Saturday, January 27, 2007

Spitzer and the Schumer/Bloomberg/McKinsey Report: Irony to make your eyebrows bleed

Unfortunately, I haven't yet had the chance to wade through the 141-page McKinsey report on New York's financial competitiveness. (Believe it or not, I have a real job.) However, U of Illinois professor Larry Ribstein, bless his Sarbanes-Oxley-hating heart, notes that NY governor and former attorney general Eliot Spitzer showed up with the report's sponsors, NYC Mayor Michael Bloomberg and U.S. Sen. Chuck Schumer, to help unveil the report:

Bloomberg and Schumer were joined at today's press conference by New York Governor Eliot Spitzer, who said the cost of complying with Sarbanes-Oxley is ``simply too great'' for small companies. ``That is why some reasonable changes there and elsewhere in the statute can and should be embraced,'' he said.
(See Bloomberg, Schumer Warn U.S. May Lose Financial Lead.)

However, Ribstein also quotes a WSJ op-ed that Spitzer made sure that the report didn't recommend anything about constraining states attorneys general from creating their own securities regulation through lawsuits and settlement agreements:
The study, however, didn't support making state attorneys general give up jurisdiction in some financial-services cases, an idea that Mr. Spitzer criticized when it was included in the report by the Committee on Capital Markets Regulation. Mr. Spitzer said he made sure the Bloomberg-Schumer recommendations didn't include such a provision.
Even for a New York politician, this level of hypocrasy is breathtaking. My hat is off to you, sir!

U.S. securities markets and the Maginot Line

Check out the latest speech from SEC chairman Christopher Cox at the 34th Annual Securities Regulation Institute in Coronado, California. (See Re-Thinking Regulation in the Era of Global Securities Markets.) The topic is the cross-border integration of stock markets, and Cox warns that if the U.S. isn't careful, it's securities laws risk becoming like the French Maginot Line. (As you probably know, the Maginot Line was a system of static fortifications that ran along the Franco-German border and built during the 1930s to keep the Germans from invading France. It was premised on the idea that the next war would be like the last -- i.e., a defense-dominated situation like WWI. Instead, technological and tactical innovations allowed the Germans to do an end-run around the Maginot Line and move deep into France before the French -- who actually had more troops and more modern equipment -- were able to respond.)

So, basically, Cox is warning that if the SEC fails to adapt, U.S. securities regulations risk becoming as potent, innovative and competent as the French military. Ouch!

Without a doubt, our regulatory defenses proved very effective in maintaining healthy markets in the 20th century. The world-beating success of America's capital markets is a testament to that. For most of the last 74 years, our ability to police our markets and maintain investor confidence in their integrity has been premised on requiring both domestic and foreign market participants that operate in the U.S. to register with the SEC — and for the most part, to follow the same rules. That approach has followed from our concern that the alternative, permitting foreign market participants to operate in the U.S. without direct SEC oversight, would threaten the integrity of our nation's capital markets.

But while this approach served us well in the past, when the world's capital markets were separated not just by oceans but by the preference and habits of most investors, the world is a far different place today. And so we have to ask ourselves: have the basic assumptions on which we've built these regulations changed?
I'm convinced that the way to surmount these new challenges posed by technology is to harness the power of that same technology. We've got to recognize that to catch a global network of market crooks, it will take a global network of securities cops.

That means that our success will be measured not by the degree to which we close off other marketplaces from our own, but rather by the extent to which we more closely integrate our regulatory efforts as our markets themselves become more closely connected.

Every regulator has an obligation to the investors and issuers within its borders to protect them from fraud perpetrated within those borders. For the SEC, therefore, every other like-minded regulator is our natural ally. We've made great strides in recent years in building ways to share enforcement information with our counterparts in other countries, and to cooperate in doing every other part of our jobs. And as the story of this success has spread, we have found new friends and allies sharing the same concerns and devoted to the same cause of protecting investors and promoting capital formation.

This process of discovering our mutual interests has led us to realize that some of the old ways of doing things are obsolete. For example, while our historical justification for having issuers, broker-dealers and exchanges to register with the SEC is sound, it may be that by working with like-minded foreign counterparts we can find ways to lower costs and increase opportunities for investors while still maintaining the highest standards of investor protection. In this regard, the Memorandum of Understanding we recently concluded with the College of Euronext Regulators should be an excellent start.

And this brings us to an interesting question. Just what is "like-mindedness"? Will we know it when we see it? I believe the answer to this question is not wholly subjective. In my discussions with our counterpart regulators in other countries, I have found one touchstone in particular that is of overarching importance. It is an acceptance by the regulator that the genius of the market is that individuals are free to investigate their options and make their own decisions. It is an appreciation for the "wisdom of the crowd" that is ultimately the consensus of that market — representing the solution of many minds working on a common problem.

Working with all of the world's regulators who share this belief in the power of markets, we can tap that same principle, so that a multiplicity of jurisdictions — each seeking to develop the best regulatory framework — can likewise investigate their options and make their own decisions about ways to handle regulatory issues within their borders. This is something from which we all can benefit: observing what works, and how the market responds, and learning from what doesn't work.

To give you just one example of what the "wisdom of the crowd" means for securities regulators, consider the global reaction to the Sarbanes-Oxley Act. There has been loud complaint about its costs, even by some in other jurisdictions to whom it does not apply. But one interesting effect of these reforms has been the degree to which they have been copied, in one form or another, in many other major markets.
A lot of interesting ideas here. My question is, is Cox really signally support for radical change to how the SEC operates internationally? Some of the ideas in this speech (regulatory competition, working with "like-minded" foreign regulators, etc.) clearly echo ideas in a recent Harvard International Law Journal article by SEC staffers proposing a "substituted compliance" approach. (See here.)

My second question is, what effect would such a radical change have for the U.S. market? The FT on Friday led with an article on comments by Lehmean Brothers vice-chairman Thomas Russo at the World Economic Forum in Davos, Switzerland where Russo basically said that despite all the sturm-und-drang over New York's falling position in world finance, it is unlikely to ever recover no matter what policies the U.S. enacts. (See NY unable to regain lost business, says top banker.) Russo, however, doesn't seem to be imagining that truly radical change is possible. To carry the Maginot Line analogy even farther (by the way, the guy who thought up that analogy -- brilliant!), in 1940 even the German Army High Command believed the invasion of France would break down into a static war of attrition. Only a radical change in tactics, envisioned by Heinz Guderian and Erich von Manstein, allowed Germany to march into Paris only 6 weeks after the invasion began. If the SEC were to adopt a radical change -- made all the more relevant by the cross-border consolidation of stock exchanges -- New York may still have its day in the sun.

Wednesday, January 24, 2007

More than half of all S&P500 firms move away from staggered boards

Alex Simpson catches an interesting article in the WSJ about how 55 percent of all S&P500 firms have ditched the anti-takeover practice of having "classified" or "staggered" boards of directors. (Alex links to the article here.) A staggered board of directors is a board whose members are like members of the U.S. Senate -- only a third are up for reelection every year, making it impossible for any shareholder or group of shareholders to take control of the company quickly (or, for practical purposes, at all). The explanations by Carol Bowie, vice president of research at Institutional Shareholder Services (a research and ratings firm that advices institutional investors on how to vote on shareholder proxies), seem plausible, but unsatisfying. Just because Enron has put S&P500 companies under a spotlight doesn't seem to me to be enough to make these companies' boards "unentrench" themselves. It seems more likely that this is some kind of signally mechanism to the market to allow these companies to lower their cost of capital. For example, the article quotes Staples proxy materials proposing to have shareholders vote to get rid of its classified board structure as necessary to "maintain and enhance the accountability" of its board members. Whenever someone votes to "enhance" their own accountability, it means something is up.

Interestingly, this trend is in line with proposals Harvard professor Allen Ferrell makes in the recently issued report of the Committee on Capital Markets Regulation. (Page 93-199, if you want to read the report itself.)

Monday, January 22, 2007

Bloomberg and Schumer publish McKinsey report on how global finance doesn't heart NY anymore

David Wighton of the Financial Times writes about it here. Apparently the report (which you can read all 130+ pages here on Chuck Schumer's website) says that New York could lose up to 7 per cent of its market share, equivalent to 60,000 jobs, over the next five years if current trends continue. As remedies, it proposes "clearer guidance on the Sarbanes-Oxley corporate governance rules, securities litigation reform, promoting the convergence of accounting standards, and easing visa restrictions on foreign professionals."

Sunday, January 21, 2007

The Problem in Islamic Finance

Today's fake fatwa actually deals with real fatwas. If that doesn't make you head hurt, nothing will.

Anyway, Islamic finance is a topic I've been thinking about a bit for some time. However, since I'm not a Muslim or Shariah scholar, I've always felt like this was one of those things where you run the risk of being an outsider offering unwanted opinions on something you know nothing about. (Does Arabic have a word for "kibitz"?) Nonetheless, I'm heartened by an article in last week's Financial Times by Muhammad Saleem, an investment banker and author of Islamic Banking: A $300 billion Deception. (See Islamic finance has much to learn from the west).

When most Americans think of Islamic finance or Islamic banking, they probably think of terrorist financing. This is wrong, of course. Terrorist financing has as much in common with Islamic finance as money laundering has in common with "traditional" banking. Though, as a general matter, any time you mix religion and finance, the results usually do not have pleasant connotations. For example, even today "Jewish banking" brings to mind conspiracy theories and pograms. How about "Catholic banking" -- indulgences and albino monks, anyone? Or "Evangelical Christian finance." Can't you just see Tammy Faye's mascara-running tears and Jim crying about hookers? Let's just say there's probably a reason Jesus drove the money-changers from the Temple.

But Islamic finance actually is something that is different from the type of financing that has developed in the West over the past 500 years -- at least in theory. And it is beginning to be big business. There are two reasons for this, I believe. The first is oil money, of course. With the price of oil being what it is, many Muslim countries are flush with cash, and it's hardly surprising that they have put a great deal of this cash into Islamic financial institutions. But this isn't the whole story. After all, these countries were flush with cash in the 1970s as well, but Islamic banking really didn't take off in any real sense until the 1990s. So some of the growth of Islamic finance, I believe, might be fallout related to Samuel Huntington's "clash of civilizations" idea. At a time of great uncertainty and conflict, when Muslims and Westerners think of each other as "us versus them," we humans have a tendency to seek solace with tradition. One way to do that is to seek out new "old ways" of doing things that allow us to reinforce our cultural and religious identities while offering alternatives to the very things that seem most foreign, uncertain and hostile. And I think, for some Muslims, Islamic banking might fall into this category.

Islamic finance has several characteristics that make it quite different -- at least on the surface -- from "traditional" Western finance. The most obvious is the prohibition on earning interest. But there are others as well. The Koranic injunction against gambling has been interpreted as a prohibition on contracts where the final terms of the contract (the thing to be delivered, how much is to be paid, etc.) cannot be determined until some future event. This interpretation effectively prohibits most Western commodities and futures contracts and insurance. There is also a third prong to Islamic finance that goes to what you can invest in, rather than the form the investment may take. This, however, is relatively straight-forward and very similar to Western concepts of "ethical investing." For example, following Islamic investing principles, because Shariah prohibits eating pork, drinking alcohol, gambling and watching pornography, investing in Hormel, Seagrams, PartyGaming and Playboy would be no-no's.

The first point -- the prohibition on earning interest -- is not unique to Islam, of course. The Old Testament (particularly Exodus 22:25-27, Leviticus 25:35-37, Deuteronomy 23:19-20, Psalm 15:5, et al.) all prohibit charging interest, in one form or fashion. (Exodus and Leviticus seem to prohibit it only if one is lending to the poor; Deuteronomy prohibits it in loans given out to fellow Jews/Israelites, but allows it when lending to foreigners.) Throughout most of Christian history, the Old Testament prohibition was adopted in canonical law, with charging interest to fellow Christians considered a sin and "usurers" ineligible to partake in the Eucharist.

This historic distaste for charging interest was not limited to the religious. Aristotle, in both the Politics and the Ethics argues that charging interest is wrong. In the Politics, Aristotle describes usury as:

The most hated sort (of wealth generation) and with the greatest reason, is usury, which makes a gain out of money itself and not from the natural object of it. For money was intended to be used in exchange but not to increase at interest. And this term interest, which means the birth of money from money is applied to the breeding of money because the offspring resembles the parent. Wherefore of all modes of getting wealth, this is the most unnatural.

It wasn't until the Protestant reformer John Calvin came along that the West rejected this view (though even Calvin thought charging interest was wrong if the borrower was poor). (By the way, I'm not a particularly big fan of Calvin, but I am very thankful it was his economic views, and not Martin Luther's, that came to dominate post-Reformation Europe.)

Islam, however, has yet to have its John Calvin. The result is that much of modern interpretation of the Koran runs directly contrary to modern financial concepts -- particularly the concepts of the time value of money and risk. For example, most Shariah scholars argue that interest is impermissible, while profit-sharing is acceptable. The idea is that a guaranteed return on an investment is wrong because the risk is not shared equally between the lender and borrower if misfortune should occur; however, if the risk is shared equally, the "lender" and "borrower" are partners and the arrangement is just. Put simply, equity investments are fine, but bonds are not.

For this reason, much of Islamic finance involves creating mechanisms that replicate the benefits of bank lending, but have the appearance of profit-sharing or buying and selling. For example, with a typical "traditional" car loan, the bank lends you money, at a certain interest rate, for you to purchase your car. If you default on the loan, the bank takes your car, sells it, and collects what it is owed and gives you whatever may be left. With an Islamic "loan," the bank buys the car and then sells it to you at a mark-up, to be paid in installments over time. You end up paying the same amount under both scenarios. However, Shariah scholars believe the Islamic loan is more just because, if you default, the bank simply takes back the car and has no further claim on you. With a traditional loan, the bank may still pursue you for any remaining principal if the repo doesn't provide enough.

(As an aside, there was a case a few years ago where a woman unknowingly bought a stolen car using an Islamic bank. She lost the car after a fender-bender brought to light that the car was stolen, after which she refused to repay the loan, saying that the bank had sold her a stolen car. Much to the bank's chagrin, the Shariah scholar charged with adjudicating the case sided with the woman. The bank's representatives complained that they specialized in making loans, not buying cars and running title searches. The scholar replied that you are either lending at interest or selling at a mark-up -- you can't have it both ways.)

However, modern finance recognizes that debt and equity are just two ends of a very smooth risk continuum. This is particularly the case in the modern world were bankruptcy laws exist. As a practical matter, car loans are secured with little more than the car itself, whether the bank is Islamic or "traditional." One corrollary of Merton Miller's and Franco Modigliani's work is that the difference between debt and equity is risk, and in an efficient market, the risk-return ratio of debt and equity are the same. In other words, if the market is efficient (and things like taxes and subsidies of various sorts factored out), the less risk I take as a lender, the less return I can expect. Or, if I'm a borrower, the more risk I expose my lender to, the more I'm going to have to pay to get the lender to part with his or her money. The calculus is as close to an iron-clad law as you can get in economics. Consequently, if I'm an Islamic bank and I'm on the hook if your car ends up being stolen goods, or if the only thing that can secure the "loan" is the car itself, the borrower is going to end up paying more at the end of the day. Whether we call it interest or profit, paying more is paying more.

The car loan example described above (called a "murabahah" or "cost plus" transaction) is relatively simple. Other types of financial transactions designed to replicate insurance products, futures contracts, and various financial hedging strategies are considerably more complicated and far less transparent. Indeed, many Islamic bond structures (sukuk), Islamic insurance (takaful), and Islamic futures contracts involve a degree of complexity and opacity that rivals those used by Enron. (Islamic insurance can even involve a certain degree of willful fiction: when a policyholder suffers a loss, the insurance fund doesn't contractually compensate the policyholder; rather, the other policyholders "donate" to help the misfortunate. Presumably, reneging on this "donation" is frowned upon.)

This, fundamentally, is the problem I have with Islamic finance as it is most commonly used. It uses very complicated structures to accomplish the exact same goal as Western finance, but with added cost and opacity. It is, as Rice University professor Mahmoud Amin El-Gamal has called it, a case of Muslim customers "paying more for less." In this sense, I believe Islamic finance today shares much in common with Christian finance of the Middle Ages, particularly after the traditional Jewish financiers were exiled. (Following the Deuteronomy passage noted above, many Jews at that time believed lending at interest was permissible, provided the borrower was not Jewish. Since Christians had the same prohibition where the borrower was Christian, Jews often became the preferred financiers for Christian enterprises, up to and including lending money to finance the construction of Christian monasteries and the First Crusade.) When Edward I in 1275 banished 15,000 Jews from England, lending money at interest did not disappear -- it merely went underground, to the detriment of borrower and lender alike. David Hume, in his second volume of the History of England writes: it is impossible for a nation to subsist without lenders of money, and none will lend without a compensation, the practise of usury, as it was then called, was thenceforth exercised by the English themselves upon their fellow citizens, or by Lombards [Medieval Italian pawnbrokers] and other foreigners. It is very much to be questioned whether the dealings of these new usurers were equally open and unexceptionable with those of the old. By a law of Richard it was enacted that three copies should be made of every bond given to a Jew; one to be put into the hands of a public magistrate, another into those of a man of credit, and a third to remain with the Jew himself.

But as the canon law, seconded by the municipal, permitted no Christian to take interest, all transactions of this kind must, after the banishment of the Jews, have become more secret and clandestine; and the lender, of consequence, be paid both for the use of his money and for the infamy and danger which he incurred by lending it.

Hume wrote this in the mid-1700s, and while the situation today is somewhat different with Islamic finance, the end result is the same. In short, the predominant interpretation of the Koran today makes it more expensive for poor and middle-class Muslims to borrow money and buy insurance. It makes them less secure in their retirement, because it increases the transaction costs and lowers the returns on their pension funds. And I believe that this is fundamentally opposed to the objective of the original Koranic injunction.

This, of course, is where I am on a bit of thin ice. I have had Muslim colleagues quite logically argue that human reason is limited and if God comes up to you and tells you not to do something, you don't ask for an explanation for His reasons. However, I still believe context is important. (Ironically, for this I must thank my Muslim colleagues' predecessors. If it weren't for Averroës and other Muslim scholars, the West would have never rediscovered Aristotle. And without Aristotle, there would have been no Thomas Aquinas and the philosophy that the will of God can be deduced from both Scripture and reason.)

For example, Sura 2:275 of the Koran (using the Penguin Classics translation -- unfortunately, I cannot read Arabic) states:
Those that live on usury shall rise up before God like men whom Satan has demented by his touch; for they claim that trading is no different from usury. But God has permitted trading and made usury unlawful.
This is as pretty clear a prohibition as you can get. But if you read the immediately preceeding passages, you see the context:
To be charitable in public is good, but to give alms to the poor in private is better and will atone for some of your sins. God has knowledge of your actions...Those that give alms by day and by night, in private and in public, shall be rewarded by their Lord. They shall have nothing to fear or regret. (Sura 2:271, 274)
Likewise, Sura 3:130 states:
Believers, do not live on usury, doubling your wealth many times over. Have fear of God, that you may prosper.
But following this passage, the Koran says:
Obey God and the Apostle that you may find mercy. Vie with each other to earn the forgiveness of your Lord and a Paradise as vast as heaven and earth, prepared for the righteous: those who give alms alike in prosperity and in adversity; who curb their anger and forgive their fellow men (God loves the charitable); ... (Sura 3:132-133)
Viewed this way, it appears that the prohibition against interest is closely tied to protecting the poor from abuse. In this sense, these Suras are very similar to several of the Old Testament passages noted above:
If you lend money to one of my people among you who is needy, do not be like a moneylender; charge him no interest. (Exodus 22:24)

If one of your countrymen becomes poor and is unable to support himself among you, help him as you would an alien or a temporary resident, so he can continue to live among you. Do not take interest of any kind from him, but fear your God so that your countryman may continue to live among you. You must not lend him money at interest or sell him food at a profit. (Leviticus 25:35-37)
In each of these cases, the prohibition on charging interest is couched in the language of charity and protecting the poor. When we consider that the bankruptcy protection -- the idea that debts can be discharged by a court if the debtor is impoverished and unable to repay the debt -- is a relatively new idea, the prohibition on usury where the poor are concerned makes sense. After all, the historical fate of a defaulting borrower was debtors' prison or worse. But bankruptcy laws change the risk calculus. All lenders today are "partners" in the sense that repayment is never guaranteed. What varies is the risk the lender takes, and the return the borrower offers. Where a free, liquid market exists, risk correlates with return, to the benefit of both borrower and lender.

The same situation exists with regard to Islamic insurance and futures contracts. Shariah law prohibits gambling, and while the Koran does not spell out the reasons for this prohibition, the moral issues that attach to gambling are well known. Gambling does not create wealth, but merely moves it from one person's pocket to another's, based on chance. It can be addictive, and a gambler's losses can not only affect the gambler, but also that gambler's family and others for whom he or she is responsible.

But chance and risk are two entirely different things. While it is certainly true that some financial speculators might as well be gambling, insurance products and futures contracts inherently are the opposite of gambling. They are about controlling and limiting risk, not profiting from chance. Consequently, Shariah scholars who interpret the Koran as equating most traditional insurance products, futures contracts, and hedging transactions with gambling are missing the point of the original Koranic injunction. If the objective is to protect the poor and generate social good, few things have contributed more to this over the past 300 years than our understanding of risk. (By the way, a really good book on this subject is Peter L. Bernstein's Against the Gods: The Remarkable Story of Risk.) The complex and opaque mechanisms used by Islamic finance to achieve precisely the same risk management that is provided by cheaper and more transparent traditional methods is a disservice to those Muslims most in need. It is hard to imagine that this was the Prophet Muhammad's objective.

There are other problematic issues with Islamic finance that Muhammad Saleem and Professor Gamal discuss, particularly those relating to the Shariah scholars hired by Islamic financial institutions to opine on whether a given investment or financial product is permissible. These scholars are hired and paid by the financial institutions themselves and, absent some kind of branding mechanism, it is easy to see that this presents a classic conflict of interest. (You can be sure that Islamic financial institutions know which Shariah scholars are sticklers, and which take a more laid-back approach to interpreting Shariah; and I imagine the latter tend to have a better employment record.) But this problem is one that can probably be addressed through regulation and market mechanisms (i.e., disclosure and branding). The bigger issues relating to the interpretation of what constitutes "usury" and "gambling" may not.

So what are the alternatives? I think the first is to return to first principles. In this regard, I believe Professor Gamal's mutualization ideas may be very valuable. Gamal argues that it is not the form of financing that is problematic under Shariah principles, but the profit motive. Therefore, financing organizations such as mutual savings and loans and mutual insurance companies, where borrowers are also shareholders in the bank or insurance company, may still be perfectly acceptable even if they charge fixed interest or use traditional insurance contracts, because they are non-profits and the benefits are shared by all members. Personally, I suspect that such banks will be less economically efficient than for-profit banks, but they likely will still be an improvement over existing Islamic financial institutions and mutualization will address certain social justice concerns. Such institutions will also be far more transparent, given that they will operate under existing banking and insurance regulatory systems.

Another approach might be for Shariah scholars (and Muslims generally) to focus on those financial activities that are similar to the types of abuses that the Prophet Muhammad was concerned about. This would be a true social justice approach to Islamic finance. For example, does the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 unduly harm the poor? Does the U.S. student loan system, which features government-backed loans, the near impossibility of discharging the loans regardless of economic circumstance, and high fees charged by the private institutions that provide these loans at no risk to themselves, have elements of the usury that the Koran decries? Or so-called "payday loans," often used by the poor despite exceedingly high interest rates and very low risk to lenders? Do these practices harm the poor to the benefit of the powerful? If so, Shariah scholars (and all Muslims, and Jews and Christians) all have a role in pointing this out. However, the current approach of most Islamic finance that focuses on mere form rather than substance does not provide a viable alternative to these abuses, and adds to the problems that the Prophet Muhammad sought to alleviate.

Thursday, January 18, 2007

Bill Gates and my own private Bizarro Universe

I was talking with my homies today about proxy rights, institutional investors, markets for corporate control, and corporate social responsibility (Ok, my homies are freaks, but I take what I can get), and on the way home I remembered an article from the Financial Times this weekend about how Bill Gates just gave a big Flip of the Bird to the ethical investment movement. (See Bill Gates in snub to ethical investing.)

This issue flared up last week when the LA Times published two articles questioning the good works of the Bill and Melinda Gates Foundation because the Foundation invests its money according to how well the investments make money (more or less), rather than on whether the company does good deeds, doesn't hurt the environment, treats sweatshop workers less sweatily, etc. (See Dark cloud over good works of Gates Foundation and Money clashes with mission.) Fortunately, being as rich as God means you don't have to suck up to stupid newspapers and social activists; rather than bow to the CSR altar, the Gates Foundation issued this statement basically saying that, while they won't invest in anything the couple considers "egregious" (which, apparently, means tobacco) or anything that presents a conflict of interest, they otherwise aren't going to grade companies on their corporate social responsibility or otherwise invest on these principles:

There are many important issues that the foundation does not focus on, such as lending laws and environmental regulation. The organizations that do work on those issues—together with governments and all of their legislative, executive, and judicial resources—play a critical role. We do not want to duplicate that role.

Bill and Melinda have prioritized our program work over ranking companies and issues because it allows us to have the greatest impact for the most people. They also believe there would be much room for error and confusion in such judgments, and that divesting from these companies would not have an effect commensurate with the resources we would divert to this activity. The foundation’s not owning a tiny percentage of a company or selling it to another investor would often go unnoticed, and Bill and Melinda would not be comfortable delegating this kind of judgment.

Shareholder activism is one factor that can influence corporate behavior. The foundation is a passive investor because we want to stay focused on our core issues. But as responsible shareholders, the investment managers do vote proxies consistent with principles of good management and good governance, and have voted against management’s recommendations when they have disagreed with them.

This is frighteningly enlightened as charitable foundations go. Basically, Bill and Melinda Gates are saying that their expertise lies with making money and with giving that money to groups and people who are able to do the most good. However, their expertise does not lie with judging such socially and politically contentious issues as the costs versus benefits of environmental protection laws, child welfare laws in extremely poor countries, the effects of minimum wage laws on developing world poverty, whether organic farming ultimately helps or hurts the poor and the environment, etc.

This is not only wise, but profoundly democratic. By contrast, much corporate social responsibility stems from developed world hubris -- the idea that there are no trade-offs in life. For example, some seem to believe that those poor souls living in the developing world would prefer that a handful of their neighbors are able to earn something approximating a developed world income than that everyone could earn more than the barely-subsistance wages they get now. Or that everyone in the developing world would prefer a pristine environment to an income.

Which raises a conundrum for me. My first computer was a Mac. For me, Bill Gates was an evil monopolist, inflicting an inferior Windows and Internet Explorer on the world through predatory anti-competitive activity. But now, Bill Gates looks good. It's Apple and Steve Jobs who are the evil-doers. And the more I think about activist shareholders, the more -- quell' horror! -- I'm starting to think Roberta Romano and even Stephen Bainbridge might be right.

What kind of bizarro world is this, when up is down and black is white? And does this have anything to do with the beard I grew?

Finally, does this mean that George W. Bush is really a genius?

Well, no universe is that bizarre...

(BTW, I particularly liked the quote in the FT article from Penny Shepherd, chief executive of the UK Social Investment Forum, who accused the Gates Foundation of having "...a rather outdated perspective. The evidence is that you can invest responsibly without damaging your financial returns." Yeah, that's why socially conscious investing in a niche market, Penny, and Bill is as rich as God. Just fifteen seconds on Google Scholar shows you're wrong.)

Tuesday, January 16, 2007

Wag of the Finger/Flip of the Bird

Stephen Colbert has a recurring segment called "Tip of the hat/Wag of the finger," where he alternately praises and condemns something or other. I thought I should have something similar, but since I rarely have anything nice to say, I've decided to call it "Wag of the Finger/Flip of the Bird."

Yes, I know both involve wagging fingers. That's not the point. It's the intensity that counts.

Unfortunately, my first wag of the finger goes to me. During the holidays, I predicted that incoming House Financial Services Committee Chairman Barney Frank would hold hearings on CEO pay (which is admittedly a no-brainer, since he had already said as much), but also that several professors would testify that high CEO pay results from a combination of a "Lake Woebegon effect" plus poor corporate governance standards. I also said all of this will be ignored and Congress will instead focus on some kind of CEO windfall tax. Then, on Dec. 27, Barney Frank let loose a broadside at the SEC regarding its year-end rule change regarding CEO compensation disclosure (see here). I noted that the SEC's decision to allow companies to disclose executive stock option awards over time, as they are exercised, made sense since that method of disclosure paralleled FAS 123R, the relevant accounting standard. However, I also said that Frank had a point, in that what many shareholders really want to know is when the board grants executive stock options (and how much), rather than how much they are costing the company each year as they become due.

Well, that was wrong. As Kevin Drawbaugh of Reuters reports (US SEC's Cox: no options hiding in exec pay rule), the new SEC rule does indeed change how public companies need to report the costs of stock options (i.e., as they options are exercised), but they still have to report option grants as they are issued, and in their entirety -- just in a different section on executive pay. I probably could have figured that out if I had actually read the SEC rule release all the way through, and parsed its extraordinarily boring language, and cross-referenced it with other SEC rules. But I didn't. Because it was boring. And I have a real job. (BTW, one of my homies was asking how I have time to do this and my real work. It's because I make these things up. If I had to actually get my facts down airtight, it would take me a long time and this wouldn't be nearly as much fun.)

So, wag of the finger to me. But while I'm at it, wag of the finger to the SEC, for writing such a deathly boring rule release and not accompanying it with a press release that highlighted, bolded, italicized, and included an XBRL-encoded .wav attachment that screamed at you that this new rule means companies now have to disclose all the information they used to, plus more!

More importantly, though, a Flip of the Bird goes out to Congressman Barney Frank. First, for making me wag my finger at myself. It's terribly bad ergonomics. But the Flip also goes for going off half-cocked like that. Don't you have anyone on your staff able and willing to read through these boring SEC rule releases? Maybe make a few phone calls on the ones they don't understand? I know House members get stuck with the dregs of Congressional staffers, but you would think with a new chairmanship you could at least hire someone who could make a few phone calls. But, no, instead Frank issues this press release and gets me (and apparently some shareholder activists) all confused. Since the Commission voted five to zero on this (and that includes two Democrats), you might want to see what's going on before getting all "very disappointed."

Or was it that you were offended that the SEC would do something like this without consulting you first? Hey, I know you've been itching a long time to get a position in Congress where you are actually relevant, but you shouldn't need that much hand-holding. Ok, ok, you're relevant and important! Now, with that little bit of affirmation out of the way, step back and get your facts straight before your next tirade. Because otherwise I'm going to have to go read all this crap, and I just don't have the time.

Monday, January 15, 2007

Hate to say I told you so, but...

BDO Stoy Hayward (the UK arm of accounting firm BDO International) is set to release a report saying that business fraud in the UK increased 40 percent in 2006. (See Fraud costs rise 40 per cent to record levels in 2006). Some of this is fraud at businesses, where companies are the victims. But others clearly involve financial fraud, with total costs to UK businesses this past year alone in the £5 billion (about $10 billion) range -- in other words, approximately the size of the Worldcom fraud.

In BDO's press release, Simon P. Bevan, the national head of BDO Stoy Hayward’s Fraud Services team, says:
“In 2007 I...expect to see problems from frauds hitting venture capitalists and corporate lenders. A lot of money has been lent over a short period of time to management teams for investment and acquisitions. Based on experience in the dotcom boom I have no doubt some business plans will have been deliberately over-optimistic, and property, including intellectual property, falsely valued. When the tide goes out you can see who is swimming without their trunks on. If interest rates continue to nudge up in 2007 under-performing but over-valued businesses will quickly be exposed.”
A related story by Paul Tharp of New York Post (who has apparently seen a pre-release copy of the report -- see Brits get bit) actually puts some of this blame on small American start-ups listing in London to avoid the tighter regulatory controls in the United States:

The report by accounting firm BDO Stoy Hayward stopped short of blaming the crime wave on the influx of tiny American startup companies and their entourages, who've fled the stricter U.S. stock exchanges in New York to London, where lately it's easier to list shares and get investors' cash.

By going public on the London Stock Exchange under its CEO, Clara Furse, or its sister London AIM (Alternative Investment Market), a startup company has fewer regulatory and auditing requirements than if they listed on a U.S. exchange - a fact that's aggravated the New York Stock Exchange and the Nasdaq, cost them listings and raised outcries here by leading politicians.


British market watchers believe that shrewd charlatans, whose financial tricks are well known to U.S. authorities, are having a field day in the laid-back London scene.

I particularly like that last part. But this is hardly surprising. As I've noted previously, the UK Financial Services Authority's risk-based approach to regulatory oversight means that the vast majority of the firms it regulates are categorized as "low-impact" and thus never inspected or looked at closely in any meaningful fashion. But, hey, you pays your money you takes your chances. When you've got a regulatory system that prides itself on its "lighter touch," you're essentially relying on the better angels of our nature to keep the financial markets clean.

And my guess is that will work as well for the UK capital market in 2007 as it did for Lincoln in 1861.

Wednesday, January 10, 2007

Global stock exchanges and the future of the SEC

The press reported today that the New York Stock Exchange has agreed to buy a significant portion of India's National Stock Exchange (see NYSE buys into Indian bourse, NYSE, Others Buy 20 Pct Stake in India's NSE Bourse). This, of course, follows on the planned merger of the NYSE with Euronext, and an agreement in the works for a link-up between the NYSE and the Tokyo Stock Exchange (Tokyo Exchange Is Close to NYSE Agreement, Japan Minister Says).

None of this is surprising, given the relatively recent demutualization of U.S. stock exchanges and their foreign brethren. Whereas once stock exchanges were owned by "members" who alone had the priviledge of trading on the exchange floor, demutualized stock exchanges are now public companies existing in not only a more globalized environment, but (more importantly) a more competitive environment, too. Not only do they face competition from foreign exchanges (i.e., all the hub-bub between New York and London), but also from upstart ECNs and ATS's -- new computer networks that match buyers and sellers away from the stock exchanges, and often faster and and lower prices.

But that raises an interesting issue, from a regulation perspective. When, in the past, stock exchanges had a certain public utility-like quality about them, there could be expected a certain degree of symbiosis between the exchanges and the regulators. The exchanges had a priviledged position that limited the competition, and, in return, the exchanges could be counted on to police their members in ways that regulators, with their limited resources, simply could not. Now, however, exchanges are losing their guild-like qualities. In the United States, this has led the NYSE and NASDAQ to formally shed their self-regulatory functions into a combined regulator. This will allow the exchanges to focus on business, rather than regulation, and eliminates some conflicts of interest. At the same time, it also heralds the end of this cosy regulatory relationship between the SEC and the exchanges.

But does this also herald a change in the SEC's mindset towards the exchanges? In the past, the European Commission, in particular, has accused the SEC of working as guardian of U.S. stock exchanges against foreign competition. This may or may not have been true, but if it was true, it might have been justified on the basis that the SEC relied on the exchanges so heavily to police the U.S. market. (All those fancy computers that notice strange trading patterns and lead to insider trading investigations belong to the exchanges, not the SEC. The SEC's own market monitoring room is basically two guys, a few Bloomberg terminals, and a hotline to the exchange floors.) Now, however, that reliance must change.

Will that change the SEC's own approach to foreign stock exchanges and foreign market participation? I think it will, one way or the other. And if not this year, than a few years down the road. U.S. stock exchanges and its financial industry might not be the world's most nimble, but it is by far the largest. That means it can bring to bear the biggest guns, and win through attrition, if nothing else. The SEC can also be a surprisingly nimble regulator, when it has to be (as when Congress passed the Sarbanes-Oxley Act). Finally, despite the recent gains by London, Hong Kong and other markets, the U.S. market is second-to-none for "quality" listings. For this reason alone many foreign government pension funds place a surprisingly large amount of their investments in the United States (which, incidentally, is what this letter to SEC Chairman Christopher Cox is all about.) Add this altogether, and the U.S. financial services industry is one of America's largest export industries, and the SEC won't kill the goose that lays the golden eggs. It will open up the U.S. market to foreign competition, if only as a way to push reciprocity abroad.

Sunday, January 07, 2007

What Europe needs is a more dirigiste stock market

Well, at least that's what Georges Ugeux seems to think. In his recent op-ed in the Financial Times (Exchange battles mask Europe's silence), Ugeux suggests that the European Commission is falling down on the job by allowing U.S. stock exchanges to buy up Euronext and the London Stock Exchange instead of (subsidizing? mandating? prohibiting the alternatives?) a true pan-European exchange to compete with the U.S. Ugeux asks, since the profits of the London Stock Exchange, Euronext, and Deutsche Börse are higher than NASDAQ or the New York Stock Exchange, why is the exchange merger impetus coming from the United States instead of Europe? He also asks why U.S. stock exchanges are trading at price/earnings ratios of 50:1 while European p/e ratios are closer to 20:1. All of which leads the this conclusion:

It is extraordinary that neither the European Commission nor Ecofin, the committee of European finance ministers, have encouraged the European exchanges to get together. Is it no matter to Europe that two of its largest equity markets will be owned by US stock exchanges? Would this not affect the internal market? Does the CME-CBOT merger not threaten the European derivatives market?


There is certainly a risk of US dominance on the regulatory front. The absence of consideration for the basic rules of international private law led to regulatory overreach beyond US borders. The Sarbanes-Oxley Act of 2002 extended its jurisdiction to non-US companies. It might happen again.

It happened before. In the 1950s, America’s interest-equalisation tax dried up the US foreign bond markets, which shifted from New York to London in the same way listings have been affected by SOX. The law changed, but the bond market never returned to New York. The European teams of the US investment banks years ago ceased promoting the US capital markets. They have used SEC Regulation S and Rule 144a to reach US institutional investors without registration with the Securities and Exchange Commission.

Will the efforts of Hank Paulson, the US Treasury secretary, convince the Congress in time to avoid a structural lack of competitiveness in the US capital markets?


The eurozone badly needs deeper and more fungible pools of liquidity if it wants to compete effectively with the US. That is why the silence of European authorities on what is in effect a fundamental policy issue is so loudly heard. Could this be a wake-up call?

Granted, I cut out some stuff in the middle, but if you read the article you can tell I didn't cut out much of substance. Which means either the FT did a hatchet job editing Ugeux's article, or he can't string together a coherent argument to save his life. (And that's putting aside his line about how the Sarbanes-Oxley Act violates basic rules of private international law. I don't see how a law violates these "rules" when it only effects issuers deliberately participating in a jurisdiction's market.)

First, if the Americans have screwed up their regulation so badly, why is Europe at risk of being dominated by U.S. exchanges and U.S. regulators? Second, don't you think there's a reason that U.S. exchanges trade at a substantial premium to their European competitors? Rather than "financing their own takeover," doesn't it seem more likely that European exchanges are trading so cheaply because investors believe they are poorly run or have comparatively low future prospects? And, third, if the Eurozone badly needs deeper and more fungible pools of liquidity, how is a EU-subsidized exchange going to create that liquidity? Liquidity is created by investors. Exchanges are just the platforms upon which the liquidity crystalizes. Even as U.S. exchanges seek merger partners, they are also facing new competitors as electronic communications networks (ECNs) and alternative trading systems (ATS's) spring up. If anything, this has seemed to increase liquidity on the U.S. market.

Ugeux's article only makes sense (and even here I'm being kind) if you believe that the government must play a central role in promoting and guiding capital markets, rather than acting as a policeman to make sure nobody cheats. And it's precisely that kind of dirigiste thinking that has Europe playing catch-up today.

Thursday, January 04, 2007

An SEC blueprint for mutual recognition?

The Harvard International Law Journal recently published an article by two members of the SEC’s Office of International Affairs which proposes that the SEC should adopt a “substituted compliance” approach to foreign stock exchanges and broker-dealers. (See A Blueprint for Cross-Border Access to United States Investors: A New International Framework.) The authors outline an approach under which the SEC would evaluate a foreign jurisdiction’s securities regulations and enforcement history and, if the regulations and enforcement philosophies are similar enough to those in the United States that investors are properly protected, the SEC would allow stock exchanges and stock brokers from that country to operate in the U.S. without having to fully register (and be regulated by) the SEC. If this proposal were to be adopted, it would signify a major change in how U.S. capital markets are regulated.

Currently, stock exchanges and broker-dealers wishing to offer their services to investors in the United States must register with the SEC and be subject to SEC oversight. American investors, of course, can invest in foreign securities that are not registered with the SEC. But U.S. brokers can’t suggest these securities to American investors, and foreign brokers can’t volunteer their services. To invest in non-registered foreign securities, American investors must first research the foreign securities on their own, and either ask their own broker or a foreign broker to conduct the transaction for them. Usually, this entails having to pay brokerage fees twice — once to the U.S. broker and again to the foreign broker who actually executes the trade. U.S. investors seeking out foreign brokers on their own will often find the brokers reluctant to conduct anything more than the most basic transactions for fear of falling under the SEC's watchful gaze.

According to the article's authors, this traditional approach protects investors, but at a cost. Yet, because other jurisdictions have adopted higher investor protection standards and American investors have shown an increasing appetite for foreign investment opportunities, Tafara and Peterson question whether the cost is always worth the benefit. Instead, they suggest that a new approach by which the SEC would coordinate with "like-minded" foreign jurisdictions would reduce transaction costs for investors, lower unnecessary regulatory barriers for foreign broker-dealers and exchanges, and increase competition in the financial services market, all while preserving critical investor protections.

The Tafara/Peterson proposal comes with some strings attached. First, the foreign government would have to have similar laws and “enforcement philosophies” as in the United States. Obviously, it’s open to interpretation about what that means. Areas mentioned in the article include:

… a comparability assessment of financial and non-financial statement disclosure requirements, the robustness of the accounting standards required in the jurisdiction, the adequacy of local auditing standards, and auditor oversight controls. It would also entail a comparability analysis of other issuer requirements designed to ensure that issuer disclosures are accurate and complete. Such requirements might include a comparison of the jurisdiction’s corporate governance, internal controls, director independence, and shareholder protection laws and regulations.
The foreign government would also have to sign an agreement with the SEC allowing for the exchange of enforcement and inspections information. And, of course, there would have to be full reciprocity — U.S. brokers and exchanges would have to be given similar access to investors in the foreign country.

The SEC would not cede all power under this arrangement. Foreign exchanges and broker-dealers would still be subject to U.S. anti-fraud laws — in particular, Rule 10b-5. However, the article seems to imply that only the federal government would have the power to enforce these anti-fraud provisions. Shareholder lawsuits would be limited to those permitted under the foreign country’s rules. (Currently, U.S. shareholders have an implied right of action under Rule 10b-5 — see here.) In addition, the foreign exchanges and brokers would have to make certain basic disclosures to the SEC, and, before engaging in any business, would have to provide U.S. investors with a warning that informs them that U.S. laws won’t apply to their transactions.

The Harvard ILJ has also published a series of comments on the Tafara/Peterson Blueprint, from Ontario Securities Commission vice-chair Susan Wolburgh Jenah (Commentary on “A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework”), Citigroup general counsel Edward F. Greene (Beyond Borders: Time To Tear Down the Barriers to Global Investing), TIAA-CREF’s general counsel George W. Madison and associate general counsel Stewart P. Greene (TIAA-CREF Response to “A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework”), and Harvard Law Professor Howell E. Jackson (A System of Selective Substitute Compliance). Wolburgh Jenah, Citigroup's Greene, and Jackson support the proposal. Greene calls the proposal “long overdue...Investing in non-U.S. markets is no longer the exclusive province of megainstitutions or the ultrawealthy; it is an essential component of prudent portfolio diversification for all investors.” Jackson agrees, and adds, “By temperament, academics like to think of themselves as being well in the forefront of government bureaucrats. But here I find myself in the uncomfortable posture of having to play catch-up with senior SEC staff who have advanced a far more ambitious program than my own.” However, TIAA-CREF’s Madison and Greene warn that the proposal is dangerous, since the SEC may come under intense political pressure to recognize a foreign jurisdiction’s rules as substantially the same as those in the U.S. when, in fact, they are not.

Interestingly, Professor Jackson, who, otherwise strongly supports the proposal, agrees that this is the most significant risk:

...there are good reasons why federal agencies do not like to get in the business of picking favorites among foreign governments. While it is possible to develop short blacklists of off-shore havens that clearly have substandard controls over money laundering and tax reporting, it is a more difficult task to distinguish between major jurisdictions, some of which will be valued political allies, on the basis of whether their regulatory controls are acceptable substitutes for U.S. oversight. Official government distinctions of this sort tend to generate reactions from the State Department and one can imagine the complexities that will arise when the first Turkish broker-dealer seeks an exemptive ruling while renegotiation of military basing rights are pending elsewhere in the government.
TIAA-CREF also raise other (somewhat strange) objections:

A key assumption of this new framework is the need for retail investors to have greater access to foreign investment opportunities. In order to deliver this greater market access, Tafara and Peterson propose measures that would lower the barriers to entry for these investors. Yet it can be argued that the lowering of these barriers may not be entirely in the interest of retail investors since these barriers can serve to protect them. Retail investors currently face high barriers, such as having to use foreign broker affiliates and facing multiple layers of fees, that make direct investment abroad difficult, although not impossible. In dealing with these barriers, the retail investor is well aware that they are going into foreign markets and leaving behind the protection of the SEC regulatory framework.
I take it this means TIAA-CREF believes that it’s good that US investors have to pay a lot more to buy foreign securities, because that keeps them from doing something stupid with their money. I’m not sure that’s in the spirit of U.S. securities laws, but, hey, the TIAA-CREF folks are professional investors, not stupid money like you or me. (Though in the following few sentences, Madison and Greene acknowledge that TIAA-CREF itself doesn't face these higher transaction costs, since it has obtained exemptions that allow it to deal directly with foreign exchanges and brokers without the exchanges or brokers having to fear violating U.S. law.)

At the end of the day, it's not at all clear how widely supported these ideas are within the SEC. While it is true that SEC Chairman Christopher Cox (see speech here) and SEC Commissioners Paul Atkins (see here) and Roel Campos (see here) have all spoken in favor of various aspects of “substituted compliance,” its seems likely that such a radical departure from current SEC policy will be an uphill battle. Nonetheless, if this proposal does gain traction, one wonders what effect it may have on other markets. Does this increase, or decrease, the value of the NYSE-Euronext merger? Will it add pressure on the London Stock Exchange to merge with NASDAQ? And, perhaps more long-term, since the “substituted compliance” framework means the foreign jurisdiction must have a regulatory approach similar to that in the United States, does this mean that Sarbanes-Oxley will end up being a major U.S. export? Or, conversely, if the foreign rules must be similar (but not identical) to the U.S. approach, will this create future pressures on the SEC to scale back its regulation if U.S. investors seem to prefer a foreign approach?

Wednesday, January 03, 2007

Nice way to ring out the old and bring in the new

You know how all this past year the British, the Committee on Capital Markets Regulation, New York Mayor Michael Bloomberg and U.S. Senator Charles Schumer, and the accounting industry have all been talking about the demise of the U.S. capital market and its usurpation by the London Stock Exchange? Well, apparently news of the U.S. demise has been slightly exaggerated...

Last week, the Financial Times reported on U.S. companies have raised the most money through IPOs since 2000, just before the tech bubble burst. (See US deals reach six-year record IPOs). At the same time, U.S. stocks enjoyed best perfomance since 2003. While Hong Kong beat out both London and New York in terms of actual capital raised through IPOs, U.S. companies as a group beat out all but the Chinese in terms of capital-raising. (The monster IPOs of ICBC and Bank of China put China firmly in top place).

Not bad for a has-been, over-regulated market.