September 24, 2005
What's That Smell?? A Presidental Campaign Burning
Majority Leader of the Senate Bill Frist (R-Tenn.) can kiss his hopes of a Presidential campaign goodbye. The SEC is checking out a very suspicious stock sale by Frist of HCA for insider trading. We thought Frist held the shares in a "blind trust," that is, a trust in which an independent administrator manages the stock portfolio without input (or knowledge) of the beneficiary. Frist himself has often told reporters he did not know how much HCA stock was in his trust. We were wrong. The Frist trust was a "qualified blind trust", a trust in which the beneficiary, Frist, can direct the sale of stock.
So what did we know: So we know Frist directed the sale of HCA stock in June, two weeks before the company announced earnings that did not meet expectations. The announcement caused a stock sell-off that lower the price of HCA ten percent or so. We also know that Frist's brother is the company's chairman emeritus. The transaction smells. At issue is whether there are any incriminating documents or witnesses. There may not be.
Whether First gets indicted (or reprimanded) is irrelevant. His Presidential campaign is dead (or at least on life support). If the SEC does nothing, he will still be under suspicion (the Chair is a fellow Republican Congressmen) and the investigation itself will be replayed endlessly in any subsequent campaign. This is Leno material "Why did Martha go to jail not Frist? His cooking was better." or "He could not help with the prison drapes." etc in the blogs. If he is indicted, of course, we all will witness another celebrity trial. Why these high profile folks cannot figure out (or get good advice) on how to handle their investments once they take public office is a mystery to me. The risk of mistakes are too high to play this close to the line.
Sympathy for the Financial Crooks
The sentences for the kings of the financial scandals (Ebbers, Olis, Rigas, Kozlowksi & Swartz) of 2002 bother some (see White Collar Crime Prof Blog). Not me. These folks cost investors billions. We all know that -- but they also created ripple effects that cost additional billions, we forget or overlook this. The legal competitors of the crooks struggled to meet the crooks rosy (and false) balance sheets. Competitors of WoldCom overpaid some employees to retain them, fired many other employees to reduce costs, changed business strategies, and were tempted to cheat themselves to meet the phony business model of WoldCom. The country's high-tech economy was trashed by these folks.
The fact that these folks are old (and an 8 year sentence if "life") is tough beans -- only the older folks can get in positions of this kind of authority to manufacture frauds of this scale.
As for "shame" as an adequate deterrent, baloney, they made millions, even billions, and at least some of the booty is stashed were no-one can get at it. Shame will one is lolling on a boat in the Caribbean (after a 6 months stay in miminum security prision) will occupy only a momentary daily thought. Moreover, many, if not most, of the bad actors are still enjoying their full liberty and spending the bounty of their misdeeds. These folks, and I have seen some up close, are pros at rationalizing away any shame. Even those convicted have no shame -- look at Martha Stewarts' response to Letterman's queston "What were you in for?" Stewart: "I don't know." Good grief.
September 23, 2005
"Price Gouging" What is it?
Eight governors and several members of Congress have complained to the President about "price gouging" around distress caused by hurricane Katrina. Gas stations sold their gas in areas starved for supply for up to $5.00 a gallon, bottled water in flooded areas went for $7.00 instead of its usual $2.00 or so. Talk show hosts on both radio and television complain that current gas prices are price gouging. The oil companies, they complain, are profiting on the distress of the country.
Claims of price gouging have always been difficult for economists. See WSJ Editorial (In Praise of Gouging), 9/7/05. Scarcity of supply drives up prices, the price allocate who gets the scarce product, and those lucky enough to have bought supply at lower prices make huge profits on the resale. During the gold rush, shovels at the mines went for prices that were twenty times what they went for in St. Louis.
There are some built in market controls to gouging -- reputation. Why do stores not mark up umbrellas whenever it rains? Their customers do not like it, the stores loses good will, and their customers will remember and go elsewhere to buy goods if they have the option to do so.
Several states, however, have anti-price gouging rules on their books. See WSJ (We're For Free Market, But Not Profiteering), 9/17/05 (Gov. of Mo.) These rules are rarely used. This is not a surprise. Regulation of raw price gouging is difficult to do because it is difficult to define and even if defined, enforcement of gouging rules may encourage problematic conduct. Is price gouging an increase of 50%, 100%, or 200% in a short period of time (how short)??? Does a rule distinguish between permanent changes in supply (there is a new clearing price) and temporary changes in supply (the price will come back down when the temporary dislocation is over)?? When does profiting become profiteering?? Apparently, a little bit of gouging is fine, even admirable as capitalistic, but too much is bad and anti-social.
Moreover, If someone has product and wants to increase prices due to scarcity and the law does not let them, they may refuse to sell at the government required price. The suppliers may either withhold product entirely until the price increases "are legal" (the price has been re-established and it is no longer a change -- gouging-- to sell at the higher price) or ship it to a jurisdiction that lets them enjoy the higher price. Suppliers surely will not ship product in to sell it all the artificially low prices. These incentives add to the scarcity and compounds the problem, making it worse, not better. Remaining suppliers have enhanced incentives to cheat on the artificially low prices; enforcement is stretched when distress means this kind of enforcement is a low priority. Suppliers will not hoard or transport only if they believe that the local legal price in distress conditions is still higher than the prices that will be available once the conditions are over. Local folks would be better off if suppliers did not hoard or take their supply elsewhere. At some point the high prices will encourage suppliers to re-enter local markets; price caps will encourage them to flee local markets. Price caps only work, even marginally, if the supply is fixed locally, like real estate, and cannot move.
There are only two real complaints about pricing in conditions of distress: Price-fixing and market manipulation by rumors.
Price-fixing: There are not enough suppliers in a given area so that those that are there fix prices with each other to raise prices to a level that would be lower (even though much higher due to scarcity) if they had to compete with each other for sales. That is, the prices are higher than the scarcity should create. This is the job of the FTC and the Justice Department and they are going to get into the fracas. The problems is that the government, under tremendous political pressure, uses price-fixing allegations to penalize price gouging that is scarcity caused not conspiracy caused. Enforcement will be random. This aids no-one.
Market Manipulation by Rumors: Cagey suppliers recognize conditions of panic and flood the market with false rumors of suppliers, scarcity, and distress. The rush of customers to hoard adds to the overall supply problem and makes scarcity conditions worse than they should be. The suppliers should be charged with ordinary market manipulation, which takes evidence of actual supplier participation in the false rumors (knowing them to be false).
Going back to the basic scarcity-caused price gouging, what is the solution?? In my view, we leave it alone unless the scarcity is in products that are critical to life and health (water). When life is on the line, the government must step in and be a provider of last resort, distributing and contributing to the supply. The severity of the problem dictates the severity of the government response. The most extreme situation would require nationalization of supply and total government distribution (I hope this is only in theory); less extreme situations would require the government to sell (or donate) product in competition with private suppliers. This is expensive but effective. The remedy imposed the most readily by most states, price caps, is the most likely to be ineffective and even counterproductive. It is a cheap fix that does not work. Price caps only work in short term distress conditions when suppliers can predict with certainty that actual, market prices will come back down in the future to below the artificial price cap levels. This is often a difficult prediction in times of distress. In short the price caps will encourage supplier hoarding in the short run and strangulation of supply in the long run.
Document Games by Trial Lawyers: The Boies Version
It has always been one of the black eyes of corporate trial lawyers -- document production. One side demands every document that could possibly be relevant, the other side provides a flood of meaningless paper (the document dump), retains critical documents with a litany of routine objections, and refuses to answer any clarifying questions (interrogatories) with any precision. Force opponents to complain to a judge (who hate these hearings) and on the eve of the hearing slip a few more documents across the table to obscure the argument. Moreover, at the hearings develop a blizzard of document complaints about the other side as well -- flood the judge with detailed, finger/pointing, he said/she said objections. Even if a judge takes the time to sort out the wheat from the chaff (and many do not) and orders production, comply with a few more but not all the documents and force opponents back to court to ask for sanctions. If an opponent is as dogged as a spawning salmon and the judge get its, pay the small fine. Now there is a new twist. The lawyer incorporates document "management" company and, as lead lawyer, hires his own family-run company to help do the dirty and bills the client for his company's efforts. Why not profit from the production document dump as well as do it??? One such lawyer happens is David Boise, one the best known lawyers in the country (and a frequent lecturer on ethics I might add). The document production systems need a serious overhaul to restrain obstruction by lawyers; it we are serious about discovery we need higher, different penalties (e.g., suspension of lawyers from practice) and specialized document magistrates that stay on top of document problems are all in order. Lawyers have not distinguished ourselves.
SEC Controls on Shareholder Voting: An archaic, cumbersome system
Each year I teach shareholder voting in the basic corporations course, I have to re-acquaint myself with the cumbersome system of shareholder voting that we accept for our publicly-traded companies. When done, I always come to the same conclusion: the procedure we use to enable the individual equity investors of United States companies to vote their interests is hopelessly outdated.
The corporations solicit votes by asking shareholder to vote by "proxy." A proxy is not an absentee ballot but a grant of agency to an individual who will be at the meeting. Firms hire a company, usual Georgeson Shareholder Communications, Inc., to prepare the proxy solicitation materials and count the votes. The proxy rules require that shareholders get a stylized, jargon laden two hundred page or so document (proxy statement) along with a single page form proxy. The requirement proxy statement begs to be thrown in the trash, if it is even opened.
Most individual equity investors, however, do not get the mailings from the company. The investors hold shares as beneficial owners in brokerage accounts or as investors in mutual funds.
A) The shares held in brokerage accounts are held in "street name." Legal title to the shares is held in a depository company maintained by the brokerage firm or a group of brokerage firms and equitable title goes to the beneficial owners (i.e. the shareholders). So the company material goes to the depository company that forwards it to the brokerage house that forwards it to the beneficial owners, the shareholders, with additional cover materials. The brokerage houses hire another firm, Automatic Data Processing Inc., to send out the materials and collect the votes. If the beneficial owners, shareholder do not vote, the brokerage company can vote the shares. Shareholder can choose to keep their identity secret, even from the company. They are OBOs (objecting beneficial owners). If they do not care they are NOBOs (non-objecting beneficial owners). The "pass-one" procedures vary for each brokerage firm. Companies must pay for their own mailings and the mailings of the intermediaries.
B) Shares owned through mutual funds are voted by the managers of the funds and until recently, the funds resisted disclosing their votes at all. The funds are still protesting the new rules forcing miminal vote disclosures. In any event, those investors owning shares in mutual funds (technically not shareholders at all) do not receive any information from the firms in the fund nor do they have any impact on how the funds votes.
This all means that individual shareholders do not vote and corporations cannot talk to their own investors in ways that shareholders may listen and read.
It is hard to believe that we are content to live with such a system. With all the calls for more shareholder participant in corporate governance, we should look at the system of communication we are pushing shareholder to use first. It would be easy to 1) reform the broker default vote rule for brokerage accounts (requiring a mirror rule/a vote that mirrors the percentages of votes actually turned in by beneficial owners) and 2) force mutual funds to solicit views from their large holders of beneficial stakes (with stakes large enough to give the investor an undiluted interest in at least one share of the company in issue).
September 21, 2005
Where Do the Nation's Largest 250 Law Firms Hire??
See the discussion on conglomerate.org for a discussion of a new National Law Journal study on which schools place the highest percentage of their graduates in the nation's top 250 law firms by size. There are some surprises in the list (Notre Dame and Illinois). A supplemental study on where the nation's most lucrative law firms (by mean partner salary) hire would also be informative.
September 19, 2005
Regulatory Arbitrage: The Latest Wrinkle
The financial community is getting extremely adept at taking advantage of regulatory glitches. The latest wrinkle is the success of those who buy floundering companies with large pension plans and increase the value of their purchase by causing the company to punt the pension plans to the federal government (the Pension Benefit Guaranty Corporation). The purchasers (e.g. Robert Miller of Bethlehem Steel, Federal-Mogul, and now Delphi) push their companies into bankruptcy and force the PBGC to pick up their underfunded pension plans. The companies restructure, emerge from bankruptcy and are resold. The turn around artists are taking advantage of a poorly designed government program that was not designed to bail out companies but is amenable to the strategy. The new bankruptcy law taking effect in October makes the strategy a bit less attractive (e.g., it limits executive compensation) but does not stop it. The lesson for government is broader than the PBGC program. Eager financial wizards with cash can adroitly exploit poorly designed legislation and, for example, leave the government on the hook for debts that it never intended to guarantee. Government will have to take more care in drafting business legislation (the PBGC legislation was a rushed mess, passed during the Nixon impeachment days) and be faster to correct legislation that is being exploited.....or just pass less of this stuff to begin with.
Must Read: SEC Chief Cox Interview in the Wall Street Journal
Deborah Solomon (an excellent reporter by the way) interviewed the new SEC chair Christopher Cox and and reported the results on page one of today's Wall Street Journal. Cox appears content to proceed with the rule initiatives proposed and passed under the regime of his predecessor, William Donaldson. This will disappoint many who hoped that Cox would bring a less aggressive rule-making stance to the SEC.
Soon-to-be-Chief Justice Roberts and Business
With Chief Justice Nominee John Roberts expected to be confirmed later this week, readers in the business community may recall my take on Judge Roberts' appointment to the court and its effect on the business community.