Committee on Capital Markets Regulation Report (Part 2)

Last week the Committee on Capital Markets (also known as the "Paulson Committee") released its Interim Report. It's a big report, so rather than bore you with a single enormously long blog, I thought I'd bore you with two long blogs. The CCMR report is divided into five parts: Competitiveness, Reform of the Regulatory Process, Enforcement, Shareholder Rights, and Sarbanes-Oxley Section 404. Yesterday I wrote about the first two sections of the report, what I liked and, more often, what I thought was dumb. (See "Paulson" Committee on Capital Markets Report and "elegant whining").

Today I'm going to write about the section on enforcement.

Enforcement

Unlike the first two sections of the CCMR report (by Luigi Zingales and Robert Glauber, respectively), the third section, by Harvard's Robert Litan, is good. Actually, I think it's the best part of the report, and, with a few exceptions, I agree with its proposals.

Litan begins by noting how strong (one might even say Draconian) the U.S. securities law enforcement regime is when compared to most other countries. Unlike the first two sections of the CCMR report, which go out of their way to praise the United Kingdom's approach to financial regulation even when such praise is clearly unwarranted (you really want to have the SEC's budget and commissioners appointed by the industry it regulates, Prof. Zingales??), Litan actually puts the UK's enforcement approach in context: in 2004, civil penalties for securities law violations in the United States amounted to $4.74 billion. In the UK, penalties for all financial sectors (securities, banking and insurance) amounted to $40.48 million. Or think of it this way -- during the late 1990s, Jack Grubman, the now-disgraced stock market analyst, was pulling in $100 million in salary and bonuses. That's a single Wall Street individual. Put in this context, $40.48 million is about the same as a large firm's client lunch budget. In other words, a cost of doing business, not a deterrent against fraud.

The problem, though, isn't that $4.74 billion is excessive. The CCMR report, wisely, points out that tough enforcement is essential for a strong securities market, since it deters wrongdoing and reassures investors that their money won't be stolen. The problem is that this $4.74 billion in civil penalties -- penalties extracted by the Securities and Exchange Commission (41%), Justice Department (14%), state agencies (21%) and the self-regulatory organizations (24%) -- are only part of the total penalties imposed on wayward companies and individuals. In 2004, another $5.5 billion were paid out by companies as part of class action lawsuit settlements. And 19-35% of this $5.5 billion did not go to defrauded shareholders, but to plaintiffs attorneys.

Litan also notes that in 2004 fully 47.9% of all pending class actions were securities cases. The vast majority of these, of course, settle out of court once the class is established. But this itself is a problem: the money for such settlements comes from the companies' profits. In other words, shareholders who bought or sold shares during the period that the class action suit covers (usually about a year) are paid from money that would otherwise go to the company's existing shareholders, who did nothing wrong and may have been defrauded themselves. Since corporate directors and officers (i.e., the people usually responsible for any accounting or disclosure mischief that led to investor losses) are insured (with the insurance premiums paid by the company), very little of this settlement money ever comes from those who actually caused the problem. Litan notes that one 1995 study found that even when directors and officers are named as defendants, settlements were funded 68.2% by liability insurance and 31.4% by the company itself, with only 0.4% actually coming out of the pockets of managers and directors. Of course, the Enron and Worldcom settlements were different (with $25 million of the $6.1 billion Worldcom settlement paid by outside directors), but these are exceptions to the rule.

Making matters worse, securities class action lawsuits seem to be very poor mechanisms for compensating shareholders for their losses. Research cited by Litan suggests that the average securities class action suit settles for between two and three percent of investors' economic losses. When you take out lawyers' fees, even this shrinks. Add to this that the average retail shareholder is a "buy and hold" type (and therefore less likely to qualify as a member of the class) and what you have is a system that costs companies and shareholders lots of money while providing rather little bang for the buck in terms of deterring managerial wrongdoing.

The CCMR accordingly makes several recommendations. First, it suggests that the SEC should "provide more guidance" regarding Rule 10b-5 liability. In particular, the SEC should lay down guidelines about what types of disclosure misstatements are "material," clarify that plaintiffs need to establish a strong inference of fraudulent intent on the part of the defendant (and not a lower scienter standard such as "deliberate recklessness," whatever that means), and clarify under which conditions shareholders need to demonstrate that they actually relied on the false or misleading statement when they bought or sold shares.

Frankly, I'm not convinced that the SEC has the authority to "clarify" all of these matters on its own, even if they are good ideas. In some cases, divisions between the appellate courts will only be settled by Congress or the Supreme Court. However, other CCMR recommendations seem more promising. In particular, the CCMR recommends that the SEC prohibit shareholder lawsuits from seeking to recover damages from an issuer if the SEC itself has already done so through Section 308 of the Sarbanes-Oxley Act (the so-called "Fair Funds" provision that establishes a compensation fund for investors). This is logical -- there shouldn't be any "double dipping" or recovery preferences given to one set of defrauded shareholders over another. Likewise, the CCMR recommends that the Labor Department prohibit "Pay to Play" practices whereby lawyers give campaign contributions to local government officials in exchange for becoming the lead plaintiff's attorney when a state or local government pension fund is involved in a class action lawsuit. This is graft, pure and simple, and should be illegal.

However, two CCMR recommendations seem problematic. The first is just pointless. Litan recommends that the Justice Department only bring criminal charges against corporations in extreme circumstances. Arthur Andersen notwithstanding, I never got the impression that corporations were charged as criminal enterprises except in extreme circumstances. CCMR uses the Arthur Andersen case to show the dangers and injustices that can result when a large firm is charged as a criminal enterprise (even though Andersen was a repeat offender). But precisely because of this, I think a strong argument can be made that, particularly with audit firms, the U.S. government is so concerned about the ramifications of bringing criminal charges that it has stayed its hand even when, by all rights, it should not have. I'm thinking in this case of the KPMG tax evasion scandal, which likely would have resulted in a criminal charge against the firm except for the fact that the audit industry is so concentrated. In other words, with some firms, not only are they "too big to fail," but they are too important to be charged with a crime. That can't be a good thing.

For this same reason, I think the CCMR's arguments for limiting auditor liability are also misplaced. Certainly a class action lawsuit that brings down one of the Big Four accounting firms would be catastrophic. However, capping auditor liability would be begging for a moral hazard problem. And the last time the government constructed that kind of moral hazard, we had the S&L crisis.

That said, Litan's point are well taken about the Justice Department's "Thompson Memo" guidelines for when criminal charges should be considered against a corporate entity. DOJ has used the threat of criminal charges as a weapon to force companies to waive attorney-client privilege and deny employees, officers and directors attorneys' fees. This is blackmail aimed at depriving corporations and individuals of their rights, and just isn't right.

Later this week: Shareholder rights and SOX Section 404!