Business Law Prof Blog

SOX and Lawyers

     Page One of the New York Times feaures "After Scandals, New Legal Stars Rise on Wall St." They are compliance lawyers that lead boards of directors through the legal thicket that came with the Sarbanes-Oxley Act of 2002.  Many, including myself, predicted that SOX would empower lawyers in the board room.  It has.  Whether or not this is good remains to be seen.  On the positive side, one could argue that boards will manager better.  On the negative side, one could argue that boards will do what they always have done but with more time and expense spent on clever procedural and structural innovations, designed by lawyers, to lower the risks of the new exposure to liability under SOX. 

SEC and Short Sales

     Three hedge funds recently paid $2.4 million to settle charges of illegal short selling. (See SEC Press Release)  What they did should not be illegal.  The SEC has too many technical rules in to many contexts regulating short selling.  First let us be clear:  Selling short and then spreading false rumors to knock down a stock should be illegal and should be prosecuted.  However, selling short around market events or announcements should not.  The hedge funds sold short before "follow-on" offerings. 

     A follow-on offering is an offering that follows on the heels of a larger public offering of shares.  Sometimes the offering is a secondary offering, designed to put cash in the pockets of managers;  othertimes the offering reflects the additional cash needs of the issuer. 

     The SEC claims that short selling on the announcement of a follow-on offering but before the offering has been priced will adversely affect the price of the offering.  So what?  The announcement does have stock price consequences, the stock price usually will dip, short selling just takes advantage of the price dip. Short selling creates the new equilibrium price faster.  Those who believe the shorts to be wrong should buy and make money at the shorts expense.  If the short sellers are wrong, they lose money.  This should not be illegal.  Nor should the SEC prohibit short selling around any other structural market events that are publicly announced.  If the SEC can show that the short spread rumors to hurt the stock after they went short, that is another matter however.   

Selecting SEC Commissioners

     The process for selecting federal judges has gone decidely political.  Both sides in the dispute, federal Republicans and Democrats, are pointing fingers of blame at the other.  The reason for the politicization of the process is that judges have become more central, political actors.  Politican decisions made by judges means that affected people will find a way to politicize the selection process.

   Will the SEC be next?  The SEC this term has decided to restructure the nation's securities trading markets.  There are many winners and losers.  One of the winners is the SEC, which will enlarge is role and, therefore, its power.  Pushing the rule change through were two Democratic commissioners and a Republican chair, Donaldson, who comes from one of the big winners, the NYSE.  The two Republican commissioners voted against the rules. The party in power selectes the chair.  The President also selects the four commissioners but two commissioners must come from each of the two major parties. 

     One of the Democratic commissioner will leave the agency at the end of the year (before the new rules become effective).  Democrats know what is at stake and want Annette Nazareth as the replacement. Ms. Nazareth is safe;  she is from within the SEC (she has been a Director since 1999) and was an ardent propenent (indeed creator) of the new market restructuring rules.  Will the President comply with the request?

     The higher profile of the SEC will no doubt cause industry participants to get involved in lobbying for a replacement.  The lobbying will get political and the Presidenct's selection of a Demoractic representatives, long a matter of curtesy, could get very interesting.  Curtesy has been lost on the confirmation of federal judges.  Is the SEC appointment process soon to follow? 

Corporations and Socialism

     It had to happen. Some American business executives struggling to compete in the new global markets have come to the conclusion that the United States government should provide pensions and health care for their workers. 

     Here is the argument: Since governments in Europe have socialist pension and health care systems, European corporations can sell their goods and services cheaper than can United States companies on the world markets.  If the United States government would take over pensions and health care, United States companies could be more competitve.

      Those in business in health care and in pension fund industries should argue that they would compete better on the world stage if the goverment would just take over the manufacture of automobiles and planes in the United States.

Judges and Corporate Defendants

Most judges do very well in handling these complex business trials.  But some do not.  I sense a growing problem from press accounts of recent trials but do not have the data to support it.
         In the suit of Ronald Perelman against Morgan Stanley, it one believes the reporters, the role of Palm Beach County Circuit Judge Elizabeth Maass was – well – high profile.  She made “chastising Morgan Stanley a spectator sport” according to the reporter for the Wall Street Journal.  Her legal rulings gave Perelman a legal edge – she told the jury that the jury should assume that Morgan Stanley had engaged in fraud – and her conduct and statements during the trial gave Perelman an edge in court atmosphere as well. (Case Coverage)
        The conduct of the judge in the Frank Quattrone case is similarly aggressive.   I have recently testified in another case involving a corporation as a defendant and the judge, in federal court, was difficult – very, very hard on the corporation’s counsel.  Is this a trend?  Do we have judges interjecting themselves into trials with unusual frequency when corporate defendants (or corporate managers) face claims from individual investors (or pubic officials)?  Are judges, anxious to help the less powerful, less guided by decision-maker objectiveness and more willing to inject their views during trial? 

Shareholders in the Movies

I took my 13 year old son to a Japanese anime movie, SteamBoy.  A family of inventors, grandfather, father, and young son, harness the power of steam at the turn of the century.   The father turns to the dark side by working with a “Foundation” which is also somehow tied into evil “corporations.”   
     The Foundation is pushing arms sales to the leaders of Europe.  We learn that the British army in league with John Louis Stevenson is also pushing competing arms development and sales. 
     I continue to be amazed at how “corporations” and, in new twist, “shareholders” were featured in the morality dialogue in children’s shows.  The grandfather, who has attempted to shoot his son (the father) because his “son is already dead” and explaining this to his grandson argues against the evil interests of “shareholders.”   Unbelievable.  The “shareholders” are driving the managers to act in cahoots with the military and with government imperialists.   
      All those folks seeking to empower shareholders to get control over unaccountable managers must be on the wrong track.  We are indoctrinating our children with the sophist declarations of those who view all large business organizations as evil.
      I reminds me of all those kids shows that make the father the dunce or the fall guy -- but that's another story. 

Section 404 of SOX

The SEC, in coordination with the PCAOB, attempted to rein in auditors yesterday.  This is worth a chuckle.
      Congress passed Section 404 of the Sarbanes-Oxley Act of 2002 that requires auditors to check company’s internal controls on financial reporting.  This year publicly traded companies had to comply.  The open ended mandate of Section 404 has auditing companies telling clients to implement a flood of technical procedures.  Companies, afraid of the draconic penalties in the Act for failure to comply and unaware of what compliance is, must listen to their accountants. It is recipe for robbery. (Firms prepare "Perspectives on Internal Control Reporting")   The bills, paid to auditors and accountants, have been huge.  Revenue at accounting firms (and partners draws) are up.
       Now the SEC is rebuking auditors for an overly technical approach to the rule.  What did they expect?  Auditors are literal and technical by trade; they will put in technical procedures to give meaning to vague definitions.  Vague definitions in financial rules, based by draconian sanctions, will generate reams of technical compliance procedures as companies and their accountants attempt to limit their exposure. 
       The SEC’s only practical response is to itself create directions on appropriate procedures, which, of course, will enmesh the SEC in the details of proper accounting practices.  Wonderful.

Granholm v Heald

In yesterday the Supreme Court, in Granholm v Heald , faced both a constitutional and policy conundrum. 
      On the constitutional question the Court split 5-4:  Does the “negative implication” of the Commerce Clause in Article II prevail over the language of the 21st Amendment, repealing prohibition.  The Commerce Clause gives power over interstate commerce to Congress.  It does not, by its express terms, prohibit the states from affecting interstate commerce and it does not define what interstate commerce is.  The 21st amendment empowered states to legalize and regulation the sale of alcohol.  The majority found the 21st amendment subservient to the Commerce Clause, even though the model view of the “negative implication” of the Commerce Clause had yet to be announced when the 21st amendment became effective.  The minority said that the 21st amendment, being later in time, amended the Commerce Clause (whose meaning, remember, had yet to be announced).  Both sides, by assuming a model view of the Commerce Clause attaches to lawmakers actions in the 20s, engage in historic fiction
      On the policy side, the Court took a clear position against local protectionism in favor of national commerce.  There is always a smokescreen of reasons to protect local merchants from national competitors.  The national economy suffers and the local protected economy, after a temporary gain perhaps, suffers as well.  Local protectionism will become more pronounced as international competitive pressures intensify and some states find themselves out of step.  Rather than innovate they will attempt to protect what they have.
      Bad constitutional history, but good policy perhaps – it is a tough case for free traders who also value legal process. 

Germans and Hedge Funds

German executives are forming up to attack hedge funds.   Hedge funds forced the Chief Executive Officer of the Deutsche Borse, Werner Seifert,  out of office after he led two doomed efforts to purchase the London Stock Exchange.
      The ouster stunned German executives and German Chancellor Gerhard Schroder.
Chancellor Schroder is rallying for the regulation of hedge funds.  And German executives are now mumbling in back rooms about basing voting rights on the time stock is held.  The Chairman of the Borse suggested that German companies may want to introduce a two-tiered system of voting rights that gives more votes to investors who hold stock for a longer period.
       The irony of the counterattack is that European companies now routinely violate the one share, one vote structure that dominates practice in the United States.  A study of Europe’s largest 300 companies found two-tier time based voting, caps on investors’ voting rights, and golden shares (government owned options for super voting rights) are common practice.  The French, of course, are the most persistent violaters.
      Chancellor Schroder’s attacks mirror those of Prime Minister Mahathir of Malaysia in 1998.  After the Asian currency crisis broke in 1997, Mahathir blamed the hedge funds, then trading predominately in currency, and Soros in particular for the crisis.  He passed laws that slowed down currency trading in the Malaysian currency to thwart hedge funds. 
       Schroder, Mahathir, and the German executives claim to worry about the economic effect of fast money.  What they really worry about is the hedge funds ability to demand accountability – from the outside, free of the traditional social restraints that create controllable “old boys” networks.