July 21, 2006
Judge Kaplan and the KPMG case
The Wall Street Journal editorial page today called the KPMG tax fraud case in New York a "fiasco" and suggested that the Justice Department "reconsider" the case at its "senior levels." The behavior of the Justice Department attorneys has been less than exemplary but there is another problem here. We are watching a Judge over control a complex case. And there is no normal relief for this until an appeal. Kaplan has written a scathing opinion in June over the government's use of the Thompson Memo. Judge's should rarely write "scathing" opinions; this should be reserved for a once in a decade case. A Judge has the awsome power to decide the fate of the people before her; she rarely needs angry words -- a decision is enough. The Judge does not like the policy of the memo (I do not either) but wrote a nutty legal analysis about its unconstitutionality. The Judge continues to "exchange barbs" with prosecutors. Judges should not "exchange barbs" with anyone (again, perhaps, with a one in a decade exception). Now the Judge has delayed trial, trial Judges should normally do the opposite and facilitate and push for a speedy trial on the merits, except in very unusual circumstances. This case is not that unusual . A Texas judge has ruled on the merits that the KPMG tax shelters are legal; a speedy trial may even benefit the defendants here.
I suspect that the Wall Street Journal may get its way and the Justice Department will drop the case. The Judge's decisions and conduct will not get reviewed. Indeed, it may be vindicated. Pity.
Federal district court judges are an admirable bunch, but a few, a very few, are not. They sit alone in important cases and can, with self-righteous sanctimony, lose patience and focus. I have been there and seen it. I have not been in this courtroom to watch this case and therefore cannot say. From long distance ...
July 20, 2006
IPOs on the Internet
The United States has long had an advantage over other countries in how it nurtures small businesses. IBM and Microsoft, among many others, both started in garages and grew to major companies.
That advantage is dissipating due to regulatory ossification.
A small business that needs to raise money to grow by selling ownership units, shares of stock, is regulated by the Securities Act of 1933. The Securities and Exchange Commission, responsible for implementing the act, crafted rules in the '30s when we were a paper and telephone based society.
We have been in the Internet Age for over ten years and we still have the paper and telephone based rules. The SEC has not adapted its rules to allow for the use of the Internet, and its cost savings, in raising money. Other countries have.
Here is how we still do it in the United States. A small company can sell shares in either a private or a public offering. In a private offering, the company cannot use the Internet to solicit buyers of its shares unless the money sought is small in amount and the company jumps through several regulatory hoops that are not worth the trouble given the small amount needed.
In a public offering, known as an IPO (Initial Public Offering), a small company must go through a full registration of its offering with the SEC. The registration offering process is based on the creation of a paper document, the prospectus, that must be delivered to offerees. The delivery of the shares revolves around the use on investment banks, underwriters, as intermediaries. The banks buy the shares and resell them to the public, taking a cut.
The underwriting process is very expensive and underwriters will only take companies that want to raise $50 million or more. A $50 million public placement will net a company only $45 million or so, a haircut of $5 million.
If small companies could use the Internet to solicit buyers and place their own shares, they would save a substantial amount of the haircut and could raise lesser amounts of cash – down to $20 million – in public offerings. But they cannot; it is illegal to do so.
The SEC has not approved the Internet offering process for small companies because they fear an increase the fraudulent fund raising activity and they worry about investors that do not have access to the Internet. I believe an increase in enforcement activity aimed at fraud is a better solution to the former concern than cumbersome procedural rules. The latter concern is silly; people who want to invest will find a way to access the Internet and many of such folks should not be investing in these stocks anyway. The small stocks are for the pros.
The truth of the matter is that the SEC suffers from regulatory ossification. It is reluctant to change its ways, that have worked in the past, in response to the new environment. The agency may make mistakes and will upset established market players, the investment banks who have political clout.
The result is that many of our companies are running to foreign markets to raise cash. The London Stock Exchange has started an Alternative Investment Market (AIM) that is luring United States companies to sell shares in London. Listing on the AIM costs less than half what the same listing would cost in the United States.
Not surprisingly, the number of IPOs in the United States is down but up in London. Allowing our small companies to use Internet solicitations would reverse the trend. If we do not wise up we are going to squander one of the country’s more precious economic advantages – the successful nurturing of small vibrant companies, companies that turn into international giants.
July 19, 2006
SEC Rules on Soft Money
The SEC has narrowed the forms of soft money payments that brokers can make to buy side funds. I am missing something here. Buy side funds "overpay" brokers (with high commissions) and the brokers return part of the commissions in services (soft money). The surplus of the paid commissions over the value of the returned services is the actual commission paid. The actual commission is passed on to customers of the funds in fund fees. If the market works, the investor fees would be at competitive rate and the actual commissions would be at competitive rates. Apparently the market is not competitive because the SEC is regulating the form of the actual commissions beyond simple rules requiring transparency. If the market is not competitive, soft money payments are least of our problems -- there are real problems in the fees structure. The SEC is imposing a salve on a bleeding ulcer. If the market is competitive, we do not need the rules. Either way the rules are ill considered.
Phillip Goldstein wrote a reply to my earlier note on his case against the SEC that successfully threw out the hedge fund registration rules. His makes a good point. Too good. His argument stands on formality -- a hedge fund manager has one client, the fund itself. The fund investors are not his clients. An argument on formality has extensions into the form of the fund -- a general partnership is different from an LLC or a corporation. In a general partnership, the partners traditionally would each be clients. The SEC was willing, by rule, to treat all the business forms the same, however. The point is that a definition of client should not stand on formality and that the SEC is in a good position to craft a definition. The definition can be functional or can be a bright line test to substitute for a case by case functional analysis. Note that the industry hates the functional tests and loves the bright line tests because it enhance the predictability of their business arrangements. The SEC choose the bright line test and the court rejected it. I did not like the SEC rules but I would not reject the rules based on formality -- this will come around to bite the industry that pushed the argument.
The backdating options scandal continues to grow. Now over 2,000 firms may be involved. Moreover, the scandal is growing raunchier as newspapers have discovered that 9/11 provided a prime opportunity for backdating. Journalists continue to misunderstand the crisis -- it is a violation of disclosure requirements and a tax fraud to call "in the money" options "at the market" options. In the money options have an exercise price below market price at the date of grant; at the market options have an exercise price equal to market price at the date of the grant. It is not illegal to grant "in the money" options as long as a firm discloses they are in the money and the recipient pays the proper tax. The disclosure advantage of lying was largely eliminated by the new rules on expensing options. The ability to lie was largely eliminated by the new SOX rules requiring disclosure of executive option grants within two days of the grant.
Lawyers, who should have sniffed out the practice (or may have even participated), are now cashing in as law firms are racking up the billing hours defending firms that may have undertaken the practice.
I am always amazed that executives who make $10 million a year and up legitimately will nickel dime their companies on the small stuff. They have their lawns mowed and their gifts of flowers to secretaries paid for by the firm. The options scandal is more of the same. Most of the executives merely saved some taxes with backdating the options and the taxes saved were a pittance of their salary. At most the executives may have felt they could get paid a little more if their compensation was hidden, but given the power of companies to set enormous salaries even this was probably not more than face saving stuff.
I have an inherent distrust for high paid executives that nickel dime their own companies -- these folks are cheaters and are likely to get their companies into trouble on the big stuff. An executive that backdates options should be shown the door, before his cheating heart hurts the company on stuff that matters.