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Stock Tip: Check Status of Exchange

Publicly traded Nasdaq may be liable for fraud, appeals court says

Posted May 1, 2007 5:59 AM CDT
By Jason Krause

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Florida attorney Steven Weissman says he had ev­ery reason to think he was making a sound investment for his retirement and his children’s trust funds. From 2000 to 2002, Weissman of Cooper City, near Miami, purchased 82,000 shares of WorldCom--the phone and In­ternet giant and market darling.

Weissman liked that the company’s auditor was Arthur Andersen and that it was being promoted by Nasdaq Stock Market Inc., the exchange that had championed fast-rising dot-coms in the late 1990s and won a reputation as the place to go to trade high-tech stocks.

Unfortunately, like thousands of other investors, Weissman trusted the wrong people--and lost big. In 2002 WorldCom collapsed, losing roughly $180 billion and resulting in a guilty verdict against former chair Bernard Ebbers for defrauding investors. That same year, Arthur Andersen imploded after being convicted of obstruction of justice in the Enron scandal.

Immunity Challenged

With Ebbers in jail and both WorldCom and Arthur Andersen defunct, WorldCom investors had little hope of seeing their money again. But Weissman has a theory about what caused his $600,000 to vaporize. Nasdaq was converted in 2000 from a traditional stock exchange--which oversees securities trading as a self-policing entity--to a for-profit enterprise that seeks investors on its own. So, says Weissman, while Nasdaq was advertising WorldCom as a sound investment, it had crossed over from being a regulatory organization to touting stock.

As such, Weissman claimed in a suit filed in 2003, Nasdaq had lost the privileges granted it under the 1934 Securities Exchange Act, among them immunity from civil liability claims. In effect, Weissman says, Nasdaq is like any other for-profit, publicly traded company that is liable for false advertising.

Last November, the Atlanta-based 11th U.S. Circuit Court of Appeals agreed with Weissman. As a publicly traded company, Nasdaq lost immunity from claims alleging that it fraudulently advertised stocks as a come-on for investors. “As a private corporation,” the court said, “Nasdaq places advertisements that are patently intended to increase trading volume and, as a result, company profits.” Weissman v. National Association of Securities Dealers, 468 F.3d 1306.

Nasdaq lost its status as a self-regulating organization, or SRO, that stands in for the government as the investors’ advocate. The Securities Exchange Act “vests [SROs] with a duty to promulgate and enforce rules concerning the conduct of their members,” wrote Chief Judge Rosemary Barkett.

“I think the big story is that without an act of Congress, the SEC eliminated the primary investor protections that have been in place since the 1930s,” says Weissman. Nasdaq, as well as the New York Stock Exchange, which went public last year, “are now publicly traded, for-profit companies whose shareholders are naturally and legitimately concerned with corporate profits--not with serving as quasi-governmental, investor protection agencies.”

Nasdaq has argued that its actions fall within the organization’s decision to list companies, which is part of its regulatory function. Nasdaq, which has declined comment, has been granted an en banc hearing scheduled for June 18.

But Weissman counters that Nasdaq’s public status created a conflict between its listing function and its business needs. To compete with the NYSE, Nasdaq needed to offer companies more than just a listing, luring them with advertisements touting companies as good investments.

“They’re in competition with the New York Stock Exchange for listings, and they need to offer companies a reason to stay with them,” Weissman says.

Weissman also alleges Nasdaq let its business interests obscure its regulatory duty. He says Nasdaq wasn’t paying attention as WorldCom neglected to meet the rules for audit committees, including that auditors be professional and independent. WorldCom openly admitted in public filings that its audit committee members were neither.

Nasdaq, says Weissman, fraudulently promoted WorldCom as a good investment when it was aware the company had failed to meet Nasdaq’s listing standards. He also alleges that Nasdaq failed to disclose its potential financial interest in touting the stock, since high trading volumes bring it more revenue.

The case may bring a new round of shareholder suits. “It certainly gives them more liability than I thought before this case,” says Ed Kwalwasser, a former executive with the NYSE and senior regulatory partner with Proskauer Rose in New York City. “I think it only applies to a small part of what they do,” he says. “But if they’re touting a stock, based on this case, courts might look at them differently as entities.”

Increased Liability

The exchanges may face a huge amount of exposure. When the NYSE went public last year, the big board closed the first day at $80 a share, a gain of almost 25 percent from the opening price. And in the 12 months after their initial public offerings, the Chicago Mercantile Exchange more than doubled in value, while Nasdaq shares more than tripled. However, this year the exchanges have underperformed, losing market capitalization as fewer new companies have come to market.

The exchanges have already faced new scrutiny since joining the ranks of public companies. The NYSE went public by purchasing a publicly traded company, Archipelago. But when investors discovered that investment banking firm Goldman Sachs served as the adviser to both the NYSE and Archipelago, a group of seatholders filed suit against the NYSE, saying the deal undervalued the big board. The suit was settled, but this sort of securities litigation wouldn’t apply to SROs.

Kwalwasser says if Nasdaq is found liable, the exchanges would have to learn to live by the same rules as investment brokerages, which have to disclose any interests in any stocks they promote.

“This is the first time I’m aware of an SRO being held liable,” he says. “It seems to me that the exchanges will have to learn to live by the same rules as other companies.”

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