In September, an investor filed a suit against Citigroup, Merrill Lynch, Morgan Stanley, UBS, and Wachovia, middlemen in Fannie Mae’s stock offering, accusing them of omitting important information from the prospectus. Karen Orkin purchased 600 preferred shares at a public offering by Fannie Mae – one of the two largest mortgage companies in the United States, recently aided by the American Treasury in the crisis deflagrated by subprime credits. In four months, the company’s shares fell 44%. The drop is due mainly to the real estate crisis, but it was in the prospectus that the investor tried to find a reason to file a claim - and find one they did.

According to her, the offering’s coordinating institutions did not issue a warning on the risks that an accounting change – the FAS 140 reform, proposed by the Financial Accounting Standard Board (Fasb) – could bring to share prices. The reform prescribes the end of Qualifying Special Purpose Entities (QSPEs), which allowed the use of off balance transactions. Financial institutions transferred part of their subprime loan portfolios to QSPEs, thus avoiding the capital requirements associated with these assets. If such change comes into force, Fannie Mae and Freddie Mac (another American mortgage giant) will have to bring no less than US$ 3.7 trillion in liabilities back into their balance sheets. “When the news about these possible changes came out in to the open, the shares plummeted”, said Orkin in her complaint. The suit is ongoing.

In Brazil, civilly engaging an intermediary would not be so simple. The law that handles the country’s securities market, namely Law no. 6.385, does not provide for intermediaries’ civil accountability. This is very different from what applies to auditors, for example, who may be taken to court for their mistakes. The same law, in its 7th chapter, determines that “...accounting audit companies or independent accounting auditors will be civilly accountable for the losses they cause to third parties as a result of fault or wrongful intention in the exercise of their duties...”. “Today, there is no criminal case that would truly harm the intermediary”, warned Marcelo Trindade, a partner at Trindade Lawyers’ Association, at CAPITAL ABERTO’s fifth anniversary celebratory debate. Held in September in the São Paulo state capital, the event gathered together the current president of CVM (Brazilian securities and exchange commission), Maria Helena Santana, and four former leaders of the autarchy, among which Trindade is included.

With nothing in the Brazilian legal framework to specifically provide for middlemen’s civil accountability, investor has two possibilities. One is going through the legal system, trying to convince the courts based on inference from other legal devices. But the easiest way would be in the administrative sphere. The CVM rule that regulates the activity of this agent in a public stock offering is Instruction 400. The first paragraph of article 56 determines that “the leading institution must take all precautions and act with high standards of diligence, answering for lack of diligence or omission”. The autarchy may install an administrative proceeding in which it requests information from the accused and checks if their activity complies with the rules. If irregularity is proven, the penalties will range from a warning to suspension of permission to exercise the activity.

For Trindade, legal instruments that would allow a civil suit to be filed against intermediaries are desirable, for a number of reasons. The main one is the fact that, per the terms of the CVM Instruction, the accountability of these agents in a stock offering is subjective, in other words, guilt must be proven. In the case of issuers, for example, accountability is objective, i.e., culpability falls to them regardless of having acted or not in bad faith. In the middleman’s case, on the other hand, it is the investor who must collect evidence. “Proving that this agent failed in due diligence is a demonic burden, practically impossible to accomplish”, assessed the former CVM president.

A lawyer who prefers not to be identified reports that his office was sought out by investors who inquired about the chances of obtaining indemnification from Credit Suisse in court. The bank had coordinated a stock offering by Agrenco, recently investigated by the Federal Police for accounting fraud. “I told them that the major problem would be collecting evidence that the intermediary institution knew about the fraudulence taking place at the company. They would have to get an employee to prove that allegation, for example. It’s very hard.”

A CAMEL WITH A TRUNK – Trindade defended a revision to Law 6,385, with the creation of a specific regulation for intermediaries, as applies to auditors. “We may also handle it specifically, for example establishing inversion of the burden of proof which applies to administrative accountability”, he affirmed.

To the lawyer, the intermediaries’ activities in a stock offering are full of traps and temptations. “The intermediary has countless more incentives to sell, and give more relevance to that, than to carry out high quality information-gathering work.”

Event gathers 5 CVM presidents At the event where CAPITAL ABERTO celebrated its fifth anniversary, each president of CVM (Brazilian securities and exchange commission) brought forth an issue that they deemed relevant to the future of the capital market. Francisco da Costa e Silva, who was president of the autarchy from 1995 to 2000, raised the issue of stock takeovers after a transfer of shareholding control. The subject isn’t new in Brazil, but gained strength recently with the acquisition of control over Aracruz by Votorantim Papel e Celulose (VCP). In August, the Votorantim group company purchased the Lorentzen family’s 28% interest in Aracruz for R$ 2.7 billion, increasing its own interest to 56%. The Safra family, which also held 28% of the pulp company based in the Brazilian state of Espírito Santo, negotiated with Votorantim and, after disbursing R$ 530 million, celebrated the creation of a holding, with 50% of the voting capital for each group. To preferred shareholders, each Aracruz share is worth 22% to 24% of the new company’s share. “Such operation offers a trade ratio that has nothing to do with the calculation basis they used to buy control”, criticized Costa e Silva. One of the points attacked by the lawyer in this type of operation was the assessment reports – documents that stipulate the price to be paid. “Is there anything less believable than assessment reports?” he said. “It is necessary to assign more accountability to the assessors who elaborate these reports.” Maria Helena Santana, current president of the autarchy, showed concern about the discussions that surround transfers of control. “How can we make the rule for handling minority interest holders more predictable and clear upon operations where there is a change in control?”, she asked. Incidentally, in the Aracruz-VCP case, this was an additional object of discussion. VCP argued that the transfer of shares would occur only among integrants who were already in the controlling block and, therefore, there would be no tag-along. “It is necessary to discuss what control is. The 254-A will become weaker and weaker in our law”, assessed Maria Helena, referring to the article that provides for transfers of control in the Brazilian Corporations Act. Luiz Leonardo Cantidiano (president from 2002 to 2004) suggested the possibility of the Brazilian market taking up some elements of the European model, which does not tie tag-along to the issue of transfer of control. It would be like a poison pill without reward: if someone acquires a certain percentage of stocks (30%, for instance), they would be obligated to make an offering to all shareholders. Ary Oswaldo Mattos Filho, who ran CVM from 1990 to 1992, remembered that the regulation will not be the only one to face challenges in the upcoming years. Self-regulation will also find some stones in its shoes, especially after the financial crisis which had yet to reach its peak on the date of the meeting. “Where is the capability of self-regulation if, at the slightest sign of trouble, it is the government who will have to step up to the plate?”, instigated the lawyer.

Luiz Leonardo Cantidiano, a partner at Motta, Fernandes Rocha Attorneys and also former CVM president, disagreed. To him, the path of law alteration through the National Congress can be tortuous and time-consuming, and often does not accomplish the desired effect. “There are projects that ask for an elephant and end up receiving a camel with a trunk”, he compares.

Francisco da Costa e Silva, a partner at Bocater, Camargo & Costa e Silva and former CVM president, also sees no need to change the law. He believes that companies and intermediaries are much more afraid of CVM’s effective and quick action than they are of a slow legal procedure. “I see the fear with which people receive a CVM notification, not only for the damage that this can cause to their image, but also for the penalties”, he tells.

THE STRENGTH OF CLASS ACTIONS – The U.S. legislation offers a more investor-friendly environment in this matter. It clearly establishes intermediaries as one of the market agents passible of being civilly engaged. Section 11 of the 1993 Securities Act sets forth that any person who acquires shares from a company whose prospectus contains untrue or undisclosed information may legally engage the offering’s intermediary, among others.

In this situation, there is an inversion in the burden of proof. In other words, the responsibility for presenting evidence is transferred to the stronger side – the intermediary, in this case. For a conviction, the intermediary must be directly tied to the supposed irregularity. “If the error originated from the work of a specialist who is not the intermediary himself, such as a report from an auditor or an engineer, for example, culpability does not fall on the intermediary”, explains Miguel Lawson, of Clifford Chance international law office.

In the U.S. the number of lawsuits filed against the actions of middlemen make up a large share of total public civil suits (known as class actions), and the number is growing. A survey by Cornerstone Research legal consultancy revealed that, from 2006 to 2007, the number of collective suits against this market agent almost tripled, from five to 19. Among the total class actions in those years, suits filed against intermediaries represented 4% and 11%, respectively. Is this a sign that underwriters are increasing their irregular practices? Not necessarily. “It is good to remember that, in the American capital market, when investor loses money, the number of lawsuits grows significantly”, says Lawson.

When the situation is going well, says the Clifford Chance attorney, nobody reads the prospectus carefully. “But as soon as the tide changes, everyone starts to read through the document thoroughly, searching for some irregularity that might incriminate the company – or anyone – and give them their money back”, he says.