Business Law Prof Blog

The Recession Scare

Now that the preliminary first quarter GDP data is in showing positive but small growth and the markets have indicated we have bottomed in all but housing prices (under which Congress is trying to put an artificial floor, a mistake)  those who were screaming about a recession since last summer should be contrite. They are not, of course.  Some continue to claim recession (the data is misleading... it will be corrected...unemployment is the real problem... and so on). Others are quietly disappointed!!  (Shucks, we are not all going to starve; we are doing better than I thought.")  My favorite group, the blamers, just pretends the data did not happen and is still screaming recession (they profit by blaming a targeted "bad" group).  The exaggerated claims of recession serve to many constituencies:  1) political candidates who want to oust incumbents by scaring voting, 2) media outlets who want to get viewers and readers by creating false crises that give enhanced incentives to view or read, 3) left wing theorist who are fundamentally uncomfortable with capitalism and claim that it needs to be "softened" to minimize income inequality (and , fill in the blank with any other political claim of exploitation), 4) and, a new group, government officials who can claim to have solved the crises (those who put together the Bear Stearns bailout, for example, and the fed that lowered interest rates precipitously).  Many of those in one group are also in another.  This cultural pathology is added by our lack-of-pluck.  We are not worried about food we are worried about whether we can upgrade our television sets (84 million were discarded last year) or drive our pickup trucks cross country.  In the face of minor setbacks we wine and moan; what would happen if we truly faced a major setback??  Would we collapse in a puddle of urine??   

Freddic Mac: What a Mess

Freddie Mac, one of two United States chartered companies that own or guarantee the bulk of home mortgages, recorded a net loss for the quarter that was reduced by accounting gimmickry.  The true loss is close to $2 billion.  Freddie Mac is 1) hemorrhaging money, 2) overleveraged, 4) gone through recent management behavior problems, and 4) will desperately need new capital soon to survive.  In other words, this company is on the edge of insolvency.  Yet Congress has increased Freddie Mac's ability to guarantee "gumbo" mortgages (the upper limit has been increased from $420,000 to $625,000 (or so) and Ofheo, its regulatory authority is considering lowering its capital requirements.  Even more astonishingly the stock is trading at around $28 a share.  The market is anticipating that Congress will bailout the company if it struggles even though there is no explicit promise or understanding that Congress must do so.  This is a case study in moral hazard.  Congress has two ways out of the mess -- neither of which it will take.  Slaughter the pig rather than dress it up; or open its mortgage guarantee program up to any financial institution that wants to get in the market (make the pig compete for its supper). 

Thanks Cox for Helping Me

I hold stock in Goldman Sachs, an investment bank that despite not getting caught holding bad mortgages has been hammered in the stock market (dropping from a high of 210 to a low of 165 or so).  Recently sanity has prevailed and the stock has been climbing (up to 195 or so), until Cox and the SEC decided to help me.  Apparently I do not have enough information on the bank. So in my best interest, Cox announced more investment bank disclosure rules. My stock dropped immediately on his speech and has flat lined ever since.  If asked he will still no doubt tell me I am better off somehow. 

Congress to Regulate Oil "Speculators"

Congress is considering a bill that will apply CFTC regulations on oil futures speculators to a London based futures trading market -- the Intercontinental-Exchange (ICE). There are two problems: First, any regulations of this type will not affect international market prices, but will cut off United States traders from directly participating in foreign exchanges.  Second, Congress ought not regulate "speculators" at all, other than to enforce rules against fraud (wash sales, touting and the like).  Congress, if it gets involved, will damage United States futures markets.

Government Intervention

Oh good gracious.  Peter Bernstein article in todays NYT's Sunday business section ("When Should the Fed Crash the Party?") is so predictable it is a bore.  He trots out all the cruel statements from "anti-interventionists" and then mentions all the governments successes when intervening in financial crises.  He throws a bone to the problems of decision-makers in predicting what to do but concludes with typical flourish the consequences of not intervening would be "unthinkable."  What drivel.  The argument is flawed because intervention gets us into crises in the first place -- prompting Bernstein and others to then call for corrections and bailouts.  At issue is how often our economic lurches are created in the first instance by intervention, not whether intervention "to correct" is always worth the effort.      

Political Arbitrage

Business is focusing on the election and guessing that a very liberal Democratic will win the White House and that Democrats will control both houses of Congress. Politics will change and business parameters will change. We will see higher investment taxes and we will see stricter anti-trust enforcement.  So better now and November expect some blockbuster cash deals -- consolidating market power with an unusual frequency of taxable versus tax free structures.  Some have come already. There will be more -- political arbitrage.

SEC Asleep at the Switch or Did It Throw the Wrong Switch?

Critics have long suggested that the SEC has been asleep at the switch when it comes to new financial frauds.  The SEC may have done more--it may have thrown the switch to the wrong track.  In 2004, the SEC changed its accounting releases to allow brokerage companies to include risky capital in the capital reserves that it requires brokers dealers to hold when engaging in securities transactions.  The brokerage companies are also banks and used the diminished capital requirements to increase leverage and participate in the asset backed securitization markets.  Great.  Recall that the Chairman of the SEC, Cox, noted that the system was fine and needed no repair on the eve of the Bear Stearns emergency bailout.   

Alice Rivlin Scares Me: Good Intentions Ought Not to Excuse Folly

In an editorial in todays NYT's Alice Rivlin showed why she should never have been a government official, much less the former vice chairman of the Federal Reserve and the Clinton's director of the Office of Management and Budget.  Consider her argument:  the government's (ie. the President's) job is to "protect" the country and "indeed the world" from a financial market meltdown.  Translated -- this means the President's job is to run the economy and make sure there are no economic downturns.  Rebuttal (that a high school student in economics should be able to make):  1) The President's job is not to run the economy.  If given the job he/she would fail miserably.  2)   All free market economies have cycles that include periodic downturns: it is as natural as birth and death; as spring and winter; as a liberal who wants to increase government regulation whenever an excuse is handy.   The government cannot stop he economic cycles and but it can make them much worse (witness the 30s).  With every economic downturn we get cries for the government to "do something" and if we listen to the Rivlins and the government "does indeed do something" we will have a ratchet upwards of increasing regulation that stifles market activity over the long term.  Rivlin's solution?  "ease the renegotiation of mortgages" "more regulatory scrutiny of financial institutions" outlaw "financial instruments... that mainly reflect the efforts of traders to outsmart each other."  Translated -- change negotiated contracts to bailout those who cannot pay; give the Fed discretionary regulatory power over all financial institutions not just commercial banks (this would include brokerage firms and investment banks as well as hedge funds and private equity funds), and outlaw any investment instrument that government officials do not understand.  Rebuttal:  1) How do we find government officials that are this smart? Is Rivlin this smart?  She is the classic Monday morning quarterback claiming she could have coached the team to victory.   2) Note the lack of detail in any of these solutions -- they all float on a cloud of well-intentioned goals (there should be no poverty, no economic pain, no death) with little or no practical sense of whether they are possible to do in practice or whether the government has informational or decision-making limits.  3)  So now all new financial instruments must pass by a bureaucrat's potential veto. Discretionary government approval of financial instruments will drive the whole business offshore.  We might as well hang up a sign saying "closed, moved to London" to the financial communty.  Good grief.  This women was at one time a senior official in the Fed?? Our best solution is to enforce the laws all ready on the books -- exact penalties for fraud and force accurate public disclosure of current asset valuations -- and let the market penalize those who have made poor market decisions.  The market needs to clear and bottom.  Government regulation that does more than penalize fraud and force public disclosure of current positions will retard us from finding the bottom.  [With the possible exception of government buyout programs such as the one used in the S&L crisis, implemented under a heavy burden of justification.]  Once the market bottoms the government can alleviate some of the suffering with means based grant in aid programs that are priced and transparent.

Treasury's New Plan

By now most have in the financial community have digested the details of Sec. Paulson's grand plan to reorganize federal financial regulations in the country.  The plan augments the power of the Federal Reserve Board to step in when there is a financial crisis.  The plan establishes three agencies with different task -- one to regulate the stability of the market, another to regulate financial market competition, and yet another to protect investors.  Part of the plan is, for example, a merger of the SEC and CFTC.  Hidden in the plan are proposals to lighten regulation -- for example, a proposal to lighten regulation of securities exchange rules on listings. This plan has no chance of approval -- it is too complex, upsets too many apple-carts, and appears in an election year and a year in which the economy is staggering.  Why propose it then?  Simple.  What makes the knees shake of government officials, even those that favor market based solutions over government based solutions to economic cycles, is getting condemned in the history books as having done "nothing" while the people suffer.  This plan is a CYA for Paulson.  He can claim to have done "something" to solve our economic problems.  The proposal of the plan itself is an illustration as to why government ought not have the power the plan gives the FED.  There is too much pressure on government officials in a downturn to "do something" and that pressure, more often than not, leads to counterproductive actions.  It is well known that Herbert Hoover should not be criticized for doing nothing during the early days of the depression; he should be criticized for doing stupid things in response to pressure -- increasing tariffs and increasing taxes.  The plan, increasing the power of the Fed in crisis times, is likely to lead to more problems than corrections.

Pension Benefit Guaranty Corporation's New Policy

Along with discussion of Bear Stearns, the WSJ's opinion page has a helpful discussion of another moral hazard problem: the Pension Benefit Guaranty Corporation.   The PBGC is a government safeguard against shortfalls by company pensions.  The PBGC is funded by "premiums paid by employers,assets from failed pension plans, recoveries from bankruptcies and returns on invested assets."  The difficulty for the PBGC is that its funding does not meet its obligations, so in order to remedy the problem the PBGC has decided on a new investment policy that will more heavily invest in equities.  Unlike some sovereign wealth funds, the PBGC does not select stocks or bonds or actively manage its own portfolio, relying instead on professional money managers and market index funds.   The PBGC believes its new strategy will both obtain better returns and reduce risk through diversification.  Still, the WSJ warns that the PBGC strategy may create more risk, and in any event it still leaves the PBGC vulnerable, which could potentially mean a government (read: taxpayer) bail-out.  The WSJ asks: If we are even going to have a PBGC, why not demand higher premiums?   The reason is, I suppose, that there would be a great outcry over the burdens placed on small businesses, similar to what has happened with the planned (but not yet realized) imposition of Sarbanes-Oxley's 404 to smaller companies.  However, the important difference between the two scenarios is that in the case of unfunded pension liabilities, taxpayers ultimately bear the risk of failure; in the case of potential losses due to the decision not to apply 404, investors bear the risk of failure (and can price accordingly).

Posted by Paul Rose

The Fed, the Treasury and the Bear Stearns Deal

Two government units, the Treasury and the Fed, are negotiating the JP Morgan buyout of Bear Stearns.  This should give us great pause.  First Paulson has agreed to write a $29 billion credit derivative swap on Bears risky mortgage backed securities for free.  In essence he is granting JP Morgan what would have been the fee on the swap, a sizable amount.  The deal, unless offered to all potential buyers (and we do not know who Paulsen had included in the selective group of offerees), stops any competitive bidding market for Bear Stearns.  The Treasury has, in essence chosen the buyer.  Second, Bernanke is setting the price. With Treasury offering up a cash induced to do the deal at issue is how the inducement is split among the lucky players -- what do the Bear Stearns shareholder get of this largess?  Bernanke apparently did not like the price at $2 a share and negotiated for $10 a share for the Bear Stearns shareholders, giving the shareholders a larger piece of the Treasury's surrogate cash grant..  So, after the Treasury choose the price, the Fed has chosen the price.  Moreover, he delayed telling Bear Stearns about his intent to lower the discount rate on funds that investment banks can now borrow (this also is new) from the Fed until after the contract was initially inked.  Bear Stearns could have used the window to borrow money to keep afloat a bit longer to negoitate a higher price or to encourage other bidders.  This heavy- handed manipulation of a buyout of the country's fifth largest investment bank ought to raise eyebrows all throughout the financial community.  Do we want Treasury and the Fed using such a heavy hand to structure the operating side of the financial markets?  I do not.  What's next, one has to wonder?  The feds had better develop a principle fast for when to get into the business of restructuring financial institutions beyond the caterwauling of "impeding doom" by wall street insiders.   The feds will find that appeals to them to "do something" by anyone facing financial loses will now step up considerably.  What a mess.

Profitable Government Buyout/Bailouts

Whenever a market is in severe distress, we can be sure that several commentators, many of whom are economists, will argue for a structured government buyout, bailout.  "The government should buy.... and then resell the assets slowly over time.  The government will stop the bleeding and may even make a small profit."  The government showed a profit when it bought failed Savings & Loan assets and when, in the thirties, it bought mortgages in default (the HOLC, Home Owner's Loan Corporation).  Remember also that government support of Chrysler by buying bonds also showed a profit (Chrysler paid off all the bonds).  The blank is filled in today by 1) failing CDOs, 2) defaulting sub-prime mortgages, and 3) struggling insurance companies that provide credit default guarantees.  All three industries have advocates for government buyout, bailouts.  Can government develop a clear ear for deciding when to do buyout, bailouts and when to pass?  Political pressures should not determine the choice; can government resist choices based on raw political pressures?  I am skeptical (but believe that a buyout, bailout of credit default companies may make some sense).

The Common Element on All Sub-prime Rescue Packages: More Federalism

Beginning with the Civil War the federal government has more or less followed a pattern of dealing with financial crises by expanding the role and power of the federal government.  With each new financial crisis we get new legislation that creates new prohibitions and new agencies to deal with those prohibitions.  Everyone in the federal government with a remedy for the sub prime mortgage loan mess has, as part of their package, a similar part -- a move by the federal government into what has been traditionally left to state law and state enforcement authorities.  Mortgage lending has traditionally been a creature of local contract law and local foreclosure laws;  lending brokers have been traditionally controlled by local real estate laws.  So yet another traditionally local area of the law is about to be federalized.  The costs of increased federal regulation rather than local regulation are no discussed anywhere in the press or in the press releases of the reformers.  Yet the costs are significant.  Local law may be better.  Local authorities are closer to local problems and local authorities compete with each other for sensible legal systems that attract investment (the competition produces experimentation and innovation in the rules).  A major after-effect of the sub-prime reform efforts will be another stop towards a more powerful central government. 

SEC and SROs: Chronic Failure to Catch Insider Traders

Gretchen Morgenson is, in Sunday's NYT's business section, shocked, shocked that the SEC does not have an updated computer system designed to catch insider trading.  What is shocking is that this is news to her.  The split between SROs and the SEC on enforcement of the securities acts has always been a tenuous marriage.  It was a political compromise in 1934 that survives today and should be scrapped.  The effect, which has been evident for over forty years is that federal enforcement lags and both the SROs and the SEC blame each other.  Neither has the full incentive to enforce because accountability is shared.  Here the SROs says it gathers data but does not act on it other than sending it to the SEC.  The SEC gets the data, which it does not gather, and attempts to sift through it to act on it.  But the SEC is understaffed and overworked (the product of relying on SROs) and their computers and not totally in sync with the newer SROs systems.  The result?  Poor enforcement.  The result is endemic to the split in enforcement responsibility and will continue to reappear in new guises -- when we can be shocked, shocked once again.

Sovereign Wealth Funds and Corporate Constituency Statutes

"Be careful what you ask for, you might get it," my mom used to say.  States, including Ohio, passed statutes that allowed boards of directors to take into account "other constituencies" (read: non-shareholder) when making decisions.  Now foreign sovereign wealth funds are buying stakes in American corporations and our concern is that they will not act like normal controlling shareholders and focus on shareholder returns.  The foreign funds may use the funds as a branch of their foreign policy departments.  In other words, the foreign funds will take into account "other constituencies."  We are worried about the effect on our capitalist system -- the same concern that should have led us not to adopt the constituency statutes.   

The Fed Ought to Float the Funds Rate

The Open Market Committee, chaired by Ben Bernanke, of the Federal Reserve System controls monetary decisions.  It has made news the past several days by 1)lowering the federal funds rate; 2) lowering the discount rate and 3) auctioning term funds (and facilitating international swaps among banks).  The stock and bond markets fell on the news of the rate drops yesterday and, after a brief period of euphoria over the auctions today, the stock market retreated into a ho-hum close for the day.  The Fed is fast becoming unable to control market conditions as the size and speed of the global markets will come to dwarf their reserves.  Consider the power of the IMF over world currency trading; once a giant, the IMF is cutting staff and trying to find things to do.  In this regard, the Fed's efforts to peg interest rates with a symbolic funds rate declaration appears, over time, doomed to decreasing effectiveness.  The Fed ought to let member banks set their own over-night lending rates to other banks; it ought to float the rate.  The Fed has real direct market power only when it is dealing with its reserves in either loaning money as a lender of last resort (setting the discount rate or in auctioning term funds) or when itself engaging in open market transaction to affect supply and demand of currency (buying and selling treasuries or foreign currencies).  The Fed, in cooperation with the Treasury, could also. perhaps, have a saving in setting and changing bank capital holding requirements and other leverage and margin requirements in credit markets.  These are the actions that ought to consume the fed, not fixing prices for member lending institutions.  If the Fed would let the funds rate float, it would decline to a rate a bit over government money market rates (the increase would be due to the increased risk of default by private banks) and banks could choose whether or not to lend.  the rate would become just another rate set by the private markets, where it should be set. 

SEC and International Accounting Standards

In a very important vote, the Securities and Exchange Commission dropped a requirement that foreign companies with United States trading exchange listings that comply with rules set by the International Accounting Standards Board (ISAB) still must reconcile their accounting records to comply with United States accounting rules.  The international accounting rules are less detailed than the United States rules and cost less to implement.  The SEC agreed with our major exchanges that have lobbied for the change so as to better attract foreign issuers.  Some United States issuers have objected, arguing that one set of rules should apply to all listed companies.  All have to agree, however, that the vote is an expression of qualification on the quality or rationality of United States accounting rules.    

Kentucky v Davis

The Supreme Court just heard an argument in the case of Kentucky v Davis.  It is a sleeper case that will not attract much press attention but that goes to the core of economic regulation in the United States.  The issue is easy to state and hard to answer:  Can Kentucky, which grants an income tax exemption to the interest on its own bonds, refuse a similar exemption on the interest on bonds issued by other states and held by Kentucky citizens??  It is protectionist;  Kentucky is favoring its own bonds.  A judicially created doctrine, the "dormant Commerce Clause" holds that a state may not pass legislation that regulates interstate commerce (that is the job of Congress).  The Court cases on the doctrine are in conflict (state milk protection laws have failed but garbage delivery protection laws have passed).  At issue is whether the Supreme Court can stop state protectionism without the intervention of Congress.  It is a mixture of good economics and political reality:  States ought not enact protectionists laws, but who should stop them?   The Court should bail; let Congress do it.  If the Court stops attempting to help perhaps Congress will get more responsible on the matter.    

Northern Rock Fallout

The Bank of England had to make an emergency loan of over 23billion pounds to Northern Rock to save the bank.  The loan stopped the run on the bank by depositors who had withdrawn somewhere close to 60% of the banks deposits.  Now the Bank has attracted vulture buyers, some foreign.  The government is angry and looking to cast blame.  So far the Financial Services Authority, that audits banks, the bank's chief executive, who has admitted a lack of financial training, the bank's chairman, a scientist and journalist and son of a previous chair, and bank's risk committee chair, and the bank's board are all under scrutiny.  Only the chair has resigned; the board has offered to resign.  Law makers will look, in the end for a procedural solution: Can we fix corporate governance to make banks more cautious?  This usually means more independent directors and more board subcommittees of independent directors.  It will not help, of course.  The bank took a gamble and lost:  It lent long and borrowed short.  When the short term borrowing costs skyrocketed the bank could not fund its long-term lending.  The banks risk testing had not run sensitivity tests on any assumptions of an extreme short-term borrowing liquidity crunch.  There is no perfect procedure that will stop poor business judgments.  And more procedural complexity does have costs as it may stop good business judgments (they get lost in a wave of individual veto power). In the end, good people make the better judgments.

Equal Disclosure Can Mean Less Disclosure

A new study by Begley, Cheng, and Gao on the effect of the Sarbanes-Oxley Act of 2002 on the accuracy of analysts' projections notes that, in essence, analysts were less able to forecast earnings accuracy after the Act was passed than before the Act was passed.  The inference is that once Congress and the SEC increased disclosure requirements and increased the penalties for inaccurate disclosure, companies actually disclose less.  The companies limit what they say to the bare bones of the requirements and, in the process, disclose less information than they have disclosed voluntarily before.  This a  familiar result. We have watched a similar effect with Regulation FD.

India and Thailand Governments Learn the Hard Way

The governments of both India and Thailand decided to control "foreign investors" in their domestic stock markets.  Each government was worried about excessive speculation in their markets and blamed foreign investors for their troubles; each government threatened their own legislative "tricks."  The effect of both effects was the same:  Their markets plummeted and they withdrew the controls in a torrent of accusations about incompetence. Goverments have, thoroughout history, believed they have more control over trading markets than they in fact do.  One by one governments learn they can destroy their markets very quickly but they cannot "tailor" them to show comfortable, steady growth.

Sovereign-Wealth Funds

The federal government will soon face a very ticklish question.  How to handle the effect of "sovereign-wealth" funds (government based hedge funds) on the United States trading markets.  With up to $2 trillion to invest, and estimates of up to $10 trillion in ten years, the funds could dominate our trading system.  Government based motives could trump profit motive at the discretion of the sovereign funds and roil the markets.  What to do?  Force more disclosure on the sovereign funds that we do no private funds?? This problem will test our international negotiators. In any event, the next post should warn our lawmakers.

SEC Compensation Report

The SEC has issued it first report on the compensation disclosure practices under the new rules.  We should not be surprised; lawyers are doing what lawyers do.  Lawyers by using traditional techniques are obscuring the data (too much technical information and too much general language, etc).  The SEC is doing what it must -- pointing out that the disclosures are deficient.  The consistently missing part of the package is apparently "analysis".  Companies are supposed to discuss why and how they adopted the packages they did.  Many of the disclosures are silent on the matter.

State Attorney General Securities Litigation

The State Attorney General, Marc Dann dumped his out-of-town lawyers in the state's lawsuit against Fannie Mae for securities fraud.  He fired a Boston law firm and replaced it with a New York City law firm.  No big news there. But wait.  The Boston law firm (and an in-state Cincinnati law firm) was selected by his predecessor, Jim Petro, a Republican.  Dann is a Democrat who ran a spirited successfully ran against another Republican.  Both the Boston Law Firm and an affiliate of the New York City law firm contributed money to the candidates in the Ohio race.  So did the Cincinnati law firm.  Danna's office states that the campaign contributions had nothing to do with the choice, but the whole thing smells.  Out of state law firms contributing to a local race for state attorney general while they are handling a case for the office or seeking to replace counsel in a pending case for the office?  Oh good grief.

Regulation of OTC Derivatives

Stephen Cecchetti has written an op-ed in the Financial Times that argues for exchange traded derivatives (futures and options) over OTC derivatives (swaps)["A better Way to Organise Securities Markets"].  He concludes that government should create incentives (tax and regulatory) to drive those who like derivatives to the exchanges.  This is a terrible ideal.  The OTC is innovative and favors those who develop and use products the exchanges do not offer.  Moreover, favoring the exchanges would make worse an already present problem of market concentration that gives the largest markets (the NYSE and the CME, for example) immense trading advantages.  Concentrated trading in select markets is a recipe for mischievous behavior and for ossification of trading practices.

SEC and Environmental Disclosures

Environmental advocates have been pressuring the SEC for some time to force publicly traded companies in the United States to disclose completely their environmental impact, World Wide.  The latest missive is from state officials who want the SEC to require that United States companies disclose potential material financial impact on company operations from "global climate change."  The political agenda is obvious but there is something more fundamental going on here.  Historically accounting rules were designed to monitor the flow of cash and assets, to make sure that those in management did not pocket the funds or otherwise divert the money. It was a very simple goal and easily accomplished with a liabilty system predicated on fixed, transactionally based accounting rules.  We now are using accounting rules to provide data that forecasters can use to predict future values.  This is a radically different philosophy for accounting rules and one that is much harder to enforce and design.  Our liability system was predicted on the old philosophy, tracing the location of funds and assets, and does not easily accommodate the new philosophy.  The liability system juxtaposed on the new function for accounting numbers could easily transpose into a system that penalizes legitimate risk taking to the disadvantage of the American business community.  More and more we see the SEC parsing rules on accounting numbers to allow room for risk taking. 

What to Expect From the Fed

History has shown that the Fed, subjected to intense pressure from the business community, is timely or even early when it eases interest rates (the federal funds rate) and, subjected to protestations from the business community, is tardy when it increases interest rates to combat increasing inflation.  Look for more of the same.

Hedge Fund Investors: How Wealth Should They Be?

The Securities and Exchange Commission is proposing to increase the net asset requirement for individuals seeking to invest in hedge funds to $2.5 million from $1 million.  The increase represents more than just a number that attempts to correlate wealth to the ability to bear losses.  It is a shift in regulatory philosophy.  The $1 million number comes from the accredited investor exception in the private offering rules (investors who are worth over $1million are not counted towards the minimum 35 in Reg. D Rule 505 and Rule 506 private offerings.  The increase will be tucked in another exemption in another act, the Investment Company Act.  Hedge funds then will not be able to do private offerings that other types of operating companies will still be able to do.  There is little justification for the division as investors can loss money in high risk operating companies as easily as they can in hedge funds.  Indeed, hedge funds are diversified and individual privately held operating companies are not -- the risk might be greater in the privately held individual companies.  Whenever the SEC focuses on individual industry rule-making it often just shuffles investors and their risk choices off to somewhere else.

Tax and Hedge Funds

Congress has figured out why over 80% of our nation's hedge funds are located offshore -- tax avoidance.  The funds use financial derivatives (swaps) to minimize dividend taxes and use other systems to minimize compensation taxes and unrelated business taxes.  Congress has scheduled hearings and will not doubt pass legislation to close today's shelter systems.  Behind the shelter is, of course, our basic double tax system (tax corporate earnings and then tax dividends) that should be eliminated, eliminating most of the tax planning devices in place today.  With no tax on dividends (and no capital gains tax on the sale of stock), funds would a minimal incentive to locate offshore.  Revenue lost could be gained back through the adjustment of remaining personal rates. 

CFIUS Reform

President Bush has signed the new legislation on CFIUS (Committee on Foreign Investment in the United States), the agency responsible for reviewing foreign acquisitions of United States companies.  The new legislation goes in the wrong direction on all fronts:  It gives Congress more say (it should have less); It widens the categories of companies that must be reviewed (the categories should be narrowed) and it has very general, open-ended categories ("critical infrastructure" and "critical technologies"), capable of political manipulation (the standards should be crisper and less susceptible to debate).  The legislation will encourage local Congresspeople to protect local firms from foreign acquisitions to keep local citizens happy.  What a mess.  Why did Bush sign it?

The Fed's Friday Action

I have read with much interest the financial news's explanation of the Fed's Friday morning decision to reduce the discount rate.  What is missing in the explanations if a description of why the market on Thursday, after twice bottoming out at a minus 300 plus points on the Dow, came back at the end of the day to finish more or less even.  What caused the market to spike upward on the close?  And why did the Fed act regardless of the final upward spike on Friday morning?  Rush Limbaugh claims that his program (and a caller stating that it was now "time to buy" just after lunch) drove the market back up.  I doubt it.  The most obvious explanation is that the problems in the money market caught the Fed's attention and officials at the Fed began making phone calls to check things out.  The phone calls and other discussions perhaps tipped some in the market off that the Friday morning action was coming and those traders with well grounded suspicions drove prices up.  How does the Fed get critical information without tipping some in the market.  Even an increased frequency of focused Fed calls (on the money market condition, for example) would do it.  I am on the outside looking in, but Thursday sharp upward spike at the close looks suspicious and merits investigation.      

Cramer After Lockhart Now

Having failed to intimidate the Fed into balling out credit speculator, Cramer has turned his attention to the OFHEO, the agency that regulates Fannie Mae and Ginnie Mae.  He wants the chair, Jim Lockhart, to allow the government charted banks (particularly Fannie Mae and its cousin Freddie Mac) to accept more delinquent loans so as to bail out the mortgage markets.  "He is responsible if people lose their homes."  I am not longer amazed that those who labor in the financial side of capitalism demand government bailouts when their speculative schemes collapse.  They are "fair weather" capitalists.  What economists know, however, is that predictable and frequent government bailouts will destroy the system in which they operate.  Financial markets work only if unfettered and go down as well as up.

Delaware Chancery Court and Auctions

The most interesting part of the new trilogy of opinions by Vice Chancellor Strine on private equity buyouts are his discussions on what a target board must do to secure the highest price.  In Lear the board did not violate its Revlon duties in securing the highest price and in Topps and Netsmart Technologies it did (or was likely to have, they were preliminary injunction motions).  The error in Netsmart was in not exploring a deal with "strategic buyers" as well as the private equity fund buyers.  The Judge, although asked to do so by the plaintiffs, did not fault the Special Committee's  blow- by- blow negotiating strategy with the private equity buyers, however.  Similarly in Lear, although critical of the Special Committee's specific negotiations as "far from ideal," the Judge refused say they were a violation of the board's legal duties.  Finally, in Topps, the Judge found the negotiations leading up to a merger agreement were reasonable.  The mistake the board made was the "go shop" period;  the board refused a higher bid and then refused to waive a standstill agreement with the second buyer (so it could not mount a tender offer or make public comment).  Again the court focused on structural decisions, not individual bargaining strategy, although the line was closer in the Topps case than the earlier two.  Slowly, the court is elaborating a list of "don'ts" for those negotiating private equity buyouts. 

Buyouts and the Delaware Chancery Court

The Delaware Chancery Court has issued recently three opinions critical of private equity buyouts.  They involve the buyouts of Topps Co., Lear Corp. and Netsmart Technologies.  Vice Chancellor Leo Strine Jr. wrote all three opinions.  In the Topps and Lear opinions, Chancellor Strine faulted the target companies with not providing information to their shareholders, asked to ratify the transactions, that may shield light on the incentives and motives of the company managers in recommending the deals.  In Netsmart, the Chancellor questioned whether the target company had disclosed adequately its efforts (or lack of efforts) to assess the market for other potential purchasers.  Each decision deals with the management conflicts inherent in modern private equity buyouts under the guise of adequate disclosure.  At issue will be how strongly management must word an adequate disclosure to meet the legal standards.  I am hopeful the legal standard will requirement something akin to a statement, if management is in the buyout group (or collecting a huge golden parachute payment of some form contingent on the deal), that "The managers of your company are on the opposite side of the deal being recommended and have a direct financial reward in paying you too little for your stock."       

Taxing Hedge Funds

The hearings have begun on taxing hedge fund and private equity fund "carry" as ordinary income.  The attack is based on 1) they make money, 2) they are speculators, and 3) they are instruments of change.  The is another attack on the financial speculators (gamblers who do not "make shoes") by those who under-appreciate their role in a capitalist economy.  There are other partnerships that allocate profits disproportionately to capital contributions: venture capital funds, which have a positive public image, REITS (holding land), oil and gas partnerships, and others.  Either Congress must exempt these groups, proving that it is taxing "speculators" and risk the inevitable line-drawing problems, or it must include them in the interest of tax neutrality and absorb the social costs of regulating efficient forms of capital investment that do not tie a divison of return to proportional capital contributions.  This is going to get very, very messy.

SEC Proposal on Shareholder Voting

The SEC is circulating a proposal, not yet formally proposed, to enable shareholders holding 5% or more of a public corporation's stock to put nominees for the board of directors on the corporation's proxy card.  The proposal will attract tremendous opposition from both company managements, who support current practice, and from shareholders, who believe the 5% requirement is too high.  The opposition will probably cow the SEC into doing nothing. 

The SEC approach is a further erosion of its "disclosure only" theory of regulation and a logic step from Rule 14a-8, a rule that requires firms to put specified items requested by shareholders on their proxy cards.  The further the SEC steps away from its "disclosure" regulation role the more it displaces state corporate codes control over corporate structure.  Some steps at the federal level seem to inevitably turn into to larger steps. 

In any event, the way out the SEC's conundrum, is to feature choice not mandatory rule.  Publicly-traded corporations could be asked to themselves produce a shareholder voting system that shareholders would have to ratify every five (three??) years or so. Shareholders could submit their own amendments at the ratification vote.  Some corporations could opt for 5 year board elections, others for 1 year elections with liberal nominations.  Supermajority requirements should require a supermajority ratification vote.  A robust system of choice could include modifications of shareholder derivative litigation rules or the choice could be limited to voting procedures.  Choice would blunt the criticism of both management and shareholder groups to the current proposal and leave the rule to a shareholder vote.       

Taxes and Takeovers

Before Congress charges into new taxes on hedge funds and private equity funds it ought to pause and consider its record on special taxes aimed at takeovers.  Beginning in 1969 with section 279 and continuing to 1989 with section 163, Congress has attempted to discourage takeovers with various tax provisions aimed at debt financing.  We also have special rules for golden parachutes and pension plan cash-outs and special rules for the carry-over (and carry-back) of tax attributes.  All the rules need careful re-examination; most of them are either easily avoided and/or have consequences in deal structuring that are counterproductive.  Now we have Congress ready to impose special rules on partnerships in which a managing partner (the hedge fund firm or private equity firm) earns a portion of the profits (the "carry") to attack another form of an equity acquisition or takeover.  Once again the results will be the same.  Deal structures will change to meet the new rules and the new structures will cost more to create, but deals will still happen and tax collections will increase only marginally once the clever planners take over.  More rules and new regulations will be needed to stop the new deal forms or, as is usually the case, we just resign ourselves to the new forms. 

The new proposals themselves confuse reporters (and the public).  One reads commonly in the press, for example, that one bill pending in Congress seeks to have publicly-traded master limited partnerships (now taxed at 15%) "taxed like corporations" (at 35%).  Publicly traded limited partnerships are now taxed as separate entities and are now taxed at 35% on ordinary income; like corporations, such partnerships are taxed at 15% on long term capital gains (the business of equity based investment funds).  If a hedge fund was a corporation it would pay 15% on investment gains.  And, by the way, most corporations have an effective tax rate, even on ordinary income, at closer to 18%.   In essence, some in Congress want special rules for managing partners in partnerships.  Congress wants managing partners to pay ordinary income taxes on their investment gains, now taxed at capital gains rates.  Corporate managers who receive at-the-money options in lieu in all corporate investments (the equivalent of a "carry") would be better off under such a rule.  Publicly traded hedge funds will incorporate on the IPO.  There is no substitute for scrapping the double tax system and designing a flow through tax system for all business entities.  It would stop all the games and enable Congress to level whatever rates it wants on business income at the individual level.                

The Tribune Takeover

With Congress worrying so much about in imposing a surrogate double tax on investment fund managers, perhaps they should look at ESOPS.  Zell is using an ESOP/Sub S structure to unwind a double tax on the Tribune Company and use the tax proceeds to fund his takeover.  No a murmur in Congress. The structure enables Zell buy the company with extreme leverage and little downside risk. The risk is borne by the employees.  If Zell cannot turn around a company that is hemorrhaging money (and he has never run a newspaper), the employees lose big and he loses $250 m (a pittance).  If he succeeds, he hits big, will make a fortune, and the employees will show modest or comfortable gains.  The lesson, long ignored, is that we need a tax system that is more neutral on business incentives.

Taxing Fund Managers

The Wrangle, Levin, et AL. bill, introduced yesterday, would double the tax paid by money fund managers on their "carry" in investment partnerships.  They currently pay 15% (the long term capital gains rate); under the bill they would pay 35% (the ordinary income tax rate for entities).  In political terms, fund managers made money too much too fast, were too public about their new wealth, and were late to fund political cover (contributions of politicians).  The story of the tremendous new wealth of the founders of Blackstone, splashed all over the newspapers due to their IPSO yesterday, was the last straw.  A tax the rich battle cry in a 2008 Presidential election and a new public identification of a new way to be rich produced the inevitable -- a proposal to double the tax on fund managers.  At issue is whether such a tax can be put into the context of current tax rules.  If so, the tax is a political and policy question; if not, the tax is a discriminatory, discretionary wealth tax on those who have recently acquired wealth (like a tax on anyone whose last name is "Buffet" or a tax on speaker fees of ex-Presidents that accumulate to over, say, $5 million ).   To me it looks like the latter form of tax.  The fund manager tax is a product of two other tax based distinctions that are interrelated:  First, the double tax on "corporate entities" (a tax at the entity level and the investor level on distributed entity earnings) and the single tax on "partnership" like entities;  Second, the distinction between income and capital gain (salary and investment returns).  The new proposal, in essence, expands on the Backus/Crassly bill (that taxes the returns of all publicly-traded fund managers differently than privately held fund managers) and re-institutes a surrogate double tax on fund managers in partnerships by calling their returns income (instead of capital gains).  The problem is, of course, that we, as most other developed nations, should not have a double tax at all.  Entity returns, in all forms of entities, should be attributed to investors and taxed once.  An argument for "taxing the rich" would appear in more progressive rates on individual returns.  This indirect double tax by re-characterizing capital gains as income will have problematic consequences.  In the simplest form of the argument, the tax penalizes that who contribute purely labor (those without capital) in partnerships (involving capital investments) in exchange for a split of the profits and leaves alone those who contribute pure capital.  As an example, Ms. Operator, with no money, finds an under-priced commercial property, and solicits Mr. Moneybags to invest cash in a partnership, both to take an even split of the resale of the commercial property one year later (after renovation and marketing). Ms. Operator will do all the work.  The tax bill hits Operator for a 35% tax and Moneybags pays only a 15% tax.  At most, Operator should pay a 35% tax on foregone salary, and a 15% tax on the investment of the foregone salary.  Taxing her on the total investment return as income makes no sense; she has the same investment risk as Moneybags. Penalizing pure labor, the clever, innovative folks with no money, has never been a good move -- aren't these the folks we want to encourage??  Moreove, those that can pay tax lawyers will work around the new tax.  For example, Moneybags, as part of the original investment, "loans" money to Operator without recourse (this part will get fancy) and Operator invests the loaned money in the project.  There will be many, many variations on this.  The small partnerships who cannot pay the tax lawyers will be stuck.  We have a "perfect storm" here;  distrust of hedge funds, tax the rich progressives, new wealth in new patterns, concern over "private" ownership of large companies; a political campaign for control of the White House; a tax deficit with calls for new social spending programs (health care) -- and we are going to sink something, something of value.               

Taxing Hedge Funds

Congress, tempting by Victor Fleischer's argument, is considering taxing the "carry" of hedge funds at ordinary income tax rates.  Hedge funds create investment pools and take 20% of the returns, if any, as compensation for their management duties.  Investors willing agree because their 80% return for a 100% investment still often shows a total return of 20% or more. 

The tax proposal is a mistake, of course, because it is not based on a general principle that makes economic sense.   There are numerous reasons to do it that do not make economic sense:  1) We should tax anyone who make large amounts of money fast at higher rates just because they are making boatloads of money or 2) We should threaten to tax those who make money and do not contribute to political campaigns to get political cover to induce them to ante up (ask Bill Gates about this).  Reason 1) is pure economic redistribution, a discretionary progressive tax system, and 2) is political extortion.

Partnerships in everything from local laundries to complex multi-national ventures have long had two types of investors, Moneybags (a passive investor who puts up the cash for a portion of the profits) and Operator (who invests labor and no cash and takes no salary but takes a portion of the profits).  Both Moneybags and Operator are taxed the same on the profits; if the profits are ordinary income both pay income tax -- if the profits are capital gains (long or short), both pay capital gains tax.  Fleischer would have the partners taxed differently on capital investments.  Operator would pay income tax and Moneybags would pay a capital gains tax. There is no theory to support this: Operator is investing foregone salary but the returns are not in any sense salary, they are speculative returns based on an investment of the foregone salary. The best one could do is tax the estimated foregone salary at ordinary income rates perhaps, and deduct it as return of capital before the capital gains rate is applied to the rest of the profits, but this is administratively difficult for little gain.  The investment return of the Operator is not salary in any traditional sense. 

Tax Plans and the Election

Astute critics of the current Presidential races in both parties have noted that tax is not high on any candidates list of preferred topics.  There is no shortage of ideas for fundamental tax changes but the candidates, by in large, seem content with a few general remarks on tax policy.  Yet economists know that government tax policy (and they include tariffs as a tax-- it is one of the oldest) has major effects on economic growth and on business incentives.  Increase the tax on dividends and corporations grow internally; increase the capital gains tax and investors buy and hold stock; increase corporate income tax and money flows abroad to tax havens.  All tax choices shape and mold business incentives and this shapes and molds economic growth.  One wishes the candidates would spend more time debating and discussing their tax programs. 

Steve Jobs and Backdated Options

The SEC has announced the civil prosecution of two Apple executives (the ex-CFO and the ex-Chief Legal Counsel) for backdating compensatory options and the settlement of one of them (against the CFO). Steve Jobs was not prosecuted.  He did take a hit in the statement made by the CFO, however, who once again noted that Jobs knew about and was involved in the backdating of at least one large option grant to Apple employees in 2001.  The SEC's failure to prosecute Jobs in light of the statement is yet to be explained.  In any event, just when I am ready to throw in with those who want to stop private securities class actions a case like this comes along and I am glad that private actions against Jobs are available (and ongoing).