The political push against private equity

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.

The UK FSA lapdogs

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.

Nasdaq and LSE: who lost?

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.

U.S. securities markets and the Maginot Line

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

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

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

But while this approach served us well in the past, when the world's capital markets were separated not just by oceans but by the preference and habits of most investors, the world is a far different place today. And so we have to ask ourselves: have the basic assumptions on which we've built these regulations changed?
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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.

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

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

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

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

In BDO's press release, Simon P. Bevan, the national head of BDO Stoy Hayward’s Fraud Services team, says:

“In 2007 I...expect to see problems from frauds hitting venture capitalists and corporate lenders. A lot of money has been lent over a short period of time to management teams for investment and acquisitions. Based on experience in the dotcom boom I have no doubt some business plans will have been deliberately over-optimistic, and property, including intellectual property, falsely valued. When the tide goes out you can see who is swimming without their trunks on. If interest rates continue to nudge up in 2007 under-performing but over-valued businesses will quickly be exposed.”

A related story by Paul Tharp of New York Post (who has apparently seen a pre-release copy of the report -- see Brits get bit) actually puts some of this blame on small American start-ups listing in London to avoid the tighter regulatory controls in the United States:

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

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

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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

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.

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

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)

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"

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 offerings—so-called global IPOs.

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

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

I've got other gripes, too. Namely:

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

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

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

Regulatory Reform

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

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

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

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

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

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

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

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

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

Committee on Capital Markets Regulation issues long-ballyhooed report

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

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?

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

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.

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

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.