June 4, 2005
Professors Beware: Public Pension Plans
Every university professor relying on a public pension plan should read the article on public pension plans in the June 13, 2005 Business Week, "Special Report- Public Pensions". Most professors use private pension plans (TIAA-CREFF, for example) but many, especially those in public schools still rely on state pension plans. The Business Week article notes that the 125 largest public pension plans are unfunded by over $278 billion. States will have to raise taxes, borrow more money, take more investment risks or reduce benefits. Some argue that the promises once made cannot be broken or modified, even in a municipal or state bankrutpcy. I am not so sure. In any event, professors on public pension plans should recognize the risk and diversify their retirement planning.
Could We Replace Greenspan with a Computer?
Robert J. Barro, a professor economics at Harvard, in the June 13, 2005 Business Week offers information that could lead one to argue that we could replace Greenspan with a written formula. He notes that the federal funds rate, set by Greenspan, has been predicatably .7% under the average 5-year Treasury yield. Could the new Fed Chairman tie the two, absent extraordinary circumstances, and make the federal funds rate more predicatable?
Grading Corporate Goverance
Individual investors can now get corporate governance grades from two services, Institutional Shareholder Services (ISS), a Maryland firm, and Morningstar, a Chicago research firm. The two services use very different strategies to rank firms and their rankings can conflict. ISS (www.finance.yahoo.com) uses public filings to compare a company with its peers. It bases its ratings on 61 criteria, including executive compensation, audit procedures, and takeover defenses. Morningstar (www.morningstar.com) starts with public data and adds information from interviews with company management and adds governance track record. Morningstar grades are not relative to other firms in the industry but based on an absolute scale.
Morningstar gives Walt Disney, for example, a D and ISS gives the same company a top scope fo 100%.
I view these competiting grading systems as a real public benefit. I hope other services will also appear. There is as yet no data indicating that a high rating will translate into superior performance however. Data will come, however, and the competition among the services will lead to the creation and publication of the data and grade method adjustments for improvements. This is wonderful stuff; no goverment agency could do this.
June 3, 2005
Cox's Record On Securities Issues
The appointment of Christopher Cox as the new Chairman of the Securities and Exchange Commission has much to say to it. He is politically savy, very smart, and an expert in federal securities law. He also seems to have, what I believe, is the correct regulatory philosphy -- catch and prosecute the crooks but do not tell the country's business people how they run their businesses. On the other hand, when he has been visible in the securities law as a Congressmen, he has taken problematic positions on important issues. He opposed the elimination of pooling accounting for mergers (a silly practice that let firms hide payments for high going concern value firms, giving incentives to high-tech mergers), he opposes the expensing of executive options (a practice that allow firms to hide salary payments, giving incentives to salary in high-tech companies), and he pushed an extreme version of the PSLRA of 1995 that (although not enacted) would have shifted attorney's fees on losses in plaintiff class actions and would have eliminated liabiltiy for "reckless" actions by exectives. The PSLRA changes were a transparent effort to kill class actions indirectly. What bothers me about these moves is that they were round-about efforts to do what could have been done more directly -- with a more open and transparent debate -- based on the policital decision that a clever attack may win while the open debate may lose. I hope he will shed this tendency as SEC chair.
June 2, 2005
Cox New SEC Chair
President Bush has announced that he will nominate Rep. Christopher Cox, a Republican congressman from Califorina, to replace William Donaldson as Chairman of the SEC. Cox is a financial conservative. He played an active role, for example, in the passage of the Private Securities Litigation Reform Act of 1995, which Congress passed over President Clinton's veto. His philosophy of government regulation is very, very different than Donaldson. At issue is whether his SEC will reverse several controversial rule changes that have been passed but are not yet effective --Regulation NMS and new mutual fund rules. Even Donaldson was caught wondering whether the rule changes would survive. This could be interesting.
Why Donaldson Had to Go
Section 404 of Sarbanes-Oxley was Donaldson's undoing. (See Article on resignation of Donaldson) The SEC's rules on management reports on internal controls over financial reporting in the reports of publicly held companies were issued in June of 2003 and after an extension of effective dates, finally hit in the latest round of filings. "Accerlerated filers" had to comply by November 15, 2004 and non-accelerated filers have to comply by July 15, 2006. Company expenditures to produce the reports and pay auditors to attest to the reports have been huge.
Foreign companies threatened to delist in the United States, many privately held United States companies decided to stay private, and some publicly held United States companies decided to "go dark" (go private). The American business community wondered whether compliance gains were worth the costs of the Section.
Error One: The SEC did not write very good rules implementing the section. Error Two: It did not help that Donaldson promised foreign companies some leniency under the Section. United States companies did not appreciate the news that their foreign competitors would be treated better than United States companies. Error Three: The SEC on May 16 chastised auditors (and United States companies for paying their auditors) for pushing expensive, technical procedures in an effort to comply with the vague rules implementing the Section. Error Four: The SEC ran an unexpected budget deficit and the GAO told the SEC to get its own house in order, in essence, chiding the SEC for a lack of its own internal controls. The business community was not amused. Error Five: The chairman, worried about sniper attacks in the new SEC building, incurred over a $1million in costs, changing building designs and delaying a move of his office to the new building.
Errors Four and Five were the buzz this week and were the final straws. It is one thing to force huge compliance costs on the entire American business community; it is another to not impose those same controls on yourself and lose control of your own budget.
June 1, 2005
Chair of SEC, Donaldson, to Step Down
The online service of the Wall Street Journal, MarketWatch, is reporting that the Chairman of the SEC, William Donaldson, has submitted his resignation. He has been chairman since February of 2003. Calls by MarketWatch to the SEC to confirm the story have not been returned.
His tenure as Chair was not successful. A Repubican appointee, he consistantly pushed for more SEC regulatory power and oversight. The capstone of his tenure came when he sided with the two Democratic commissioners and against the two Republican commissioners to adopt Regulation NMS (for National Market System) that micro-manages the structure of the United States securities trading markets. He also has pushed mutual fund structural board regulation that has no empirical tie to performance.
Needed regulatory decisions, on the other hand, came slowly. It took several years, for example, to act on the Nasdaq's request to register as an exchange. The new rules on public stock offerings in the era of the internet are five years late and tepid (the changes are margin given the opportunities of the new medium).
In sum, he championed micro-regulation where it was not needed and delayed regulatory changes that have been long overdue. The country will do better with a new Chair.
New SEC Public Offering Rules
The Securities and Exchange Commission, the federal agency that oversees the country’s stock markets, has a full plate.
In 2002 Congress, in the Sarbanes-Oxley Act, directed the agency to pass a plethora of new rules aimed at stemming financial fraud. In an effort to keep up with the investigations of Eliot Spitzer, the Attorney General of New York, the SEC has promulgated new rules for mutual funds and hot IPOs (initial public offerings). The agency has recently proposed a blockbuster new Regulation NMS (for National Market System) that will restrict the nation’s stock market trading systems. On top of all this, the SEC has proposed a stunning new release, reforming the system of public offerings.
The public offering release, No. 33-8501, is not getting its due in all the clamor. The release reflects a fundamental shift in SEC policy, long overdue, on issuer communications to the public during the registration process.
Since 1934, when Congress created the SEC, the agency has tightly controlled issuer communications around public offerings of securities, regulation under the authority of the Securities Act of 1933. Before a firm filed its registration statement, the firm could say nothing to the public (the quiet period). After filing and before the SEC had clearing the registration, the issuer could use only form written communications. It was only after the SEC had cleared the registration (the effective date) that a firm could use “free writing” sales materials. There heavy restrictions on communication are known as “gun-jumping” restrictions.
All this is about to change.
The SEC, recognizing the information age, is allowing issuers to more freely communicate with the public during the registration process.
There are special rules for three types of companies: large companies that are already publicly traded; smaller companies that are already publicly traded; and companies coming to the public markets for the first time (in IPOs), the so called “non-reporting” companies. Space permits a discussion of only one group and I will focus on the group I most favor, the non-reporting companies coming to the market.
For non-reporting companies there are three new rules. First, the SEC proposes to grant the non-reporting companies a “safe-harbor” for the dissemination of regularly released ordinary course factual business information to customers and suppliers (non-investors) before the effective date of any registration statement. The safe-harbor does not cover “forward-looking information” (projections), however, as it does for reporting companies.
Second, the SEC proposes to provide most all companies, including non-reporting companies, a bright-line time period, ending thirty days prior to a company’s filing of a registration statement, in which the company may communicate most anything to anybody without the risk of violating any gun-jumping provisions. The only limits are, first, the issuer may not make reference to an anticipated securities offering and, second, the issuer cannot be a shell company.
And third, during the “waiting period,” the period after filing and before SEC clearance, an issuer may disseminate more written information to the public markets about itself and its business and may more openly solicit indications of interest and conditional offers to buy. Non-reporting issuers could issue media releases as long as they did not pay people to publish them. “Road-shows” even in electronic form would be permitted.
The electronic road show will be of particular interest to emerging companies going public in an IPO. The SEC proposes to allow road shows over the internet as long as a version is made available to any potential investor and the issuer files any written material used in the show with the SEC on its use.
The new rules will enable new issuers to take significantly greater advantage of the Internet and other electronic medial to deliver information to potential investors. This is, as noted above, long overdue but a very welcome change nevertheless.
Credit Derivatives: A New Gloss on an Old Game
Several weeks ago the credit rating agenices downgraded the bonds of both General Motors and Ford Motor Company. The downgrades had the anticipated effect of dropping the value of the bonds of both companies. We also learned, however, that hedge funds had taken large losses in the "credit derivatives" market. Credit derivatives are financial instruments that are linked to and therefore rise or fall on the value of underlying credit obligations. The credit derivatives most affected by the GM and Ford downgrades were "collaterized-debt" obligations. Banks pool credit obligations of a company and slice and package the debt for investors. Some investors buy the "first-loss" piece; they absorb the full loss on a first debt default. Other investors buy pieces that are not affected until their are multiple defaults.
In any event, hedge funds and other investors combine the fancy credit derivatives based on computer models. And -- surprise-- the computer models did not predict how price would respond in the face of the downgrades. Hedge funds who thought they had hedged their risk had not and absorbed big, big losses.
I am convinced that much of the game in the financial community is the constant invention of "new" financial investment vehicles (usually some form of financial derivative) or "new" combinations of old investment vehicles (hedges) to hoodwink investors. The inventions, complete with complicated computer models, enable snake oil salepeople to use time honored techinques to hoodwink investors. The salesperson of the derivatives hooks investors with promises of high returns and no risk, snows them with complexity and unverifable detail that leads to false confidence in their expertise, takes their money, and then gets out of town before the losses attach.
May 31, 2005
2 New Blogs Join Law Professor Blogs Network
We are pleased to announce the launch of two new blogs as part of our Law Professor Blogs Network:
These blogs join our existing blogs:
- AntitrustProf Blog (Shubha Ghosh (SUNY Buffalo))
- ContractsProf Blog (Carol Chomsky (Minnesota) & Frank Snyder (Texas-Wesleyan))
- CrimProf Blog (Jack Chin (Arizona) & Mark Godsey (Cincinnati))
- Health Law Prof Blog (Betsy Malloy (Cincinnati) & Tom Mayo (SMU))
- LaborProf Blog (Rafael Gely (Cincinnati))
- Law Librarian Blog (Joe Hodnicki (Cincinnati))
- Law School Academic Support Blog (Dennis Tonsing (Roger WIlliams) & Ellen Swain (Vermont))
- Media Law Prof Blog (Cristina Corcos (LSU))
- Sentencing Law & Policy Blog (Douglas Berman (Ohio State))
- TaxProf Blog (Paul Caron (Cincinnati))
- Tech Law Prof Blog (Jonathan Ezor (Touro) & Michelle Zakarin (Touro))
- White Collar Crime Prof Blog (Peter Henning (Wayne State) & Ellen Podgor (Georgia State))
- Wills, Trusts & Estates Prof Blog (Gerry Beyer (Texas Tech))
LexisNexis is supporting our effort to expand the network into other areas of law. Please email us if you would be interested in finding out more about starting a blog as part of our network.
Alan Greenspan's Power
The news is full of speculation over whether Alan Greenspan has identified and will try to pop a "housing price bubble." (See Article) Those who believe he will are betting that he will raise short term interest rates until the bubble bursts. Others are entreating Mr. Greenspan to "Reminber 2000" when he raised short term interest rates in the face of a market slow down and facilitated the recession of 2001.
At some point we should wonder why a country that prided itself on an open market economy puts such power in the hands of one man. We are fortunate that he is not political, but there is no guarantee that his predecessors will not be. Moreover, he can make mistakes and when he does they are whoppers.
Can we not design a banking system that does not do this -- that relies more on market forces to set interest rates and yet still has a mechanism for putting on the brakes to stop financial panic? Surely there is a better system than this.
The French and Treaties
The international community of intellectuals has pilloried this country for not signing favoring international agreements, the Kyoto Treaty and the International Criminal Court agreement are two of the most prominent. Look at France, our traditional ally, they have signed and they are critical of us for not signing -- we are losing the respect of our traditional allies. Intellectuals dismiss our refusal to give up national sovereignty to these international supra-government bodies as just -- well-- selfish and stand-offish. We need to join the global community, they argue.
The truth of the matter is that in signing these international agreements France gave up very little and hoped to recieve more -- some say in United States policy. France showed its true colors when the shoe was on the other foot, when it was the big dog ceded sovereignt to a coalition that included many smaller contries.
France rejected the proposed European Union constitution. Why? France refused to cede national sovereignty. The country could lose jobs "offshore" and might be forced to allow more immigration. Over seventy percent of the French farmers voted no despite the fact that French farmers are the largest recipient of EU farm subsidies (a deal necessary get to France to agree to EU expansion).
This was a very selfish vote. Even those who voted in favor of the EU constitituion did so under a conviction that their personal economic interest would be served thereby. The high- minded moral principles that French intellectual use to bludgeon the United States in the debate over the ICC, for example, were largely absent in this vote.
In a very short (13 page) opinion, the Supreme Court reversed the criminal conviction of Arthur Andersen for the obstruction of justice. A jury had convicted Arthur Anderson in October of 2002, a the height of the disgust over the 2002 corporate scandals. The judge sentenced the company to a $500,000 fine and five years probation. More damaging was the effect of the criminal conviction on the company; it had to surrender its accounting license and could do no public audits until state authorities re-instated the license.
The practice effect of the 2002 conviction was huge. A company with 28,000 employees world wide went out of business. The 2005 opinion of the Supreme Court is too late. Now we have the almost comical decision of the United States District Attorney on whether he or she will retry the case again.
There are many lessons here. The most important perhaps is the case's effect on magnifying the power of indictments against financial companies, as opposed to executives in those companies. An indictment against a financial company is often a death sentence itself -- even a trial is unnecessary. Financial companies depend on the confidence of market participants, participants that can and do leave very very quickly when things go wrong. Threats to a financial company's reputation can create the stampede out the door that is these companies' undoing.
When federal prosecutors threaten finanical companies with prosection, the companies must acquiese, the companies' cooperation is coerced. Prosecutors demand that companies turn in their own employees, waive attorney client privilege, refuse to comply with executive imdemnification or defense agreements, and fire managers. The company complies, hoping to stave off any indictment --"Look what happened to Arthur Andersen."
Arthur Andersen won in the Supreme Court--- so what, it died three years ago. Federal prosecutors have a new weapon against financial companies, the threat of indictment, and they have been and will continue to use it -- in our best interests of course.