Tuesday, October 31, 2006
I love it when the French lump us and the Brits together as "Anglo-Saxons". It makes me want to grab my horned helmet and defend the great hall from Grendel the troll.
However, if anyone out there is qualified to offer contradictory opinions, it is the French. It just has to hurt that they feel forced to do this with an English broadcast.
Monday, October 30, 2006
As Adolf Berle and Gardinar Means noted 70 years ago, the modern corporation is characterized by a "separation of ownership and control" -- in other words, the people who own the company (shareholders) do not actually run it. This is in stark contrast to most other models for organizing human economic behavior, such as partnerships, where the entrepreneurs who put in their money to create the organization actually have a close hand in running it (and face a significant personal risk should it fail). In fact, this single feature of the modern corporation is both its greatest strength and most dangerous weakness. The strength comes from the fact that modern corporations can draw on financing from millions of investors willing to accept a (comparatively) small risk for a small return, rather than the handful willing to take a major risk for a big potential return. But the weakness is that corporate managers are using "other people's money" when they run the company, and this poses an inherent conflict of interest.
This strength and weakness was recognized as long ago as 1776, when Adam Smith wrote in The Wealth of Nations:
This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of. ...The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxioux vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion therefore, must always prevail, more or less, in the management of the affairs of such a company.Corporate governance and securities laws are two tools designed to reduce this problem. Corporate governance laws are meant to provide shareholders with mechanisms by which their own interests are protected against management, while securities laws are designed to give them accurate information about how the company is performing so they can make informed decisions. In the United States, corporate governance is mostly a function of state law and, in practice, of Delaware law in particular. And Delaware didn't become the home jurisdiction of 70 percent of U.S. public companies because of its particularly pro-shareholder approach. Quite the contrary. Delaware permits a number of anti-takeover devices, such as poison pills and staggered board member terms, designed to make it very difficult for shareholders to kick poorly performing managerial teams out of their coveted positions.
This issue recently became more prominent in the United States when the Second Circuit Court of Appeals ruled last year in AFSCME Pension Plan v. AIG, Inc. that the SEC's rule on proxy voting is unclear. When that decision came out, the SEC agreed to clarify the rule to state whether companies must include in proxy materials proposals to modify how board members are elected. However, the SEC recently backed off on when it will conduct this clarification, as apparently there is no consensus among the five Commissioners about how to do this.
This is a shame, as a recent letter to SEC Chairman Christopher Cox from 16 U.S. and international investors points out. As a large number of these investors are foreign (including the Association of British Insurers and the Third Swedish National Pensions Fund), they note in the letter that:
It cannot be emphasized enough how difficult it is for investors based outside the US to come to grips with the fact that shareholders of US companies lack basic rights which they take for granted in other developed markets. Both in principle and in practice, the American board election procedure is both outdated and detrimental to the maximization of long-term shareholder value.Normally I would say that this sounds like typical UK whining. ("It cannot be emphasized enough..."? I mean, who says that?? And anyone complaining about the lack of shareholder rights in the U.S. clearly hasn't seen the system in France or Japan.) That said, they do have a point. Under the current system, the only control investors have over board performance is by "voting with their feet" -- divesting themselves of companies with underperforming boards or management. However, for large pension funds or index-based mutual funds, such divestments may not be practical or even permitted. At the same time, given how difficult hostile takeovers are in the United States, "normal" market mechanisms that might act to discipline a corporate board just aren't there, and the only real mechanism for a shareholder to assert his or her rights is through shareholder derivative litigation -- a costly, often self-defeating process.
As a practical matter, the institutional investors' letter may tie in closely to efforts underway by the so-called "Paulson Committee" (see here), though it seems likely that Hal Scott, Glenn Hubbard and John Thornton might not see it that way. Restraining tort lawyers may go a long way to improving the competitiveness of U.S. capital markets. However, such restraint will not be likely (or helpful) if other mechanisms for disciplining corporate boards and managers are not available. Therefore, improving shareholder proxy voting processes so shareholders are given back the right to appoint their own boards of directors, is important. It will make corporate managers more accountable for long-term performance, and better align the interests of those who control modern companies with those who own them.
Sunday, October 29, 2006
This view was repeated this week by Representative Barney Frank (D-Mass.), who is clearly trying out for size the chairman's seat of the House Finance Committee. (As the senior Democrat on the committee, Frank is in line to become chairman should the Democrats gain a majority in the House.) In an interview with the Financial Times ("Top Democrat casts doubt on regulatory co-operation"), Frank stated that European concerns about the possible "export" of Sarbanes-Oxley were overblown, because "it's not going to happen" and "[s]ix months from now it will be less of a burden for companies than it is today. ...They [the SEC and Public Company Accounting Oversight Board] have the authority to thin out what is required. We think the accountants probably overloaded on the audit requirements."
However, Frank also cast doubt on the value of international regulatory cooperation:
"Joint action is theoretically [good] but what does that mean? In American baseball, if the runner and the ball arrive at the base at the same time, the tie goes to the fielder. Who breaks a tie if there is a disagreement over policy between the SEC and FSA?"Frank then stated that he wasn't sure if a supra-national regulator was a good idea, but it might be something useful to look at in the future.
I'm not sure what to make of that statement, frankly. Frank certainly knows that the idea of a surpra-national financial regulator is a non-starter in the United States, unless, of course, the U.S. regulator were to be the international regulator. Even if the U.S. political environment changed so radically that international-level financial regulation were to become politically acceptable (and it certainly won't), current American laws make it illegal for U.S. securities and banking regulators to delegate any oversight or powers to an international organization. So, either Frank was talking without thinking (which wouldn't be the first time a politician has done that), or he was thinking of something else entirely. If he was thinking something else entirely, it is not at all clear what that might be.
Thursday, October 26, 2006
Nor should we really concern ourselves with why, if MDF is right, hypersensitive nonsmokers don't constitute sufficiently large demand to create a market for nonsmoking restaurants. After all, MDF is a country boy living in the midwest, which as any good eastern elite like myself knows, is a vast wilderness where there are dragons and only a very small number of tiny villages with very few people. 10% of the population wouldn't be large enough to create a market for non-smoking restaurants -- that's, like, 1 person. In Chicago, maybe 2 or 3 -- totally not enough to support a restaurant. So we have to cut him some slack here.
The real problem with MDF's model of market failure is that ... he's not proposing a model of market failure. Market failure is when there exist costs or benefits that are not borne by the decision makers AND this alignment leads to over- or underproduction. It's kind of odd that MDF imagines the first requirement is being met -- apparently positionally sensitive nonsmokers are imagined to go to restaurants just as often and be willing to pay just as high a price when there is some smoking as when there's not. (If they went less, restaurants would get less profits, in which case they're internalizing the costs of their decision, right?) But okay, fine: let's suppose they don't go less and so there are external costs. But these external costs aren't translating into decreased restaurant attendance or food consumption (again, this is a necessary consequence of the stipulation that the costs of smoking borne by nonsmokers don't affect the restaurants' bottom lines). So where's the market failure? The market is producing the correct amount of output -- all we're talking about is the division of the value of the output.
The only way out is to say that positionally sensitive nonsmokers make their restaurant-attending decisions premised on the assumption that they will definitely not be affected by smoking, but then they get to the restaurant, sit next to the smoke, and think, "Crap! I forgot that there's such a thing as a smoking section! I really need to write that down -- or maybe we should just pass a law, because I can't be expected to remember stuff like that." Which is to say, they're irrational (which I suppose one could believe: I'm just not sure why, given that one believes some nonsmokers are irrational, one would also believe that those same nonsmokers should be allowed to make decisions about what kind of restaurant they're going to eat at ... or, much more importantly, what kind of restaurant I am going to eat at).
But leaving aside the possibility of irrationality, the only possibilities are that nonsmokers never decide to stop going to restaurants because of smoking, or that they do, but that the decrease in restaurant attendance by nonsmokers is more than made up by the increase in smoker attendance because smoking is allowed. Either way, there's no market failure.
Okay, so if there's no market failure, why are smoking bans so politically popular? Well, as MDF pointed out, 80% of the population doesn't smoke. So if all smokers vote against smoking bans and all nonsmokers vote for bans, how does that work out? Again, this doesn't mean there's a market failure -- elections don't count intensity of preference. (In other words, a vote of 2 yes's and 1 "no, oh no, please God, no!" still goes to the "yes" people.) So what we might have here is a plain old-fashioned story of rent-seeking: smoking bans might have higher costs than benefits, but why would a non-smoker care so long as the costs were borne by other people?
This might run into problems if voting for smoking bans will make even nonsmokers worse off (which it might very well). But who said people vote in a narrowly self-interested fashion? Some people who haven't been to a bar in years vote on whether we should ban smoking in bars -- how on earth could either outcome matter to them enough to justify going down to the voting booth? Well, it might matter if they also care if you are smoking in bars. So how's that one likely to break -- are there more people who (a) think that smoking is bad and therefore you should be kept from smoking (or kept from working around smoke), or (b) who think that it's none of their business whether you smoke or work in a bar? If you think (b), you need to get out more.
Finally, this could just be a matter of expressive voting. Look: unless your name is "Sandra Day O'Connor" or "Anthony Kennedy," your vote doesn't count. You will not ever break a tie. But you're not stupid and you know this -- so why would you vote as if the election turns on your decision? The answer is you probably don't. There are people in Texas who voted for Nader in 2000. Did they think Texas might not go to Bush? Of course not -- a lot of them would have voted for Gore if they thought their vote mattered. Given that your vote doesn't matter, you might just vote the way that makes you feel good. So, what, you want to be the kind of person who votes for blowing smoke in children's face? What about proposition "Let's not kick puppies?"
So, fine, let's ban smoking. But please let's not pretend that there's a market failure or that there's some sort of greater public interest story here. Nonsmokers have a majority and they can do what they want, or think they want, or like to tell other people that they want. End of story.
Tuesday, October 24, 2006
This photo (from Rick Yi of Taiwan News) is Lee Ao, a Taiwanese parliamentarian. Apparently, the Taiwanese equivalent of a filibuster is to let loose a can of tear gas in the legislature. Hey, practical solutions for practical people.
Unfortunately for Lee, tear gas is notoriously ineffective against the superior lung capacity of most politicians. (You can see this from the picture; Lee himself doesn't actually need to use the gas mask he brought along.) Bug spray, on the other hand...
Monday, October 23, 2006
Proponents of smoking bans contend that they address the "negative externality" smokers impose upon nonsmokers, shape individual preferences against smoking (thereby reducing the incidence of smoking), and alleviate the health risks associated with exposure to environmental tobacco smoke or "ETS." Considered closely, though, each of these arguments fails to justify the government-imposed restrictions.He then argues that: (1) there are no widespread negative externalities (because if non-smokers or restaurant employees don't like smoky restaurants, they will go somewhere else, leaving the restaurant owner to take on the costs of the externalities); (2) the government has no business shaping individual preferences (and, besides, campaigns against smoking only make children want to smoke more as a symbol of rebellion against authority); and (3) the dangers of ETS are overblown.
I'll only look at Point 1 here. Point 2 is worth an entire debate. (Also, the point about childhood smoking is ridiculous, since it's not smoking per se that's the problem, but habitual smoking. It is clear that the proportion of the population that smokes regularly has decreased steadily over the years as smoking bans and Surgeons General warnings have come into play. To argue that smoking bans do not have an effect on habitual smoker preferences is to suggest that a smoker's demand for cigarettes is infinitely inelastic and they will smoke no matter how costly or inconvenient smoking becomes.) Finally, I think restaurant smoking bans revolve around Point 1 and not Point 3, at any rate.
My question is, if there are no negative externalities to restaurant smoking, then why have these bans proven so politically popular? I suggest that this fact alone demonstrates that there is some kind of market failure here. Non-smokers make up the vast majority of the U.S. population. According to the Centers for Disease Control, nearly 80 percent of the U.S. population does not smoke, up from only 57 percent in 1965. With this kind of discrepancy, you would think smoking in restaurants would be a non-issue. If non-smokers preferred non-smoking restaurants, the sheer weight of their numbers would make most restaurants non-smoking. On the other hand (and this is the interesting question), if non-smokers do not care about whether they share restaurants with smokers (and this might otherwise seem to be the case, since so few restaurants voluntarily become completely smoke-free), why are restaurant smoking bans so politically popular?
I suggest two possibilities: first, only a relatively small portion of non-smokers are hypersensitive to smoking in restaurants (and I don't mean "hypersensitive" in a negative way). This group is not large enough to have an economic impact on restaurants by themselves, but it is large enough to initiate a political ban. This hypothesis, however, begs the question why, if hypersensitive non-smokers are not numerous enough to have an economic effect on restaurants, why are they still numerous enough to defeat the political interests of smokers and restaurants, who presumably enjoy smoking in restaurants more (in aggregate terms) than hypersensitive non-smokers gain from a smoking ban.
My second suggestion is that in addition to this core group of hypersensitive non-smokers, there is a much larger group of "positionally sensitive" non-smokers who support such bans. "Positionally sensitive" (PS) non-smokers are willing to share a restaurant with smokers, provided the smokers are confined to a distinct part of the restaurant away from where they are (i.e., the "smoking section"). This situation is satisfactory perhaps 90 percent of the time. However, PS non-smokers run the risk (particularly during busy periods) of either having to sit directly adjacent to the smoking section or having to choose between taking a seat in the smoking section or having to wait for a table to open in the non-smoking section.
You can then see how this changes non-smoker political incentives, even if it does not change restaurant economic incentives. If 20 percent of the population wants to smoke in restaurants, but only 10 percent of the population is hypersensitive to smoking and won't frequent restaurants that allow smoking, most restaurants will allow smoking. If an additional 50 percent of the population are "positionally sensitive" non-smokers (with the remaining 20 percent of non-smokers having no preference whether they sit directly adjacent to a smoker during meals),* then most restaurants will have an economic incentive to have smoking and non-smoking sections. This seems to be the case now.
However, at any given time, 5 percent of the population (or one-tenth of PS non-smokers) are being inconvenienced by having to sit directly next to the smoking section or wait for a non-smoking table to open. This means that, at any given time, 15 percent of the general population is strongly in favor of a universal smoking ban. The size of this group is still not as large as the population that smokes, but the 5 percent of inconvenienced PS non-smokers is a rotating 5 percent. That means that, over the course of 10 restaurant visits, 65 percent of the population would support a universal ban.
The reason that this issue has shifted from the economic to the political realm, however, is lottery effect for positionally sensitive non-smokers. A 10 percent risk of being inconvenienced is not sufficent for PS non-smokers to stop frequenting a given restaurant. While they might otherwise forgo the benefit they receive from the restaurant if the risk of being inconvenienced was 100 percent, they are not willing to do this if the risk is only 10 percent. However, by supporting a legal ban on restaurant smoking, PS non-smokers can eliminate this 10 percent risk at little cost to themselves. (There is still some cost. A universal ban on restaurant smoking might present a slight risk to the viability of any given restaurant, and positionally sensitive non-smokers would suffer if their favorite restaurant went bankrupt.)
In other words, what restaurant smoking bans are really about is an attempt to force 20 percent of the population (smokers) to absorb the 10 percent risk they cause to 50 percent of the population (PS non-smokers) , plus the 100 percent risk they cause to 10 percent of the population (hypersensitive non-smokers). The market failure comes in because, even with these preferences, no individual restaurant can afford to ban smoking on its own, since only 15 percent of the population is ardently in favor of a smoking ban at any given time in his or her restaurant, versus 20 percent opposed. However, 65 percent of the population is harmed by this situation at one time or another.
Because of this, I suspect restaurant smoking bans will prove to have a negligible effect on restaurants. This situation has characteristics of an arms race. If any one restaurant adopts a ban, that restaurant loses out to the competition, since they can reliably expect to gain only 10 percent new customers versus a loss of 20 percent of existing customers. If all adopt a ban, however, none lose. (To argue otherwise is to suggest that smokers so enjoy smoking with dinner that they will stay home and cook themselves rather than go out. While possible, this seems unlikely. Smokers must forgo smoking in all sorts of places today, so they are likely used to having to wait a little to enjoy a smoke. Plus, how good is your own cooking likely to be if your sense of taste has been destroyed by tobacco smoke?)
Bars, on the other hand, may be a different story. It's unclear whether smoking makes people drink more (in which case bar owners have an incentive to allow smoking) or drinking makes people more inclined to smoke (in which case bars are currently being ripped off by the tobacco companies and should start demanding a cut).
*Other than the CDC figures, these percentages are fictional and merely used to demonstrate the idea.
Sunday, October 22, 2006
I'm sure Fernandez deviated from the official script; and it's probably true that the translation may have missed some nuances. But, given the current situation in Iraq, there doesn't seem to be any harm in admitting to mistakes, even if you don't honestly believe there have been any. After all, the Iraqis are mad and believe there has been arrogance and stupidity, and U.S. troops on the ground (particularly those reservists and National Guard members held over on extended tours) certainly believe mistakes have been made. Further, Fernandez's comments don't say who was arrogant or stupid. (People can read into that all they want, but all that means is that they already have a firm opinion about who is stupid and arrogant. Renouncing Fernandez's comments is only going to reinforce their views.)
Friday, October 20, 2006
Damn! Even if the Chinese envoy is exaggerating things, if the North Koreans don't immediately come out and denounce this, we'll know who's running the show in that neighborhood.
萬歲, 萬歲, 萬萬歲!
Ms. Tam is a WSJ reporter who covered HP until last year. As I've mentioned in previous posts (here, here, and here), HP undertook an investigation of its directors after someone on the board apparently leaked board strategy talks to reporters. This investigation crossed the line when the investigative firm used pretexting in order to obtain telephone and other records of the board members to see who they were talking to. This was bad enough. What we now know is that this investigative firm also used pretexting and internet viruses to obtain telephone, email and IM records from a number of reporters as well.
Now Tam reveals that HP's investors also engaged in dumpster diving, among other tawdry investigative techniques:
The trash study was carried out in January by Security Outsourcing Solutions Inc., a Needham, Mass., investigative firm that H-P employed, according to a briefing H-P officials gave me yesterday. Whether the sleuths ever encountered my toddler's dirty diapers, H-P said it doesn't know.
I learned this -- and more -- as I sat in a conference room at H-P's outside law firm yesterday in San Francisco, where attorney John Schultz ran through a litany of snooping tactics H-P's agents used against me as part of its effort to identify which of its directors might be leaking news to the press. For around a year, Mr. Schultz told me, H-P collected information about me. H-P's investigators tried at least five times, he said, to get access to my home-phone, cellphone and office-phone records. In several instances, they succeeded: H-P now has lists of calls I made to people such as my editors, my husband, my insurance company and a reporting source employed by one H-P rival.
H-P's agents had my photo and reviewed videotaped footage of me, said Mr. Schultz, of the law firm of Morgan, Lewis & Bockius. They conducted "surveillance" by looking for me at certain events to see if I would show up to meet an H-P director. (I didn't.) They also carried out "pre-trash inspections" at my suburban home early this year, Mr. Schultz said.
Mr. Schultz was carrying out a public promise by H-P Chief Executive Mark Hurd, who pledged before Congress last month that he would give investigation details to the targets of H-P's snooping. The company told me, in an email, that I would receive "a complete accounting of the information that H-P gathered about you and exactly what methods were used to collect it."The nature of the information that Tam knows was provided to the board makes it pretty clear that Patricia Dunn at least had reason to suspect that not all of these techniques were legitimate or legal.
Many details of what H-P had done in my case I had already gleaned from some now-public investigation documents. According to those documents, H-P built up information on my husband, including where we got engaged and married. H-P sleuths reviewed voicemails I'd left for an H-P director, and got a description of my car. They read my instant messages to an H-P media-relations executive. According to the California attorney general, H-P's investigators also used the last four digits of my Social Security number to impersonate me in order to obtain my phone records, a technique known as "pretexting."
H-P's lawyer shed no new light on these details, but one thing's increasingly clear: H-P went to some truly strange lengths to dig up personal details.
Tam mentions HP's classy touch at the end:
At first, I thought the company had simply accessed a month's worth of my phone records. But I grew more concerned as the scope of H-P's tactics became clearer. I learned from documents released to Congress last month -- but not by Mr. Schultz yesterday -- that H-P's investigative team unearthed factoids about myself that I never knew. In one PowerPoint slide prepared for Ms. Dunn, H-P's team noted that I live precisely two miles away from former H-P director Mr. Keyworth. In another slide that mapped out -- like a spider's web -- Mr. Keyworth's relationships with the press and others, I learned that my real-estate agent, Mavis Delacroix, had once worked with his wife.
By July 2005, H-P had compiled background on many of its subjects, including me, according to documents released by Congress last month. In an investigation summary, H-P listed my educational background, the date I joined The Wall Street Journal, and information about my husband. The document also notes that I made 78 phone calls from my cellphone between April 16, 2005, and June 16, 2005. "An analysis of the subscribers of the 78 numbers is in progress," the document says.
That 2005 analysis, which H-P's lawyer wasn't able to provide me, probably yielded nothing more than a portrait of frenzied planning for my sisters' weddings. At the time, my family had just finished the wedding preparations for one of my sisters and we were busy organizing a bridal shower for my other sister. That meant frequent phone calls to and from my mother.
Still, H-P's investigative team compiled information on me. In November 2005, one of H-P's then directors turned over voicemail messages I'd left him earlier that year, according to an email from H-P's investigative team. That gave the company a record of my voice, which was stored away. Mr. Schultz, H-P's outside lawyer, told me yesterday that such records were collected to provide "context," in an attempt to link me to a source of the leaks.
H-P's probe ramped up again in January, after articles ran in The Wall Street Journal about H-P's talks to acquire technology outsourcing and consulting firm Computer Sciences Corp. and after an article appeared on CNET about a board of directors' retreat that same month. By late January, the second phase of the company's investigation -- known as Kona II -- was in full swing. (The investigations were dubbed Kona by Ms. Dunn, who named the probes after the location of her Hawaiian vacation home.)
That was when some of H-P's creepiest incursions on me occurred. On Jan. 30, Security Outsourcing Solutions reported that a "pre-trash inspection survey is in progress for the Tam residence," according to a document Mr. Schultz gave me yesterday. But there was more to the story: H-P investigation documents that Mr. Schultz didn't provide me reveal that in early February H-P's investigators also conducted "pre-surveillance reconnaissance" on directors and several journalists, including me.
H-P didn't just plan to infiltrate my neighborhood, however. According to the documents released by Congress, in one PowerPoint slide from February -- which was, again, missing from Mr. Schultz's briefing yesterday -- H-P investigators proposed sending in their team to pose as cleaning crew members or clerical staff in The Wall Street Journal's and CNET's San Francisco offices. Mr. Schultz said that as far as he knows, "that was never done."
By mid-February 2006, H-P had obtained my cellphone records for mid-December 2005 through mid-January 2006, Mr. Schultz told me. H-P's investigators later accessed my cellphone records for February and my home-phone records for January and February, he said.
H-P now had printouts of names and numbers of people I called. From these records, copies of which Mr. Schultz gave me, H-P discovered that of the 25 calls I made from my cellphone between mid-December and mid-January, I called home 20 times. In other records, H-P's investigators highlighted calls I made to current and former H-P executives, as well as calls I was making to my editors in San Francisco and New York. Twice, H-P saw that I called my insurance company. They saw that I often called my sister.
Among the calls H-P's investigators saw were those I made to sources for other stories I was reporting for the Journal -- including sources at H-P competitors. One call was to Marlene Somsak, a former H-P media-relations executive who now works at H-P competitor Palm Inc. H-P's phone records list Ms. Somsak's name and address. Ms. Somsak declined to comment. The list provided by Mr. Schultz also shows reporting calls I made to Lucasfilm Ltd. and the San Francisco Police Department. A spokeswoman for Lucasfilm declined to comment.
H-P's briefing of its spying on me is mum about other events around February 2006. Mr. Schultz had no information, for example, on how the H-P investigative team handed out a photo of me and a description of my car to their surveillance teams -- something that a congressional subcommittee has now made public. It's unclear where they got the information. H-P began researching my husband and whether he had any relationships with H-P directors and others -- work that was "90% complete" at the time, according to a note in a February document.
Also missing from Mr. Schultz's briefing was H-P's snooping on my instant messaging. In February, H-P's investigative team focused on my communications with one of their own media-relations executives, Mike Moeller, whom I frequently talked to as part of our jobs. That was when they accessed our instant messages, which generally included witty repartee such as the following transcript that H-P had in its files: Me: Nice results (for H-P's financial quarter). Mr. Moeller: Real nice. Nice guidance. Me: Yup.
Since then, H-P officials have apologized repeatedly for the investigations. Mr. Hurd apologized in a news conference and before Congress. Ms. Dunn emailed all nine journalists who were under scrutiny a similar apology. (In the copy she sent me, my name was written in a different font from the rest of the message.)I find all of this mind-boggling. You don't need to be a lawyer to suspect that any investigative firm providing the information that Security Outsourcing Solutions Inc. was making Powerpoint slides of may have crossed into illegal territory. (Though maybe you do have to be a lawyer to imagine a scenario where collecting this kind of information on reporters wouldn't be considered illegal.) But it's the clear lack of judgment that gets me. It doesn't matter how much damage a leaky board member can cause a company -- it can' t possibly be as bad as having your chairman indicted, and a shadow cast on your CEO that he or she might be next.
And a word of wisdom to John Schultz and Morgan, Lewis & Bockius: unless you want to come off looking like Larry Sonsini and Wilson Sonsini Goodrich & Rosati, really really do your homework on this case, particularly before talking to victims who happen to work for very large newspapers.
Thursday, October 19, 2006
All the same, it seems that the Daily Star ditched the idea after the newspaper's staff revolted against the idea. Frankly, there's your problem! If you are going to go down that route, especially in a heavily Muslim country, be prepared to go all the way. And, second, you're going to let a bunch of reporters push around your newspaper?? Unionized reporters?? Would Rupert Murdoch put up with that crap?
No wonder you lost your empire.
Seems to me that that might be the kinda thing you just want to remain unsaid for the moment. Maybe a little strategic ambiguity? You know, maybe a little, "Oh, you know, I forgot to ask... What do you think, Mr. Zhu?"
Wednesday, October 18, 2006
The Sarbanes-Oxley Act has provoked intense criticism among many public companies (including many foreign companies) because of the costs the Act imposes. However, as I have discussed more in-depth here, the principle costs of the Act involve Section 404, which requires a company's auditors to opine on the company's own assessment of its internal controls. By this December, the Public Company Accounting Oversight Board, which oversees the U.S. audit industry, likely will change the audit standard governing this process (see here).
Yet SOX is hardly the only cost the U.S. system imposes on public companies--nor even the most significant. If you are an issuer, your biggest concern is and long has been private lawsuits. As one securities law partner once told me, when you have an IPO in the United States, it's not a question of whether you will be sued, but when. If a company's stock drops significantly, "strike suit" attorneys have a strong incentive to file a class action lawsuit against the company, because the law firm's take from such suits ranges up to a third of the settlement (and once a judge certifies a class in a shareholder suit, most companies settle).
Of course, many shareholder rights to file private lawsuits are contained directly within the federal securities laws. For example, if a company's prospectus contains wrong information about the company's financial performance (other than inconsequential typos and the like), shareholders have a right to sue the company under the Securities Act of 1933. However, the Paulson Committee is focusing in particular on the SEC's Rule 10b-5. This Rule, which is a jewel of regulatory drafting, states simply:
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.
Isn't that beautiful? Personally, I think it ranks right up there with "Thou shalt not steal" in terms of simplicity and universality. Pretty much anything naughty you can think up involving the stock market or a public company could fall under it.
What the Committee apparently would like to do, however, is have the SEC "dis-imply" that this Rule allows for a private right of action from shareholders. In other words, right now the rule "implies" that individual shareholders can sue a company or individual for a 10b-5 violation, even if the SEC doesn't. If the SEC stated that Rule 10b-5 belongs to it alone, the SEC could sue someone for violating Rule 10b-5, but the courts could say an individual shareholder couldn't. And an investor certainly couldn't if the SEC hadn't also brought a case. Since 10b-5 is so broad, that would mean that "defrauded" shareholders would have to find some other cause of action to sue. Depending on the case, this may not be hard; but it won't necessarily be easy, either.
This proposal (which apparently comes from Columbia Law professor Jack Coffee) is smart--much smarter than proposals to throw out Sarbanes-Oxley. For one thing, SEC Chairman Christopher Cox is well-known for his belief that strike suits should be dramatically scaled back. When he was in Congress, he was the principle author of the 1995 Private Securities Litigation Reform Act, which was designed to do precisely this. Second, it addresses a factor about the U.S. capital market that actually does make it less competitive internationally. (Though one may argue that the private right of action contained within U.S. securities laws acts as a much better policeman of U.S. securities markets than the SEC, Justice Department and Eliot Spitzer combined ever could.)
That said, the trial attorneys are a formidable opponent, and we can expect that they will lobby the SEC (and Congress) hard to make sure this proposal is never made a reality.
Tuesday, October 17, 2006
There are so many stupid things about this bill that it's hard to know where to begin with my Fatwa. But let's look at two of the most glaring:
- A $4 billion fund for research is created by imposing a 1.5% to 6% tax on California-produced oil. Not on oil generally. Not on gasoline. Just California-produced oil. Since this means that California oil will cost 1.5-6% more, and California is not a major oil-producing place, how is this going to reduce U.S. dependence on foreign oil? For that matter, how is it going to raise $4 billion?
- The proposal "prohibits producers from passing the tax on to consumers." How exactly does that work? Where's the money coming from? From the companies themselves? If so, why would they produce oil in California when there are other more profitable places to do it? And if they don't produce as much (because it's not as profitable anymore), doesn't that mean the supply will decrease and the price will go up? How do you prohibit that?
The problem here is a massive failure of the public education system. If you want to tax something, you have to ask where that tax is coming from. And when you say its coming from "the corporations," I want you to show me one of these corporations. Fair warning, though: If you point at a building with a company's name on it, I will smack you with a 2-by-4 and put a fatwa on your ass! That's a building with a corporation's name on it, not a corporation. I want you to show me a corporation!
OK, trick question. Because there's no such thing! A corporation is a legal fiction, idiots! It's just a bunch of people! Some of those people are rich; some are poor. Most are paid a salary; some get paid dividends. In California, a lot of the people getting paid dividends are members of the California Public Employees Retirement System. If you want to take people's pension money, why don't you just do that, instead of screwing around with moronic propositions that will just get some schmuck laid-off or relocated to Oklahoma?
Why must stupid people plague me so? Why? What did I do to them?
The first of these laws is the Credit Rating Agency Reform Act. As I discussed, this new law has plopped into the SEC's Division of Market Regulation broad new powers to regulated some of the most powerful financial firms in the world--credit rating agencies such as Moody's Investor Services and Standard & Poor's. The second new law does the opposite--the Financial Services Regulatory Relief Act takes away a good dollop of the SEC's powers over banks that offer both retail banking and brokerage services (which are most brokerage houses these days). Section 101 contains the really juicy part:
SEC. 101. JOINT RULEMAKING REQUIRED FOR REVISED DEFINITION OF BROKER IN THE SECURITIES EXCHANGE ACT OF 1934.
(a) FINAL RULES REQUIRED.
(1) AMENDMENT TO SECURITIES EXCHANGE ACT. Section 3(a)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4)) is amended by adding at the end the following:(F) JOINT RULEMAKING REQUIRED. The Commission and the Board of Governors of the Federal Reserve System shall jointly adopt a single set of rules or regulations to implement the exceptions in subparagraph (B)..(2) TIMING. Not later than 180 days after the date of the enactment of this Act, the Securities and Exchange Commission (in this section referred to as the "Commission") and the Board of Governors of the Federal Reserve System (hereafter in this section referred to as the "Board") shall jointly issue a proposed single set of rules or regulations to define the term "broker" in accordance with section 3(a)(4) of the Securities Exchange Act of 1934, as amended by this subsection.
"Damn!" I can hear you saying. "Nobody told me law stuff was going to be on the exam!" Don't worry, it just means that the SEC has to coordinate with the Federal Reserve when issuing rules and regulations regarding stock brokers. As Jim Hamilton explains here, "The measure is intended to ensure that regulators do not create a new and burdensome maze of requirements that would disrupt or interfere with the business practices of banks and thrifts that offer traditional bank products and services." As Hamilton also explains, this bill has been in the works for several years, as had promises by the SEC to coordinate its brokerage rules with banking regulators. Now, with this new law, it will have 180 days to do so. (You can also check out the SEC's press release on the matter here.)
Cutting through all the legal language and political niceties, what this means is that the SEC will have to coordinate its rules on brokers with the Federal Reserve. And, as all of us know, the Federal Reserve gets to wear the pants in that relationship. (This is the hierarchy in U.S. financial regulation: When the Fed and the SEC are involved, the Fed is butch. Basically, when the Fed is involved with anybody, it gets to be butch. When the SEC and the Commodity Futures Trading Commission are involved, the SEC is the dominant player. When the SEC and the Treasury Department are involved, the SEC stalls until the next election. When any federal financial regulator other than the Fed is involved with a State Attorney General, the federal regulator will get this deer-in-the-headlights look and start arresting or suing everybody in sight.)
There are several reasons for this change (other, that is, than the stated reason Hamilton notes--to cut down on conflicting cross-functional regulation.) The Gramm-Leach-Bliley Act broke down the barriers between retail and investment banking, and since then, every local bank has opened a brokerage arm to sell securities to its customers. (You've probably gotten these brochures yourself when you opened a bank account and were offered "investor services" as well.) All of these local banks are much more comfortable dealing with the Federal Reserve than the SEC. And, let's be honest--so is pretty much everybody else. It's been said that the Federal Reserve is like the Good Samaritan who nurses your wounds after you've been mugged, but lets the mugger escape; the SEC, on the other hand, has been described as the cop who ignores you as you lie bleeding on the floor and instead chases down the mugger and beats him to a pulp. If you are a potential mugger (and, since we're being honest here, most brokers are), who would you prefer to be regulated by?
So the SEC's Division of Market Regulation is very concerned right now that the Financial Services Regulatory Relief Act of 2006 has made them irrelevant. The ironic part about this, of course, is that it is not the Division of Market Regulation that has made the SEC so feared and loathed among bankers-cum-brokers. (That honor goes to the SEC's Office of Compliance, Inspections and Examinations.) If the SEC behaves like a bureaucracy (and I'm guessing it will), this will mean that we can expect the Division of Market Regulation to do everything it can to hang on to whatever power it has left. And this may not be a good thing, if it gets in the way of other reforms designed to improve the competitiveness of the U.S. capital market.
Friday, October 13, 2006
New form of Extreme Fighting becomes popular with today's youth: Frozen-shrimp-in-the-pants Wrasslin'
In my opinion, Bilwin deserves his fate. Everyone knows that the power three bags of frozen shrimp in your pants can give you will be lost if two of those bags fall out. And, trust me, you will need that power if you are going up against two Giant grocery store managers. That's why I always wear contour-hugging tighty-whities (and nothing else) when stuffing bags of shrimp down my pants.
(Thanks again to Pokey for the tip.)
Ouch. Don't get me wrong. I'm all in favor of cyborgs. But a bionic butthole wouldn't be my first choice of replacement parts.
(Many thanks to Pokey for the tip.)
Osbourne's point is:
The question is crystallised by debate over Nasdaq’s interest in the London Stock Exchange. When I meet Nasdaq’s management in New York I will make clear that I have no problem with overseas ownership. I am not one of those opposition politicians who make a song and dance every time a British company is taken over. The openness of the British economy is one of its great strengths; to block foreign takeovers is to block foreign investment. Rather, the problem is fear of overseas regulation. If US regulation were applied to listing requirements, it would impose a burdensome, rules-based system on top of the lighter-touch, principles-based UK regime: US regulations could be applied to UK listed companies in the same way that the Securities and Exchange Commission tries to regulate UK hedge funds.
I welcome the fact that the British government has responded to calls from myself and others to act to protect London-based exchanges from the risk of regulatory creep.... How do we best regulate large international financial companies in a world where sovereign states have less independent influence? The current system is not working as well as it should. We have drifted to our current position without enough debate about how to tackle this challenge.
There are three potential approaches. The first is unilateral action: to build the best possible regime by improving domestic regulation and by taking the power to remove regulation imposed by others. That way we can set the level of regulation appropriate to the UK. The government’s proposed new powers on exchange regulation will accomplish that in their narrow sphere.
But action at home is only a partial solution. It can help to stop international regulatory creep from hitting all companies in the UK, domestic and international, but it fails to tackle the regulatory overlap for those wanting to operate in several jurisdictions. Worse still is the risk of tit-for-tat extra- territorial regulation. Some say that if, by opening a US operation, a company exposes itself to US regulation of the whole business, that is a cost of expansion. But I think we should be more ambitious in tackling this overlap.
The second approach would be to establish a supra-national institution that regulates at a regional or global level. But we know that this solution also has its flaws. Take the European Union. I want to see a single market in financial services, so that British companies can compete freely on the Continent. But sadly too many directives coming out of the Commission have been over-regulatory and bureaucratic, threatening London’s competitiveness. So I fear that taking a further step forward and creating a single European regulator would probably hamper our global position, not enhance it.
The third and best approach is for national bodies to work together. That will never be perfect, but the multilateral Basel accord shows how much can be achieved. We should promote the benefits of a principles-based system and lobby more strongly against future extra-territorial rules, whether from the EU or US. We should argue that the regulatory system sits at arm’s length from politicians and government. We should promote mutual recognition of standards instead of overlaying one regime on top of another.
I have no idea if regulatory creep exists or if it's a problem, but let's suppose it does and is. Well, why does it exist? Are regulations rewriting themselves? Are accounting regulations kind of like the creep in Starcraft, only scarier -- slowly expanding to cover the world in one thick layer of green eyeshades and 10-K forms until all shall know the true power of Sarbanes-Oxley? Probably not. Probably there's some person or group of people who have a desire to expand the scope and intensity of US regulation. If that group is the American public, then he's just plain silly. After all, cooperation is something that people do for their mutual benefit. If the US is imposing regulation as yet another way of taking over the world and extracting whatever it is that we want from the rest of the world (hey, that's entirely possible), then it hardly seems likely that we'd stop taking over the world just because the world asked nicely. (That kind of "talking over our differences" thing might work with pansy dictatorships like Saddam's Iraq or North Korea, but it doesn't work with us Americans.)
But what if it's not in the United States' interests either? That's probably what Osborne has in mind -- he says that "the current system is not working ... We have drifted to our current position without enough debate." Okay, sure. I'm going to go out on a limb and suggest that maybe most people don't know a lot about international securities regulation. I can't even be bothered to balance my checkbook -- there's no way that I'm going to know what is and what is not a good accounting rule or how much regulation is enough regulation. So maybe the story is that the SEC is trying to expand its power and influence and get a bigger budget by overregulating foreign markets, and since the issue is kind of boring (and about foreigners) most Americans don't follow it and so don't stop the SEC from doing what might not be in their interests. (Incidentally, ever notice how this issue is front page with the UK's Financial Times, and rarely, if ever, covered by the Wall Street Journal?) It's a basic principal-agent problem: the interests of Americans overall might not be the same as the interests of financial regulators.
Does this make the problem easier? Actually, it makes it much harder. If the SEC is nefarious, or corrupt, or just suffers from bad incentives that come from just being a bureaucracy, and this makes them overregulate foreigners, then it's not likely that they are going to cooperate with foreign regulators and stop doing that. If it's in their interests to overregulate, then it's not in their interests to cooperate in such a way as to stop overregulating. But if it's not in their interests to overregulate ... well, what is Osbourne worried about? If there is any regulatory creep, it seems to be entirely accidental.
What the other idea: creating a supra-national group to regulate the regulators? That, also, seems to be a bad idea--which Osbourne himself admits. If our financial regulation is inefficient or too burdensome or what-have-you because of a principal-agent problem and for reasons of rational ignorance, how can adding an even more distant, less accountable, and more bureaucratic group solve that problem? If voters are ignorant enough that we need an international group to protect us from a domestic group that's supposed to be working for us, how are we smart enough to know how to keep the international group in line?
But fundamentally, Osbourne really misses the entire nature of the problem (or, rather, he touches on it and dismisses it out of hand, as if securities regulation were just like regulating electrical socket safety). He implies that the United States is ready to export Sarbanes-Oxley "in the same way the Securities and Exchange Commission tries to regulated UK hedge funds." But this underscores the problem. The SEC hasn't tried to regulate UK hedge funds. It's tried to regulate hedge funds selling fund shares to U.S. investors. Some of these hedge funds just happen to have their headquarters in the UK because today's technology has rendered borders meaningless for many business operations. But regulation, of all sorts, is still a matter of national sovereignty--which is why this little hub-bub in the UK is so curious. The United States can't export Sarbanes-Oxley to other countries. But the SEC can apply it (and other regulations) on anyone operating within the United States. If NASDAQ were to buy the London Stock Exchange, there would be business pressure to harmonize NASDAQ's and the LSE's trading and listing rules, so that British investors could easily buy U.S. securities and American investors could buy LSE-listed securities. However, that can't happen under current SEC rules. By putting a regulatory hurdle in front of NASDAQ and the LSE merging their exchanges to combine London's international listings with America's enormous number of investors, UK politicians hope to make the LSE a much less attractive take-over target.
** "Shadow Chancellor" is just about the coolest job title since "Dark Lord of the Sith." Possibly cooler. Which is kind of fitting, because it's just about as interesting as the acting in the recent Star Wars movies. I mean, you get to be the guy who would be finance minister if only your party were in power? (But not the guy who gets to be finance minister if your party actually does come to power--that's someone else entirely.)
Thursday, October 12, 2006
During his speech, Balls said:
At the same time as arguing for a sensible and light touch approach at the global and EU levels, we must also take what action is needed to protect our domestic regulatory approach. The Government’s interest in this area is specific and clear – to safeguard the light touch and proportionate regulatory regime that has made London a magnet for international business. That has made London an economic asset for the UK, for Europe, and for countries throughout the world. That is why I announced last month that the Government would legislate to enhance the FSA’s powers over recognised investment exchanges and recognised clearing houses, building on this regime. Tonight I want to explain in more detail what we have in mind in respect of legislative procedure and substance.
The bill he unveiled states:
In a statement on 13 September, I announced that the Government would legislate to enhance the FSA’s powers over recognised investment exchanges and recognised clearing houses. In that statement I promised further detail in due course. I am now able to provide details on how we intend to take this issue forward.
The Government has decided to introduce a stand alone bill to enhance the FSA’s powers in the next Parliamentary session. The short bill will seek to modify Part 18 of the Financial Services and Markets Act which deals with recognised investment exchanges and clearing houses. We intend to introduce the bill as early as possible in the new session, with a 2nd reading expected before Christmas.
Our aim is to enable the FSA to stop recognised investment exchanges and clearing houses making changes in their regulatory provisions whose effects are likely to be disproportionate. To this end we expect that the provisions will:
Cover all of our recognised investment exchanges and clearing houses, including the full range of markets operated by our recognised ivestment exchanges.
Enable the FSA to veto changes to regulatory provisions introduced by recognised exchanges and clearing houses or those applying for recognition that impose an obligation or burden.
Limit the circumstances in which the veto can be used to those where the relevant requirement is excessive, that is it is disproportionate to the end it seeks to achieve or does not pursue a reasonable regulatory objective.
Any exercise of the veto will be subject to appropriate processes. In particular:Where the FSA decides to call in a regulatory provision to determine whether it is excessive, it will need to specify a period during which representations can be made to it about the provision.
If the FSA decide to veto the regulatory provisions called in that decision can be challenged by judicial review.
These provisions are not intended to put into question existing regulatory provisions of investment exchanges and clearing houses. They are not intended to involve the FSA in micromanaging the regulatory provisions of investment exchanges or clearing houses. And they are not intended to make overseas ownership of UK exchanges any easier or more difficult than it is at the moment.
The legislation is simply about providing a back-stop to ensure certainty for stakeholders about the proportionality of the regulatory provisions of investment exchanges and clearing houses. We will consult shortly, including with the investment exchanges and clearing houses and their stakeholders, about the detail of what we will be proposing.
Wednesday, October 11, 2006
The first of these new laws is the Credit Rating Agency Reform Act. (The second will be discussed in a different post.) This is an interesting law with a very convoluted history that some day will make a good study for public choice theorists.
The story basically goes like this: The SEC requires investment banks and broker-dealers and other people who hold your money on your behalf to keep some of that money in reserve to cover losses that the company might experience as a result of operational failures, employee theft and the like. (The risk you face as a result of your bad investment is your own problem, but the idea is that you should be protected from losses that happen if somebody at the company types in the decimal point in the wrong place after you place an order.) Since 1975, the SEC has said that if the investment company keeps some of its money in particularly safe and liquid assets (i.e., investments that most likely aren't going to lose much value tomorrow and can be sold on a moment's notice), then the reserves don't have to be so big. But how do you know if an asset is safe and liquid? Well, one way is to look at the asset's credit rating. If a rating agency says U.S. government bonds are "Triple-A" (in other words, short of a nuclear holocaust, the U.S. government is going to pay you back, particularly since it can print the money to do so), then an investment company holding a lot of those bonds doesn't have to set aside as much cash as would a company investing in "junk" (very risky) bonds or equities.
But which rating agencies are acceptable? Some (such as Moody's, Standard and Poors, Fitch, etc.) are famous and respected. The one I just started in my basement where I assign credit ratings based on the shape of chicken entrails is somewhat less so. So, as part of this 1975 SEC "Net Capital Rule," the SEC said that if the credit rating agency is "nationally recognized," its ratings could be used in determining reserve requirements. So, how do you know if a rating agency is nationally recognized? Up until now, if you were an investment firm, you sent a letter to the SEC asking if they would take an enforcement action against you if you relied on XYZ Ratings, and, after some time (maybe a long time) and after deliberating deep within the SEC's offices, they just might send you a "No Action" letter saying they won't go after you if you do. Or they might not. And, if some rating agencies are to be believed, the SEC rarely tells you why they make the decisions they do, or what they are looking for. As for the SEC, they say they merely poll "the market" to see how widely a given rating agency's ratings are used.
It is an opaque system. Worse, it's arguably anti-competitive. Since 1975, the SEC and a number of other government agencies (and foreign governments) have piggy-backed on this "NRSRO" (Nationally Recognized Statistical Ratings Organization) system for banking, mutual fund and insurance regulation. Even private companies use the SEC's NRSRO status in their own contracts, under the theory that if a rating is good enough for the SEC, it's good enough for them. In the late 1970s, there were 7 NRSROs, but by 2000, mergers had cut this number down to 3. Since then, and under pressure, the SEC has increased this number to 5 (adding the Toronto-based Dominion Bond Rating Service and A.M. Best to Moody's, Fitch and S&P).
This situation has annoyed issuers and smaller rating agencies. Issuers pay NRSROs to rate them, because the NRSROs have figured out that information about their ratings spread so quickly that they face a collective action problem with fees. Nobody (with the exception of Bloomberg and other news services) will pay for their ratings, since they can get it free through the gossip mill. So, instead, the big rating agencies charge issuers for a rating, much like your bank charges you to run your credit score for a car loan. Further, issuers have to pay for more than just one rating, since investors want a second--or third--opinion before parting with their money. Making it worse, they don't want a rating from just anybody. If you don't go with an NRSRO, the investors will just assume you paid me off to rig the chicken entrails in such a way to get you a good rating. (And they'd be right.) So issuers are facing an oligopoly, and new entrants are closed out of the market.
But while issuers have been peeved, in the grand scheme of things NRSRO ratings, while overpriced, are not nearly as overpriced as are underwriting fees. (If you have a $100 million bond offering, you really don't care if S&P sends you a bill for $75,000--particularly since your investment banker's bill will probably be $6-7 million.) At the same time, new entrants to the ratings market tend to be small and politically weak. Consequently, there really wasn't much political momentum for change. That is, until Enron. Enron raised investor hackles because all of the major rating agencies missed the boat and failed to predict the company's collapse until just beforehand. (In their defense, of course, it should be noted that the immediate reason for Enron's collapse actually was a ratings downgrade, since Enron had a number of large loans that came due immediately upon Enron's debt being downgraded to junk status. Nonetheless, Moody's, S&P and the rest seem to have taken at face value whatever Enron was feeding them beforehand.) This event changed the politics of NRSRO recognition and put pressure on the SEC to regulate the industry and open the doors to competition.
In early 2005, after unsuccessfully petitioning the SEC to grant his little operation NRSRO status, Sean Egan, the owner of Egan Jones Ratings Co., asked his congressman, Michael G. Fitzpatrick (R-Penn.) to introduce legislation that would basically take from the SEC the authority to determine which rating agencies could be NRSROs. The resulting legislation, which passed the House this past summer, was called the Credit Rating Agency Duopoly Relief Act ("duopoly" referring to the 70+ percent market share of Moody's and S&P.) House Republicans strongly supported the bill, not so much because they thought that the ratings industry needed more competition, but because certain House staffers instinctively distrust the SEC and Fitzpatrick is a first-term congressman facing a tough reelection battle. Legislation bearing his name might lend him some campaign ammunition (though why his Pennsylvania constituents would care about ratings agency legislation is beyond me). The House bill would have prohibited any rating agency from issuing ratings in the United States unless it was first registered with the SEC, and would have mandated that the SEC would permit registration of any rating agency that had three or more years experience and no obvious conflicts of interest. (How this mechanism would actually promote competition is also beyond me, since you couldn't do business if you weren't registered, and you couldn't register if you hadn't been doing business for at least three years. But, of course, Egan Jones had been doing business for more than three years, so who cares, right?)
This bill passed the House by a wide margin. But a funny thing happened on the way to the Senate. The Senate's version of the bill, which was only drawn up after the House bill had passed, largely paralleled the House version but for a few, very important, changes. In particular, rather than mandating that the SEC permit any rating agency to register as an NRSRO, the Senate version said the SEC should designate any rating agency an NRSRO provided the rating agency submitted certifications from at least 10 financial firms stating that they actually rely on the agency's ratings. The SEC is also given the power to set other rules to determine who qualifies as an NRSRO, and any registered NRSRO is subject to SEC rules and oversight. (Prior to this law, there were questions about whether the SEC had the legislative authority to regulate the NRSROs--see, for example, former SEC Chairman William Donaldson's speech here). This Senate bill passed and the House agreed to the Senate version without hammering out any differences in conference. President Bush signed the bill into law on Sept. 29.
So, what does this all mean? It means that that while the SEC has been forced to clarify how it designates certain rating agencies as "nationally recognized," the SEC also has considerable new powers to regulate them. At the same time, Congressman Fitzpatrick and his constituent, Sean Egan, seem to have lost control over the truck they set in motion. Rather than opening the NRSRO designation to everyone, the Credit Rating Agency Reform Act actually tightens who can qualify as an NRSRO and gives the SEC broad new regulatory powers. Not exactly what Mr. Egan wanted, I suspect.
This new law likely will have two broad results. The first is that it may actually increase the number of NRSROs. Most of these new NRSROs, however, probably will not be small firms like Egan Jones, but foreign companies like JCR or R&I. A second result may be a new raft of "me-too" foreign legislation, particularly in Europe. The entire issue of credit rating agencies is more political in Europe than in the United States, with European issuers often complaining that the big "Anglo-American" ratings agencies don't understand how business is conducted on the Continent, and hence give them too low ratings because of under-funded pensions and the like. A new set of European laws on rating agencies likely will be more protectionist and focus on "issuer rights" rather than actual ratings quality. This could have a detrimental impact on the cost of capital on European markets.
Monday, October 09, 2006
In a way, this threat is heartening. It shows that stupid politicians aren't unique to the United States. First, these guys are outgoing. There's going to be a new administration in Mexico, and the president-elect Felipe Calderon has already said that this is a bilateral issue to be resolved by Mexico and the United States. Second, there is no legal case. Provided a border fence doesn't interfere with international trade (which is covered by various treaties -- none of which, I believe, would actually fall under the U.N.'s jurisdiction), there are no international agreements or customary international law that says a country can't build fences, moats, or whatever within their own countries and along their own borders. (However, if you fill the moat with crocodiles, you may actually violate international law. Since crocodiles are endangered, I'm guessing there might be a problem with the Convention on the International Trade of Endangered Species. Same goes for sharks with laser beams strapped to their heads.)
Also, I'm heartened to see the Mexican Foreign Secretary Luis Ernesto Derbez plans to raise the fence and immigration issue with his Spanish and Italian counterparts this week. Seeing that neither Spain nor Italy have illegal immigration problems of any sort, I'm sure Derbez will have a receptive ear.
Schmidt's article does a good job explaining Paulson's views and the pressure the Treasury Secretary would like to mount in a campaign to repeal Sarbanes-Oxley, but only touches on how limited Paulson's ability to maneuver is in this area. It also fails to mention that Paulson's objectives do not seem to be limited to just SOX but all U.S. financial regulation. This has several important implications.
First, while Paulson is indeed the most powerful Secretary of Treasury that the Bush Administration has had, the Treasury Department is still comparatively weak vis-a-vis the power the agency wielded during the Clinton years. Unlike many countries, the Securities and Exchange Commission (the country's securities market regulator) does not report to the Treasury Department (or, for that matter, to the president directly). With the exception of the Office of Comptroller of the Currency (OCC) , nor do the nation's banking or insurance regulators. With banks, the big daddy regulator is the Federal Reserve, with OCC and the Federal Deposit Insurance Corporation (FDIC) playing second fiddle. Insurance regulation in the United States is conducted at the state level.
What this means is that the Treasury Department, while it represents the United States at such international organizations as the Financial Stability Forum, the Organization for Economic Cooperation and Development and the Financial Action Task Force, really isn't the boss of anyone important. It collects taxes, protects the president, and heads the Financial Crimes Enforcement Network, but really doesn't set regulatory policy in any area except for taxation. So Paulson can use the weight of his (diminished) office to try to push through regulatory changes, but he's in a poor position to do it by himself.
The one thing that he can do, and which he apparently is considering, is streamlining banking regulation by moving the OCC under the Federal Reserve's authority. The OCC has been blamed by some for the mess that now is the Basel II Accord, which the Federal Reserve has since said applies only to large U.S. banks with international operations, and not small U.S. banks (a position that has caused some consernation among European financial regulators, who see this as giving smaller U.S. banks a competitive advantage). If Paulson does move the OCC under Federal Reserve authority, it will simplify U.S. banking regulation. But U.S. banking regulation isn't what has the U.S. Chamber of Commerce and its Committee on Capital Markets Regulation with their underwear in a wedgie.
In the end, however, Paulson may be able to claim victory for events underway before he took office. As I noted previously, the Public Company Accounting Oversight Board is in the process of drafting a new Audit Standard 5, which will take much of the pain out of Section 404 of the Sarbanes-Oxley Act. This new AS5 may well be out by December. That, combined with new SEC deregistration rules (which likely will be released at or before the new AS5 is) will make it difficult for foreign issuers to complain about the costs of Sarbanes-Oxley. The costs of implementing Section 404 (the provision on internal controls) will drop, and, if you don't like it, it will also be much easier to get out of the American market.
This will not solve the Sarbanes-Oxley issue for many foreign (and domestic) issuers. The PCAOB will still be policing audit firms, which will make it harder for companies to reward or punish auditors who don't go along with their interpretation of U.S. Generally Accepted Accounting Standards (US GAAP). CEOs and CFOs will still need to certify the accuracy of their companies' financial statements -- which, while not costly, is something CEOs and CFOs would rather not do, since it more clearly puts their butts on the line if someone is lying. And companies will still need to give a statement about the quality of their internal control systems. What will be different is that the steps the audit firm will use to check on the validity of this statement will be far less rigorous and costly.
Public companies will still complain about this last point, but the strength of these complaints will be far weaker. Right now, a company legally can announce (truthfully) that its internal control are weak and that it has no idea about how its money gets spent. And they will still be able to do this after implementation of Section 404 is "improved" (i.e., AS5). The problem with this, of course, is that no sane investor will pay much for the securities of a company making such an announcement, and companies know this. Hence, some issuers will continue to complain about the internal controls provision, arguing that it still requires them to adopt expensive new internal controls or else face a dramatic drop in stock price. But, frankly, that's a little like a used car dealer complaining that a law that mandates used cars be sold with accident and repair reports will lead to car buyers paying less for damaged cars. In other words, an argument that's a little harder to feel sympathy for.
Saturday, October 07, 2006
Niemeier’s remarks come just as the PCAOB is in the middle of a complete revision of Audit Standard 2 (which, rumor has it, will be renamed Audit Standard 5). AS2 is the PCAOB’s rule that specifies how independent audit firms should audit a public company’s internal controls as part of the dreaded Section 404 of the Sarbanes-Oxley Act. Its detailed specifications have permitted audit firms (who were burned so badly following Enron that one of their largest, Arthur Andersen, collapsed) to force issuers to pay large sums to ensure that their internal controls are strong enough that another Enron or Worldcom doesn’t happen again. However, critics accuse AS2 of focusing on such picayune matters that the costs involved do not justify the additional safety to investors. (In reality, when companies complain about Sarbanes-Oxley, they mean Section 404. The costs created by the rest of the act are minor.)
Niemeier’s speech offers a defense of high U.S. regulatory standards and against the charge that the Sarbanes-Oxley Act is driving foreign issuers away from the U.S. market. In doing this, he makes several interesting points:
- Individual investors enhacne the competitiveness of companies listed in the United States by offering low-cost, long-run funding at a level unparalleled in any other country. These investors are able to do this because of the degree of investor protection found in the U.S. market. Niemeier cites data showing that the cost of capital for foreign firms cross-listed on their home markets and in the U.S. is significantly lower (from 7 percent lower for Japanese companies, to 25 percent lower for Egyptian firms).
- Not every company wants to pay the price that comes with this low-cost capital. In particular, companies with powerful insider may not wish to list in the U.S. becuase their abilities to extract private benefits from the companies they control are limited in the United States because of U.S. laws protecting minority shareholders.
- Over time, as more and more foreign markets adopt stronger securities regulations and shareholder protection laws, these markets also become attractive places to invest. U.S. markets now face more competition because of this.
- The decline in the U.S. share of world IPOs long predates Sarbanes-Oxley and is likely related to other polistical and economic factors. Niemeier cites data showing that the U.S. portion of world IPOs has been decreasing since 1996, and has actually recently seen a 15 percent uptick. Part of this is due to low interest rates around the world, which has made private equity and leveraged finance firms more attractive vis-a-vis equity issuances. In addition (and as I have noted here), a large number of recent IPOs by privatized state-owned enterprises (particularly in France and China) has boosted foreign markets, notwithstanding the significant valuation premium the IPOs might have gotten had they listed in New York. (SEC Chairman Cox made a similar observation in a speech he made in China just prior to the China Construction Bank IPO in Hong Kong.)
- Niemeier notes that the number of U.S. companies having IPOs has dropped dramatically since the collapse of the dot.com bubble. He also takes a swipe at the UK, noting that the London Stock Exchange's Alternative Investment Market (AIM), which advertizes itself as a low-regulation market for new companies, is really looked at more as an alternative to private financing than having an IPO on the U.S. market.
- Niemeier also states that he expects changes to SEC and PCAOB rules to help address the costs associated with Section 404.