RebelCapitalist: Financial Information for the Rest of Us

Are Financial Conglomerates Sunk?

Jan 22, 2009 | By: Mr_Blue | Tags: financial bailout, securities laws, bank of america

The financial conglomerates such as Bank of America, Wells Fargo and J.P Morgan Chase may be sunk and not because of what is on their balance sheets. Did they fail to publicly disclose information as required by law? Publicly traded companies, such as the financial conglomerates, are required to disclose important and “material” information regarding financial condition of the company. Failure to do so may make them vulnerable to shareholder class action lawsuits which could be very costly if the financial conglomerates lose.

I certainly don’t want to encourage litigation but there has to be consequences if a financial conglomerate failed to meet its legal obligations. Securities laws can be complicated but I am providing a very brief summary to give people a taste of the legal obligation publicly traded companies have regarding public disclosure of financial information.

Securities Exchange Act of 1934 (34 Act)and the Securities and Exchange Commission (SEC) rules require a certain level of public disclosure of publicly traded companies. One of the important purposes of 34 Act and corresponding rules is to prevent fraud and deception with publicly traded stock. Insider trading is probably the most popular violation under the 34 Act and rules.

Rule 10b-5 may be the most important rule adopted by the SEC. The rule reads as follows:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

1. To employ any device, scheme, or artifice to defraud,

2. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

3. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

There is similar language Section 14 of the 34 act and corresponding rules which cover proxy statements.

The typical situation that Rule 10b-5 would effect is the one where a corporate officer (or someone with insider information) would say something untrue but positive on CNBC, but at the same time sell his/her shares of the company. The effect of the “untrue” public information on CNBC was to manipulate the stock price in a way that allows the corporate officer time to sell his/her stock at an inflated price. This is a typical insider trading case.

Rule 10b-5 or Rule 14a-9 can apply to the situation where certain “material information” is not disclosed such as the financial condition of a company being acquired by a financial conglomerate. The Rule allows for criminal liability but is also the basis for many shareholder class action lawsuits. If found liable for violating Rule 10b-5 or Rule 14a-9 these companies may have to pay billions in damages.

It looks like the lawsuits are starting.

If these financial conglomerates are vulnerable to 10b-5 violation should we be pouring taxpayer money in them?