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Regulators on the Beat
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Mark Cuban and his attorney wrote a piece in the Wall Street Journal today that is worth reading. Cuban successfully beat back insider trading charges by the Securities and Exchange Commission. To do so, he took the relatively unusual step of going to trial instead of settling with the SEC. Defending oneself against an SEC enforcement action is costly financially, but can also take a toll on one's mental and physical health, family life, and career. For that reason, many people choose--regardless of the validity of the SEC's allegations--simply to settle and move on with life as best they can. Cuban maintains that the SEC should operate under a rule currently applicable in the criminal context that requires the government to turn over to the defense material exculpatory evidence. Cuban's commentary raises broader questions about regulatory agencies' enforcement programs.

In three coordinated settlements this week, JPMorgan paid approximately $2.5 billion mostly based on its failure to alert US authorities to the Madoff fraud. Employees of JPMorgan, which had banking and investing relationships with Madoff, had periodically questioned the legitimacy of his activities. In mid-2007, JPMorgan employees discussed rumors about Madoff, but, as one senior employee asked, could a firm regulated by the Securities and Exchange Commission and other securities regulators really be perpetrating a massive fraud? Over the next year, certain employees of JPMorgan continued puzzling over how Madoff was earning his returns. In October 2008, they formally notified British authorities about the bank's deepening concerns and its plans to reduce its Madoff exposures. This week's settlements fault JPMorgan for not simultaneously filing anti-money laundering reports in the United States. Settlement documents reveal that suspicions about Madoff also were not effectively communicated within JPMorgan to US operations that had significant exposure to Madoff.

Earlier this week, the Bureau of Consumer Financial Protection filed its first lawsuit against an online lender. The alleged offense was making loans in violation of state usury and licensing laws. The Bureau alleges that, because the loans were illegal under state law, making them and collecting them violated the federal prohibition against unfair, deceptive, and abusive acts and practices. Some state attorneys general have filed their own suits on the same facts. This move by the Bureau raises a number of questions. Should the Bureau target high-cost consumer financial products even if the costs are disclosed? The loans in question come with very high interest rates, but the Bureau's complaint reproduces a table from the offending lender's website that clearly sets out how high those rates are, how many payments will have to be made, and what the amount of each payment will be. Is it the role of the new federal consumer finance regulator to enforce state laws designed to prevent consumers from taking out certain types of loans? States presumably adopted those laws with the view that the prohibitions were of sufficient importance for the states to dedicate the necessary resources to enforce them. But should a federal agency's resources be spent on enforcing consumer lending limits the merits of which it has not considered? Even well-intentioned caps constrain credit availability to consumers, which may lead to more serious financial consequences to the consumers than paying high interest rates would have. Before championing these laws, the Bureau ought to undertake the necessary analysis to determine whether they hurt or harm consumers.

JPMorgan's Unsettling Settlement
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After much anticipation, JPMorgan and its government negotiating partners emerged this week from their diet-Coke-filled backroom (smoke-filled backrooms are passé) to announce "a $13 billion settlement with JPMorgan--the largest settlement with a single entity in American history." The federal and state claims against JPMorgan were grounded in failures to be fully forthcoming about the quality of the mortgages backing securities the bank was selling. The press release explained that JPMorgan's actions "along with similar conduct by other banks that bundled toxic loans into securities and misled investors who purchased those securities, contributed to the financial crisis." Such a broad, unfocused accusation against multiple banks cannot alone justify a $13 billion settlement with JPMorgan, but the eleven-page statement of facts does not provide much more insight. We are told that "a number of the loans included in at least some of the loan pools" that JPMorgan bought and securitized did not conform to the bank's representations to buyers. We are further told that Bear Stearns and Washington Mutual--which JP Morgan purchased during the crisis--withheld information about the poor quality of certain mortgages from purchasers of their securities. The settlement documents include what appears to be a comprehensive list of the residential mortgage-backed securities issued or underwritten by JPMorgan, Bear, and WaMu, but there is no indication of which of these included mortgages that the banks knew did not comport with their representations to investors. Nor is there any indication of the basis upon which the entities split the $13 billion among themselves and the seemingly arbitrary group of consumers and other non-parties to the settlement that will receive a piece of the $13 billion. The government accused JPMorgan of hiding behind generalizations about the types of mortgages backing the securities it was selling. Yet, in settling the case, is the government hiding behind generalizations too.

Vinny Sidhu
Legal Intern, Manhattan Institute's Center for Legal Policy

Recently, the Manhattan Institute released its latest Trial Lawyers, Inc. publication on patent "trolling," a practice that involves companies accumulating the rights to large patent portfolios and suing those who engage in unlicensed usage. One of the major problems with this practice has been that these so-called Patent Assertion Entities have been able to acquire patents on some of the most basic technological innovations, and thus stifle the ability of others in the industry to innovate and improve upon the technology.

Now, Congress itself is in danger of stifling technological innovation. Derek Khanna, in an article for Slate Magazine, has discussed a proposed change to Section 230 of the Communications Decency Act. This change, signed on to by 47 state attorneys general, would amend Section 230 to grant state criminal statutes immunity from the federal mandates of the section. Ostensibly, this proposed alteration would allow states to hold host websites liable if user-generated content propagated illicit activity, like ads for sex trafficking on Craigslist.

The problem is that this amendment would allow state attorneys general the broad power to prosecute the host website owners for user-generated content. This would in turn make website owners wary of allowing users to post on their sites, and therefore effectively remove potentially important dialogue and feedback from being placed on the site. Moreover, the national scope of many Internet companies compounds the fear of being potentially prosecuted under 50 different penal codes.

Khanna offers a telling example of the benefits of Section 230 in its current form:

Let's say Section 230 was never implemented, and Reddit's future founders arranged a meeting with their members of Congress to propose changing the law to facilitate their market model for a message board on the Internet. Assuming they didn't ask the member of Congress who referred to the Internet as "a series of tubes," it is likely that the politicians would respond, "This is such a small market, and a silly idea, so why would we bother changing the law for you?" And yet, today Reddit is a billion-dollar company and according, to one study, 6 percent of adults on the Internet are Reddit users (including me).

Section 230 is simple and intuitive to entrepreneurs, and it doesn't require a lawyer to implement. It's essentially a permission slip telling the Internet: "Go innovate." And entrepreneurs, such as Alexis Ohanian, co-founder of Reddit, responded by launching a diverse array of websites with user-generated content. Facebook--which currently has 1.2 billion users, or one-eighth of the world's population--would have been impossible without Section 230. Ben Huh, CEO of the Section 230-enabled Cheezburger Network, told me: "Section 230 is one of the hidden pillars of the free speech of the Internet."

If Section 230 is opened up to state criminal sanctions, the entire innovation-enhancing purpose behind the section's enactment will be destroyed. While the regulation of user-generated illicit activity is an important end, the means presented by the state attorneys general are not narrowly-tailored enough to prevent the creation of a considerable disincentive for Internet companies to grow and expand, as well as a disincentive to allow public forums in which users can offer suggestions as to how the company can improve its products and services.

Congress needs to maintain a free public sphere in which companies can feel comfortable in allowing user-generated content on their websites. Anything else would constitute a stifling of those animal spirits of innovation which have allowed the Internet to be placed at the vanguard of societal progress.

We're All Fabulous, Fab
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Last week, a jury agreed with the Securities and Exchange Commission that Fabrice Tourre, a former Goldman trader, had committed securities fraud. Tourre's violation, which could earn him a permanent bar from the securities industry and a penalty, was a failure to make clear to sophisticated parties in a complex transaction that another sophisticated party was betting against the transaction. In bringing cases like this, the SEC is encouraging market players, even sophisticated ones, to adopt the extremely naïve view that everybody is on the same side of a deal.

SEC Settles on Poor Cases
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There has been much discussion recently of the merit of the SEC's no-admit settlement policy. Companies and individuals routinely enter into enforcement settlements with the SEC that include a detailed rendition of the facts as the SEC sees them and a disclaimer that the company or individual is settling without admitting or denying the allegations. The practice has allowed the SEC to be very sloppy in constructing its enforcement actions.

The Securities and Exchange Commission issued long-awaited guidance yesterday about companies' use of social media in a manner that comports with Reg FD, the SEC's regulation governing companies' disclosures of material nonpublic information. The guidance came in the form of a Section 21(a) Report announcing the SEC's decision not to bring an enforcement action against Netflix CEO Reed Hastings. The SEC had contemplated taking action against Mr. Hastings for a posting he made on Facebook announcing to his more than 200,000 friends that Netflix users had watched a record one billion hours of content in a month. To the SEC's dismay, he did so without "input from Netflix's chief financial officer, the legal department, or investor relations department."

The SEC gave Mr. Hastings a pass, but warned other CEOs--even those with "a large number of friends or other social media contacts"--not to count on getting similar mercy unless investors are told in advance that they need to friend the CEO to keep apprised of corporate developments.

The SEC's guidance provides some helpful clarity, but the unfortunate reality is that, even with such guidance, the SEC's rules make it difficult and legally treacherous for companies and their executives to communicate with investors and the public. As the SEC cautioned in the 21(a) Report, there are no bright lines; each case will be reviewed according to its facts. Fear of a possible SEC enforcement action will continue to dampen companies' ability to use new--and more traditional--media effectively. It might be time for legislators and regulators to take another look at whether the rules governing corporate communications are actually good for investors.

Fixing LIBOR from Afar
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The Commodity Futures Trading Commission this week brought its latest LIBOR enforcement action. Its targets were the Royal Bank of Scotland and RBS Securities Japan. The CFTC's enforcement order is largely a rendition of snippets from numerous electronic and telephonic conversations between traders and employees responsible for making rate submissions used to determine Yen and Swiss Franc LIBOR. The traders cajoled--usually without much effort--the submitters into raising or lowering rates to benefit their trading positions. The order leaves the reader wondering whether the efforts by traders with an interest in seeing rates driven down were being offset by the equally unseemly efforts of other traders trying to drive them up. Another question worth pondering is whether--particularly in the wake of the CFTC's MF Global and Peregrine debacles--the CFTC ought to be using its resources to pursue this type of behavior, most of which occurred outside the U.S. LIBOR is a benchmark set by a private, non-U.S. organization, but the CFTC hangs its jurisdictional hat on the effect that LIBOR submissions based on "impermissible and illegitimate factors" had on commodities in interstate commerce. Is the CFTC really the regulator best suited to dictate where bank employees in London sit and how frequently supervisors in Romania and Indonesia are monitoring employees, which are two of the many issues addressed by the CFTC's order? Pulling in a $325 million penalty is a tempting feather for the CFTC's cap, but the CFTC might not be the right policeman for this beat.

Facebook Disappointments
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Everything about the Facebook initial public offering was disappointing. This week's action by the Massachusetts securities regulator is no exception. Massachusetts entered into a $5 million settlement with Morgan Stanley, the lead underwriter of the Facebook IPO. The basis for the settlement was Morgan Stanley's alleged violation of the terms of the 2003 Global Research Analyst Settlement. The 2003 settlement--entered into with the Securities and Exchange Commission, the New York Attorney General and other regulators--involved research analyst conflicts of interest at ten Wall Street firms. There were concerns that research analysts were doing the bidding of investment bankers.

As part of the settlement, the firms agreed to a number of undertakings that fundamentally changed research analysis about companies. In an unfortunate instance of backdoor rulemaking, the regulators changed the industry's regulatory structure without going through the procedures required for agencies conducting rulemaking.

Morgan Stanley allegedly broke the undertakings it agreed to in 2003 when the investment banker managing the Facebook IPO apparently got too involved in the company's discussions with research analysts. As a result of those discussions, research analysts modified their forecasts for Facebook revenue downwards. Regardless of what one thinks of the 2003 settlement, an investment banker's attempt to get updated information to research analysts so they could appropriately downgrade their revenue forecasts in advance of the IPO does not seem to be the type of scenario the settlement was intended to cover.


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