Monday, December 04, 2006

"Paulson" Committee on Capital Markets Report and "elegant whining"

While flying into snow storms this past weekend, I managed to slog through the Interim Report of the Committee on Capital Markets Regulation. I say "slog" not so much because the report is poorly written as that it's long and I have a short attention span. MTV generation and all that. Even the Executive Summary was long. (Though, to be honest, I haven't yet read the Executive Summary. I thought it most fair to start with the actual report, since most of the reporters and commenters and assorted pundits will probably only read the summary, so you got all that already.)

First thing I want to react to is the news. To start, Carrie Johnson of the Washington Post notes in "Report on Corporate Rules is Assailed" that:

Investor groups sounded alarms yesterday after it emerged that a foundation with ties to a pair of well-heeled business donors and an executive battling civil charges had funded a controversial new report seeking to slash corporate regulation.
The charity has longstanding ties to Maurice R. "Hank" Greenberg, the former American International Group chief who was ousted from his post last year and is contesting civil charges filed by the New York attorney general. ... Two committee members, Wilbur L. Ross Jr., a private investor, and Citadel Investment Group manager Kenneth C. Griffin, contributed "a few hundred thousand dollars" more, Ross said in an interview.
I find this appalling. Not that certain "interested parties" funded the CCMR report. Of course they did! Where did you think the money was coming from, the research foundation fairies? What I find appalling is that certain opponents of these proposals have become so embedded in the Washington way that their first reaction to anything is the classic Washington ad hominem attack. Who cares what the report says or the strengths or weaknesses of its arguments? Look who's funding the thing! My God, don't you realize they would benefit from these ideas??

Idiots. These so-called investor groups should be ashamed. Or, rather, the Washington Post should be, since Johnson's article is rather sparse on who is actually saying that the CCMR report is corrupted by Hank Greenberg, et al., and I'm less inclined to give reporters the benefit of the doubt than I am pretty much anyone else. And, let's face it, scandal sells copy and it's much easier to explain to a general audience that a report on a dense, complicated topic such as finance is "tainted by special interest" than it is to say why its proposals are dumb.

That said, my own views of the CCMR Report are best reflected by a quote from former SEC chairman Richard Breeden (a Republican who ran the agency during the Bush I administration): "It is a bunch of warmed-over, impractical ideas, many of which have been kicking around for a long time... It is very elegant whining." (See Jenny Anderson's "Sharply Divided Reactions to Report on U.S. Markets" in the NYT.)

By the way, in case you want to see what inelegant whining looks like, look no further than the comments Eliot Spitzer gave about the report: "I will personally appear on Capitol Hill and appear with tens of thousands of investors to defend against these wayward and wrong-headed proposals... This is the same old tired response from the defenders of the status quo who time and again jump to eviscerate the prosecutorial power of the only office who did anything in the past decade."

It's clear, of course, that Spitzer hasn't actually read the report. All I can say is, thank God he's now more New York's problem than the nation's problem. You guys deserve him.

But enough with the pundits who aren't me. What have I got? I'm glad you asked!

The report is divided into five sections, that basically read like five separate papers: (1) Competitiveness, (2) Regulatory Process, (3) Enforcement, (4) Shareholder Rights, and (5) Sarbanes-Oxley Section 404. The primary authors are Luigi Zingales, a professor at the University of Chicago Graduate School of Business; Bob Glauber, former head of the National Association of Securities Dealers and currently a visiting professor at Harvard Law School; Robert Litan, a senior fellow at the Brookings Institution; Allen Ferrell, another professor at Harvard Law; and Andrew Kuritzkes, a managing director of Mercer Oliver Wyman, a management consulting firm.

Each of these sections has an associated "task force" that, presumably, provided input. As an aside, I make one observation: if you recall back in September when the Committee was formed (which I wrote about here), Harvard Law professor Hal Scott, director of the Committee, stated:

We generally tried not to include regulators...They may have a lack of objectivity. Anybody on this committee is in the real world and will bring with them real-world perspectives.
By looking at the task force members, we now know that apparently only American regulators "lack objectivity" and "real-world perspectives". One of the two members of the CCMR's task force on competitiveness is Sir Howard Davies, former head of the UK Financial Services Authority. So British regulator input is good. American regulatory input bad. Since the British financial industry allegedly benefits from the U.S. not being competitive, I wonder what the CCMR folks were thinking here?


Anyway, as I said, the first section of the Report is called "Competitiveness" and is designed to show that (1) the competitiveness of the U.S. financial industry is important to the U.S. economy, and (2) this competitiveness is suffering. For the first point, Zingales does a decent job. But, of course, it's also an easy job. As for the second, I have some serious questions.

First, minor point. Zingales says:
If one examines recent data on growth in the most advanced economies, one sees that countries with a bigger stock market (like the United States and the United Kingdom) enjoyed a much better record of economic growth than other similarldevelopeded European economies (such as Germany, France and Italy) with less developed stock markets (Carlin and Mayer, 2000).

While I clearly think having a strong capital market is a good thing for your economy, this statement begs two questions: causation (does economic growth cause strong capital markets or vice versa), and why are you focusing on European economies when the second largest capital market is in Japan, not Europe?

Second minor point: as evidence of the importance of U.S. capital markets, and their decline, Zingales discusses the role venture capitalists play and how important IPO exits are to VCs.
Not only are IPO exists much more profitable than exists in the private market, but they also affect the profitability of acquisitions exits. The value of VC acquisitions exits is correlated with the number of IPO exits: when there is a "hot IPO window," the average value of acquisition exits increases. For example, in 1999, there were 304 disclosed VC backed acquisition exits, with a disclosed average valuation of $142 million; in 2004, there were 413 with an average valuation of $57 million. The failure of the U.S. "IPO window" to reopen after 2001 has caused considerable anxiety among American VCs.
This may be true, but isn't this just a bit like saying that venture capitalists make more money during market bubbles, when "dumb money" is plentiful and retail investors are willing to invest in any Internet dog-walking dot.bomb that comes their way? How does this add to the economy, rather than just shuffle the money around? And what the hell is a University of Chicago business professor doing suggesting that there is a valuation difference between public and private investors? Isn't that perilously close to suggesting that markets aren't efficient? Can't you get your tenure revoked for such heresy?

However, these two points are nothing compared to my major complaint. That is, after a lengthy discussion about why capital markets are important to the U.S. economy, Zingales begins his principal argument (Section II: The U.S. Public Equity Market is Losing Competitiveness to Foreign and Private Markets) with this statement:

A leading indicator of the competitiveness of U.S. public equity markets is the ability of the U.S. market to attract listings of foreign companies engaging in initial public offerings—so-called global IPOs.
Why? How come? Luigi, where's your support for this statement? Because pretty much everything else in this section of the CCMR Report is predicated on this statement, and, to me at least, this is not obvious.

Other questionable points: why do most of the data the Report uses start with 1999, at the height of the last market bubble? If Al Greenspan was right, and the market was experiencing "irrational exuberance" (which is clearly true in hindsight), isn't establishing your baseline at that point a little like an electric utility predicting annual air conditioning usage based on what people were using on the hottest day of the year? In other words, if 1999 involved an overheated U.S. market, wasn't the explosion of IPOs (and foreign IPOs) a result of a bubble rather than a "competitive" U.S. market? After all, it's not hard to attract issuers (foreign or domestic) if money is free. Competitiveness has nothing to do with it.

I've got other gripes, too. Namely:

Figure I.9 -- doesn't that demonstrate that Asia is "catching up," rather than that Europe is? After all, Europe's portion of global advisory and underwriting fees seem pretty steady since 1999, whereas Asia's has increased by nearly 90 percent. Indeed, relatively speaking, the greatest increase in Europe's portion of these fees happened between 1998 and 1999 -- way before Sarbanes-Oxley.

Table I.2 and Figure I.19 -- Zingales says that the U.S. listing premium nearly halves between 1997-2001 and 2003-2005, at a .10 confidence level. I don't know much about statistics, but isn't .10 just borderline for research purposes? Also, doesn't Figure I.19 merely demonstrate that the lower the quality of corporate governance standards in the foreign market, the greater the variance in listing premia? Am I missing something here? It doesn't seem to say anything about decline at all, does it?

Higher listing costs and underwriting fees in NY -- Nice try, but it seems that Zingales' dismissal of the effects listing costs and underwriting fees might have on foreign listings only holds true if all else is held equal. If, as Zingales elsewhere suggests, the listing premium in NY has decreased, higher listing costs and underwriting fees should increasingly influence a foreign company's decision on where to list.

Regulatory Reform

My biggest gripe about this section, written by Bob Glauber, is that wherever Glauber says "other markets," "other countries," or "other financial regulators," the single example he gives is the United Kingdom and the UK Financial Services Authority. (The rest of the Report does this as well. Zingales, in fact, approvingly cites the fact that the UK FSA is governed by a board made up of representatives from the very industry it regulates. Yeah, good luck with that idea. No wonder Paulson has been distancing himself from the CCMR since his November 20 speech -- see here.)

The UK FSA is five years old, for all intents and purposes (seven if you count when the lease was signed). It has no enforcement teeth, and basically follows a risk-based, principles-based approach because it has neither the staff nor the expertise to do anything else. It has been very lucky that in its five years of existence it hasn't run into any major meltdowns, and its one big scandal (Royal Dutch Shell) was policed mostly by the U.S. SEC. It was only 23 months ago that the Economist said the FSA had problematic procedures and an incompetent staff (see "Regulator, heal thyself"). Accordingly, holding it up as an unqualified success story that should be emulated in the United States seems a bit premature.

Glauber's other proposals are equally half-baked. Glauber suggests that the SEC should conduct more in-depth cost-benefit analyses before creating new regulations (and that these analyses should not increase the amount of time the SEC takes in developing these regulations). Certainly, the idea that regulation should provide more benefits than costs is a good one. But the SEC already has an Office of the Chief Economist charged with conducting cost-benefit analyses of proposed regulations. The fact that the SEC did not adequately follow its own rules in this regard is what lead a U.S. appellate court to twice overturn the SEC's proposed regulations requiring mutual funds to have independent chairmen (see Chamber of Commerce v. SEC). Furthermore, as Glauber himself notes, many U.S. securities laws (such as the Sarbanes-Oxley Act) require the SEC to impose regulations regardless of whether the costs outweigh the benefits, and in the vast majority of cases, the costs and benefits of a proposed regulation are impossible to quantify beforehand with any degree of confidence. Why then the insistence on new cost-benefit requirements? Does anyone seriously think the SEC staff sets out to create rules that impose greater costs than benefits? Why would someone do that, unless the benefits went to some preferred group while the costs were borne by someone they didn't care about?

Enough has already been said about Glauber's proposals about creating more principles-based regulation, so I won't say much more. But I will say one thing. You want to see the perfect example of a principles-based rule? Try Rule 10b-5:

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, a. To employ any device, scheme, or artifice to defraud, b. 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 c. 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.

In legal parlance, this is about as principles-based as the Seventh/Eighth Commandment (depending on how you count these things): Thou shalt not steal. Why then does everyone hate it? They hate it so much that one of the CCMR's recommendations is to "resolve existing uncertainties" about 10b-5 liability and provide more "guidance" on, for example, when shareholders have to demonstrate that they relied on the misstatements or omissions of an issuer in order to sue the issuer under 10b-5.

The answer, of course, is simple: principles are broadly written, and different courts might apply them in different ways. Principles are great when they cut your way, but they suck when they don't. So, the CCMR's elegant whining really is about passing new, more lax rules, that issuers can interpret their way, but that courts can't. Frankly, I just don't see that happening.

Glauber does have one very good point, though, and if the CCMR has legs on anything, it should be this: securities regulation should be made through the procedures established by the Administrative Procedures Act, and not through enforcement actions. Over the past few years, there have been too many cases of "settlements" with companies that have involved them agreeing to do or not do something and because these companies form the bulk of the industry, these settlements have the effect of regulation. But they do not have the public comment and input required of regulation in the United States. This should change. This tendency has been particularly egregious where states attorneys general (particularly Eliot Spitzer) have been involved. Securities regulation in the United States should be set at the federal level, through transparent procedures, and not at the state level through the threat of criminal or civil enforcement proceedings. While there may be a case made for competing enforcers on the U.S. market (the SEC, Justice Department, state attorneys general, private class action lawsuits), the end result is a mess, inefficient, and profoundly undemocratic.

I will complain about the remainder of the CCMR Report in a second post.


Anonymous said...

Is Japan really a bigger capital market than the UK? The TSE has about US$4.5 Trillion in market cap whereas the LSE has nearly US$7 Trillion... Is there some other large pool of capital in Japan that I'm unaware of?

M.D. Fatwa said...

According to the World Federation of Stock Exchanges last annual report, the TSE's domestic equity market cap at the end of 2005 was US$4.572 trillion, while the LSE's domestic market cap was US$3.058 trillion. Domestic and foreign bond listings on the TSE were US$4.730 trillion, while the the LSE's were US$2.574 trillion. It's possible that the US$7 trillion LSE figure includes cross-listings, but then you are essentially counting shares twice, aren't you?