My Daily Fatwa

The political push against private equity

2007-10-03T14:42:00.001-05:00

Private equity has taken a bit of a back seat recently to the subprime mess, but an article in the Financial Times today (see "Capital markets face shift to opaque investors") shows that the issue is hardly forgotten. As the hidden assumptions and unquoted opinions in the FT piece show, much of the concern about private equity is not coming from the United States (this time), but from Europe. And, surprisingly, some of the most concerned are not the locust-basing Germans, but the British.

In the US, of course, private equity is also an issue -- albeit for different reasons. US Senators Byron Dorgan (D - North Dakota) and Tim Johnson (D - South Dakota) have asked the General Accounting Office to study the issue of private equity, particularly as it relates to the safety and soundness of the US financial system. European regulators have similar concerns, but, in addition, they have other more "societal" issues. These include concerns that private equity investors do not provide sufficient information to corporate "stakeholders" -- particularly labor unions and government regulators. Citing a new study by a management consulting firm, Joanna Chung's article in the FT highlights these issues by focusing on how "regulators" now have less information about their markets because private equity firms are "opaque":

Global financial markets face a permanent shift in power from traditional money managers to opaque groups such as petro-dollar investors, Asian central banks, hedge funds and private equity groups, according to a study out Thursday.

These power brokers had amassed $8,400bn in assets by the end of 2006, three times what they held in 2000 when they were “little more than fringe players” in the capital markets... . Their holdings now represent 5 per cent of the world’s $167,000bn of financial assets. If current trends continue, they could control assets worth $20,700bn, or nearly three-quarters of the size of global pension funds, by 2012.

However, the study says the four investor groups often lack transparency and are out of the reach of regulators.

“It is true that there is not the kind of light shed on some of these activities in the way we are used to,” said Diana Farrell, director of MGI and one of the authors of the report. “The Anglo-Saxon model of capitalism will be challenged. We need to evolve in terms of regulatory oversight.”

Not stated in the article, however, is the considerable (though subtle) divide that exists between the United States and Europe on the issue of "investor transparency." In the United States, "transparency" is a matter for issuers and financial firms -- a tool to protect investors. Investor disclosure generally only comes into play where a takeover is involved or where an "insider" is purchasing or selling securities. Neither of these issues depend on whether the investor is a regulated investment bank or a private equity firm. In short, US market regulation largely doesn't care about "investor transparency".

In the UK, on the other hand, things are quite different. The United Kingdom's "light touch" oversight, in many ways, works at all because there is an underlying monopsony of large investment firms. These firms, with deep roots in the City of London, act as the primary UK market police. They mandate corporate codes of conduct, punish boards of directors by having the (rarely used) power to vote off recalcitrant board members, and, generally speaking, act like a good old fashioned guild.

Add private equity firms into this City mix, and suddenly the guild system is in danger. Private equity firms are numerous, have different values, with members who didn't all go to the same schools. A lot are not British at all. Suddenly, a market that prides itself on its "light touch" oversight is calling for greater regulation of these outsiders. We shouldn't be surprised.

All of this serves as an interesting case study in how politics and regulation intersect. Over the past year or so, there has been a lot of discussion about the philosophical differences between regulation in the United States and the UK, with the UK often portrayed as more flexible and far less heavy-handed. But the reality is that regulation in the United States and the United Kingdom (and pretty much everywhere else) is designed to benefit a domestic constituency. In the United States, for historical reasons, there are two (often conflicting) constituencies -- issuers and retail investors. Hence, strong shareholder litigation rights, a strong SEC enforcement regime, and almost no other shareholder rights or constraints on management. Contrary to popular opinion, New York's financial industry is not a major political constituency.

In the UK, by contrast, the City's financial industry is a major political power, while retail investors and issuers (comparatively speaking) are not. This latter point may seem odd when you consider that the London Stock Exchange and the UK Financial Services Authority advertises the UK as a "Sarbanes-Oxley-free zone". But, while UK-based issuers do not have to deal with SOX, they do have to deal with a host of other, frankly more nettlesome, regulations regarding labor, advertising, environmental and consumer protection, etc. At the same time, the LSE's SOX-free zone isn't designed to benefit issuers -- at least primarily. By offering London as a low-oversight market, the City attracts foreign issuers, which means money for London's financial firms. Since sophisticated investors in the UK (or in the US, for that matter) do not rely primarily on the regulator for protection from dishonest issuers, potentially greater fraud in the UK retail market is but a small price to pay for the extra fees these firms can draw by attracting foreign issuers.

In other words, there is no "Anglo-Saxon" model of capitalism to be challenged, at least in the financial realm.

All of that said, Chung's article does touch on a separate issue of concern in the United States -- sovereign wealth funds. These foreign government-owned funds do present transparency (and trade, and strategic) issues for the US government. But these concerns are quite different from the purportively non-transparent investor concerns otherwise highlighted in the article.

Avoiding the "lapdog" label

2007-09-03T21:24:00.000-05:00

The UK media roundly criticized former Prime Minister Tony Blair for his close association with US President George W. Bush's invasion of Iraq, frequently labeling him a "lapdog." The term has become so devastating that UK politicians will go out of their way to avoid the ruinous epithet. But there is a greater danger to Great Britain today than just a particular alliance with Bush's failed policies, and that is the general risk of allowing your government to be a lapdog to short-term economic interests.

This isn't a risk peculiar to the British, of course. Indeed, it's a general risk for all governments. For some governments, it is the normal course of doing business. However, it wasn't always the case for the UK. Nonetheless, recently the United Kingdom seems to be creating the appearance of subsuming their national interest to short-term economic gain. This came to my mind today when it was announced that British prosecutors were dropping charges against two prostitutes who allegedly (and by "allegedly" I mean "most probably") were beaten to a pulp by the son of Libya's intelligence chief. (See Call girls drop charges against Gadhafi's kin)

I'm not blaming the prosecutors in the case. They can only do so much when the chief witnesses withdraw their complaint. And, of course, this wouldn't be the first case of witness intimidation. However, it does seem strange that the UK police and intelligence services would permit Mohammed al-Sanussi to be in London without being subject to constant surveillance -- or that Libyan intelligence operatives could surrepticiously videotape the two prostitutes in question without themselves being under MI5 surveillance. In other words, it's one thing if you have some neighborhood thug able to intimidate witnesses in some run-of-the-mill criminal case. But having Libyan intelligence do it in your own backyard shows something is wrong. Could they be pussyfooting around the Libyans for fear of botching business negotiations?

If this were a one-off situation, that would be one thing. But coming on the heals of the Alexander Litvinenko assassination and the BAe-Saudi bribery scandal, it's a bit too much.

And another thing...

2007-08-31T20:20:00.000-05:00

I want to continue my rant on the New York Times' recent article about how the subprime mess has led some in the "international community" to call for more input into US financial regulation. (See my screed here and the NYT article here.)

Clearly, greater international regulatory cooperation can be a great boon. However, the arguments posited by Peter Bofinger and Professor Dick Bryan in Heather Timmons' and Katrin Bennhold's article are not among the reasons we need this cooperation. International regulatory cooperation exists for two purposes -- so bad guys can't use the international system to undermine national sovereignty (quite the opposite of what Bofinger is suggesting) by permitting regulatory arbitrage; and, second, so the world's regulators don't step on each others' feet so much, to the detriment of global markets.

I'm harping on this point because these academicians really should know better. For example, the article notes:

Their argument is simple: The United States is exporting financial products, but
losses to investors in other countries suggest that American regulators are not properly monitoring the products or alerting investors to the risks. “We need an international approach, and the United States needs to be part of it,” said
Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.
While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.
“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

Rather than an argument that the US regulators are asleep on the job, isn't this an argument that the European regulators aren't monitoring the risk management practices of their own firms? Were these firms really snookered into believing that the subprime mortgage securities were safer than they are -- particularly when anyone with half a bucket of sense could tell you otherwise?

Likewise, it is certainly true that US regulators have not been keen on engaging foreign governments in determining what US financial regulations should be. Indeed, I suspect that if the US public knew anyone in the United States was even considering it, they would be hanged from the nearest lamp post (which may explain why Basel II is as complicated as it is -- US banking regulators, after all, have such skinny necks). All of that said, I fail to see why US financial regulators would particularly care if foreign investors, in particular, stopped investing in any specific US security. Regulators might care if investors, writ large, started having a problem, but there is nothing magical about foreign investors.

And this, fundamentally, is why these academics' arguments fail. The Fed, the SEC and most other US financial regulators draw no distinctions between US and foreign investors. This is the strength of the US system and why the United States is able to import capital so cheaply, regardless of how many boneheaded statements Congressional leaders might make about foreign capital. What's good for foreign investors is good for American investors, and vice versa. US regulators are unlikely to take advice from foreign regulators who historically have a problem with attracting even domestic investors to their own market.

NYT: World wants a say in US financial regulation

2007-08-30T20:50:00.000-05:00

Yesterday, the New York Times had an article on the subprime mess quoting a number of foreign talking heads demanding more international input into US financial regulation. (See Calls Grow for Foreigners to Have a Say on U.S. Market Rules.)

Yeah, what's new? Actually, that should be the title of the article. What I found most amusing, of course, is the arguments put forward about why there needs to be more of an "international" approach -- whatever that means.

“We need an international approach, and the United States needs to be part of it,” said Peter Bofinger, a member of the German government’s economics advisory board and a professor at the University of Würzburg.

While regulators in the United States have not been receptive to the idea in the past, analysts said that Europe and Asia had more leverage now. Washington might have to yield if it wants to succeed in imposing bilateral regulations on government-owned investment funds from emerging economies.

“America depends on the rest of the world to finance its debt,” Mr. Bofinger said. “If our institutions stopped buying their financial products, it would hurt.”

I believe logicians call that the "we're your customers, therefore we should have a say into how you run things" argument. I suggest you try it with your cell phone carrier some time -- it really does work.

(As for the "we're going to stop buying your products" thought, Mr. Bofinger, you'll stop buying when we stop being so damn profitable, and not a day before--or a day later, for that matter. Do I have to explain everything to you European government types?)

Granted, I expect that kind of thinking from European academicians. (Do you ever stop and wonder what happened between Rene Descartes and today? I mean, seriously. The Europeans actually invented deductive reasoning, and today we get this?) However, the Aussies are in on it, too.

As geographical boundaries are broken down, “a problem in one location is a problem everywhere,” said Dick Bryan, a professor of economics at the University of Sydney.

“There is the need to challenge the sovereignty of national regulators,” he said. “Why should the rules of lending in the U.S. be left to U.S. regulators when the consequences go everywhere?”

There's your problem, Professor Bryan. You are following the lending rules of the United States because you are actually lending in the United States. If you were lending in Australia, the rules might be different. If you don't like it, stop lending to damn ferriners. (Oh, I guess I don't mean you, personally. I mean Australian financial institutions, who, as we all know, are demanding significantly more regulation in the United States...)

Please, everyone. The old saying is don't confuse brains with a bull market. On the flip side, don't confuse conspiracy with a bear market.

You investors and borrowers out there want to know who's to blame for the subprime mess? Look in the mirror.

Bernanke's competence on subprime crisis brought into question

2007-08-21T14:55:00.000-05:00

After all, nothing will bring into question your competence on an issue than for Sen. Chris Dodd (D-Conn.) to say you "get it." (See Fed ‘Gets It’ on Mortgage Crisis, Senator Dodd Says.)

I'm all for addressing liquidity crises, but there is a very fine line right now between holding off a wider, preventable systemic crisis, and repeating the Fed's past mistakes regarding moral hazards and banking bailouts. (Which, in my opinion, include pretty much every Fed banking crisis intervention in the past.)

Just as an example, has there ever been a more blatant case of begging for corporate welfare than Jim Cramer's beserk attack on Bernanke two weeks ago? (Watch here or here if you're interested).

"Bernanke is being an academic!... [William Poole, St. Louis Fed President] has no idea what its like out there--None! They know nothing! The Fed is asleep! My people have been in this game for 25 years ! They are losing their jobs and these firms are going out business!... This is a different kinda market!"

First, never trust anyone who says this is a different kind of market. For 400 years, it's been the same kind of market.

Second, why should we care if you are losing your jobs over your poor investment decisions? (Some people, particularly those betting against you, have been making a lot of money.)

I could be wrong, but given Congress' involvement in previous market-related matters, I can't help but suspect that Chris Dodd is just a slightly more calm version of Jim Cramer (particularly given the number of hedge funds operating out of Connecticut).

Why the Heritage Foundation is getting its butt kicked by Cato

2007-08-17T01:50:00.000-05:00

You don't have to go much farther to understand the ideological break up of the Republican Party than the Heritage Foundation's support for an internal US passport. See Federal ID plan raises privacy concerns. Cato, on the other hand, is right: a national ID card is more about illegal immigration than national security.

And Mr. "Shared Responsibility" Chertoff should be credited for being able to say without smirking that he's part of a Republican administration and that: "This is not a mandate," Chertoff said. "A state doesn't have to do this, but if the state doesn't have -- at the end of the day, at the end of the deadline -- Real ID-compliant licenses then the state cannot expect that those licenses will be accepted for federal purposes." Which, of course, means that those of you living in those 20+ states opposed to this plan will either have to suck it up or start using your US passport to board planes, trains and buses.

Chertoff, of course, assures us that our privacy is guaranteed and that the government would never abuse this information. In other words, he's from the government and he's here to help. (Makes you wonder what Reagan would think of his party these days...)

So I guess this means that if I'm in favor of small government and opposed to unfunded mandates, I'm a Democrat?

Roel Campos to leave SEC

2007-08-09T22:51:00.000-05:00

Democratic Commissioner Roel Campos announced today that he will be leaving the Securities and Exchange Commission by the end of September. The media is making a big deal out of the fact that Campos is the SEC's first Hispanic commissioner and a Democrat in a highly divided Commission. However, Campos is also the "international" commissioner--he represents the SEC before a number of international organizations and is currently the Vice Chairman (and prospective chairman) of the developed markets committee of the International Organization of Securities Commissions. With Campos leaving, SEC Chairman Cox will have to nominate someone new to represent the SEC before the world--though, given Cox's own interest in international matters, I wouldn't be surprised if he takes up this job himself. If he does, we can expect a new emphasis placed on IFRS-US GAAP convergence and mutual recognition.

The conspiracy theorist in me expects Paul Atkins to leave soon as well, in a quid pro quo that will reduce the SEC to three commissioners. The Financial Times has reported that Atkins may be heading over to the Commodity Futures Trading Commission. Even if he does not, his term ends in a year and he may be interested in more remunerative work even before then. As it stands, the 5-member Commission will soon be down to 4 members, only one of whom is a Democrat at precisely the time that some very important decisions are coming due and an upcoming election season.

If Atkins leaves for the CFTC, I expect Bush will leave the SEC with three commissioners for the remainder of his term. This is because, despite all the talk about a shift in the balance of power, the current Commission is ideologically dysfunctional. Previous SEC chairmen (particularly Arthur Levitt) ran the SEC as a corporate chairman--i.e., largely by fiat, with the four other commissioners more or less falling in line. However, starting with Harvey Pitt and his battles with fellow intellectual heavy-weight Harvey Goldschmid, individual commissioners started having their own ideas and pursuing their own political agendas. The media story on current SEC chairman Cox's predecessor, William Donaldson, was that he "sided" with the Democrats and chaired a fractious Commission. However, the same fractures are starting to appear with Cox as well. And the source of these cleavages? Atkins.

Atkins, in particular, is a thorn in any Republican SEC chairman's side, basically because he has yet to see a securities regulation he likes. He is an ardent deregulator, and such views can be particularly unhelpful to more "responsible" (i.e., vulnerable) Republicans during an election season. Cox is no investor-hugging hippie, but he does recognize that an SEC that appears to be in the pocket of industry is not something good for his party. (Hence his vote with the Democrats to petition the Solicitor General to file an amicus brief on behalf of the investors in the Stoneridge case.) Atkins, on the other hand, would rather be ideologically pure than in power. Furthermore, he has a tendency to get the other Republican commissioner (whoever that might be) to get onboard with him.

Reducing the Commission to three members might, then, help Cox pursue his own (and his party's) wider agenda. Under a 2-1 Commission, Cox likely could count on support from his remaining fellow Republican commission Kathleen Casey, and Democrat Annette Nazareth likely would go along to get along.

A nice, quiet SEC for the remainder of George W.'s term. What's not to like?

China's "Nuclear" Currency Option

2007-08-08T00:53:00.000-05:00

The London Telegraph is reporting that the Chinese government is threatening a massive sell-off of the $1.3 trillion-worth of US dollars it holds if the US Congress passes trade sanctions as a result of China's policy of undervaluing its currency. (See China threatens 'nuclear option' of dollar sales.) What's worse, the Telegraph breathlessly reports this as a threat.

OK, I'm a bit lost here. The US accuses China of hoarding dollars as a way to keep the Chinese yuan artificially low, thereby making Chinese products artificially cheap and flooding the US market with Chinese imports. To protect US consumers from having to pay so little money for these products, Congress is threatening to slap trade sanctions on China if it doesn't stop these currency policies. In response, the Chinese goverment basically says, "Oh, yeah? Well, if you slap sanctions on our companies, you know all those dollars you paid us for everything you buy at Walmart? Well, we're going to give them away for free! That'll show you!"

How am I not exaggerating? The US says stop keeping your currency low or we'll hit you with sanctions, and the Chinese say, if that's how your going to be, then we're going to stop keeping our currency so low! Is that a threat? A negotiating tactic? Who are these people?

The Telegraph goes on to suggest that a massive sell-off of Chinese-held US government debt could "...cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession." Granted, a firesale of US bonds might cause a spike in US bond yields (and an excellent investment opportunity for the rest of us), but even if that caused a recession, which products are these newly impoverished American consumers most likely to forgo most quickly? You think it might be all those Chinese products that suddenly doubled in price?

And all those poor American consumers, suddenly seeing their property values drop. Do you think they might be able recoup some of the loss with a better-paying job at a US exporter? You know, maybe a company like Boeing, since the prices foreigners have to pay for a new Dreamliner just dropped dramatically with a devalued dollar?

All I'm saying is that I wish these Chinese negotiators would come over to my place sometime for a night of poker. I could use the cash...particularly with a recession coming up.

Foreign Policy: Five things my economist told me that I'm too dumb to understand

2007-08-05T01:52:00.000-05:00

The web issue of Foreign Policy Magazine (which Kids Prefer Cheese calls the People's Magazine of international affairs) has an article called "Five Lies My Economist Told Me". I don't know why some people say ostensibly respectable journals can let their editorial standards go to hell where an Internet edition is involved. In this case, Foreign Policy hits it on the nose. Speakin' the truth, brotha! For example:

1. High productivity and low unemployment make us all better off: Despite six years of sustained growth, with unemployment averaging around 5 percent, the median U.S. worker is not faring well. Since 2001, middle-class Americans have seen their pay drop by 4 percent, although labor productivity went up by 15 percent during the same period.

Now we know this is a lie! It's low productivity and high unemployment that's the secret to success! Bring back stagflation and 10 percent unemployement. Middle class incomes are sure to rise then. And while you're at it, we need to get rid of Tivo. I don't know about you, but my middle class life hasn't improved one wit by fast-forwarding through 40 minutes of TV ads every day. After all, if it's not salary, I don't care.

2. It’s hard to grow without good banks and private property: One word: China. The gross domestic product of this Asian giant has increased sixfold between 1984 and 2004, with a stunning average growth of roughly 9 percent since 2005. Yet only in 2007 did the protection of private property acquire equal footing in Chinese property law. Moreover, experts still deem China’s banking system to be shaky despite a major overhaul that started in 2002.

Good banks and private property are a lie! It's easy to grow if you don't have banks or private property! Which, of course, is why Mao's China was going gangbusters. In fact, China would be growing much faster now that it was in the past if they had just stuck to Mao's glorious policies. After all, why do you need a bank if you don't own any property? Clearly, economic growth has never been linked to a strong financial system or some kind of assurance that you aren't going to be robbed. And any economist who tells you otherwise is just lying to you.

3. Capital must always be let free to flow: The Asian financial crisis. Starting in 1996, overvalued real estate prices collapsed in Thailand, spurring a devaluation of the Thai currency. Soon enough, the contagion spread to nearby Malaysia, Indonesia, and South Korea. Capital flight triggered painful recessions in most of East Asia. Only China and Taiwan, which had maintained tight capital controls, weathered the crisis unscathed. Malaysia split the difference by introducing capital controls in 1998, a last-minute attempt to avoid the worst.

This is completely a lie! After all, if you keep capital out of your economy, clearly it won't flee when the corrupt underpinnings of your market become apparent. Which, of course, is why Zimbabwe is an economic powerhouse, and Western markets, which got rid of their capital controls in the late 1970s, have been in the economic shitter ever since.

4. The euro will never work: In January 2002, the euro made its entrance on the world stage and into the wallets of the citizens of 13 European countries. Five years later, it is still alive and healthy—stronger than the U.S. dollar, in fact. And despite grumbling from countries like Italy, where policymakers wish they could still boost exports by devaluing the old lira, nobody is seriously considering going back to single national currencies.

That's right, you liars! The Euro is stronger than the US dollar! And the only people complaining about the Euro are little whiners like the Italians and all the lower-wage EU markets getting burned by the strong Euro. Because, you know, a strong currency is a sign of economic strength. Just ask the Chinese, and their pathetically devalued Yuan. Not an economic growth sign in sight there. (By the way, why does the FP then go on to say that the critics are right and the Euro is essentially just a political tool divorced from economics? Why back down when you've got such a compelling argument?)

5. Japan—no wait, China—is going to take over the world economy: As of 2007, the United States is still the greatest capitalist economy in the world, with a gross domestic product roughly three times as big as that of Japan, the world’s second largest economy. True, Japan’s car industry is still a rising star: Toyota briefly overtook General Motors a few months ago as the world’s largest automaker. Yet, as Newsweek columnist Fareed Zakaria put it, the Japanese “ran into a brick wall.” After more than 15 years of economic stagnation, repeated currency deflations, and record-high unemployment, the Japanese economy is just now coming out of the doldrums.

Again with the lies! All those lies in the late 1980s by such reknown economists as Clyde Prestowitz, Chalmers Johnson and Robert Reich. OK, so maybe they weren't "economists" in the U.S.-sense of the word. And by that I mean they didn't know anything about economics. And by that, I mean that Paul Krugman, who actually is an economist and knows something about industrial policy, calls them a bunch of policy poseurs (he's such an asshole like that). But somebody once said "economics" and "the Japanese and Chinese are going to crush us" in the same sentence, and if that's good enough for Foreign Policy, it's good enough for me.

Sub-prime credit rating agencies

2007-08-04T16:09:00.000-05:00

Sean Egan, head of boutique rating agency Egan-Jones and co-founder of some lobbying group designed to get his firm recognized by the SEC as a Nationally Recognized Statistical Rating Organization ("NRSROs" as they are known to their friends) wrote an op-ed in last Thursday's Financial Times (see Sobering lessons of the Bear Stearns losses). Given Egan's previous writings to the SEC and other groups, the FT piece is actually pretty good. Which means, of course, that I doubt he really wrote it. (Must have hired a new PR firm recently.) Egan correctly points out that the Basel II accord has basically made the role of credit rating agencies (CRAs) more important than ever, even as recent structured finance deals and the all-to-predictable sub-prime fiasco call into question whether these CRAs really can be trusted to properly rate the component parts that go into a structured finance deal or a collateralized debt obligation (CDO).

Structured financing and CDOs have become an important part of our economy. In "finance for dummies" terms, these are complex arrangements that let banks or others lend money, and then sell off the IOUs from those debts to other investors. Groups of these IOUs are broken into "tranches" according to the risk that the borrowers will default, and then bits of those tranches are sold off as securities. The idea is that the lender can diffuse its risk among a wide range of investors, each with a different risk preference. You want to invest in rock-solid debt? Then you buy securities from the AAA tranche. You want to take your chances, buy low with a very high chance you'll get nothing, but a chance that you'll make a killing? Then you buy into the "junk" (or sub-prime) tranche. You're an idiot and don't want to get paid back at all? I've got securities in the M.D. Fatwa tranche right here!

In an ideal world, this system is great and, according to some economists, is the reason that the last two recessions in the United States were as painless as they were. (You think they weren't? Then you are a punk and obviously can't remember the early 1980s.)

However, in the latest go around, Egan notes:

Investors in two hedge funds managed by US investment bank Bear Stearns were wiped out in June, which was surprising given that the securities in the funds were rated either AAA - the same level of safety as US Treasury bonds - or one notch lower at AA. Within a couple of months, $1.5bn of capital was lost in only two funds. This development is particularly sobering because, from the obvious indicators, the two funds were insubstantially better financial condition than most banks: they had equitymore than twice that of most banks, at 15 per cent of assets compared with only 6 per cent or 7 per cent for the majority of banks. These funds therefore met and exceeded the requirements of debt-to-equity ratios under Basel II. Additionally, the assets of the funds were rated higher than the typical bank's assets.

This event is a reminder of the weak underpinnings of the mortgage financing market. The problem is a shift in the mortgage business to a situation where all the participants have an incentive to complete the transactions; the mortgage brokers, bankers, investment banks and rating firms are paid if and only if a deal is completed.

This structure is significantly different from the markets of yore, in which a local banker would check borrowers' income and grant a loan only if there was an adequate ability to pay. Even if the banker became too aggressive, there were bank regulators to keep the business on the straight and narrow. One could argue that rating firms today are capable of assessing credit quality and halting the flow of garbage by withholding a rating. Unfortunately, in the ratings field, the tough rater is likely to be the underemployed rater. One of the major rating firms, Moody's, announced last week that it lost market share when it became less liberal than its
competitors.

Egan's point about Moody's is very good. Moody's recently noted that ever since it toughened up its standards for reviewing commercial mortgage bonds, it has been shut out of 70 percent of this market. (See Moody's Shut Out of Rating Commercial Mortgage Bonds.) Moody's is one of the biggest CRAs and if it is being ratings-shopped, it's not hard to imagine that CRAs may be becoming subject to the same types of pressures that undermined securities analysts a few years ago.

However, as cogent an argument as Egan makes, he actually undermines his point (and his own firm) in his op-ed. In particular, as Egan has consistently noted, the big CRAs are all paid by the issuers they rate. A clear conflict of interest. The big guys argue that if they didn't charge issuers, then no one would pay them since email and fax machines mean that once they issue a rating to even one person, news of that rating travels fast (and the more respected their ratings, the faster the news travels). However, Egan-Jones and other small CRAs are paid by subscribers and investors, and not by the issuers they rate. No conflict of interest, right?

But then Egan writes:

...regulators must pay better attention to incentives. If a rating firm receives 90 per cent of its compensation for ratings from sellers of securities, it is difficult to envision that the interests of investors are paramount. This issue of incentives is all the more pressing given the great difference ratings make to a bank's capitalisation requirements. Under the Basel II accords, $100 of AAA securitised assets requires a bank to hold 56 cents of equity to back up the debt. However, if the bank or fund holds $100 of BBB assets, it has to hold $4.80 of equity - a far more onerous proposition. (Last week Standard & Poor's cut the ratings of several securities from AAA to BBB in one day.) This greater burden of holding lower-rated assets increases pressure on ratings firms, which depend on issuers of debt for business.

Wait a minute. Sure, I get your first point -- if a CRA receives 90% of its revenue from issuers (sellers) of securities, it's hard to see how the CRA will make the interests of the investors (buyers) of these securities paramount. But then you say that, under Basel II, the greater burden investors face in holding lower-rated assets increases pressure of the CRAs to up the ratings. But aren't the banks getting screwed by a lower rating the investors you were just talking about? So who's putting the pressure on the CRAs? Sure, I can see an issuer not wanting a low rating on a debt offering, but once that debt is out there, the pressure will be coming from the banks and investors. And aren't those guys the ones paying your bills, Mr. Egan?

So who's conflicted here?

99 percent of Chinese exports safe

2007-08-02T11:55:00.000-05:00

This according to Chinese Commerce Minister Bo Xilai, as reported in the FT. This makes some sense, when you keep in mind that 1 percent of all Chinese exports these days are for the new Mattel Swishy Switchblade (TM) Vodka Bottle Opener and Child Home Defense Kit (now with more lead flavor!) What can I say. It's not China's fault that kids thing this is the hottest thing since the Bat Masterson Derringer Belt Gun.

Risk, of course, is such a fun topic. Basically, Minister Bo is reassuring us that 99 out of every 100 Chinese products we have in our house or that we use are safe. Personally, I'm completely reassured. After all, it's not like we use a lot of Chinese-made goods every day, is it?

The Clinton Service Academy

2007-07-30T01:19:00.001-05:00

OK, I hate Hillary as much as the next guy, which means I fully expect her to win the next election. But her new proposal to have a national service academy for public servants is one of the most boneheaded idea in an election season full of boneheaded ideas. (See Clinton: Create Public Service Academy). Does the United States really need a École Nationale d'Administration? After all, that's proven such a font of ingenuity for all things French and bureaucratic. And, besides, don't we already have Georgetown University?

The UK FSA lapdogs

2007-07-29T17:30:00.000-05:00

I know it's been a while since I bitched about the UK Financial Services Authority, but last Monday the Wall Street Journal (of all places!) published an article by Alistair MacDonald titled Assessing U.K. Watchdog -- FSA's Regulatory Model Gets Some Raves in U.S.; A Lapdog at Home? Of course, you have to have a subscription to the WSJ to read it -- a silly policy that's contributing to why Rupert Murdoch is going to buy out their asses and fire a quarter of the staff. Nonetheless, for a newspaper committed to a "principles-based" approach to financial regulation, I found the article both fun and interesting.

The WSJ article describes the FSA as a toothless "lapdog," barely regulating and never enforcing even the rules it has. (You can really get the British goat by calling something a "lapdog" these days. Ah, the effects of Murdoch already...) The WSJ draws on some recent research by Howell Jackson, a Harvard Law School professor currently studying how different countries regulate their securities markets. (One of Jackson's recent preliminary papers on this topic can be read here.) Jackson's research, along with a recent paper by Columbia Law School professor John Coffee (which can be read here), show that the degree of enforcement of securities regulations in the United States is qualitatively different from other countries. When compared to the UK FSA, this is particularly apparent. The US spends considerably more on securities regulation than does the UK, even when accounting for market and economic size. But the area that really stands out is enforcement. Between 2002 and 2004, on average, the US Securities and Exchange Commission took 639 enforcement actions, and levied $2.1 billion in fines. By contrast, the UK FSA took 72 enforcement actions per year, and on average levied $27 million in fines.

And this actually understates the differences, since the FSA combines within it many of the regulatory functions that in the US are divided among the SEC, the self-regulatory organizations (such as the National Association of Securities Dealers), and some state regulators. When all of those are added together, the US brought 2,985 enforcement cases and levied $5.3 billion in fines. Even this, however, understates enforcement activity in the US since, as Coffee shows, US private enforcement activity (i.e., securities class action suits) levies the equivalent of another $2 - $9.7 billion per year.

What this all means is that if you misbehave in the United States, you can expect to be slapped with a market-adjusted fine that is 10 times greater than similar activity might fetch you in the UK. And that's not counting the private lawsuits, which are very rare in the UK. Or the criminal penalties. Did I mention the criminal penalties? Oh, yeah -- Coffee notes that between 1978 and 2004, joint SEC-Department of Justice investigations led to criminal indictments of 755 individuals and 40 companies for various kinds of severe market shenanigans. The indictments led to 1230.7 years of incarceration (or 4.2 years in the hoosegow on average). In the UK, criminal indictments for securities law violations are very rare, and convictions as rare as hens' teeth.

Your chances of getting busted in the US are also much higher, not least because the US devotes considerably more resources towards investigating infractions. Coffee notes that 40 percent of the SEC staff are part of the Division of Enforcement, while only 12 percent of the UK FSA is in enforcement -- and this group splits it time between policing the securities, insurance and banking sectors.

None of this necessarily means anything, of course. It's possible that the US devotes so much of its regulatory resources to enforcement because its market is plagued by crooks. It's also possible that you can over-enforce -- an argument that Coffee also makes, particularly with regard to private lawsuits. In other words, a scourge of scorpions may not be the best thing for market efficiency. However, another recent study -- this by the team of Craig Doidge, George Karolyi, and René Stulz argues that the stronger investor protections and enforcement system in the US provides a markedly lower cost of capital for foreign issuers listing on a US exchange. (See "Has New York Become Less Competitive in Global Markets? Evaluating Foreign Listing Choices over Time" (July 2007)). Doidge, Karolyi and Stulz also show that this US listing premium has not diminished since passage of the Sarbanes-Oxley Act. So take that, all you SOX haters out there. Yeah, I'm talking about you, Bainbridge. You too, Ribstein.

And while I'm at it, you too, Paulson Committee and Chuck Schumer and Michael Bloomberg. One of the interesting points in the Doidge, Karolyi and Stulz paper is that, when you look at the types of foreign companies that have listed with NASDAQ and the New York Stock Exchange in the past, there hasn't actually been a drop-off in IPOs in New York since passage of SOX, contrary to what the Paulson Committee and others claim. Doidge, et al. analyze the types of companies that traditionally have listed in New York in the past and find that these tend to be larger companies with a history of cash flow and high Tobin's q ratios. By contrast, many of the IPOs over the past several years have been smaller companies, with no cash flow, and low Tobin's q ratios. Indeed, these types of companies have become the bread-and-butter of London's Alternative Investment Market (AIM). (I'm not saying these companies suck, but can you say "Russian corporate governance"? I mean, without snickering, ducking, or hiring a food-taster.) In other words, most of the issuers "not going to New York" these days wouldn't have gone to New York even before SOX. Most likely, they would have just borrowed from a bank or had to recapitalize earnings.

None of this is much comfort to the NYSE or NASDAQ. Even if these issuers would never have gone got New York to begin with, slumming is big bucks these days and high US standards and a toothy watchdog preclude them from competing with AIM in attracting mobbed-up Russian issuers and risk-tolerant ~~suckers~~ investors. But, in my opinion, US regulators shouldn't be in the business of improving the NYSE's bottom line. They should be in the business of providing US companies with the lowest cost of capital. That's a key difference between the US and UK market.

New New Name for Consolidated Regulator

2007-07-25T23:19:00.000-05:00

Last March, the New York Stock Exchange and the National Association of Securities Dealers announced that they would combine their self-regulatory organizations (SROs) into a single consolidated oversight body. The idea behind this was to end some of the minor differences that crop up over time between the NYSE's rules and the NASD's rules, and also further separate the regulatory side of what the exchanges do from their business side. Originally, this new organization was to be named the Securities Industry Regulatory Authority (SIRA). However, just recently it was discovered that "Sira" in Arabic means a biography of Mohammed. Of course, it doesn't mean that in English--in English, it just means Tom Cruise's artificial child. But, rather than risk offending anyone, ~~Sira's~~ head Mary Schapiro announced a name change, which you can read here. The new name? The Financial Industry Regulatory Authority, or "FINRA". They decided on "FINRA" rather than the more appropriate "FINIRA" because, of course, "Finira" is a goddess in the religion of Poetology, which I invented when writing a science fiction novel. (Tom Cruise, as you might expect, is a charter member.) Since I was potentially so offended, FINIRAwas out.

But that just leaves one question: Didn't Finra fight Godzilla in one of those 1960s Japanese monster flicks? You remember, the guy in the fish suit who twirled around knocking over the little buildings with his radioactive fins? Anybody?? Buddies with Gamera? Hey, you don't believe me, just Tivo it on Nick at Night or Spike or something. I've even got a picture (see right).

U.S. signs on to implementing Basel II

2007-07-22T12:39:00.000-05:00

This is one of those really really big deals that practically nobody knows about--a case strong enough to resurrect Mancur Olson just so he can point his finger at all those Public Choice haters out there and say, "See, this is exactly what I meant!"

"Basel II" is the second set of international agreements on banking regulation created by the Basel Committee on Banking Supervision, which is itself a group of central banks from a dozen or so of the world's most developed economies. Unlike securities regulation, which tends to focus on investor protection, and insurance regulation, which tends to focus on the safety and soundness of the institutions, banking regulation is all about systemic risk. (Of course, all financial regulators focus on investor protection, soundness of financial institutions, and systemic risk, but we're talking about emphasis here.) From a banking regulator's perspective, the worst case scenario is not that a bank fails or some customers get ripped off, but that the system itself is brought into question. When that happens, as it did in 1929, you get the proverbial run on the banks, and then the world goes to hell in a handbasket, regardless of how many investor protections you've built into your regulation or how strong the individual institutions are. And, as we all know, the only thing that's going to save your economy's sorry ass when that happens is Jimmy Stewart explaining basic finance to a bunch of town yokels.

The second accord of the Basel Committee on Banking Supervision (or Basel II, as it's known to its friends) is designed to help protect the international financial system against systemic shocks by setting global standards on capital reserves and other aspects of banking regulation. The lessons of banking crises over the past 30 years or so (and particularly the 1997 Asian Crisis) shows that a collapse of the financial system in one country can be contagious and produce risks to the financial systems in other countries as well--even if those other countries have better regulatory oversight. That's because, in today's world, everybody is invested in everybody else, so if everybody in one market defaults at the same time (as happens more often than you might think), it could effect a major international bank invested in that market. And if that major bank goes belly-up, people start wondering about the strength of all those other major banks--and pretty soon you have a run. So, to put a stop to this type of problem, the big country central banks got together to create a uniform world standard on how banks should measure risk and set cash aside for a rainy day. Being a world standard would make it harder for some countries to "cheat" and let their banks set aside less than everyone else.

The first Basel accord, agreed to in 1988, was very basic by today's standards and was soon overtaken by new risk-measurement tools. Hence, Basel II. The fun thing about Basel II is that it is absolutely incomprehensible to everyone other than a handful of banking regulators, who themselves are incomprehensible to all other humans. Nonetheless, like all banking regulation, it involves a whole lot of money. I mean, really really really large sums of money. So, a tweak here or there can mean some bank goes out of business or else the president of that bank gets a $1 billion check in his or her Christmas stocking. Making matters more fun has been the long-standing disagreement between two of the United States' myriad banking regulators--the Federal Reserve and the Federal Deposit Insurance Corporation. I don't really understand the details of this disagreement--and by "details," I mean "anything at all"--except that the large US banks wanted one thing and the small US banks wanted something else, with the result that the European banks were worried that in the end they were going to be really screwed over. Hmmm, so many delicious choices! But all of this led to a very interesting situation where you had Congressmen holding hearings on this issue and reading questions off index cards to the various banking regulators, with neither the questions nor answers being understood by either the Congressmen or their staffs. This, itself, is not that unusual, but what was really interesting was that the industry lobbyists pushing for various concessions often didn't understand what they were pushing for, either. It's just that arcane.

Which gets back to Public Choice theory. Public Choice says that most policy issues are just too complex and tiresome for most people to pay attention to, unless the issue has a very strong impact on them. Hence, we get subsidies for milk producers, even though the average taxpayer and consumer is made worse off by these subsidies--but only a little worse off, while a few milk farmers are made very much better indeed. With Basel II, however, we have a situation were the policy issues may be just too complex and tiresome for anybody. What happens then?

The Financial Times writes about it here.

SEC Terrorist Sponsor List Deep-Sixed

2007-07-21T01:12:00.000-05:00

Not the brightest bunch, but at least they have something of a learning curve. By that, I mean the folks in SEC chairman Christopher Cox's office who came up with the "search tool" that was really just a blacklist of US-listed companies that somewhere, somehow, in some connection mentioned Cuba, Iran, North Korea, Sudan and/or Syria in their SEC filings. "Context," unfortunately, wasn't a feature built into this search tool, with the result that a company mentioning that it was completely divesting of all its assets in Iran (for example) joined the blacklist just as readily would "Bombs 'R' Us" when it mentions that North Korea is its brightest future market.

Cox's statement on this about-face is here. Seems the SEC decided to pull this little fiasco after both Barney Frank (D-Mass.) and Spencer Bachus (R-Ala.) publicly said it was a boneheaded idea. (On the bright side, Cox should be congratulated for helping forge a bipartisan consensus here.)

It's hard for me to feel all that worked up on this issue, particularly since some of the biggest whiners about this have been European companies that really are working too closely with some bad people and are worried that European human rights activists might actually call them on it, via the SEC's blacklist. But the SEC's execution was pathetic enough to give these companies enough ammunition to make themselves look like victims. Cox's office initiated this half-assed scheme as a way to keep Congress from enacting even more draconian rules (though why Cox would care if Congress wanted to shoulder the blame is beyond me).

A much better approach would have been to develop a real search tool--perhaps one based on Cox's beloved XBRL. Such a tool would let an investor (or anyone, for that matter) run a search for a specific country (any country) and pull up their own private blacklist of companies mentioning the nasty country in question, with links to the references so they can do their own research on whether Company X deserves to be blackballed for whatever reason your heart fancies. If you care about only the 5 countries that the US State Department lists as state-sponsors of terrorism, then you just punch in Cuba, Iran, North Korea, Sudan and Syria. If you don't like China because of the way they treat Tibetians, then punch in "China." You don't like the Belgians because they share a border with the Dutch, then... you get the point. Some kind of electronic data gathering, analysis and research tool. Just, you know, more so.

Why didn't the SEC do this? Well, probably because this was being driven by politics rather than real concern over investor interests. Bloody shame. But, hey, that's Washington.

I'm not saying W has burned up some of his credibility with me...

2007-07-18T00:57:00.001-05:00

But I am saying these guys at Stratfor seem more plausible.

Al Qaeda has reconstituted itself? As strong as they were pre-9/11? Really?? Then what the hell have you been doing for the past six years?

Bush's problem is that the idea that Iraq is linked to al Qaeda rests on
semantic confusion...

Yes, we have a winner! Give Dr. Friedman the "Diplomatic Euphemism of the Month Award"!

Russia and Banana Republics

2007-07-17T05:19:00.000-05:00

The news today is that the UK expelled a bunch of Russian diplomats to protest the Russians not extradicting a ~~Soviet~~ Russian spy who probably dropped the polonium sugar cubes in former-Russian spy Alexander Litvinenko's tea. (I once stayed in the London Millenium Hotel. And if there were ever a hotel where you'd expect someone to poison a former Russian spy, that would be it. Also, the breakfast bangers are way overpriced...)

Anyway, Bloomberg had the news, plus this interesting quote from Konstantin Kosachyov, the head of the Russian lower house of parliament:

You can act this way toward a banana republic, but Russia is not a banana
republic.

Two things. Apparently, Russians are generally fine with kicking around banana republics. Not so much news there, but interesting to actually see someone say it. Second, Russians are really really worried that they are getting treated like a banana republic. (Can you imagine the United States or China saying, "You can't treat us like we're a banana republic!")

I'm baaack....

2007-07-16T06:56:00.000-05:00

Yeah, it's been a while. I finished some research and got bored a few months ago, so took a hiatus. But I just started thinking bout a new project, which means blogging is back as a way to think out loud or otherwise divert myself. Plus, there's just so much happening to annoy me, so why shouldn't I complain here?

EU wants everyone to do things its way

2007-02-19T01:20:00.000-06:00

An amusing article from the FT (EU wants rest of world to adopt its rules). A European Commission paper soon to be released says the European Union should promote “European standards internationally through international organisation and bilateral agreements.” Doing so will give an advantage to European companies since it “works to the advantage of those already geared up to meet these standards”.

Yeah, good luck with that. A word to the wise: if you're trying to slip one over on someone, it's best not to announce that this is what you're trying to do.

The FT adds that the sheer size and wealth of the Union’s single market means that few corporations can afford to ignore it. “By harmonising the rules for a market boasting 500m consumers, the Union has set standards 'which partners then have to meet if they are to benefit from the single market'.”

Except, of course, that the rules for the EU really haven't been harmonized for 500 million consumers. Actual implementation of EU directives varies widely among the different EU countries, and where real harmonization would be too painful, EU directives are nebulous to the point of pointlessness. In other places (such as labor and environmental laws), EU standards place EU member states at a competitive disadvantage vis-a-vis their American, Chinese and Japanese competitors.

Sure, the EU is too big to ignore. But it's not big enough to truly set global standards, and as the size of its economy shrinks relative to the US, China, India and elsewhere, it will eventually be ignorable. That's why its more important to get the standards right, than to try to convince everyone else to go along with them.

Nasdaq and LSE: who lost?

2007-02-12T22:45:00.000-06:00

I haven't written in a while because I was busy sabotaging an international stock exchange hostile takeover. Which brings me to this question: now that Nasdaq has admitted defeat on its efforts to take over the London Stock Exchange at £12.43 per share (with the LSE trading well above that over the past few months), who is screwed the most?

First, Nasdaq: it lost on its bid and now faces a transatlantic NYSE/Euronext monster. It still owns nearly 30 percent of the LSE. While it bought most of those shares when the LSE was trading at £11 (LSE shares closed at £12.82 today), it will be hard to unload that position. The LSE has launched a £250 million share buy-back, but this is still small potatoes against Nasdaq's holdings. Nasdaq can hold on to those shares to deter other bidders, but that likely will prevent it from making other link-ups at the same time that the NYSE is looking at markets in India, Japan and elsewhere.

On the plus side, however, Nasdaq has avoided a classic pitfall of many a merger — paying too much. If Nasdaq's board is right and the current price of the LSE is overvalued, then the hedge funds that bought LSE shares after Nasdaq announced its intentions will suffer big time. Despite the LSE's press about how it is stealing market share from New York, there are serious questions about its future profit margins, particularly (if Nasdaq is to be believed) after the EU MiFID (Markets in Financial Instruments Directive) fully comes online.

London will also look to go on the offensive, but the fact that it is a perennial prey rather than a hunter may be telling. While it has a new technology platform coming online, so does everyone else. And the LSE's share buy-back (at £12.70 per share), designed to make future takeover attempts harder, will also chew up cash that the LSE could be using on future technology modernizations. In this sense, while it is in a decent position at the moment, the LSE doesn't have the deep pockets of either the NYSE or Nasdaq when it comes to future development. While the LSE has kept out ahead of the New York exchanges because of quirks in the US system (quirks that essentially let New York operate in a hothouse, sheltered from outside competitive forces), now that New York is facing competition, it seems to be showing itself surprisingly aggressive.

So who's screwed the most? Hard to say at this point, but my guess is the LSE's hedge fund shareholders. They gambled that Nasdaq would raise its price rather than lose, and they lost instead.

"Going private" short-changes shareholders

2007-02-04T23:56:00.000-06:00

The FT has an article today by James Politi and Francesco Guerrera (Investors ‘short-changed’ in buy-outs) on a survey showing that private equity groups are buying out public companies at surprisingly low takeover prices. The survey, conducted by Weil Gotshal & Manges (a big NY-based law firm) shows that of 50 private equity takeovers last year, bidders on average paid only 6 percent more than the highest price the target company had been trading over the previous 12 months. In a takeover, a bidder can typically expect to have to pay significantly more than what the target company is trading at on a stock exchange -- after all, when you buy a share on the New York Stock Exchange, you are buying a right to a tiny portion of the company's profits. When you are buying 51 percent of the shares, you are buying not just a right to the company's profits, but also control of the company. (Hence the term "control premium" for the amount a bidder pays above what the company was trading at in order to take control.)

The Weil Gotschal study is interesting because it suggests that corporate boards are quite literally giving away the store in these private equity deals. It's possible, of course, that private equity groups are sniping off companies in a downward spiral, with the hopes of replacing management, restructuring the target company, and improving performance. However, given the amount of equity existing corporate officers and directors are given as part of recent deals, this seems somewhat dubious. The fear is that these equity deals are bribes to corporate officers and directors in exchange for an agreement to sell the company at firesale prices, which will then be sold back to the public at some future date at a much higher price.

The FT quotes Simpson Thacher & Bartlett partner Alan Klein as saying “They are not forcing anyone to sell. For a private equity deal to be attractive they need to put a lot of leverage on the business. A lot of institutional investors and managements can’t live with that.” But that isn't quite the whole story; the target company's board of directors often is forcing shareholders to sell. And leverage is just debt. If a leverage buy-out makes sense to the tune of a 15 percent return on assets per year, why won't institutional investors live with it?

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

2007-01-27T14:57:00.000-06:00

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

2007-01-27T11:29:00.000-06:00

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.

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

2007-01-24T22:01:00.000-06:00

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.)

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

2007-01-22T01:02:00.000-06:00

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."

The Problem in Islamic Finance

2007-01-21T19:48:00.000-06:00

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:

...as 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.

Bill Gates and my own private Bizarro Universe

2007-01-18T00:24:00.000-06:00

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.)

Wag of the Finger/Flip of the Bird

2007-01-16T00:02:00.000-06:00

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.

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

2007-01-15T02:08:00.001-06:00

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.

Global stock exchanges and the future of the SEC

2007-01-10T20:16:00.000-06:00

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.

What Europe needs is a more dirigiste stock market

2007-01-07T02:00:00.000-06:00

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.

An SEC blueprint for mutual recognition?

2007-01-04T06:51:00.000-06:00

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?

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

2007-01-03T16:02:00.000-06:00

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.

My 2007 Predictions: Does this count?

2006-12-31T17:38:00.000-06:00

Not really, I guess. On Dec. 27, just a few hours before I made my New Year's predictions (here), incoming House Financial Services Committee chairman Barney Frank issued this press release criticizing the SEC's December 22 decision to align its executive compensation disclosure rules with existing accounting rules. This new rule, which you can read here (if you a real masochist), replaces the existing SEC rule that says that when companies give executives stock options, these options have to be disclosed at the time of the grant. The new rule follows Financial Accounting Standard 123R (which you can read here, if you are really really really masochistic), so that public companies now only have to disclose the grant as they are exercised (i.e., when the executive actually calls in the grant and the company has to fork over the money to buy the shares).

There is some logic to this new rule, since a grant of stock options is worthless until it is exercised, and they can be exercised at different times. In other words, under the old approach, a company could disclose that it issued a CEO 1000 stock options in one year (not necessarily indicating the price of the stock), and nothing over the next five years, with an annual salary being (for example) $500,000. The disclosure would then look like $500K +1000 stock options in Year 1, then $500K for Years 2 through 6. Under the new rule, the company would have to disclose the stock options, and the fair market value, when the options become exercisable. In other words, if 100 of the 1000 options become exercisable each year, in Year 1, the company would disclose $500K in salary, in Year 2 $500K + 100 stock options at $1000 per share, in Year 3 $500K +100 stock options at $1100 per share, etc. The idea is to give investors an idea about how much the CEO is costing the company each year, and how much the CEO is actually making in each year. Furthermore, this is how companies currently have to account for stock options. (In the past, issuers did not have to expense stock options at all.)

Despite the logic behind the SEC's decision, you could argue that it comes at a bad time. Executive stock options are in the news because of the backdating scandal. Most people don't understand what the issue is about, except that it's bad. Add on top of that the view of some that what investors really want to know about is when the board decides to grant stock options (not necessarily when the come due or when the CEO exercises those options), and it could look like the SEC is making it harder for investors to know how overpaid the CEOs of their companies are. And that, of course, is what Barney Frank is saying.

I am very disappointed with both the substance and the procedure used to reach the SEC’s Christmas Eve decision to loosen reporting requirements for the pay of the top executives of public corporations. It is especially ironic that the SEC would relax the rules regarding stock options at precisely the time that widespread abuses of the practice are coming to light. The problem of executive pay that is both greatly excessive and deliberately obscured is a grave one. I had been encouraged when the SEC recognized this problem in its initial proposal, and while that continues to provide improvements in the relevant rules, this slippage is regrettable both substantively and for not having been open to more public discussion. Backtracking by the SEC on this important matter of stock options reinforces my determination that Congress must act to deal with the problem of executive compensation that is now unconstrained by anything except the self restraint of top executives, a commodity that is apparently in insufficient supply.

Frank also indicated that he will seek legislation to allow shareholders to vote on executive compensation. If this legislation succeeds, it will be the second direct foray of the federal government into corporate governance issues, an area of U.S. law that traditionally has been the province of state law. (The first, of course, being the Sarbanes-Oxley Act, which set requirements for issuer board composition.)

So, I guess my prediction that Barney Frank will hold hearings on executive compensation is a no-brainer. (I guess we'll have to see about the professors and Lake Woebegon.) However, if Frank does go ahead with corporate governance legislation rather than some kind of windfall tax, I'll have been happily proven wrong.

Apple stock options backdating and SOX Section 404

2006-12-28T16:55:00.001-06:00

With the latest revelation that someone at Apple Computer falsified records to give the appearance that a full board meeting had taken place to approve giving 7.5 million stock options to CEO Steve Jobs, why is there still any debate about the need for public companies to have strict internal controls? (See Apple ‘falsified’ files on Jobs’ options.) With executive pay procedures being circumvented in stock option backdating cases, and with German companies having secret slush funds to bribe foreign government officials, why are there still any questions over whether these internal controls need to be tested by outside auditors?

And speaking of secret slush funds, I don't mean to be picking on only the Germans here. Apparently British companies also have secret slush funds -- with the difference being that the British government is even more reluctant to investigate them. (See Blair pressed on BAE bribe probe.)

Predictions for 2007

2006-12-28T00:53:00.000-06:00

It's pretty much a slow news week(s) when it comes to international finance. So I thought I'd give you some predictions for the year. I'm not very good at making predictions. As Yogi Berra once said, it's tough to make predictions, especially about the future. But here are a few:

Hilary Clinton will get the Democratic nomination. This will actually happen in 2008, but I'm just putting it in here anyway. She'll win the election, too, unless the Republicans actually come up with a decent candidate -- and they won't.

Incoming House Finance Committee chairman Barney Frank will hold hearings on CEO pay. Several academic types will testify that high CEO pay results from a combination of a "Lake Woebegon effect" (everyone wants an above-average CEO and tries to pay above-average to get one), plus poor corporate governance standards that make even independent board members unresponsive to the concerns of shareholders. All of this will be ignored and Congress will instead focus on some kind of CEO windfall tax.

Very very few foreign companies will deregister from the U.S. market. Those that do will tend to be small, and will see a drop in stock price of about 10-20 percent the 120 days leading up to and following the deregistration announcement. Most of these companies will be European.

NASDAQ and the London Stock Exchange will agree to a merger sometime around February. The UK Financial Services Authority will press for an agreement with the SEC similar to that signed to by the SEC and the European college of regulators regarding the NYSE-Euronext merger. The FSA won't get it -- the Americans will argue that the Balls Clause already gives the UK all the comfort it needs.

The SEC will begin to seriously consider a mutual recognition scheme to allow non-US investment banks and stock exchanges to operate in the United States under their home market laws, without registering with the SEC under the Exchange Act. However, there will be strings attached. Lots of strings.

Senator John E. Sununu will reintroduce the Optional Federal Chartering bill to create a National Insurance Office that would permit American insurance companies to choose to be regulated at the national level rather than at the individual state level. It won't go anywhere, mostly because of opposition from New York politicians.

Despite a lot of pressure from Europe and complaints to the Treasury Department, the Federal Reserve will not waver from its plans to implement only a watered-down version of Basel II in the United States. This will effectively undermine the banking accord and force the world's banking regulators back to the drawing table for some quick fixes.

At least one, and maybe two, SEC commissioners will leave this year for the private sector.

PCAOB releases long-awaited AS5 revising implementation of SOX 404

2006-12-19T17:47:00.000-06:00

It's been a busy day. In addition to the NYSE and Euronext merger (see here), and the Thai market falling through the floor (see here), the Public Company Accounting Oversight Board today released a revision to its vilified Audit Standard 2 with a new Audit Standard 5. The proposals are designed to take much of the sting out of how Section 404 of the Sarbanes-Oxley Act is implemented. A copy of the proposed AS5 can be found on the PCAOB's website here.

SOX 404, of course, is a provision of the Sarbanes-Oxley Act that mandates that the management of public companies not just provide investors with a statement about the strength of the company's internal controls (the systems the company uses to track how the company is spending its money and make sure managers are stealing it), but that the company's independent auditor attest to this management statement. Following the collapse of the accounting firm Arthur Andersen, auditors have been extremely reluctant to make such attestations without thorough (and expensive) testing of company internal controls.

The new AS5 (which has been in the works for some time -- see here) has two components. The first is a complete revision of AS2 that:

Directs the auditor to the most important controls and emphasize the importance of risk assessment;

Revise the definitions of significant deficiency and material weakness, as well as the "strong indicators" of a material weakness;

Clarify the role of materiality, including interim materiality, in the audit;

Remove the requirement to evaluate management's process;

Permit consideration of knowledge obtained during previous audits;

Direct the auditor to tailor the audit to reflect the attributes of smaller and less complex companies;

Refocus the multi-location testing requirements on risk rather than coverage; and

Recalibrate the walkthrough requirement.

In addition, the PCAOB is revising certain provisions of AS2 regarding when an audit firm can rely on the work of others when assessing a company's internal controls. According to the PCAOB, the new provisions would:

Allow the auditor to use the work of others, and not just internal audit, for both the internal control audit and the financial statement audit, eliminating a barrier to integration of the two audits;

Encourage greater use of the work of others by requiring auditors to evaluate whether and how to use the work of others to reduce their testing;

Require the auditor to understand the relevant activities of others and determine how the results of that work may affect the audit;

Provide a single framework for using the work of others based on the auditor's evaluation of the combined competence and objectivity of others and the subject matter being tested; and

Eliminate the principal evidence provision previously included in AS No. 2.

The PCAOB's press release announcing the proposal can be read here. The various PCAOB board members' statements (as well as the briefing paper I'm cribbing all this from) can be read here.

Despite what some had urged, the new AS5 does not exclude small companies from having to have auditors attest to their internal controls, but it does try to make the internal controls testing "scalable," so that audit firms will not have to apply exactly the same standards to small companies as they might for large issuers. This actually follows the (somewhat surprising) recommendations of the Committee for Capital Markets Regulation (see here).

The new AS5 proposal comes less than a week after the SEC also released "management guidance" designed to provide companies with cover should they not do everything audit firms would like them to in testing their internal controls. (See this post here. The SEC management guidance can be read here.)

The SEC also published a press release praising the PCAOB for its work, which you can read here.

NYSE and Euronext to vote on merger today

2006-12-19T16:30:00.000-06:00

The New York Stock Exchange and Euronext announced today that they had formally agreed to a merger. (Euronext's press release can be read here. The NYSE's website announced it as a "merger of equals" -- much like the merger of British Petroleum and Amoco and Daimler Benz and Chrysler were mergers of equals as well...)

This was supposedly a done-deal for the past several weeks, notwithstanding some recent maneuvering by various European governments to extract a few more concessions out of the deal. (See Norma Cohen's and Ian Bickerton's FT article, Dutch seek control of NYSE body. A copy of the Dutch Finance Minister Gerrit Zalm's letter to Euronext and the NYSE can be found here.)

Which brings to mind this question: is the NYSE buying itself another Airbus? The recent Dutch push isn't just an attempt to protect against American "regulatory creep". That's been a red-herring from the very beginning. What it is, rather, is an attempt for the Dutch finance ministry to remain relevant. In addition to a promise that there would be no "spill-over" of U.S. financial regulation into Europe (something that would not be possible without the consent of European governments at any rate), Zalm's letter demands:

-- Safeguards for the local operation of Euronext NV and Euronext Amsterdam NV, to be ensured (among others) by the availability of adequate resources; and

-- Safeguarding proper and effective supervision by local supervisors on the securities exchanges in the Netherlands.

So, basically, the Dutch want to make sure that the New York Stock Exchange won't consolidate the Amsterdam exchange or render the Dutch AFM (the Netherlands financial regulator) irrelevant. But this, fundamentally, is not a US-Europe issue. It's a intra-European issue. Europe right now has dozens of small stock exchanges and dozens of small financial regulators, at a time when the pressure to consolidate, converge and harmonize has just gotten a whole lot more pressing. How relevant will individual European financial regulators remain, when overarching regulatory policy is now set in Brussels?

More importantly, what happens next? Despite the SEC's honest assurances that the United States has no intention of "exporting" its regulation to Europe, European regulators are already greatly affected by what goes on in the U.S. (See, for example, this post about how much of Europe has already adopted significant provisions of the Sarbanes-Oxley Act, even as they have criticized SOX as excessive.) What would happen if the SEC were to adopt some kind of "mutual recognition" model (as the European Union regularly demands), but this model were based on some type of regulatory convergence? Would the EU insist on "going its own way," if "importing" certain U.S. provisions were to give European financial firms more direct access to the enormous U.S. investor base?

Second, what now happens in London? The London Stock Exchange continues to fight against NASDAQ's hostile onslaught. (See Norma Cohen's LSE rejects Nasdaq approach.) Will it still try to hold out, now that it is no longer the most significant stock exchange in Europe? Will UK financial regulators attempt to lower their regulatory requirements even further, to make the London market even more attractive to foreign issuers (even if this approach has recently backfired with the LSE's Alternative Investment Market)?

Third, what happens now with the United States' own Chicago-based derivatives exchanges? Last October, the Chicago Mercantile Exchange and the Chicago Board of Trade merged to form the world's largest derivatives exchange. The CME and CBOT have studiously avoided any talk of buying out one of America's smaller equities exchanges, so as to avoid falling under the jurisdiction of the SEC. (The SEC's smaller cousin, the Commody Futures Trading Commission, seems so much easier to deal with...) But now the CME Group faces NYSE Euronext, which, because it owns Liffe (the London derivatives exchange), has a foot in both worlds. Will this put pressure on the CME Group to get into the equities business? (If the CME does, will this be enough to finally push a combination of the SEC and CFTC? And what would such a beast look like?)

It all looks like it will be an interesting New Year.

Don't mess with the markets

2006-12-19T14:35:00.000-06:00

Thailand is learning the hard way that, if you impose capital controls that prevent foreign capital from exiting your market, not only will foreign capital not come to your shores, but those who can leave will stampede out the door before the new law becomes effective. See the FT's Amy Kazmin, Thailand revokes capital controls on equities. Also the FT's op-ed, An abrupt baht turn that harms everyone.

Ouch. Having to revoke a law the same day as it comes into effect. That's gotta hurt.

Which reminds me...Maybe this would be a good time to mention Floyd Norris' recent NYT article, SEC to firms: Keep money, forget rules. (Unfortunately, you need a subscription to read it. Which, frankly, is ridiculous. None of the New York Times' writers is worth paying for.) Anyway, Norris comments on the SEC's new proposed deregistration rule that would permit foreign issuers to withdraw completely from the U.S. market (and cease having to make most SEC filings) provided less than 5 percent of their shares trade in the United States. Norris says:

It looked like a simple deal: Companies that wanted to raise money in the American capital market had to agree to comply with the market's rules. The promise remained binding as long as a substantial number of Americans owned the stock. But now, under pressure from foreign companies that do not want to be bound by such a bargain, the Securities and Exchange Commission is proposing rules that will let all but a handful of foreign companies abrogate the deal, even if there are tens of thousands of American owners. As long as the primary trading market for a stock is overseas, American shareholders can be ignored. The companies will be able to keep the money that was raised from the securities, but they will no longer have to comply with the rules. Thousands of companies will be eligible to deregister from the United States. If American investors don't like living without such protections, one commissioner, Annette L. Nazareth, said, they can ''vote with their feet'' and sell their shares. Now, there's investor protection.

Frankly, I would have phrased it a little differently than Nazareth (she does need a speech writer, doesn't she?), but she does have a point, despite Norris' snidetry. This is a one-time only shot to screw over investors: if an issuer takes it, it's name will be mud, and not just in the United States. And it won't just be U.S. investors voting with their feet. Foreign issuers taking advantage of this proposed rule will try to paint it as a reaction to the excesses of the Sarbanes-Oxley Act, but investors aren't idiots (no matter what Norris might think). It will be a signal that the foreign issuer has got something to hide.

But the bigger point, Floyd, is the same as in Thailand. Give the slightest impression you might be a crook, and nobody will invest in your company. Make your market a prison, and nobody will walk through your door. In that sense, the market is as unforgiving of governments as it is of issuers.

Siemens: An advertisement for SOX Section 404?

2006-12-17T17:17:00.000-06:00

Last week's op-ed from the Financial Times regarding the unfolding Seimens scandal reads like an advertisement for the need for strengthening Section 404 of the Sarbanes-Oxley Act. (See Scandal at Siemens Troubles highlight questions for German corporate culture.) Of course, it comes at precisely the same time that the SEC and PCAOB are considering revising down Section 404 implementation requirements in the face of enormous pressure from issuers and the U.S. financial industry (see here and here). But, hey, timing is everything, right?

Siemens is the latest German company caught up in a bribery scandal. (Previously, DaimlerChrysler, Volkswagon, Infineon and Commerzbank were all also found to have hidden slush funds useful for making discrete payments to foreign officials to smooth the way for large business transactions.) But the Siemens case is impressive for its size: no matter what country you are operating in, you can buy a lot of politician with $555 million! (Notably, Siemens' board finally decided to actually investigate the bribery allegations after Transparency International voted to kick the company out of its membership, and just before the German police started making arrests. See Former Siemens executive under arrest.)

Bribing foreign government officials is illegal in the United States, and, increasingly, in other countries (such as Germany) as well. In the U.S., this prohibition came about under the Foreign Corrupt Practices Act passed in the wake of Watergate. For years, the United States pressured other governments to follow suit (since most U.S. companies complained that the prohibition put them at a competitive disadvantage vis-a-vis the companies from other countries). However, it really wasn't until the formation of Transparency International and the OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions that this campaign gained any international traction. However, as Germany shows, old habits die hard.

Interestingly, in the U.S., the types of slush funds Siemens and other German companies are accused of having would constitute a violation of the U.S. securities laws. The reason is that these funds are undisclosed on the corporate accounts. (After all, a company is not likely to disclose a line-item saying "$555 million -- slush fund for making illegal bribes".) Also, the types of internal controls that have cause such sturm und drang with Section 404 (hey, that's German! Get it?) were actually first mandated by the FCPA.

Given all this, what the FT says is very very amusing:

It takes a big group to get in a mess as big as this. Siemens this week put its own estimate on the scale of the alleged embezzlement being investigated by prosecutors, saying that Euros 420m in suspect payments from 1999 onwards would be examined. The scandal should provoke change at Europe's largest conglomerate and prompt wider debate within corporate Germany.

Siemens' response to the probe has been less than emphatic. It was only after being on the brink of expulsion from Transparency International, an anti-corruption watchdog, that it appeared to recognise its compliance arrangements needed a serious overhaul. On Monday it appointed a new compliance adviser and said that an external law firm would review its systems. These moves are welcome as a first step. Companies seeking large-scale contracts across so many countries - Siemens has operations in 190 - need extremely robust systems for ensuring that money is clearly tracked. They also need a structure that lets businesses within a group operate as independent but accountable units with greater clarity of responsibilities.
More broadly, there are two issues for corporate Germany to consider. The first is transparency. The fullest account of what had been going on at Siemens came because the group had to make a filing to the US Securities and Exchange Commission. German company regulation would not have required it to be so open.

The second is board structure. This is especially high-profile for Siemens because the chairman of the supervisory board is Heinrich von Pierer, chief executive of the group from 1992 to 2005. As such, he is presiding over the group's response to inquiries into activities on his watch. This is a vivid instance of the discomfort that can arise when chief executives become chairmen in a way that is common among Germany's largest quoted companies. But the practice can be damaging in less prominent ways - for example, making it harder for a new chief executive to alter strategic direction.

This point would matter less if German supervisory boards were full of non-executive heavy-hitters. Two factors make this difficult to achieve. The first is that half the supervisory board must be made up of employee representatives. This limits the other places available. It also makes it much more likely that proceedings will be conducted in German - which itself may be a deterrent to appointing anyone not fluent in the language. Second, there is not a German business tradition of retiring from executive life while still young enough to seek an extended career as a non-executive director.

Germany has made considerable progress over the past decade in modernising its corporate governance framework. The Siemens case should serve as a wake-up call for companies that have not yet fully implemented the changes.

Indeed. Makes you wonder if all the European complaints about Sarbanes-Oxley are a case of protesting too much...

Why U.S. and European corporate scandals are different (hint: it has to do with stock options)

2006-12-17T15:40:00.000-06:00

Columbia Law School professor John C. Coffee, Jr. has an interesting paper out there on why U.S. and European corporate scandals have been different. (See "A Theory of Corporate Scandals: Why the U.S. and Europe Differ," March 2005.) It's already more than a year and a half old, but the reason I bring it up is that what is says now has new pertinence given the recent stock option backdating scandals.

Coffee's notes that, while Europe has had its share of financial scandals since the bursting of the stock market bubble in 2000 (Parmalat, Shell Oil, Royal Dutch Ahold, Vivendi, and now Siemens), these scandals have differed in significant ways from those in the United States. In particular, Coffee notes that, while Enron, Worldcom and other big scandals have grabbed all the news, actual accounting restatements in the U.S. between 1997 and 2002 were far more numerous than is commonly understood (at least 10 percent of all listed companies). (Accounting restatements involve a company announcing that previous financial statements it made contained errors. Earnings restatements involve the company announcing that its earlier statements about how much money it made were wrong. Sometimes these involve mistakes where the company actually made more money than it thought it did, but most, as you can imagine, involve the company overstating how much it made. Obviously, a company that announces it is making a lot of money tends to see its stock price go up.)

Coffee also notes that it hasn't always been this way. In 1990, for example, there were only 33 earnings restatements; in 1995 there were 50. By 1999, there were 233; 270 in 2001; 330 in 2002; 323 in 2003; and 414 in 2004.

While, comparatively speaking, only a handful of these accounting restatements have resulted in fraud charges brought against corporate leaders, stock markets have reacted to these restatements as if they were evidence of fraud -- restating issuers lost on average 11 percent of their stock market value within 3 days of the restatement announcement, and on average 25 percent of their market value in the 120 days prior to the announcement. (Incidentally, if this isn't a sign of rampant trading based on inside information, I don't know what is. For all of those insider trading law haters out there (e.g., Stephen Bainbridge), it seems clear that enforcement isn't a plus-minus variable, but a continuum. And, at least in absolute terms, the prohibition on insider trading in the U.S. is honored more in the breach than in the observance.)

Why the difference? Coffee claims it comes down to executive compensation. Starting in the 1990s, U.S. companies shifted the way they pay their executives from cash to stock and (particularly) stock options. The reason for this shift was an attempt to align the interests of management with those of the shareholders -- a problem that had been recognized since at least 1932 when Adolf Berle and Gardiner Means wrote about the "separation of ownership and control" in The Modern Corporation and Private Property. (Somewhat interesting side note: Coffee holds the Adolf A. Berle professorship at Columbia.) Since stock options mean the option holders make more money the higher the company's stock price goes, the idea is that this would encourage executives to work hard to improve the company's performance.

Of course, it hasn't always worked that way in practice. CEO salaries have increased significantly over the past 15 years (from an average $1.2 million in 1990, with 92 percent of that cash, to over $6 million in 2001, with 66 percent of that in stock and options). As Coffee explains, this creates tremendous incentives for CEOs to manipulate a company's financial statements, particularly when those stock options are "in the money" (originally issued at the then-current stock price). For example, say a CEO that holds options on two million shares of the company's stock and that stock is trading at a price-to-earnings ratio of 30 to 1. If that CEO can cause the company's financial statements to "prematurely" recognize future revenues such that the annual earnings increase by only $1 per share, the value of the CEO's options increase by $60 million.

Further, Coffee cites studies showing that this temptation is powerfully effective. One study shows that in 2001-002, the factor with the most influence on the likelihood of a restatement was the presence of a substantial amount of "in the money" stock options in the hands of the CEO. If the CEO held options equalling or exceeding 20 times his or her annual salary (not something terribly unusual), the likelihood of a restatement was 55 percent!

By contrast, Coffee shows that, in Europe, the incentives are very different. Ownership of major companies in most of Continental Europe is much more concentrated than in the U.S. In the United States, for example, only about 15 percent of public companies are "controlled" by one shareholder or a small, interconnected group of shareholders (i.e., where these controlling shareholders own or vote 50 percent or more of the company's shares). In Italy, 59.6 percent of public companies are controlled, while this figure is 64.6 percent in Germany and 64.8 percent in France. Under such a system, a company's managers are much more easily monitored by the company's owners. (In some cases, such as Parmalat, the majority owners were the managers.) Consequently, there is less need for the company to align the interests of the company's executives with shareholders, since managers have less discretion to engage in opportunistic activities or loot the company. In addition, the controlling shareholder also has much less of an interest in the day-to-day price of the company's stock, since these shareholders rarely, if ever, sell their shares to the public, as this would dilute their control over the company.

Rather than massage earnings disclosures to artificially boost stock prices, European corporate scandals such as Parmalat tend to involve controlling shareholders expropriating corporate assets for their own benefit. Of course, there is no incentive to do this where the controlling shareholders own all of a company; however, if they own only 51 percent and have sold 49 percent of the company's shares to the public, that means (essentially) that 49 percent of the company's assets are available for the taking. For example, as with Parmalat, the board of directors could vote to transfer company funds to a travel agency owned by the controlling shareholder's daughter, in exchange for worthless or nonexistent services or products.

Coffee points out that some of Europe's recent financial scandals, however, have involved earnings restatements -- but that these tend to prove the rule, since most of these companies had evolved into American-style operations with diversified shareholding (i.e., Vivendi, Royal Dutch Ahold, Skandia Insurance and Adecco).

What I found most interesting about this paper is the focus apparent danger presented by "in the money" stock options. The recent options backdating scandals involved an attempt to make out of the money options into in the money options by changing the dates of the option issuances. In a sense, then, options backdating presents two dangers -- outright fraud regarding disclosure of the value of the options given to executives, and an increase in the incentives for management to massage earnings.

For previous posts giving some background on the options backdating scandals, see:

Robert Reich and backdating stock options

Stock options backdating continued

Even more on stock options backdating

Wilson Sonsini and options backdating scandal

Stock option backdating: apparently companies also think you are stupid

Busy agenda for SEC today -- SOX 404, deregistration and mutual funds

2006-12-13T06:06:00.000-06:00

Today's open meeting of the SEC (currently being webcast and in the future archived here) has several significant items on the agenda:

New exemptions for banks that have stock brokerage arms (see here);
New SEC guidance on management's implementation of Sarbanes-Oxley Section 404;
A new rule proposal to permit foreign private issuers to deregister from the SEC;
A new rule proposal on who can invest in hedge funds;
A new rule proposal on the internet availability of company proxy materials; and,
An additional request for comment on whether mutual fund company chairmen should be separated from the mutual fund's top manager.

The new management guidance on SOX Section 404 is designed to make it much less costly for U.S. and foreign companies to implement the internal controls requirement of the Act. It pushes auditor testing of a company's internal controls into a "risk-based" and "scalable" model designed to reduce auditing costs and relieve some of the burden on smaller companies. The guidance actually offers relatively few examples of what it means, in an effort to make the guidance more of a "principle" and less of a "rule". (Examples tend to become rules under the U.S. securities law system -- lawyers tend to point to the examples the SEC gives as a bright-line description of what is permitted, even if the example, applied to a particular circumstance, doesn't seem to apply.) Ironically, this approach was criticized by SEC Commissioner Paul Atkins, who said that the lack of examples doesn't provide enough comfort to issuers. (Didn't I say this would happen? For example, here?)

The new foreign issuer deregistration proposal greatly increases the abilities of foreign issuers to leave the U.S. market and stop following all those pesky SEC rules. Currently, it is relatively easy for a foreign company to "delist" from a U.S. stock exchange, but even when a foreign issuer does this, it is still required to make financial disclosures and follow other SEC rules unless it has less than 300 (or 3000, depending on the circumstances) U.S. resident shareholders. Of course, many foreign companies that have never even sold shares in the United States have more than 300 U.S. shareholders, since U.S. residents often invest abroad. Consequently, this rule has been called the "Roach Motel" rule (roaches check in, but they don't check out) or the "Hotel California" rule (you can check out but you can never leave). The new proposal says that a foreign issuer can deregister with the SEC if less than 5 percent of its total trading occurs in the U.S. This was a compromise decision -- some in the SEC wanted a rule that said that a foreign issuer could leave if 25 percent or less of its shareholders were outside the U.S., others wanted something that said 5 percent but excluded institutional investors, still others argued for drawing a distinction between where the U.S. investors bought their shares (in the U.S. or abroad). The new proposal is designed to be something easily measured and achievable, while still offering a modicum of protection to U.S. investors (though this could be argued).

Unlike previous preposals, it does not focus on actual U.S. ownership of the foreign securities, but where these securities are traded. (Also, the proposal focuses exclusively on secondary trading. If you had an initial offering in the U.S., you're still on the hook.) There is also a 12 month waiting period between when securities can be traded on the U.S. market and when a foreign company could seek deregistration. The focus on trading rather than shareholders is designed to get around the institutional/retail issue (which is not always easy to detect). And, since many foreign companies trade the majority of their shares on their home markets, the 5 percent hurdle supposedly won't be onerous.

It will make for an interesting academic study in 5 years whether this new rule decreases the premium investors pay for U.S.-registered securities of companies from developing markets, since under the new proposal, a company could announce a deregistration at any time after a year of entering the U.S. market, provided less than 5 percent of the shares trade in the United States. It will also be interesting to see how many foreign companies take advantage of this new deregistration rule. I suspect there will be a host of smaller foreign companies that deregister, just as SOX has pushed a number of smaller U.S. issuers to "go dark" (stop public trading so they can stop needing to comply with SEC regulations). However, I'd be amazed if many large foreign companies deregister. The signal sent to investors would be bad, and the reactions of even foreign investors may well be dire.

The funny thing about the new request for comments on the mutual fund governance issue is that the SEC has already received more than ten thousand comments from the public on this very topic. (I understand it is the second largest set of comments the SEC has ever received.) This is, of course, an attempt by SEC Chairman Christopher Cox to delay having to propose a rule on this topic when there is a deep division among the five commissioners (the past two proposals on this subject where approved by 3-2 votes, with former Republican SEC Chairman William Donaldson voting with the two Democrats on the Commission against his Republican colleagues.)

DOJ's "Thompson Memo" out, sorta

2006-12-12T20:52:00.000-06:00

The Department of Justice today announced it was revising it's "Thompson Memorandum." (See the McNulty Memo here) This memo, drafted in 2003 by Deputy Attorney General Larry Thompson (see here) basically lays out guidelines that says that federal prosecutors will look nicely on a corporation suspected of breaking the law, and not indict the company if it cooperates with the government. Since an indictment (not just a conviction) of an entire company can be devastating (precluding it, for example, from certain work such as government contracts or, if an audit firm, from auditing the financial statements of a public company), this memo has proven controversial. The most controverials aspects have been the sections stating:

II. Charging a Corporation: Factors to Be Considered

A. General Principle: Generally, prosecutors should apply the same factors in determining whether to charge a corporation as they do with respect to individuals. See USAM § 9-27.220, et seq. Thus, the prosecutor should weigh all of the factors normally considered in the sound exercise of prosecutorial judgment: the sufficiency of the evidence; the likelihood of success at trial,; the probable deterrent, rehabilitative, and other consequences of conviction; and the adequacy of noncriminal approaches. See id. However, due to the nature of the corporate "person," some additional factors are present. In conducting an investigation, determining whether to bring charges, and negotiating plea agreements, prosecutors should consider the following factors in reaching a decision as to the proper treatment of a corporate target:
...
4. the corporation's timely and voluntary disclosure of wrongdoing and its willingness to cooperate in the investigation of its agents, including, if necessary, the waiver of corporate attorney-client and work product protection (see section VI,
infra);
...
Another factor to be weighed by the prosecutor is whether the corporation appears to be protecting its culpable employees and agents. Thus, while cases will differ depending on the circumstances, a corporation's promise of support to culpable employees and agents, either through the advancing of attorneys fees, through retaining the employees without sanction for their misconduct, or through providing information to the employees about the government's investigation pursuant to a joint defense agreement, may be considered by the prosecutor in weighing the extent and value of a corporation's cooperation. By the same token, the prosecutor should be wary of attempts to shield corporate officers and employees from liability by a willingness of the corporation to plead guilty.

Don't underestimate how powerful these two provisions have proven to be. Basically, the Thompson memo, among other things, tells the company's board of directors that the company itself won't be prosecuted if they can lay out a roadmap to the "guilty" individuals -- and while they're at it, they better not be paying for these guys' lawyers, either. It has made the jobs of federal prosecutors significantly easier when pursuing white collar criminals, since, in the past, a crooked CEO could defend himself or herself with company funds while protecting incriminating evidence under the company's attorney-client privilege, provided the crooked parties got the company's crooked inhouse counsel involved.

This blackmail threat -- for blackmail it is, even if the results are positive and justified -- has provoked a backlash. Not only was it cited by the recent Committee on Capital Markets Regulation report as a problem (see here), but Senator Arlen Specter recently introduced legislation that would basically prohibit the Thompson memo. (See here).

What I don't get is why it took DOJ so long to come up with a fix to this issue, such that it now looks like that they are not only buckling to Congressional pressure, but that they got their asses kicked by the Committee on Capital Markets Regulation. I mean, seriously, if you are going to go down, jump out in front of that train and say you were planning on doing it all along. That's the Washington way.

Interestingly, this new McNulty Memo tries to recover some of its dignity (and usefulness to prosecutors) by taking the same approach that the Securities and Exchange Commission took in 2001 with its "Seaboard Report" (incidentally showing that Harvey Pitt is a much smarter lawyer than Larry Thompson). In other words, while the DOJ is now saying it will no longer "punish" a company for not cooperating, it will "reward" those that do cooperate.

In other words, I won't dunk your head in the toilet if you don't cooperate. But I will stop dunking your head if you do.

Former SEC enforcement chief to join JP Morgan Chase

2006-12-12T20:41:00.000-06:00

Stephen Cutler, who until last year was head of the SEC's Division of Enforcement, has left his temporary port-of-call at Washington law firm WilmerHale to become the General Counsel of JP Morgan Chase & Co. Apparently 18 months is the appropriate amount of time you need to wait before you go from investigating a firm to working for it without it looking really improper. (I guess he learned that lesson from his predecessor, Richard Walker, who didn't bother with such appearances of propriety when he jumped to Deutsche Bank.)

"Paulson" Committee on Capital Markets Regulation Report (Part 3)

2006-12-07T19:09:00.000-06:00

Last week the Committee on Capital Markets (also known as the "Paulson Committee") released its Interim Report. As I noted earlier this week (See "Paulson" Committee on Capital Markets Report and 'elegant whining'" and "Committee on Capital Markets Regulation Report (Part 2)"), this is a long report, so I've broken my review up into three parts. This is the third part, reviewing the CCMR's sections on Shareholder Rights and Sarbanes-Oxley Section 404

Shareholder Rights

If you've read anyone commenting on the CCMR's report and this person was universally critical of the report, it's a pretty sure sign that they haven't actually read it. (See, for example, New York governor-elect Eliot Spitzer's comments that, "This is the same old tired response from the defenders of the status quo who time and again jump to eviscerate the prosecutorial power of the only office who did anything in the past decade.") They particularly haven't read the section on shareholder rights, written principally by Harvard Law professor Allen Ferrell. (Ferrell is one of those increasingly common law professors with a Ph.D. in Economics.)

Ferrell's section has two targets -- "staggered" (or "classified") boards of directors, and "poison pill" anti-takeover defenses. Both phenomenon are actually devices to prevent "hostile" takeovers of corporations. Any corporate merger or takeover, of course, involves one company purchasing from another company's shareholders their ownership in the target company. A "hostile" takeover occurs when the purchasing company goes directly to the target company's shareholders and offers them money for their shares, without the express approval of the target company's board of directors or managers.

What's wrong with that, you ask? After all, if you own shares of a company and somebody comes along and offers you a lot of money for them (more than you think they are worth), why shouldn't you sell? Well, because then the company's managers and board of directors might lose their jobs, that why! And something had to be done about that! Remember all those '80s and early '90s movies about "corporate raiders" and the like -- you know, "Other People's Money," "Wall Street," "Barbarians at the Gate" and even "Pretty Woman"? You know why you don't see that plot device anymore? It's because hostile takeovers rarely happen anymore, mostly because of the adoption of staggered boards of directors, poison pills and similar anti-takeover devices.

Staggered boards of directors are corporate boards with member terms set like the U.S. Senate -- only a portion of which are up for election at any given time. This means that any group taking control of a majority of voting shares of a company still can't control the company's board. Even if all of the company's shareholders became so fed-up with the company's performance that they wanted to install a new board, it would not be possible for several years. (In reality, in the United States it would not be possible at all, since the board controls the board nominating process and board elections are like old Soviet elections -- you can vote for the candidate or you can abstain from voting, but you can't vote for a competing candidate.)

A "poison pill" is a resolution of the board that gives company shareholders (but not the purchasing company) the right to purchase additional shares of the company at a price substantially below market prices. In other words, if an acquiring company buys 10% of the target company's shares, and the board adopts a poison pill defense, the target company suddenly issues thousands or millions of new shares to existing shareholders, at pennies on the dollar, effectively diluting the purchasing company's ownership. Theoretically, a target company's board could do this infinitely many times, effectively making the price of the acquisition infinitely high.

Ferrell cites numerous academic studies that demonstrate that share prices drop when state laws permit either staggered boards or poison pill defenses, and that the use of poison pills is correlated with poor corporate performance. In other words, while anti-takeover devices are typically sold to the public as a way to "protect jobs," the evidence is clear that the jobs these devices are designed to protect are those of poorly performing CEOs and board members. Ferrell even shows that staggered boards of directors are correlated with high CEO pay that isn't linked to company performance. (Incoming House Financial Services Committee Chairman Barney Frank might wish to keep that in mind when he holds his promised hearings on soaring executive pay, particularly since his state of Massachusetts actually makes staggered boards of directors mandatory.)

As a response to these problems, the CCMR recommends that Delaware, or the stock exchanges, develop standards prohibiting companies that have staggered boards of directors from adopting poison pills without first getting shareholder approval, unless the company is the target of a takeover. If the company is a takeover target, the board could adopt a poison pill, but must get shareholder approval for the pill within three months. That would allow the board to make its case for why the takeover is not in the best interests of the shareholders, while also not making the takeover impossible should the shareholders disagree. (CCMR recognizes that the SEC probably does not have the power to make this a requirement itself. What is strange, though, is that no one ever seems to imagine taking all of this authority away from Delaware and actually having Congress pass a national corporations law, applicable for any company doing business across state lines.)

The CCMR also has a number of other recommendations to improve shareholder rights, most of which are good ideas. It recommends that the SEC resolve the issue of whether shareholders should have the right to put election-related materials on an issuer's proxy ballot -- something that the SEC is likely to consider this January in response to the 2nd Circuit's AFSCME v. AIG decision.

One recommendation I'm not sure I agree with, however, is CCMR's proposal that corporations should be able to adopt provisions that mandate that shareholders must settle disputes with the company through arbitration rather than through the courts (and, in particular, through class action lawsuits). As I mentioned in my review of the CCMR Report's Enforcement Section, I think it is clear that shareholder class action lawsuits are not necessarily a good thing. I also believe that, for the CCMR's proposals on limiting class action lawsuits to work, shareholders must have greater abilities to remove poorly performing boards of directors. However, mandatory arbitration clauses likely will go too far and return power to corporate boards and managers at a time when power should be shifting to shareholders. Without the disciplining effect of a real lawsuit (and not a slap-on-the-wrist arbitration board), it is hard for me to imagine that board member fiduciary duties won't suffer.

Sarbanes-Oxley Section 404

The last section of the CCMR Report deals with Section 404 of the Sarbanes-Oxley Act, and it is not so much bad as it is unnecessary. (This part of the CCMR Report was written mostly by Andrew Kuritzkes, a managing director of Mercer Oliver Wyman, a management consulting firm.)

The much-reviled Sarbanes-Oxley Act has quite a few provisions, but the one that most companies find really unpalatable is Section 404. Section 404 states that a company's management must give a report about the company's internal controls (the controls designed to track how and by whom money is spent), and that the company's independent auditor has to give an opinion about this report. Despite what Kuritzkes writes, mandating that issuers have internal controls is not new, but is actually a requirement of the Foreign Corrupt Practices Act of 1977. Independent auditors were always supposed to test these internal controls -- it's just that, prior to Sarbanes-Oxley, this testing was largely perfunctory. However, now, following what happened to Arthur Andersen and with the Public Company Accounting Oversight Board's Audit Standard 2 (AS2), this testing has become extremely thorough. And costly.

Kuritzkes notes that there likely are some efficiency benefits to Section 404, in terms of improved corporate management. In a prior life, I was involved in "strategic sourcing" and supply chain management at a management consulting firm, and I can attest that profitable, well-run companies know how they spend their money; and companies that don't know how they spend their money are rarely profitable or well-run. In this sense, Section 404 could be seen as a government-mandated management consulting exercise of the type that companies regularly spend millions of dollars on without complaint -- only, now that it's mandatory, there's a lot of complaining. That said, if this is the principal benefit to Section 404, it's hard to see that it should be government's business to require it. Section 404 stands or falls on whether the direct benefits to investors in aggregate outweigh the costs.

By now, it is not entirely clear that Section 404, as it is now implemented by AS2, is cost-effective. But that is what makes this part of the CCMR Report largely unnecessary. The SEC has already agreed to offer "management guidance" on Section 404 implementation, effectively forcing the PCAOB to revise AS2 (through a new AS5) in a way that should dramatically reduce audit costs. In other words, on Section 404, the CCMR is largely preaching to the choir, using the same sermon some other preacher gave last Sunday.

The only interesting point Kuritzkes makes on Section 404 is that the planned reforms should not include a blanket exemption for small and medium enterprises. He notes that, while SOX compliance costs for firms with less than $700 million in market capitalization are more than five times greater on a relative basis than for issuers with more than $700 million in market cap, these smaller firms historically have also posed a much greater risk of having to restate their financial statements because of poor internal controls. Exempting these issuers from Section 404 would be exempting precisely those firms most likely to present a risk to investors. While Section 404 compliance cost might force some of these small issuers away from the U.S. equity markets, exempting them likely will raise their cost of capital anyway as investors grow wary of all small issuers. Consequently, the CCMR recommends that small firms be subject to the same Section 404 requirements as large firms, or that Congress should redesign Section 404 as it applies to small companies. (Without Congress weighing in on this matter, the CCMR believes audit firms will bear unacceptable liability should the SEC exempt small firms from the audit-testing requirements of AS2 and a problem with internal controls later arise.)

Conclusions

In short, my review of the Committee on Capital Markets Regulation Interim Report can best be summarized as:

Section 1 on Competitiveness: Really Sucks. It's clear that capital markets are important for the U.S. economy, but Luigi Zingales is entirely unconvincing that U.S. competitiveness is suffering as a result of U.S. securities regulation, or that this competitiveness is reflected by whether foreign issuers want to list in New York.

Section 2 on Regulatory Process: Mostly Sucks. Robert Glauber's attempt to paint the UK's "principles-based" regulatory approach as a panacea to any U.S. competitiveness issues is unworkable and just generally a bad idea. It would undermine investor confidence in a market where investors are everyone and where investors matter most. It won't work in the U.S. -- and, for that matter, it probably won't work in the UK long-term, either.

Section 3 on Enforcement: Some Very Good Ideas. The "public" enforcement system (the SEC, Justice Department and exchanges) needs to remain strong and threatening to deter market fraud. However, the threat posed by shareholder class action lawsuits is so great and so universal that it has lost its deterrence value and is now just a cost on shareholders everywhere. Clarifying certain aspects of rule 10b-5 is a good idea, and practices such as "pay-to-play" where lawyers essentially bribe local officials to represent local pension funds in class action lawsuits should be banned. Likewise, the Justice Department's "Thompson Memo" should be revised so it stops serving to blackmail companies into waiving attorney-client privilege or paying for lawyers for their employees.

Section 4 on Shareholder Rights: Some Really Good Ideas. Staggered boards of directors and poison pills should stop, particularly is, as above, shareholder class action lawsuits are restricted. The only thing I would say about this part is that it doesn't go far enough: other corporate anti-takeover tactics should also be prohibited. But I guess you have to start somewhere.

Section 5 on Sarbanes-Oxley 404: Mostly Moot Points. But a good point that smaller firms should not be exempt from a revised, more cost-effective Section 404.

Committee on Capital Markets Regulation Report (Part 2)

2006-12-05T20:28:00.000-06:00

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

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

Enforcement

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

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

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

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

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

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

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

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

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

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

Later this week: Shareholder rights and SOX Section 404!

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

2006-12-04T22:10:00.000-06:00

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

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

Investor groups sounded alarms yesterday after it emerged that a foundation with ties to a pair of well-heeled business donors and an executive battling civil charges had funded a controversial new report seeking to slash corporate regulation.
...
The charity has longstanding ties to Maurice R. "Hank" Greenberg, the former American International Group chief who was ousted from his post last year and is contesting civil charges filed by the New York attorney general. ... Two committee members, Wilbur L. Ross Jr., a private investor, and Citadel Investment Group manager Kenneth C. Griffin, contributed "a few hundred thousand dollars" more, Ross said in an interview.

I find this appalling. Not that certain "interested parties" funded the CCMR report. Of course they did! Where did you think the money was coming from, the research foundation fairies? What I find appalling is that certain opponents of these proposals have become so embedded in the Washington way that their first reaction to anything is the classic Washington ad hominem attack. Who cares what the report says or the strengths or weaknesses of its arguments? Look who's funding the thing! My God, don't you realize they would benefit from these ideas??

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

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

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

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

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

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

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

We generally tried not to include regulators...They may have a lack of objectivity. Anybody on this committee is in the real world and will bring with them real-world perspectives.

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

Competitiveness

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

First, minor point. Zingales says:

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

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

Second minor point: as evidence of the importance of U.S. capital markets, and their decline, Zingales discusses the role venture capitalists play and how important IPO exits are to VCs.

Not only are IPO exists much more profitable than exists in the private market, but they also affect the profitability of acquisitions exits. The value of VC acquisitions exits is correlated with the number of IPO exits: when there is a "hot IPO window," the average value of acquisition exits increases. For example, in 1999, there were 304 disclosed VC backed acquisition exits, with a disclosed average valuation of $142 million; in 2004, there were 413 with an average valuation of $57 million. The failure of the U.S. "IPO window" to reopen after 2001 has caused considerable anxiety among American VCs.

This may be true, but isn't this just a bit like saying that venture capitalists make more money during market bubbles, when "dumb money" is plentiful and retail investors are willing to invest in any Internet dog-walking dot.bomb that comes their way? How does this add to the economy, rather than just shuffle the money around? And what the hell is a University of Chicago business professor doing suggesting that there is a valuation difference between public and private investors? Isn't that perilously close to suggesting that markets aren't efficient? Can't you get your tenure revoked for such heresy?

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

A leading indicator of the competitiveness of U.S. public equity markets is the ability of the U.S. market to attract listings of foreign companies engaging in initial public offeringsÂso-called global IPOs.

Why? How come? Luigi, where's your support for this statement? Because pretty much everything else in this section of the CCMR Report is predicated on this statement, and, to me at least, this is not obvious.

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

I've got other gripes, too. Namely:

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

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

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

Regulatory Reform

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

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

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

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

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, a. To employ any device, scheme, or artifice to defraud, b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

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

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

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

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

Committee on Capital Markets Regulation issues long-ballyhooed report

2006-11-30T09:00:00.000-06:00

I've been busy this week and haven't had a chance to read over the "Paulson Committee" report released today, but for those of you looking for the report and willing to form your own opinions, here it is.

My previous blatherings on this committee (before it released today's report) are:

"Paulson Committee" may soon take on the trial lawyers by proposing limit on shareholder lawsuits

Bloomberg says Paulson in drive to reform U.S. financial Regulations

The future of world capital markets (Part 1): The Committee on Capital Markets Regulation

A Thanksgiving Holiday of Stock Exchange Cheer

2006-11-25T11:02:00.000-06:00

This is the Thanksgiving holiday in the U.S. this week, where I use my vacation holidays to work, like every other nervous American. Hey, you don't see the Chinese slacking off at the end of the November, watching the Packers and munching on deep-fried cheeze-whiz, do you? Unless you plan on learning Mandarin soon, I suggest you get working, too, kids. As for me --
對不起! 拜託不要解僱我!

This past week, while I was stuffing myself with roasted overgrown poultry, reporters all over the United States were waking up to the boring stock exchange battles that I've been writing about, much to the chagrin of my friends and family. Clay Risen of The New Republic writes in "Is London the world's new financial capital? The New New York" about the anti-Sarbanes-Oxley backlash developing in the United States, the Schumer-Bloomberg Wall Street Journal op-ed (see here), and the NYSE's John Thain's recent speech (see here). however, rather than piling on SOX, Risen asks:

Anti-Sarbanes-Oxley pundits would have us believe that the only thing to change in recent years, and thus the cause of London's surge, is the tightening noose of post-Enron regulations. But, while there's no doubt that reform has raised the cost of going public in the United States, a whole lot has also occurred to make going public in London--or Hong Kong, or any of a growing number of global financial centers--easier. Which raises the question: Did Sarbanes-Oxley cause the capital shift, or is something more fundamental going on here?

In particular:

...[W]hat the anti-Sarbanes-Oxley narrative really misses is that the shift to London is, in fact, part of a much larger tale: the globalization of capital. Just as the second half of the twentieth century saw manufacturing freed from its national moorings, the last few decades have seen capital become increasingly mobile, able to move in and out of markets irrespective of borders. Ironically, the globalization of capital is facilitating the regionalization of capital markets. No longer do European companies, with investors and customers centered on the continent, need to come all the way to New York, across a workday's worth of time zones, to float stock. Ditto with East Asia--for all the talk about London's financial rise, it is actually Hong Kong, with its easy access to Chinese companies, that will take first place in the size of its IPOs this year.
To be sure, capital doesn't flow completely freely, and national regulatory systems--including Sarbanes-Oxley--are still a major factor. But they are far from the only ones. Even more significant is the perception that the United States is culturally and politically averse to the international market system. It is hard to express just how offended the global finance world was by the blunt nativism surrounding the Dubai Ports World debacle earlier this year, or the rise of protectionist sentiment in Congress, or the fact that it is now much harder for international financial workers simply to move in and out of the country--a key requirement in a fluid global economy. "Just getting into America, even if you're British, is an issue,'' one headhunting executive told The New York Times. ''We've had candidates that arrived for an interview, were told they couldn't leave a room in the airport, and were put on the next plane back."

Risen concludes with something I consider obvious, but which many regulators and even industry people seem to find difficult to grasp:

The day is fast emerging when globally mobile capital will pick and choose among exchanges based on a wide set of criteria. Some will go for exchanges in countries where money is cheap and questions are few; others will go for the security that comes with weightier regulations. In a recent op-ed in the Financial Times, American Stock Exchange Chair and CEO Neal Wolkoff wrote that Sarbanes-Oxley "has effectively created an opportunity for regulatory arbitrage favouring the lowest-cost host nation." But, while Wolkoff considers this a bad thing, it is in fact a very good one--over time, national exchanges will have to compete directly for listings and, in doing so, to differentiate themselves. True, some will try a lowest-cost, lightest-regulation approach, and they will win a certain amount of attention in doing so. But market listing is hardly a commodity; with lighter regulation comes increased risk. Many companies will just as likely seek stability and accountability. Which is why the United States should stand behind, not tear down, its reputation as the best-regulated and most transparent financial sector in the world.

Next up, we have a Businessweek commentary ("London's Freewheeling Exchange: It's winning the listings war against New York, but investors can get burned"). The BW op-ed discusses the growth of the London Stock Exchange's Alternative Investment Market (Aim), which the UK holds out as a low cost/low regulation exchange for smaller start-ups (sort of a NASDAQ for really small dot.bombs.) The problem (as I've also discussed earlier in my NY-Lon post), is that returns on Aim-listed securities are dismal.

But just because London's listings are soaring doesn't mean it's doing a better job of raising capital. All major stock markets have weak companies, but the new issues in London these days seem especially so. "This is the worst dreck I've ever seen," the renowned short-seller James Chanos of Kynikos Associates declared recently in a New York speech. Chanos, who has sounded alarms about U.S. companies such as Tyco, Conseco, and Enron over a 25-year career, now maintains a London office and research staff to short-sell LSE issues.

To be sure, dependable companies like BP, HSBC Holdings, and GlaxoSmithKline still dominate London, one of the oldest and most developed centers of capitalism in the world. But when half a dozen stocks of online gambling companies plummeted recently, London's easier standards were cast in an unflattering light. The biggest loss in stock value came from online casino operator PartyGaming, one of the LSE's biggest offerings in five ears when it listed in June, 2005. Investors forked over $1.9 billion, all of which went to PartyGaming's founders instead of the company itself. (In U.S. deals, insiders take only about 15% of an initial public offering's proceeds, if any.) PartyGaming is owned mainly by an American couple who live in Gibraltar. Operating PartyPoker.com from computers in a Native American territory in Canada, the company was getting nearly 90% of its revenue from U.S. residents, where online gambling was and remains illegal.

Businessweek concludes:

But there are other signs that the bloom is off LSE IPOs. Of new issues over $100 million this year, LSE-listed stocks are up only 11%, vs. 20% for NYSE stocks, a reversal of 2005 results, according to Dealogic. The share prices of NASDAQ issues of at least $100 million beat those on London's AIM, rising 5.5%, vs. a 0.5% drop this year, and 35.2% vs. 12.3% in 2005.

The Financial Times also had an interesting article that juxtiposes some of these ideas to give a much broader picture of what is happening behind the scenes of these exchange wars. Norma Cohen, in "A clash of titans: why big banks are wading into the stock exchange fray," writes the debate over the NYSE-Euronext and NASDAQ-LSE mergers misses the larger point: stock exchanges are entrenched monopolies and investment banks and large investors are determined to inject competition into this market to limit the monopolistic fees stock exchanges have been able to extract from their customers. "Project Turquoise", the plan several of the world's largest investment banks announced two weeks ago to create an independent trading platform to compete with Europe's stock exchanges, is an example. Stock exchanges, particularly in Europe, tend to operate without competition, despite a "code of conduct" created by the European Union's Markets in Financial Instruments Directive ("MiFID"). This has led to enormous profits for the London Stock Exchange and Deutsche Börse, with trading charges remaining steady even as trading volumes have increased 50 to 75%. Marginal costs on an exchange trade are effectively zero, but exchange customers find that the more volume they direct towards and exchange, the greater the portion of their profits are absorbed by exchange fees. In this regard, this is an area where the United States, "burdened" as it is by SEC regulations designed to promote exchange competition, actually has an advantage over much of the rest of the world. (This, however, begs the question of why, if European super-profits are transitory, why is NASDAQ, in particular, willing to bid so much for the London Stock Exchange?)

The latest issue of the Economist also has an article on the subject. ("What's wrong with Wall Street") . Unfortunately, this article reads like the editor just plagarized Hank Paulson's speech from last week. (See here.) In particular, the Economist writes that the U.S. should overhaul it's corporate governance approach (which is correct, but rather unlikely -- see here), that shareholder lawsuits should be curbed (also a good idea, but even more unlikely -- see here), and that the SEC and CFTC should be merged (pretty much a no-brainer, but, again, I'm not holding my breath. See here.)

With all of that said, however, my question is, is there really a crisis with U.S. capital markets? The more oppressive aspects of Section 404 of the Sarbanes-Oxley Act will soon change. The "Roach Motel" aspect to the U.S. regulatory system ("roaches check in, but they don't check out") will also soon be changed as well. (Some call this the "Hotel California" effect, as in Todd Malan's FT op-ed ["Time to change rules at Hotel California"], but I think "roach motel" is a little more descriptive, given the activities of some issuers.) And the U.S. system is otherwise very investor-friendly and competitive. Sure, the exchanges may be getting squeezed, but as I've said before, is it really the government's job to make sure U.S. stock exchanges are the most profitable in the world? Isn't it rather government's job to see that investors get the highest returns given their risk preferences, and U.S. issuers get the lowest cost of capital given the risks they offer?

Europe violates Muppet copyright laws, sings "It's not easy being green"

2006-11-24T23:47:00.000-06:00

Andrew Bounds of the Financial Times writes today in "Green laws ‘may harm Europe’s economy’" that Günter Verheugen, the EU's industry commissioner, is warning that “We have to recognise that ... our environmental leadership could significantly undermine the international competitiveness of part of Europe’s energy-intensive industries and worsen global environmental performance by redirecting production to parts of the world with lower environmental standards.”

I'm shocked! Shocked!! And here all this time I thought these new green technologies were going to give the European Union a competitive advantage versus the rest of the world when demand for these technologies skyrockets.

Well, at least all is not lost. I've invested the other half of my money in developing baseball fields in the middle of Iowa corn farms. Because, you know, if you build it, they will come and buy it.

Well, at least he gave me an "A" once

2006-11-21T17:10:00.000-06:00

Truth be told, I was not a very good law student. First, I hate lawyers. That's always a strike against you in law school. Second, I hate legal precedent. I mean, why should I reference some idiot's clearly bad decision 20 years ago just because he or she happens to have gotten appointed to the Supreme Court?

Be that as it may, I did do well in a few classes. Cass Sunstein's was one of them, and I always wondered why given that I rarely agree with him on much. (Plus, there was that time I accidentally implied his life resembled a country/western song. Hey, how was I to know his dog had just died??)

However, I'm starting to figure it out. I may not agree with Sunstein on much, but apparently he agrees with me! In a recent article by Sunstein & Bo Cowgill in The New Republic ("Can predictions markets forecast elections? Good Bet") , Sunstein and Cowgill argue that, even though online prediction markets (such as Tradesports.com) failed to predict the Nov. 7 Senate elections (as I noted here), they are still better at making predictions than pretty much anything else. Sunstein and Cowgill also rightly find the lack of faith of Reason Magazine's Katherine Mangu-Ward, the DailyKos' Markos Moulitsas, and Atrios disturbing.

That said, as Sunstein and Cowgill allude, the really interesting question is where and why prediction markets will consistently provide wrong answers. (And to think they won't is to have too much faith.) Some markets will have too few bettors and too little information. Those are easy. But are their other types of events that will consistently stymie prediction markets, for less obvious reasons? If you can figure out what those events are, you can make a lot of money. But then, of course, the prediction markets would be working, wouldn't they?

U.S. Treasury Secretary jumps in front of parade and starts waving baton

2006-11-21T00:58:00.000-06:00

Treasury Secretary Hank Paulson gave his long-awaited capital markets speech in New York yesterday. A copy of the speech can be read on the Treasury Department's website here. Little of what the speech discusses is new, of course. In fact, much of it has been debated in detail for nearly a decade (principles versus rules-based regulation, accounting convergence, costs versus benefits of regulation, etc.) However, given how many new proposals are in the pipe to reform post-Sarbanes-Oxley capital markets regulation (including SEC and PCAOB proposals to reform how Section 404 is implemented -- see here and here), I get the feeling that Paulson is preparing to take credit for reforms that have been in the works for quite some time.

Paulson's discussion of foreign market development, though, is worth a read. As he notes (and as I noted in this post previously), part of the shift away from New York's dominance of the IPO market comes from the growth of other non-US (and non-European) markets with high regulatory standards. This shouldn't be a surprise; if the US was getting something right in the 1990s, it's only natural that other countries would try to figure out what that was and do it themselves . This is even more the case when the United States, as a member of international groups such as the International Organization of Securities Commissions (IOSCO), goes around preaching exactly what it is that makes a capital market work well.

Nonetheless, Paulson's reference to the principles-based International Financial Reporting Standards (IFRS) as being better that US accounting standards strikes me as a little odd. Not that I disagree with this. However, as Manuel Conthe, the chairman of the Spanish securities regulator noted at last week's IOSCO Conference in London, issuers can't simultaneously demand principles-based regulation and then be upset when regulators interpret those principles in ways different than they do. That's the thing about principles: they leave a lot open to interpretation and, at least in the United States, do you really want a judge to second-guess how you've interpreted and applied an accounting principle? (Because, trust me, they will.) Arthurs Docters Van Leeuwen, the chairman of the Netherlands Authority for Financial Markets and chair of the Committee of European Securities Regulators (CESR), at the same conference also noted that, given principles avail themselves of a wide degree of interpretation, global market participants should be aware of the inherent conflict between principles and a level international playing field -- "You can have principles or you can have a level playing field, but you can't have both."

Too bad Paulson didn't attend the conference.

Does anyone know what Michael Kinsley is talking about?

2006-11-21T00:45:00.000-06:00

Holy context-less arguments, Batman! But I swear, I can't really make out what Kinsley is trying to say in his most recent Washington Post op-ed ("A Capitalist Swindle"). Is he talking about squeeze-outs in a hostile takeover? Either Kinsley's article has been edited down to the point where critical elements of his argument have been deleted (wouldn't be the first time an editor has done something stupid like that); or Kinsley doesn't understand the topic well enough to describe what he is upset about.

Any ideas out there?

If you think the US legal system is screwed up...

2006-11-17T14:40:00.000-06:00

This past weekend the London Times reported that the United Kingdom's Home Office (which is something of a combination of the US Departments of Justice and Homeland Security) agreed to pay 198 heroin-addicted convicts £5,000 each (about $9000) because the UK Prisons Service forced them to go "cold-turkey" in prison. The prisoners sued the British government for trespass, arguing that they had not consented to the "treatment" of being deprived of the drug. They also sued for breaches of the European Convention on Human Rights, which prohibits discrimination, torture or inhuman or degrading treatment or punishment.

The Home Office agreed to the £1 million payout after agency lawyers warned that the government was likely to lose the lawsuits.

See "Inmates win 'cold turkey' payouts".

SEC Chair Chris Cox and MP Ed Balls trade shots in London

2006-11-16T19:43:00.000-06:00

Rather than the FSA's Callum McCarthy carrying London's water (as I predicted here), Member of Parliament and Economics Secretary Ed Balls (of the famous "Balls Clause") spoke as first keynote at the IOSCO Technical Committee conference in London today. Balls stated that there is a need throughout the world for a "risk-based, proportional regulation" and for others to "respect the rights of each nation to regulate its own financial services industry and the financial markets that operate in its territory as it thinks best." (Take that, America!)

Towards this end, Balls announced he was proposing today a bill in Parliament (discussed earlier here) called the "Investment Exchange and Clearing House Bill" that would give the FSA a veto power over future rules and operations that apply to UK exchanges and clearing houses, if those new rules were not "risk-based or proportional." Because, you know, industry is always imposing harsh and disproportionate regulations on itself.

The bulk of Balls' talk focused on hedge funds. Hedge fund regulation is important to the City of London because, while 70 percent of the hedge fund market is in the United States, quite a few of the funds marketing to U.S. clients are actually in the UK. Consequently, when the SEC talks about regulating hedge funds in the United States, London hears "extraterritoriality".

Yet, despite Balls' focus on hedge funds, the decision by the Deutsche Borse to rescind its offer for Euronext was a specter in the room, as was the decision by several major investment banks to form their own trading platform to avoid the high costs of conducting trades on the London Stock Exchange. This combination has put new pressure on the LSE, as it effectively now faces two new competitors -- an NYSE-Euronext merger and a new electronic trading platform being put together by its biggest customers. Unsurprisingly, shares in the LSE dropped 5.7 percent yesterday, while Deutsche Borse shares dropped 4.6 percent.

A copy of Balls' speech can be found here.

SEC Chairman Christopher Cox followed Balls with a second keynote address where he quoted Max Weber, Louis Brandeis and even French radical Jean Jacques Rousseau in warning against the "temptation for regulators to relax their standards to attract investors and issuers, at the expense of the other jurisdictions -- with the result that the overall standard of regulatory quality suffers." Cox also announced that the SEC would be introducing management guidance, to supplement new audit standards from the PCAOB, designed to radically reduce the costs to U.S. issuers of implementing Section 404 of the Sarbanes-Oxley Act.

In the weeks ahead, the U.S. will unveil significant changes to the implementation of section 404 of Sarbanes-Oxley that are designed to make it more useful for investors. Those changes will be aimed at ensuring that the internal control audit is top down, risk based, and focused on what truly matters to the integrity of a company's financial statements. They will provide guidance for both companies and their auditors to permit common sense reliance on past work, and on the work of others.
...
In 1932, U.S. Supreme Court Justice Louis Brandeis wrote that "one of the happy accidents" of a system of multiple jurisdictions is that "a single courageous state may, if its citizens choose, serve as a laboratory, and try novel social and economic experiments." Some of the experiments in regulation that we have witnessed around the world seem to have worked. Others have failed. So long as our experiments are aimed at providing high-quality investor protection, we all stand to gain. But if our experiments are guided by the desire to beggar our neighbors, we will all surely lose.

A copy of Cox's speech can be found here.

Really, I swear, It's a Market Failure

2006-11-15T18:50:00.000-06:00

If this isn't because of a market failure**, why would they be passing a law? You know, the article quotes people saying this is a brave law, but it's so clear that it's not. Why did they leave such a glaring loophole that allows people to smoke in their own homes if it's a single-family dwelling? Are they really such cowards that they're going to allow people to hurt themselves at home? Will no one think of the children? What a travesty!

**The failure, obviously, is the absence of a market for giving wedgies to people who just can't stand it when other people have fun. Or the absence of a market for automatically impeaching for gross stupidity any legislator who says, "You can’t walk down the street with a beer, but you can have a cigarette. You shouldn’t be allowed to do that."

Forbes Magazine: NY hearts smart money

2006-11-14T00:09:00.000-06:00

Forbes Magazine's Elizabeth MacDonald writes in the November 8th issue that the much ballyhooed City of London/London Stock Exchange study released last July actually shows that trading costs on the New York Stock Exchange are lower than in London or elsewhere. (See "The Safest Financial Capital?") (A link to the LSE study can be found in my July 24 article, "The Financial Times is the London Stock Exchange's bitch".)

In other news, today is the first time I've ever written a sentence with the word "ballyhooed" in it.

MacDonald also notes several other studies that seem to contradict the key point of the City of London/LSE report that the LSE offers issuers a lower cost of capital than New York. In particular, she cites a joint study of internal controls at 667 companies by the University of Wisconsin-Madison, the University of Texas at Austin, the University of Iowa and the MIT-Sloan School of Management which finds that the dreaded Sarbanes-Oxley Act has helped lower the cost of equity capital for US-listed companies by 50 to 150 basis points. A separate study by the consulting firm Orchestria (see here) suggests that US capital markets have been much better at internalizing a "compliance culture" than London has, and this compliance culture makes deterring financial misconduct easier.

MacDonald's recent articles are interesting because they join a growing counterattack against industry groups lobbying to have the law modified or repealed. This debate pits industry groups such as the "Paulson Committee," the U.S. Chamber of Commerce and the CEOs of the 6 largest auditing firms against former SEC chief accountant Lynn Turner and Consumer Federation of America investor protection guru Barbara Roper (see "Stock Market Brawl") and, of course, the New York Times editorial board (see here).

And me. But for me it's less about SOX than it is the LSE. I just think they're obnoxious.

SEC and UK FSA chairs to speak at IOSCO Technical Committee Conference in London

2006-11-13T06:55:00.000-06:00

This week, the leaders of the world's largest financial markets will meet in London at the 3rd annual "Technical Committee Conference" of the International Organization of Securities Commissions. The host will be Callum McCarthy, chairman of the UK Financial Services Authority. The conference is designed to be a venue for industry leaders to meet with and discuss regulatory issues with the leaders of the world's securities markets, in an appropriately fancy setting. The conference itself will be held at the mega-posh Savoy Hotel.

Interestingly, SEC Chairman Christopher Cox will present the event's keynote address. Cox will be the first SEC chairman to attend an IOSCO event outside the United States since Arthur Levitt. (Callum McCarthy himself very rarely attends IOSCO meetings, perhaps reflecting his general disdain for the international organization.)

Given the tensions between the UK FSA and the US SEC, expect Cox and McCarthy to take very polite, very well-concealed jabs at each other in their respective speeches. Both will say very nice things about international cooperation and the globalization of national securities markets. McCarthy likely will say something about how regulation must be "balanced" and "cost-effective" (in contrast to the U.S.), while subtlely pointing out how successful the London Stock Exchange has been. Cox probably will say something about the need to protect investors while being "adaptable," as shown by the SEC's plans to change how the Sarbanes-Oxley Act is being implemented. He might also say something about how securities regulators around the world should be careful to avoid undercutting each others' regulation or else face a "race to the bottom" (by which he'll mean the UK).

NYT takes a swing at SOX opponents

2006-11-12T18:31:00.000-06:00

The New York Times' editorial today (see "The Corporate End Run") comes out arguing that the business groups proposing significant changes to the Sarbanes-Oxley Act are greedy crooks trying to take advantage of the fact that both Senator Sarbanes and Congressman Oxley have just retired to push for relaxed regulations and protection from shareholder lawsuits. (In fact, the editorial repeats the same arguments I've made here, here, here, and here, in many cases citing the same sources. Guess I'm just ahead of the curve.)

In particular, the NYT states:

United States markets lost their dominance of initial stock offerings for numerous reasons that had little to do with regulation. Some of last year's biggest deals were Chinese and French privatizations. Markets elsewhere are bigger and more liquid than they once were. There are also intangibles, such as America's recent unpopularity, increased barriers for visa seekers and extraordinary budget and trade deficits, which might make an issuer think twice about a dollar-denominated stock.

The London Stock Exchange, one of the leading beneficiaries of the American decline, commissioned a study showing that underwriting fees in London are just 3 percent to 4 percent of a transaction, compared with an average of 6.5 percent to 7 percent in the United States.
When workers confront globalization, they are told to adapt, take their pink slips and go to night school. It is the harsh downside of an integrated world economy that has on balance significantly enriched the country. When financiers feel the pinch from competition in Hong Kong and London, they run to the Bush administration for rule changes.

America's investor protections and corporate regulations have made it a nation of share owners, with almost 57 million American households owning stocks either directly or through mutual funds. The Securities and Exchange Commission has already signaled that it will smooth the implementation of Sarbanes-Oxley, especially for smaller companies. And abuses of the private litigation system like pay-to-play should be stopped. There is room for reform. But over all, the system is working. It may need tweaks, but it does not need a revamping.

I don't usually take the same "Worker's of the world, unite!" tone as the NYT, but it's still good to see that they occasionally get something right. Even if it has been said elsewhere by others already -- but, hey, it's the NYT. Don't ask for too much.

The editorial also references this NYT article by Stephen Labaton ("Businesses Seek Protection on Legal Front").

Germany considering charges against Rumsfeld

2006-11-11T01:43:00.000-06:00

And pretty much everybody else in the Bush Administration (see Time Magazine article here).

Why is it again that the Europeans seem surprised we didn't agree to sign on to the International Criminal Court?

(In fact, if I recall, when the United States originally objected to the ICC, citing exactly this kind of thing, European governments and some legal scholars in the US assured everyone that these concerns were overblown. Oops.)

Of course, this is probably just another case of a frivolous lawsuit -- or a serious lawsuit brought under a very problematic German law that the Germans will continue to find embarrassing. But if the German prosecutor accepts the charges, it turns into another case of a local prosecutor/politician/judge trying to meddle in a country's foreign policy (in this case, Germany's foreign policy). Whether it's local judges bringing charges against Chilean dictators, or local attorneys general trying to create national financial regulations, this type of meddling should stop. There is a reason countries have national governments -- it's so there is a single voice setting national-level policy. If you don't like that policy, in a democracy you have a perfectly good venue for redress (called an election).

Wow. Even Tradesports got that wrong

2006-11-10T00:23:00.000-06:00

Now that the Virginia Senate race between George "Macaca" Allen and James "Thunder Thighs" Webb is finally decided, the Democrats have taken control of not just the U.S. House of Representatives, but also the Senate. When you do the political math, this is pretty amazing. Thanks to Republican House Whip Tom DeLay, Congressional districts have become so highly gerrymandered that the 2004 election had barely 30 to 40 truly competitive seats, out of 435. Over the past several elections, House incumbents have tended to be reelected 95 percent of the time -- with a record 99 percent of incumbents winning in 2002.

Senate seats aren't able to be gerrymandered, of course. Nonetheless, incumbents historically win 90 percent of Senate races. Since only 33 out of 100 Senate seats were up for election this week and the Democrats needed to win 6 of those to take control, the historical odds were not good. Even if the Democrats took all the Senate seats with no incumbents (Maryland, Minnesota, Tennessee, and Vermont), that would have given them one additional seat (Tennessee, which in fact has remained Republican).* Under a "normal" election cycle, we could then expect the 90 percent incumbent victory trend to mean the Democrats would have picked up 1.4 seats from the 14 Republican incumbents facing reelection, while losing 1.5 seats to the Republican. In other words, even if Senators are rarely, if ever, actually physically partitioned, we would still expect Democratic gains to be offset by nearly identical losses.

Instead, six incumbent Republican senators lost their reelection bids -- a 57 percent reelection ratio, versus the 100 percent reelection ratio for the 15 Democrats facing reelection. While those in the financial industry are fond of saying "past performance is no guarantee of future performance," this is still amazing. So amazing that the "futures" market Tradesports had been giving odds in the 70 to 80 percent range throughout October that the Republicans would maintain control of the Senate. Since such markets are supposed to reflect the "wisdom of crowds", it might be a good time to reflect that markets still aren't crystal balls.

What are my predictions? I'm glad you asked!

First, both major political parties in the United States tend to draw their leaders from their most senior members. Most of these members got to be senior by coming from very "safe" states or Congressional districts. And safe states and districts, in practice, tend to be very strongly liberal or conservative -- in other words, statistical outliers in a country that for the past several elections has been evenly divided between Republicans and Democrats.

Political party leaders are not stupid. Well, some of them aren't. Still, by temperament and necessity they reflect the voters who elected them. This means that the voters who elected the Democratic Party leaders probably are not very similar to the voters who this past Tuesday brought the Democratic Party to power in Congress. This means the Democrats now face the very real threat the Republicans faced in 1994; that the less moderate faction of the party will set Congress' agenda for the next two years, against the wishes of the majority of "swing" voters who just put the party in power. The litmus test to see whether this is happening will be the reactions of those Democrats seriously vying to be President in 2008 -- Hillary Clinton, Barack Obama, John Edwards, and a few others. Most of these potential candidates have not been in office as long or come from as safe seats as Nancy Pelosi, David Obey, Barney Frank, or Charlie Rangel. If we see these presidential contenders begin rebelling, it will be a sure sign that the new Democratic Congress is heading in an unpopular direction.

* While Jeffords in Vermont was nominally an Independent, he caucused with the Democrats.

NYSE's Thain on competing for global capital: Why does everyone get this wrong?

2006-11-09T23:20:00.000-06:00

The New York Stock Exchange's chairman John Thain spoke before the first annual conference of the Securities Industry and Financial Markets Association (SIFMA) in Boca Raton, Florida this week. (This is the first conference for the SIFMA because it only came into existance this year, as a merger of the Securities Industry Association and the Bond Markets Association.)

Jeremy Grant of the Financial Times writes about Thain's speech here. Unfortunately, neither the NYSE or the SIFMA have yet to publish Thain's remarks, so I'm not sure what he actually said (since I didn't attend the conference). But Grant's description of this speech, which includes the now-expected language about how Sarbanes-Oxley, state regulators, and class action lawsuits are pushing foreign companies away from U.S. capital markets, includes this:

[H]e said that the proliferation of lawsuits, Sarbanes-Oxley and overlapping regulations could stifle the country’s ability to compete for global capital. In a thinly veiled reference to London’s success in attracting company listings, Mr Thain acknowledged that US competitiveness was also threatened by exchanges around the world.

Most people, regardless of what they might think about this whole capital markets competitiveness debate (see here, here, here and here, if you want more), might just pass this off as typical speechifying. But it actually makes the same mistake that Stephen Bainbridge made a few weeks ago and which I wrote about here. That is, competing for public offerings and securities listings and competing for capital are not the same thing! Competing for capital means you are competing to attract investors -- i.e., the suppliers of capital. Competing for listings means you are competing to attract companies -- the users of capital. Of course, over the long-term, if you are good at attracting capital you will attract companies wanting to list on your market. But over the short- and medium-term, it's not at all clear that laws and regulations companies find onerous has any effect on your ability to attract capital (that is, investors). Indeed, you can easily imagine a situation where such laws actually attract investors, who become more confident in the integrity of your market. (Capital gains taxes, on the other hand, might actually hurt your ability to attract global capital.)

Why are these concepts so easily confused?

Big Audit Firms Release (Self) ''Serving Global Capital Markets and the Global Economy" Report

2006-11-09T02:16:00.000-06:00

The CEOs of the Big Four accounting and auditing firms (PricewaterhouseCoopers, KPMG, Deloitte & Touche and Ernst & Young) and two smaller firms (Grant Thornton and BDO International) yesterday issued a report titled, "Serving Global Capital Markets and the Global Economy" (see link here.) The past few years have been simultaneously tough and extremely profitable for these firms, and this report represents a response to the industry's critics. Following age-old advice, these firms apparently believe the best defense is a good offense.

The bad part of the past few years has been obvious: Enron, WorldCom, Parmalat, Shell Oil and a host of other companies were all caught in accounting scandals. In each case, the independent auditors charged with confirming that public companies weren't cooking the books were all found asleep at the post--or worse. Arthur Andersen ceased to exist after the U.S. government brought criminal charges against it for destroying evidence related to the Enron scandal. Italian prosecutors indicted the local branches of both Grant Thornton and Deloitte & Touche as a result of the Parmalat fraud. And, in the United States, the Sarbanes-Oxley Act created a new regulator (the Public Company Accounting Oversight Board) to end the industry's self-regulation.

On the plus side, however, with this new oversight has come record profits. Auditing used to be a loss-leader accounting firms used as a foot-in-the-door to sell big companies much more lucrative management and IT consulting projects. Now, with passage of the Sarbanes-Oxley Act and the new focus on internal controls, auditing has suddenly become very profitable. Particularly since, with Arthur Andersen gone, there's one few firm to compete with.

It is the cost of these auditor fees that is now driving the PCAOB to revise U.S. audit standards. (See here.) Nonetheless, the audit industry is feeling unloved, and "Serving Global Capital Markets" is an attempt to influence the public debate on how U.S. securities regulation might best be reformed. (In this regard, the six auditors join a bandwagon that includes the "Paulson Committee" and the U.S. Chamber of Commerce.)

The report begins, as one might expect, by admitting to, and then downplaying, past failures. "In the late 1990s and earlier this decade, however, in a small, but highly publicized number of cases in the United States, Europe and Japan, certain members of our profession failed to meet the standards of quality that govern our profession." Yes, mistakes were made. But we're all past that now. The report goes on to note how important the audit industry is to the world economy, and how over-regulation of it and its clients might kill the goose that lays the golden eggs.

The report then makes several recommendations, four of which stand out:

The world's accounting and auditing standards need to be harmonized and based on principles rather than rules; and audit industry regulation should be coordinated at the international level (rather than, as is currently the case, effectively dictated at the international level by the PCAOB);
Securities regulations should change so that issuers no longer need to report quarterly financial statements (i.e., 10-Qs and 10-Ks in the United States), but instead should report financial and non-financial information to the public on a "real-time" basis, over the Internet;
Laws governing the audit industry should change so that accounting firms are no longer prohibited from offering consulting and tax advice to their audit clients "in light of the capital markets’ clear interest in assuring the continued attractiveness of the profession and its ability to bring in and retain individuals with the requisite talent and skills"; and,
Auditor liability should be capped in shareholder lawsuits so that audit firms don't go under should they make another Enron-esqe mistake. ("Audit firms and their global networks are not insurance companies. Legal and regulatory systems must reflect this reality. Individual auditors who engage in wrongdoing must be punished but without threatening the financial viability of their firms.")

The first point is a long-standing issue that, to date, has hinged mostly on accounting standards. The U.S. Financial Accounting Standards Board (which sets accounting standards for U.S. companies) and the International Accounting Standards Board (which sets accounting standards for many European companies) have been working together over the past several years to harmonize U.S. Generally Accepted Accounting Principles and International Financial Regulatory Standards. Everyone agrees, in theory, that a principles-based approach is superior to a rules-based approach, but reality has proven less than cooperative. A principles-based approach works only with strong, and fair, enforcement and oversight. Where shareholder lawsuits are a risk, however, rules trump principles -- you can prove to a court that you followed a rule. Demonstrating that you adequately adhered to a principle is more difficult and more open to second-guessing.

But more significantly, the report attempts to link the success of the U.S. GAAP-IFRS convergence project with the far more difficult effort to harmonized global auditing standards. Currently, International Standards on Auditing (ISAs) are a pale shadow of U.S. Generally Accepted Audit Standards (U.S. GAAS), and convergence is a long way off. (At the time of the Parmalat scandal, ISAs did not even require audit firms to confirm that a company's reported inventory existed. In other words, I could tell you that I have a warehouse in Hoboken with $3 million worth of product waiting to be sold, and you would not be remiss in your duties as an auditor if you just took my word for it.) For this reason, pushing for global harmonization of auditing standards -- and global "coordination" of auditor oversight -- could easily be seen as an attempt to weaken the iron grip of the PCAOB.

The second proposal is very interesting. But it is also pretty much a rehash of a proposal put forward by former SEC Chairman Harvey Pitt in 2001. Real-time disclosure of material information to investors would be a great boon, provided the quality and volume of information made available to the market increases, rather than decreases. At the same time, one can easily see how a real-time disclosure regime (particularly one enforced by a strong securities regulator) would be a God-send for accounting and law firms, which would pretty much have to become permanent fixtures in their clients' offices to ensure that the proper information was being disclosed. (The Financial Times has several articles on this proposal, here, here, and here. And given the way Barney Jopson writes, you might think the auditors' report is heralding the Second Coming.)

The third proposal, of course, is a desire to undo the conflicts of interest prohibitions contained in the Sarbanes-Oxley Act so that accounting firms can return to selling their audit clients very profitable management consulting work. However, it was the threat that they might lose such work that led to many of the financial scandals of the late 1990s through Enron and WorldCom. When a client holds out the promise of a multi-million dollar corporate restructuring consulting job, one can see how the pressure would mount on the audit partner to not upset the client with a harsh assessment of how it has accounted for its offshore "special purpose entities". Likewise, if an accounting firm has advised a client on how it should structure a corporate tax shelter, it's hard to imagine that same firm's auditors concluding that its colleagues over in the tax division screwed things up. The idea that accounting firms must be able to offer multiple services to the same client in order to attract bright young MBA and CPA employees properly deserves all the derision I can send its way.

And, finally, the issue of auditor liability is real, even if self-serving. (The New York Times' far more sceptical Floyd Norris writes about that aspect of the report here.) One problem world capital markets face today is that there are only four major international accounting firms left who are capable of offering a major multinational corporation a full multiple-country audit. (It is interesting that the heads of the Big Four pulled in the CEOs from Grant Thornton and BDO International for this report, since concentration in the audit industry is currently a topic of considerable discussion among securities regulators in North America, Europe and Asia. Representing the industry as a "Biggish Six" rather than a "Big Four" might be an attempt to stifle critics who argue audit industry concentration presents a risk to international financial stability and that governments should undertake to promote new rivals.) Consequently, in both the recent ChuoAoyama/PwC scandal in Japan and the KPMG tax evasion case in the United States, concerns were raised that a criminal indictment of either firm might pose a risk to the global financial system itself.

That said, "Serving Global Capital Markets" cannot help but be read as the audit industry's new campaign to limit its liability for future mistakes. The report cites an "expectation gap" regarding what they can do at a reasonable price, and what investors expect of them when it comes to detecting corporate fraud.

"...[T]he “expectations gap” arises because many investors, policy makers and the media believe that the auditor’s main function is to detect all fraud, and thus, where it materializes and auditors have failed to find it, the auditors are often presumed to be at fault. Given the inherent limitations of any outside party to discover the presence of fraud, the restrictions governing the methods auditors are allowed to use, and the cost constraints of the audit itself, this presumption is not aligned with the current auditing standards."

The problem with this view, of course, is that Enron, Parmalat and other corporate fraud cases were not simply matters of an auditor failing to detect an elaborate con perpetrated by evil masterminds. In the Parmalat case, it involved an auditor taking at face value an obviously forged letter purportedly from Citigroup attesting to the existance of an $800 million bank account. (The woman whose signature was forged actually did work for Citi, but apparently as a corporate librarian.) And, of course, while the report focuses on criminal penalties ("It is essential, going forward, for enforcement authorities to focus penalties for any auditor wrongdoing or negligence they may uncover on those directly implicated in such activities, rather than on the entire firms that employ them or with which they may be affiliated"), it is civil liability that is the crux of the matter. While auditors are not insurers against fraud, to argue that they cannot be held accountable for negligently overlooking fraud at the companies they audit is to suggest that their sole role is to check companies' financial statements for typos and math errors. Given that other participants in the global financial market (lawyers, investment banks, brokers, etc.) also face liability for negligence in the performance of their duties, why should auditors be different?

What’s wrong with the “NY-Lon debate”

2006-11-07T00:02:00.000-06:00

I’ve been too grumpy to write recently because of a case of bubonic plague (or a nasty cold — can’t quite figure out which at the moment). However, an op-ed in the Financial Times today (“The NY-Lon Debate”) forced me away from my hot toddy long enough to get even more grumpy.

The FT notes a recent Wall Street Journal op-ed by New York City Mayor Michael Bloomberg (a Republican) and New York Senator Charles Schumer (a Democrat) (“To Save New York, Learn From London”). This op-ed demands changes to the Sarbanes-Oxley Act, U.S. shareholder litigation rights, and U.S. accounting standards (where did that come from??) in order to allow New York to fight back against the London onslaught on our financial markets.

Bloomberg’s opinion makes sense. To call Bloomberg “anti-regulation,” of course, would be a joke, given his nanny-state ideas about banning smoking, trans-fats and pretty much everything else he thinks is bad for you. But, as a former businessman and financier, you might expect him to be sensitive to anything that might impact the U.S. financial industry, if not the U.S. financial market (which isn’t at all the same thing).

For Schumer, on the other hand, the irony is just overwhelming. After all, Schumer was one of the foremost advocates of the strong version of the Sarbanes-Oxley Act, even adding his own provision banning corporations from making loans to their own executives. During SEC Chairman Christopher Cox's Senate confirmation hearings, Schumer also asked for (and received) assurances that Cox would not “roll-back” SOX. Best of all, of course, is that Schumer’s concerns about excessive regulation and litigation for some reason don't seem to include New York Attorney General Eliot Spitzer. Gee, I wonder why that is?

(The answer is because Schumer is an opportunistic hypocrite. Yeah, I know — big surprise.)

But back to the Financial Times op-ed. My favorite parts says:

...New York has now fallen behind London in raising capital for international companies. New York needs to overhaul its markets and its regulation but its verve as a city, its depth of human experience and its access to US capital mean that a fightback is guaranteed.

The question for New York is whether the damage is permanent. A 1963 tax law, which made it unattractive for foreign entities to borrow in New York, suggests that it may be. The 1963 law created London's Eurobond market but, on repeal in 1974, bond issuance stayed in Europe. Even if Sarbox disappeared tomorrow, New York might not win back business - such as Russian share issues - where London now has critical mass.

New York, though, should never be underestimated as a financial centre or as a city. It has great strengths. It is home to most of the world's top investment banks. It has the world's most efficient clearing and settlement infrastructure. And it can draw on the companies and investors of the world's largest economy.

My first question, as usual, is, what are these “international companies” we keep hearing about? For me, at least, an “international company” is a company with international operations. And if you are looking at that, New York is still by far the largest market for international companies. It’s just that most of the companies with international operations trading in New York happen to be headquartered in the United States. Notwithstanding the pain of Sarbanes-Oxley, no major U.S. public company has made London its primary listing.

Yet for London, “international” apparently means what we in the U.S. call “foreign.” So what about these foreign companies? While over the past year or so more non-British issuers have listed on the London Stock Exchange than non-U.S. issuers have listed in New York, foreign listings on the New York Stock Exchange still exceed those on the LSE. The difference, of course, is proportion — foreign listings are a relatively small proportion of total NYSE companies, while they make up a much larger proportion of the LSE.

And that gets me to my second question: why are foreign listings so important anyway? I’m not quite sure I’ve seen an answer to that, in either the Bloomberg/Schumer article or the FT op-ed. As the Financial Times notes, part of New York’s strength is that it can “draw on companies and investors from the world’s largest economy.” But isn’t that actually all of New York’s strength? Particularly the investors part? Right now, London is a world marketplace. And, as such, the City of London makes a profit off of the transactions that take place on that market. But the London Stock Exchange increasingly is a market for foreigners. It is not necessarily where British citizens put their money. The proportion of UK households invested in the UK capital market is approximately half the proportion of U.S. households invested in the U.S. capital market. For the U.S., then, a capital market is not just a place where financial firms turn a buck (or a pound) as middlemen, but a place where U.S. companies go to get low-cost capital and — more importantly — where U.S. investors go to get a high return on their dollars.

This point is underscored by several recent articles on the LSE’s Alternative Investment Market (AIM). An FT article last week by Sarah Spikes (“Evolution's profit warning highlights problem of dependency on Aim market”) notes that the poor performance of companies listing on the LSE’s low-cost/low-regulation exchange have put a serious dent in the profits of several investment banks. Indeed, over the past six months, as both the NYSE and NASDAQ have grown, shares listed on AIM have lost 20 percent. At the same time, many small and medium-sized UK enterprises are finding it far more costly to raise capital on the AIM than they expected. (See “Over-optimism causing UK mid-market failures”). Spikes’ first article quotes Andy Brough, a fund manager who specializes in small and mid-cap UK stocks for the UK investment firm Schroders as saying, “Surely the point of AIM should be to make money for investors, not just to make money for the stockbrokers that list companies on AIM.”

Indeed. Which brings up my final question. If the goal of a well-run capital market is to make money for investors and provide cheap capital to hungry companies, should it really be U.S. regulators’ concern if London now has a “critical mass” in certain areas — for example, Russian share issues? Given the corporate governance problems now plaguing Russian companies (see the Guardian’s Terry Macalister, “The Russians are coming — and bringing the threat of scandal to the City”), bragging about how your exchange is attracting the lion’s share of these questionable listings is a bit like a West Virginia trailer park bragging about how it is beating the pants off Martha’s Vineyard in the fast-growing mobile home market. It may be true, and it may be true that trailer park developers in West Virginia are making a ton of cash, while real estate developers in ritzier neighborhoods are getting hosed. But is it really the job of financial regulators to protect the profits of the “real estate developers” of the financial markets (i.e., the exchanges and market intermediaries)? Shouldn't the focus rather be on investors and issuers — no matter how many multi-billion dollar Rosneft or ICBC IPOs the market intermediaries lose out on?

John Kerry: Just shut up

2006-11-01T18:51:00.000-06:00

I'm not a Don Imus fan, but he's right: John Kerry just needs to shut up. As I've said before, Kerry is still an idiot, and his comments to college students that if they don't study, they'll end up in Iraq just confirms it. Why the Democrats ever thought he was a suitable alternative to Bush still boggles my mind. What's amusing, though, is now many Democratics seems to be having those same thoughts. (See here.) What's also amusing is that the lesson Kerry seems to have drawn from the "Swift Boat Veterans" in 2004 is that any attack calls for an immediate and violent counterattack. I think this shows Kerry has a learning curve, in the sense that that is what he should have done (but didn't) in 2004. However, that this incident is a completely different kind of problem for him shows that the learning curve isn't too steep. Rapid nasty counterattacks are great if your opponent has made ridiculous and false accusations about you and you want to stop them from gaining traction; but if you are the one who stepped in the dog poop, they won't do.

In this sense, I think Kerry offers a good lesson for Democrats in what (not) to look for in 2008 presidential candidates. The first and most important lesson is to pick a candidate who actually won an election in a state with a large number of Republican voters. Massachusetts is not such a state. Fidel Castro, from his hospital bed, could run as a Democrat in Massachusetts and, if he were the only Democrat on the ballot, he would win. Bill Clinton, by contrast, came from a state (Arkansas) that goes either way. This has several advantages: first, it means the candidate knows how to appeal to a broader base and has the political skills to keep it from looking like obvious pandering. But perhaps more importantly, it means the candidate has enough touch with the broader electorate that that person automatically sees a red flag before saying something really stupid. If you are only used to Massachusetts voters, I can easily see how you might think Kerry's "botched" joke was funny. And, indeed, tell that joke to a bunch of Amherst students, and you'd probably get a lot of laughs. But you just come off looking like an idiot to the rest of the country.

Interestingly, what does this mean for Barack Obama? After all, he does come from a state with a sizable number of Republican voters. That said, he only won after his Republican rival self-destructed in a divorce scandal involving a beautiful cyborg ex-wife, and was replaced by an insane carpetbagger from Maryland. Does Obama have what it takes to take on a real opponent? Right now, nobody knows.

On the other hand, will Kerry's comments have an effect on the Republicans' chances of retaining the House next Tuesday? I kinda doubt it. Bush is still the face of the Republican Party, but Kerry is no longer the public face of the Democrats.

C'est le CNN contradictoire

2006-10-31T22:17:00.000-06:00

The Agence Française de Presse is reporting that the international French news channel France 24 will start broadcasting worldwide in both English and French in an attempt to offer a "contradictory" view to those offered by the "Anglo-Saxon" CNN and the BBC. ("French news channel to challenge 'Anglo-Saxon' CNN, BBC").

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.

Shareholder democracy in the U.S. brought to task

2006-10-30T01:05:00.000-06:00

An interesting article by Kate Burgess and Andrew Grant in this past week's Financial Times ("Investors 'lack basic rights' on US boards") notes a peculiar feature of U.S. corporate governance and securities law. In particular, while the United States has been at the bleeding edge of securities law reform designed to strengthen corporate disclosure standards and come down hard on managerial malfeasance, the actual rights of shareholders of U.S. companies to "kick the bums out" (i.e., replace not just crooked but also poorly performing managers and board members) is surprisingly weak. This is even more so when the U.S. is compared with other Common Law countries such as the United Kingdom and Australia.

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.

Prospective chair of House Finance Committee raises questions about global financial regulation

2006-10-29T19:35:00.000-06:00

On a recent trip abroad, I was asked several times about the likelihood that the Sarbanes-Oxley Act would be repealed in the coming year, given Treasury Secretary Hank Paulson's stated desire to streamline U.S. financial regulation. (See here and here.) This is an understandable question. After all, if most of your U.S. news comes from the Wall Street Journal and Financial Times and you don't have a thorough understanding of the U.S. political system, you could see how someone might come to think that it is a matter of time before SOX gets pulled. However, as I've noted before, the Treasury Department in the United States is not as powerful as the finance ministries of most countries. Further, if the Democrats take control of the House of Representatives on November 7 (which seems more likely than not at this point), chances of a repeal of Sarbanes-Oxley drop considerably. Chances drop even more if, as expected, the SEC and PCAOB radically restructure how SOX Section 404 is implemented (see here).

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.

Restaurant Smoking Bans Redux

2006-10-26T12:10:00.000-05:00

In a previous post ("Restaurant Smoking Bans"), M.D. Fatwa argued that smoking bans probably make sense, because there's very clearly a negative externality and a market failure. MDF suggests that the political popularity of smoking bans is evidence of a market failure. This is, to say the least, a deeply problematic statement. A proposal that would take $20 away from one person, burn half of them, and then split the rest among ten other people might be extremely politically popular -- over 90%! -- but the market's failure to provide this "service" is an argument in favor of markets and against government. But let's set this aside: it's not his main point.

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.

The face of a healthy democracy

2006-10-24T21:30:00.000-05:00

You ever wonder why the U.S. Congress has a "sergeant-at-arms", or why the British Parliament has those yellow lines the MPs aren't supposed to cross?

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...

Restaurant Smoking Bans

2006-10-23T16:13:00.000-05:00

Thomas A. Lambert, associate law professor at the University of Missouri School of Law, writes an op-ed in today's Washington Post against the proliferation across the country of restaurant smoking bans ("Against Restaurant Smoking Bans").

Lambert says:

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.

What's wrong with admitting arrogance and stupidity?

2006-10-22T17:30:00.000-05:00

Frankly, I'm not quite sure why the U.S. State Department has jumped so quickly to refute Alberto Fernandez's interview with Al-Jazeera in which he apparently says the U.S. has shown a bit of "arrogance" and "stupidity" in some of its dealings with Iraq. (See "Envoy: U.S. Showed 'Stupidity' in Iraq".) In particular, State Department spokesman Sean McCormack, from Moscow, apparently has said "the quote as reported is not accurate."

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.)

Kim Jong-Il tells Chinese "sorry" for nuclear tests

2006-10-20T02:16:00.000-05:00

Hey, North Korea! Who's your daddy?!

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!

"How HP raped my privacy and Patricia Dunn sent me an e-mail apology"

2006-10-20T01:02:00.000-05:00

I'll admit to blatant plagarism in the title of this post, but when you need to verbally kick somebody's ass, Mary-N-Texas is hard to beat. And when you read Pui-wing Tam's story in Thursday's Wall Street Journal ("A Reporter's Story:How H-P Kept Tabs On Me for a Year"), you'll realize that the Hewlett Packard folks, and their lawyers, need a serious ass kicking. (Unfortunately, you need a WSJ subscription to read the link.)

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."

...

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.

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.

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.

Tam mentions HP's classy touch at the end:

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.

"Daily Fatwa" dies; "My Daily Fatwa" lives on

2006-10-19T15:07:00.000-05:00

Here I was, thinking I was building a UK fan base with my incessant harping about the London Stock Exchange, and it turns out all you Brits out there are looking for news about the Daily Star's spoof "Daily Fatwa" newspaper! While I admit that "Page 3 Burka Babes" is a nice idea, it all seems a bit derivative, if you ask me. Particularly the title. Also, if you UK guys are looking for free speech protection for parodies and the like, you're living on the wrong continent, amigos. (However, I'll admit your recent high court decision extending protections against libel charges to reporters covering political figures is a step in the right direction--even if it's about seven decades late.)

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.

Japan assures U.S. that it doesn't plan on building nukes

2006-10-19T00:36:00.000-05:00

I'm a bit confused. Given that North Korea has just detonated a nuke, and China isn't helping with the situation perhaps as much as it could (certainly not in the UN), and what China really doesn't want is a nuclear-armed Japan, why are we asking Japan for assurances that it won't develop its own nuclear arsenal? (See David Sanger's "Japan Assures Rice That It Has No Nuclear Intentions".)

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?"

"Paulson Committee" may soon take on the trial lawyers by proposing limit on shareholder lawsuits

2006-10-18T22:30:00.000-05:00

Securities Litigation Watch is reporting that the Committee on Capital Markets Regulation may recommend by next month that the SEC undertake certain policies that will reduce the abilities of shareholders to file certain types of class action lawsuits against public companies. This is an interesting shift from the Committee's original implied purpose of lobbying for repeal of the Sarbanes-Oxley Act. It also may represent a shift in focus to better reflect political and regulatory realities. (The Committee apparently is now called the "Paulson Committee" because it will give its report to Treasury Secretary Hank Paulson; but also because, as I discuss here, Hank Paulson himself has a keen interest in "reforming" U.S. financial regulation and has signaled support for the group.)

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.

California ballot initiatives: The stupidest thing I've seen today

2006-10-17T20:51:00.000-05:00

Trust me. I see a lot of stupid things on a daily basis. But California's Proposition 87 on alternative energy is the stupidest I've seen today. You can read a summary on the California State website here, if you don't want to read the longer link above.

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?