My 2007 Predictions: Does this count?

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

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

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:

1. 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.



2. 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.



3. 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.



4. 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.



5. 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.



6. 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.



7. 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.



8. 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

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

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

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?

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)

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

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

1. New exemptions for banks that have stock brokerage arms (see here);
2. New SEC guidance on management's implementation of Sarbanes-Oxley Section 404;
3. A new rule proposal to permit foreign private issuers to deregister from the SEC;
4. A new rule proposal on who can invest in hedge funds;
5. A new rule proposal on the internet availability of company proxy materials; and,
6. 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

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

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)

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?