What the GM bondholders get from the IPO (Detroit Free Press)

Posted: Nov. 15, 2010
In GM IPO, stakeholders could walk away with billions as stock hits the market this week

Some will see billions as stock is released to public this week
By CHRISSIE THOMPSON
FREE PRESS BUSINESS WRITER

This week, General Motors' stakeholders will see some cash. Finally.
If all goes as planned, GM will price its initial public stock offering on Wednesday, and the stock will hit the market on Thursday morning with new owners.

As trading begins, owners such as the U.S. Treasury will walk away with billions of dollars in exchange for releasing their GM stock to the public.

But that doesn't include GM bondholders -- many of whom are Detroiters who supported the home team years ago through their investment portfolio.

During GM's bankruptcy last year, the bondholders were given a 10% stake in the new GM. But they won't actually receive the shares until the liquidation of the cast-off portion of the old GM that is still in bankruptcy. That's expected to take three to six months, according to an insider from a firm that's a major bondholder.

Until then, GM's bonds will continue to trade. And starting this week, so will the stock -- with everyday Joes like Kris Trexler eager to get a piece from the stock's first public owners.

Trexler, a Los Angeles film and video editor, said he cried when he turned in the EV1 electric car that GM canceled a decade ago. He's now one of the consumer advisers testing a Chevrolet Volt for three months -- and he already has a Volt on order for when the test ends.

"After driving this car ... I can't think of any reason I wouldn't buy some stock," Trexler said. "This company is back, and they've proved it to me."

Old GM bonds guarantee shares of new GM stock

"I've been holding them for years. What's another couple of months?"

That's the strategy Northville's Frank Drew says he's using for his General Motors bonds. The bonds, with a face value of about $150,000, are now trading at about a third of their original value. But once the part of the old GM still in bankruptcy is liquidated, Drew will get GM stock. His bonds will be put in a pool with about $37 billion worth of bonds and other unsecured claims, and 10% of GM's 1.5billion common shares will be issued to bondholders proportionately to the value of their bonds.That stock will be Drew's to do with as he wishes -- just as it will be for the buyers of GM's stock when it hits the market Thursday, 16 months after the company exited Chapter 11 bankruptcy.

GM is planning to sell up to 419.75 million common shares and 69 million Series B preferred shares to hedge funds, money managers and long-term investment firms. Those firms will then trade the stock on the New York and Toronto stock exchanges.

The automaker set a target range for the common shares at $26 to $29 each, but GM is expected to raise that range early this week by no more than a few dollars, according to two sources familiar with the situation. As executives finish their road show presentations to investors in North America and Europe, they're gauging the interest of the all-important long-term investment firms. GM needs those firms to hold stock for months, or even years, to keep it stable.

By all accounts, demand for GM stock is strong, likely enough for every possible share to sell. And the recent market improvements only help. The Dow Jones Industrial Average has gained about 500 points in the last month, and more than 1,000 in the last two months, closing Friday at 11,283.

Probable buyers include GM's Chinese automaker partner SAIC and investment funds from the Middle East.

That could create controversy for the IPO's largest seller, the U.S. Treasury, which is planning to use the sale to lower its stake in GM from 60.8% to slightly more than 40%. The treasury has said that some foreign investors would be allowed, but consumer advocate and former presidential candidate Ralph Nader cosigned a letter last week to President Barack Obama, urging him to suspend the IPO, partially because of the need to keep investment in the U.S.

Nader was also concerned that the government plans to sell part of its stake at a loss. The government needs to average $43.67 per share to break even on its $50-billion investment in GM, above the likely range. The treasury is hoping GM's stock will grow in value over the coming months and years so it can make more money when it sells the rest of its shares.

An increase in stock price is likely, said a person from a firm that owns a large number of GM bonds. The firm expects GM's stock to quickly reach the mid-$30 range the bond trading currently implies. And by 2013 or 2014, the person said, the firm expects the stock to hit $60 to $70 each, as long as GM fulfills executives' predictions that the company will make $11 billion to $13 billion annually before interest and taxes in an average sales climate.

GM bondholders will also receive warrants to buy more stock by either 2016 or 2019. Bondholders will be able to receive that extra stock by paying either $10 or $18.33 per share, which will count as revenue for GM. The warrants will take bondholders' total share in GM to 23.85%.Contact Chrissie Thompson: 313-222-8784 or cthompson@freepress.com

The True Cost of Waiting (from trulia.com)

Dangers of Analysis Paralysis
The cost of overthinking finances | Inman News

The cost of overthinking finances
Mood of the Market
By Tara-Nicholle Nelson, Tuesday, November 9, 2010.
Inman News

Recently, I read the pithy but powerful business inspiration book, "Rework," by Jason Fried and David Heinemeier Hansson, the founders of small business software company 37signals. The book is formatted into mini-chapters with provocative titles, including a couple that put me in mind of this column's current series of mindset-shifting recommendations for Americans around money matters.

One, ASAP is Poison, reminded me of the much-needed mindset shift away from instant gratification. Another, Inspiration is Perishable, "inspired" me to think of the Conscious Bookkeeping approach to your relationship with money, including transforming your monthly budget into a "map of intentions," renaming the staid, standard expense categories by what they really mean to you, rendering it much juicier and more likely that you will honor your own values and intentions with your dollars.

But the third "Rework" chapter that got my money mindset gears shifting was this: Planning is Guessing. The American obsession with books and television shows on retirement planning belies the truth that 43 percent of Americans have less than $10,000 in retirement savings -- and 27 percent have less than $1,000, according to the Employee Benefit Research Institute's 2010 Retirement Confidence Survey.I know a number of very smart people who have waited a very long time -- procrastinated, actually, to get serious about their financial planning -- not only for retirement, but also for big-ticket purchases like homes and children.

We procrastinate because we don't think we have enough money to save, so we put it off until that someday when we make more, not realizing that as we make more, most of us also spend more, so the surplus for savings never magically appears unless you intentionally create it.

We procrastinate because we don't think we have the time in our daily schedules for financial planning. We procrastinate because we fear what we don't understand, and we don't understand how to approach large dollar amounts, projections and investment accounts.

And we also procrastinate because we are overly confident that we have many years ahead to plan.

So, the book's "Planning is Guessing" mantra can be useful to those of us who procrastinate at financial planning in two different ways. First off, knowing that all planning is a form of guessing can extract some of the intimidating fear factor out of the process, and in that way, help activate us out of procrastination.

Your financial plans aren't boring, set-in-stone treatises that lock you into a certain way of life -- they're just guesses about what your future might look like that can help you set yourself up to have funding for the things you may want to do in years to come.

In discussing the implications of Planning is Guessing, the book's authors suggest that in business, much of the long-term planning that goes on should be eighty-sixed entirely and immediately swapped out for action. Even erroneous action and course correction is better, under the Planning is Guessing belief system, than simply planning and planning and planning.

And I agree -- if you can include managing and largely eliminating large impulse purchases in your immediate action plan, it is better for you to immediately activate your 401(k) or set up an automatic deposit of even 5 percent of your income into an automatic savings account today, with no planning at all, than it is to wait for three years until you think you have enough cash to make it worth your while to meet with a financial planner. (Of course, 10 percent would be better.) Pay off a credit card with your next paycheck -- no planning necessary.

The best approach may be a hybrid one: setting forth your vision and intentions for both the short and long term on paper. Calendar some time to set up an income and expense plan that prioritizes what's important to you. The earlier you plan for retirement and other major financial goals, the better -- but if you're struggling with that, just start doing things that further those goals. Now.

If you're struggling to get in motion on your financial planning, consider this: We humans hate the idea of losing money, more than we love the idea of making it -- this is a phenomenon behavioral economists call myopic (i.e., shortsighted) loss aversion. However, we also often commit the financial logic error of underestimating opportunity costs -- the money we miss out on by our actions (or inaction, in this case).Financial expert Manisha Thakor explains, "Assume Jane starts saving at 45 years old, because she spends her money on grooming in her 20s and on her children in her 30s. Joe, on the other hand, starts saving at 25 years old. Each saves $5,000 a year, with an average 7 percent annual growth until they are 65 years old. Joe will have $1 million at age 65, while Jane will only have $200,000 -- the head start gives Joe five times as much cash as Jane!"OK, so 7 percent seems high, but it is a hypothetical that proves a critical point: Jane incurred opportunity costs of $800,000 by failing to start saving money at the time Joe did. Note: the loss was not incurred by failing to plan -- it was incurred by failing to save. Delayed action to further your financial future -- whether saving for retirement, emergency fund, children's college or a home -- is actually costing you money.

"Planning is guessing." So get over it, and get on with it -- and if you can't do that, just do something you know will benefit your financial situation. And do it now.

Tara-Nicholle Nelson is author of "The Savvy Woman's Homebuying Handbook" and "Trillion Dollar Women: Use Your Power to Make Buying and Remodeling Decisions." Tara is also the Consumer Ambassador and Educator for real estate listings search site Trulia.com. Ask her a real estate question online or visit her website, www.rethinkrealestate.com.

Quantitative Easing: Greed Kicks In (Bloomberg News)

Stocks Beat Junk by Most Since 1999 Amid Fund Flight
By Bryan Keogh and Lynn Thomasson - Nov 15, 2010

U.S. stocks are returning more than junk bonds after trailing them for a decade, valuations have fallen to a record low compared with credit -- and investors are pulling more money than ever out of equity funds.

The Standard & Poor’s 500 Index rose 17 percent including dividends since June, compared with 10 percent for the Barclays Capital U.S. Corporate High Yield Index. The equity gauge is on pace for its biggest six-month gain against the bond index since 1999, data compiled by Bloomberg show. At the same time, the more than 120 percent rally in junk bonds since 1998 has left them more expensive than ever versus stocks, based on earnings yields measuring annual profits as a percentage of price.

“People have pushed the trade too far,” said Peter Sorrentino, who helps oversee $13.8 billion at Huntington Asset Advisors in Cincinnati. “The next step is to move from fixed instruments into stocks.
Junk bonds have so little premium right now. It’s like the last chapter where people are finally going to capitulate.” Individuals are ignoring the advice, pulling $55.3 billion from stock mutual funds since the end of June after $11 trillion was erased from U.S. equity values between October 2007 and March 2009. Third-quarter withdrawals came as the S&P 500 rose 11 percent, the first time a three-month advance failed to spur investments, according to LPL Financial Corp. in Boston.

Favoring Stocks
Huntington, PNC Wealth Management and Goldman Sachs Group Inc. say stocks will beat speculative-grade debt as the economy improves. S&P 500 per-share earnings are poised to rise 37 percent in 2010, the biggest increase in 22 years, estimates from more than 10,000 analysts tracked by Bloomberg show.

Futures on the S&P 500 expiring in December rose 0.1 percent to 1,196.4 at 9:37 a.m. today in London.

The benchmark index for American equities fell 2.2 percent to 1,199.21 last week as profits from Cisco Systems Inc. in San Jose, California, and Burbank, California-based Walt Disney Co. trailed analysts’ estimates. S&P 500 earnings that beat forecasts more than 70 percent of the time have helped push the gauge up 7.5 percent this year, data compiled by Bloomberg show.

Stocks remain cheap compared with bonds even after the rally. Debt rated below Baa3 by Moody’s Investors Service and BBB- by S&P pays an average yield of 7.25 percent, compared with an earnings yield of 6.64 percent for the S&P 500, data compiled by Bloomberg show. That’s the smallest gap since the Barclays index began in 1991.

‘Overweight’ Rating

Goldman Sachs in New York advised clients last month to begin raising the proportion of equities they own relative to debt, citing the expanding economy. The world’s most profitable investment bank lowered its rating on investment-grade corporate bonds to “neutral,” saying they were likely to return next to nothing while equities gain 14 percent over 12 months, according to an Oct. 15 note to clients.

Junk bonds, which Goldman rates “overweight,” will likely trail stocks, offering returns greater than 10 percent in the coming year, according to credit strategist Alberto Gallo.

“It’s going to be harder for high yield to outperform stocks over the next 12 months,” he said in an interview. “We already had two years in a row where high yield did better.”

Investors should be buying stocks that “look like bonds” with international sales, below-average debt and growing dividends, said Chris Hyzy, New York-based chief investment officer at U.S. Trust, a Bank of America Corp. unit overseeing $339.9 billion in client assets.

‘Sweet Spot’

“That’s the sweet spot for a balanced investor looking to reallocate from excessive ownership of fixed income,” he said. “High yield is fairly valued. We expect the gap between the earnings yield on equities and fixed-income yields to close considerably in the next 12 to 18 months.” Shares of retailers and technology companies such as J.C. Penney Co. and Motorola Inc. have surged since June 30, outperforming their bonds in a reversal of the first half, when equities slumped and junk rallied.

Department-store chain J.C. Penney in Plano, Texas, has returned 47 percent since June 30, compared with a gain of 0.02 percent for its senior unsecured debt, rated Ba1 by Moody’s and BB+ at S&P. That contrasts with the first six months, when shares fell 19 percent and the debt rose 7 percent.

Motorola, the second-largest U.S. mobile-phone maker, has surged 23 percent this half, five times the 4.2 percent gain for its debt. In the first six months, Schaumburg, Illinois-based Motorola’s bonds returned 16 percent, while its stock lost the same amount.

Rental Cars

Avis Budget Group Inc. shares rallied 38 percent since June 30, while the company’s bonds returned 11 percent. Year-to-date, the bonds of the rental-car company have risen 16 percent, compared with 3.6 percent for the stock.

“If I had to add money into a portfolio, I’d add it into equities,” said James Dunigan, chief investment officer at PNC Wealth Management in Philadelphia, which oversees $105 billion. “Stock valuations remain attractive. The earnings prospects continue to be positive. We’ll likely get back to an economy which is expanding in the early part of 2011.”

While the S&P 500’s advance has restored $2.15 trillion to market values since July, shares are getting cheaper compared with profit forecasts. Income growth that analysts predict will top 13 percent in each of the next two years means the index is trading at 12.5 times 2011 earnings and 11 times projections for 2012, data compiled by Bloomberg show. The S&P 500’s average price-earnings ratio since 1954 is about 16.5, the data show.

Quantitative Easing

At the same time, the Fed’s so-called quantitative easing policy to buy as much as $600 billion of Treasuries has pushed down government bond yields that are the benchmark for corporate borrowing and mortgages. Rates on junk fell to a 5 1/2-year low of 6.97 percent on Nov. 9, from 9.5 percent five months earlier and a record 23 percent in December 2008, according to the Barclays Capital index.

“Quantitative easing is extremely supportive of equities in the short term,” said Lucette Yvernault, who helps oversee the equivalent of about 7 billion euros ($9.5 billion) at Schroders Investment Management Ltd. in London. “The detrimental impact of the QE is that investors don’t necessarily reinvest in the U.S. economy, but instead fuel more growth in emerging markets.” U.S. earnings may keep rising as more executives than ever increase forecasts compared with those lowering them. EBay Inc., United Parcel Service Inc. and 196 other companies raised profit estimates above analysts’ projections last month as 130 firms cut them, the biggest gap since Bloomberg began tracking the data in 1999.

Greed Kicks In
The S&P 500’s earnings yield averaged 5.6 percent through the last bull market that ended Oct. 9, 2007, according to data on reported profit compiled by Bloomberg. Using estimated income, the index yields 7.1 percent, 0.2 percentage point less than the average for speculative bonds tracked by Barclays.

“The greed will kick back in, and that’s what will propel the equity markets,” Huntington Asset’s Sorrentino said.

While stocks have beaten bonds in the past 4 1/2 months, investors have fared better this year with fixed-income securities. The Barclays measure of junk bonds has returned 15 percent since Dec. 31, double the advance in the S&P 500.

Investors piled about $190 billion into U.S. bond funds this year through Oct. 31, a pace that would surpass last year’s record-setting $214.1 billion, according to Cambridge, Massachusetts-based research firm EPFR Global. Clients pulled about $56 billion out of equity funds and $74.6 billion in 2009.

Flows into junk bonds fell to $1.7 billion in October from $3.35 billion in September, the most all year, provisional EPFR data show. That brought the total to about $8.6 billion as of Oct. 31, compared with $19.9 billion in 2009.

“Ultimately the Fed will succeed,” said Wayne Lin, a money manager at Baltimore-based Legg Mason Inc., which manages $677 billion. “It’s just a question of how well they will succeed and how long it’s going to take for them to convince people to take money out of the mattresses and start putting it to work.”
To contact the reporters on this story: Bryan Keogh in London at bkeogh4@bloomberg.net; Lynn Thomasson in Hong Kong at lthomasson@bloomberg.net.

To contact the editors responsible for this story: Paul Armstrong at parmstrong10@bloomberg.net; Nick Gentle at ngentle2@bloomberg.net.

The Sleep at Night Portfolio: Make Your Own Pension (WSJ)

New ways to create a gold-plated pensionBY ELEANOR LAISE,
The Wall Street Journal
The Wall Street Journal — 10/30/10
The financial crisis has given some investors a case of pension envy. In an era of volatile markets, the idea of steady, guaranteed payments for life holds obvious appeal.
The problem, of course, is that investors are less likely than ever to get that kind of deal from their employer. Companies tend to be freezing their pensions or closing them entirely, rather than beefing them up. About a third of today's Fortune 100 companies have frozen or closed a pension plan since 1998, according to consulting firm Towers Watson.

But that doesn't mean investors can't set up their own. New tools are emerging to help investors fashion portfolios that mimic the steady payments generated by the pension plans of yore.

The trick: to focus more on constructing a portfolio to cover future expenses—not just maximize returns—and to rethink old retirement-planning rules of thumb, such as a "safe" portfolio withdrawal rate of 4% annually.

Financial firms and advisers are catering to the demand for pension-like portfolios. New bond-based products can be tailored to produce income to pay living expenses for a period of, say, five or 10 years, leaving a significant chunk of the portfolio to invest in higher-growth assets with long-term potential. Some target-date mutual funds, meanwhile, are aiming to match their investments to the expenses investors face in retirement.

The new strategies often mean heftier helpings of bonds and inflation-fighting investments like real estate and commodities. While bigger bond holdings can mean lower returns, the approach also can give investors the confidence to stick with the more volatile stock investments in other parts of their portfolio, advisers say—reducing the chance they will sell shares at a market bottom.

When investors know that a few years' worth of basic expenses are covered by safe, high-quality bonds, "they can sit back and worry a whole heck of a lot less" about stocks' ups and downs, says Joe Chrisman, director at wealth-management firm Lourd Capital Management, which uses a pension-style approach with clients.

The most painful part of the process may be simply saving more. Since the financial crisis, "there's been a much greater recognition that the markets are not going to rescue everyone," says Timothy Noonan, managing director at Russell Investments. Building a secure retirement "is not a function of going and finding higher returns."

The pension approach seems to work: Over the long term, defined-benefit pension plans have outperformed 401(k) plans by roughly 1 percentage point annually, according to Towers Watson.

Small investors can't—and shouldn't—invest exactly like pension plans, though. For a pension plan acting on behalf of many beneficiaries, with people entering and retiring each year, the age of an individual worker makes little difference. But a person investing on his own must tone down portfolio risk—and generally accept lower returns—as he approaches retirement.

Pension plans also can buy into some investments that most small investors can't access, such as hedge funds and private equity, and get better deals on fees.

That isn't to say pension plans have some magic formula. Many suffered big losses in 2008, for example, though overall they held up better than 401(k)s, according to Towers Watson.

Neither type of retirement plan provides the perfect answer, says Zvi Bodie, a finance and economics professor at Boston University School of Management. "We need to combine the best of both."

Annuities may seem the simplest solution for investors seeking a steady income stream. One approach: Buy an immediate annuity that provides for basic expenses, leaving other parts of the portfolio to cover nonessentials. A number of firms now are working to marry funds with annuities within 401(k) plans.

Still, many advisers suggest investors first consider the greater flexibility, and often lower costs, that can come with a do-it-yourself approach.

A homemade pension plan starts by acknowledging that people, like companies, have a balance sheet with both assets and liabilities, advisers say. The liabilities include the money you will spend on food, shelter, travel and other expenses. Yet advisers and money managers traditionally have focused mostly on the assets, trying to maximize investment returns for a given level of risk.

Pensions, by contrast, are more likely to employ liability-driven investing, choosing particular investments to match their future expenses. Investors can do this, too—by buying long-term bonds, for example, to match payments to be made decades from now.New tools can help people size up future expenses. At goalgami.com, a free calculator launched earlier this year by financial-planning technology firm Advisor Software Inc., people can enter information on their income, assets, debt and long-term goals like real-estate purchases. Taking a lifetime view of the "household balance sheet," rather than a single snapshot, the tool analyzes whether future sources of cash will pay the bills and cover other retirement costs.

Most people want to maintain their standard of living in retirement. So if you have just retired and live comfortably on $100,000 a year, you want that income to keep up with inflation as long as you live, says Tom Idzorek, chief investment officer at Morningstar Inc.'s Ibbotson Associates.

A "laddered" portfolio of Treasury inflation-protected securities, or TIPS, can help. Investors who buy TIPS that mature in each year of retirement ensure a steady income stream that rises with inflation and matches spending, Mr. Idzorek says.

Ibbotson in recent years has been designing target-date fund strategies with retirement liabilities in mind. It has built two sample portfolios—one using traditional asset allocation and one with a liability-focused approach—that have roughly the same allocations to stocks and bonds. But the liability-focused portfolio allocates roughly 28% to assets that can act as inflation hedges, including commodities and real estate, versus about 16% in the traditional portfolio.

Since people are likely to spend their retirement money in U.S. dollars, they also can more closely match their assets with their liabilities by investing more in U.S. stocks and bonds as they approach retirement, Mr. Idzorek says. In the sample portfolios, the liability-focused approach devotes only about 8% to non-U.S. holdings, versus about 18% in the traditional portfolio.

The liability-focused portfolio's expected return, 5.9%, is only slightly less than the 6.4% expected in the traditional portfolio, according to Ibbotson.

Of course, given the recent bond rally, it can be pricey to match many years' worth of retirement expenses with TIPS and other bond investments. Asset Dedication LLC, a Mill Valley, Calif., money-management firm, aims to address that by building custom bond portfolios to produce precisely the income to cover client expenses for a given number of years, leaving plenty to invest in higher-growth assets.

The firm's Defined Income product, launched this year, invests in certificates of deposit, TIPS and other high-quality bonds and holds them to maturity. Bulking up on fixed-income might seem counterintuitive right now. But by holding bonds to maturity and then rolling them over, the strategy can capitalize on higher yields later.
If a client wants to spend $50,000 in each of the next five years but also wants to buy a vacation home in year three, the account can help plan for that, says Mr. Chrisman of Lourd Capital, which uses the Asset Dedication program and other liability-driven strategies with clients.

Mickey Patrick, 57 years old, says his do-it-yourself pension allows him to stop worrying about short-term stock-market swings. Mr. Patrick, a technology manager in Houston, earlier this year started investing most of his individual retirement account in TIPS, CDs and other high-quality bond holdings. Though several financial advisers had told him to keep most of the money in stocks, Mr. Patrick determined that the account needed to cover only about one-fourth of his retirement spending, since a pension and Social Security would provide the rest—and therefore he didn't need to take that much risk.

"They said I was crazy," Mr. Patrick says. But while he used to check market moves daily, now "I don't worry at all about it," he says.

People who are focused on matching investment assets with retirement "liabilities" challenge some conventional retirement-planning wisdom. One rule of thumb says investors should have a stock allocation equal to 100 minus their age. (A 40-year-old, for example, would keep 60% in stocks.) But Boston University's Mr. Bodie says risk-averse investors, even younger ones, might want to put most of their money in safer assets.
Bob Kirchner, 63, a retired economist in Fort Washington, Md., has found that a liability-matching strategy reverses the traditional planning process. Instead of first deciding to put, say, 50% in stocks, he says, it's "let's get all this safe stuff lined up first," leaving stock decisions for later. He now has more than half of his portfolio in TIPS.

Liability-driven investing also involves rethinking the "safe" portfolio-withdrawal rate. Many advisers say retirees can withdraw 4% of their initial retirement balance a year, adjusting annually for inflation. But while the 4% spending rule is rigid, the investments tend not to be. Someone might automatically spend a preset amount, disregarding the fact that his portfolio has gained or lost, say, 30% over the past year. With the 4% rule, "there's a chance you'll wind up with nothing, and there's a bigger chance you'll leave quite a bit," says William Sharpe, a professor of finance, emeritus, at Stanford Graduate School of Business.

A bill introduced in Congress last year would require 401(k)s to show participants a projected monthly retirement income based on their current account balance, instead of just a simple lump sum. Russell Investments is developing tools to help financial advisers look at similar metrics for clients' portfolios, says Russell's Mr. Noonan.

If investors can look at their progress in terms of their personal goals rather than market events, Mr. Noonan says, "it's easier for them to remain invested when the market is doing scary gyrating things."
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Copyright © 2010 Dow Jones & Company, Inc. All Rights Reserv

Big New Bounty Program for Whistleblowers ( Boardmember.com on Dodd - Frank Financial Legislation)

October 28, 2010


Opening the Floodgates: The Dodd-Frank Whistleblower Provisions’ Impact on Corporate America


by Doug Clark, Wilson Sonsini Goodrich & Rosati
During Corporate Board Member and NYSE Euronext's Annual Boardroom Summit audit committee peer exchange, the whistleblower provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) excited discussion and concern. That’s not surprising, as a fair amount of government activity focused on Dodd-Frank is presently in the works. In October, the Securities and Exchange Commission (SEC) will report to Congress concerning its whistleblower bounty program, as well as the establishment of its own whistleblower office. In November, the SEC will propose rules to establish a Whistleblower Incentives and Protection Program and will appoint the head of the new whistleblower office. That sound you hear is the sound of our government growing. [1]

The corporate world should watch the evolution of this bounty program closely. To help set these developments in context, this article provides some background and thoughts about the future.

A Short Summary: Dodd-Frank requires the SEC, in any action in which it levies sanctions in excess of $1 million, to compensate whistleblowers who provide original information with between 10 to 30 percent of the amount of the sanctions. [2] Is This New News? Part I: Kind of. The SEC actually has had a bounty program in place for more than 20 years. This original bounty program rewarded whistleblowers for information leading to the recovery of a civil penalty from an insider trader, a tipper, or someone who controlled an insider trader. The bounty was limited to 10 percent of a civil penalty exacted pursuant to a court order. The decision to award a bounty, and to whom, was within the sole discretion of the SEC (as it will be under Dodd-Frank).

This bounty program was a fairly well-kept secret, as the Office of Inspector General (OIG) noted in a March 29, 2010, report: “[T]he Commission has not received a large number of applications from individuals seeking a bounty over this 20-year period. We also found that the program is not widely recognized inside or outside the Commission.” [3]

In fact, the OIG determined that between 1989 and 2009, the SEC had paid a total of seven bounties to five claimants amounting to less than $160,000 and had denied five bounty applications. Consequently, the OIG made a number of recommendations to improve the bounty program, including coming up with a communication plan to raise the profile of the program, posting an application form on the SEC website, and developing specific criteria for awarding a bounty. The OIG also suggested that the SEC incorporate best practices from more successful Department of Justice (DOJ) and Internal Revenue Service (IRS) bounty programs, both of which are discussed below.

For purposes of this discussion, the old bounty program is just an interesting reference point. The Dodd-Frank mandate to the SEC is broader and more lucrative for whistleblowers. The Whistleblower Incentive and Protection Program to be implemented by the SEC will not be limited to insider trading and will not cap bounties at 10% of a civil penalty. It’s also apparent that the new bounty program will not be a secret inside or outside the Commission.

Is This New News? Part II: Anyone outraged at the concept of our government paying whistleblowers for reporting unlawful activity might be surprised to find out that it’s been going on for a quite a while and that it’s a big, lucrative business. Two federal bounty programs stand out and are worthy of discussion.

The False Claims ActThe False Claims Act, 31 U.S.C. § 3729, et seq., generally creates liability for persons who make false claims to or defraud the government in order to receive money from the government. For example, a defense contractor who knowingly submits a false invoice to the government for payment would run afoul of this act. Section 3730 permits a whistleblower – called a relator in False Claims Act jargon – to bring an action for the government. The procedure for initiating and maintaining such an action, called a qui tam action, is complex and beyond the scope of this article. Where the government proceeds with an action brought by a whistleblower, the whistleblower is entitled to at least 15 percent and up to 25 percent of the proceeds of an award or a settlement. If the government declines to proceed with the case and the relator proceeds with it and obtains a recovery, the whistleblower is eligible for a higher percentage.

The False Claims Act, once known as the “Lincoln Law” was enacted in 1863 to address government contracting fraud during the Civil War. It was substantially amended most recently in 1986 (note that the old SEC bounty program went into effect in 1989). Since 1986, according to DOJ statistics, qui tam lawsuits have returned more than $15 billion to the government and have generated $2.5 billion in awards to whistleblowers. That’s real money, and it has attracted real plaintiff law firms to represent whistleblowers in qui tam actions. Needless to say, the SEC’s old bounty program did not spawn a thriving plaintiffs’ bar.

Early indications are that the plaintiffs’ securities class action and qui tam bar are acutely interested in the Dodd-Frank whistleblower provision. For example, one of the leading False Claims Act plaintiffs’ firms has created a portion of its website for this opportunity, as I’m sure others have. [4] In addition, a reference to the Dodd-Frank whistleblower provision has worked its way into the standard press releases seeking plaintiffs for securities class actions. One does not have to be an economist to see the direction in which this is heading. Plaintiffs’ lawyers follow the money, and they smell money in this new law.

Tax Fraud CasesIn 2006, the IRS seriously entered the whistleblower field with the passage of the Tax Relief and Health Act of 2006. The whistleblower provisions of that act offer a bounty to those who provide the IRS with information about tax underpayments of $2 million or more, with whistleblowers eligible for up to 15 to 30 percent of the amount recovered by the IRS. The program is young, but statistics for 2008 are illustrative of the kind of traction a whistleblower program can get in its early days: In that year alone, the IRS received 476 whistleblower complaints alleging tax underpayment by 1,246 taxpayers. It’s not clear how much money whistleblowers yielded from those complaints. [5]

It is not beyond belief that the whistleblower office the SEC will give birth to this month will administer a program that could generate a similar or greater number of complaints. The impact on the SEC’s Enforcement Division and Corporate America will be tremendous. More on that below.

What About My Hotline?: The Sarbanes-Oxley Act of 2002, passed in reaction to the spate of corporate scandals (Enron, Worldcom) that preceded the spate of corporate scandals that spawned Dodd-Frank (Countrywide, Bear Stearns, Lehman Brothers), required public company audit committees to establish procedures for “confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.” [6] Public companies faithfully complied, and it became a routine part of audit committees’ lives to review, examine, and investigate anonymous complaints. Most companies set up a hotline that employees could use to report potentially fraudulent activity.This provision of Sarbanes-Oxley worked. Employees registered complaints and Audit Committees considered them and, in many instances, retained counsel and experts to investigate them. Companies did not set up bounties, however, and are poorly positioned to compete with the SEC’s promise of a 15 to 25 percent cut of any potential fine. Let’s say you were a well-intentioned employee of a publicly listed company and are distressed when you learn that high-ranking employees at your company are bribing government officials in foreign countries. Do you call the audit committee hotline and sleep the sleep of the righteous? Or do you contact the SEC’s brand spanking new whistleblower office and, perhaps someday, sleep in Gstaad after a day on the slopes? In 2008, the SEC reached a settlement with Siemens AG for violations of the Foreign Corrupt Practices Act (FCPA) and obtained a $350 million disgorgement of profits. Feel free to pause and do the arithmetic. It is not unreasonable to assume that the Dodd-Frank whistleblower provisions will largely render moot the Sarbanes-Oxley audit committee procedures.

FCPA—Where the Real Money Is: Having mentioned the FCPA anecdotally, it’s appropriate to bring the point home. Pursuant to the FCPA’s anti-bribery provisions, it is unlawful for any issuer, domestic concern, or person acting in the United States to offer anything of value to members of a foreign government, international organization, or political party for the purpose of: (1) influencing duties; (2) inducing them to use their influence to affect a foreign government’s or agency's decision; (3) obtaining or retaining business for anyone; or (4) directing business to anyone. Fines and penalties for violating the FCPA tend to be higher than fines for violations of other aspects of the securities laws. The reason for that is simple: The fines are driven by the profits a company makes by virtue of the wrongful conduct. The SEC has made it clear through its public statements that it intends to focus on investigating and taking action on violations of the FCPA. More importantly, the SEC has made the point clear through its enforcement program. In 2010 alone, the SEC concluded 12 FCPA investigations and assessed monetary penalties totaling more than $360 million.Putting aside the Goldman Sachs settlement of $550 million this year for alleged unlawful activity relating to the financial crisis, these numbers are staggering compared to standard SEC settlements. Settlements in more typical SEC enforcement matters relating to insider trading and false financial reporting this year ranged from $20,000 to $28 million. While whistleblower activity under the new regulatory regime will be robust in all areas, the FCPA will be the belle of the ball.

You Can Be a Whistleblower: So can I. Anyone can. Renowned Enron whistleblower Sherron Watkins was an Enron employee and perhaps that created a perception that whistleblowers and corporate employees are one and the same. That’s not an accurate association, however. Dodd-Frank defines whistleblower as follows: “any individual who provides, or 2 or more individuals acting jointly who provide, information relating to a violation of the securities laws to the Commission, in a manner established, by rule or regulation, by the Commission.” [7] This is drafted broadly enough to encompass, for example, forensic accountants poring through public filings for perceived inaccuracies. Could a competitor or customer become a whistleblower? Sure. Anyone can be a whistleblower, assuming they can dredge up information or an analysis indicating a violation of the securities laws.

Obvious Statements about the Future: Although the SEC has work to do to flesh out the Dodd-Frank whistleblower provisions, for the first time the agency has the benefit of a significant incentive program for people to identify corporate wrongdoing. The infrastructure and rules the SEC puts in place to implement the law will be modeled after the successful DOJ and IRS bounty programs. There will be hundreds of whistleblower complaints to the SEC annually, and the Division of Enforcement and the new whistleblower office will be under a severe burden to handle them all. Numerous investigations will ensue, prompting companies to respond to the SEC investigations and, in some cases, initiate audit committee investigations about the allegations. Follow-on class and stockholder derivative actions may be filed in reaction to SEC investigations.

Lastly, at some point in the next year or so, it is quite likely that the SEC will announce a substantial bounty payment arising from the Dodd-Frank whistleblower initiative. Then, the floodgates will truly open.


[1] See www.sec.gov for more information about the SEC’s Dodd-Frank implementation program and rulemaking/comment process.
[2] To see the Dodd-Frank text, go to http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/content-detail.html.
[3] See http://www.treas.gov/tigta/auditreports/2006reports/200630092fr.pdf.
[4] See http://www.phillipsandcohen.com/CM/Custom/Whistleblowers-for-SEC.asp.
[5] http://www.irs.gov/pub/whistleblower/annual_report_to_congress_september_2009.pdf
[6] Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204 §301, 116 Stat. 776 (2002)
[7] http://www.gpo.gov/fdsys/pkg/PLAW-111publ203/content-detail.html



Topic tags: audit committee, corporate governance, Dodd-Frank Wall Street Reform and Consumer Protect Act