SEC Proposes Measures to Curtail "Pay to Play" Practices


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Chairman Schapiro discusses the SEC proposal:
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Text of Chairman's statement

Washington, D.C., July 22, 2009 — The Securities and Exchange Commission today voted unanimously to propose measures intended to curtail "pay to play" practices by investment advisers that seek to manage money for state and local governments. The measures are designed to prevent an adviser from making political contributions or hidden payments to influence their selection by government officials.

The proposals relate to money managed by state and local governments under important public programs. Such programs include public pension plans that pay retirement benefits to government employees, retirement plans in which teachers and other government employees can invest money for their retirement, and 529 plans that allow families to invest money for college.

To help manage this money, state and local governments often hire outside investment advisers who may directly manage this money and provide advice about which investments they should make. In return for their advice, the investment advisers typically charge fees that come out of the assets of the pension funds for which the advice is provided. If the advisers manage mutual funds or other investments that are options in a plan, the advisers receive fees from the money in those investments.

Investment advisers are often selected by one or more trustees who are appointed by elected officials. While such a selection process is common, fairness can be undermined if advisers seeking to do business with state and local governments make political contributions to elected officials or candidates, hoping to influence the selection process.

The selection process also can be undermined if elected officials or their associates ask advisers for political contributions or otherwise make it understood that only advisers who make contributions will be considered for selection. Hence the term "pay to play." Advisers and government officials who engage in pay to play practices may try to hide the true purpose of contributions or payments.

"Pay to play practices can result in public plans and their beneficiaries receiving sub-par advisory services at inflated prices," said SEC Chairman Mary Schapiro. "Our proposal would significantly curtail the corrupting and distortive influence of pay to play practices."

Andrew J. Donohue, Director of the SEC's Division of Investment Management, added, "Pay to play serves the interests of advisers to public pension plans rather than the interests of the millions of pension plan beneficiaries who rely on their advice. The rule we are proposing today would help ensure that advisory contracts are awarded on professional competence, not political influence."

The rule being proposed for public comment by the SEC includes prohibitions intended to capture not only direct political contributions by advisers, but other ways advisers may engage in pay to play arrangements.

Restricting Political Contributions

Under the proposed rule, an investment adviser who makes a political contribution to an elected official in a position to influence the selection of the adviser would be barred for two years from providing advisory services for compensation, either directly or through a fund.

The rule would apply to the investment adviser as well as certain executives and employees of the adviser. Additionally, the rule would apply to political incumbents as well as candidates for a position that can influence the selection of an adviser.

There is a de minimis provision that permits an executive or employee to make contributions of up to $250 per election per candidate if the contributor is entitled to vote for the candidate.

Banning Solicitation of Contributions

The proposed rule also would prohibit an adviser and certain of its executives and employees from coordinating, or asking another person or political action committee (PAC) to:

  1. Make a contribution to an elected official (or candidate for the official's position) who can influence the selection of the adviser.
  2. Make a payment to a political party of the state or locality where the adviser is seeking to provide advisory services to the government.

Banning Third-Party Solicitors

The proposed rule also would prohibit an adviser and certain of its executives and employees from paying a third party, such as a solicitor or placement agent, to solicit a government client on behalf of the investment adviser.

Restricting Indirect Contributions and Solicitations

Finally, the proposed rule would prohibit an adviser and certain of its executives and employees from engaging in pay to play conduct indirectly, such as by directing or funding contributions through third parties such as spouses, lawyers or companies affiliated with the adviser, if that conduct would violate the rule if the adviser did it directly. This provision would prevent advisers from circumventing the rule by directing or funding contributions through third parties.

Public comments on today's proposed rule must be received by the Commission within 60 days after their publication in the Federal Register. 



A Fraudster's Mia Culpa: Marc S. Dreier-I Just Wanted Respect

If you have seen my posts on Madoff, you can tell that I am curious about the criminal mind. With normal securities fraud I have always subscribed to the thought that people simply get caught up in little lies, which get bigger, and then out of control. It mostly happens as a series of events, gets covered up, until bad economic situations cause the fraud to be revealed. But rarely have I seen the two lives these people live as we have seen with such highly regarded individuals as Madoff, and now Marc Dreier---the leader of a 250 man now-destroyed law firm to which some of my former colleages went based upon Dreier's reputation and promises of rewards.

In a recent letter Dreier wrote to convince the Judge who is going to sentence him, we see another amazing sad story of refusing to fail at all costs...and perhaps a true lack of self esteem. While Madoff never appeared to lack self-esteem, he did grow up on the wrong side of the tracks...so to speak...for the social circles he wanted to accept him so badly. Dreier just outright confesses to this desire. His letter is reprinted below in its near entirety. If you are unfamiliar with the crime...just read on. Dreier lays it our for you. Read it for what it reveals...and skip the excuses:

Marc S. Dreier

c/o Law Offices of Gerald Shargel

570 Lexington Ave., 45 th Fl.

New York, NY 10022 


July 7, 2009 


Dear Judge Rakoff, 


Please consider this letter in connection with my sentencing on July 13, 2009. 


I know of course that no words can diminish the harm I have caused to so many people. Those who were victimized by my bogus loans lost millions of dollars. Clients of my law firm lost escrow funds they entrusted to me. The attorneys and staff at my firm who put their faith in me lost their jobs. My friends and colleagues have been tainted by their association with me. And the families of all these people have no doubt shared in the suffering — as has my own family. My children have lost the father they knew, as well as their good name and the happiness they deserve. I have betrayed the people I care about most, and I suffer every day from the shame and self-loathing and regret with which I will always have to live. 


My crimes are inexcusable. I expect and deserve a significant prison sentence. 


Nevertheless, I am writing to give some context to what I did — certainly not to minimize my crimes but to try to explain how a person with my background and advantages came to do the unconscionable. Perhaps in learning how I made these terrible decisions which have ruined my life, others may avoid such mistakes. I have requested that my attorneys file this as an open letter, available in the public record, in the hope that it may do some good as a warning to others not to follow in my path. 


I was raised in New York by a loving family. in a comfortable home. I always succeeded in school. I attended Yale College and Harvard Law School. After law school I spent 20 years in several prominent law firms, first as an associate, then as a partner. I performed well, but I was achieving less satisfaction and recognition than I expected. Colleagues of mine and certainly clients of mine were doing much better financially and seemingly enjoying more status. By my mid-forties I felt crushed by a sense of underachievement.


So I started my own firm in 1996. My intention was to try to attract lawyers who, like myself, were dissatisfied with large firms and were looking for a more gratifying way to have a sophisticated practice. I had virtually no cash and very few clients. but I was able to grow the firm modestly over the next few years by investing my life in it. 


I had planned poorly. however, for the expenses. I couldn't get bank loans without better credit or collateral, so I was funding the firm partially with advances from some clients but primarily through "factors" who charged exorbitant fees and interest and were highly intrusive in monitoring the firm's accounts. By 2001 I was deeply in debt. 


In January 2002, my wife sued for divorce. I had been married for 15 years. We have two children. We entered into a settlement agreement under which I took on financial obligations to her and our children which were actually far more than I could afford. I believed that my fledgling law firm could not survive a contested divorce. 


All of this left me feeling overwhelmed — by my debt, by a disappointing career, by a failed marriage. And so, incomprehensibly, in 2002 I started stealing. First, I invaded some settlement proceeds due a client. Then I arranged a few bogus investments with some individuals. And soon I stumbled upon the brazen idea of arranging fictitious loans from hedge funds, ostensibly to my principal client (the real estate developer referenced in the Indictment), and diverting the loan proceeds to myself. 


As I sit here today, I can't remember or imagine why I didn't stop myself. It all seems so obviously deplorable now. I recall only that I was desperate for some measure of the success that I felt had eluded me. I felt that my law firm was my last chance to make a mark for myself, and I was fearful of seeing it fail. I know of course that this amounted to nothing more than self pity, but this was my state of mind when I became a criminal. I gave in to being overwhelmed by the anxieties of life that we are all expected to cope with every day, and most people do, but I just could not manage to do so. I had no one close to me with whom I could talk. I had isolated myself, both personally and professionally. I lost my perspective and my moral grounding, and really, in a sense, I just lost my mind. 


At the beginning, I spent most of the money on growing the law firm. Much of the money also went to servicing the "debt" itself. But, as time went on, I was more and more self-indulgent.I bought extravagant things — a beach house, an apartment, a boat, expensive art. Obviously, other men suffer through divorce and "mid-life crisis" and manage not to steal. And, other people grow their business without resorting to crime. I just wasn't in control of myself. 


It is hard to explain how my crimes in 2002 reached the level that they did by 2008. Certainly I never intended when this began to steal on the scale I eventually did. I took the first money thinking that I could and would repay it shortly with revenue derived from the law firm. Soon, however, I exhausted the money, and it was evident not only that I would be unable to repay the initial "loans" but that I would need more. I had stepped in a quicksand of spending. By 2008 I had hired over 250 lawyers and opened additional offices in Los Angeles. Pittsburgh and Connecticut. The expenses were more and more uncontrollable, and the "loans" became more and more expensive. As the credit markets worsened, hedge funds were demanding much higher interest rates and, in many cases. substantial discounts to principal. In some cases, when I desperately needed new money to pay back loans becoming due, I was selling loans for 60-65 cents on the dollar, meaning that I was paying back far more principal than the hedge funds were actually paying me, which obviously was dramatically deepening the hole I was in. 


In this way, without ever actually planning to. I found myself running a massive Ponzi scheme with no apparent way out. No doubt as is typical in Penn schemes, there was always the unrealistic expectation, or at least the hope, that I could use the "borrowed" money to eventually make it all work out. Obviously, and predictably, I was unable to do so. 


When I was no longer able to pay off old "loans" to the real estate developer by creating new ones, I placed a few other fictitious loans, in much the same manner, by using instead as the purported borrower a Toronto pension fund that I had once represented. Finally, when there were no loans I could invent, I began to pull money again from a few of the firm's escrow accounts, knowing of course that it was terribly wrong but still thinking that I could somehow restore the funds in short order. Typically, I did restore this money, but in early December 2008 I was unable to restore about $40 million to one such client account as the due date for its disposition was nearing. As a result, I engaged in the most desperate and irrational act yet - impersonating an attorney from the pension fund in Toronto in order to "close" a loan from a hedge fund which would have given me the funds to return the escrow money. I knew very well that this time I would most likely be caught. I was caught, and that escrow money was not restored. 


In some sense, being caught was a relief. I had been living a self-inflicted nightmare, scrambling every day to sustain the charade. I had three "full time" jobs: First, I was managing a large active law firm, with all the daily challenges that come with such responsibility. Second, I was head of the firm's litigation department, with a very heavy active practice and caseload of my own. Finally, I was managing a huge portfolio of fraudulent loans, which required me to constantly prepare and update bogus financial statements and loan documents, field inquiries from lenders and prospective lenders, arrange payments of principal and interest on existing loans, obtain new loans as old ones matured, and do all that was necessary to keep the scam a secret. At the same time, I was trying to spend as much time as possible caring for my son, who lived with me full-time, and my daughter, who lived about half the time with each parent. It was all I could do to get through each day, and each day it got harder. It was a frantic life which I had created for myself, and it left me exhausted and impaired. 


Your Honor has rightfully observed that as a lawyer I have dishonored the legal profession, and I am very painfully ashamed of that. My whole ambition in life was to be a lawyer who would distinguish himself and honor the profession. Over the course of 33 years of practice, I represented many clients well and devotedly. I made my work as a lawyer the center of my life. 


Obviously, I then strayed very far from those goals. I lost myself to my ambition and sacrificed everything else.


Recently, I have had the opportunity to read the letters sent to the Court by the victims of my offense. I am shamed by these letters. During the time I was committing my fraud. I tried to convince myself that I was hurting only "institutions' . and not "individuals - (as if that were less contemptible), because I was borrowing almost entirely from hedge funds. I knew of course then and I know now that this was all nonsense - my fraud devastated "real people" in a very real way. The letters from these individual victims show their suffering first-hand. I will only add that I believed these individuals would not be harmed. because I always made certain that there were sufficient funds still available to repay them when their money came due. At the time of my arrest, there were in fact sufficient funds in the firm's account (over $10 million) to repay all f these individuals. After my arrest, while I was jailed in Toronto, I instructed the controller of the firm to transfer $10 million to a separate non-law firm account, believing that by doing so I could shield the money owed to these individuals from any competing claims until I returned to New York. As I understand it now, however, several individuals remain unpaid in the wake of the firm's collapse, and these individuals who trusted the firm I controlled have been terribly harmed. I never intended for them to lose their money, but obviously I am responsible for even he unintended consequences of my wrongdoing. 


Since my arrest, I have done whatever little I can to start to make amends for my crimes. From the outset I acknowledged my guilt. I never considered putting my victims through the burden of a trial. I have also cooperated fully with the Receiver and Trustees appointed by the ourt. In numerous meetings and discussions I have tried to help them identify and recover funds and other assets to start to compensate those who are owed money. 


More than that, I can only explain to the people I betrayed how I came to make these mistakes and express my profound remorse. In the brief time I may have to speak at my sentencing, I hope to express my remorse to those I have hurt. Perhaps at least they will feel some degree of my shame, which I will have to live with for the rest of my life. 


For rne, the punishment that I receive from this Court will only be part of my sentence. I have already been disgraced beyond anything I could ever have imagined. Despite whatever good I once accomplished in my life, and what I had hoped to accomplish, I will always be remembered as a thief. I have lost all my friends. I have lost my law firm, my law license and all that I ever owned. 1 have seen my family suffer the unimaginable. I have lost my past and y future. I have lost everything a man can lose. And now I will lose my freedom as well, and rightly so. 


All that I have left in my life is the prospect of still sharing in my children's lives, both while I am in prison and, I pray, for some time thereafter. My son is 19; my (laughter is 17. We are very close. I have devastated their lives, and unfortunately nothing I do now can diminish that. I can only try to be there for them to whatever extent I can. 


I don't know what gives some men the strength of character to lead virtuous lives for all of their lives, and what causes others, such as myself, to lose their way. There is no excuse whatsoever for what I have done. I have explained it the best I can. 1 will try to learn from this, and hopefully others will as well. 


Respectfully yours.

Marc S. Dreier


Did Matrixx ( MTXX ) Commit Securities Fraud By Withholding Adverse Reaction Reports From the FDA?

Matrixx Initiatives, Inc. (Nasdaq: MTXX), the makers of Zicam products, looks like it committed securities fraud statutes when it failed to provide the Food and Drug Administration (FDA) with more than 800
reports relating to the loss of sense of smell associated with the Zicam Cold Remedy intranasal products.

According to the FDA, as of Dec. 2007, Matrixx was required to provide reports of adverse reactions to the agency per the Dietary Supplement and Nonprescription Drug Consumer Protection Act, which President Bush signed into law Dec. 22, 2006. The Act requires manufacturers, packers, or distributors whose name appears on a nonprescription drug or dietary supplement product label to notify FDA of any serious adverse event report associated with the product's use within 15 business days of receipt of such information. The industry was given a one-year grace period to begin to comply with the law.

In a letter to Matrixx, dated June 16, 2007, the FDA informed Matrixx it concluded that certain Zicam products may pose serious risks to consumers who use them, and that Matrixx marketing practices violate several laws relating to the products.

It also stated that the "agency is aware that Matrixx appears to have more than 800 reports related to loss of sense of smell associated with Zicam Cold Remedy intranasal products" and directed Matrixx "to arrange ubmission of all reports related to loss of sense of smell associated with Zicam Cold Remedy intranasal products" and to "indicate which of these reports have been previously submitted to the FDA."

Upon release of this letter by the FDA, Matrixx stock plummeted from approximately $19 per share to less than $7 per share. From the FDA ranscript:

Lisa Stark: Thank you. Actually most of my questions have been
asked. But let me ask you one thing. You mentioned that I think it was
after December 2007 the companies had to provide adverse event reports
to the FDA. They didn't have to do so prior to that. Did this company
since that time provide any adverse event reports to you based visa vie
these products?

Deb Autor(FDA): As Dr. Lee said, the reports that we have are
from consumers and healthcare providers. And in the warning letter we
have asked Matrixx to provide to us the more than 800 reports that we
know that they have relating to the lose of sense of smell associated
with the Zicam Cold Remedy intranasal products.Those have not been
provided to the agency at this time.

Lisa Stark: Should they have been under the current regulations?
Should you have received those reports?

Deb Autor: I can't address that question today.

On July 23, 2009, Matrixx acknowledged the Securities and Exchange Commission (SEC) is launching an informal inquiry. Since December 2007, insiders, including the Executive VP and CFO, the VP of Sales and the VP of Research and Development, have sold more than $2.7 million worth of Matrixx shares.

According to new reports, the COO said Matrixx first learned during the FDA's on-site inspection last month that the federal agency wanted all such "adverse events" reports immediately after consumers filed them with the company. Matrixx, acting on its legal advice, thought the company merely had to make such reports available to FDA inspectors during on-site visits."We have complaints here, clearly, but we weren't required to send them; at least we didn't believe we were required to
send them," he said.

The Hagens Berman press release regarding their investigation of this matter can be found here.



Oracle vs. Household Finance---A Tale of Two Securities Fraud Class Actions

My friends at a competitor firm have had their ups and downs recently, and always have. They invested years of their lives into litigating a securites fraud suits against Household Finance and Oracle. Last month, the case against Household Finance paid off (at least for the time being) with a jury verdict worth perhaps hunderds of millions. The case is discussed here. The case is a model showing why defendants should settle before trial.

A second case, filed about the same time...and which went up and down on an appeal over pleading issues, however met a different end (at least for he time being.) Just days ago, a Judge in the Northern Distict of California, threw out the securities fraud class action against Oracle on a summary judgement motion. Much of the opinon is based on the failure to tie the alleged fraud to the reasons the stock dropped. The case was by no means a clean case. Oracle had undisclosed messes at hand, and Larry Ellison sold almost $1 billion in stock just before the disclosures that caused the stock to drop. The problem, according to the Court, is that the stock seemed to drop based on an unexpected slowdown...or predicted slowdown in sales that cropped up during the last few weeks...not the accounting issues and product issues the plaintiffs case was built upon. The opinion can be found here. This case is a model showing why defendants  never settle before trial.

I observed both cases in their infancy and through much of the discovery while I worked with many of the attorneys involved. The energy in prosecuting such cases is intense, and the attorneys devoted much of the last 8 years to these cases. I am both happy and saddened for my former colleagues. But that is the life of a securities fraud litigator...and perhaps any litigator. The difference is that the defense attorneys get paid either way.


Yes, Institutional Investors Can Make A Difference In Securities Fraud Litigation

Institutional investors do in fact make a difference as lead plaintiffs in reaching larger settlements and improving corporate governance. A forthcomingpaper to be published in the Journal of Financial Economics, entitledInstitutional Monitoring through Shareholder Litigation,concludes that relative to securities fraud class actions with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed, have significantly larger settlements and are associated with more board independence after the lawsuit.The paper, which can be found here, is written by professors from four different universities: C.S. Agnes Cheng of Louisiana State University, Henry Huang of Prairie View A&M University, Yinghua Li of Purdue University, and Gerald J. Lobo of the University of Houston. As stated by the authors in a Harvard blog, here, the paperwas motivated by the lack of evidence on the effectiveness of institutional investors exercising their monitoring power through litigation:

Such evidence is much needed because the Private Securities Litigation Reform Act of 1995 (PSLRA) established a preference of granting lead plaintiff status to plaintiffs with the largest financial stake in the class action, thus providing institutions an opportunity to critically affect the litigation by serving as the lead plaintiffs. Given the costs of serving as a lead plaintiff and the free rider problem, institutional investors may not want to lead class action lawsuits even if they hold the largest financial stake in the defendant firm. Consequently, it is important to provide empirical evidence on the effectiveness of institutional monitoring through class action litigation. In addition to documenting the implications of the lead plaintiff provision in the PSLRA Act, our findings also underscore the important monitoring role of institutions, from both an immediate disciplining of management as well as a long-term corporate governance perspective.

The authors hypothesized that generally an institutional investor will be a "free-rider" and take the benefits of class actions led by other individual plaintiffs, unless the potential benefits to them outweighed their agency costs. The study, as described by the authors, used a sample of 1,811 securities class actions filed between 1996 and 2005, and confirmed that hypothesis.Thus the study found that:

  1. when the likelihood of winning is high, the potential damage is large, and the defendant firm is important to the institutional owners, institutional owners are more likely to step forward to serve as the lead plaintiff.
  2. institutional investors are more likely to serve as the lead plaintiff when the lawsuit:
    • involves an accounting-related allegation,
    • has an accounting firm as the co-defendant,
    • has a longer class period, has a larger negative market reaction to the revelation event, and
    • has a larger potential investor loss.
  3. the probability of having an institutional lead plaintiff is also higher when the defendant firm has a larger market capitalization, has a higher level of institutional holdings, and is operating in a high-tech industry.

The authors then sought to control forthese determinants to find our whether, even then, their was a difference in litigation outcomes when institutions became involved. Using multivariate regression analysis to control for these determinants of when institutions are likely to get involved, the authors concluded:

  1. that relative to lawsuits with an individual lead plaintiff, lawsuits with an institutional lead plaintiff are less likely to be dismissed and have significantly larger settlements;
  2. all types of institutions show significantly better litigation outcomes with public pension funds generating the largest settlement amount;
  3. within three years of filing the lawsuit, defendant firms with institutional lead plaintiffs experience greater improvement in board independence than defendant firms with individual lead plaintiffs.

These findings should be reason enough for institutional investors to step forward and serve as lead plaintiffs. So institutions, get involved!