranties insurance is currently generally priced as a percentage of the limits of coverage purchased. Nowadays, in the United States, a price range of 2.0% to 3.5% of the coverage limits is typical. Thus, a $20 million reps and warranties insurance policy on a moderately complicated deal might cost approximately $600,000. Who pays this premium is generally a function of the deal, and depends to some extent upon who is deriving the benefit from the insurance. If, for instance, a buyer-side policy is being purchased because a seller doesn't want to deal with putting up an indemnity or hold-back, the premium would generally be the seller's responsibility.

In order to facilitate the due diligence process (described below), many carriers require payment of an up-front underwriting fee. These fees can run from $25,000 to $50,000, and are used by the carrier typically to hire outside counsel to advise it during the underwriting process.


Carriers typically determine the policy's deductible according to the transaction value of the deal. In our experience, the current standard deductible ranges from 1% to 3% of the transaction value. The deductible will, however, vary from deal to deal based upon the risk involved. Buy-side policies alternatively tend to use the "hold-back" negotiated between the parties as a deductible.

Process to Get the Insurance in Place

The reps and warranties insurance market has evolved in response to prior concerns about the amount of time and effort necessary to put a policy in place. The carriers and brokers understand that, as with the deals themselves, the need for the insurance is typically on a very fast track.

Many of the large national insurance brokerages have specialized units that deal with reps and warranties insurance. These units, for the most part, are run not by "insurance people" but by former M&A lawyers who left private practice to become dedicated resources at the brokerages. They are fully familiar with the ins and outs of M&A and private equity transactions, and very little time is needed to get them up to speed. Though not all brokerages provide the same level and depth of resources, the right broker can become quickly integrated into the deal team and, importantly, will serve as an advocate with the insurance carriers.

Within 24 hours, a good broker will have you engaged with one of the handful of carriers that are known to service the reps and warranties insurance area. Be advised that not all carriers are created equally, and your broker should assist in advising as to selection of the best carriers for your purposes (including as to responsiveness, experience in corporate transactions, and reputation for proper claims payment decisions).

The best insurance carriers in this arena will typically provide a price and coverage quote (called a "Non-Binding Indication" or "NBIL") within two or three days of the first conversation. Either in connection with the receipt of the NBIL or in a subsequent phone call, you should expect to receive a list of due diligence requests, and likely a request of the carrier for data room access (both the broker and carrier are accustomed to negotiating and executing a Non-Disclosure Agreement early in the process). The best carriers in this arena are, in our experience, capable of running a very efficient due diligence process and getting up to speed as a quick as possible regarding potential risks associated with the deals (e.g. intellectual property, environmental, etc.).

Within a week of receipt of the NBIL, the carrier, its counsel, the insured, its business people, its deal team members and its counsel (including sometimes the private equity sponsor) will typically discuss the due diligence done on the transaction, and answer questions of the insurance carrier to ensure the absence of any risks that might imperil the insurance transaction. Assuming the due diligence call goes well (and there might be follow up diligence calls as well on particular issues), the carrier involved will normally issue a draft insurance policy, which is normally then negotiated with the parties (assisted by the broker). A key issue will be "conforming" the insurance so that it matches what would otherwise have been provided by the PSA in the absence of the insurance (or otherwise serves the particular need for which it is being purchased). In negotiating such policy, focus will often be placed on defining the scope of losses included and excluded, the impact of knowledge qualifiers, the term of coverage, operational restrictions, subrogation provisions, and a host of additional issues beyond the scope of this article.

In Summary: Reps and warranties insurance (1) can be purchased quickly and efficiently, and won't delay the deal, (2) can provide real coverage for troublesome aspects of a deal for which alternative solutions may not be readily available, and (3) can serve as a flexible tool to distinguish one's offer in a competitive bidding situation. Teaming up with a well-experienced broker and insurance carrier is essential to making this happen. We have enjoyed the benefits of utilizing reps and warranties insurance into numerous transactions, and would be happy to share with you our thoughts in this arena in further detail.

April 15, 2013
D&O Insurance: Fourth Circuit Affirms That Convicted Exec Must Repay Insurer for Defense Expenses
by Kevin LaCroix

Lee Farkas, the criminally convicted former Chairman and majority shareholder of the defunct Taylor Bean and Whitaker Mortgage Corporation, must repay the nearly $1 million in defense fees the company's D&O insurer had advanced on his behalf, according to an April 11, 2013 Fourth Circuit opinion. The terse three-page appellate opinion adopts the ruling of the lower court, holding that Farkas's criminal conviction triggered the D&O insurance policy's "in fact" conduct exclusions which in turn triggered the insurer's right to recoup the defense fees it had previously paid. The Fourth Circuit's opinion can be found here, and the March 21, 2012 district court opinion, which the appellate court affirmed, can be found here.


In June 2010, Farkas was indicted on multiple counts of committing and conspiring to commit bank, wire and securities fraud. On April 19, 2011, a jury found Farkas guilty of all 16 counts of fraud and conspiracy to commit fraud. As detailed here, Farkas was, among other things, alleged to have conspired with employees of the failed Colonial Bank to sell the bank approximately $400 million of mortgage assets that had no value. Taylor Bean was also alleged to have engaged in numerous other transactions with the bank that had no value. The bank's collapse followed after the fraudulent scheme unraveled.

After he was indicted, Farkas sought to have his criminal defense fees paid by the company's D&O insurer. With bankruptcy court approval, the D&O insurer advanced $928,977 toward Farkas's defense. Farkas incurred significant additional defense expenses, and the carrier's request for the bankruptcy court's leave to pay those additional amounts was pending when the jury returned the guilty verdict. Following the verdict, the carrier informed Farkas that, as a result of the verdict and in reliance on the policy's conduct exclusions, it would no longer fund Farkas's defense costs, and it reserved its right to seek recoupment from Farkas of the amounts it had previously advanced.

Farkas filed an action in the Eastern District of Virginia seeking a judicial declaration that the jury verdict did not terminate the insurer's defense obligation, and that in any event all of the fees he had incurred prior to the jury verdict must be paid. The D&O insurer filed a counterclaim seeking a judicial declaration that Farkas was not entitled to coverage under the policy and that Farkas was obligated to repay the amounts the insurer had previously advanced. The parties cross-moved for summary judgment. In her March 21, 2012 opinion, Eastern District of Virginia Judge Leonie Brinkema granted the insurer's motion for summary judgment. Farkas appealed.

In arguing that as a result of the jury verdict coverage for Farkas's criminal defense fees was precluded under the policy, the insurer relied on the policy exclusion specifying that "The Insurer shall not be liable to make any payment for Loss in connection with a Claim against an insured ...arising out of, based upon or attributable to the committing in fact of any criminal, fraudulent or dishonest act, or any willful violation of any statute, rule or law."

In seeking to have Farkas repay the amounts that it had advanced, the insurer relied on the language in the policy specifying that "advanced payments by the Insurer shall be repaid to the Insurer by the Insureds or the Company, severally according to their respective interests, in the event and to the extent that the Insureds or the Company shall not be entitled under the terms and conditions of this policy to payment of such Loss."

The Fourth Circuit's Opinion and the Ruling Below

On April 11, 2013, in a terse three-page per curium opinion, a three-judge panel of the Fourth Circuit affirmed the district court's ruling. The appellate court said that "having carefully reviewed the briefs, record and appellate law, we affirm for the reasons stated by the district court in its thorough opinion."

In her March 2012 opinion, Judge Brinkema had granted summary judgment for the D&O insurer, finding that the jury verdict in the criminal case represented an "in fact" finding that triggered the conduct exclusion; rejected Farkas's argument that he was entitled to the payment of the defense costs incurred by not yet paid before the verdict was returned; ruled that the insurer was entitled to recoup from Farkas the defense cost amounts it has advanced prior to the verdict; and rejected Farkas's argument that the district court should stay its ruling while Farkas's criminal appeal was pending. (Farkas's criminal conviction was in any event subsequently affirmed.)

In ruling that the jury verdict triggered the policy's conduct exclusion, Judge Brinkema stated that "there can be no reasonable dispute that the jury verdict here is an objectively verified and pertinent factual finding." She added that none of the courts that have held that an "in fact" wording in a policy exclusion requires a final adjudication had defined a final adjudication as an appeal. She concluded that "there is simply no support in the case law for plaintiff's position that a jury verdict does not trigger the 'in fact' requirement in the exclusion."

With respect to Farkas's contention that the insurer should at least pay the defense costs he had incurred but that the insurer had not yet paid when the verdict was returned, Judge Brinkema said that Farkas's argument "ignores the consequence of a particular claim being excluded." Farkas's conduct "was never actually covered under the Policy, and he was therefore never entitled to the monies advanced to him." Pursuant to the policy language, the insurer, she found, "has the right to seek recoupment of any costs that it advanced before it determined that an exclusion applied."


The question of an insurer's right to seek recoupment of advanced defense expenses is a recurring topic. As I have previously noted (here), although D&O insurers frequently assert their right to seek recoupment, it is still relatively rare for the insurers to actually do so. Among other reasons why the insurers rarely seek reimbursement is that it is relatively unusual for a D&O claim to proceed to the point that there has actually been a factual determination triggering an exclusion. Indeed, one of the many reasons why civil claims triggering D&O coverage frequently settle is that an insured defendant would risk a factual determination that might preclude policy coverage if the defendant were to press the case forward rather than settle.

This case's criminal context obviously presents a different set of circumstances than does a civil case. A criminal defendant does not have the option of a pre-trial settlement that avoids a potentially coverage precluding outcome.

Just the same, the coverage outcome here is also due in part to an unusual feature of the policy at issue According to the court record, the D&O insurance policy at issue here was first issued to the Taylor Bean firm in 2008 and subsequently extended by endorsement. Even in 2008 it was standard for most D&O insurance policies to be issued with the "final adjudication" wording, rather than the "in fact" wording. With the final adjudication wording, the preclusive effect of the conduct exclusion does not apply under there has been a final judicial determination that the precluded conduct has occurred. The presence of the "in fact" exclusion language in the Taylor Bean policy is an anachronism that is unexpected and frankly a little bit surprising.

Because the policy had the "in fact" exclusionary language, Judge Brinkema had little trouble concluding that the jury verdict precluded coverage. Had the policy had the now-standard "final adjudication" language, the parties would then have had to argue about whether or not the criminal judgment against Farkas was "final" while his appeal was pending. I am well aware that there is extensive case law on the question whether or not a district court judgment if final and enforceable while an appeal is pending. But if the policy had contained the "final adjudication" language rather than the "in fact" language, Farkas might have had a better argument that the insurer was obligated to continue to advance his defense fees unless and until the conviction was affirmed.

It is worth noting that these circumstances demonstrate why the preferred exclusionary trigger is not just the "final adjudication" wording but rather the "final non-appealable adjudication" formulation. If the policy had the "non-appealable adjudication" wording, the insurer here would have been obligated not only to advance the amounts Farkas had incurred prior to the verdict but that the insurer had not yet paid, but also to continue to advance his defense expenses for his appeal. Farkas would have been able to continue to use his preferred counsel through his appeal (rather than, as Judge Brinkema noted, counsel appointed for him under the Criminal Justice Act). Farkas may well feel that the appeal might have turned out differently if he had been able to rely on his preferred counsel. I know for sure that if it were me, I would certainly want to be able to use my preferred counsel while appealing a criminal conviction.

The fact that Farkas had to rely on appointed counsel for his appeal suggests that he did not have resources of his own to rely on -- which begs the question of why the carrier went to the trouble to obtain an order requiring Farkas to repay the advanced amounts. I mentioned at the outset of this discussion that it is relatively rare for carriers to seek recoupment of advanced amounts, and among other reasons why it is rare is that often there is no point for the carrier to seek recoupment because usually by the time a serious D&O claim has concluded, the defendant is usually broke – which seems to be the case here, which in turn begs the question why the carrier even bothered to pursue a recoupment order. It probably is worth noting in that regard that the D&O insurer did not initiate the coverage lawsuit here, Farkas did. The carrier only sought recoupment in its counterclaim, after Farkas had sued the insurer. Whether the carrier ultimately will recover anything under the recoupment order is a different question.

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D & O Diary: D&O Insurance: Fourth Circuit Affirms That Convicted Exec Must Repay Insurer for Defense Expenses

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