June 18, 2005
Tyco CEO and CFO Convicted
Dennis Lozlowski and Mark Swartz, the ex-CEO and ex-CFO of Tyco were found guilty on all but one count (23 in total) on Friday, June 17, 2005. The trial took four months and was the second trial -- the first ended in a mistrial in April of 2004. There were guilty verdicts on 12 counts of grand laceny, 1 count of consipracy, 1 count of illegal stock sales, and 8 counts of making false filings. The 1 count that failed was also a false filings allegation.
Court watchers say the prosecutors learned from the first trial and their case was better focused and organized. Kozlowski testified in the second trial and not the first. Swartz testified in both trials. One of the jurors, Juror No. 4, from the first trial sat in on the second and was dismayed by the verdict. She thought they were both innocent of all charges.
Testimony in the case on the formalities of the board meetings was shocking for a muli-million dollar, publicly traded company. The board rarely took accurate minutes and some minutes were drafted before the meetings were held.
Both defendants still face tax fraud charges and their former company faces a tsumani of private suits by shareholders. Tyco's new management is also considering suits against Kozlowski and Swartz. The litgation will take years to complete.
June 17, 2005
The Power of the Fed
The new chairman of the Council of Economic Advisers is Ben S. Bernanke, an outstanding choice. He disagrees with Alan Greenspan, the Chairman of the Federal Reserve, on the power that the Fed should have in setting the country's economic climate. He would reduce the Fed's discretion, and its power, by requiring the Fed to be more transparent and more predictable by market participants. Greenspan wants the Fed to "maintain flexibility" (read power), by not binding itself in advance to a predicable strategy. Bernanke would be a great successor to Greenspan and get us out of the crazy game of hanging on every word of the Fed Chairman to "read the tea leaves" of the next Fed move. In the middle of a market economy, the Fed currently simply has too much influence.
Hedge Fund Regulation
This falls in the category of "be careful what you wish for you may get it." The German Chancellor has called for international regulation of hedge funds, citing the United States example as his support. The SEC recently passed a rule requiring hedge funds to register. Treasury Secretary Snow is now defending a tough position, "we can regulate hedge funds 'lightly' but an international body should not regulate them 'heavily'."
Times are a changin. KPMG, once known for its stone-wall, hard-ball tactics when faced with litigation, has rolled over and played contrite in the face of the charge by the Justice Department that the firm sold illegal tax shelters to clients. KPMG apologized, took "full responsibility," and offered to help the authorities find and charge KPMG employees. This the direct result of the Arthur Anderson criminal prosecution, which although recently reversed, still killed the firm. KPMG and other financial institutions now know that even a criminal charge could be a death knell. Wins on appeal or even at trial are still losses in an industry that depends on investor or client confidence for its revenue.
Goldschmid to Delay Departure
The tenuous nature of several pending rule initiatives is evident in the decision of SEC commission Harvey Goldschmid statement that he will delay his exit from the commission from the end of the month for up to another 18 months. Goldschmid, a law professor at Columbia, had voted with the departed chair, Donaldson, and the other Democratic nominee and against the two Republican nominees on a series on controversial SEC rule changes. The rules, although adopted, have not yet become fully effective. The rules include rules on mutual fund governance, on securities market structure, and on Secion 404 of Sarbanes-Oxley. Mr. Goldschmid's delay signals the unease that Democrats in the Senate have with their power to control the appointment of new Democratic nominees. Will President Bush find "conservative" Democrats to replace the incumbent Democrats and ignore the wishes of the Democratic leadership of Congress?? The rules for appointing members of the opposite party to the commission have never been formalized; they rest on tradition and courtesy. Will the President respect the tradition in light of the increasing politicization of the agency??? The uncertainty of the answer to the effort of Democratic leaders in Congress to persuade Goldschmid to delay, at least until the new rules become effective.
June 16, 2005
Section 404's Effect on Small Companies
On the heels of the financial scandals of 2001, Congress passed the
Sarbanes-Oxley Act of 2002. President Bush signed the new law, hailing it as
the most significant piece of federal legislation on business regulation
since the New Deal legislation, the Securities Act of 1933 and the
Securities and Exchange Act of 1934.
Sarbanes-Oxley was a polyglot of provisions, patched together in a
hurry to reassure the American people that Congress and the president were
responding to the financial scandals. Several of the provisions phased in
over time. This means we are just now learning the effect some of the act's
more important provisions will have on business practice.
The most problematic provision - Section 404 - is just now coming on
line. The section is seductively simple. The section directs the U.S.
Securities and Exchange Commission, our federal agency that regulates
securities trading, to write rules requiring the managers of a publicly
traded company to declare, in the company's annual report, that the company
has internal control procedures in place to test the accuracy of the
company's financial statements and that the procedures are "effective."
Congress then requires that a company's auditors must "attest" to the
It seemed like a minor incremental improvement in a company's
reporting requirements. Since 1977, Congress has required that all publicly
traded companies have internal control procedures in place. Now Congress
wanted companies to "take them seriously."
The SEC wrote the Section 404 rules in 2003 and estimated costs of
around $90,000 per company to implement the rules. The SEC dismissed the
additional audit costs as "minimal." It was one of the worst understatements
in the agency's history.
Companies with total capitalizations of more than $200 million have
had to comply with the new rules since November. We now know that it costs
an average of $4.3 million per company to comply with the new rules, with
$1.3 million of that in additional audit costs.
Smaller companies with less than $75 million in total
capitalizations have until July 2006 to comply; they have asked for and
received three extensions, arguing that they cannot afford double or triple
the audit fees. The costs are regressive; the new rules create a larger
percentage cost increase for smaller companies than for larger companies.
The immediate effect, in anticipation of the effectiveness of the
rule on smaller companies, is to cause smaller companies to "go dark," that
is, to reduce their number of shareholders to less than 300 so they do not
have to comply with the rules. Initial Public Offerings are off as small
private companies have decided not to go public by selling stock in
registered offerings to the general public.
The long-run affect of Section 404 on smaller companies is that the
smaller companies will be disadvantaged in their competition with larger
companies, as if they did not have enough problems already. The SEC has
formed an advisory committee, chaired by a Chicago lawyer, to consider the
plight of small companies. It is not clear what they can do.
Section 404 looks good from 30 feet away, but up close, it has some
very unappealing dents and paint chips. The nation's smaller companies are
paying a disproportionate tax for the sins of Enron Corp. and WorldCom Inc.,
two financial disasters caused by large companies.
Professor Hillman on Law Partnerships
Robert W. Hillman has posted a new paper, soon to be published in the Wake Forest Law Review, on the changing nature of law partnerships. It is a good read.
SEC Report on Auditing
Several provisions of Sarbanes-Oxley directed identified federal agencies to prepare reports on topics of concern. Section 401 requires the SEC to study the nation's accounting rules and specifically to study the accounting rules for "off-balance sheet" transactions. Enron's use of Special Purpose Entities to hide debt prompted the Congressional directive. The SEC delivered its report on financial statements to Congress yesterday.
The SEC in the report found that the balance sheet "is not nearly as transparent as it ought to be." The SEC recommended changes in the new FASB special purpose entities rule (it is too complex), criticized the current pension accounting rules (for income smoothing), and discussed the variety of choices for lease accounting. In sum, the SEC noted that the accounting rules were vulnerable to exploitation by clever professionals who were intent on obscuring the true state of a given company.
June 15, 2005
Chapter 11: Often Misunderstood
Holman Jenkins editorial in the May 25th Wall Street Journal, in which he argues that United Airlines should be liquidated, reflects a common misunderstanding of Chapter 11. A company reorganizes in Chapter 11 under one condition, when its operating revenues exceed its operating costs (that is, it shows an operating profit), but its accumulated debts exceed its operating profit. The company is worth saving because it operates at a profit once the debts are forgiven. The creditors forgive the debts and take ownership of an otherwise profitable firm. If the operating revenues do not exceed its operating costs, the company should be liquidated in Chapter 7. United shows an operating profit and needs its debts restructured. It is a classic Chapter 11 case. The problem in Chapter 11's is in the execution. Poor judges either misdiagnosis whether there is an operating profit or let equity holders and classes of creditors get to much in the restructuring. The theory is sound; at issue is whether consistant application is possible.
Congress and Business Structure
In response to an argument that Congress should not often get into the business of structuring the governance structure of American business, a task it undertook in the Sarbanes-Oxley Act of 2002, SEC officials have noted that Congress has done it before -- in the Investment Company Act of the 1940. This is hardly a rousing endorsement. After the mutual fund scandals of 2003, the SEC has moved to increased structural control of mutual funds by increasing the percentage of independent directors on boards to 75% from 50% and to disable the fund managers from being chair persons of the board. There is little or no data on whether this will work. Why is 50% not enough and why will 75% be better? Noone has a sensible answer. The answer also overlooks two other acts that most believe have failed, the Public Utilities Holding Company Act of 1935, which Congress is trying to repeal and the Glass-Steagal Act of 1933, which Congress finally repealed in the late 90s. Both acts structured a large segment of Amercian business, increasing operating costs and providing marginal and disappearring benefits. Once passed, however, it takes years to correct the acts. The belief in Congress's ability to struture business governance is hard to stifle, however. Some are now claiming that the Glass-Steagal Act should be repassed. We have a cultural pre-occupation with precedure and structure, believing that perfect results will follow perfect procedures and structure (which is false) and that government can discover and implement perfect procedures and struture (also false). It is a utopian fantasy --- one that has real costs if allowed to become reality.
SEC and Securities Exchanges
Monday's Wall Street Journal contained a must read editorial for all those interested in the structure of the Unites States securities trading markets. Meyer Frucher, the Chairman and CEO of the Philadelphia Stock Exchange, wrote a very measured but very clear editorial on the effect of new SEC Regulation NMS on the country's six regional stock exchanges. I will state what Mr. Frucher politely implied; Regulation NMS puts the nation's six regional stock exchanges on a death watch. How? The Regulation increases regulatory costs that are more easily borne by the bigger exchanges (the costs impose a regressive tax on the business of operating an exchange). Moreover, the SEC has created a data monopoly (on stock trades and on open prices)and divides up the spoils (the revenue is divided up by formula and reduces the regional exhanges percentage of the revenue). Do we want the SEC to structure the American markets? No, but that is what they are doing. Mr. Frucher asks the critical question: "Where will the next Arca or Instinet come from?" These are the market innovators that were borne in an open competition with the established markets. By cutting off competitors to the established trading centers we are cutting off an important source of trading market innovation.
June 13, 2005
Census of Law Professor Bloggers
This morning's PrawfsBlawg has an interesting census of the current law professor blogging population. They report that 103 law professors currently blog; we have 24 law professors who blog as part of our Law Professor Blogs Network.
PrawfsBlawg notes that of the 103 law professor bloggers, 80.6% (83) are male and 19.4% (20) are female. The comparable numbers for the 24 members of the Law Professor Blogs Network: 62.5% (15) male and 37.5% (9) female.
Here are the law schools with the most law professor bloggers:
Law Schools with Most Law Prof Bloggers
Number of Bloggers