Business Law Prof Blog

Tulane Study Says SEC Estimate of Cost of Conflict Mineral Rules is 100x Too Low

Here's a follow-up on yesterday's post concerning the SEC's proposed conflict mineral rules.

The SEC estimated that the cost to implement the new requirements would be just over $70 million. As I indicated yesterday, the SBA's Office of Advocacy disputes the SEC's cost estimates. Now, a study out of Tulane University claims that the actual cost will be $7.93 billion, more than 100 times the SEC's estimate. The study is available here. I haven't reviewed the Tulane study carefully but, as I said yesterday, none of this bodes well for the SEC if it adopts the rule and it is challenged in the D.C. Circuit.

-Steve Bradford

SBA Office of Advocacy Criticizes SEC Conflict Minerals Rulemaking

Here's something that doesn't happen every day: one federal government agency arguing that another federal goverment agency isn't complying with the law.

Last December, the SEC proposed rules to implement section 1502 of the Dodd-Frank Act. Section 1502 adds a new subsection 13(p) to the Securities Exchange Act; that section requires the SEC to adopt regulations requiring disclosure about so-called "conflict minerals" originating in the Democratic Republic of the Congo or adjoining countries. The Commission has yet to take action on the proposed rules.

On Tuesday, the Office of Advocacy of the Small Business Administration submitted this letter arguing that the proposed rule fails to comply with the Regulatory Flexibility Act. The Regulatory Flexibility Act requires proposed rules to include an initial regulatory flexibility analysis that includes, among other things: (1) a description and the estimated number of regulated small entities, and (2) a description and an estimate of the compliance requirements, broken down by different categories of small entities, if there will be any differential effects. The Office of Advocacy contends that the SEC has significantly underestimated both the cost of the proposed rule and the number of small businesses that will be affected. The SEC's proposal indicated that compliance costs "are likely insignificant," but the Office of Advocacy's letter quotes small business sources claiming that median compliance costs could be $65,000 or $170,000.

Administrative agencies often underestimate the cost of their proposed rules, but the SEC is still stinging from its recent loss in the Business Roundtable case. In that case, the D.C. Circuit held that the SEC’s adoption of its proxy access rule violated the Administrative Procedure Act because the SEC “inconsistently and opportunistically framed the costs and benefits of the rule; failed adequately to quantify the certain costs or to explain why those costs could not be quantified; neglected to support its predictive judgments; contradicted itself; and failed to respond to substantial problems raised by commenters." That decision follows on the heels of several other recent losses in the D.C. Circuit, some of which were also based on the SEC's failure to adequately consider the cost of its rules.

If the conflict minerals rule is challenged, it certainly won't help the SEC's case to have another federal agency arguing the plaintiff's case.

-Steve Bradford

Are We Maximizing the Benefit of Our Securities Regulation Dollars?

The SEC, like every other government regulator, has limited funds. Its challenge is to use its limited budget to achieve the biggest bang for the buck. Or, to move the analysis one step back in time, Congress faces the same challenge in enacting the laws in the first place. The goal in either case should be to allocate those limited regulatory dollars to maximize the net benefit of the regulation.

Lately, I have been thinking about the regulatory tradeoffs our federal system of securities regulation makes. In particular, I have been wondering if we might be better off worrying less about the registration of securities offerings, the purview of the Securities Act of 1933, and more about fraud and industry regulation, the purview of the Securities Exchange Act of 1934.

The question is how to allocate regulation at the margin, but here’s a more extreme thought experiment: what would happen if we junked the Securities Act entirely and devoted all those dollars to antifraud enforcement?

This reallocation wouldn’t eliminate mandatory disclosure requirements. Public companies would still have to file the periodic disclosure required by the Exchange Act. And, as a practical matter, even non-public companies would have to release some information to investors on a voluntary basis or no one would buy their securities.

By itself, the elimination of Securities Act registration requirements would probably result in additional fraud, particularly by first-time issuers. But the enhanced enforcement activities made possible by the resulting reallocation of regulatory dollars would presumably reduce the amount of fraud. The net result is indeterminate.

This reallocation would also redistribute the regulatory costs incurred by businesses. The cost to all companies, honest and dishonest, of offering securities would decrease because of the elimination of the registration requirement. But increased antifraud enforcement would impose increased costs on those engaged in fraud. The net effect on the cost side would be a reallocation of costs from honest companies to dishonest companies.

Notice that this is not an argument about whether Securities Act registration is beneficial. In a world of limited regulatory dollars, one could believe that the Securities Act registration requirement is beneficial and still argue for its elimination if other ways of using the money are even more beneficial.

-Steve Bradford

Reporting Back From the Ohio Securities Conference

Yesterday, I had the privilege of participating in a panel discussion at the 2011 Ohio Securities Conference entitled, "Dodd-Frank: One Year Later."  A complete list of the panelists, along with a link to related material follows:

Barbara Black: How to Improve Retail Investor Protection After the Dodd-Frank Wall Street Reform and Consumer Protection Act

Eric Chaffee: The Dodd-Frank Wall Street Reform and Consumer Protection Act: A Failed Vision for Increasing Consumer Protection and Heightening Corporate Responsibility in International Financial Transactions

Stefan Padfield: The Dodd-Frank Corporation: More than a Nexus of Contracts

Geoffrey Rapp (moderator): Legislative Proposals to Address the Negative Consequences of the Dodd-Frank Whistleblower Provisions: Written Testimony Submitted to the U.S. House Committee on Financial Services

SJP

Manesh on Contractual Freedom Under Delaware Alternative Entity Law

Mohsen Manesh has posted “Contractual Freedom under Delaware Alternative Entity Law: Evidence from Publicly Traded LPs and LLCs” on SSRN.  Here is the abstract:

Notwithstanding the ongoing academic debate, little is known empirically about how unincorporated alternative entities - LLCs and LPs - actually utilize the contractual freedom afforded under Delaware law. To what extent do alternative entities take advantage of contractual freedom to wholly eliminate fiduciary duties? And to what extent do alternative entities employ so-called “uncorporate” substitutes - certain contractual devices designed to discipline and incentivize mangers - in lieu of fiduciary duties? In response to calls for empirical evidence on this issue, this study analyzes the operating agreements of every publicly traded Delaware alternative entity in existence as of June 2011. This study, the first of its kind, provides a snapshot of contractual freedom as it is applied under Delaware alternative entity law.

In particular, this study finds that the use of fiduciary waiver and exculpation provisions among publicly traded Delaware alternative entities is widespread. Yet, despite the widespread use of such provisions, this study also finds that publicly traded alternative entities have either failed to adopt uncorporate substitutes or adopted uncorporate substitutes that only trivially constrain managerial discretion. Thus, this study suggests that publicly traded alternative entities have largely utilized the freedom of contract to reduce managerial accountability to investors without committing to significant offsetting constraints on managerial discretion.

SJP

Volcker Rule Proposed by the SEC

 

More than a year after the passage of Dodd-Frank, the S.E.C. voted today to propose a rule to implement section 619 of the Dodd-Frank Act, commonly known as the "Volcker" rule.  The Volcker Rule under Dodd-Frank generally prohibits federally-insured banks and their affiliates from engaging in derivative trading for the bank's own account.  Dodd-Frank also prohibits banks from owning or having a substantial relationship with a hedge fund or private equity fund. The SEC proposed rules seek to fulfill this mandate by requiring institutions trading in derivatives to report quantitative measurements to the SEC while also allowing for a broad range of exemptions to the registration and reporting requirements under the rule. (SEC Press Release; Commissioner Shapiro's comments on the Volcker Rule).  The SEC, which is acting in concert with the FDIC, Federal Reserve, and the OCC, will be taking comments on the proposed rule until January 13, 2012-- both the text of the proposed rule and the comment process are available here.

SSRN has a laundry list of articles dissecting Dodd-Frank, but here are a few that are focused on the Volcker Rule:

• Charles Whitehead (Cornell), The Volcker Rule & Emerging FInancial Markets
• Andrew Tuch (a Harvard SJD candidate), Conflicted Gatekeepers
• Hrishikesh Vinod (Fordham Econ Dept.), Financial Reform, Innovative Hedging and the Volcker Rule

--Anne Tucker

 

The Failure to Regulate as Success

H.R. 2308, the “SEC Regulatory Accountability Act,” would establish a significant number of additional specific standards for cost-benefit analyses for Commission rules and orders.  Said SEC Chairperson Mary Shapiro:

My fear about this legislation is that it layers so much analysis on top of what we already do that we’re set up to fail.  There is no way this agency or any other agency could do all of these things, some of which conflict.

Well, perhaps not so much “fail” as “fail to regulate.”  To some that’s failure, to others that’s success.

SJP

What's Wrong With Picard v. Katz? Just About Everything.

Editor’s Note: The following post comes to us from Dr. Anthony Michael Sabino, a Professor in the Department of Law at The Peter J. Tobin College of Business at St. John’s University. (SJP)

WHAT’S WRONG WITH PICARD V. KATZ? JUST ABOUT EVERYTHING.

By

Anthony Michael Sabino, Professor of Law, St. John’s University, Tobin College of Business; Partner, Sabino & Sabino, P.C. 

    I have long been an admirer of Judge Jed Rakoff of New York’s Southern District.  Like many, I have long considered him to be the dean of the federal securities bar, at least as to its judicial contingent.  However, I found his latest decision, entitled Picard v. Katz,[1] to be so deeply mistaken, particularly as to its usurpation of settled bankruptcy law doctrine, that I can scant believe this is the same jurist.  Since an appeal is a near certainty, I can only look forward to the Second Circuit righting this wrong. 

    For the (few that remain) unacquainted, the plaintiff is Irving Picard, the trustee of the defunct investment advisory business of the infamous Bernard Madoff, now about two years into his 150 year prison sentence for masterminding the greatest Ponzi scheme of the new century.  Defendant “Katz” is Saul Katz, business partner of Fred Wilpon, and, along with Wilpon, an owner of Major League Baseball’s New York Mets.  All are defendants in the instant case.    

    The Wilpons and various of their enterprises were heavy investors with Madoff, and reaped many millions in profits over the years, some of those profits going to fund the Mets’ cash flow.  With the vast majority of those profits now proven to be fictitious, and the discovery that said “profits” were paid from monies deposited by subsequent Madoff victims, at bottom this litigation is all about Trustee Picard’s efforts to recover anywhere from $ 300 million to $ 1 billion from the Mets’ owners, based upon various theories, the paramount ones being “fraudulent conveyances,” as set forth in the Bankruptcy Code[2] and New York state law.[3]

    In addition to the above preface, let me be clear that, in this limited space, I am not addressing Judge Rakoff’s earlier decisions, both as to these parties and similarly situated Madoff defendants, where the court discarded somewhat “novel” theories that the Trustee claimed entitled him to recover up to a billion dollars from the Wilpons alone.  Rather, I am strictly confining myself to the new Katz decision, wherein Judge Rakoff tossed out causes of action so fundamental and traditional to litigation of this kind, that I was frankly aghast at the outcome.  My consternation is focused upon three key points.

    First, Judge Rakoff dismissed the “constructive fraud” count of the fraudulent conveyance claim.  Briefly, constructive fraud is proven by a straightforward and purely objective test, to wit, a simple arithmetical calculation of what you received as compared to what you paid.  By its nature, the early beneficiaries of a Ponzi scheme receive more than they paid in, and so easily fail the test.  Case law, including that of the Second Circuit, is clear that Ponzi beneficiaries unfailingly are liable to return false profits, since those monies came from subsequently defrauded investors.  Indeed, the Second Circuit’s most recent decision in the Madoff case, in validating Trustee Picard’s methodology for calculating the actual losses of Madoff’s victims, reflects that jurisprudence.[4]  Then how can Judge Rakoff’s decision be so at odds with those clear precedents?  Not for long, I hope.

    In addition, constructive fraud, because it is an objective test, will survive where the “actual fraud” allegation, dependent upon subjective proof, will oft times fail.  Yet Katz is permitting the actual fraud allegations, the ones far more susceptible of being tossed for a lack of proof of the defendants’ state of mind, to proceed, while the more durable allegations, based upon simple math, are dismissed.  This makes no sense.  Lastly, Katz limits the fraudulent conveyance claims to the two year statute of limitations found under the Bankruptcy Code.  Wrong---Trustee Picard sued in parallel under New York’s fraudulent conveyance statutes, which provide a more liberal six year limitary period to reach back to recover fraudulent conveyances.  This misapplication of the correct statutory periods is sure to be corrected by the appellate court. 

    My second point of contention is Katz’s complete confusion of “settlement payments,” as defined in Title 11, with the ill gotten goods the Defendants allegedly received here.  The court immunizes the Defendants’ receipts from the Trustee’s allegations, by characterizing them as settlement payments from a broker.  That misses the mark by a country mile.  First, while the statutory definition of settlement payment is admittedly lucid, both the text and its history make clear as crystal that monies so paid are protected because they represent payments by brokers to customers as part of actual securities transactions. 

    That is not what happened here.  These defendants allegedly took out far more than they invested, based upon fictitious profits produced by Madoff’s fertile and devious imagination.  As we learned to our sorrow, Bernie Madoff never actually bought or sold any securities.  As such, monies received by these defendants are inapposite to the settlement payments (and the underlying transactions) the law is designed to protect.  Put another way, Congress wrote statutory protections for settlement payments into the Bankruptcy Code, at the behest of the legitimate securities industry, in order to protect the orderly flow of actual business.  Money paid out in a Ponzi scheme is light years away from that, and thus wholly undeserving and unintended for such protections.[5]

    Moreover, Katz is internally inconsistent in this regard.  It notes that Ponzi schemes such as Madoff’s transpire “without any actual securities trades taking place.”  Yet in the next paragraph it bestows statutory protection upon those same non-existent transactions.  If the transaction is a sham, how can it be deserving of the law’s “safe harbor”? 

    Third, Katz purportedly seeks to reconcile important provisions of the Bankruptcy Code with the federal securities laws, foremost from the latter body the Securities Investor Protection Act, called “SIPA.”  Having extensively litigated and written about the intersection of bankruptcy law with the federal securities statutes,[6]    I agree this is no small task.  But Katz does not provide an intersection; it gives us a train wreck.  For instance, Katz asserts that in this context “bankruptcy law is to be informed by federal securities law.”[7]  Yet what this opinion provides instead is an annihilation of the Bankruptcy Code in favor of misconstrued concepts of the securities laws.    

    Katz ignores that a SIPA liquidation of an investment firm (as is the case here with Madoff’s investment advisory business) is to be conducted in harmony and in conjunction with the Bankruptcy Code.  That is why the Code contains specific provisos for stockbroker liquidations, and SIPA cases are administered in bankruptcy courts by bankruptcy trustees.  Trustee Picard was not stripped of his traditional powers to recover fraudulent conveyances under bankruptcy or state law.  Nor are the securities laws to be construed to artificially restrict his powers.  This has long been the law of the Second Circuit, and things will surely be put to rights on the appeal (Trustee Picard’s attorneys have already indicated that an interlocutory appeal will be sought).[8]   

    In closing, Katz perpetrates a great wrong: first by utterly misunderstanding fraudulent conveyance law, particularly the aspect of “constructive fraud;” second, by misconstruing portions of the federal securities laws to immunize fraudulent conveyances from rightful recovery; and third, by crushing established bankruptcy and SIPA provisos via the misapplication of the federal securities laws. 

    The fortunate news is that the cases are legion, especially in the Second Circuit, in proof of the errors of Katz.  Surely a swift appeal will put this misbegotten decision to rest, and these defendants will find their exposure on the “constructive fraud” fraudulent conveyance counts will amount to nearly $300 million.[9]  We should yet see legitimate victims benefiting by recoveries from the recipients of fictitious profits paid out with their money. 

AMS/dal      

______________________________________

 

[1] ___ F.Supp.2d ___ (S.D.N.Y. Sept. 27, 2011) (11 Civ. 3605) (JSR). 

[2] 11 U.S.C. § 548.  The Bankruptcy Code is often referred to as “Title 11,” per its ordination in the U.S. Code.

[3] New York Debtor and Creditor Law (“D.C.L.”) § 270, et seq. 

[4] In re Bernard L. Madoff Investment Securities LLC, ___ F.3d ___ (2d Cir. August 16, 2011) (Jacobs, C.J.). 

[5] Compare Sabino, “Applying the Law of Fraudulent Conveyances to Bankrupt Leveraged Buyouts: The Bankruptcy Code’s Increasing Leverage Over Failed LBOs,” 69 North Dakota Law Review 15 (1993). 

[6] Sabino, “Failed Stockbrokers and the Bankruptcy Courts in the 21^st Century: Bringing Order to Chaos,” Annual Survey of Bankruptcy Law 2002 317 (West 2002). 

[7] Katz, slip op. at 14. 

[8] Parenthetically, Judge Rakoff claimed that he declined the defendants’ request to convert their Rule 12(b)(6) motion to dismiss to a motion for summary judgment pursuant to Rule 56.  Katz, slip op. at 13 n.8.  Yet I find that contradictory, as in pertinent part it appears to me the court is more according summary judgment on these claims than merely dismissing them. 

[9] Katz, slip op. at 11 n.6. 

Verret on the Economic Analysis of SEC Rulemaking

J. W. Verret has posted a very interesting outline of an article he is writing on economic analysis of SEC rulemaking. He discusses the proposed article here and here. As I have discussed earlier, when the SEC engages in rulemaking, it has a statutory obligation to consider the effect of its proposed rule on “efficiency, competition, and capital formation.” This requirement, which  was added in 1996 by the National Securities Markets Improvement Act, was the basis for the D.C. Circuit’s recent opinion in Business Roundtable v. SEC, striking down the SEC’s proposed proxy access rule.

Verret plans a two-part article. The first part will discuss what he calls the “four pillars” of securities regulation: investor protection, efficiency, competition, and capital formation, the history of the NSMIA requirements, and the logistical problems those requirements create. The second part of the article will try to relate these ideas to various strands of economic theory: public choice, Austrian economics, behavioral economics, and financial economics. 

It’s an ambitious undertaking that should be fascinating when he finishes it, but the outline alone is worth reading.

-Steve Bradford

Davidoff on Britain’s new takeover rules

Over at DealBook, Steven Davidoff provides some excellent analysis of Britain’s new takeover rules, which went into effect this past Monday.  The title of his post sums up his predictions:  “British Takeover Rules May Mean Quicker Pace but Fewer Bids.”

If this sort of thing interests you, you’ll definitely want to read the entire post—but I’ll note some of the highlights here.  First, Davidoff reports that a wide array of rules were originally considered by the Takeover Panel of Britain, but the most controversial of these (requiring a two-thirds vote, requiring disclosure upon acquisition of 0.5 percent, and disenfranchising shareholders who acquired shares after the offer was announced) were rejected.  Second, the rules that were adopted, “set up a nice dichotomy with the American takeover scheme”:

In the United States, targets can agree to large termination fees and provide extensive deal protections to an initial bid. Targets can also adopt a shareholder rights plan, or poison pill, which can prevent a company from acquiring the target. But in Britain none of these devices are allowed.

As mentioned above, Davidoff sees the net result of these new rules being less initial bids (because bidders will be entering the fray subject to more risks), but more competition for targets once bids are launched.

SJP

Westbrook on the 100th anniversary of the first “blue sky” law

Amy Westbrook has posted “Blue Skies for 100 Years: Introduction to the Special Issue on Corporate and Blue Sky Law” on SSRN.  Here is the abstract:

Kansas enacted the first state securities law in the United States on March 10, 1911, thereby ushering in a new era of financial regulation. House Bill 906, entitled “An Act to provide for the regulation and supervision of investment companies and providing penalties for the violation thereof” (1911 Act), was the product of disparate forces, including the ongoing struggle over Kansas’ new bank guarantee act, progressive pressures within the Republican Party, strong agricultural markets, the increasing prevalence of traveling securities salesmen, and the work of the charismatic Kansas Commissioner of Banking, Joseph Norman Dolley. This year marks the 100th anniversary of the Kansas “blue sky” law, and this issue of the Washburn Law Journal uses the occasion to look back on the genesis of securities regulation and to think about its future. It is true that the financial markets in 2011 are profoundly different from the markets in 1911. Moreover, the 1911 Act was passed under a specific combination of politics, economics, technology and social forces at work in Kansas in 1911. Although a lot has changed in 100 years, the persistence of the regulatory systems established during the early twentieth century, with respect both to securities and to corporate governance more generally, suggests that era may have more to interest us than “mere” history.

SJP

Harmonizing the Federal Securities Laws’ Treatment of Small Businesses

The Securities Act treats small businesses in a fundamentally different way than the Securities Exchange Act. Harmonizing those two statutes would go a long way towards solving the problem of small business capital formation in the United States.

The Mandatory Disclosure Requirements

Both statutes impose mandatory disclosure requirements on American businesses. The Securities Act requirement is episodic. When a company offers securities, it must file a registration statement with the SEC and make a prospectus available to investors. The mandatory disclosure in the Exchange Act requirement is periodic. Companies must file annual and quarterly reports (Forms 10-K and 10-Q), and also report on certain important events occurring between those regular filings (Form 8-K). The Securities Act disclosure protects investors at the entry level; the Exchange Act disclosure protects existing investors.

Small Business Under the Exchange Act

The two federal statutes treat small businesses very differently. The Exchange Act absolutely and categorically exempts small businesses from the mandatory disclosure requirements. Unless a company’s securities are traded on a national securities exchange or the company has both $10 million in assets and a class of equity securities with more than 500 record holders, it usually doesn’t have to worry about Exchange Act registration.

Small Business Under the Securities Act

The Securities Act does not categorically exempt small business offerings from its registration requirement. In fact, the Securities Act doesn't exempt small business offerings at all. The registration requirement applies regardless of the size of the offering or the size of the company making the offering. (The statute exempts non-public offerings, but the Supreme Court held long ago that the private offering exemption depends primarily on the character of the offerees, not the dollar amount of the offering.)

The Securities Act does authorize the SEC to create exemptions for smaller offerings, and the SEC has adopted several such exemptions, but all of those exemptions add non-trivial restrictions and conditions. There is no unconditional exemption for small offerings or small companies.

It is almost universally recognized that, because of economies of scale, the cost of registering smaller offerings is prohibitive. The Securities Act’s registration requirement therefore imposes a serious burden on small business capital formation.

A Proposal for a Categorical Securities Act Exemption

Why not just follow the approach of the Exchange Act and free all smaller companies from the Securities Act registration requirement as well? The SEC usually points to the higher risk of fraud in small business offerings and argues that registration, or at least some limitations on the offering, are needed to protect investors from that fraud.

It’s true that small businesses are riskier, and that includes a disproportionate risk of fraud. But that risk exists whether the small business is engaged in an offering of securities or just dealing with its existing investors on a day-to-day basis. If the offerees in small business offerings need the protection of one-time mandatory disclosure, then the investors in small businesses equally need the protection of periodic mandatory disclosure. The fraud argument, if you accept it, works for both statutes.

Requiring small companies to file annual and quarterly reports would, of course, be silly. The enormous cost of Exchange Act reporting clearly outweighs any possible gain to the investors. Requiring a company with a total value of only $200,000 to file Exchange Act reports would quickly bankrupt the company.

But the same is true under the Securities Act. Assume that a new business startup wants to raise $100,000 by selling securities. The most that the investors in that offering could possibly lose is $100,000, so the maximum possible benefit of registration is $100,000. (That assumes investors would lose everything without registration and that registration would completely prevent such losses.) Registering that offering would clearly cost more than $100,000, so it doesn’t make economic sense to require registration, no matter how risky the offering is. In short, for the same reason a categorical Exchange Act exemption makes sense, a categorical Securities Act exemption makes sense.

How about adding something like this to the Securities Act:

Section 5 of this Act shall apply only to offerings by an issuer that

(a) has, or will have after the offering, a security traded on a national securities exchange;

(b) has, or will have after the offering, total assets in excess of $10 million.”

-Steve Bradford

Coates and Lincoln on Fulfilling the Promise of Citizens United

John Coates and Taylor Lincoln have posted “SEC Action Needed to Fulfill the Promise of Citizens United” over at the Harvard Forum.  Here’s a brief excerpt:

[T]he Supreme Court’s Citizens United decision to let corporations spend unlimited sums in federal elections was premised on a pair of promises: Corporations would disclose expenditures, and shareholders would police such spending. Those promises remain unfulfilled …. The best chance to fulfill those promises may now rest with the SEC, which was recently petitioned to begin a rule-making process to require disclosure of political activity by corporations.

SJP

White House Endorses Crowdfunding Exemption

I have blogged before about crowdfunding—the use of the Internet to raise funds through small contributions from a large number of investors. See here, here, here, and here. I have written an article arguing that the SEC should exempt crowdfunding from the registration requirements of the Securities Act and should exempt crowdfunding sites from having to register as brokers or investment advisers.

Given the SEC’s history when it comes to small business exemptions, I have not been optimistic that such an exemption will come to pass. But President Obama just changed the odds. The White House has released a statement supporting a number of changes to the regulation of small business, including a crowdfunding exemption. According to the release “"The administration . . . supports establishing a “crowdfunding” exemption from SEC registration requirements for firms raising less than $1 million (with individual investments limited to $10,000 or 10% of investors’ annual income) and raising the cap on “mini-offerings” (Regulation A) from $5 million to $50 million.” That's all the release says; no further details are provided.

Both of these suggestions make sense, but the devil will be in the details. The crowdfunding proposal on which the administration’s proposed exemption is based imposes substantial disclosure and other regulatory requirements that would make crowdfunding too expensive for micro-businesses. As I explain in my article, a crowdfunding exemption that imposes substantial requirements at the issuer level won’t be very helpful. The administration proposal also doesn’t address preemption of state law; absent preemption, a federal crowdfunding exemption will be ineffectual. And the administration proposal doesn’t say a thing about whether crowdfunding sites will be exempted from treatment as brokers or investment advisers.

Nevertheless, the White House suggestions are a welcome baby step towards meaningful reform. A number of other changes are needed to make federal securities law friendly to small business: elimination of the general solicitation restriction in Regulation D; elimination or substantial modification of the integration doctrine; simplification or elimination of the restrictions on resale of exempted securities. Given the many obstacles to small business capital formation in federal securities law, it’s hard to see why the White House chose to focus on these two. But it’s a start.

-Steve Bradford

Awrey on Complexity, Innovation and the Regulation of Modern Financial Markets

Dan Awrey has posted his paper, “Complexity, Innovation and the Regulation of Modern Financial Markets,” on SSRN.  Here is the abstract:

The intellectual origins of the global financial crisis (GFC) can be traced back to blind spots emanating from within conventional financial theory. These blind spots are distorted reflections of the perfect market assumptions underpinning the canonical theories of financial economics: modern portfolio theory; the Modigliani and Miller capital structure irrelevancy principle; the capital asset pricing model and, perhaps most importantly, the efficient market hypothesis. In the decades leading up to the GFC, these assumptions were transformed from empirically (con)testable propositions into the central articles of faith of the ideology of modern finance: the foundations of a widely held belief in the self-correcting nature of markets and their consequent optimality as mechanisms for the allocation of society’s resources. This ideology, in turn, exerted a profound influence on how we regulate financial markets and institutions.

The GFC has exposed the folly of this market fundamentalism as a driver of public policy. It has also exposed conventional financial theory as fundamentally incomplete. Perhaps most glaringly, conventional financial theory failed to adequately account for the complexity of modern financial markets and the nature and pace of financial innovation. Utilizing three case studies drawn from the world of over-the-counter (OTC) derivatives – securitization, synthetic exchange-traded funds and collateral swaps – the objective of this paper is thus to start us down the path toward a more robust understanding of complexity, financial innovation and the regulatory challenges flowing from the interaction of these powerful market dynamics. This paper argues that while the embryonic post-crisis regulatory regimes governing OTC derivatives markets in the U.S. and Europe go some distance toward addressing the regulatory challenges stemming from complexity, they effectively disregard those generated by financial innovation.

SJP

The SEC's Destruction of Documents

I’m back from an extended vacation and ready to begin blogging again. (By the way, if you’re a backpacker and haven’t experienced Wyoming's Wind River range, it’s definitely worth it. Just avoid the killer hike known as Porcupine Pass.)

Regular readers of this blog know I’m not a big fan of the SEC, but I think the recent brouhaha about the SEC’s destruction of documents is overblown. For those of you who haven’t seen the stories, the allegation is that the SEC routinely destroyed documents related to preliminary inquiries that did not turn into formal investigations. You can read the stories here, here, and here.

As J. Robert Brown, Jr. explains, the problem is that a government agency may not destroy documents except pursuant to a disposition schedule approved by the National Archives and Record Administration. Since the NARA had not approved a disposition schedule for these documents, their destruction violated the law.

The SEC’s destruction of these documents was careless and stupid, and I agree with Steve Bainbridge’s claim that this is another instance of the SEC itself being unable to comply with the type of rules it expects those it regulates to follow.  But I see nothing venal in the SEC’s actions. The New York Times tries to tie it to the revolving door at the SEC and former staffers representing clients before the SEC. I think the suggestion that this document destruction facilitated the ability of SEC investigators to “do undetected favors for former colleagues and their clients by quashing investigations” is just silly.

-Steve Bradford

Chen on Modern Disaster Theory

Jim Chen has posted Modern Disaster Theory: Evaluating Disaster Law as a Portfolio of Legal Rules, available on SSRN here.  The abstract is as follows:  

Disaster law consists of a portfolio of legal rules for dealing with catastrophic risks. This essay takes preliminary steps toward modeling that metaphor in quantitative terms made familiar through modern portfolio theory. Modern disaster theory, by analogy to the foundational model of corporate finance, treats disaster law as the best portfolio of legal rules. Optimal legal preparedness for disaster consists of identifying, adopting, and maintaining that portfolio of rules at the frontier of efficient governance.

Part I of this essay defines disaster and disaster law. In an effort to develop an analytically rigorous basis for modeling and evaluating disaster law, Part II expounds the principles of modern portfolio theory, a framework for assessing financial returns according to risk. Part III outlines the principles of modern disaster theory as the legal analogue of modern portfolio theory as a branch of finance. Part IV conducts an exercise in applied modern disaster theory. It evaluates legal tools for compensating disaster victims ex post and spreading catastrophic risk ex ante according to the terms of modern disaster theory’s catastrophic preparedness asset model. Part V concludes that modern disaster theory, through the use of sophisticated quantitative methods analogous to those used in financial analysis, promises to place disaster law and policy at the efficient frontier of legal preparedness.

This is an interesting read.  Dean Chen concedes that using modern portfolio theory has its flaws. He also notes that "behavioral biases in the perception of risk, by policymakers and by members of the public, severely distort legal responses to disasters."  There is no doubt that is true, and it's true with legal responses, and it's true in planning for disasters, as well. (For more on that, see, in a bit of shameless self-promotion, here.)  Still, he proceeds with his analysis, and concludes:

My survey of risk management techniques in disaster law — from private insurance to public subsidies, the involvement of government as ultimate reinsurer, and the promise of enhancing catastrophic preparedness through private capital markets — shows how disaster law represents a single, theoretically coherent exercise in societal risk management.

. . . . A diversified disaster law portfolio — namely the optimal mixture of policy instruments for reducing environmental hazard and human susceptibility and for enhancing social resilience and capacity — represents the efficient frontier of legal preparedness in times of disaster.

I'm working my way back through it more closely, but I found it a throught-provoking piece, and I recommend taking a look. 

--JPF

Rewarding the Risk Averse

I just had a chance to read my most recent edition of ERN Economics of Networks eJournal Vol. 3 No. 107, 08/12/2011.  In it, I found Professor Olufunmilayo Arewa's paper, Risky Business: The Credit Crisis and Failure, available on SSRN here.  I have just started looking through it, but the following paragraph caught my eye (footnotes omitted):

Rhetorically bashing financial institutions has become common place among the media, public officials, regulatory agencies and the general public. A focus on blaming financial institutions, however, deflects attention from other failures that contributed to the credit crisis. Further, few discussions focus to a sufficient extent on dealing with the industry and regulatory failures that led to the credit crisis. The credit crisis aftermath could be seen as actually rewarding those most responsible for the failure to manage or regulate risky financial market business activities. Through programs such as the Troubled Asset Relief Program (TARP) and the Public-Private Investment Program (PPIP), which are government initiatives to address problems resulting from the presence of illiquid and troubled assets on financial institutions balance sheets, industry participants received government bailouts that permitted them to avoid assuming the full risk of their activities. The bailouts have thus rewarded risk management failures by averting firm failure, which presents the same significant moral hazard implications that spawned the current financial crisis in the first place.

I'm inclined to agree.  In 2008, I argued that, "without any measures to mitigate the harm and cost of government intervention, all bailouts place government (meaning taxpayers) in the role of fee-free insurer for the largest companies."  I look forward to reading more of Professor Arewa's article.

--JPF

J.W. Verret Starts Open-Source Article Writing Project on SEC Rulemaking

Here's how Verret describes open-source article writing:

By that I mean blogging about an article idea and updating it as I progress.  Some say it’s a bad plan…people might steal your ideas, or maybe you expose yourself to the possibility of being wrong.  I don’t think it’s an issue, particularly if readers take my musings in the rough-and-tumble blogging spirit.  If you think I have interpreted a provision incorrectly, great. Email me and tell me why.  Better that you send me a case I missed than I learn about it after the article is published.

He then goes on to outline a project to define what he describes as the four guiding principles of securities regulation as set forth in the National Securities Markets Improvement Act of 1996: (1) investor protection, (2) efficiency, (3) competition, and (4) capital formation.  You can read the full post here.

I agree with Joan Heminway (as she states in a comment to the post) that the project is certainly a worthy one.  However, I am even more excited to watch the open-source article writing process itself, since I think there could be all sorts of interesting offshoots from that project that could improve collaboration, interdisciplinary work, and the overall utility of our scholarly works.

SJP

Coates on Citizens United

John Coates has posted "Corporate Governance and Corporate Political Activity: What Effect Will Citizens United Have on Shareholder Wealth?" on SSRN.  Here is the abstract:

In Citizens United, the Supreme Court relaxed the ability of corporations to spend money on elections, rejecting a shareholder-protection rationale for restrictions on spending. Little research has focused on the relationship between corporate governance – shareholder rights and power – and corporate political activity. This paper explores that relationship in the S&P 500 to predict the effect of Citizens United on shareholder wealth. The paper finds that in the period 1998-2004 shareholder-friendly governance was consistently and strongly negatively related to observable political activity before and after controlling for established correlates of that activity, even in a firm fixed effects model. Political activity, in turn, is strongly negatively correlated with firm value. These findings – together with the likelihood that unobservable political activity is even more harmful to shareholder interests – imply that laws that replace the shareholder protections removed by Citizens United would be valuable to shareholders.

SJP