April 3, 2010
How Corrupt Are We?
This will be a "thinking by blogging" post. [Insert reader query: "As opposed to all your other posts?"]
The Wall Street Journal has a story today wherein it is argued that government corruption is not necessarily bad for an economy. If there is enough profit left over for the investors and the corruption is predictable (i.e., the business owner can count on having to make only a certain regular side payment), corruption and growth may go hand in hand. (For some reason, I can't find the article on the web. It is on page W3 and entitled, "Corruption You Can Count On.")
One passage in particular caught my eye:
"Th[e] insight on the evils of decentralized corruption was first made by Andrei Shleifer and Robert Vishny, who noted that after the fall of the Soviet Union, the Russian bureaucracy splintered into an assortment of bureaucracies. Starting a business required bribing the local legislature, the central ministry, the local executive branch, the fire authorities, the water authorities and myriad others . . . ."
This does not seem to be an isolated incident. Witness the recent Daimler AG settlement:
"Diamler AG reportedly has agreed to pay $185 million to settle a long-running FCPA investigation. According to the court papers, beginning in 1998 the company paid million of dollars in bribes to secure business in China, Nigeria, Russia and Vietnam among others. Overall bribes were paid in 22 countries."
That seems like a lot of corruption. So, just how corrupt are we? Some Christians would suggest that we are all weak sinners, with no chance of earning Heaven without Grace. My Buddhist friend occasionally reminds me that I should be grateful that I haven't murdered anyone, since the only thing standing between me and that act is conditions. Such teachings suggest we are very corrupt.
On the other hand, a law and econ person may argue such philosophical musings are irrelevant. All we need to know is that people generally act rationally in their own self-interest. If the expected benefit outweighs the expected cost, we should expect the action to be taken--moral labels are irrelevant. However, it seems to me the question of how corrupt we are still matters because the "cost" part of the equation should include feelings of guilt regarding illegal or immoral behavior. One could argue that the more corrupt we are, the less guilt "costs" and so we need stiffer penalties.
On the third hand, perhaps differing conclusions about how corrupt we are wouldn't impact the law much at all. For example, while concluding that we are very corrupt may lead us to conclude that the business judgment rule presumption that corporate fiduciaries act in good faith is a joke, we really wouldn't likely lose much in practical terms by simply rephrasing the presumption to say: "We presume market efficiency is maximized by only holding corporate fiduciaries liable for gross negligence." (Certainly, some have argued for precisely some version of that definition.)
I'm not sure where that leaves me, other than to say that there certainly seems to be no lack of evidence to suggest the answer to the headline question is: "Very."
April 2, 2010
Ong on Chinese Financial Regulation
Allan Verman Yap Ong has posted How the Implementation of Securitization in China Can Avoid the Problems that Caused the Financial Crisis that Arose in the United States on SSRN with the following abstract:
In 2008, the subprime mortgage crisis in the United States brought about a global financial crisis. Although there are many complex reasons for the subprime mortgage crisis, the securitization of credit has been determined to be one of the most important reasons for the coming about of the crisis. The implementation of securitization in China, in accordance with the Administrative Rules for Pilot Securitization of Credit Assets issued by the People’s Bank of China and the China Banking Regulatory Commission, as well as current laws and policies, could also bring about the problems that arose in the United States. China’s banks extend loans to state-owned enterprise in accordance with the requirements of the central government, and are not concerned with the ability of these enterprises to make good on their loans, bringing about a moral dilemma. Also, although securitization in China is regulated by certain government agencies, these agencies cannot individually apprise the asset pool of each securitization project and must rely on credit-rating agencies. This can likewise lead to the problems that arose in the subprime mortgage crisis.
Simmons on Corporate Governance
Omari Scott Simmons has posted Corporate Reform as a Credence Service on SSRN with the following abstract:
With the recent meltdown of the U.S. economy, there is no shortage of blameworthy corporate directors and managers. But this Essay focuses on another significant dimension of the current crisis: the crucial role of lawmakers and the need to reform the reformers. In a sense, corporate governance reform is like a service: corporate constituents (e.g., managers, shareholders, employees, and populist groups) function like consumers, and corporate lawmakers (e.g., federal government and the state of Delaware) function as monopoly suppliers of reform services. These reform services, however, exhibit credence characteristics, which are service attributes whose quality cannot be fully determined even after significant use. Credence characteristics, at least in the short term, make it difficult for corporate constituents to discern the impact of corporate reform due to information asymmetries. In light of these informational constraints, corporate constituents normally rely on an array of decision-making heuristics as a risk reduction strategy. As the current crisis reveals, corporate constituent overreliance on these heuristics may not adequately prevent corporate opportunism. Making matters worse, the unobservable impact of corporate reform (i.e., credence characteristics) creates perverse incentives for lawmakers (on the supply-side) to engage in opportunistic behavior at the expense of corporate constituents (on the demand-side), who are lulled into a false sense of security. This Essay focuses on an important chapter in the story of the current economic crisis and corporate scandals that cannot be ignored because it highlights the real potential for supply side (i.e. lawmaker) inefficiencies and the need to discipline lawmaker behavior as well as enhance lawmaker competence.
It's Not Sovereign Debt -- Really
As I discussed last week, I don't like the idea of finding “implicit guarantees” in contracts between sophisticated parties. Nonetheless, I was happy to hear that Treasury Secretary Timothy Geithner today stated specifically that Fannie Mae and Freddie Mac should not be considered “sovereign debt.”
The Wall Street Journal Blog reports that Secretary Geithner and other administration officials are seeking to get their financial regulation reform legislation through Congress before deciding what to do with the two mortgage finance institutions. I can’t help but wonder if his statements today might be a little foreshadowing. Of what, though, I have no idea.
April 1, 2010
Can an investor reasonably rely on a promise of a return of 4900% in two months?
On March 18, the SEC "charged a South Carolina-based attorney and a cohort with securities fraud for bilking investors in a high-yield investment scheme that promised rates of return as high as 4,900 percent in just two months."
Meanwhile, Prof. Bainbridge blogs on a recently filed case wherein the alleged culprit, "a self-described 'natural psychic, trained Remote Viewer, [and ] intuitive consultant,' was charged ... over his alleged role in a multi-million dollar offering fraud in which he touted his psychic ability to predict stock market movements."
These sorts of cases should pose problems both in terms of reasonable reliance and materiality, which turns on whether a reasonable investor would have considered the misstatement important. As Bainbridge opines: "The mere fact that some investors are idiots does not tell us anything about what the proverbial reasonable investor would have done in these circumstances. After all, as PT Barnum put it, there's a sucker born every minute."
At the same time, a comment to Bainbridge's post reads: "No rogue should enjoy his ill-gotten plunder for the simple reason that his victim is by chance a fool." This seems to express a reasonable sentiment. Can we find a middle ground?
I did a little digging around and found this further explication from a bankruptcy case, Sanford Institution for Sav. v. Gallo, 156 F.3d 71, 74 (1st Cir. 1998):
Title 11 U.S.C. § 523(a)(2)(A) bars from discharge in bankruptcy a debt for money … obtained by false pretenses, a false representation, or actual fraud. In Field v. Mans, the Supreme Court construed this provision to require the creditor to prove that its reliance on the misrepresentation was justified in order to avoid discharge. 516 U.S. at 61 …. The Court rejected the argument that the more demanding “reasonable reliance” standard applied. See id. at 70 … (citing and adopting Restatement (Second) of Torts § 545A, cmt. b, which states that plaintiff's conduct does not have to conform to “reasonable man standard”). The Court adopted the dominant common-law formulation of the elements of fraudulent misrepresentation as set forth in the Restatement (Second) of Torts §§ 537-45 and Prosser and Keeton on Torts § 108, at 750-52. In contrast to the reasonable reliance standard, in order to show justifiable reliance, the creditor need not prove that he acted consistent with ordinary prudence and care. “‘The design of the law is to protect the weak and credulous from the wiles and stratagems of the artful and cunning, as well as those whose vigilance and security enable them to protect themselves' and ‘no rogue should enjoy his ill-gotten plunder for the simple reason that his victim is by chance a fool.’” Prosser § 108, at 751 (citations omitted). The rationale for placing this relatively low burden on the victim of the misrepresentation is rooted in the common law rule that the victim's contributory negligence is not a defense to an intentional tort. See Restatement (Second) of Torts § 545A & cmt. a; Prosser § 108, at 750 …. In such circumstances, the equities weigh in favor of giving the benefit of the doubt to the victim, careless as it may have been, and even though it could have been more diligent and conducted an investigation.
While this all seems quite fair, the reasonable investor standard is in fact the one used under Rule 10b-5, and to date I am not aware of any exception made for cases like those set forth at the beginning of this post. Rather, the SEC and courts have seemingly simply ignored the glaring problem of reasonableness. Perhaps it would be better to craft an explicit exception.
Chaffee Steals One of My Blog Posts
Depriving me of the opportunity to use such great lines as:
I cite myself. I want you to cite me.
Why blog, if not to shamelessly self-promote?
But seriously, I bow in gratitude to my dear friend for kindly posting the link to my draft. The article is to be published in the Case Western Reserve Law Review, and I have till August 9th to get my final draft in--so any and all comments are appreciated.
March 31, 2010
Padfield on Securities Regulation
Stefan J. Padfield has posted Immaterial Lies: Condoning Deceit in the Name of Securities Regulation on SSRN with the following abstract:
The financial crisis of 2008-2009 is once again raising the issue of investor trust and confidence in the market. Investors are questioning how managers could have taken such significant risks in the subprime lending and credit default swap markets without apparently providing adequate disclosure to the market. The pending flood of lawsuits following in the wake of this financial crisis provides an opportunity, however, for courts to restore some of this lost trust. This Article argues that one of the ways courts can do this is by curtailing their over-dependence on materiality determinations as the basis for dismissing what they deem to be frivolous lawsuits under Rule 10b-5. There are at least four good reasons for doing so. First, condoning managerial misstatements on the basis of immateriality arguably has a negative impact on investor confidence because whenever courts find a misstatement to be immaterial as a matter of law they are effectively concluding that there will be no relief for shareholders even if the statement was made with full knowledge of its falsity and with the requisite intent to defraud. Second, the materiality “safety valve” doctrines that have evolved to assist courts in dismissing frivolous suits are often in direct conflict with Supreme Court guidance as to both the proper definition and analysis of materiality in the context of Rule 10b-5. Third, the routine categorization of managerial misstatements as immaterial in order to dismiss frivolous suits creates a tension with the disclosure rules, which are premised on ideals of full and fair disclosure and often turn on materiality determinations. Finally, the dependence on materiality is unnecessary because other elements of Rule 10b-5, such as scienter, have been strengthened to the point where they allow courts to deal with the problem of frivolous suits without having to rule on the issue of materiality.
Even if Stefan was not my friend and co-blogger, I would still recommend this article.
Dalley on Business Associations
Paula J. Dalley has posted Imagining Business Associations Without Agency Law on SSRN with the following abstract:The application of agency law to business associations presents a variety of problems. This essay considers an alternative conception of the business association that does not incorporate agency law principles. Borrowing from early ideas of partnership, this alternative conceives of the organization as a pool of assets. The asset pool is the bearer of liabilities; the shareholders and managers have powers and rights relating to the asset pool and to each other. This essay then considers how the law would differ under an asset-pool approach and identifies the potential benefits and disadvantages of the asset-pool conception of business entities.
Reconciling the Joneses
The Seventh Circuit determined that under § 36(b)(1) of the Investment Company Act of 1940, “[a] fiduciary must make full disclosure and play no tricks but is not subject to a cap on compensation.” Jones v. Harris Assoc. L.P., 537 F.3d 728, 729 (7th Cir. 2008). The United State Supreme Court disagreed, unanimously stating: “By focusing almost entirely on the element of disclosure, the Seventh Circuit panel erred.”
The Supreme Court instead determined that even a disinterested board’s fee approval is subject to review in certain circumstances: “[A] fee may be excessive even if it was negotiated by a board in possession of all relevant information, but such a determination must be based on evidence that the fee ‘is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm’s-length bargaining.” Jones v. Harris Assoc., L.P., slip op. at 15 (quoting Gartenberg).
I am inclined to agree with that the Seventh Circuit's view that market forces and disclosure should carry more weight than they are currently provided under Gartenberg. However, I also agree that disclosure, alone, is not sufficient under current law. Nonetheless, it seems to me that these cases could be reconciled, provided that under the Seventh Circuit’s standard, evidence that a fee "is so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining” is evidence that a fiduciary is, in fact, “play[ing] tricks.”
March 30, 2010
Supreme Court Rules on Jones v. Harris Associates
The eagerly anticipated Supreme Court decision in Jones v. Harris Associates came down earlier today. The case asked whether mutual fund customers could utilize the Investment Company Act to contest excessive adviser fees. In a unanimous decision, the Court remanded the case to the Seventh Circuit with the instruction to use a standard announced in the 1982 Second Circuit case of Gartenberg. That standard requires a showing that an adviser charged a fee so large as to bear "no reasonable relationship to the services rendered."
Today's decision is available at http://www.supremecourt.gov/opinions/09pdf/08-586.pdf.
And the first shelved reform is...
...the harmonization of the standards of care owed customers by, respectively, brokers and investment advisers. For although successive administrations called for the move (and the courts long ago abolished SEC attempts to distinguish the two), lobbyists simply couldn't let the notion proceed to debate.
As described in the March 26th speech by SEC Commissioner Luis Aquilar:
The Senate Bill, however,
has abandoned its strong position in the face of determined lobbying by
the insurance and brokerage industries. The revised version that was
voted out of the Senate Banking Committee on March 22nd has eliminated
the provision applying the fiduciary standard to brokers who provide
investment advice. It would, instead, require a one-year study by the
SEC concerning the effectiveness of existing standards for "providing
personalized investment advice and recommendations about securities to
As a result, the sizable number of brokers who in recent years registered as both brokers and investment advisers (in anticipation of the long overdue reconciliation) find themselves voluntarily subjected to regulations not required by law any time soon.
Talk about your reverse moral hazard. Funny, most of us thought the most exotic contribution of the Crisis would be a multi-tiered debt obligation securitized by means of a series of unrelated multi-tiered debt obligations...
March 29, 2010
Perhaps a little more light has shone...
There was an interesting article in The New York Times this past Friday. "Does This Bank Watchdog Have A Bite?" by Andrew Martin highlighted the preemption controversy continuing between State banking regulators and the Office of the Comptroller of the Currency, one of five federal banking regulators purportedly on the beat. See generally http://www.sec.gov/answers/bankreg.htm.
The Times piece quotes two Attorneys General who cite outright favoritism towards banks at the OCC, an agency from which tens of thousands of customers annually seek redress. The OCC chief is a former bank lobbyist who during the present crisis has voted against 1) limits on banks' ability to raise interest rates on existing credit card balances and 2) assessments on banks to strengthen the FDIC insurance fund, Joining the State officials in bewilderment are a law professor, a lawyer for the Center for Responsible Lending, an official at the Consumer Federation of America - even a judge who debunked one bank's effective choosing of the more lenient regulator by filing for a national charter amidst a State investigation. See Capital One Bank v. McGraw, 563 F. Supp. 2d 613 (S.D.W.Va. 2008 )(J. Goodwin). As Judge Goodwin aptly noted,
If the OCC fails adequately to enforce state law against national banks, state officials could bear the brunt of public disapproval while federal officials remain insulated from the electoral ramifications of their enforcement policies. Moreover, it is questionable whether the OCC will be as motivated or as effective in protecting the consumers of West Virginia as is the West Virginia Attorney General.
If there is a sliver of a silver lining in this recession, perhaps we've collectively learned that what masquerades as bureaucratic waste can be something much more pernicious. And if there is to be justice, perhaps Congress will eliminate the right duplicative banking agency when it takes up H.R. 4173, the House reform Bill from December that proposes the outright elimination of the Office of Thrift Supervision (at section 1207).
Pro-Market and Pro-Business: A Prescription for Confusion
Ezra Klein at the Washington Post today writes about the differences between “pro-market” and “pro-business” in the healthcare context. Without delving into the health care issue he raises, I very much appreciate the overarching point: Pro-business does not necessarily equal pro-market. In fact, often pro-business is anti-market because businesses (appropriately) want as much of the market as they can get for themselves.
A similar discussion surrounds the North Dakota Pharmacy Ownership Law (NDCC 43-15-35(e)), which requires pharmacies in the state to be majority owned by a licensed pharmacist. As such, the mass-market retail chains in the state (like Target and Wal-Mart) do not have pharmacies. This law has been criticized by large retailers and others as anti-market and anti-consumer, but certainly it is “pro-business” for current pharmacy owners in the state.
As Klein notes in his piece, pro-business forces often confuse the issue by using pro-market rhetoric, and this is true in the North Dakota pharmacy debate, too. A press release announcing a study by the Institute for Local Self-Reliance (ILSR) claims that repealing the law could lead to $23 million in lost economic benefits. The release continues, “North Dakota residents not only benefit from ready access to pharmacies, but the state’s average prescription price is well below the national average.”
Notice how this quote tries to imply the law is pro-market. First, it states that the law provides more pharmacies to rural areas. This seems to imply more competition, and certainly provides more access to pharmacies for certain regions. Next, the quote states that prescription prices are lower in the state than most of the country. This tries to imply causation, but the report never provides any support to indicate anyone actually thinks prices would be higher without the law.A more accurate statement would probably be: “The North Dakota pharmacy law provides greater access to a pharmacy in many parts of the state that would not otherwise have access. Because the average price of prescriptions in the state is lower than the national average, you should be okay with paying more than you need to for prescriptions.”
And that may be a choice people would like to make – we often balance such decisions in the same way we might choose to pay an extra dime a gallon to buy gasoline from the local service station instead of going to a big company station. But note that the decision under the pharmacy law is not, “Do we prefer to buy local?” Rather, it is,” Do we prefer to ensure the market only offers local options?”Note that I’m not criticizing any group for using language that puts their position in the best light, and I am not saying that both sides haven't confused the issues for their benefit. (They have.) I’m simply saying we need to read and listen closely to ensure we frame the issues for ourselves. That way, we can know exactly what we are choosing to support – businesses or markets – and why.
-- Josh Fershee
March 28, 2010
Caron, Kowal, and Pratt on Pursuing a Tax LLM
Paul L. Caron, Jennifer M. Kowal, and Katherine Pratt have posted Pursuing a Tax LLM Degree: Why and When? on SSRN with the following abstract:
This Article and a related article, Pursuing a Tax LLM Degree: Where?, provide information and advice about Tax LLM programs to American law students and JD graduates who are thinking about pursuing a Tax LLM degree. This Article (1) discusses the costs and benefits of pursuing a Tax LLM degree, (2) explains the circumstances in which prospective Tax LLM students may be able to expand their employment options by pursuing a Tax LLM degree, and (3) compiles information and advice that tax law professors typically provide to prospective Tax LLM students in individual counseling sessions. This information includes a primer on tax practice employment opportunities, which vary based on (1) the nature of the work (i.e., transactional work or controversy work) (2) the type of tax subspecialty that is the focus of the tax practice and (3) the type of tax practice employer. The primer includes descriptions of various tax subspecialty areas, including business tax, international tax, estate planning, employee benefits, tax-exempt organizations, and tax controversies. This Article also offers advice to prospective Tax LLM students who are searching for tax positions with various types of employers, including (1) law firms (large, elite law firms, medium-size law firms, or smaller law firms), (2) accounting firms (Big Four accounting firms or smaller accounting firms), (3) the IRS, Treasury Department, or Department of Justice, (4) state taxing authorities, (5) corporations or other organizations, or (6) the U.S. Tax Court. For prospective Tax LLM students who hope to become full-time law professors, this Article also discusses the value of a Tax LLM degree in making the transition from tax practice to academia. In addition, this Article provides information regarding aspects of Tax LLM programs about which prospective Tax LLM students frequently inquire and addresses some common misconceptions about Tax LLM programs.